T Mboweni: Central Bank Governors' Club

2 September 2006

South Africa’s economic policy challenges

Governors,
Honoured guests,
Ladies and gentlemen,

1. Introduction

I am grateful to the Central Bank of the Russian Federation for inviting me
to address the Governors’ Club today. I have been informed that one of the main
objectives of the Governors’ Club is to promote co-operation in the sphere of
central banking among member countries. In the light of the rapid developments
in the global financial system, there is little doubt about the benefits of
associations such as the Governors’ Club. I trust that the experience of South
Africa and the southern African region that I am going to highlight today will
be informative to the objectives and activities of the Governors’ Club.

2. South Africa’s economic growth performance

Similar to the many countries participating at this meeting, the South
African economy can be described as an economy in transition. It is the largest
economy in Africa with gross domestic product in 2005 measuring US$239,4
billion (R1 523 billion), compared to US$135,8 billion (R482,1 billion) in
1994. Gross Domestic Product (GDP) per capita increased from approximately US$3
500 in 1994 to approximately US$5 000 in 2005, in a country with a population
of approximately 47 million people and an annual population growth rate of
marginally below 1 percent. Because of the legacy of the apartheid, there is
still a highly skewed distribution of income and wealth in the country.
According to recent estimates, the Gini coefficient is approximately 0,65. One
of the primary objectives of the current government is to rectify these
inequalities. This is particularly challenging given the high levels of
unemployment in the country. The most recent unemployment rate for 2005 was
approximately 27 percent, slightly higher than a year earlier.

Although South Africa is a major commodity producer, and commodities or
commodity-based products make up a significant proportion of our exports, the
contribution of mining to GDP is relatively small at 6 percent. The largest
sector in the economy is the finance, real estate and business services sector
which accounts for almost 20 percent of GDP, followed by the manufacturing
sector which accounts for just over 16 percent. The agricultural sector is one
of the smallest sectors, contributing about 2,4 percent of GDP.

Only twelve years ago the country emerged from apartheid, international
isolation and economic and financial sanctions. The new dispensation inherited
an economy characterised by low growth and high levels of inflation. Growth
averaged 1,0 percent over the period 1984 to 1993, while inflation averaged
14,3 percent during the same period.

Since then, macroeconomic performance has improved significantly as a result
of improved policies. In sharp contrast to the 1,0 percent GDP growth attained
during the decade preceding 1994, South Africa has since experienced twelve
years of uninterrupted GDP growth, averaging 3,3 percent per annum. The economy
grew by 4,5 percent and 4,9 percent during the last two years and growth this
year is also expected to exceed 4 percent.

Prudent fiscal management has seen South Africa's budget deficit reduced
from 5,2 percent of GDP in 1994 to 2,0 percent of GDP in 2004, and 0,3 percent
of GDP in 2005. Monetary policy also underwent a significant ‘regime change’
during the period, with the adoption of an inflation-targeting framework in
February 2000. One of the fundamental objectives behind the adoption of the
inflation targeting framework was to enhance policy transparency and
accountability and thereby decrease and anchor inflationary expectations over
time.

The improvement in the performance of the South African economy needs to be
maintained if meaningful progress is to be made in meeting the economic and
social challenges facing the country, particularly the eradication of poverty
and unemployment. The South African government has, therefore, set itself the
goals of halving poverty and unemployment by 2014. To meet these challenges,
the government seeks an annual GDP growth rate that averages 4,5 percent or
higher between 2005 and 2009, and an average growth rate of between four and at
least six percent between 2010 and 2014. Public infrastructure investment to
the value of R370 billion is also planned for the next three years. The
targeted interventions in public transport, communication and electricity
provision should not only contribute to the growth performance over the next
couple of years but also go some way towards increasing the growth potential of
the economy.

