T Mboweni: Cape Town Press Club

5 October 2007

Honoured guests
Ladies and gentlemen

1. Introduction

Thank you for providing me with the opportunity to address you this evening
on the recent turmoil experienced in global financial markets which began in
July this year. At the time of our last Monetary Policy Committee meeting in
August, the turbulence on the international financial markets had intensified
and it was unclear how developments would unfold. As we prepare for the
Monetary Policy Committee (MPC) meeting next week, the dust appears to have
settled. In fact, if one looks at the conditions in the financial and commodity
markets today and compares them to the conditions prevailing in mid-July, one
would not think there had ever been any disruptions. My remarks to you this
evening will focus on the developments in the international and domestic
financial markets, potential implications for global growth and the policy
implications.

2. The build up to the turbulence

For the past few years now, global financial markets have prospered and seen
innovation and integration on an unprecedented scale, leading to more prominent
roles being played by investors such as hedge funds, and new derivative
instruments and structured products. This boom in financial markets was a
result of low interest rates in developed markets, and the financial system
being flooded with liquidity. Investors, in an attempt to earn higher returns,
invested in riskier assets. As more and more investors jumped on the bandwagon,
and demand for riskier assets increased, the excess yield these assets offered
diminished. However, this strategy remained beneficial given that the global
economy was characterised by low and falling inflation and robust economic
growth. This demand for excess yield gave rise to, amongst other things, the
boom in the United States (US) sub-prime market.

The economic and financial environment has almost been a utopia situation in
certain respects, displaying a remarkable resilience, even during recent
periods of correction. However, this resilience only served to increase the
level of complacency about the nature of the risks involved. The central
banking community had consistently expressed concern about the level of pricing
observed in markets, which did not seem to adequately reflect the level of risk
being taken.

Now, the sub-prime 'bust' has led to a tightening of both liquidity and
credit conditions, creating turmoil in financial markets. I am reminded of a
comment by Warren Buffet: "It is only when the tide goes out that you learn who
is been swimming naked."

3. Recent financial market turbulence

A rising wave of risk aversion prompted by increasing foreclosures in the US
sub-prime mortgage market resulted in an abrupt deterioration in global
financial market conditions in August 2007. Rising foreclosures and
delinquencies were linked to sub-prime borrowers who had taken out adjustable
rate mortgages. As interest rates reset to higher levels, in line with the
rising US interest rate environment, these borrowers found it difficult to pay
their mortgage loans. This turbulence was not confined to the US sub-prime
market, spreading to the broader mortgage market and financial markets more
generally.

In mid-June and July, the ratings agencies cut the ratings on a number of
securities backed by sub-prime loans and put on review a number of mortgage
backed securities for downgrade. Soon after, US foreclosures were reported to
be almost 90 percent higher than the previous years' level. Two large hedge
funds were shut down as a result of exposure to the sub-prime market.
Thereafter, some large sub-prime lenders collapsed, while holders of sub-prime
residential mortgage backed securities also suffered losses. These events
resulted in a tightening in underwriting standards, with fewer households
qualifying for sub-prime loans. Investors reassessed their tolerance for risk,
most notably for structured financial products and for securities of highly
leveraged firms.

All of these events culminated in increasingly impaired short-term and
inter-bank funding markets in August. Many issuers of asset-backed commercial
paper programs found rolling over their paper increasingly difficult. This
occurred due to a lack of transparency in the financial system, with no-one
quite sure of whom owns what and therefore uncertainty regarding the losses
faced by financial institutions and their counterparties. Investors started
treating all counterparties with suspicion.

The exposure to the sub-prime market became all the more pervasive, with
banks and hedge funds in the US, United Kingdom (UK), and Australia, to name a
few, indicating exposure to this market. The global nature of the problem was
particularly highlighted when the second largest bank in the Euro zone froze
access to certain of its investment funds on 9 August 2007. Risk aversion
increased over this period, as clearly witnessed in the almost 200 basis points
drop in the US three-month Treasury bill yield in early August. Banks began to
hoard cash to cover their funding needs and as interbank liquidity dried up,
banks found it difficult to raise term funding. Surging liquidity demand
spilled over into the short-term money market, causing overnight interest rates
to soar.

Volatility in financial markets, as measured by the VIX1 index, moved from
14 index points on 17 July to touch a record 31 index points on 16 August.
Volatility at levels of around 20, has generally led to a re-pricing of riskier
assets. Major equity markets lost between 8 and 12 per cent, with the Japanese
equity market worst affected as it was dealt a double blow with the
appreciation of the Japanese yen.

Emerging market equity markets followed their international counterparts
lower as risk aversion increased and investors fled to safe.

