Meeting with South African Reserve Bank Governor

Meeting report

FINANCE PORTFOLIO COMMITTEE
22 SEPTEMBER 2006
MEETING WITH SOUTH AFRICAN RESERVE BANK GOVERNOR

Chairperson:

South African Reserve Bank Presentation on Second Quarter Economic Report
South African Reserve Bank Presentation on Second Quarter Economic Report (with commentary)
South African Reserve Bank Second Quarter Economic Report

SUMMARY
The South African Reserve Bank said that world growth was going to be at 5.1% this year and 4.9% next year. What was of significance here was the slowdown in the US economy from 3.4% to 2.9% next year caused by the downturn in the housing market. There were some inflationary risks evident in the producer price indices. According to the International Monetary Fund, inflation was to remain under control at 3.8% this year and 3.7% next year.

In the domestic economy, quarter on quarter annualised GDP growth in the second quarter was 4.9%, up from 4% in the first quarter. Household consumer demand rose from 7% to 8% so consumers were still going on "spending sprees" especially for durable and semi-durable goods. Employment increased slightly in the first quarter of this year, and over the last four quarters, private sector employment increased 5% and in the public sector by 2.9%.

Since about the 10 May, the Rand had depreciated by about 18% which was a sizeable amount. This had implications for the inflationary outlook. The producer prices had increased by 8.1% in July which was much higher than the rate in previous months. House prices were going up but the rate at which house prices increased was declining. The year on year increase was at about 13% according to the ABSA Housing Price Index which was a significant increase compared to real income increases of 7%.

Governor Mboweni added that it was illogical to stop buying goods from China and expect them to continue buying goods from South Africa. He said it made "no economic sense." It was concerning that households continued to finance their current expenditure through debt. Debt as a percentage of disposable income at 70% was worrying especially since it was climbing and going towards 100%. This may reflect that something was wrong in the lending and borrowing market.

MINUTES
Dr B Kahn, the Senior Deputy Chief Economist of the South African Reserve Bank (SARB) began by outlining some of the international economic developments. According to the Organisation for Economic Cooperation and Development's (OECD) leading indicator, there could be downturn in the economies of OECD countries in the next six to eight months. This was also confirmed by the International Monetary Fund (IMF) Global Economic Outlook. This report said that world growth was going to be at 5.1% this year and 4.9% next year. What was of significance here was the slowdown in the US economy from 3.4% to 2.9% next year caused by the downturn in the housing market.

The emerging markets and developed countries were going to maintain robust rates of growth. It was noticeable that a downturn in the US economy did not have as much effect on other economies as was the case 10 or 15 years ago because of the growing importance of countries like China and India on the global economy. The growth seen this year was despite the rise in the price of oil due to higher inventories and reductions in risk premiums.

There were some inflationary risks evident in the producer price indices. According to the IMF, inflation was to remain under control at 3.8% this year and 3.7% next year. In most of the advanced economies, inflation was to remain low but it was going to be slightly higher in emerging and developing countries with Africa being the only area with double-digit inflation which was caused by a few outliers. Inflation seemed to be contained by tighter monetary controls such as the raising of rates. Notables such as Brazil, Russia, Poland and Mexico had lowered their rates.

In the domestic economy, quarter on quarter annualised GDP growth in the second quarter was 4.9%, up from 4% in the first quarter. Excluding agriculture, GDP growth was actually 5.8%. Overall, the 4.9% annual GDP was not going to be reached. Sectors responsible for most of the growth were in the secondary and tertiary areas. The primary sector exhibited negative growth but mining that was negative in the first was positive in the second quarter where it grew at 3%. Agriculture contracted 18% in the first and 3% in the second quarter so agriculture was the main reason for the decline in the primary sector.

In the secondary sector, manufacturing output was up to 6% from 4.5% in the first quarter. The strongest sub sector was construction at 14%. The tertiary sector continued to grow strongly at 5%. On expenditure, GDP expenditure came down from 14% to 7.4% in the second quarter due to inventory adjustment, but overall final demand, which included inventory adjustment, remained strong. Household consumer demand rose from 7% to 8% so consumers were still going on "spending sprees" especially for durable and semi-durable goods. Part of this higher expenditure was due to higher real income which grew at 7.6%. This resulted in consumer expenditure growth exceeding disposable income growth leading to higher debt levels of about 70% of personal disposable income. This was also fuelled by banks' total loans and advances with a lot of credit extension to the private sector especially mortgage and motor vehicle finance.

Real final consumption by general government rose very strongly in the second quarter due to arms procurement by 16.1%. Gross fixed capital formation by all institutional sectors was growing strongly at 11.3%. This meant that investment as a proportion of GDP was at 18.5%. This figure was rising steadily over the years. For example, three years ago it was at about 15%. The National Savings Ratio rose at about 13.5% which was still lower than the investment ratio. This increase was due to increased savings by the corporate sector.

