South African Reserve Bank on its March 2008 Quarterly Bulletin

Meeting report

Mr J van den Heever, Head: Research Department: SARB, presented the South African Reserve Bank Quarterly Bulletin for March 2008. He began by reviewing recent international economic developments. Here, the still robust economies of China and India were highlighted. Regarding the world inflation outlook, high oil and food prices were of concern going forward. He reviewed the situation in the United States of America,noting the strong drop in the interest rate in the last three months.This was an attempt to moderate the impact of the sub-prime crisis.

Within the Southern African Development Community (SADC), the Consumer Price Index (CPI) trend was generally higher. The hyperinflation situation in Zimbabwe (recently peaked at 100 580 %) was not included in these figures. Oil prices had peaked to record high levels. The pattern that had emerged here was an almost continuous upward trend, with occasional short-lived declines, followed by the next round of increases. Key metal prices (gold and platinum) continued to be favourable, with platinum reaching $2000 per ounce. This constituted a boost to the terms of trade and exporters.

Domestic expenditure growth slowed to almost 0% (0.2%) in the last quarter of 2007. Household consumption expenditure showed a massive decline in growth. This was the lagged effect of earlier monetary policy changes. Government expenditure showed slow growth over this period. Household debt and the debt service ratios remained high and fixed capital formation showed an increase stronger than growth in the Gross Domestic Product (GDP). This was a result of South Africa’s drive to invest in infrastructure, meant to deliver long term benefits. The mining sector recorded a drop in inventories due to strike activity, energy disruptions, rain and logistical problems. Manufacturing inventories also contracted. However, subdued domestic demand meant the wholesale and retail inventories actually increased. Business confidence also saw a decline, while an upward trend was observed in employment. Wage settlements were edging higher, averaging 7.3% in 2007, following inflation expectations. Concerning inflation, Statistics South Africa was currently revising the CPI methodology. Despite this, the CPI and PPI were relatively high, with CPIX above the 3 - 6% target band since April of 2007. Food price inflation was most concerning. This reflected the energy market, the effect of biofuel substitution, world economic growth and the weakening of the exchange rate due to import and export parity changes.

The narrowing trade account deficit was moderated by the fact that financing of this deficit was being overtaken by other investment (previously portfolio investment was dominant). SARB had a comfortable reserve position. As far as economic indicators were concerned, the effective rand exchange rate declined by 13.5%, improving the picture for exporters. A slowdown in the growth in the M3 money supply aggregate was observed. Credit extension experienced a deceleration and the money market interest rate increased stepwise. Housing prices were holding steady, showing moderated increases but no sign of full-blown decline.

Mr Tito Mboweni, Governor: South African Reserve Bank, noted that the exact losses due to the sub-prime crises were not yet known, but were estimated at over a trillion dollars and had originated mostly from the flexible part of the sub-prime market. He highlighted the international problem of interbank trading collapse that had put undue pressure on the world’s central banks. South African banks did not seem to be exposed to these problems.

He noted that even after food and oil prices had been removed from the CPIX, the trend was still on the upside. He concluded by saying that the mandate of the SARB was to anchor inflation and that all South Africans would have to “tighten our belts”.

Discussion
Mr K Moloto commented on the turmoil in global financial markets and asked what the impact was on credit ratings agencies. He asked if the prudent fiscal stance cushioned South Africa from external risk. He noted that the financial inflows used to finance the current account deficit were mostly composed of “other investment” and asked if this type of investment was sustainable as a source of financing. He finished by asking what SARB’s position was on the derivatives market and if much was known what the underlying assets were.

Mr Mboweni agreed with the commentary on the financial market situation and said that financial innovation had gone wild. Unchecked recklessness in trading was leading to a volatile world market. On the derivatives front, he said that the underlying assets were not a focus. He added that efforts must be made to curb rogue trading. On rating agencies, he said their standing had been reduced in the wake of the sub-prime crisis. However, they still played an important role but had to be monitored more closely to “clean up their houses”. The biggest problem facing everyone now was the issue of contractual conflicts where rating agencies perform ratings on companies to which they were otherwise contracted. This mechanism needed review.

Mr S Marais (DA) asked what the relation was between the exchange rate and the CPIX (Consumer Price Index less mortgage rates) is.  He noted that consumer spending was appreciably down and was concerned that this might be overkill for the demand side of the economy. He worried that this would weaken the economy's capacity to absorb the growth on the supply side. He asked about mining production inventories levels being down and also queried the increase in the balance of payments deficit. Was South Africa ready to respond to export opportunities? He was concerned about foreigners being net sellers of financial flows. Finally, he asked if the independence of the SARB would stay intact in the future.

Mr Mboweni replied that Foreign Direct Investment (FDI) was the preferred type of investment in a globalised economy. On the relationship between monetary policy and inflation, he referred to the transmission mechanism. Key components were the forces of demand and supply. The action taken so far would, according to the mechanism, assist the inflation outlook. The mandate of SARB was to anchor inflation. Certain sectors of the economy were already adjusting their inflation expectations upward. As to fears of high inflation harming the real economy, he did not think so and cited periods of higher inflation in the past that the economy had survived. Mining production was, in fact, declining due to the energy crisis.

Mr Johan van den Heever added that energy could not be controlled and that this was a major contributor to mining slowdown.

Mr Mboweni said that the independence of the central bank was entrenched in the Constitution. He added that he did not know of any plan to change the Constitution accordingly. Parliament's oversight role of the SARB did not amount to control of monetary policy or inflation. The SARB, like other central banks, must be held accountable and this was no threat to independence.

