T Mboweni: Chintaman Deshmukh Memorial Lecture

2 November 2007

Governor Reddy,
Deputy Governors of the Reserve Bank of India
Honoured Guests
The Consul-General of the Republic of South Africa
Members of the India-South Africa Business Forum
Ladies and gentleman

Monetary policy challenges in turbulent times

Thank you for your kind invitation. I am delighted to be in India for the
first time at this juncture as you celebrate the 60th anniversary of your
independence and enjoy the international spotlight as the result of your
splendid economic performance.

It is a great pleasure and privilege to deliver this address today for two
main reasons. Firstly, this lecture is in honour of a truly great person, Mr
Chintaman Deshmukh. The contribution of Mr Deshmukh to the Indian economy
cannot be exaggerated as is borne out by his long service to this country as
Governor of the Reserve Bank of India.

Member of the Planning Commission of the Government of India, Minister of
Finance, Vice-Chancellor of the University of Delhi and as President of the
Indian Statistical Institute from 1945 to 1964, among others. Secondly, I
understand that this lecture series has been graced with the presence of some
truly remarkable speakers. I am indeed very grateful to be accorded the
privilege to deliver this the 13th lecture in this series.

The relationship between South Africa and India is a very strong one today.
This relationship, however, goes back a long way in history.

President Nelson Mandela, the former President of the Republic of South
Africa encapsulated this quite well when he said that "India and South Africa
are two countries held so closely by bonds of sentiment, common values and
shared experience, by affinity of cultures and traditions and by geography".
The contribution of one of your and our favourite sons, Mohandas Karamchand
(Mahatma) Gandhi, and the support received from the Indian authorities during
the liberation struggle went a long way towards assisting South Africa to
achieve democracy in 1994. The important role that India played in South
Africa's transition to democracy is without question and highly appreciated
back home.

Currently, strategic relationships on the bilateral and multilateral fronts
hold promising opportunities of mutual benefit for both our countries. Already,
bilateral trade between India and South Africa has increased by well over 100 %
in the past four years and a Preferential Trade Agreement between South Africa
and India aims to treble trade by 2010. In addition, South Africa has been
benefiting from India's rich entrepreneurial and educational skills base, with
many teachers and other skilled personnel being employed in various
institutions in our country.

South Africa is currently India's biggest investment partner in sub-Saharan
Africa, serving as an important entry point into the rest of Africa. Indian
investments in our country have grown significantly over 1 India Digest, volume
4, 1996 the years, and have become more diverse, ranging from vehicles (Tata,
Mahindra), steel (Arcelor Mittal), telecommunications (Neotel) and
pharmaceutical companies such as Ranbaxy. Investments from South Africa to
India are also growing. South African Breweries acquired stakes in various
Indian breweries. Other areas in which South African companies have invested
include insurance, diamond exploration and infrastructure. In February 2006,
the Airports Company of South Africa (ACSA) won the contract for upgrading the
Mumbai Airport. I also gather that SASOL is interested in a coal-tosynthetic
automotive fuel project in India and many other South African companies have
signed up marketing contracts with Indian companies in the pharmaceutical
sector.

On the multilateral front, initiatives such as that involving India, Brazil
and South Africa (IBSA) and Brazil, Russia, India, China and South Africa
(BRICSA) provide useful platforms for the strengthening of ties between our two
countries and the South-South economic relations in general. In addition, over
the last few years India, South Africa, Brazil and China have been recognised
as systematically important countries to the extent that they have been
regularly invited to the G7 meetings in order to contribute to the discussion
on global economic and financial matters. On the one hand, this participation
has taken place usually on the fringes of the main G7 meetings, thus raising
the question about the seriousness with which the G7 countries give to these
meetings. On the other hand, these four countries have started to meet on a
regular basis in order to strengthen co-operation on issues of common
interest.

As you may well be aware, one of the burning issues at the moment relates to
increasing the "voice" or representation of emerging-market economies in
international financial institutions such as the International Monetary Fund
(IMF) and World Bank. This issue, together with other matters relating to the
reform of the Bretton Woods Institutions have also been key agenda items
addressed this year during the preparatory meetings for the G20 meeting of
Ministers of Finance and Central Bank Governors. As we know, South Africa
currently chairs the G20 Forum and it will be our pleasure and privilege to
welcome the Indian G20 delegation in South Africa during November. There are
many issues which are the centre of focus to the G20 this year, but most
prominently are the fiscal elements of growth and development and the impact of
commodity prices on member countries. South Africa and India do not only share
common policy positions on many of these issues, but have also been very active
in advocating the interests of emerging-market economies in this new world
order.

