Meeting with the Governor of The South African Reserve Bank

Meeting report

FINANCE PORTFOLIO COMMITTEE & FINANCE SELECT COMMITTEE - JOINT SITTING
19 March 2002
MEETING WITH THE GOVERNOR OF THE SOUTH AFRICAN RESERVE BANK

Co - Chairpersons: Ms Hogan (ANC) & Ms Mahlangu

Documents handed out:
Presentation by the South African Reserve Bank
South African Reserve Bank: Quarterly Bulletin march 2002
Governor's Statement on 14 March 2002 (See Appendix)

Reserve Bank website: http://www.resbank.co.za/

SUMMARY
The South African Reserve Bank (SARB) made a presentation on the state of the International and Domestic Economy. The outlook for the US, UK and the Uero Area is positive. Africa however is experiencing high levels of inflation.
On South Africa it was said that the decline of the Rand led to high food prices and as a result there were serious inflationary pressures. The governor explained that the SARB could just not sit by and do nothing. In the Governor's statement of 14 March 2002 he states that the increase in the repo rate might have a negative effect on domestic growth over the short term but monetary discipline is essential for price stability and sustainable economic growth.

MINUTES
The Deputy Senior Economist, Mr de Jager made a presentation to the committee on the recent economic developments. Mr Mboweni, Governor of the SARB indicated that he would answer any questions thereafter.

Presentation
The presentation was divided in two parts, the state of the international economy and the state of the domestic economy.

International Economy - SARB vies on what is happening in the International Economy.
Slide 1 shows the pressure on oil prices. The pressure is as a result of the US / Iraq conflict and the uncertainty over production in the Russian Federation. Mr de Jager said that oil prices have a serious implications for our domestic inflation.

Slide two and especially the OECD leading indicator shows that the fortunes of the advanced economies are changing for the better.

Slide three gives the world economic outlook. The graph shows a recovery towards the end of last year. The growth rate on the African continent is expected to remain the same this year at 3.5%.

Slide 4 - The IMF does not see serious inflationary pressures. Only Africa is expected to have a 8.3% average. Countries in our region is mainly responsible for this high figure.

USA Economy
Slide 5 - In the third quarter of 2001 the US economy shrank but there was a turnaround in the fourth quarter. This indicates that the worst is behind us and that there is a global recovery.

Slide 6 - there has been a decline in the unemployment rate in the US economy.

Slide 7 - Headline inflation is down at 1.1% and this is the lowest that has been seen in the US since the 1970's. core inflation that excludes food and gas is at 2.5%. it is expected that it will remain in the area of 2.5 - 3% during 2002.

Japan: Slides 8 - 10
Japan is the only area where the SARB believes the economic activity is languishing. Recovery is not yet properly underway. There is a decline in unemployment. Slide 10 shows that consumer prices are falling. There was a 0.8% decrease in January.

Euro Area - Slides 11 -13
The Euro area is an important trading partner for SA. It shows an improvement in the third quarter of 2001 and in the fourth quarter output is likely to shrink by 0.2%. the German economy is recovering nicely and this is important because it is a driver in the Euro Area. The unemployment rate is not a problem and is expected to remain constant during 2002. Consumer prices is higher by 2.7& in January and it was said that it was due to a harsh winter.

United Kingdom: Slides 14 - 16
There is no signs of negative growth. Indications are that the economy is no longer deteriorating. The labour market is tightening and the trend is that the unemployment rate is going down. The inflation target in the UK is not a range but a point which is 2.5%. At the moment inflation is at 2.6% and this is good.

SADC
This region is characterised by high levels of inflation. the two areas contributing to the high average is Angola (121%) and Zimbabwe (116%). This means a more than doubling of prices over a 12 month period. Countries like Swaziland (11%) and Namibia (8.7%) have expressed that they are experiencing fiscal problems. it will help be a help to these countries if South Africa can keep its inflation rate down.

South Africa
Slide 19 - slow growth was expected in the third quarter but there was an acceleration. Export and manufacturing did well and were the drivers of the acceleration. Despite the weaker conditions in the primary sector there was still faster growth in the fourth quarter than the third. Producers were more competitive in the export market but the consumer sector growth was muted.

