South African Reserve Bank (SARB) 2007 Annual Economic Report

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Finance Standing Committee

13 November 2007
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Meeting report

FINANCE PORTFOLIO COMMITTEE
14 November 2007
SOUTH AFRICAN RESERVE BANK (SARB) 2007 ANNUAL ECONOMIC REPORT

Chairperson:
Mr N Nene (ANC)

Documents handed out:
Annual Economic Report 2007
Monetary Policy Review
South African Reserve Bank Annual Economic Report and Monetary Policy Review

Audio recording of meeting

SUMMARY
The Governor of the Reserve Bank and its Head of Research presented the Annual Economic Report and the Monetary Policy Review to the Finance Portfolio Committee. A main issue was that the inflation rate had been above the target range for six months. 

The reports looked at long and short term trends within the South African economy. SARB and the Committee discussed economic growth, consumer spending, debt levels and factors influencing inflation.

Members focused on the issues regarding Headline CPI and the CPIX, specifically looking at food and energy prices and how they affected inflation. The Governor reassured the Committee that while inflation and interest rates were high, economic growth was still positive.

Members and the Governor also addressed the SA bond markets, relationships with other markets, actions to be taken with regard to high inflation and the relation between interest rates of banks and the repo rate.

The Governor informed members that the international environment was fairly favourable, and that a contractionary Monetary Policy had been implemented but that it would take some time to show the effects. He also stated that consumption expenditure had slowed and that SA’s growth performance was strong and consistent. 

MINUTES
The Chairperson welcomed Mr Tito Mboweni (Governor of the Reserve Bank) and Mr Johan van den Heever (Head: Research Department for SARB).

Mr Mboweni stated that he was pleased to be interacting with the Committee as this was a crucial time for him. He informed members that he was in the process of consolidating his relationship with pensioners. The Governor said that he was there to discuss the Annual Economic Report with the Committee as well as the Monetary Policy Review which was the latest report from the bank that showed what has happened in the economy. Mr Mboweni reported that the Monetary Policy Committee (MPC) was traveling around the country having discussions about the Monetary Policy Review. The MPC was explaining why the cost of borrowing has tightened.

The Annual Economic Report: presentation
Mr van den Heever presented the Annual Economic Report for 2007 that looked at the broad economic context within which South African Monetary Policy was conducted and looked at longer term trends.

He stated that the report showed a few exceptional record levels which made the current period quite an exciting time, not just for South Africa but also for the world economy. For the world economy, real economic growth was good as it had been positive for the past three years. Also, growth rates for most countries have been consistent, the range of growth rates have narrowed which helped toward a smoother world economy as things developed.

With regard to inflation, Mr van den Heever reminded members that the world had suffered because of high inflation in the 80s and 90s. He reported that world inflation, presently, was quite low and that there were very few outliers.

Mr van den Heever said that SA had had four years of consistent growth at about 5% per annum in real terms. The result has been an improvement in living standards as well as momentum, and an increase in capacity utilisation in manufacturing and in the economy overall which then resulted in more fixed investment.

The Head of the SARB Research Department stated that over the past four years, domestic expenditure was stronger than domestic production. South Africans bought more than they produced. The result was a balance of payments deficit on the current account. Mr van den Heever said, however, that there has been moderation in consumption expenditure. He also warned that growth in consumption expenditure was still high. Because of high consumption expenditure, there was an accumulation of household debt and the debt service cost ratio has increased. The household debt ratio was at an all time high but the debt service cost had not exceeded the highest record so it was not an excessively burdensome debt service cost.

Mr Mboweni noted that when interest rates were high during the period 1998-2001, household debt as a percentage of household income decreased. Since 2002, when interest rates lowered, there was an increase in household debt as a percentage of disposable income. He said that households should have been paying their debt and not increasing it as interest rates decreased. People took on more debt because interest rates were lower. Mr Mboweni warned that this was wrong as people should have paid off debt instead of accumulating more. It was a human phenomenon that when money was cheap, more debt was taken on.