Both countries have benefited from the economic reforms implemented over the
last decade or so. However, both countries have similar economic challenges
which in the main relate to, inequality, poverty alleviation and the reduction
of unemployment. As a central banker, I wish to dwell on some issues and
challenges facing monetary policy in emerging markets.

The "Great Moderation"

One of the defining characteristics of global economic developments over the
last three decades has been termed the "Great Moderation" – the sustained
decline in the volatility of output and inflation. This development has been
due to the structural changes that many economies have undergone. Some have
attributed these changes to the implementation of better policy options and
others to simply good luck. Professor Kenneth Rogoff of Harvard University has
argued on many occasions that improved competitiveness as a result of increased
globalisation coupled with better policies has had a major positive impact on
inflationary trends in many countries. The declining trend in inflation since
1990 is clearly evident in India and South Africa.

Inflation in India has declined steadily from an average of 10,3% between
1990–1994, to 8,9% between 1995–1999 and to 4,3% in this decade. Similarly in
South Africa, inflation has declined from an average of 12,5%, to 7,3% and to
5,1% over the same time periods.

The economic growth performance of both countries has also been quite
impressive. Since 1990, India has experienced average growth rates of around 6
% per annum, increasing to an impressive 9% in the last two years. It is now
widely expected that the Indian economic growth rate trajectory would be very
close to, if not, in double-digit territory in the short to medium term. South
Africa has not been performing badly either, with an average economic growth
rate of about 3,4% per year since the advent of democracy in 1994, compared to
an average of below 1 per cent in the previous decade. Over the last three
years, however, growth has averaged about 5% and the current trend in the
economic growth rate is the longest experienced in the country's recorded
history.

Improved macroeconomic performance: some side effects

A side effect of strong economic growth in many emerging market countries is
the growing middle class. This has been particularly true for both India and
South Africa. The rapid emergence of this middle class brings opportunities
that will have a significant impact on future prosperity, but also poses a
rather unique set of challenges for policymakers. With increasing affluence,
there is bound to be a change in consumption levels and patterns. Related
policy concerns centre on the implication of these changes on the demand for
credit, the level of imports and the effect on asset markets.

Then, there is the added concern that the unequal distribution of wealth
brings with it a tension between the haves and the have-nots. Under these
circumstances, the broadening of access to financial services becomes an
important policy objective. It is well recognised that the financial inclusion
of the lower echelons of society into the financial sector is a powerful
contributory factor to poverty alleviation through, for example, the provision
of micro-finance. As the demand for consumer finance increases, a greater range
of financial instruments are needed and the financial sector will need to
adapt.

Over the past few decades, alongside financial deepening, household debt
levels have been on the rise across a number of countries, both in developing
and advanced countries. Rapid increases in household indebtedness have been
associated with increases in asset prices, mainly house prices. These
developments have indeed increased the probability of defaults, stemming in the
main from adverse external shocks and rising interest rates.

Whilst household debt ratios in emerging-market countries like South Africa
are low in comparison to developed countries, the rapid rise in household debt
and credit levels has raised some concerns. In addition, high levels of
inequality could mean that some groups are more affected than others. Hence,
the close monitoring of lending practices and detailed reviews of credit
standards can contribute towards the integrity and stability of the financial
system. In the case of South Africa, an Act of Parliament (the National Credit
Act) was introduced to address this issue. It is still too early to ascertain
the impact that this Act has had on borrowing and lending practices in South
Africa. There is little doubt that positive outcomes may be realised.

The role of monetary policy

Central bankers have more often than not found that the role of monetary
policy in the economic growth process is not fully understood or appreciated by
all stakeholders. Let me use the South African case to illustrate this
difficulty. Monetary policy in South Africa is implemented within an inflation
targeting framework – the target range being an inflation rate, namely CPIX
(headline inflation less mortgage interest costs) of between 3 and 6%. CPIX
inflation in South Africa has been outside the upper end of the target range
for the past six months. In addition, there has been a deterioration in the
inflation outlook. This has mainly been (initially) as a result of higher
international food and fuel prices as well as robust consumer spending.

However, underlying pressures have also become more broad-based. Although
credit growth has slowed somewhat in response to previous monetary policy
tightening, persistently high food and fuel costs have meant that the risks to
the outlook are on the upside. Inflation expectations have consequently risen
to the top end of the target range, with possible adverse implications for wage
and price setting decisions.

These risks to the outlook have necessitated the tightening of monetary
policy from 7% in May 2006 to 10,5% currently.