Mr B Mnguni (ANC) asked what the ratio of foreign debt held by South African banks was and what risks this posed for the domestic banking sector's liquidity. He asked if the trade account deficit was appropriate. He noted the strong impact of food and energy prices on the upward movement of the CPIX.

In response, the Governor said that it was a tough time to be central bank governor and the planned increases in the electricity price did not help. He recognised Eskom's difficulty and stated that South Africans were much too accustomed to low energy prices. The central bank was in talks with Eskom to discuss a way forward with regard to alternatives. The current account deficit was attributed largely to a massive infrastructure investment programme. This required large amounts of imported intermediate and capital goods and for this reason, the import bill would continue to increase. The effect of this would hopefully be moderated by a weakened exchange rate and mining and manufacturing exports.

As to the issue of non-resident investors, Mr Mboweni said that perceptions here were vitally important. This was most important, as this was how the current account deficit would be financed. Loss of confidence could not be allowed because the only alternative when financing could not be generated, was the International Monetary Fund (IMF) and that route was most undesirable.

Mr van den Heever said that South African banks were well integrated into the world financial markets and had enormous flexibility due to well managed asset positions. Coupled with SARB's comfortable reserve position, this made South Africa much more robust so the need for IMF financing was distant. The interest rate differential in favour of South African asset investment also led to a lagged capital inflow, used for financing purposes.

Mr D George (DA) noted the upward trend of the CPIX and suggested that inflation targeting was not a sharp enough instrument. He asked if there was not a better tool to target core inflation. As the current account deficit widened, what would the bank do to stabilise the currency under these circumstances?
Mr Mboweni responded that the measure of inflation as it stood was appropriate. The SARB could not remove certain elements as it suited them. This would lead to a situation where the core inflation indicator would no longer reflect reality. This in turn would create a situation where the necessary steps could not be taken to maintain long term stability. They could not shy away from volatile items such as food and oil prices and noted that all serious investors would continue to use a more complete measure. There were no liquidity problems with banks so far. SARB would be monitoring the situation to ensure that should a liquidity squeeze begin, it did not decline rapidly into full blown insolvency.

Mr N Singh (IFP) referred to figures indicating strong growth for China and India, despite financial market difficulties. He asked what South Africa could learn from these economies. He brought up the fact that the Business Confidence Index had declined and voiced concern about this. He also asked about the biofuel substitution effect vis á vis food prices.

On what could be learned from China and India, Mr Mboweni said that these countries had poor labour practices and their success lay in their low labour costs. South Africa’s base was very different and from an objective point of view South Africa was not doing too badly. The decline in business confidence could only be remedied if South Africa continued with a prudent economic approach and that it was seen to be consistent and stable in order improve perceptions and expectations.

Ms N Mokoto (ANC) noted a statement in the SARB Quarterly Bulletin that a slowdown in developed countries was less likely to affect emerging markets. She asked the Governor to explain this statement. She asked how much government spending was affected by the current economic turbulence. Next, she noted the changes in consumer behaviour coupled with increases in remuneration being above the inflation target band (3-6%). She asked what the government was doing to reduce the cost of doing business.                     

On the slowdown in developed economies, Mr Mboweni said they had not intended for it to come across in this way. The changes in developed economies must eventually impact on the emerging markets due to the interrelated global environment. This would eventually lead to a slowdown in even the most robust economies currently. On the behaviour patterns of consumers, the way the transmission mechanism worked was that an increase in interest rates rebalanced spending portfolios.

Ms J Fubbs (ANC) said that although the growth figures were good news, she was concerned about the long lag before positive impact was appreciable. There was a need to retain capacity (labour and finance specifically). She asked how productive the finance sector was and if value was being raised significantly. Perhaps the full effect of the sub-prime crisis was yet to be ascertained? On the issue of biofuels, the cost of maize had increased, due to supply and demand pressures. As maize was a staple this was of great concern. Next she asked what was being done to ensure that houses were not priced out of the reach of the lower to middle income groups.

Mr van den Heever spoke to the question of productivity. He said that GDP was rising at about 5% per annum and employment was also steadily increasing. Development and increases in productivity would require more skills training and capital stock being reduced.

Mr Mboweni said that there were long lags in gross capital formation investment and that that was simply the nature of this type of investment. Research on biofuels showed that it put pressure on the prices of inputs and this needed to be balanced against the perceived gains. He referred members to the Department of Trade and Industry, saying they had a unit that dealt with biofuels. In reply to the question on housing prices, he said that the banks needed to be compensated when people could no longer make their bond payments. Banks must be able to recoup some of their investment.

Ms Denise Robinson (DA) commented on the petrol price hikes and asked if consumers would not benefit from the deregulation of the petrol price.

Mr Mboweni replied that the potential impact of deregulation was unknown and that other countries that had instituted it, on the whole had not escaped the fuel price increases.

Mr M Johnson (ANC) asked about the investment clause in the PFMA. He asked what should be done about municipal investment when service delivery was shoddy and government departments and agencies continued to request more funds. He asked what the risks were to growing the economy on a provincial basis to improve their planning capacity.

Mr Mboweni responded that he was the wrong person to ask about provincial spending arrangements.

Mr Mnguni referred to China and asked if the Reserve Bank could not adjust its liquidity requirement in order to influence food prices

Ms Fubbs noted rising administered prices. Energy costs were endogenous. Could there be a reduction in administered prices as these were within our control?

In response, the Governor said that the rate of increase in administered prices must be consistent with the prevailing interest rate.

Finally, Mr Mboweni raised the issue of private healthcare costs that was currently making headlines. In an already pressurised economy, the cost of private healthcare was of concern to him and that it had disproportionately skyrocketed. He said that help was needed on this front, but also made it clear it would have to come from some other sector as it was not part of the SARB's mandate.

The meeting was adjourned.