The SARB’s primary mandate according to the Constitution of the Republic of South Africa is to “protect the value of the currency in the interest of balanced and sustainable economic growth.” In this piece I argue that the SARB is currently violating this constitutional mandate in that it stifles economic growth by trying to control supply side inflation using an instrument meant to control demand driven inflation (the repo rate).
When Fitch and S&P downgraded SA to junk status recently, they cited SA’s poor economic growth as a major factor in their decision.
SA’s slow growth rate is unsustainable considering that low growth must lead to even higher unemployment, inequality and poverty, and we are already at crises point. And the reason our growth rate is too slow is because the SARB’s inflation targeting mandate prioritizes inflation control over growth and employment, and does not distinguish between supply side and demand driven inflation, and thus uses the repo rate to slow the economy even when inflation is mostly supply side as it has been recently.
Our priority right now should be growing our economy to create employment and reduce inequality and poverty. Inclusive growth must lead to increased demand because more people will have more money to spend. Inflation is the inevitable side-effect of added demand, unless supply also increases along with demand. So effectively, the best way to target inflation is to ensure growth in the supply of goods and services, and given our high unemployment rate, we are ideally suited to this strategy as there is massive scope for job creation. But by killing demand with its misplaced inflation targeting policies, the South African Reserve Bank is effectively making the growth in supply impossible.
Unemployment and poverty in South Africa are currently as high as they were at the height of the Great Depression in the USA. That fact should be more of a concern than our current moderate inflation rate of around 6%. And yet the South African Reserve Bank has steadily increased its repo rate over the last years to 7%. Why? Because unlike the US Federal Reserve Bank (which balances several mandates), the SARB is not mandated to stimulate economic growth, or reduce unemployment. Instead the SARB has only one mandate: Inflation targeting. This lack of a balanced mandate is the reason why, despite our extreme poverty, unemployment and inequality, and a GDP growth rate of near 0%, and the fact that our inflation has been mainly supply driven, the SARB has moved to further slow down economic growth by raising the repo rate several times over the last few years.
Central banks are extremely influential institutions with the power to make or break nations. The question we should be asking is: Are we being systematically broken?
Economist Thomas Piketty’s thesis is based on the mathematical fact that inequality cannot decrease unless GDP growth is more than the rate of return on capital. And yet, the SARB raised its repo rate to 7% and maintained it there, even though our real GDP growth had been hovering around 0%.
The repo rate hikes show that the SARB clearly believes that despite the warnings from the ratings agencies that they would downgrade SA due to slow growth, and the subsequent downgrades due to that continued lack of growth, our moderate inflation rate is more of a concern to the SARB than our near zero GDP growth and our 30% unemployment.
Furthermore, the SARB has admitted our inflation is mostly supply side (caused by a shortage in supply of goods), which means the only way to limit price increases using the repo rate is to create a corresponding shortage in the supply of cash…hence our flirtation with recession.
The value of money depends on its relative scarcity. The cash value of goods is determined by the supply of goods and the demand for them. When more people have more money, there is more demand, and so the price of goods and services goes up, and the value of money diminishes. This is called demand side inflation. The SA Reserve Bank rightly controls demand side inflation by raising and lowering interest rates, which is its mechanism for increasing or lessening the supply of money in the economy.
Supply side inflation is a different matter, as it is caused by the scarcity of goods. Because the prices of goods such as crude oil are set on the international market, the SARB’s interest rate has no affect on its price. Also, some prices are set by international markets and our government, such as fuel and electricity, and are not affected by the SARB’s repo rate. Another example of supply side inflation is the recent increase in food prices due to shortages caused by drought. Increasing interest rates to counter supply side inflation is counterproductive as higher costs of borrowing for businesses increases the costs of production, adding to supply side costs which means producers must increase prices to break even.
Supply side inflation on fuel, electricity etc affect demand similarly to interest rate increases, because they leave consumers with less to spend on other goods and services, meaning reduced demand and reduced demand side inflation. So in effect raising interest rates to counter supply side inflation is unnecessary and quite frankly stupid, as it just doubles the bad news for the service, retail, agricultural, and manufacturing sectors and for growth in general. Yet the SARB does it anyway.
If the reserve bank mandate is price stability, it would make sense for it to subsidize local production of agricultural and manufacturing goods when inflation is supply side, and with reserves of around R700 billion it is ideally suited to that task! By subsidizing local production, supply of goods would increase, in turn limiting supply side inflation: a far more effective strategy than interest rate hikes in times when inflation is not demand driven.
Clearly the SARB’s single narrow band inflation targeting mandate, which prioritises inflation control and return on capital over growth and employment is dangerous, as it institutionalises increasing inequality in a country already on the edge.
The SARB either needs a new mandate which balances inflation control and price stability with the responsibility to stimulate growth and employment just as the reserve banks of the US, Europe and China are mandated to do, or government must raise the SARB inflation target in times of supply side inflation to allow for increased growth and employment.
Explaining its limited mandate of inflation targeting only, the SARB web site curiously says:
That statement is puzzling. There is no question that reserve banks around the world lower interest rates to stimulate growth and reduce unemployment. Lowering borrowing rates increases demand, as consumers have more money to spend on goods and services. The increased demand makes the increase of supply more viable, which leads to more service and manufacturing jobs (if local manufacturers remain competitive). And, as the cost of borrowing capital is part of a business’s running costs, cheaper borrowing costs make it easier and less risky to start a business, and easier to keep it running, and they allow businesses to be more competitive internationally, as a company borrowing money at 2% spends less on its capital than a company borrowing money at 15%.