Mr van den Heever discussed fixed capital formation/fixed investment saying that it was at quite a high level. It was a sign that full capacity was in reach and it showed confidence in the economy by both households and businesses.  The public sector fixed capital programs were progressing and the private sector was also doing well.

Mr van den Heever addresses the balance of payments deficit again. He reassured the Committee that South Africa was not the only one, as the USA was also experiencing a large deficit. South Africa was importing more than it was exporting. Even though the prices of commodity exports had increased favourably, the volumes of production and exports of commodities did not increase as strongly. Nevertheless, quantities had risen and prices were good and this helped support the export proceeds. But, given the strong boom in consumption and investment, import consumption was strong because South Africa imported most of the consumer goods and investment (capital) goods and therefore import volumes and ratios have risen. This has been financed by attracting money from abroad. Foreign debt increased mainly due to portfolio investment. Foreigners have invested in the bond market and this has brought money into the country. Because foreign debt levels have increased, the interest on foreign debt has increased.

In terms of trade, export prices have increased more than import prices. All in all, South Africa has benefited from price effects and trade has been favourable. Prices for platinum and gold were good as well. According to Mr van den Heever, this benefited SA’s living standards. He added that the country made more money through the financial account than the current account. This meant that more money was flowing in to the country through the financial account than flowing out through the current account. The result was that SARB was able to add to its foreign exchange reserves.

Mr van den Heever added that South African share prices had set new record levels for the past three years. Share prices have gone to extremely favourable levels which resulted in positive wealth effects for owners of shares. Mr van den Heever noted that house prices increased despite the increase in interest levels.

Monetary Policy Review: presentation
Mr van den Heever announced that the monetary review was in a shorter term context and spanned over the past six months. Inflation rates were above the target level. This contributed to additional pressure on monetary policy. According to Mr van den Heever, the pressure originated from exogenous forces, it came from forces outside the short term control of the SA authorities. Pressures consisted of unfavourable oil prices and shocks from food prices which was not entirely unrelated to oil prices. The breach of the inflation target was of concern to SARB and the mandate remained, which was to get inflation within the target range.

Mr van den Heever informed members that even though there was volatility, there were signs that the South African economy was responding to changes made to the monetary policy stance. He warned that the Committee should be mindful of the time lags in monetary policy; it usually took 12 to 24 months for impacts to be felt.

The Head of Research discussed recent developments in inflation. CPIX inflation was currently in unfavourable territory and that Headline CPI inflation was slightly higher. Headline inflation included interest on mortgage bonds. He added that headline CPI inflation was slightly higher than CPIX inflation because of the increase in interest rates. Food prices played a significant role in pushing CPIX inflation up. Food price inflation was strongest in vegetables and grain products as grain products were related to biofuel programs around the world where grain was used as a substitute for oil and petroleum. This had impacted on wholesale as well as retail prices of food.

Mr Mboweni told members that the relation between CPIX and food inflation was very important. The Governor expressed concern at reports of bread prices being fixed. It was a very serious problem and such tendencies should be checked.

Mr van den Heever added that maize had been under produced and thus the price had moved up to import parity which was quite a bit higher than export parity.

He then discussed the contributions to CPIX inflation. Most contributions came from food and housing costs, specifically the administrative components such as rates and levies by municipalities. Mr van den Heever announced that transport, fuel and power year on year increases were satisfactory but that price levels for petrol were high. He looked at production price inflation. Following the decrease in the exchange rate, many prices increased but recently inflation decreased again because of the exchange rate and a number of other reasons, including the price of petroleum products.

Mr van den Heever reviewed the factors affecting inflation. If world demand was robust and strong, then it created an environment where output gaps were smaller and risks of inflation danger was greater. He added that economic growth for 2007 was still strong. World inflation, excluding Zimbabwe, was modest with very few outliers.