1 VIX is the ticker symbol for the Chicago Board Options Exchange Volatility
Index, a measure of the implied volatility of S&P 500 index options. It
represents one measure of market's expectation of volatility over the next 30
day period.

The Morgan Stanley Capital International (MSCI) index for emerging markets
lost over 16 percent. The 'flight to safety' led to a precipitous fall in
developed bond market yields. In the space of a month, the two year US Treasury
yield dropped almost 70 basis points, below 4,00 percent. The EMBI plus spread
above US Treasuries widened by 82 basis points to 250 basis points. Currency
markets also experienced increased volatility. The USD appreciated from USD1,38
to USD1,34 against the euro, and appreciated against most major and emerging
market currencies. The Japanese yen (JPY) was the exception, as it appreciated
by 9,0 percent against the USD from over JPY122 at the end of July to JPY112 in
mid-August, reflecting the role that Japanese interest rates played in
supporting risk-taking in recent years. The unwinding of carry trades in
particular supported the JPY. The same trend was witnessed in the International
Monetary Market data which showed a significant turnaround in speculative
forward currency positions from net short JPY positions in July to net long
positions in August.

4. Central banks react

Central banks responded in order to prevent a potential financial crisis
caused by near-dysfunctional money markets in developed countries. Since 9
August 2007, the Fed and ECB offered three-month term funding, and together
with other central banks injected significantly more liquidity into the
financial system. The types of securities against which banks could borrow were
broadened by the Fed and ECB to include mortgage backed securities, the Fed
went a step further and accepted asset-backed commercial paper.

The relaxation of key restrictions on lending between banks and broker or
dealers also helped to reduce liquidity pressures as it allowed banks to fund
their own and other non-bank dealers more easily. On 16 August, the Federal
Open Market Committee lowered its discount rate by 50 basis points, returning
some calm to markets. In the case of the United Kingdom, it was necessary for
the Bank of England to provide emergency liquidity assistance to one financial
institution, Northern Rock. As central banks rarely provide this kind of
assistance easily to one institution, financial markets will continue to keep a
watchful eye on possible subsequent developments in the United Kingdom.

The most significant action, however, was the 50 basis points reduction in
the target federal funds rate and a further 50 basis points reduction in the
discount rate by the Federal Open Market Committee (FOMC) in mid-September.
This had a pronounced impact on financial markets. Risk appetite returned, and
the VIX index declined from over 31 index points to 19 index points by 21
September. Stock markets rebounded between 7 and 16 percent and bond yields
increased as investors moved back into riskier assets. The increased risk
appetite over this period led to the JPY reassuming its depreciating trend,
from JPY112 in mid-August to JPY116 on 21 September. The USD, however,
depreciated to over USD1,40 against the EUR, breaching the USD1,40 level for
the first time on 20 September, pressured by interest rate expectations. Market
expectations of monetary policy have changed markedly since these events from a
general environment of tighter monetary policy to easier monetary policy.
Commodity prices have reached highs not seen for over 20 years. The gold price
has moved above USD740 per fine ounce, but sadly, oil prices have also risen,
to over USD80 per barrel.

Emerging markets also regained their composure since the Fed lowered its
target federal funds rate. The MSCI for emerging markets gained over 25 percent
since mid-August and the Emerging Market Bond Index (EMBI) plus spread declined
by 56 basis points. It is notable however, that throughout this crisis, there
has been limited reaction from emerging markets. One can ascribe this to
healthy economic fundamentals. Emerging markets over the past few years have
increased their reserve levels significantly, reduced their external balances
and debt servicing. Equally important is the fact that debt buybacks have
continued and net external debt reduction is still prevalent in many key
emerging market countries. Thus, overall, it would appear that emerging markets
are far less susceptible to credit events than they may have been in the
past.

5. South Africa's experience

South African money markets were relatively unaffected by these events as
our banking system had negligible exposure to the sub prime market. Liquidity
conditions domestically remained healthy, and there was no need for the South
African Reserve Bank to provide extra liquidity to markets. However, South
African financial markets did not go unaffected. After trading below R6,80
against the USD in July, the rand depreciated to over R7,60 in mid-August.
Domestic bond yields increased and the Alsi retreated quickly from the almost
30 000 level reached in July to below 26 000 in August. As calm returned to the
markets, so the rand appreciated to below R7,00 against the USD, the Alsi
ratcheted up gains above the 30 000 level, surpassing the record.

