The unfolding South African Reserve Bank challenge
By Cees Bruggemans, Chief Economist of FNB.
Last week, SARB Governor Marcus made her annual report. It was another opportunity to lift the veil on events, and give the SARB’s take.
Nothing, it seems, is simple in what is challenging the SARB today.
There is a major inflation shock underway.
But it is mainly commodity and supplyside-based, with no evidence of demand side pressures (the economy is still well below potential and credit is undersupplied).
According to the SARB there are as yet few second-round effects (behaviours that follow first-round price shocks such as oil, food, electricity, sustaining the higher inflation momentum if not further increasing it).
The SARB notes that mainly supplyside forces are taking inflation higher after a period of benign performance.
CPI recently reached 4.6% but is projected to temporarily breach the upper target boundary of 6% by early next year, thereafter falling back but remaining near the upper boundary for the rest of 2012.
In the process real forward-looking interest rates have been eroded, appropriately so under recent circumstances in which the economy and credit underperformed.
The economy is now nearly two years into recovery, with annualized GDP growth reaching 4.8% in 1Q2011, not an unimpressive performance (even if boosted by some short-term manufacturing catch-up revival not elaborated).
But this expansion has so far been mostly consumption fuelled, with fixed investment trailing, and there was fallback in manufacturing during 2Q2011 (though mainly for temporary reasons again not elaborated).
There has been some job growth since the start of recovery, but for nearly 70% in the public sector, not a satisfactory state of affairs.
So, yes, there is an inflation shock underway.
But it is of the kind that makes you pause as a policymaker for it isn’t demand or credit fuelled, and the forces propelling it forward are so far primarily first-round supply shocks (oil, food, electricity, some of it partially countered by Rand firmness).
And, yes, there is an economic recovery underway, already well developed considering it started in 3Q2009.
But this recovery is unbalanced. It is mostly consumption and far too little fixed investment driven, with export volumes heavily underperforming peer economies and private job growth so far dismal.
Not a reason either for policymakers to become less supportive, also as fiscal policy is allowing recovering tax revenue to reduce the budget deficit, already below 5% of GDP and gradually easing further.
The clincher, though, is the presence of global crises.
These major crises have so far been partly responsible (along with the Asian catch-up growth story) of positively boosting our terms of trade (export prices relative to import prices) and as such have enriched our national income. They are also a major cause of our enhanced capital inflows.
Between them, these external boosts are overvaluing the currency (good for countering inflation and pushing domestic demand, but bad for our export volumes).
It is the risks for South Africa residing in these global crises that provide daily food for thought and that are apparently a major reason for policymakers to keep their powder dry for when it may be necessary to intervene.
SARB never mentions upside risk publicly. This is a peculiarity of many years standing, given the nature of the global processes involved making for big windfalls naturally favouring us.
Such understatement, though, is fully understandable.
For external windfalls, even if they enrich us temporarily, potentially inject greater volatility in our affairs and are nearly never sustainable, yet may entice all kinds of unwarranted behaviours in the short-term.
It is presumably not advisable to fan excessive expectations and least of all to encourage consumption excesses, producer overinvestment, leveraged financial speculation and/or unwarranted government promises (been there, done that, too many times in the past).
This despite De Kieviet’s long-standing dictum that apparently South Africa progresses via economic windfalls (and political disasters), mainly because the country has not as yet fully mastered the ability to sustain fast economic development on its own volition, retaining an excessive dependence on global largesse for its progress.
Be that as it may.
It is the downside risk inherent in these crises, potentially abruptly deteriorating global growth conditions to the point of recession, in turn undermining commodity prices, along with the potential of abruptly reversing capital flows, which are most terrifying to an open economy still mainly dependent on commodity exports.
Not only does Europe possibly face a major banking crisis with global spillover potential. The world economy at large remains unbalanced in major ways, particularly the international adjustment mechanisms.
There are even bigger risks than only the European ones.
As things stand, already for 18 months the SARB Governor has with some patience and great persistence been mentioning the huge European banking exposure to questionable peripheral EU sovereign debts (being as much as $2.5 tril for Greece, Ireland, Portugal and Spain alone, with a comparable figure for private exposures).
If any of such debt were to default, the consequences would likely be dire, with the resulting global shocks likely buffeting the Rand as sudden changes in risk behaviour, capital flow reversals, commodity price collapses and adverse terms-of-trade developments could make their appearance.
This could catapult our inflation yet higher while causing our growth to fall off heavily (potentially into another major recession).
It is mainly this downside that makes the SARB cautious, wishing to be in a position where it can take appropriate action, if necessary supportive of growth.
For as Governor Marcus again emphasized last week, it is stability that is the ultimate overarching aim, as much price stability as financial stability and banking stability.
And though rising inflation in the short term might warrant higher interest rates for the time being, it is the relatively hesitant (even fragile) performance of the domestic economy and these massive global (downside) risks that might for now advise the very opposite (at least keeping rates stable at present low levels, aiming to maintain a greater overall stability and to see what comes next).
These are huge dilemmas.
To face an inflation shock that may not quite have staying power. Being in domestic recovery yet one that is unbalanced and underperforming. And all this in the presence of global crisis potential that may shock and buffet our economy, financial system and banking sector unpredictably (but likely excessively either way).
It leaves the impression of wanting to keep the policy powder dry for as long as possible, to see whether inflation can stay relatively benign (mostly target contained), the economy recover more adequately than so far the case, and most of all to see where the global crisis potential takes us next, for good or evil.
These are indeed complex challenges, as Governor Marcus remarked, and need all to be carefully taken into account and traded off before changing the policy stance.
Though real interest rates may eventually have to be normalized, it will take time to see to what degree this will require nominal rate changes.
For now we apparently remain on hold, with prime stuck at 9%, as we navigate these many challenges.
Source: Cees Bruggemans, FNB, July 3, 2011.
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