The Head of Research informed the Committee that monetary policy in the rest of the world was mixed. More countries were increasing interest rates than decreasing interest rates.

Another driver of inflation was the exchange rate. In May 2006, the Rand exceeded quite a bit, it declined by roughly 20% which meant import prices were higher resulting in higher inflation.

With regard to expenditure, household consumption expenditure was still growing but less strongly than before. Fixed capital formation was still strong on the demand side which was good because it added to future capacity. Exports were also growing in real terms whereas imports had receded slightly. Share prices were also quite strong. The only part that was growing slowly was the circulation of notes and coins. Mr van den Heever explained that M3 was the broad money supply that included coins in the hands of the public plus all deposits from households and South African companies with the South African banking centre. M2 looked at short term deposits and was a shorter term version of money supply. M1 was notes and coins as well as cheque deposits with up to 24 hours notice. When one looked at all of them, then one could see fairly rapid money supply growth.

Mr van den Heever considered monetary policy. He informed members that there was a change in the monetary policy stance over the past six months. There were changes in the Repo Rate as well as the Prime Overdraft Rate. The MPC was always focused on getting the inflation rate within the target rate. Mr van den Heever reminded members of the lag between monetary policy changes and inflationary reactions to changes. He said that the MPC could not just react to the latest changes; adjustments would also have to be taken in to account.

The domestic outlook looked good. The aim was for domestic growth to remain robust. It was forecast that there would be relatively favourable growth prospects for 2008 and 2009. Consumer and business confidence moderated during the year but were still looking very strong. Mr van den Heever stated that expectations for inflation were that it would stay below the 6% mark in 2008. The Bank’s CPIX inflation forecast said that inflation would rise in 2007 but would taper off in 2008 and 2009. He warned that there was uncertainty around the values as the tools used in economics were not perfect, however, the best estimates were given. Mr van den Heever noted that the model on which the forecasts were based was published in the interest of transparency.

To conclude, from a monetary policy perspective, the past six months had been both exciting and challenging. Inflation had deteriorated somewhat despite the tighter monetary policy stance and a moderation in consumption expenditure. The outlook on monetary policy would depend, to quite a degree, on whether the signs of moderation would be sustained and sufficient enough to bring about the desired inflation outcome. The main focus would be on getting inflation back to within the inflation target range.

Mr Mboweni said that he wanted to highlight a few points. He stated that despite current difficulties, the global economy was still strong. Given strong growth in China and India, there were strong expectations for global growth. For Central Bankers, the inflation outlook was still positive despite the persistently high oil price. This gave an indication of the thought process of Central Banks. The Governor said that they would be thinking about how to deal with exogenous shocks.

The Governor stated that they were encouraged by the economic performance of Africa in general and the major changes that took place on the continent. Inflation rates had been decreasing, although Zimbabwe would have to be excluded from that observation as their economy was a total disaster. The key issue for Africa was to sort out the infrastructural backlogs and basic services such as education and having clean drinking water.

Mr Mboweni said that inflation pressures were on the upside for South Africa, specifically from electricity and food industries. The outlook showed that inflation was likely to stay above the target range until the middle of 2008. The task of the Central Bank was to tighten monetary policy, not to loosen it. The Governor suggested that rates be increased in December. The Government decided on the inflation target, it was just his duty to implement it.

According to Mr Mboweni, the South African economy was still very robust and was growing above potential; therefore there were many supply constraints. He told members that he noticed that an Eskom delegation had come to Parliament. The Governor thought that they had gotten off lightly as the increased tariffs had a negative impact on inflation which would cause them to tighten monetary policy even further. He suggested that Eskom raise funds through the Treasury or by issuing bonds in the market.

Discussion
Mr B Mnguni (ANC) noted that there was an increase in the issuing of bonds by the corporate sector. He wanted to know what risk this posed to stability. The second question centered on the oil price. Mr Mnguni predicted that the oil price would be double the current price in five years time. He wanted to know what the Reserve Banks strategy would be to cap inflation. He also discussed SASOL saying that they were producing very little fuel from coal. He wanted to know how SASOL could play a role in reducing inflation.