Highs reached before the crisis, and government bond yields declined. As
with many other emerging economies, South Africa's macroeconomic position
places it in good stead. Despite the turmoil in global financial markets,
non-resident interest in South African assets remained positive. In fact, for
the month of August, South Africa witnessed record purchases of domestic bonds
by non-residents. Non-resident purchases of South African shares exceeded R10
billion. Nonetheless, the sustainability of these inflows will depend in part
on global liquidity conditions as well as domestic growth prospects. Conditions
in the local foreign exchange market also allowed for further accumulation of
foreign exchange reserves.

There does not appear to be any evidence at this stage that the recent
turbulence in the international financial markets will have marked effects on
the domestic growth outlook, although this will depend to some extent on the
impact of these developments on the US growth performance.

6. Implications for global economic growth

Whilst initially the developments in the financial markets appeared to be
limited to a liquidity problem, they later transpired to present a credit
problem as well. The big question now is to what extent these developments will
affect the real economy. It seems logical that the US economy will bear the
brunt of the damage of the sub-prime crisis. The tightening of lending
standards and therefore the restrictions of credit extension to weaker
households could exacerbate the housing downturn in the US even further.
Dampened business sentiment and falls in the equity market, combined with the
weaker housing market and deterioration in consumer sentiment could mean a more
intense negative impact on wealth. The most recent evidence by way of economic
data releases seems to suggest that the problems in the housing market may be
deeper than initially assumed and harbour real risks for consumption and
growth. The recent policy actions from the FOMC very much seem to acknowledge
this change in prospects.

As the International Monetary Fund (IMF) has noted, most of the world will
likely emerge relatively unscathed from this crisis. The recent shifts away
from the US as being the key driver of global growth, together with the better
balance achieved during the last two years represents significant support for
the global economy. However, the ramifications of any sharp slowdown in the US
always remain and should not be underestimated.

As for emerging markets, lower external debt, better reserves levels, more
prudent fiscal management, leading to much more improved fundamentals, have
undoubtedly already delivered dividends. Whilst the global economy is deemed to
be robust enough to shake off US weakness, contagion effects means that the
sub-prime problems can contaminate other countries. As noted, emerging markets
are better prepared for, but certainly not immune to global financial market
risks. A reduction in global risk appetite would curb net capital inflows into
emerging markets, placing downward pressure on emerging market currencies and
in turn exacerbate inflationary.

7. Policy implications

The recent events and actions by central banks around the world have raised
an interesting debate on "moral hazard". It raises the question of whether
central bank support of the markets does not amount to a bail-out of careless
investors, thereby paving the way for more careless behaviour in future. In a
recent speech by Federal Reserve Bank Chairman, Ben Bernanke, he noted that
well-functioning financial markets are essential for a prosperous economy.
Central banks need to ensure the functioning of financial markets, but in a
very difficult balancing act, also need to guard against recreating conditions
of careless lending that preceded the market turmoil.

In this context it is important to point out that central banks can
ill-afford to take any chances with systemic risks. In the process of
addressing problems "for the greater good" there could be some by product of
unintentionally providing help to those who do not quite deserve it. This was
the dilemma faced by the Bank of England when it eventually had to provide
assistance to Northern Rock. But this should never allow financial market
participants to work on any assumption of some inbuilt automatic guarantees
against failure.

As the IMF points out in its September 2007, Global Financial Stability
Review, policymakers and market participants need to learn from the present
situation and make amendments to the global financial system in order to
strengthen it. Key in this is the recognition that there needs to be
improvements in a wide range of areas:

* greater transparency between on- and off-balance sheet entities, so that
the market is able to properly differentiate and price risk
* better risk monitoring
* improvements by ratings agencies
* better valuations of complex financial instruments and products; and
finally
* Wider risk perimeters that go beyond the accounting and legal perimeters.

Policy makers in both mature and emerging markets therefore face
considerable challenges going forward, to ensure the stability of the financial
system and continued healthy global growth.

8. Conclusion

In recent weeks, the present situation has been likened to events in 1998 or
2001. However, what should be borne in mind is that the current situation has
occurred against the backdrop of broad-based strength in the global economy. A
deeper understanding of what led to the turmoil is required, lessons need to be
drawn and where necessary, improvements made.

The correction we have observed may have proven painful for many, and I have
little doubt that the pain is not yet over. Ultimately, the correction should
be seen as positive for the financial sector and the economy overall,
especially if spill-over to the real economy can be contained. Hopefully it
will allow for more differentiation in pricing of credit and less aggressive
mortgage lending and leveraged loan practices, and in so doing, compensate
investors and lenders more appropriately for the risks they are taking.

I thank you.

Issued by: South African Reserve Bank
5 October 2007
Source: South African Reserve Bank (http://www.resbank.co.za)