Side 20 shows real gross domestic expenditure. Spending accelerated faster than income growth. The figures of 6% in the third quarter and 3 % in the fourth shows demand is healthy but society spends at a faster rate than what the income levels are rising.

Slide 21 - total spending by households increased from 2.5% in the third quarter to 3.5% in the fourth. Fourth quarter spending was mainly on durable goods, in particular motor vehicles. It is suggested that it was pre emptive buying due to expected price increases.

Slide 22 shows that real household income is steadily growing enabling households to spend more without additional debt. As a result slide 23 illustrates that the debt to income ratio declined from the third to fourth quarter.

Slide 24 - government real final consumption expenditure rose from 2.5% in the third quarter to 3% in the fourth.

Slide 26 - suggest that producers expect demand to remain strong because they have added to their inventory levels. The inventory increase was at a lower rate during the fourth quarter but it still indicates confidence in demand in the first quarter of this year.

Slide 27 - Historically corporate savings contributed the most to gross savings as a % of GDP. Corporate savings is now weakening because a smaller amount of profit is being held back. Some say that this is so because there are no investable opportunities but it is probably because of the lower cost of capital. The corporate bond market is rather used than the holding of funds.

Slide 28 - the employment level in the formal non - agricultural sector declined. But the official unemployment rate is not deteriorating (Slide 29). The void in the non - agricultural sector is being filled by the service sector and the informal labour market.

Slide 30 - from the third to the fourth quarter there was a growth in nominal wage remuneration in the formal sector. Output growth is slowing down from 4.5% in the third quarter to 3.5% in the fourth but remains healthy.

Slide 32 - as a result of the nominal wage growth and the decrease in productivity, the unit labour cost in the non- agricultural sector increases. The rise in the unit labour cost is more visible in the manufacturing sector because the numbers are accurate (slide 33). The rise has implications for prices.

Slide 34 - the all goods production price rose from 8% in December 2001 to 11.5% in January 2002. This is a serious inflationary pressure. Other indirect pressures are the weak Rand and the effect of higher labour costs.

Slide 35 - inflation was at 7,1% in February this year. headline inflation that includes mortgage costs is 5%. The new updated numbers is expected later today. The acceleration in the CPIX at the end of 2001 was as a result of the increase in food prices.

Slide 26 - Balance of payments: Current account
The trade account (exports less imports) shows a modest improvement from the third to the fourth quarter. There is a negative balance on the services account that takes the current account into deficit. The deficit on the services account shows that we are still paying more for importation. The negative balance on the current account is smaller in the fourth quarter because of a recovery in exports and a decline in net service payments to non - residents.

Slide 37 - the balance on the financial account shows investment flows between Sa and the rest of the world. There was an outward movement of capital in the fourth quarter and the account wen from surplus to deficit.

Slide 42 - illustrates the Net Open Position in Foreign Currency (NOPFC). There is a decline from $4.8 billion in the fourth quarter to $3 billion at the end of January

Slide 44 - exchange rate
The currency depreciated 32% last year. there was a recovery at the end of last year and at 28 February 2002 the Rand recovered on a trade weighted basis of 7.1%. But following the recent weakness the recovery dropped to 1.8%.

Slide 46 & 47 - there was a growth in money supply from December 2001 to January 2002. The growth was a result of domestic credit extension to particularly the private sector. The acceleration in credit demand from the private sector signals increased activity.

Slide 52- the turnover in the secondary share market shows that companies expected better profits.

Slide 55 - the revenue of national government is well ahead of the budgeted projection.

Slide 56 - growth in expenditure by national government is on target. Expenditure matches the budgeted amounts. For this reason the budget deficit has shrunk significantly. On the face of it government finances are boringly correct bit if other items like losses on forward contracts, capital adjustments on inflation linked bonds and the recalculation of the foreign debt, the finances look less impressive but the fiscal position is still good.

The Governor made a few comments:
The governor raised tow issues in the quarterly bulletin.

