Monetary Policy Review; Forward Book; Division of Revenue Bill

Meeting report

FINANCE PORTFOLIO COMMITTEE
28 March 2001
MONETARY POLICY REVIEW; FORWARD BOOK; DIVISION OF REVENUE BILL

Chairperson: Ms B Hogan

Documents handed out
Monetary Policy Review presentation by South African Reserve Bank
Forward Book Presentation by National Treasury
Monetary Policy Review
Summary of Monetary Policy Review (see Appendix)

South African Reserve Bank website: www.resbank.co.za
National treasury website: www.treasury.gov.za

SUMMARY
The South African Reserve Bank has published its first Monetary Policy Review which looks at the factors which affect inflation and the outlook for inflation. The review is intended to contribute to openness and transparency.

The Governor of the Reserve Bank expects the rand to appreciate because of the Reserve Bank’s inflation policies. If they pursue the monetary policy without fail then they should see an improvement in the exchange rate. In this regard he noted that irresponsible statements ''feed the market''. More responsibility within the political debate is necessary for the benefit of the economy.

National Treasury’s Deputy Director General explained that the Reserve Bank had moved the Forward Book down from R21 billion to R14 billion and it is no longer providing new forward contracts. Winding down the Net Open Forward Position (NOFP) must be done in such a manner that it does not become disruptive to the SA economy. The size of the Forward Book and the NOFP will continue to be lowered.

MINUTES
Monetary Policy Review: Presentation by South African Reserve Bank
Dr Kahn and Dr Smal from the Monetary Research Department at SARB made the presentation. Mr T Mboweni (SARB’s Governor) was present and answered questions.

Dr Kahn said that this is the first Monetary Policy Review (MPR) to be published and it is intended to contribute to openness and transparency. SA has decided to produce the MPR twice a year. SARB also produces a quarterly bulletin which deals with a detailed look at economic policy in the country. They will try not to repeat this information in the MPR. Thus, the MPR is not replacing the bulletin it is simply complementary to the bulletin.

The Review contains many things. One of the things it looks at is an overview of inflation targeting. It also looks at various factors affecting inflation.

Factors affecting inflation:
- In the year 2000 there was major growth followed by a downturn in the US economy. This put pressure on US interest rates (it rose a few times during the year). South Africa faced a world economy with rising interest rates. This also applied in the Euro area which is significant because SA trades with that area.

- Exchange rates also affect markets. The SARB has no target for the exchange rate but it cannot ignore the exchange rate. The rand declined significantly during the year but this was not unique to SA. It followed the European and the Australian dollar.

- Labour markets also affect the inflation rate but there is no pressure on that level.

The MPR also looks at administered prices. In the year 2000 paraffin went up by 14%. Education and medical care also went up. These are important prices in the economy because if, for example, school fees go up by 14% then people think that inflation is going up by 14%. It affects inflation expectations.

Outlook for inflation - the world economy is expected to decline. It is uncertain whether this will be a sharp decrease followed by a quick recovery.

Inflation forecast - in 2002 inflation should attain 6%. There are uncertainties around this projection but the target of between 6 and 3% in 2002 should be achieved.

Dr D Smal said monetary policy must be forward looking. This means that there must be a forecast. Monetary policy works through the economy over time. This is called ''transmission''. The period for transmission depends on many factors. Although no definite time is set within which this takes place it is internationally accepted that it takes between 12 - 24 months.

The SARB has developed many models to help with the forecast. The models are based on economic theory.

Discussion
Professor Turok (ANC) asked what the experience of other primarily commodity exporting, developing countries like South Africa has been in respect of inflation (in light of the US downturn). He asked if the change in exchange rate had a long-lasting effect on inflation.

Governor Mboweni replied that they try to understand inflationary trends in developing countries. They do not find a country comparable to SA in Africa. They have to look at Asia and Latin America. The question arises why inflation rate cycles in other countries were lower but in SA the rates remained unchanged. SA did not have the luxury of the US or the UK of both low inflation and low interest rates. One must look at the SA situation within the South African context. Generally SA is 1.7% above the target. Once they chose to bring the inflation rate down between 6 and 3% then they must do it. They cannot be careless about it.

Professor Turok also asked for a comment on the social effect of monetary policy adjustments.

Governor Mboweni replied that reducing inflation is good because it improves people's buying power. It is good for job creation and the economic well-being of the country. Fiscal policy actually creates, for example, the clinic. Monetary policy however creates the environment so that one can build the clinic. Monetary policy is good for social development.