3. Monetary policy

It is our firmly held view that the best contribution that monetary policy
can make towards the attainment of sustainable higher growth rates is to ensure
price stability. The mandate of the South African Reserve Bank is defined in
the Constitution of the Republic of South Africa as the protection of the value
of the currency in the interest of balanced and sustainable economic growth in
the Republic. Deriving from this constitutional mandate, the Bank regards its
primary goal in the South African economic system as "the achievement and
maintenance of price stability". This is currently interpreted as consumer
price index (CPIX) inflation – that is headline inflation less mortgage
interest costs – being between 3 to 6 percent.

Despite some initial setbacks in late 2001 and during 2002, when inflation
increased rapidly in reaction to the significant depreciation of the currency,
the inflation targeting framework has served us well. Having averaged 7,9
percent from 2000 to 2002, inflation has been contained within the target range
since September 2003. For the past two years inflation has averaged 4,0
percent. Without getting into the merits and demerits of inflation targeting,
the inflation targeting framework has served as a good anchor for monetary
policy in South Africa. It has led to better co-ordination of monetary policy
and other economic policies than was the case in the past. The political
commitment, as evident in the pursuance of prudent fiscal policies, has been
crucial to the containment of inflation within the target band.

In addition, the inflation target provides the basis for the accountability
of the central bank and it improves public understanding of monetary policy
decisions. The inflation targeting framework has also helped to anchor
inflation expectations within the target range, thereby further enhancing
confidence in monetary policy. This has, however, not been achieved easily.
Although it proved to be unpopular in some quarters, a stringent monetary
policy stance had to be adopted initially in order to demonstrate the
commitment of the Bank to meeting its statutory obligations and ensuring the
credibility of monetary policy. The initially painful experience had a positive
outcome, given the subsequent favourable impact on price and wage-setting
behaviour in the economy.

4. South Africa’s financial markets

South Africa is a small open economy by international standards. This in
itself presents some challenges for the pursuit of price stability, not least
of which is the nature of the South African financial markets. South African
financial markets are relatively deeper, broader and more sophisticated than
those in a number of emerging markets. According to the latest World
Competitiveness Yearbook, South Africa is ranked 46th overall but 22nd in
Banking and Financial Services, higher than countries such as Ireland, Spain,
France and even the
United Kingdom.

Trading in bonds and equities is fully automated and exchange-driven through
the Bond Exchange of South Africa (Besa) and the Johannesburg Securities
Exchange Limited (JSE), respectively. Corporates currently account for about 32
percent of the total debt listed on Besa. The turnover on Besa has increased
from R2,1 trillion in 1995 to R8,1 trillion in 2005. As at the end of 2005, 388
companies were listed on the JSE. The JSE has evolved into a truly
international bourse, with more than 60 companies listed on at least one other
exchange internationally, and non-residents accounting for about 20 percent of
the daily turnover. Turnover on the JSE has also grown sharply over recent
years, increasing from an annual turnover of R22 billion in 1992 to R1,279
trillion in 2005. The All-share index of the JSE reached record highs in April
2006, gaining around 18 percent in the year to the end of April. The All-share
index is currently trading at levels close to those in April, having recouped
some of the losses incurred in May 2006 as a result of developments in
international financial markets.

The foreign exchange market in South Africa is the biggest domestic
financial market, with an average daily net turnover of US$14,5 billion in July
of this year. This consisted of US$1,9 billion spot transactions against the
rand, US$1,0 billion forward contracts against the rand, US$7,5 billion swaps
against the rand and the balance of US$4 billion consisting of transactions in
third (non-rand) currencies. The foreign exchange market is very liquid which
makes it an easy target for portfolio re-alignment by international investors.
Thus, the potential for a direct impact on the exchange rate of the rand
emanating from this source is great. As a result, the exchange rate of the rand
is generally more volatile than that of most other emerging-market
currencies.