On pg. 36 under the heading exchange rate he said that the factors mentioned that could be a cause of the rands decline are comments of market participants and not the SARB.

The following paragraph about dubious transactions states that the President was influenced to appoint a commission on inquiry. The correct phrase should be that the President decided because he was not influenced.

Slide 5 illustrates real GDP of the US. There was small growth in the second quarter. Then in the third there was negative growth. People said the US was in recession. The fact is that they were never in recession. The fourth quarter figures proves this. the economists consider there to be a recession when there are two consecutive quarters of negative growth.

Slide 7 illustrates USA consumer prices. People have asked why do we not cut interest rates like the US. If the price of all the items are looked at it can be seen that the US has no problem with inflation and can afford to cut interest rates.

In South Africa slide 35 shows that overall inflation is 5% and PIX is 7.1%. the US figures are 1.1% and 2.6% respectively. When people say we must cut rates it must be borne in mind that people should not compare things that are not comparable.

He asked Mr De Jager to say something about the dividend outflows because the graph on the balance of the current account does not give the full story.

Mr de Jager said that the graph is a sign of success because we want equity investment in SA. If there is investment there must be reward. What is happening is that payments to other countries is more than what SA companies are earning abroad. He said that the deficit on the current account is not a disaster and is easily financed by inflow of capital.

The Governor continued. On the Net Open Position in Foreign Currency he said that at the Rand commission some contributors who speak with 'forked tongues' state that this account is a major contributory factors to the weakness of the Rand. When the NOPFC is removed it will be good for the country because a negative factor is now gone. There will be one less liability that needs to be settled. Hopefully during the course of the year it will be gone. Good progress has already been made. Once it is gone then government has greater flexibility to do what they want to do.

Discussion
Mr Moloto (ANC) said that commentators have said that SA is experiencing cost based inflation rather than demand based inflation. They express a view that increasing the repo rate will not help. He asked for the Governors views.

Secondly, he asked if the governor could shed more light on why food prices and especially the maize price is so high.

The Governor answered the question on food prices first because it was the easier one. He replied that he discussed with the Ministers of Finance and Trade & Industry why there is such a significant growth rate in food prices. The answer was alluded to in the Budget Speech where the Minister said that an investigation is needed. What is clear is that the agricultural sector underwent major transformation, the pricing system is radically restructured, boards were phased out and real market prices prevail as opposed to previous subsidised prices. SA is also caught up in globalisation and our economy is integrated into the world economy. Certain prices in SA are international prices because why should the same commodity be priced differently in SA and the US. He said that if availability is low in SA we have to import and the price paid is an international one. As a result prices will go up. He concluded by saying that an investigation is still needed.

In response to the first question the governor replied that the SARB is interested making sure the CPIX less mortgage cost averages between 3 - 6% at end of 2002 /03. At the inflation is experiencing pressures. The main pressure points are:
there is excess expenditure, meaning expenditure is greater than the gross disposable income.
for 2 quarters the current account showed a deficit which says that demand is far exceeding output.
There are a variety of other factors like the depreciating Rand, food prices and the unit labour cost.

The governor said that with all these factors some of which is demand related and some cost, the result is a high CPIX. The question then is what does the SARB do. Does it go to sleep and hope it is gone the next day. Linked to all this is the expectation in SA. People expect inflation to rise and their consequent behaviour adds to the inflation. an example is that trade union expect inflation to be about 8%. Their behavior at wage negotiations is influenced by that expectation and therefore want to settle only at 12%. If the 12% is achieved then the unit labour cost increases and this adds to inflation. The Governor said that the SARB is trying to nip it in the butt and believe they will be successful.

He continued by saying that there are demand factors and cost factors but the SARB must do something to show its seriousness about the inflation targets. He hoped that other people who must help in achieving the targets will play along because there are other contributing factors. The behaviour of government and government aligned organisations is important. If a working class person wants to send a child to university and education increases by 10% each year then wage negotiations will be pitched at that level. The same is true for municipalities because there are inflationary consequences if they raise rates and taxes by 10%. The Governor said for this reason he has advised Mr Mufamadi to discuss the inflation target with mayors. He advised the same to the Minister of Water Affairs because the water board should just not increase rates at a whim. He concluded by saying that a combined effort is needed to achieve the target.