Mr M Mbili (ANC) wanted to know the underlying reasons for the sharp increases in the oil price. He understood that there were tensions between Nigeria and the Middle East and he wanted Mr Mboweni to expand on that. He noted that the high interest rates did not deter consumers from spending and that it was unfortunate as it placed enormous pressure on the poor. He asked if there was an alternative instrument or mechanism to fight inflation besides using the interest rate.

Mr S Marais (DA) touched on factors that influenced inflation negatively. He compared international trends of interest rates and inflation and noted that with respect to SA’s competing emerging markets in Africa and India, that SA was not far off in terms of inflation. However, SA’s interest rates were very high. He was concerned that the high interest rates attracted enough Portfolio Investment but Foreign Direct Investment (FDI) was what was needed as it was a more sustainable way of funding the balance of payments deficit. Mr Marais stated that he did not think that the problem was being addressed properly.

In terms of growth in loans and advances, Mr Marais reminded the Committee that when interest rates were low then banks’ accumulated profits were also low and this instigated banks to get people to borrow more money so profits could increase. Mr Marais said that this was a vicious cycle and he wanted to know to know how they could address the issue.

Mr Mboweni responded to the issue of risks to financial stability through the issuing of bonds. The Governor said that he did not see any problem with it.  He stated that we were lucky that South Africa had a growing bond market as it encouraged growth and depth. He added that he would encourage Eskom to join the market.

The Governor agreed that the oil price could double in five years. However, he was of the opinion that the oil price could be half the current price in five years. Mr Mboweni added that he thought it would be bad business for SASOL to charge a domestic price for fuel instead of a global price. He said that they were competing in the market with global companies so they had to charge global prices. The notion of domestic pricing would not work as well as the notion that the Government should fix prices. Mr Mboweni advised that they stay with competitive pricing.

Mr Mboweni said that when the market felt that there were supply disruptions from one country or another caused by conflict, then supply and demand conditions came in to play. So if supply was short and demand was high then the prices would be high. Difficulties arose with local agents and activists who were threatening the supply of Nigerian oil. This was an area of concern to the oil markets as the supply of oil from Nigeria was no longer guaranteed.

Mr Mboweni also touched on the tensions between some western countries and Iran. He wondered whether Iranian oil would still reach the market if there was conflict and what the implications would be for oil prices if it did not. There was lots of speculation but there was very little that South Africa could do as one lived by the dictates of the global economy.

Mr Mboweni then replied to the question on whether there were other tools to use for inflation beside the interest rates. He said that he wanted to make a technical differentiation between consumer spending and what could be done about it and then overall inflation and what monetary policy could do about it. He stated that the focus of monetary policy was not on consumer spending, it was on the overall inflation outcome which could be influenced by consumer spending, oil and food prices. If the overall outcome showed that they had to tighten monetary policy, then they would. Regrettably, there were no other tools that they could use in monetary policy; the only tool to be used for monetary policy purposes was the interest rate. The Governor said that Open Market Operations (OMO) was only a mechanism used for implementing interest rates and reserve requirements were only a way of making banks short of cash which would lead them to charge higher interest rates if people borrowed from them. Thus there was no other tool.

Mr Mboweni commented on the statement that South African interest rates were higher than the competing emerging markets. He pointed out that interest rates in Russia were much higher than SA’s. The interest rate in Brazil was also higher that SA’s even if their inflation was slightly lower. Even though interest rates in India were much lower than SA’s, their inflation was much higher.

