T Mboweni: Graduate School of Business University of
KwaZulu-Natal

2 November 2006

Honoured guests
Ladies and gentlemen

Thank you for the opportunity to address you in KwaZulu-Natal. I should note
that my presence here is due to the persistence of Dr Singh who has been
berating me for some time for neglecting your province. It is indeed true that
it has been some time since I have made a public address in KwaZulu-Natal, but
I can assure you that this has not been by design.

My address today relates to recent international economic developments and
how they impact on our own monetary policy decision making. South Africa is
very much part of the global village and as such is heavily influenced by
international economic developments. Many of these developments have resulted
in increased uncertainty and risks. The emergence of China as an economic
powerhouse means that the world is a different place to what it was just a
decade ago. Most parts of the world have also been experiencing a period of
robust world growth, but while it may be true that every cloud has a silver
lining, sometimes a silver lining may have a cloud. In some respects this holds
true for the current world growth performance. Some of the current
uncertainties relate to the issues of global imbalances, asset price movements,
oil prices and tighter conditions in financial markets. These issues add to the
uncertainty within which monetary policy has to be conducted.

World economic growth

In the recent world economic outlook published by the International Monetary
Fund (IMF), the global economic environment is characterised by economic
activity that has exceeded expectations, and signs of a build up of
inflationary pressures. These pressures originally emanated from oil and other
commodity prices, but more recently have been a result of emerging capacity
constraints. Central banks have responded by generally tightening monetary
policies. Global imbalances however remain large. The balance of risks to the
global outlook is seen to be biased to the downside, and although a benign
market led process of unwinding of global imbalances is seen to be the most
likely outcome, the potential for disorderly unwinding remains.

Estimates by the IMF show that world growth has averaged 4,2 percent since
2000, as compared to 3,2 percent for the preceding decade. Current projections
indicate that the economic expansion is likely to continue with growth rates
being very close to five percent in 2006 and 2007. In fact, the global
expansion since the turn of the 21st century ranks amongst the highest since
the early 1970s.

While the global expansion has in general been broad based, the improved
growth performance of developing and emerging economies relative to those of
developed economies has been most noteworthy. For example, in 2005, emerging
economies accounted for more than half of total world Gross Domestic Product
(GDP) in purchasing power parity terms; around 43 percent of world exports;
about 70 percent of the world's foreign exchange reserves, half of the world's
energy consumption and around 80 percent of the growth of oil demand in the
past five years.

China was the fastest growing economy over the last few years and in 2005
the country became the world's fourth largest economy (at market exchange
rates) after the United States of America (US), Japan and Germany. It is the
second largest economy in purchasing power parity terms after the United
States. China is becoming increasingly important in the world economy by a wide
range of measures. The country's average contribution to global GDP growth in
purchasing power parity terms, for example, has increased from 9,5 percent in
the 1980s to 18,0 percent in the 1990s and further to 24,5 percent in the six
years to 2005. The United States' average contribution to global growth, on the
other hand, has decreased from 23,3 percent in the 1980s to 20,2 percent in the
1990s and further to 16,3 percent since 2000.

Chinese economic growth has been accompanied by an increase in the demand
for raw materials which, in turn, has reinforced the boom in commodity prices.
For example, China accounts for 40 percent and 33 percent of the world demand
for cement and coal respectively. Furthermore Chinese demand accounts for over
20 percent of steel, copper and aluminium.

The emergence of China means that the world economy is probably less
dependent on the US for overall global growth. It used to be said that if the
United States sneezes, then the rest of the world catches a cold. Although a
slowdown in the US will have implications for the world economy, the global
economy may not be as susceptible to a US slowdown as it was a decade or so ago
when the US cycle was almost synonymous with the global cycle. Today, the
outlook for world growth and commodity prices is also dependent on the growth
outlook in Asia in general and China in particular.

Global growth has implications for our own monetary policy through a number
of channels. Higher global growth may, in the absence of productivity growth,
result in either higher world inflation or tighter monetary policies in high
growth economies. At the same time, strong world growth is generally positive
for commodity prices, which may cause the rand to be stronger. Often the
implications of world growth developments for monetary policy are far from
clear, and this underlines the uncertainties we face.