Mr Andrew (DP) commented that there has been uncertainty about the accuracy of data. He asked how this impacts upon modeling in SARB.

Governor Mboweni replied that whatever the doubts there are regarding statistics they must start from the point of view that Stats SA's figures are correct. They cannot cast doubt on the figures that they are using. It would mean that their forecasts and projections are just ''shooting in the dark''. One cannot dismiss national statistics. Other statistics that they use are assumptions about international growth rates based on OECD figures. Some figures they get from the National Treasury. It is true that SA must improve on its data collection but no matter how many holes one punches in the data system SA, still has a good statistical base.

Mr Andrew asked why GDP growth for 2000 was lower in SA than what it was in any other developing country. He wanted to know why South Africa performed so poorly.

Governor Mboweni replied that their focus is on inflation and not on growth. The questions on growth must be put to the Treasury.

Dr Rabie (NNP) said that the exchange rate of the rand has declined over the past few weeks. He asked if the Governor forsees that the rand will strengthen because of inflation targeting or will it stay the same.

Governor Mboweni replied that if they pursue the monetary policy without fail then they should see an improvement in the exchange rate. He expects the rand to appreciate because of SARB’s inflation policies. He expects to see some improvement. He noted that irresponsible statements feed the market. A larger measurement of responsibility within the political debate is necessary for the benefit of the economy.

The Chairperson asked what had led to a relaxation of the relationship between the PPI (production price index) and the CPI (consumer price index).

Governor Mboweni replied that the traditional three-month lag between the increase in the PPI and the resultant increase in the CPI has not been seen lately. This could be attributed to various factors. One possibility is that the time lag between the two has strengthened. The effects may still be seen later on. This can be seen in a number of countries. There is an increase in production prices but not a major increase in consumer prices.

Mr Andrew said that businesses say that they cannot absorb further production price increases without passing it on. He asked for a comment.

Governor Mboweni replied that they are not in a position to comment on fiscal policy.

Ms Mahlangu (ANC, Gauteng) asked what the role of SARB was in defending the currency. In the past, the Forward Book was used to do this. Are they defending it now or are they leaving it to the market?

There was an approach of defending the currency. It had benefits and it had costs. The question is whether intervention is a tool that banks must use. This debate is going on. The currency finds its levels in the market. They must be in a position to ask institutions to verify every trade taking place and that it is taking place within South African law. If institutions (example banks) cannot comply then there is a problem. On the whole South African institutions are very responsible.

Presentation by National Treasury on Forward Book
The Deputy Director-General from the National Treasury made the presentation. Mr Masimela from the Macro-Economic Unit in the Treasury was also present. For the presentation, see document).

Discussion
Mr Andrew said that it is a desirable objective to bring down the Forward Book. Ordinary taxpayers are subsidising imports. Why not simply say to the private sector that it is over and Treasury is not doing this anymore. Why should private taxpayers subsidise imports?

The DDG replied that in 1998 SARB told the private sector that they would not be providing any more forward contracts. They have moved the Forward Book down from R 21 billion to R 14 billion. One cannot just step away from it. They no longer provide new forward contracts but it is still on the books. In winding down the NOFP it must be done so that it does not become disruptive to the SA economy.

Mr van Zyl (from the International Relations department within SARB) added that in the absence of forward cover SA companies would have had to borrow domestically. SA does not have the dollars for this, the federal reserve is not big enough. The Forward Book was costly (maybe the cost was a subsidy) but one must remember that the Forward Book has served a purpose.

Professor Turok commented that the rand depreciates and importers depend on a forward contract in order for business to survive. How does this affect SA’s integration into the world economy?

The DDG replied that foreign exchange markets do overshoot. Integration into the world economy is a consequence of globalisation. Matters outside South African borders will affect SA.

Select Committee amendments to the Division of Revenue Bill
The Portfolio Committee agreed to an amendment made by the Select Committee in respect of the Division of Revenue Bill. The word ''unauthorised'' in line 43 has been replaced with ''fruitless and wasteful''.

The meeting was adjourned.

