Interest rates fall as politics stalks the SARB

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The Monetary Policy Committee (MPC) of the South African Reserve Bank (SARB) announced a 25 basis point (bps) cut in the benchmark interest rate at its 20 July meeting, thus dropping the repo rate from 7.00% to 6.75%. Most market analysts had expected interest rates to remain unchanged at this meeting, but had nevertheless expected the Bank to cut rates later this year. The Reserve Bank last adjusted interest rates in March 2016, when they increased rates by 25bps. According to the MPC statement, the decision to cut rates was not unanimous, with four members voting for a 25bps rate cut and two voting for rates to remain unchanged. Once again, the SARB highlighted that the downside risks to economic growth have increased, while the outlook for inflation remained encouraging, but not without risk.

Although a much improved inflation outlook was a clear prompt for the reduction in the interest rate, the MPC painted a bleak picture of growth prospects, saying the cut would help only “at the margins”. The Bank also warned that the environment was highly uncertain and that it would not hesitate to reverse its decision to cut the rate should the inflation outlook deteriorate again. The 25bps cut seemed to surprise many in the market because few commentators had expected the cut to come so soon. Many economists had argued that lower inflation over the next couple of years created space for cuts later in 2017 or early in 2018. Many had also expected the Bank to be cautious in the face of political risks to the rand that could derail inflation. The Bank revised down its average inflation forecast for each of 2017 and 2018 by 0.4% and then by 0.3% for 2019. The Bank now sees inflation coming down to average 5.3% in 2017, 4.9% in 2018 and 5.2% in 2019. At the same time it downgraded its growth forecast to just 0.5% for 2017, then moving up to 1.2% for 2018 and 1.5% in 2019.

The committee said that it was unclear where the drivers of accelerated growth would come from “in the absence of credible structural policy initiatives that will reduce uncertainty and increase business and consumer confidence” and warned that growth could come in even lower than its forecast. Lower international oil prices and a slightly stronger rand are expected to underpin lower inflation, as are more subdued food price inflation and the weak state of the economy itself.

The decision to cut the interest rate came as the SARB faces a direct attack on its mandate by South Africa’s new Public Protector who had made a very controversial recommendation to eliminate its price stability mandate. This outburst from the Public Protector has resulted in an opposing high court challenge to this recommendation that the Constitution be amended to change the Bank’s mandate. In her response to the rapid high court challenge, Busisiwe Mkhwebane quickly indicated that she would not oppose the application. The court challenge had also been supported by Parliament and the Court has indeed decided in favor of the SARB.

Some of the initial commentary following the MPC announcement was from ratings agency Moody’s. Moody’s suggested that the first interest rate cut in five years by South Africa’s central bank would likely boost the country’s economic growth potential, but warned that the policy decision also signaled growing political pressure on the bank. “Political pressures on the SARB to maintain expansionary monetary policies are likely to prevail, alongside heightened pressures for fiscal spending,” said Moody’s, which rates SA’s debt just one level above sub-investment grade, with a negative outlook. “The timing of the public protector’s report (that is, after a major cabinet reshuffle and before the ANC policy conference) points to growing political pressure for less independent monetary policy, a key pillar in our assessment of South Africa’s gradually deteriorating institutional strength”. Moody’s then emphasised that they were in support of the rate cut decision, saying that it was justified by economic circumstances and that the Reserve Bank’s independence remained strong despite political pressure. The agency, which has SA on review for a downgrade, said it remained concerned about the country’s deteriorating institutional strength and warned that without “decisive structural reforms” economic growth would remain subdued in the medium term and would continue to put pressure on ratings. In June this year, Moody’s had already flagged the gradual deterioration of SA’s institutions as one of the factors that could lead to a downgrade, along with low growth and fiscal pressures. SA’s independent monetary policy has been a key pillar in Moody’s assessment of SA’s institutional strength.

Moody’s lead sovereign analyst for SA, Zuzana Brixiova, said in an interview at the end of July that the rate cut had been “perfectly justified by economic circumstances and in the realm of very reasonable action”, with inflation falling faster than expected, very low growth and contracting fiscal policy creating room for cyclical stimulus. Brixiova then added that the timing of the Public Protector’s comments on the Bank’s mandate and the call for state ownership of the Bank pointed to growing political pressure for less independent monetary policy.

Pravin Gordhan has also weighed in against the political attack on the SARB. The well-respected and highly regarded Mr Gordhan, who was fired as Finance Minister in a midnight Cabinet reshuffle by President Jacob Zuma in March, suggests that South Africans should send a message of encouragement to Reserve Bank governor Lesetja Kganyago. While delivering the closing address at the recent Democracy Works Foundation’s discussion on democracy defenders, Mr Gordhan warned: “We must be careful, there is a new campaign to discredit the South African Reserve Bank”. “Even if we disagree with monetary policy, don’t undermine the institution – have a constructive debate”. “Say if you do not want inflation-targeting, but debate the issue in a way that does not destroy institutions”, he said. “To governor Kganyago we must send a message of encouragement in this difficult time,” said Gordhan. Gordhan also paid homage to former Department of Social Development director-general Zane Dangor and erstwhile South African Social Security Agency CEO Thokozani Magwaza, who quit abruptly two weeks ago, for standing up to their Minister, even going all the way to the Constitutional Court, saying both had paid the price for doing the right thing.

We have earned our credibility and will protect it – this was Mr Kganyago’s emphatic response to questions about whether the Bank had been under pressure or was concerned about its credibility following this largely unexpected decision to cut interest rates. An editorial in the Business Day newspaper pointed out that

…if anything demonstrated how solid is the credibility that the Bank has built under Kganyago and predecessors Gill Marcus and Tito Mboweni, it was the orderly way in which the rand/dollar exchange rate behaved following the rate cut.

The rand weakened to above R13 to the dollar on news of the decision – which was entirely to be expected. Most of the market had been taken by surprise. There were also bound to be concerns in the market about what prompted the cut. However, the rand rapidly rebounded as the market digested the news and by the end of the week was comfortably back below the R13/dollar level.

The much lower inflation outlook was a significant driver of the cut in interest rates. The issue now is whether this is the start of the long-awaited cutting cycle. This is the first interest rate cut since July 2012 and the committee should not normally be starting to cut unless it expects to carry on that way for a while. The trouble is that the outlook is still highly uncertain and risks to the exchange rate and to inflation have by no means gone away. Chief of those is the risk that SA will shoot itself in the political foot again. Even if global investors continue to embrace emerging markets, there are surely limits to how much they will tolerate dodgy political outcomes in SA.

There is also a high probability of a downgrade to SA’s local currency ratings by mid-2018, which is likely to cause sizeable capital outflows and put pressure on the currency. No wonder then that two of the MPC members were reluctant to start the cutting cycle now, and that the Governor cautioned that the committee would not hesitate to reverse its decision if the risks materialised and the inflation outlook deteriorated. The committee’s decision was the right one for now and if anything, reinforces the Bank’s credibility.

At the moment the forward rate market is pricing in at least two more interest rate cuts over the next twelve months.

The fact that the SARB governor expects the rate cut to help only “at the margins” means that no one should be welcoming a cut in the context of an economy that is so weak or a political environment that remains so fraught – nor should they necessarily rely on any further cuts.

Source – APS Monthly Economic Commentary