The tightening of monetary policy has not gone down well in all parts of
society. Not everyone appreciates that sacrifices – albeit short term
sacrifices – are sometimes needed to secure medium to long term benefits. In
general, due recognition is not always accorded to the role that price
stability plays in securing sustainable economic activity. In our modern world
where remote controls and microwave ovens are the order of the day, not
everyone – market participants included – always comprehend or appreciate that
monetary policy relatively long lag. So in essence, one of our primary
challenges as central bankers relates to the issue of regular and consistent
communication.

Communicating monetary policy has become complicated because the
transmission channels have become somewhat clouded. Structural changes in the
economy have had an impact on functional relationships, with the result that
the transmission mechanism of monetary policy has become more complex. Advances
in econometrics and economic theory have facilitated the construction of
sophisticated structural models incorporating complex behavioural
relationships.

However, as Professor David Hendry argues, forecast errors are very often
the result of unanticipated large changes or shocks within the forecast period.
Hence, anecdotal evidence that provides a better understanding of the risks to
the inflation outlook is essential to monetary policy-making. As the Chairman
of the Federal Reserve Board, Mr Ben Bernanke recently remarked, good economic
forecasts "involve art as well as science"3.

The recent South African experience has shown that some of the conventional
observations do not always hold in practice. For example, the South African
currency (the Rand) has on more than one occasion weakened when interest rates
were increased or appreciated when interest rates were lowered or when they
remained unchanged.

Furthermore, emerging-market currencies in general are subject to extreme
volatility resulting from shifts such as was the case with the USD recently,
having an impact on domestic monetary conditions. An added challenge relates to
the fact that many emerging-market countries have a relatively short track
record of credible monetary policy. Credibility is earned over time and yet it
is central to the anchoring of inflation expectations.

Communication is further complicated by the global context in which
inflationary pressures occur. On the one hand, there are downward inflationary
pressures as a result of lower-priced goods due to globalisation. On the other
hand, increased trade protectionism, coupled with rising commodity prices due
to robust world growth, pose risks to price stability.

Monetary economics

Workshop of the National Bureau of Economic Research Summer Institute,
Cambridge, Massachusetts.

China and India play a significant role in the global economy today. This
assertion to many is without question. The disinflationary benefits of
globalisation have been manifested in China's contribution to lower global
inflation over the last decade, through lower import prices of manufactured
goods, more specifically clothing and footwear. India has also played an
important role through the supply of low-cost knowledge based services such as
in the field of information and communications technology (ICT). However, the
utopia of strong economic growth with low inflation may be reversed as China
and
India, because of their appetite for commodities, contribute to the surge in
commodity prices, notably in base metals and minerals, especially oil prices.
China and India have been the world's fastest growing energy markets with oil
demand currently increasing at around 6% for China and 5 per cent for India. As
is not foreign to this gathering, oil prices have reached nominal record high
levels recently, thus placing upward pressure on inflation and complicating the
task of monetary policy, specifically in the anchoring of inflation
expectations.

Regarding the commodity boom, South Africa is faced with a double-edged
sword. Whilst the demand for commodities boosts export revenues, surging energy
price increases have had a significant upward pressure on import costs and
inflation in South Africa.

Global financial market integration

Global financial market integration has increased significantly in recent
years, posing further challenges to the conduct of monetary policy. There are
divided opinions on the advantages and disadvantages of global financial market
integration, but to a large extent most would agree that globalisation has been
positive insofar as it has imposed market discipline on policymakers. There are
many who think that globalisation increases economic growth prospects and
reduces volatility. In some respects, globalisation and financial market
integration also make policymakers aware of the importance of independent
central banks. Market participants are more comfortable in situations where
central banks are seen (and actually are) going about their primary objectives
without fear, favour or interference from not only the political executive, but
all other stakeholders.

One of the main challenges of this new global environment relates to the so
called "contagion effect". The 1997/98 global financial crisis is one example.
Another more recent example relates to developments in the United States (US)
sub-prime market. To begin with the 1997/98 crisis, economies with relatively
weak macroeconomic fundamentals were punished the most. South Africa, in
particular, at the time suffered from capital outflows, a depreciation of the
currency and subsequently inflationary pressures. As a result, monetary policy
had to flow with the tide, and interest rates were increased by a full 7
percentage points between April and September 1998. However, as painful as the
process was, not only for South Africa, but for most other emerging markets,
lessons have been learnt and major reform of existing financial structures and
adjustment in macroeconomic policies emerged.

