`` Presentation to the OECD policy Seminar: How to reduce debt costs in Southern Africa, Paris, 7 October 2004 Monetary Policy, Real Interest Rates and the Cost of Capital in South Africa Brian Kahn South African Reserve Bank

1 Introduction u ‘lower interest rates in South Africa, in particular a less volatile and lower rand currency premium are essential to bringing down financing costs……’ u Are South Africa’s real interest rates excessively high? u Monetary policy is an important element in the question of the costs of capital in South Africa through its impact on real and nominal interest rates and the currency premium. u the best way the Bank can contribute to a lower cost of capital is by maintaining low and stable inflation.

The Monetary Policy Framework u Inflation Targeting adopted in 2000, with initial target of 3-6 per cent u CPIX inflation reached the target in Sept/Oct 2001, but then accelerated following the depreciation of the rand. u Peaked at 11,3 in Oct/Nov 2002 u Within the target by September 2003 (5,4 per cent) and has remained within the target since then. u Latest measure for August was 3,7 per cent (CPIX) and 1 per cent for headline CPI.

u This allowed for a significant reduction in the repo rate- 550 basis points in 2003 and 50 basis points in August u Policy rate now the lowest in nominal terms since 1980.

Source: Statistics South Africa Figure 1 Consumer price inflation: CPIX and CPI CPI and CPIX Inflation

Monetary Policy and Nominal Interest rates u Monetary Policy impacts directly on short-term rates u Impact on long-term rates more indirect, through the impact on inflation expectations. u Reduction in repo rate could have a positive or negative impact on LT rates. u An aggressive reduction in interest rates which raises inflation expectations, will also increase the currency premium if interpreted as a move away from IT (increased uncertainty and increased risk of rand depreciation).

u The recent reductions in interest rates have helped reduce the cost of capital by lowering long-term rates through policies that have credibly reduced current and expected inflation. u Maintaining the commitment to low inflation will result in low real and nominal interest rates. u Result will be lower variability of interest rates, lower exchange rate volatility and a decline in currency and equity risk premia.

Is IT appropriate in South Africa? u A view that ‘structural’ factors prevent inflation from declining to low levels. u Administered prices are sticky and therefore high costs in bringing inflation down within 3-6 target u Evidence that admin price inflation is now declining, and no compelling reason why the inflation rate cannot be maintained within the band.

Consumer price inflation and administered prices

u Raising the target would not necessarily bring about a lower real interest rate, but could increase risk premia. u Rather act on the ‘structural’ elements.

Real Interest Rate developments u Difficult to determine the natural real rate. Recent history is not a good guide given the multiplicity of shocks experienced. u Useful to look at pattern of real interest rates and compare to international trends. u Until the 1990s, real interest rates broadly followed international trends.

Figure 1 Alternative measures of short-term real interest rates

Figure 2 Short-term real interest rates

Figure 3 South Africa and Australia: short-term real interest rates

Figure 4 South Africa, UK and US: short-term real interest rates

Figure 5 Short-term real interest rates

Real long term rates SAUSGermanyFrance

Real long term rates SAUKJapanAustralia

u Real rates higher in the 1990s: u -abolition of the financial rand u rand crisis u -reaction to rand crisis in 1998 u -higher risk premia

u Taylor rule: the further the current rate is from the target, the higher real interest rates should be. Nominal rate has to be raised by more than the expected acceleration in inflation in order to make the increased in the nominal interest rate equivalent to an increase in the real interest rate. u Countries that have achieved their target can have lower real rates and more flexibility in adjusting rates. u Recently, as CPIX inflation reached target, real interest rates have declined, and are more in line with international trends.

Inflation Expectations u Monetary Policy must have credibility. Expectations are a measure of this. u BER survey: for labour and business expectations are still above 6 per cent, but have followed a consistent downward trend (adaptive).

u Inflation outlook also evident in movements in the breakeven inflation rates (difference between the nominal yield on conventional bonds and the real yield on inflation-linked bonds. u Down to around 5 per cent in September (5-9 year maturity).

Break-even Inflation rates

Exchange rate issues u Exchange rate is determined in the market. u Lower inflation means there is no longer an expectation of a continuous depreciation. u Exchange rate has been volatile but reason to believe it will be less so: u - elimination of NOFP u -closing out of the forward book u -accumulation of reserves which could act as a credible deterrent to speculative attacks. u Should move more on the basis of fundamentals.

u Rand is still likely to have some volatility: u - volatility a fact of life in floating regimes u -contagion effects, sentiment shifts, changing risk perception in emerging markets etc u A higher level of reserves may help, but not a guarantee of stability. u As exchange control liberalisation increases, easier access to the forex market may result in higher spot market turnover, which could contribute to lower volatility.

Concluding comments u The cost of capital is high in South Africa but has declined. We are moving in the right direction. u Monetary policy will continue to focus on the inflation objective. Monetary policy has probably contributed to the reduction in the currency premium. u The more interest rate stability and monetary policy credibility there is, the less uncertainty there will be. This should contribute to a lower currency premium and a lower cost of capital.