Employment increased slightly in the first quarter of this year, and over the last four quarters, private sector employment increased 5% and in the public sector by 2.9%. The wages in the non-agricultural sector increased in the first quarter and because of the increased employment, productivity declined which resulted in an overall labour unit cost of 7.6% in the first quarter which was much higher than the 3.4% average for last year. But in manufacturing, unit labour costs remained low with a growth of 0.8%.

In trade, reflecting the strong expenditure in the economy, the trade account deteriorated further in the second quarter. On the services account, payments to non-residents for the net services income and current transfers account improved because of increased inflows. The deficit on this account contracted slightly so the overall current account deficit improved slightly in the second quarter. As a percentage of GDP it improved from 6.4% to 6.1% but this was still a very high level. Real imports increased sharply but exports were fairly flat over the last few quarters but had improved over the last few months. There was a smaller surplus on the financial account which had financed the current account deficit. The bulk of the inflows over the quarter were portfolio flows and net direct investment outflows as a result of South Africans investing abroad.

The net reserves were still positive but they were much lower. The official forex reserves of the SARB had grown at a gradual rate. The gross reserves at the end of August were at R24.4 billion and the international liquidity position was at US $2.9 billion. After being stable for long time over the last year and a half, the Rand came under pressure in May of this year in response to the repricing of the emerging market risk that took place. It came under further pressure in June when the current account figures were published.

Since about 10 May, the Rand had depreciated by about 18% which was a sizeable amount. This had implications for the inflationary outlook. The producer prices had increased by 8.1% in July which was much higher than the rate in previous months. The CPIX inflation was also climbing. The rate in July was 4.9% which was within the inflation target range but there were inflationary risks for the future. The two main drivers of the higher CPIX were food and fuel prices. There was a reduction in the fuel price next month so this would help this situation.

There was a difference between the inflation rates on goods and services. The goods inflation rate had been climbing over the last few months but services prices had fallen to the lower regions of the inflation target range. Because of the risks perceived by the Monetary Policy Committee (MPC), there were two increases in the repo rate. This caused the short term money market rates to rise as well. The market also expected some further interest rates hikes. The long term rates had also responded to the higher repo rates so yields on the long term rates increased also.

Share market activity remained brisk but in May there was a significant decline in the JSE All Share Index but the Morgan Stanley Emerging Market Index showed a decline at the exact same time so the same trend was evident in all of the emerging markets. Foreign holders of South African shares had also seen a sharp decline in the value of their shares. However, since that decline the market had recovered and reached a new all-time high in September. The performance of the JSE was also better than the Standard & Poors Index for the US.

House prices were going up but the rate was declining with the year on year increase at about 13% according to the ABSA Housing Price Index which was a significant increase compared to real income increases of 7%. Fiscal policy was under control and things were in line with projections but more would be revealed in the medium-term budget which was due next month.

In summary, the world economy remained strong but there were some signs of weakness in the US. The oil price had moderated but risks remained and the world inflation remained relatively low in part due to monetary policy tightening. Domestic growth was going to be slightly lower than that achieved last year although there was a good recovery in the manufacturing sector. Domestic expenditure remained buoyant and the current account of the balance of payments remained under pressure and the exchange rates movements reflected these pressures. Net capital inflows allowed for a moderate increase in forex reserves and although CPIX remained in the acceptable range there were some risks of it going up.

Governor Mboweni added that the IMF and World Bank had just completed their talks in Singapore out of which came the World Economic Outlook. It showed a measure of confidence in the world economy growing, but in a subdued way at about 5% which was still a robust level.

There should be pleasure at the fact that three of the countries that South Africa had economic and political ties with (Brazil, India and China), were growing at very impressive levels, which was why any notion of protectionism against any of these countries was ill-advised. Doing so could attract some form of reciprocal protectionism against South Africa. It was illogical to stop buying goods from China and expect them to continue buying goods from South Africa. He said it made "no economic sense." With the current prospects of further growth in China and its greater demand for commodities, South Africa should benefit by exporting to them. This was an emotional issue and was difficult to deal with.

Global inflation was moderating around 4% which was good. In Africa it was going to accelerate from 9.9% to 10.6% which could be attributable to a couple of outliers which distorted the true picture. There should be more talk about the positive attributes and developments on the African continent. There was still uncertainty about the oil price and growth at home remained robust in manufacturing and the tertiary sector.

Growth was more robust in the tertiary sector so more jobs were being created there than in mining and agriculture for example. This meant that a better skilled human resource environment was needed which was a challenge that had to be dealt with by a strategic approach. What was concerning was that households continued to finance their current expenditure through debt. Debt as a percentage of disposable income at 70% was worrying especially since it was climbing and going towards 100%.

This may reflect that something was wrong in the lending and borrowing market. He had tried to communicate to the public that this was going to cause many problems, perhaps in the middle of next year while many houses and cars are being repossessed. Despite this, banks were still lending willingly. This willingness "boggles the mind." Parliamentarians could also play a role in communicating this message to their constituents. Many argued that the situation was not as bad as in the UK or US, but their levels of economic development and sophistication and availability of resources was very different to South Africa’s.