Since 2005, the rand has traded in a fairly stable range. However, as you
are aware, the rand is seen as both a commodity and emerging-market currency.
As a result, the volatility of the currency has recently increased due to
developments in commodity prices and changes in investors’ risk appetite for
emerging-market currencies. The rise in precious metals prices has provided
support to the rand while the currency experienced some weakness – particularly
in May – due to the repricing of emerging-market risk. The currency depreciated
to levels around R6,60 to the dollar in mid-May from levels of around R6,00 to
the dollar at the beginning of the year. The weakening of the currency was
essentially due to the sell-off in emerging–market assets in May 2006. The rand
depreciated further in June in response to concerns about adverse developments
in the current account of the balance of payments. Unlike many of the other
commodity producing countries, South Africa has a deficit on its current
account, which increases the country’s vulnerability to currency movements. I
will return to this issue a little later on.

Historically the South African Reserve Bank practised a policy of
intervening in the foreign exchange markets in an attempt to smooth the
volatility of the exchange rate. With no success, I must mention! These
activities resulted in huge losses amounting to almost US$24 billion emanating
from the oversold net open forward position of the South African Reserve Bank
(SARB). The unsuccessful and costly policy of intervening in the foreign
exchange market has convinced us that it is better to leave the determination
of the exchange level of the rand to the market. The SARB has stuck to this
policy even when the rand depreciated to R13,89 to the US dollar in late 2001
from levels around R8,00 to the US dollar at the beginning of 2001. Some
analysts believe that this was a test of SARB’s resolve not to intervene in the
foreign exchange market.

Currently, the Bank’s activities in the domestic foreign exchange market are
aimed at building foreign exchange reserves, smoothing money-market liquidity
conditions through intra-month foreign exchange swaps and meeting clients’
foreign currency needs. The strategy of accumulating reserves is done in such a
way that we “cream off” excess “dollars” in the market without any significant
influence on the exchange rate. The accumulated gross gold and other foreign
exchange reserves now amount to over US$24 billion and, combined with prudent
macro-economic policies, have led to South Africa’s credit rating moving up
four notches over the last twelve years - from BB in 1994 to BBB+ in August
2005. As you know, maintaining reserves is an expensive exercise – the
challenge is therefore to ascertain and maintain a level of reserves that
supports the economic fundamentals of the country. However, the increase in
reserves, together with the eradication of the Net Open Foreign Currency
Position, should contribute towards the stability of the currency and reduce
uncertainty for both domestic and non-resident investors.

5. Monetary policy challenges

Let me now turn to some of the monetary policy challenges currently facing
South Africa. The favourable inflation trend over the last couple of years has
allowed for nominal interest rates to fall to levels last seen some three
decades ago. Between June 2003 and April 2005, the repo rate was lowered to 7
percent, representing a total reduction of 650 basis points over the period.
After remaining unchanged for 13 months, the repo rate was increased by 50
basis points at each of the Monetary Policy Committee (MPC) meetings in June
and August this year. Given the increase in inflationary pressures and the
resultant deterioration in the risks to the inflation outlook, the Monetary
Policy Committee considered it necessary to tighten policy at the last two
meetings.

The main factors that have recently led to the heightening of the risks,
namely the high levels of consumer spending, adverse movements in the exchange
rate, a larger current account deficit, higher food prices and high oil
prices.

Consumer spending has been increasing at robust levels for some time now.
The low interest rate environment has fuelled rising levels of credit extension
to the private sector. Growth in bank loans and advances extended to the
private sector measured at annual rates has recently increased to levels
exceeding 20 percent. While the inflationary effects are limited at this stage,
the impact is manifesting itself via the deficit on the current account of the
balance of payments, which had increased to 6,4 percent of GDP by the first
quarter of this year.

While the deficit is currently more than adequately financed by capital
inflows, these are mainly portfolio inflows, which increase the risks of
adverse movements in the exchange rate, especially if the current account
deficit is perceived to be unsustainable. This situation makes the exchange
rate particularly vulnerable to changes in investor sentiment and risk
tolerance, which can result in a tapering off or even withdrawal of portfolio
inflows. This issue is of particular relevance given the way in which
international markets have been re-rating emerging market risk recently. In
such circumstances, there is an increased risk of a significant exchange rate
adjustment which could threaten the longer-term attainment of the inflation
target. However, the best way to avoid this happening is by maintaining sound
and prudent macroeconomic policies.

