Presentation to the Parliament Committee on Finance The South African economy: recent developments and monetary policy Ben Smit BUREAU FOR ECONOMIC RESEARCH UNIVERSITY OF STELLENBOSCH 28 March 2007

Outline Overview of the March 2007 SARB Quarterly Bulletin The MPC statement of 15 February 2007 The performance of Monetary Policy

Overview of the March 2007 SARB Quarterly Bulletin

The SA economy continues to produce quite high and stable economic growth

Growth in the 4 th quarter supported by all the main production sectors 2006Share of GDP Q1Q2Q3Q4Year Primary sector-9½-7¼-41-4½11,910,6 Agriculture-18¾ ½-134,62,7 Mining-5½3½¼4½-¾7,37,9 Secondary sector4¾7¼5½8½5¾27,723,0 Manufacturing3¼6¼4¾8¼4¾20,918,2 Tertiary sector7¼6¼4¾5¼660,466,4 Total55½4½5½5100

While both household consumption expenditure and gross fixed investment contributed strongly to expenditure

Household consumption expenditure supported by real disposable income …..

…. and by credit extension

… and by consumer confidence 2006Q election WC soccer bid announcement

Gross fixed capital formation increased in all three institutional sectors, led by the public corporations

The upbeat overall economic conditions is reflected in, and supported by, continued high business confidence …… To 81 in 07Q1 from 83 in 06Q4 Manufacturing ( 78(75)) Building (90(90)) New vehicles ( 72(71)) Retail ( 87(91)) Wholesale ( 76(88))

Employment continues to recover (BER Surveys: net balances)

CPIX inflation increases but remain in target range January 2007 CPI= 6.0 CPIX= 5.3 PPI= 9.8

… but production prices have increased substantially during 2006

The deficit on the current account increased to very high levels …….

Current account: Including / excluding oil

The exchange rate has broadly stabilized

Monetary Policy Committee Decision 15 February 2007

The decision: “….the MPC is satisfied that the inflation outlook has improved somewhat and expects inflation to remain within the target range for the forecast period. As the mandate of the Bank is to keep inflation within the target range, the MPC has decided to leave the repo rate unchanged for now at 9 per cent per annum.” Statement of the Monetary Policy Committee 15 February 2007 p4

MPC Statement: June 06 – Feb 07 Causal factors / MotivationDecision Inflation outlook Breach target Strong demand Current account deficit Oil priceRepo rate MPCA 8/06DeteriorateQ107YesConcern +0,5 MPCS 3/08DeteriorateQ107.Q207YesConcern Less concern +0,5 MPCS 12/10Upside risk Around 6% Q2-Q407 YesConcern Less concern +0,5 MPCS 7/12ImprovedQ207Yes Deficit improve somewhat Concern+0,5 MPCS 15/02ImprovedNoYes Sharp deterioration (but oil) Less concern 0

MPC statements on the BoP current account deficit 1.“In previous statements the MPC expressed concerns about the expanding deficit on the current account of the balance of payments. Current account deficits are a reflection of higher domestic expenditure and in themselves inflationary. There is however a possible risk to the exchange rate if the deficits are perceived to be unsustainable, particularly if the deficits are reflecting higher consumption expenditure.” MPCS 3/08/07 2.“We have explained on a number of occasions that the MPC does not have a target for the current account, nor does the MPC view deficits on the current account to be inflationary in themselves. The mandate to the Bank is to maintain inflation within the target range of 3 to 6 per cent. The risk to inflation arises if the market perceives a particular level of the current account to be unsustainable, which could have implications for the exchange rate and, consequently for the inflation rate. To date the current account deficit ….. Has been adequately financed. Current developments appear to indicate that the current account deficit will continue to be adequately financed given the coherent macroeconomic policy framework of the country and positive growth prospects.” MPCS 15/02/07

Current account vulnerability

Balance of payments as % of GDP

Current account balance as % of GDP – 2005 relative to EM countries 2006 X (-6,4)

Whose the culprit? Trade balance & services and income balance as % of GDP

(Disappointing) export and (booming) import volume indices and the Terms of Trade Exports: 100  Imports: 100  ToT:100  113.6

Saving and investment as % of GDP Saving % GDP: 15.8  13.9 Investment % GDP: 15.9  20.3

Does the current account matter? Empirical evidence Size of deficits (Edwards (2004,2005)) –157 countries, 1970 – 2001 –>50% of countries, deficits >3,1% of GDP –>75% of deficits (3 rd quartile) ≤ 7,2% of GDP –26 of 157 countries experienced high deficits for 5 years or longer once Reversals –Edwards (2005)  Incidence 9,2% (11,8%) –Milesi-Ferretti and Razin (1997)  116 reversals in 60 countries (1974 – 1990) –Output cost of reversals

SA’s resilience to sudden stop/reversals Floating currency Borrowing small part of inflows Rand denominated foreign debt (“original sin”) Forex reserves improve

MPC – The right decision? Trade-off between improved inflation outlook and continued strong domestic demand and the associated balance of payments deficit. Choice determined by judgment of risk of deficit becoming unsustainable and associated exchange rate, inflation and output consequences and of strong demand fuelling inflation.

Performance of Monetary Policy

Inflation record

Anchoring inflation expectations 2006Q4

Handling of supply shocks “The response of monetary policy to supply shocks appears to be countercyclical, i.e. dispelling somewhat the idea that monetary policy may have been overly procyclical in response to supply shocks.” Frankel, Smit & Sturzenegger (March 2007): Macroeconomic challenges after a decade of success, p68

Policy transparency “Central bank transparency in South Africa has improved greatly under inflation targeting, from a score of 5 in 1994, to 9 in 2004 (out of a possible 15)” Aaron and Muellbauer (March 2007): Transparency, Credibility and Predictability of Monetary Policy in South Africa, Mimeo, p5

Forecast accuracy “… no other forecasting agency consistently produced more accurate inflation forecasts than the Bank in the period May 2003 to December 2005.” SA Reserve Bank (Nov 2006): Monetary Policy Review, p31

Other issues Contribution to output and price stability Room for the “pursuit” of other goals such as exchange rates/Bop, growth Overly conservative / too high interest rates

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