Appendix 1:
South African Reserve Bank
Monetary Policy Review: a summary March 2001

Introduction
In February 2000 an inflation-targeting monetary policy framework was introduced in South Africa. This meant that a target was set for the inflation rate and the objective of the Reserve Bank is to bring the inflation rate in line with this target. The target was set as an inflation rate of between 3 and 6 per cent on average in 2002. At the time when the framework was introduced, the inflation rate was 7 per cent. It then rose gradually to 8,2 per cent in August before beginning to decline. The rate reached 7,6 per cent in December, but in January it rose to 7,7 per cent.

Note that the inflation rate measures the rate at which prices are rising, so when the inflation rate falls it does not mean that prices are falling too. It just means that prices are rising more slowly. It also does not mean that all prices are rising at the same rate. For example, higher oil prices caused transport prices to rise at a fast rate for most of the year before they moderated. Pressure from higher food prices has declined rapidly since August, while medical care and health expenses rose sharply in December and January.

How is monetary policy conducted?
The monetary policy of the Reserve Bank is determined by the Monetary Policy Committee (MPC). The committee analyses the factors that affect inflation, and also considers the forecasts for inflation that are produced by the statistical models of the Bank. These assessments are used when the Bank decides whether to change the monetary policy stance. If the expected inflation is higher than the target, then monetary policy has to be tightened; if lower than the target, policy can be relaxed. If the committee feels that the current stance is right for meeting the target, then monetary policy will remain unchanged.

The Bank conducts monetary policy by controlling the repurchase rate, generally called the repo rate. Banks are required to hold a certain proportion of their deposits at the Reserve Bank. If they are short of funds to meet the required ratio (and they usually are), they borrow from the Reserve Bank by bidding at the daily auction. The interest rate they pay on these borrowed funds is the repo rate. If the Bank decides to tighten monetary policy it will raise the repo rate. Because the banks will then have to pay more for borrowing from the Reserve Bank, they will pass this on to their customers by charging them higher interest rates for borrowing, for example on overdrafts and mortgages. They will also pay depositors higher interest rates. In this way the Reserve Bank influences interest rates generally in the economy.

Monetary policy therefore impacts on inflation through changes in interest rates. If for example higher inflation is caused by higher demand in general, higher interest rates will lessen these demands by making it more expensive for people to borrow money for their purchases. Overdraft, hire purchase and mortagage rates will rise. Higher interest rates also cause investment to fall because they raise the cost of borrowing the money for the investment. At the same time, higher deposit rates encourage people to save. In this way, higher rates will reduce demand and thus reduce the pressure on prices.
The repo rate remained constant between January 2000 and October 2000, when it was raised slightly from 11,75 per cent to 12 per cent. The banks did not increase their rates too because this would have been expensive in terms of administration costs. Banks usually wait for at least a half a percentage point change before they react. So for most of the year, interest rates including home loan rates were stable. The fact that the repo rate did not change much during the year does not mean that the Bank was doing nothing about inflation. It meant that the Bank's opinion was that it would reach its inflation target in 2002 with the prevailing level of interest rates. The Bank assessed the factors that affect inflation to arrive at this opinion. These factors are outlined below to show the reasons for the decisions of the MPC.

Factors affecting inflation
There are external and internal factors that affect South Africa's inflation rate. We first consider the external factors. For most of the year, external pressures tended to push the inflation rate away from the target. Probably the most important factor was the oil price increase. International crude oil prices peaked at around US$35 per barrel in October, after having been below US$10 in 1999. This resulted in a significant rise in the petrol price, and therefore increased measured inflation.

Monetary policy can do little to prevent the rand price of oil from rising as a result of an increase in the imported price of oil. However, there is always the danger that oil price increases may lead to other price increases (called the second-round effects). This happens if wages and other prices also rise in order to compensate for the oil price increase, and in this way cause a more generalised price increase. The focus of monetary policy would be to try to prevent these second-round effects. In other words, the best thing to do would be to raise interest rates under such circumstances.

Another external factor was the exceptionally high growth in the United States. Although this was good for South Africa because it meant that there was a sustained demand for our exports, it also meant that the high demand that was generated in the United States could put upward pressure on inflation in the US. Because of such fears, the US Federal Reserve (the US central bank) raised interest rates on six occasions between June 1999 and May 2000. In addition, inflationary pressure in the euro area, partly a result of the higher oil prices, also kept euro area interest rates high. Euro rates rose on seven occasions between November 1999 and October 2000. UK rates have been stable since February as UK inflation rates were kept below their target range of 2,5 per cent. This upward pressure on world interest rates made it difficult to lower interest rates in South Africa. If our interest rates fall in relation to, say, US rates, then capital might flow out the country. This could cause the rand to weaken against other currencies.

