Utilising the economic policy experiences of other markets
Recently, I attended a global financials conference where I had the opportunity to meet with leaders from both listed and unlisted UK financial institutions. The event was filled with many intriguing anecdotes, such as how the introduction of deposit insurance[1] (recently introduced in South Africa) has stimulated the emergence of challenger banks like UK-based Starling Bank. This newfound confidence boost has also fuelled lending activity in the UK mortgage market, especially in the buy-to-let segment. During our discussions, we engaged with several mid-tier banks and financial institutions primarily focused on the buy-to-let market.
Another significant observation relates to the structural changes in the UK pensions market. Recent increases in interest rates have shifted many defined benefit schemes from an unfunded deficit to a surplus. Consequently, numerous pension funds are transferring their assets and liabilities to insurers. To illustrate the magnitude of this shift, the UK pensions transfer market has grown from £30 billion per annum to £70 billion per annum. This expansion is set to boost the future earnings of insurers operating in this segment. The pensions transfer market tends to favour large players with specialised skills and sufficient capital to seize these opportunities. Legal & General and Pension Corporation (a subsidiary of the South African-listed Reinet Investments) are examples of market leaders in our domestic and global client portfolios poised to benefit from this trend.
However, the most meaningful insight gained was the role of low interest rates in stimulating lending and overall economic growth. When interest rates are low, borrowing becomes more attractive. Consequently, asset prices rise, creating capital for asset owners. If individuals and businesses invest this capital wisely, it can lead to compounding growth across various sectors of the economy. Notably, property investments tend to be significant beneficiaries, given their long duration and sensitivity to funding costs. While this observation may not be revolutionary, it is widely accepted by casual observers: low interest rates can indeed lead to compounding growth. However, it is the magnitude of this compounding effect that truly stands out.
It is in this context that it became very clear to me that South Africa’s high interest rates are stifling economic growth. South Africa’s real bond yields are high relative to other developed and emerging markets.
[1]Deposit insurance or deposit protection is a measure implemented in many countries to protect bank depositors, in full or in part, from losses caused by a bank’s inability to pay its debts when due. Deposit insurance systems are one component of a financial system safety net that promotes financial stability.
Unconventional monetary policy tools
While it is true that the South African Reserve Bank (SARB) faces limitations in directly influencing the free market’s bond yield assumptions, there are still policy options available to address economic stagnation. The lessons from Quantitative Easing (QE) programs implemented by various central banks during the Global Financial Crisis (GFC) showcased the tools of unconventional stimulatory monetary policies.
Negative interest rate policies were adopted in many developed economies and demonstrated the potential impact of these unconventional measures. However, as an emerging market reliant on foreign capital, we concede South Africa’s policy toolkit may be more constrained. Nevertheless, we need not look too far for solutions. Our positive real interest rates leave us with scope to stimulate the economy while utilising conventional measures.
South Africa’s Reserve Bank has proven to be credible
The SARB is held in high regard around the world. Under their vigilant oversight, South Africa has skilfully navigated many of the pitfalls that have plagued the global financial system. Our financial institutions emerged relatively unscathed during the tumultuous financial crisis. More recently, the SARB demonstrated foresight by promptly recognising the threat of inflation and proactively raising interest rates to mitigate it.
In stark contrast, the 2023 failure of Silicon Valley Bank (SVB), resulting from fundamental breaches of basic banking principles, underscored the importance of robust monitoring and evaluation functions. Even the formidable U.S. Federal Reserve has room for improvement in this regard. Notably, it is my view that the SARB would not have overlooked an SVB-type error.
Regarding interest rates and inflation, the SARB’s strategy is astute: anchoring inflation expectations within the midpoint of the 3-6% range fosters sustainably lower inflation and contributes to stable long-term interest rates. This prudent approach reflects sound economic reasoning.
A case for a more accommodating monetary policy
The drivers of South Africa’s inflation more recently are less responsive to monetary policy. The lower inflation target would likely have been achieved were it not for the following exogenous shocks:
1. Administered prices
- Administered costs have accelerated faster than the average consumer basket. This has nothing to do with demand but rather the collapse of municipalities and State-Owned Enterprises (SOEs). The average price of electricity increased by 653% during the 15-year period from 2007-2022. For example, consider your recent electricity bill.
- After the 2020 pandemic-related lockdowns, the world experienced an unexpected surge of demand. Supply chains, which were closed or idled during COVID, were not able to cope with the demand. This was exacerbated by port constraints, chip shortages and the impact on world energy supply because of the invasion of Ukraine by Russia. This resulted in a global inflation shock. As an example, food prices, which have a 17% weight in the South African CPI basket, increased by 10% p.a. over the past two years.
- Achieving long-term interest rate expectations hinges on South Africa’s fiscal stability. Unfortunately, fiscal instability has weakened the domestic currency, leading to higher inflation of the imported basket. The critical point here is that monetary policy discipline is being undermined by fiscal outcomes.
Tellingly, despite global inflation shocks in recent years, South Africa’s inflation expectations remain anchored around the 5% mark, not far from the desired mid-point target.
A healthier fiscus and growth will improve long term economic health
Looking ahead, I believe that unless South Africa’s fiscal position improves, it will jeopardize the SARB’s inflation target. The country’s fiscal situation is precarious, and it’s likely to worsen unless nominal GDP grows. Presently, South Africa’s debt-to-GDP ratio stands at +70%. At an interest rate of 10%, the cost of borrowing (equivalent to 7% of GDP) surpasses nominal GDP growth (which is at 6%). If the economy fails to grow by more than 7% in nominal terms (and 2% in real terms), the debt-to-GDP ratio will continue to rise, leading to a challenging debt trap. This persistent trend increases the likelihood of significant currency depreciation (and higher inflation). While the SARB’s policy is focused on inflation and has been successful, our economy’s failure to grow could impinge on the SARB’s very ability to keep long term inflation control.
BCA Research, a well-regarded provider of independent global research recently opined the following about the South African economy:
“Faced with a myriad of macroeconomic problems—a stalled economy, staggeringly high unemployment, and runaway public debt—policymakers adopted very tight policies. When adjusted for core inflation, non-interest government spending is contracting by 5% year-over-year. Real borrowing costs are an exorbitant 7%, while the economy is barely growing at 1% in real terms. Extending the current policy mix will entail years of pain as the necessary macro adjustments will happen via job and real income losses. The new government could pursue ultra-easy fiscal and monetary policy. This will push the nominal growth rate above the government’s borrowing costs, a necessary condition for stabilizing the public debt-to-GDP ratio. Such a policy will generate inflation but rein in real interest rates. Low real rates will lead to currency depreciation, but they will also help improve competitiveness and contribute to real growth. Crucially, adopting the easy policy path will be the less painful way to rebalance South Africa’s chronic macro imbalances. Much of the adjustments would occur via nominal variables such as inflation and currency depreciation. Jobs and incomes will not be hurt too gravely.”
From this excerpt one can opine that South African policy makers (including monetary policy) must prioritise GDP growth. If the SARB lowered interest rates, it would boost near-term GDP. The fiscal situation would begin to stabilise at a faster rate. It is true that this will require a weaker currency and higher inflation, but the faster economic growth should limit the extent of such adjustment.
While we may not know the full impact of this looser policy, the SARB which is typically cautious, can be data-dependent in how they approach this. It seems that this is a lesser evil than an uncontrollable debt trap, coupled with stagnation and a higher inflation rate in future.