Despite what some people were saying, there was an improvement in employment growth of about 5% over the year. He was very encouraged by the lower growth in unit labour costs which was good for inflation and there was a visible retraction in the quantum of the current account deficit. Capital inflows were also encouraging and they had financed the current account deficit. Inflation remained under control but there were risks of it going up.

Before closing, Mr Mboweni remarked about the disappointing number of committee members in attendance. He said that he put in lot of effort getting to these meetings, including waking up at 4h00 in the morning to make it to Cape Town in time, but it seemed as though some of the Members of the Committee did not appreciate this. Some simply did not attend the meetings, while others arrived late.

Discussion
Mr K Moloto (ANC) said that there had been an article in the FinWeek magazine that claimed that interest rates were a blunt instrument in trying to bring down inflation. What was the Governor’s reaction to this statement? What were the winter electricity tariffs he referred to in the statement he made on 3 August?

Dr Van Dyk (DA) asked if investor confidence would be affected by the case against Jacob Zuma being dropped. Taking into account the flexibility of fuel prices, why was there a need to increase interest rates? Other methods could be used to reduce inflation so why were they not being used?

Governor Mboweni replied that monetary policy had to be forward-looking and aimed at containing inflation expectations. Part of the arsenal of instruments available to the central bank in combating inflation was the containment of inflation expectations. These expectations were anchored at or around the inflation targets. The prices and wage formation processes may begin to gravitate in that direction, and if they did; it meant victory in the war against inflation. So in their meetings, they assessed closely what the expectations were. He said that it was also a pity that the trade union movement did not participate in the SARB’s inflation expectation survey. This survey was a very important input to the MPC. They just did not reply to invitations.

The SARB also looked at the break-even inflation rate which was the difference between the inflation linked bond rates and the long term government bond rate. This gave them an indication of what the market’s expectorants were of inflation. Then they looked at the yield curve of the term structure of the bonds or debt.

The SARB was not bound by the expectations however. It was but one of the factors that the MPC looked at. They were convinced that some of the actions they had instituted had assisted towards the curtailment of inflation.

A monetary regime that emphasised things like credit limits or other quantitative limits (as in Zimbabwe) simply did not work. In an open and competitive and normal economy, monetary policy was effective through interest rates. Interest rates made people think about their activities and the consequences of their actions. They made the cost of borrowing higher which should make people adjust their behaviour. There were also other macro-economic adjustment processes such as exchange rate and share market movements. These all had an effect on inflation.

With regards to the winter electricity tariffs, Dr Kahn said that Eskom had different prices for winter and summer. The higher tariffs were applied between June and September so they were not a permanent part of the Producer Price Index (PPI) but they were reflected in the PPI.

Governor Mboweni said he could not answer the question regarding Jacob Zuma.

Mr I Davidson (DA) asked what the core inflation rate was. Did it include food and fuel and what was the sensitivity of the inflation rate to food and fuel? Why was there not a greater emphasis on productivity, and what impact would the new textile quotas have on inflation especially as the prices of clothes had been going down by 7.6% year on year?

Governor Mboweni replied that this question was influenced by the differences among central banks about which inflation rate to target. The US paid a lot of attention to the core inflation rate while the Bank of England targeted CPI where they did not consider mortgage costs. These other measures were too complicated for South Africa so here the CPIX was used as it could be understood by the public.

There was a debate in the world’s central banks (excluding the US) about the usefulness of core inflation and the way it was calculated. Some countries could "calculate their problems away" where all the volatile elements in the inflation rate were removed leaving a "tame" rate that could lead to the wrong monetary policy decisions being made. South Africa was of the view that it was prudent to adjust monetary policy now to influence future outcomes.

He said he had been following the discussion about textile quotas very carefully and he admitted that he did not really understand it. Since 1994 South Africa had been trying to make the textile industry competitive. Nothing had worked since then, so imposing short-term quotas to try to make a difference would not work. He "wished them well" and hoped he was wrong. It was wrong to focus only on China. If quotas were going to be imposed, then they would have to be applied to Thailand and Malaysia and other countries in the East.

Mr B Mnguni (ANC) asked if the SARB had any strategies to keep inflation within the target range given the fact that wages were going up while productivity was going down.

Governor Mboweni replied that despite the strong demand and the adjustments to wages, the SARB was not too concerned about the effect these things would have on inflation.

Mr M Johnson (ANC) commented that he was not happy with the way that the Governor had referred to some of the Members being late or absent. They respected him and appreciated his efforts. He himself had arrived late for this meeting because he had been in another meeting. Some of these issues should have been resolved outside of the meeting.

Governor Mboweni conceded that the matter could have been brought up in a better way but he said he did so to spark debate. He thought that issues about the scheduling of Committees had been dealt with long ago. He would talk to the Speaker and the Chief Whips about this if he got the opportunity.

The meeting was adjourned.