Brian Kantor is one of the most respected and long serving South African economists. He has been employed at Investec since 2001 but prior to that was the founding chairman of the Victoria and Alfred Waterfront, leading that company and the redevelopment of Cape Town Waterfont from 1988 to 2001. Kantor has been a professor of Economics at the University of Cape Town since 1981, and served as Dean of the Commerce Faculty from 1997 to 2001. In the article below Kantor questions the South African Reserve Bank’s narrative on inflation and interest rates and says the Bank should rather take into account economic realities when making monetary policy decisions. In his research Kantor says that if inflation in say two years cannot be predicted with any degree of accuracy or conviction, as would appear obvious given all the unknowns that could impact on consumer prices over any 24 month period, then one can have little confidence that monetary policy and changes in the repo rate will help realise some narrowly targeted rate of inflation. A fascinating read ahead of the local Monetary Policy decision due next week. – Stuart Lowman
By Brian Kantor*
The Reserve Bank needs to change the narrative on inflation and interest rates to take full account of the economic realities
The rand exchange rate since 1995 has proven to be anything but predictable. Despite this, with the help of hindsight it is possible to explain why the rand has behaved as it has over the years. It can be shown that, since 2014, it has been more a case of US dollar strength, against almost all currencies, than rand weakness that explains the rand/dollar exchange rate. In recent weeks the rand has also weakened against the euro, again also in line with almost all other emerging market currencies.
Explaining dollar strength is an art form all of its own. It has much to do with the superior performance of the US economy over the past few years, allowing US interest rates at the long end of the yield curve to rise relatively to rates prevailing in Europe and Japan. The strength of the US recovery has also led the money market to believe that short monetary policy determined rates in the US are soon about to rise – adding to the demand for US dollars.
A consistently important influence on the foreign exchange value of the rand is the state of global capital markets. When global allocators of capital feel more secure about the state of the global economy, they favour riskier assets and riskier currencies. And vice versa: when caution rules, funds flow in the opposite direction to safer havens. The rand as a well traded emerging market currency (as well as rand denominated bonds and equities) falls into the category of one of the more risky, that is volatile, currencies and markets, as do most other emerging markets (EM) currencies. Currency moves associated with the Global Financial Crisis (GFC) of 2008-09, shown in the figure above, illustrate the vulnerability of the rand to such events.
It is possible to measure such risks in the bond markets. Measures in the form of a wider or narrower interest rate spread between South African or other EM debt can help identify the degree of risk aversion or appetite prevailing in the global capital markets. RSA and other EM US dollar-denominated debt trades at higher yields than US Treasury Bonds. These higher yields compensate investors for the risk that the debt issued in US dollar may not be honoured.
Foreign investors may also hold local currency denominated debt, for example rand debt, and so receive interest income in rands and other local currencies rather than dollars. Since the local central banks print their own currency and as much as they choose, there is no danger of any formal default on such debt, only that they may lose some of their US dollar value should inflation accelerate. The risk to these offshore investors holding local currency denominated securities is that the guaranteed interest income paid in a local currency will lose dollar value should the higher interest currency depreciate over time. The higher interest rates on rand-denominated debt compensate investors for expected rand weakness. The equilibrium and relationship between the difference in the interest rate for securities of the same duration and risk class and the contemporaneous percentage difference between spot and forward exchange rates is known as interest parity. Arbitrage maintains this relationship.
It can be demonstrated that the spot rand will generally weaken as these interest rate spreads widen – and vice versa when the spreads narrow. In the figure below we show two measures of SA risk: exchange rate risk and sovereign or default risk. The yield spread between RSA 10 year bonds and US Treasury bonds of the same duration is shown on the left hand scale while the cost of insuring RSA dollar debt of five years duration against default, known as the Collateralised Debt Security (CDS) spread issued by global banks, is shown on the right hand scale. Higher spreads of either kind are generally associated with rand weakness and vice versa for rand strength. It may be noticed how these spreads widened dramatically in 2008. Both spreads have moved in a narrower band since 2010 while the CDS spread fell back towards about 200bps.
It is possible to identify risks of default associated more specifically with SA rather than with EM bonds generally by comparing the CDS spread for RSA bonds with the spreads attached to all other EM debt, as estimated by JPMorgan. As may be seen in the figures below, SA risk and EM risk measures are highly correlated over time, indicating very similar forces at work. A wider difference between the EM Index spread and the RSA CDS spread, indicates a more favourable relative status for SA and vice versa. It may be noticed that this difference narrowed after August 2012 indicating a deterioration in RSA credit rating. However it may also be seen that the credit standing of SA has improved relative to other EM debt over the past year. Russia, Brazil, Turkey, Malaysia and Indonesia have all been making heavy recent weather of their connections to global finance. It may also be noticed that SA’s relative standing in the debt markets deteriorated before the GFC, as the repo rate increased and then improved in a relative sense compared to the EM average during and after the global crisis.
The rand may however also weaken or strengthen in response to perceptions of SA specific risks, independently of developments in global markets. Political and economic developments in SA may cause the market to sell or buy rand-denominated securities, leading to wider or narrower spreads or for the debt rating agencies to change their credit ratings.
The unrest and violence at the Marikana platinum mine in August 2012 was one such unfortunate SA event that weakened the rand against all currencies, including other emerging market currencies. It can be shown that the rand has traded off the weaker post-Marikana base ever since; though much of the direction of the rand exchange rate since can be explained by global rather than further SA influences.