Mr Taabe (ANC) referred to pg. 36 of the SARB quarterly bulletin under exchange rates where it is stated that the President appointed a commission to investigate the Rands decline on the basis of evidence by Mr Wakeford (SACOB). Mr Wakeford alleged that dubious transactions that were contrary to foreign exchange regulations led to the depreciation. He said further that the Governor was reported to have said that this reason for the decline of the Rand was a populist view. The member wanted to know what informed this statement of the Governor.

The Governor said that Mr Wakeford had allegedly came across dubious schemes were people created financing structures and used it to manipulate the currency and that exchange control rules were flouted. The SARB approached Mr Wakeford because it is responsible for exchange control. He refused to give any information to the SARB to enable it to investigate. The Governor commented that he would have thought that if a citizen knows of something illegal the evidence will be handed to the responsible authority. The SARB pursued Wakeford but he continued to refuse. The SARB considered legal action but then Wakeford made a statement that part of his reason for not disclosing the information was that public officials were involved. If public officials are involved then they can only be from SARB or SARS. The Governor said that if this is the case then a commission is needed.

The Governor continued and said that while speaking generally to students at Wits he said that the information could have been given to the responsible authority but because Wakeford is such a populist, ' the white knight who wants to save the Rand', he did not.

He added that the commission brought about a boom in the legal industry in Johannesburg. Every Senior Counsel is busy. The SARB has one Senior Counsel, one Junior Counsel, a Senior Attorney and a Junior Attorney. Lots of time and money is spent on the commission. The SARB submission was 48 pages and the full document was about 450 pages.

The Governor said that he has to be careful about what he says about the commission and will not say anything more.

Dr Rabie (NNP) asked when the NOPFC will be settled.

Secondly, he asked what effect the 116,7% inflation in Zimbabwe will have on SA inflation.

The Governor replied that the intention is to close the forward book. He said that during the times when SA had no access to international markets a scheme was devised where capital could be accessed through the forward book. The consequence of sanctions was the build up of the forward book. It is a kind of public insurance for future exchange rate risks to the private sector and parastatals. When the exchange rate weakened huge losses were built up. The losses were for the account of government and as a result the taxpayers must pay. It is therefore important to get rid of it. Now there is access to the market and anyone who wants to take a risk must do so them selves. He added that if the privatisations take place this year the forward book will be phased out.

On SADC inflation he said that the countries are doing the best they can to fight inflation. The Zimbabwe inflation is a result of political instability, high budget deficits and complicated exchange rate policy. If the structural problems can be overcome then the inflation rate will come down. To the extent that this impacts on SA, he said that it depends on Zimbabwe exports to SA. There can only be an impact through trade no other direct impact.

Ms Taljaard (DP) said that lots of domestic factors were mentioned as being responsible for increased inflation. there are also other factors such as the oil price. She referred to a communication between the Treasury and the SARB where it was stated that exogenous factors can result in the targets not being achieved. Further, the escape clause can only be invoked in a response to exogenous factors. She expressed concern about how little is known in the public about the escape clause. She continued to say that the inflationary pressures discussed now were all domestic pressures and not exogenous factors. She commented that SARB is required to explain why the targets have been missed but as yet there has been not enough explanation.

The Governor replied that the escape clause does exist. The issue to be dealt with in the future is when can the clause be invoked, assuming government wants to. He said that it does not make sense to invoke it 8 months before the end of the target period when it is not known if the target will be missed or not. he said that only when Stats SA release the figures do we know that the targets have been missed.

The exogenous factors could include floods and droughts. i.e. factors that there is no control over. The current food prices is not included in this so the escape clause cannot be invoked for this.

He commented that the oil prices is no shock because it has settled at a high level.

He added that the real significant external shock is the exchange rate. Whether this one factor is sufficient to invoke the escape clause is a matter of judgment. The governor said that the SARB has never discussed / considered with the Treasury of invoking the escape clause.