Even though the US has one sixth of SA’s unemployment and faster real GDP growth, the Federal Reserve Bank in the USA held its repo rate at 0,25% for 8 years until December 2015 because, unlike the SARB, it is mandated to stimulate economic growth when that is needed. The Fed only raised its rate once unemployment declined to its mandated employment target of 5% which is what it considers “full employment”.
Despite the fact that SA currently has 6 times higher unemployment and even slower real growth than in the US, in 2015 the SARB repeatedly increased its repo rate to 6,25%, 25 times what the US Fed’s rate was (0,25%) at the time (November 2015). Even with the latest US rate hike to 1%, the SARB rate is still 7 times higher at 7%(April 2017).
Part of the reason the SARB has given for its high rates is that it wants to maintain stability in the price of the Rand. Yet in explaining the deterioration of the Rand value against the Dollar the SARB bulletin for the 2nd quarter 2015 contained the following explanation:
“The rand’s weakness could be attributed to weak domestic economic fundamentals such as subdued economic growth and the sustained high level of unemployment over the period. ”
And yet the SARB raised the repo rate, which in turn must slow growth and increase unemployment. Go figure!
To get an idea how the interest rate hikes throttle our economy consider this: The total domestic credit extended by banks in SA amounts to R3,1 trillion, so every 0,25% interest rate hike by the SARB sucks R7,75 billion out of circulation from the economy per year.
The effects of each 0,25% hike siphoning an extra R7,75bn out of the economy per year is quite massive when you consider the “multiplier effect” each Rand siphoned from the economy would have added to the GDP as it passed through different hands through the year. R7,75bn is the cost of 155 000 jobs paying R50 000 per year (60% of employed people in SA earn less than R60 000 a year).
Its quite feasible that over the last 9 years (a worldwide low inflation rate environment) the SARB repo rate could safely have been nearer to zero like in the US and Europe. As each 0,25% rate drop effectively adds R7,75 billion per year into the economy, a repo rate at 1% instead of 7% for example would mean an extra R186 billion per year circulating in the economy: Enough to fund the employment of 3,7 million people at R50 000 pa even without taking into account the multiplier effect.
The SARB has stated several times that part of its reasons for raising rates is to make SA more attractive to foreign speculators. It says it raised its rate in anticipation of the US Federal Reserve bank raising its rate December 2015 to 0,5%, which would lead to foreign carry trade investors pulling their money out of SA. So in effect, in ensuring foreign speculators can profit handsomely from a good spread between US and SA repo rates, the SARB is confiscating around R200 billion per year from South Africans. The irony of this situation is that in guaranteeing foreign speculators a high return, wealth flows out of SA in the long term, affecting our current account negatively, which in turn devalues the Rand and leads to more inflation.
Income from foreign speculators is beneficial in the short term but detrimental in the long term. Investors always aim to get out more than they put in. An investment is only successful once investors get more out than they put in. Is it healthy to encourage short term gain at the expense of long term pain? Instead of squeezing local businesses in order to enrich foreign investors, we should be concentrating on growing local wealth and local businesses.
And the argument that lowering interest rates will lead to more debt needs unpacking. Firstly, it is quite possible to limit new debt through tougher credit qualification requirements and by raising bank reserve requirements (China does this but we don’t for some reason). Secondly, South Africans are already highly indebted (our debt to disposable income ratio is 75%), so lower interest rates will mean borrowers can pay off their debt faster, and with less debt, and more jobs and increased incomes as a result of economic growth, maybe more people will be able to save a little. Statistics show this to be true: In the lower interest rate environment from 2009 to 2015, the SA Household debt to GDP ratio dropped from 50% to 46%. And in the US, household debt decreased when the Fed dropped its rate to 0,25% in 2008 and kept it there till last December.
This makes sense because debt increases through 2 processes: The first is the issuing of new debt. I’ve explained above that legislation can control the issuing of new debt.
The second way debt increases is through interest charged on it. So with higher interest debt increases faster than with lower interest. If interest on debt is 10% then that debt increases at 10% per year. If interest rates on debt is 3% per year then that debt increases at 3% per year. For example. I can afford to pay a certain amount into my mortgage bond every month which is a few thousand rands above the monthly interest repayment required by the bank. When the interest rate increases, more of my payment goes to pay the interest and so my total debt decreases slower than when interest rates are lower.
Economic growth is extremely important, not just to reduce unemployment and poverty, but also to reduce inequality and debt, and with around 30% unemployment, SA has massive potential for growth. Unfortunately, economic growth will always be elusive as long as the SARB believes it has no mandate to stimulate it, and instead deliberately stifles it.
The SARB is obsessed with controlling inflation, but inflation is the inevitable side effect of increased growth, employment and poverty reduction: Income growth must lead to inflation unless the supply of goods and services increases along with demand, so the trick to inflation control in growing economies is to ensure that increased demand leads to increased production of goods locally. To do this local agriculture and manufacturing must become competitive, by keeping production costs down, implementing flexible and sustainable labour legislation like salary gap moderation and through subsidising agriculture and manufacturing, as is done in the US, China and Europe.
And if SA really wants to keep inflation in check, we should concentrate on keeping inequality in check, as highly unequal economies are far less efficient and they require greater monetary stimulus (inflation of the money supply) than more equal economies do. For an explanation on this see Reducing inequality to control inflation.
(Note this article was last updated on the 9 April 2017. It was originally written in December 2015).