The Governor then concentrated on what SA should be doing. He stated that SA’s inflation target was 3-6%. It should be stated as 6-3% and not 3-6% to indicate a declining trend instead of an increasing trend. This would mean that monetary policy could be much more accommodating and it would be easier for people to access credit. If the outlook was that they would be outside the target, then the MPC could tighten monetary policy. There had been times when the interest rate was raised and there was an outflow of capital. There were also times when the interest rate was maintained and there was an inflow of capital.

Mr Mboweni warned the Committee about something that he thought was very dangerous. He told members that there were come commercial banks that were going to pensioners saying that they wanted to help them raise their standard of living. The idea was to use the pensioners’ house as collateral for cash that they could spend monthly. This gives the bank the ability to take the house and sell it. He stated that this should be discouraged and dealt with from a regulatory point of view.

Mr N Singh (IFP) thanked the Governor for his comments about the electricity price increase and the impact that the tariffs would have on the consumer and inflation. He also thanked him for his comments on food prices and the suggestion that the Competition Commission needed to look at products other than bread.

Mr Singh noted that when the repo rate went up or down, the “Big Four” banks operated independently of each other. He wanted to know if it was necessary for all the banks to increase their rates when the repo rate increased or decrease rates when the repo rate decreased. He wondered if this was a cartel that was operating and what the reasons were for this move. The consumer paid the price and wanted to know what intervention could occur.

He also touched on real estate. It was the middle to upper class that were using their assets to borrow and it was having an impact on consumption expenditure. The poor were paying the price for the middle and upper class spending more on luxury goods. This was a major problem as the majority of people in the country were poor. He asked the Governor to comment further on the biofuel industry as he knew that alternative energy sources were needed but that it was impacting on food inflation. He wanted to know how it could be balanced.

Mr M Johnson (ANC) commented on issues of low interest rates and increased debt. He said that the reality of the situation was that when rates decreased, a number of people especially the middle class jumped at the opportunity. He noted that many houses and cars were being repossessed, specifically within the middle to upper classes. Mr Johnson asked the Governor to comment as wondered what the impact was on the inflation rate.

Mr Mboweni said that he wanted to deal with the issue of underlying inflation. He wanted the Committee to note that the CPIX was on the upside when energy and food prices were excluded. The CPIX was still above the inflation target range when both underlying pressures were excluded.

The Governor reminded the Committee that Stats SA was in the process of renewing the CPIX basket. He agreed that renewing the basket was good as older, out of date commodities had to be excluded. The CPIX basket had to move with the times.

Mr Mboweni stated that one of the best things that had happened in the world was the growth of the middle class. This occurrence took place in SA, China, Brazil, India and other parts of Latin America and Africa. Middle class growth has led to additional pressure on the supply of certain types of food.

Mr Mboweni said that the monetary policy lag was usually 18 to 24 months so the impacts of a decision made today would most likely be felt almost two years later. The process would impact on change in behaviour, substitution effect, capital markets and prices. The Governor focused on whether actions taken so far had impacted on the economy. One would have to look at whether the CPIX would return to within the target range and at which period it would happen. The probability distribution told them that the probability of the CPIX returning to the target range by the end of the year was 1% and that there was a 60% chance that it would return to within target by the second half of 2008.

The Governor said that new economic possibilities had emerged with the result that new businesses had emerged as well. He noted that people were paying off their cars quicker than their houses. It was odd that people paid off their cars before their houses as houses were assets that grew in value over time. Mr Mboweni thought that houses should be paid off first.

Mr Mboweni responded to the question of why the banks increased their rates when the repo rate increased. The logic was that they were all charged the same amount when they came to the Central Bank so they get compensation from the people that borrowed from them.  In reality there were competitive interest rates but most people were paying prime minus two. It was unfortunate that the poor were always paying more. They were charged prime plus and additional amount. He had discussed with banks that they should always have a margin of 3% with the repo rate but the issue had never been resolved.

He addressed the real estate market saying that he was sure that members were very concerned about the issue. Mr Mboweni thought that the Minister of Agriculture should have been very concerned by it as agricultural lands were being turned into housing estates. He worried about food production and warned members that they should be very careful about the future.