Global imbalances

Although the world economy may have achieved a degree of immunity from
cyclical downturns in the United States, it is probably still true to say that
if the US had to catch a cold, the rest of the world would run the risk of
catching a bad case of flu. The possible disorderly unwinding of global
imbalances is a case in point. The main manifestations of the global imbalances
are the current account deficit in the United States and the current account
surpluses in a number of Asian economies and the oil exporting economies.

The dominant view in the market appears to be that it is not a question of
if, but rather when and how the adjustment will take place. As I noted earlier,
the IMF view is that although there is a risk of a disorderly adjustment, a
smooth market led adjustment is the most likely outcome. By contrast, in the
2005 annual report of the Bank for International Settlements it was noted that
the unwinding of the imbalances could be uncomfortable, either through profound
market turbulence or a protracted period of slow world growth.

A number of solutions to the problem of global imbalances have been
proposed. In his keynote address to the recent conference on macroeconomic
challenges that was organised by the Bank, Professor David Llewellyn argued
that none of the proposed solutions would be sufficient on their own, and that
unless a number of solutions were implemented concurrently, a negative outcome
was more likely. In his view, the required adjustment includes increased
savings in the US including a reduction in the fiscal deficit; reduced savings
in China, combined with improved social security safety nets in that country; a
move away from the dollar peg by Asian economies and a depreciation of the US
dollar; and a rise in aggregate demand in Japan and the euro area, accompanied
by structural reform in the latter.

Unfortunately there does not appear to be a co-ordinating mechanism to bring
about the adjustment, and it is also unclear how long these imbalances will
persist. The persistence has already confounded a number of analysts who have
been predicting a major readjustment of the US dollar for at least the past
four years.

Going forward, there is always the concern that the underlying international
imbalances could be resolved through a significant realignment of global
exchange rates. Estimates of how much exchange rates would have to adjust vary
greatly. In 2005, Obstfeld and Rogoff for example, argued that the dollar
adjustment could exceed 30 percent. An adjustment of this order of magnitude
will inevitably impact on the rand, but it is not clear whether under these
circumstances the rand would find itself moving with the dollar, or in the
opposite direction. Much will depend on how world growth and risk perceptions
are affected in such a scenario.

Whether or not there will be an orderly or disorderly unwinding of these
imbalances, there is very little that some economies such as South Africa can
do to pre-empt these effects. The onus is on the large industrialised countries
to try and ensure an orderly adjustment or to minimise the negative
consequences that may ensue in the wake of a disorderly resolution.

International interest rate and inflation developments

At the beginning of the 1990s, world inflation averaged around 30 percent
compared to an estimated 3,8 percent in 2006. In 1992 there were 44 countries
with inflation rates in excess of 40 percent compared to three in 2003. At the
Jackson Hole conference organised by the Federal Reserve Bank of Kansas City in
2003, one of the issues that was hotly debated was the cause of this decline.
Central bankers of course claimed the credit, arguing that it was because of
more disciplined monetary policies. Others however argued that it was the
forces of globalisation and the emergence of China. As one commentator
observed, it reads a bit like an Agatha Christie mystery. The questions are,
who killed the victim, how was the victim killed, and is the victim really
dead?

I think it is true to say that monetary policy has become more disciplined
in the 1990s, but globalisation has probably played its part as well. There is
no doubt that China has had an impact despite the upward pressure on commodity
prices. For example, footwear and clothing prices, which have a weight of just
over four percent in our Consumer Price Index (CPIX), excluding interest rates
on mortgage bonds, have been falling since October 2003. In the year to date,
footwear and clothing prices have fallen by 6,6 percent. There is no doubt that
this has had a moderating effect on our domestic inflation.

Recently there have been signs that the victim has been showing signs of
life, and world inflation has risen somewhat, although the IMF still expects
world inflation to remain under control and to average 3,7 percent next year.
Some of the pressures are a result of rising international oil prices, although
more recently high levels of capacity utilisation and strong consumer demand
have also been observed. Consequently we have seen a general monetary policy
tightening cycle globally. In the past year for example, most industrialised
and emerging market central banks have raised interest rates at some point.

We are often asked if we follow the world interest rate cycle. There is not
a simple interest rate cycle. Interest rates in the United States, the United
Kingdom and the euro area have not followed exactly the same path. We do not
and cannot slavishly follow international interest rate developments. The fact
that we have adjusted our monetary policy stance recently is not in response to
interest rate developments abroad. Our interest rate decisions are determined
by the domestic inflation outlook. Of course, this outlook in turn may be
affected in some instances by the same factors that may cause monetary policies
to be tightened in general, but this is not necessarily the case.

