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Bad timing for interest rate hike

Sarb’s decision out of touch with the reality of a lethargic economy.

The South African Reserve Bank’s (Sarb) decision to continue hiking the interest rate at which accommodation is provided to the commercial banking sector (the so-called ʺrepo rateʺ) seems to be out of touch with the reality of a lethargic economy.

In mid-2012, the repo rate was 5% and it now stands at 6%. As a result, the prime overdraft rate has increased by an equivalent of 100 basis points over the last three years, representing an increase in the cost of working capital of 11.8% – hardly what the economy needs at a time when several sectors are facing the prospect of contraction and the leading business cycle indicator is heading south.

Primary sectors seem to be the hardest hit, with mining activity continuing to feel the pinch of a five-year commodity price slump and the lingering effects of exceptionally steep wage increases.

Regular strikes, often accompanied by violence, intimidation and damage to plant and equipment, have also contributed to a decline in investor confidence in the industry. Last year, value added by mining amounted to R287 billion, which is 7.2% less, in real terms, than in 2007.

Agriculture is also confronted by steep declines in a number of producer prices, with the added woes of a serious drought in several regions of the country. Continued uncertainty over land reform has contributed to a marked decline in the ratio of capital formation to value added by agriculture.

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The Reserve Bank’s arguments in support of the tightening of monetary policy are flimsy and even contradictory.

The rather lengthy statement by the Monetary Policy Committee (MPC) that accompanied the repo rate announcement implicitly acknowledges the existence of a number of threats to sustained economic growth, while also specifically mentioning the following:    

  • A weak domestic growth outlook as both the supply and demand sides remain constrained;
  • Declining business and consumer confidence;
  • Further downward revisions to the global growth outlook, with the initial forecast of around 3% now likely to be closer to the 2%-level (structurally lower growth in China is one cause);
  • Low commodity prices, which are exerting a negative effect on the South African trade balance.

Against this background, the logical economic observation is that inflation is not a major problem, especially due to the consistent strong inflows on the financial account of the balance of payments, which have negated the effect of large current account deficits.

In the process, the rand exchange rate has performed better against the US dollar and the euro than the currencies of several trading partners and emerging market peers, particularly over the past year. This point is actually acknowledged by the MPC, which stated that inflation pressures remain benign, reinforced by declining commodity prices, including oil.

It is not surprising, therefore, that the monetary policy stance in most advanced countries and emerging market economies has either remained unchanged or become more accommodative since the beginning of the year.

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Arguably the most puzzling statement by the MPC (in relation to the repo rate hike) is the confirmation of an unchanged outlook for headline inflation over the next 30 months. In its discussion of the inflation outlook for South Africa, the MPC is optimistic about headline inflation averaging 5% in 2015 (in line with the forecast of the Economist Intelligence Unit).

Although the Reserve Bank does expect inflation to breach the upper end of the target range (3% to 6%) during the first half of next year, its forecasts for an average of 6.1% in 2016 and 5.7% in 2017 remain unchanged.

Then comes the surprising anomaly – the MPC announces that, despite an apparent sound formulation of arguments in favour of an accommodating monetary policy stance (or neutral at worst), the repo rate is increased. For consumers with mortgage bonds, the rate increase boils down to a combined loss of around R3 billion in consumption expenditure (if the increase is fully translated into higher bond repayments).

Some economists have speculated that the Reserve Bank may have decided to preempt a return to higher money market rates in the US (and possibly Europe as well) later in the year, in an attempt to attract so-called ʺcarry tradeʺ, where speculators borrow in low-interest currencies and invest in higher-yielding currencies.

In theory, however, this should not be a focus of monetary policy. The so-called principle of ʺuncovered interest rate parityʺ states that the difference in interest rates between two countries will equal the expected change in exchange rates between them.

The currency of the country with the higher interest rate will therefore tend to depreciate, which makes imports more expensive. For a country like South Africa, which is highly dependent on oil imports, this would aggravate inflation and run contrary to the objectives of monetary policy. A central bank should also not encourage currency speculation.

Although statistical evidence has often refuted the theoretical relationship between spot interest rates, forward interest rates and exchange rate movements, a currency strengthening would be even more unwelcome for the South African economy, due to its negative effect on international competitiveness.

The Reserve Bank needs to realise that attempts to influence the rand exchange rate via marginal increases in the repo rate are futile. It also needs to revisit its stated intention of balancing the objective of price stability with that of supporting economic growth. The latter is not served well when interest rates are increased at a time of economic frailty.

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Great article but sadly the boffins at SAB will ignore such logical arguments

Must say I’m surprised with the graph comparing the Rand against some other currencies.

The SARB’s rationale for rate hikes is, less broader economy based, and more premised on the fact that South Africa has a largely retail-sector/consumption-driven economy, hence inflation being such a sticky, but focal point.

For as long as the ratings agencies continue to breath down their necks, they have to be seen to be as pro-active, even if through only ‘token’ steps, that may be considered counter-intuitive by many.

Don’t be ridiculous. Higher interest rates are not going to make the currency depreciate, make imports more expensive and aggravate inflation. This is a common cause of confusion. In South Africa the interest rate is a market phenomenon. The floor is set by the marginal bondholder and the ceiling by the marginal productivity of capital. If interest rates fall too low then overpriced bonds are sold. If interest rates are too high then marginal capital is sold. South African bond yields have increased about about 1.5% in the last two years.

The SARB is merely raising rates on the cues it gets from the market- actually ‘inflation” is only one factor setting interests rates. Don’t forget sovereign risk. Inflation adjusted interest rates in risky countries are higher- as they must be. If SARB did not raise rates there would be a huge incentive on the part of speculators to short the rand. Borrow huge amounts of ZAR cheaply (thanks SARB) and dump them in exchange for US$. This would send the ZAR into a tailspin and bond yields would rocket, the SARB would have to raise rates to shake the speculators out by which time it would be too late. High interest rate, major recession. R100 per liter petrol. Speculators close their short positions and make a bundle on the misery of SA inc.

Yes, the SARB should not encourage speculation as much as carry trades lower interest rates and cause currencies to appreciate.

I take a dim view of those who espouse the “beggar thy neighbour” theory of currency debasement. It is preposterous to think that debasing the Rand will make South Africa more competitive internationally. In the 1970s one ZAR could buy US$1.30. How about that? Currently one ZAR buys about US$0.08. All that debasement over 4 decades and one would expect South Africa to be an economic powerhouse by now. China, Germany eat your hearts out. *gosh*. The mundane truth is the effects of the debasement are ephemeral – as we well know. Imported goods rocket in price along with inflation and wage demands. One must never ignore the marginal terms of trade. If the currency loses 50% of its value then SA must now export twice as much to import the same amount of goods. Ponder that!

A stable currency and low capital costs go hand in hand with the ability to control operating expenses especially the imported component thereof. A country running huge trade deficits with a currency falling off the cliff with sky high interest rates is not competitive. Contrary to monetarist doctrine a weaker currency it is not trade deficit correcting. There are many examples in history e.g. USA Japan 1970s, 1980s. How is it that the best countries to live in have low inflation rates and stable economies?

End of comments.

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