The 1997/98 crisis highlighted concerns surrounding debt sustainability. As
a consequence, many emerging-market countries reduced their domestic and
external debt, and in the process, reduced currency mismatches which in some
respects rendered these emerging markets less vulnerable to currency
depreciation. There have also been efforts to reduce the external vulnerability
through debt buybacks, while reserves accumulation has also been gathering pace
over the past few years. India's reserves are the world's seventh largest at
over USD250 billion. While South Africa's are but a fraction of this, one needs
to bear in mind that we have moved from a position of a negative net open
forward position of almost USD26 billion at the end of 1998, to positive net
reserves of US$28 billion currently, the result of which means that today the
country boasts an investment grade rating.

Furthermore, central banks have shifted towards market-based instruments
which enhance their ability to respond to shocks. India is one such example,
with the increased use of repo and reverse repo operations since the early
2000s, increasing the role of interest rates in the transmission mechanism of
monetary policy. In South Africa's case, we have come a long way in terms of
the development of our own bond market, a process in which the South African
Reserve Bank played a major role for a very long time. Today, we have a very
deep and liquid bond market, if not the most liquid bond market in the
emerging-market economies.

The positive impact of these financial market and macroeconomic developments
have been put to the test on numerous occasions since the 1997/98 crisis. The
most recent event has been that of the US sub-prime mortgage market. This
episode has been well documented and I shall therefore not spend time on its
detail. As you are aware, it was a liquidity and credit crisis, emanating from
financial institutions having exposure to the sub-prime market and thereby
incurring huge losses as delinquencies and foreclosures increased in the wake
of tighter monetary policy. Although the sub-prime mortgage market was an issue
related to the US, the adverse developments were transmitted to other developed
and emerging markets without much relation to domestic developments.

At the height of the crisis, developed and emerging-market equities were
sold. Foreign exchange markets witnessed a significant increase in volatility
as carry trades were rapidly unwound and emerging-market spreads rose
significantly between late July and mid-August. However, the rise in
emerging-market debt spreads was not quite as pronounced as that of credit
markets in developed economies. Spread movements also reflected higher risk
credits moving the market in either direction.

Although South African financial markets were affected by the events
surrounding the sub-prime crisis, our money markets were relatively unaffected.
Our banking system had very little exposure to the sub-prime market and
liquidity conditions domestically remained healthy.

As such, there was no need for the South African Reserve Bank to provide
extra liquidity to markets. Throughout this turmoil, the principal challenge
for the Monetary Policy Committee has been to address inflation concerns.
Inflation developments in South Africa have been such that at a time when
global monetary policy seems generally to have turned from a tightening bias to
an easier or neutral stance, our MPC has had to tighten monetary policy.

Since the recent turmoil experienced in financial markets, money market
conditions have eased considerably, most notably in the US, following the Fed's
decision to cut interest rates by a cumulative 75 basis points. Money market
conditions in Europe, however, remain a little more strained, probably partly
due to the fact that a significant amount of the structured investment products
were in fact purchased by European and other overseas investors. Up until the
end of October, financial markets recovered, with equity markets in particular
bouncing back to levels higher than at the time of the turmoil. However,
experience has taught us that financial market gains could easily be reversed
in times of uncertainty.

Emerging markets could still feel the impact of an abrupt and sustained
change in global financial conditions and international investor appetite for
risk. Such a scenario could play out in the event of a significant slowing in
global growth and rapid reversal of capital inflows in spite of better
macroeconomic fundamentals. In a more globalised world, emerging-market
economies may be more vulnerable to shocks originating in developed economies
than was the case previously.

Under these circumstances, extreme vigilance on the part of policy makers
remains the order of the day. The current uncertainties in global financial
markets will remain fixed on the radar screens of policymakers for some time to
come.

Conclusion

In an interdependent world, the effects of uncertainties will not only be
exaggerated, but could also affect innocent third parties. We have to remain
vigilant to global and domestic developments in order to ensure that prosperous
outcomes are not unduly threatened. Under these circumstances, policymakers
have to ensure that strong economic fundamentals are maintained. The role of
monetary policy in this process should not be underestimated. For emerging
economies, like India and South Africa, the challenge remains to reinforce and
build on the achievements of the last decade or so.

Thank you very much, once again dear colleagues and Governor Reddy for
inviting me to deliver this address. I will leave this remarkable country truly
inspired and I am certain that this is not my last visit to this beautiful
country.

Thank you for your attention.

Source: South African Reserve Bank (http://www.reservebank.co.za)
2 November 2007