While we do not target any specific level of the exchange rate, exchange
rate developments impact significantly on inflation. For a small and open
economy like South Africa, the pass-through effects of exchange rate changes on
inflation are significant and rapid. Hence, monetary policy has to take due
cognisance of the fluctuations in the exchange rate of the rand insofar as
their effect on the inflation forecast is concerned.

On the issue of oil prices, these have been at sustained high levels for
some time now. Given the prevailing geopolitical tensions, there is little
doubt that oil prices pose the single biggest threat to global growth and
inflation. However, the challenges for monetary policy emanating from high oil
prices are not so straightforward. The textbook recommendation is that monetary
policy should not react to first-round oil price effects but rather prevent
second-round effects from taking hold. The pass-through effects from oil price
increases to the different indicators of inflation have been relatively low,
with the result that pre-emptive monetary policy decision-making has not been
easy. However, there are indications that secondary inflationary pressures from
the oil price increases are starting to occur in South Africa, as is evident in
the recent acceleration in domestic producer price inflation.

The recent tightening of monetary policy should thus be viewed in the
context of the deterioration in the risks to the inflation outlook and the
objective of the SARB to ensure the credibility of monetary policy and
sustainable economic growth in South Africa.

5. Regional co-operation among central banks in Africa

Let me now move to the issue of regional co-operation among central banks in
the southern African region. Initiatives such as the Governors’ Club, which
promote regional co-operation, are vital for success in our modern world, one
that is becoming increasingly globalised. Globalisation has brought many
benefits, not least of which have been the disinflationary trends that many of
our countries have experienced. However, the painful experience emanating from
the adverse developments in international financial markets is also fresh in
our memories and hence, one cannot over-emphasise the importance of
co-operation, particularly among central banks. I am glad to report that
central banks in Africa have been actively co-operating on different
initiatives for some time now.

As you may be aware, African political leaders have adopted the New
Partnership for Africa’s Development (NEPAD). This is a multidimensional
development framework encompassing economic, political, security, social and
cultural dimensions of development. The African Monetary Co-operation Programme
(AMCP) which underpins monetary co-operation between central banks, forms an
important part of the economic objectives of NEPAD. In the main, this involves
a single monetary union, encompassing a common currency and a common central
bank by the year 2021.

At the continental level, the Association of African Central Banks
subscribes to the AMCP while the Committee of Central Bank Governors (CCBG) in
the Southern African Development Community (SADC) spearheads the various
continental initiatives in the southern African region. The SARB plays an
active role in both these fora.

The CCBG was established in 1995 with the specific purpose of achieving
closer financial/ monetary co-operation and integration in the SADC area. There
are a variety of initiatives that the central banks have been, or are currently
involved in, which promote monetary integration within SADC. These have inter
alia spanned the areas of national payment systems, bank supervision, human
resource development and legal issues.

In some instances the co-operation has been formalised through the signing
of Memoranda of Understanding (MOU). There is little doubt that all the central
banks in the region have benefited from co-operating with one another. We have
found that co-operation is not only advisable, but a necessity for efficiency
in central bank operations in southern Africa.

6. Conclusion

In conclusion, I would once again like to reiterate my sincere appreciation
for this invitation to address you today. I wish the Governors’ Club every
success in its endeavours and would like to assure you of our co-operation and
support. I believe that sharing experiences can provide invaluable lessons
going forward.

Thank you very much.

¹ The Governors’ Club is an association of central banks from Central Asia,
Black Sea Region and Balkan Countries. It consists of 19 members from the
following countries: Azerbaijan, Albania, Armenia, Bulgaria, Bosnia and
Herzegovina, Greece, Georgia, Israel, Kazakhstan, Kyrgyz Republic, Macedonia,
Montenegro, Moldova, Russia, Romania, Serbia, Tajikistan, Turkey and
Ukraine.

Issued by: South Africa Reserve Bank
2 September 2006
Source: South African Reserve Bank (http://www.reservebank.co.za/)