The Governor discussed biofuel. He said that for developing countries, the use of maize and corn as an input into the biofuel production would have a negative impact in terms of food prices. He suggested that sugar cane be used. Sugar cane could be bought from Cuba.

Mr Mboweni addressed the issue of repossession of houses by banks. The Governor suggested that if people defaulted on mortgage repayment, then the banks should take in to account previous payments. People should be given a chance to move i to houses that they could afford, instead of being thrown out on to the streets.

The Chairperson noted that the current business cycle was the longest that SA had experienced and  that upswings did not last forever. He wanted to know what the Governor anticipated in terms of negative impacts. He asked if unfavourable weather conditions had impacted on the high production prices for domestic agricultural food. Looking at consumer price inflation, he said that the difference in percentage change between headline CPI and CPIX looked quite erratic. He asked for an explanation.

Mr K Moloto (ANC) commented that it was being said that SA bond markets were more lucrative than most developed countries bond markets. He asked the Governor what it was that made SA’s bond market more lucrative.

Mr S Asiya (ANC) stated that the government was supposed to commission research on the issue of the food production in SA. He said that the issue of global warming should be addressed as farmers, especially in the Northern Cape were starting to redefine their role in farming. Mr Asiya also looked at the comparison of SA’s inflation target with reference to other countries in Africa. He asked if it was a fair analysis as other countries depended on loans. Also, are they trying to cap the flow of counterfeit money?

Ms N Mokoto (ANC) wanted to know what the Governor’s view was in terms of actions that could be taken by Government to ensure that while inflation existed, the poor were still able to live properly. She also enquired about the US economy wanting to know if the sluggish growth in the US economy was a deliberate move by the US government to deal with other internal issues that people were not aware of. Ms Mokoto asked if the Reserve Bank thought that there was any threat to the international liquidity position of South Africa.

Mr Mboweni agreed that the business cycle expansion was the longest one experienced in SA -  the longest upward trend in a business cycle. Part of the explanation was that SA had come out of a closed economy and had become a more open economy with the result that business confidence has shown quite a positive trend. He warned that it would not last forever as business cycles went up and down.

The Governor addressed agricultural production saying there was no doubt that agriculture’s contribution to GDP had decreased. People needed to be aware of this as the country had lost a lot of agricultural skills and this was unfortunate as agriculture was a large industry. Something would have to be done about it. The Government needed to protect agricultural land, train people and ensure that basic resources were provided. The potential for agriculture had to be increased as it would contribute to employment.

Mr Mboweni agreed that Headline CPI and CPIX were erratic. They needed to look at the Core Inflation rate. To do this, they would need to remove food and energy as well as some other elements. The CPI was largely influenced by the interest rate. If the interest rate decreased, then the CPI was likely to decrease as well.

The Governor stated that SA had a very strong financial market structure as it was driven by policy decisions and the process of growing the capital market. SA had a significant government bond and corporate bond market. He thought that it was important for parastatals to be involved in the bond market.

Mr Mboweni looked at inflation in Africa. He said that Africa had seen some major economic achievements. He added that the poor suffered most when inflation was high while the rich barely felt it. Also, when inflation increased, then pensions became meaningless. Thus low inflation was good for the working class. The Governor stated that when inflation was sorted out, the poor would benefit.

According to the Governor, the sluggish movement of the US economic growth was not deliberate. He stated that it could be the timing of interest rate movements and the behavior of the global economy. The strong dollar could also have impacted on US exports.

With regard to liquidity issues for SA, only one bank had announced that it would have to write off a certain amount of money because of their exposure to sub prime issues. Mr Mboweni thought that the SA banking sector was fairly safe as there was no major liquidity exposure to the sub prime. He hoped to persuade the MPC to tighten the monetary policy stance.

The Chairperson announced that the Committee was out of time and thanked the Governor for the report.

The meeting was adjourned. 

 

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