Interest hike debate

Posted On Friday, 18 January 2002 03:01 Published by
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Question must be weighed in terms of aim of creating high economic growth for SA
Question must be weighed in terms of aim of creating high economic growth for SA

ALL right, Mr Governor. You've made your point. The Reserve Bank is independent; it is not being run by the treasury. Trevor Manuel and Maria Ramos should mind their own business.

Reserve Bank Governor Tito Mboweni sent a powerful message to the finance minister and his director-general when he lifted the repo rate by a full percentage point to 10,5% on Tuesday. Manuel and Ramos both had earlier dampened expectations that rates would rise in the wake of the rand's crash. As long as Mboweni remained mum, it looked like Manuel and Ramos were calling the shots.

Mboweni's action this week has made it clear that the Bank's independence is no illusion. But, if reasserting the Bank's independence was one of the reasons for the move, it certainly is not the most important one. Nor should it be.

This is not about a battle for territory or for control for control's sake. It is about what is best for the SA economy. The Bank and the national treasury share the same aim that SA enjoy a sustainable, high rate of economic growth that generates jobs and is accompanied by a low rate of inflation. Is the Bank doing its bit?

The argument against hiking rates goes something like this: a hike in interest rates will, perversely, aggravate the rand's weakness against major currencies. The view is perverse in the sense that the argument goes against conventional, 'textbook' economic theory, which holds that higher interest rates will attract foreign capital and will therefore boost the currency.

But the conventional theory does not hold water, as yields on interest-bearing investments in SA fall far short of the rates of return that can be earned in high-growth emerging economies or high growth areas in rich countries, such as on the Nasdaq.

For those investors who aren't chasing growth, the absence of risk in industrialised countries outweighs the benefits of higher yields in riskier ones. SA's yields are not high enough to compensate for the perceptions of local risk.

SA's interest rates do not offer enough of a risk premium to compensate for political, and especially, currency risk. Perceptions of risk might be regarded as unfair, but who said that markets are fair? Anyway, who would not see currency risk in a country when its blue chips seek every escape route possible?

Investors, aware that SA still has exchange controls, and that there is still cash trapped locally, see the words 'currency risk' written all over SA Inc's prospectus.

The interest rate hike might encourage local business people to take their cash out of SA, to seek growth opportunities elsewhere. Don't blame local businesspeople if that is what they want to do. Already they are not impressed by SA's tepid 2% real growth rate, and higher interest rates will chip away further at that rate.

In terms of this argument, interest rate hikes will fuel rand weakness, lessening their effectiveness in the battle against inflation.

The way in which higher interest rates will keep a lid on inflation is by curbing domestic demand. As a result, the economy is likely to expand by less than 2% this year, which does not even keep pace with the population growth rate.

There is little sign of demandpush inflation. The pressure is coming from the cost side, and killing off demand is a drastic remedy.

Medical aid costs, education, food and fuel prices have hit consumers hard; they now have to face higher mortgage rates as well. In the year to November, medical aid costs have risen 11%, education costs more than 10%, food prices are up 8,5%, and fuel and power more than 7%. By contrast, clothing and footwear prices were down 3,8%. These figures suggest that consumers' spending power is already constrained, and is not exerting huge pressure on inflation.

In summary, the argument against raising rates hinges on the view that the rand, and inflation, won't benefit much unless truly massive increases in lending rates took place. That would kill off economic growth.

Now for the argument in favour of lifting interest rates. One would expect the central bank to provide the argument in its monetary policy statement, but no such luck. The statement communicating the increase in the repo rate was terse and lacking in detail, to put it mildly.

Whatever happened to the transparent central bank which provided detailed monetary policy statements outlining the nuances of the Bank's thinking?

Nevertheless, this is what the Bank had to say: 'The steep depreciation of the rand has altered inflationary expectations in SA which endangers the attainment of the inflation targets. To counter secondround effects of the depreciation on inflation, the monetary policy committee decided to increase the repo rate.'

The argument is that the rand's collapse makes it easier for companies to raise prices, even before they are hit by the rand's effects, because consumers' expectations have changed. In a climate of heightened inflationary expectations, labour is able to bargain for higher wage increases.

The argument goes that the lack of demand-pull inflation is no reason not to cut interest rates if a cost increase threatens a wage-price spiral. The rand's collapse has created the potential for a wage-price spiral.

SA has set a target of a 3%-6% monthly average for CPIX inflation consumer inflation excluding mortgage rates. The latest Reuters poll of economists shows that economists have raised their projections for the CPIX rate to 7,35% this year.

So which side is right?

The first point to make is that the move has failed to strengthen the rand. The currency has been volatile, and there is still a lot of lost ground to be regained.

Secondly, the move won't save this year's inflation target and it might not be enough to save next year's. Still, it does send a signal: it curbs inflationary expectations, emphasises the Bank's independence and its commitment to the battle against inflation.

Perhaps the point needed to be made. But the signal is more than enough. Does it really matter if SA's inflation rate is closer to 8% than 6%? My sense is foreign investors are much less worried about SA's inflation than its other problems.

Steyn is Managing Editor.

Publisher: Business Day
Source: Business Day

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