This leads to another important factor, namely the exchange rate. This is the value of the rand compared with foreign currencies such as the US dollar and the British pound. The Reserve Bank does not have a specific target for the exchange rate, but when the rand depreciates, import prices become more expensive. For example, it an imported computer costs US$1000 and the rand per US dollar exchange rate is R7, then the rand cost of the computer would be R7000. If the rand depreciates to R7,50, the same computer, although still the same price in US dollar terms, would now cost R7500. So higher import prices cause higher consumer prices (unless the importers decide to absorb the costs themselves). As in the case of the oil price rise, the Reserve Bank would be concerned that such price increases may involve second-round effects which it would want to try and avoid by raising interest rates.
During the course of 2000, the US dollar was extremely strong which meant that the rand as well as most other currencies were weakening. Although the weaker rand increased the price of imports from the US or those priced in dollars, the rand did not weaken as much against other currencies such as the euro. Our imported inflation from the euro area for example, was fairly low for most of the year.

Sources of pressure on inflation in our country were fairly moderate. One of the important factors influencing inflation is domestic unit labour costs (i.e. the price of each unit of output produced by a company). These costs have been rising at a very low rate and have not put much upward pressure on the inflation rate.

For the first half of the year, overall demand in the economy was quite low. Private sector demand was fairly strong throughout the year, but growth in government consumption expenditure was negative in the earlier part of the year, and investment grew very slowly in the beginning of 2000. So on the demand side there was little pressure on prices, although such pressures may have picked up later on in the year. In addition, the economy was operating at less than full capacity which meant that output could adjust to higher demand without major increases in costs.

In October 2000 the conflict in the Middle East became more intense, and there was a fear that the oil prices could rise further. In addition the value of the rand depreciated more than expected and there were signs that the exchange rate could weaken further as capital continued to flow out of the country. At this stage the MPC was concerned that higher oil prices and higher import prices would cause higher inflation expectations. These expectations might result in higher wage demands and higher prices charged by producers and retailers. As a signal that it would react strongly and decisively if such pressures showed up, the MPC announced a marginal increase in the repo rate from 11,75 per cent to 12 per cent. Because of the small size of the increase, the banks were not expected to raise their rates too, an expectation that proved correct.

Towards the end of the year there was a sudden and significant change in the factors that affected inflation. The oil price had fallen markedly and seemed to have stabilised. In addition there was an unexpectedly large decline in economic growth in the United States. In order to prevent a recession there, the US Federal Reserve lowered interest rates by half a percentage point at the beginning of January and again at the end of January. Central banks in other countries including the United Kingdom, Japan, Canada and Australia followed suit. At the same time inflation remained low in these countries.

In South Africa however, the economy seemed to be picking up. Expenditure (including private and government consumption and investment) was rising, so although inflation pressures were subsiding on the international front, the improvement in our economy meant that domestic pressures were threatening to push inflation up. Given the uncertain outlook, the MPC decided not to change interest rates at its January and March 2001 meetings until the new trends became clearer.

The outlook for inflation
Because there is a fairly long lag between the time monetary policy actions are taken and their impact on inflation, monetary policy has to be forward looking. That is, it needs to react not so much to current inflation trends but to expected inflation developments. It is therefore necessary for the MPC to analyse the expected developments in the factors that determine inflation, in addition to looking at the forecasts of the statistical models of the Bank.

Internationally, developments in the oil price and in the US will be critical. Oil prices are expected to stabilise at current levels, and therefore they may not have the same negative effect on inflation as they did in 2000. The outlook for the United States economy is less certain. Some believe that the US economy will turn around by the middle of the year. Others expect a lengthy recession. But inflation in the US and the rest of the world is not expected to rise significantly and interest rates are expected to remain relatively low.

Our economic growth will be determined largely by the extent and duration of the economic downturn in the US. Although economic growth of over 3 per cent is expected, this growth could be stunted by a prolonged international recession. The general expectation is that although the economy will grow at a faster rate than over the past two years, it is not likely to grow so fast that it will put significant upward pressure on inflation.

Although the MPC does not rely only on the Bank's model, this model does show that inflation is expected to fall low enough over the coming months to reach the target of between 3 and 6 per cent in 2002. Like all forecasts, this is subject to uncertainty because the outlook for many of the inflation determinants simply cannot be known with certainty.