Economic theory suggests that a primary influence on the exchange value of a currency is the difference between the rate of inflation in the home currency and inflation experienced by its trading partners. The exchange rate is expected, in theory, to move to compensate for these differences in inflation in order to maintain global competitiveness for producers and distributors in both the domestic and foreign markets. What is lost or gained by relatively fast or slow inflation of prices and costs, is expected to be offset by compensating movements in the exchange rate, thus maintaining Purchasing Power Parity (PPP). Unfortunately for the theory and the SA economy, PPP can contribute very little to any explanation of the exchange value of the rand since 1995.
It is the capital account rather than the trade account of the SA balance of payments (BOP) that has dominated the rand exchange rate ever since the capital account was integrated with the trade account of the BOP in 1995. The figure below makes the point very clearly. The difference between the theoretical PPP equivalent rand and the market rand makes for the real rand exchange. It is the deviation from PPP that makes a real difference to exporters and importers. A weak real rand makes exports more profitable and imports more expensive. According to Reserve Bank estimates, the real trade weighted rand is now about 20% weaker than its PPP equivalent and 10% weaker against the US dollar according to our own calculations, using comparative CPIs in SA and the US to infer the theoretical PPP USD/ZAR exchange rate.
The reality is that the highly unpredictable exchange rate leads changes in the SA CPI. Currency depreciation does not accompany or follow changes in the CPI as PPP theory would presume, it tends rather to lead inflation. How much inflation will actually follow a weaker rand will also depend on the underlying trends in the global commodity markets. Also important for subsequent inflation will be the impact of changes in tax rates and administered prices, also hard to predict.
As we show below, there is a highly variable relationship between changes in import prices and consumer prices in SA, even as changes in import prices tending to lead changes in headline inflation, the lags are also variable. Hence to forecast inflation in SA, with any degree of accuracy or conviction, would require not only an accurate prediction of the essentially unpredictable exchange rate, but also of the almost equally difficult to predict pass through effect of a weaker rand on the CPI. Import price inflation is now running well below headline inflation, so helping to contain the inflation impact of the weaker rand.
If inflation in SA in say two years cannot be predicted with any degree of accuracy or conviction, as would appear obvious given all the unknowns that could impact on consumer prices over any 24 month period, then one can have little confidence that monetary policy and changes in the repo rate will help realise some narrowly targeted rate of inflation. The fan charts of the Reserve Bank published in its 2015 Monetary Policy Review that indicate the possible inflation outcomes, confirm the difficulty in forecasting inflation with any confidence. The chart below shows that there is a 90% chance of inflation in SA in 2017 being somewhere between 3% and 10%.
In practice in these unpredictable circumstances, all the Reserve Bank can do is react to inflation, rather than anticipate inflation and act appropriately to help stabilise inflation and the economy. In reacting to realised inflation by raising its repo rate when inflation is accelerating, the Reserve Bank has a further problem. The impact of interest rate changes on the rand is itself unpredictable. The impact of higher interest rates on the exchange value of the rand is as likely to weaken as strengthen the rand. Higher interest rates, if they are regarded as likely to slow down the economy, may well imply lower returns to capital and discourage capital inflows. If this turns out to be the case, higher interest rates may well be associated with more inflation.
However what can be predicted with conviction is that higher interest rates will suppress spending and reduce the rate of economic growth. Hence it is possible that higher interest rates will lead to no less inflation and perhaps lead to more inflation, given what might subsequently happen to the rand, and could be accompanied by slower growth.
The policy implication of the unpredictable rand and inflation is that the Reserve Bank should only react to inflation when prices are rising because domestic demand is increasing faster than domestic supplies, perhaps because money and credit supplies are growing too rapidly. It should not react to higher prices irrespective of the cause of such higher prices. For example, higher prices that follow exchange rate or other supply side shocks, following droughts or higher taxes on domestic goods or services. These shocks depress demand and higher interest rates will depress demand even further to no useful anti-inflationary effect.
The Reserve Bank might argue that if it didn’t react to higher inflation, whatever its cause, inflation would trend higher because of so-called second round effects. If it failed to react, more inflation would come to be expected and in turn lead by some self-fulfilling prophecy and producer pricing power, to more inflation itself. There is no evidence to support the view that more inflation expected leads to more inflation.
Indeed inflation expected in SA has remained remarkably stable around the 6% level, the upper range of the inflation targets. Expected inflation is a constant rather than a variable in the SA inflation story.
The problem for policy makers is that the market has been conditioned to expect higher interest rates, irrespective of the cause of higher inflation and the implications this may have for the economy. The task for the Reserve Bank is to change the narrative to take full account of the economic realities. The value of the rand and its impact on inflation is unpredictable and monetary policy should not be expected to react to it or other supply side shocks to the CPI that are of a temporary nature. The flexible exchange rate should be regarded as a shock absorber for the economy – not a threat to it. The proper task for the Reserve Bank is to manage aggregate spending in SA in a counter cyclical way. Chasing inflation targets, regardless of their provenance, can lead to pro-cyclical monetary policy.
*Brian Kantor is the Chief Strategist and Economist at Investec Wealth and Investment in South Africa. The article first appeared in the Investec Wealth and Investment Daily.