Even with no targets the Governor said that he would still try to achieve lower inflation because high inflation is not good. The SARB has started a process of interaction with ministers in the economic and social clusters to raise issues of the inflation target. A system has also been designed to meet the Director - Generals maybe twice a year and one of the items on the agenda will be the inflation target to make them conscious of the significance thereof.

Mr Mnguni (ANC) asked what effect public sector borrowing would have on inflation.

Secondly, he said that during the Budget Hearings it was said that the R15 billion PIT relief was equal to a drop in the interest rate by 4%. He asked for the Governors view on this.

The Governor replied that public sector borrowing would have no effect on inflation.

To the second question he said that the R15 billion will work itself out of the system by June / July. Only a few clever people will square up debt. He said that there should only be a short term increase in spending.

Mr Ralane (ANC) commented that before the Zimbabwe crisis between 1994 - 1999 there was very little foreign direct investment (FDI) in SA. He asked what government must do to attract FDI.

Secondly, he asked what the government should do about food prices and if it should be subsidised.

Thirdly the member commented that the Select Committee and the Portfolio Committee must consider playing an oversight role over the inflation target.

The Governor said that from his position what he must do to attract FDI is get the inflation rate lower. The rest the Ministers of Finance and Trade & Industry must do. There is competition for FDI in the world. Countries that are stable, taking care of the social problems, friendly to investors and have less disruptive productivity will benefit more from FDI. If companies do not think they can make a profit they wont invest.

Ms Joemat (ANC) asked for a graph that reflects the food price increases.

The Governor replied that it would be easy to produce a graph and forward it to the committee but the questions should be directed to the Department of Agriculture who would be able to answer them more fully.

Ms Taljaard got the impression that the SARB is more interested in the inflation target than its constitutional mandate. The member wanted the Governor to comment.

"Section 214 (1) of the constitution states that the primary object of the SA Reserve Bank is to protect the value of the currency in the interest of balanced and sustainable economic growth in the Republic."

The governor replied that a lower inflation rate will lead to growth. He questioned what the interpretation of the relevant constitutional provision is. He said that he interpreted the clause to obligate the SARB to ensure that the buying power of the people is protected. The interim constitution referred to the internal and external value of the money and some people still have this clause in mind when interpreting the constitution. Some say that in terms of the constitution the SARB's objective is a balanced economy, growth and development. The Governor said that this is wrong because if the first part of the clause is achieved then the latter part will be achieved. If the constitution is not clear then it needs to be redrafted.

There were no further questions.

The chair thanked the Governor and the SARB.

The meeting was closed.

Appendix
SOUTH AFRICAN RESERVE BANK
STATEMENT OF THE MONETARY POLICY COMMINEE
14 MARCH 2002

Issued by Mr T.T. Mboweni, Governor of the South African Reserve Bank, after a meeting of the Monetary Policy Committee in Pretoria.

Inflationary pressures began to build up during the fourth quarter of 2001, activated by the first round-effects of the depreciation in the value of the rand and steep increases in food prices. This became clearly reflected in the quarter-to-quarter change in the all-goods production price index (PPI) which rose from a seasonally adjusted and annualised rate of 6,4 per cent in the third quarter of 2001 to 11,3 per cent in the fourth quarter. The twelve-month rate of increase in this index also accelerated from 7,8 per cent in September 2001 to 8,3 per cent in December and 11,5 per cent in January 2002.

As could be expected, CPIX inflation was not immediately affected to the same extent because of the lag between producer and consumer price increases. The quarter-to-quarter increase in the CRIX index nevertheless rose from an annualised rate of 5,9 per cent in the third quarter of 2001 to 6,8 per cent in the fourth quarter. Measured over periods of twelve months, CPIX inflation accelerated from below the psychologically important level of 6 per cent in September 2001 to 6,5 per cent in December and 7,1 per cent in January 2002.

