High interest rates will not protect the rand long term, writes Charles Millward
In his governor’s address in 1995, Chris Stals referred to certain economists who were calling for a substantial devaluation of the rand; such a devaluation would be, he said, no more than a panacea given that South Africa’s problems of competitiveness were more deeply rooted. Subsequent to the collapse of the rand in February 1996, the same Stals called on exporters to take advantage of the newly weak rand.
The overriding theme of this year’s speech is the Reserve Bank’s heroic defence of “financial stability” in the face of the real possibility of a collapse in the country’s external financial relations pursuant to the currency crisis of February 1996. While the bank allowed the market to take its course in the short term and let the rand slide with minimal intervention, its longer-term response was to manage interest rates upwards.
According to the governor, the pain attendant upon higher interest rates as real economic activity slowed down was essential to “avoid even greater disruption later on”. The country cannot afford unsound monetary policies, he says, as they will lead to long-term disruption of financial stability.
He re-affirms that the bank intends to use interest rates “more frequently and extensively to pursue its overriding objective of protecting the value of the currency”. It restored financial stability after the currency crisis of 1996 and inflation is now well below 10% again. He notes, “To achieve these results required a consistent restrictive monetary policy with relatively high interest rates.”
He notes that as South African markets are integrated into the world financial system, the relative level of local interest rates to those prevailing internationally becomes significant. Too low a level will result in a weak currency and depreciation of the rand. Too high a level “will attract speculative capital from abroad” and lead to appreciation in the currency and excessive domestic liquidity. He concludes that the “domestic levels for interest and exchange rates can no longer be determined . in isolation”.
The governor’s comments about integration in the world economy are no more than lip service. The bank is resolutely bound on a course to influence both interest and exchange rates and thereby “protect the internal and external value of the rand”. Whether it can succeed is, of course, another matter entirely.
In its fulfilment of its mandate since 1989 it has deliberately intervened in the domestic money market, as well as the foreign exchange market, through a variety of measures. In the money market it has consistently kept real interest rates high by increasing the banks’ reserve requirements, as well as absorbing liquidity through open market operations. This has meant real interest rates have stayed consistently above 5% since 1990, and in recent years have approached 10% and more.
In the foreign exchange market, it has been able to influence the exchange rate and capital flows directly by being the effective market-maker in rand forward contracts. To maintain the rand exchange rate, it has consistently set forward cover levels at favourable rates. In particular, this has resulted in the massive switching by corporate South Africa from domestic to foreign sources of borrowing, since the latter are so much cheaper, even after forward cover costs.
Combined with large inflows of speculative capital in pursuit of the high domestic interest rates available, the bank’s policy has left the currency at the mercy of speculators. Consider that of the approximately R28-billion of capital that flowed into the country in 1995, probably three-quarters of this represented short- term credits and speculative inflows. The problem with these short-term inflows is, as the governor correctly identifies, that they cause an over-valued currency. Thus the rand’s value held steady for over 18 months from mid-1994 to February 1996, a substantial inflation differential with the dollar notwithstanding.
It was only a matter of time therefore before economic reality took hold and the rand adjusted downwards. Yet the bank does not appear to have learnt its lesson. Real domestic interest rates are, if anything, higher now than in 1995. And the level of intervention in the forward market is as extensive as ever.
According to Rob Lee of BoE NatWest, the Reserve Bank is committed to forward dollar sales of some $21-billion while possessing net reserves of only $4,2-billion. Lee argues that the bank will avoid cutting interest rates because of the size of its forward book. As the bank writes more forward contracts, the risk of a rand collapse becomes ever more unacceptable because of the attendant foreign exchange losses.
As recently as two years ago these losses on the forward book were estimated at R30- billion. With the slide of the rand, the ongoing forward cover programme and the steady repayment of standstill loans covered at favourable rates up to 10 years ago, the loss situation is probably worse than ever. Of course, these losses are generally not funded by the Treasury but by pure money creation.
To neutralise the inflationary pressure created by its own attempts to manage the value of the currency, the bank needs to absorb liquidity from the system – an expensive exercise in its own right (in addition to the excess liquidity problems created by the artificially high level of domestic interest rates). Yet it dare not cut interest rates precisely because this would threaten the value of the rand and thus its entire exchange-rate management programme.
The bank’s policy initiatives have come at massive cost to borrowers who are paying interest rates probably 5% or more higher than would strictly be necessary. The unfortunate part is that these huge costs, inflicted on sectors of the society that can least afford them, will prove fruitless in the long term. The rand will find its true value, the bank’s interventions notwithstanding, and the benefits of the reduction in inflation by a few percentage points are arguable, if not illusory. The sooner the governor realises this, the better for all of us.
Charles Millward is investment adviser to Numsa. The views expressed are his own.