Asset prices and international liquidity

Much has been said in the past few years about the impact of increased
international liquidity which is in part a consequence of the global
imbalances. Stock markets and property markets around the world have reached
record highs and emerging market spreads have narrowed significantly. South
African equity and property prices have also reached record highs. The question
that is often raised in this context is whether the market is correctly pricing
risk, and whether the system is vulnerable to a reversal.

Our asset markets have a significant degree of participation by non
residents. For example, since the beginning of 2006 to 26 October, non resident
net purchases of South African bonds and equities totalled R20,8 billion and
R64,7 billion respectively. However, as an open emerging market economy we are
always vulnerable to changes in international sentiment which may have little
to do with domestic economic developments. The appetite for South African
financial assets is, to a certain extent, influenced by developments in global
bond and equity markets.

Asset price developments have important implications for monetary policy
although the appropriate response is far from clear. The wealth effects that
are generated by high asset prices have an impact on consumer demand and,
therefore, potentially on inflation. Various issues emerge here. Firstly, it is
not always easy to recognise a bubble. Secondly, there is the question of
whether or not monetary policy should try and prick asset price bubbles in
order to avoid the consequences of the bubble popping at even higher levels
with the attendant risks to financial stability.

Generally the response of central banks has been to argue that the best
monetary policy can do is to try and anticipate the impacts of asset price
movements on inflation, and to react in the same way that we react to any
factor that can cause inflation to rise beyond the inflation target. This is in
essence our approach as well. However in most countries there is not a full
understanding of how these wealth effects affect the inflation process and the
transmission mechanism of monetary policy.

International oil prices

In any discussion of international developments we cannot ignore the oil
price. As we all know, international oil prices have increased significantly
over the past few years. It is almost unbelievable that the price of Brent
crude was around US$11 per barrel in January 1999. By January 2004 Brent crude
oil prices had exceeded US$30 per barrel and had subsequently reached a high of
around $80 per barrel during August 2006. Since then there has been some
moderation and the price has fallen to current levels of below US$60 per
barrel. The causes of these increases have been the tight supply and demand
conditions in the market, as well as periodic bouts of geopolitical
tensions.

The increases in oil prices have had a significant impact on domestic petrol
prices. During 2006 for example, the price of 95 octane petrol in Gauteng
increased from R5,49 per litre in January to peak at R7,04 per litre in August.
Fortunately, as a result of falling international prices, we have experienced
three successive declines totalling R1,07.

The contribution of transport costs to CPIX inflation provides an indication
of the direct inflationary impact of petrol price increases. This has averaged
around 15 percent of the overall monthly increase in the CPIX during 2005 and
around 17 percent during the first nine months of this year. We also saw that
for most of 2004 and 2005, most of the volatility observed in CPIX inflation
was directly attributable to petrol price movements. More recently, other
factors have also been exerting upward pressure on CPIX inflation.

We have often emphasised that it is not the first round effects of oil price
increases, that is, the direct impact on petrol prices, but rather the second
round effects that are of primary concern for monetary policy purposes. While
there is little we can do about first round effects, we have to ensure that
these effects do not adversely affect inflationary expectations and become more
generalised and stimulate inflationary impacts across the economy. If
sustained, the recent decline in oil prices augurs well for inflationary
developments going forward. Nevertheless, given the underlying market
conditions and the vulnerability of oil prices to geopolitical tensions, these
lower prices cannot be taken for granted and oil prices continue to pose an
upside risk to our inflation outlook.

Monetary policy has to be formulated against the backdrop of increasingly
integrated goods and financial markets. This increases the uncertainty
surrounding the workings of the monetary transmission mechanism. Monetary
policy making becomes more complicated since the nature and extent of influence
of exogenous shocks on the domestic economy is difficult to determine in
advance. With highly integrated money and capital markets, changes in
sentiment, whether justified or not, can have profound implications for our
economy. Similarly, changes in growth prospects in the industrialised countries
or emerging Asian economies will also affect us. The exact nature and timing of
these developments are always uncertain. As is often said in monetary policy
circles, the only certainty is uncertainty. This is highly applicable to the
uncertain impact of international developments on domestic monetary policy.

I thank you

Issued by: South African Reserve Bank
2 November 2006
Source: South African Reserve Bank (http://www.resbank.co.za)