This increase in consumer price inflation was mainly due to changes in food prices. The CPIX inflation excluding food rose by only 5.6 percent in January 2002 when compared with the same month in the preceding year. The steep increase in food prices, in turn, was largely the result of a depreciation in the external value of the rand. On a trade-weighted basis the exchange rate of the rand declined by more than 34 per cent in the last half of 2001. Import and export parity pricing have become common practice in the now largely deregulated agricultural sector. Despite relatively good crops in 2001, food prices accordingly increased substantially. In particular, a rise in the maize price was the main driver of food price inflation because of its effect on the prices of other agricultural produce.

The depreciated value of the rand also began to affect the prices of other commodities towards the end of 2001. The weakness of the rand was probably related to a number of factors, such as domestic spending in excess of national disposable income, unfounded expectations of an immediate abolition of exchange control, leads and lags in foreign payments and receipts and negative socio-political perceptions of the region. Although changes in monetary policy will have little impact on the first-round price effects of the depreciation of the rand, it is nevertheless important that measures be taken to prevent a continuation of upward price adjustments. The timely response of monetary policy is intended to help prevent second-round price increases, making the attainment of the inflation target far less onerous.

A tighter monetary policy stance is also indicated by other developments, including:

1. A rise in inflation expectations. The survey conducted by the Bureau of Economic Research of the University of Stellenbosch, released today, clearly indicates that inflation expectations in South Africa have increased. This is confirmed by other indicators of inflation expectations such as the higher and steeper yield curve and the increase in the monthly average implied or breakeven inflation rate since December 2001. (This rate equates the nominal return on government's conventional long-term bonds with the real yield on inflation-linked bonds.)

2. Domestic spending in excess of national disposable income. Growth in domestic expenditure accelerated during the second half of 2001. This was the combined result of an increase in inventory investment and real domestic final demand. The consumption expenditure of households and government as well as gross fixed capital formation continued to increase at a steady pace. The higher rates of growth in domestic spending than in income were reflected in deficits on the current account of the balance of payments in the third and fourth quarters of 2001. These deficits, which were still relatively small, mainly reflected a strong demand for imports and a decline in the volume of exports which were neutralised somewhat by an improvement in the terms of trade. Projections show that the current account will remain in deficit during most of 2002. It is also disconcerting that the rise in domestic spending was accompanied by a substantial increase in credit growth. The quarter-to-quarter growth in the credit extension of banks to the private sector accelerated considerably from an annualised rate of 2,8 per cent in the first quarter of 2001 to 14,2 per cent in the third quarter and 17,9 per cent in the fourth quarter.

3. A rising trend in nominal unit labour cost. Unit labour cost picked up from an average rate of 2,9 per cent in 2000 to a year-on-year rate of 4,3 per cent in the first nine months of 2001. The unit labour cost in the manufacturing industry rose even more sharply from a year-on-year rate of 1,6 per cent in the first quarter of 2001 to 7,1 per cent in the third quarter. This development reflects a slower pace of increase in productivity than in nominal compensation of labour.

4. The high growth in money supply. Although the quarterly growth in the broadly defined money supply slowed down in the fourth quarter of 2001, growth over twelve months remained high at levels of 17,0 per cent in December 2001 and 19,3 per cent in January 2002. Moreover, the narrowest monetary aggregate (MIA) continued to increase at exceptionally high quarter-to-quarter rates in the second half of 2001. This may merely reflect a strong preference for liquid assets, but it could also indicate a positioning to step up future spending.

Although the effects of these developments can be neutralised to some extent by the excess production capacity in the economy and continued fiscal discipline, the Monetary Policy Committee is of the opinion that they warrant a more restrictive monetary policy stance. The committee has therefore decided to increase the repo rate by 100 basis points to 11,50 per cent per annum with effect from 15 March 2002. It is expected that this wilt lead to similar adjustments in deposit and lending rates in the domestic market.

The Monetary Policy Committee realises that this increase might have a negative effect on domestic economic growth over the short term in an international environment characterised by a hesitant and apparently slow economic recovery. Monetary discipline is, however, essential for price stability and sustainable high economic growth. The negative effect of higher interest rates on short-term growth may also be neutralised to a large extent by the very competitive external value of the rand, which will in all likelihood lead to substantially higher exports when the world economic recovery gathers momentum.

T.T. Mboweni
GOVERNOR