1. The role of interest rates in a market economy
The interest rate is one of the most important prices in the market economy. It represents the price of loanable funds and, like all other prices, has a fundamental role to play in the allocation of a scarce commodity, and in the determination of the amount that will be supplied, on the one hand, and of the amount that will be demanded, on the other, of this special commodity.
The main source of loanable funds is saving by the community; the demand comes mainly from consumers, investors and governments that borrow funds to finance their expenditure. If the demand increases without a balancing increase in supply, the price of the commodity, that is the interest rate, will rise. If supply grows faster than demand, or demand declines to a lower level with no change in supply, interest rates will decline.
This very simple and basic economic law of demand and supply is complicated, in the case of interest rates, by the process of the creation of new money, by capital inflows from and outflows to the rest of the world, and by inflation. The layman often finds it difficult to see beyond the veils surrounding interest rates and to accept the normal demand and supply disciplines of the market economy, particularly when it comes to the pricing of this very special commodity traded in the financial markets as loanable funds.
In South Africa, where the economy is based primarily on the foundations of a market structure, interest rates are determined in well-developed and well-functioning financial markets to reflect underlying demand and supply conditions. But, unfortunately, the South African economy operates in a financial environment where the demand for funds chronically exceeds a relatively limited supply. Total domestic saving of the private sector now amounts to about 20 per cent of gross domestic product. Government requires about 5 per cent of gross domestic product to cover the annual deficit on the budget, which leaves only about 15 per cent of gross domestic product for investment in the private sector. And yet, this country needs investment of at least 25 per cent of gross domestic product every year to increase the production capacity and to create new jobs for the growing population.
Unless the low level of domestic saving can therefore be supplemented with a regular large net inflow of real long-term investment funds from the rest of the world, equal to about 10 per cent of the South African gross domestic product of R500 billion per annum, there will be a continuous upward pressure on interest rates. This is the built-in self-regulating force of the market economy. Higher interest rates must encourage more saving, and discourage the excessive demand for funds emanating from government and the private sector. High interest rates therefore depress the economy, restrict new investment and consumption, and make it more difficult for governments to finance budget deficits. High interest rates represent one of the most important disciplinary actions of the market economy to bring about better balance between the demand for, and the supply of, loanable funds. It is understood and accepted that high interest rates hurt the economy, but this is, after all, what they are intended to do.
2. Can the Reserve Bank create lower interest rates ?
The Reserve Bank is a special institution that has been given the power to create money, and to control the creation of money by other banking institutions. This power, conferred on the South African Reserve Bank by Parliament in 1920, gives the Bank a powerful position in the economy, but also a great responsibility. This responsibility has been clearly identified and was included in the Reserve Bank Act, and also in the Constitution of the Republic of South Africa. It is to protect the value of the currency.
The South African legislation does not provide any specific target for inflation, but it is clearly understood that the Bank must avoid inflationary policies and must, in the exercise of its duties, keep inflation as low as possible. Economists will always disagree on what an appropriate target for inflation should be. In countries where predetermined inflation targets are pursued, they represent a joint decision reached between government and the central bank, with, in some cases, the support of business and labour. In the absence of such a target in South Africa, the Reserve Bank uses as its guideline the objective to bring the rate of inflation more or less in line with the average rate of inflation in the economies of South Africa's major trading partners and world competitors. As long as this objective is not achieved, the exchange rate of the rand will remain vulnerable and subject to periodic volatile adjustment. With a higher rate of inflation than in the rest of the world, nominal rates of interest in South Africa will also remain at higher levels than in other countries with lower rates of inflation.
In view of its ability to create money, the Reserve Bank can influence the supply of loanable funds in the economy by creating more, or less, money from time to time. The Bank has a number of operational instruments at its disposal to create more money, for example open-market operations, through which the bank can exchange assets (government bonds) held by the private sector for money. The minimum cash reserve requirements of banking institutions can be reduced to release funds for on-lending by the banks. Or the Reserve Bank can simply lend more money to banks at the discount window.
Whatever method the Reserve Bank may use to try and reduce interest rates in a market economy, it will require the creation of more money. Anybody who asks the Reserve Bank to reduce interest rates on its initiative, therefore wants the Bank to create more money. In certain circumstances, this can be an acceptable policy option for the Bank, for example when the Bank is satisfied that the creation of more money will not jeopardise the main responsibility of the Bank, and that is to protect the value of the currency.
The decision of whether the creation of more money will be good or bad for the economy will often require a subjective and discretionary assessment of the general state of the economy. Central banks try to make this decision more transparent by announcing in advance certain guidelines or criteria that will influence their decisions on monetary policy. In South Africa, as in most other countries, these guidelines are defined in terms of major macroeconomic financial aggregates such as:
changes in the money supply;
changes in bank credit extension;
the level and the maturity structure of interest rates;
the level of and changes in the official foreign reserves;
movements in the exchange rate of the rand, and, of course,
current and expected trends in inflation.
Statistics on the actual developments in these financial variables are made public as expeditiously as possible, and the markets make their own judgement on trends and movements in the underlying forces. Adverse developments in these financial aggregates serve as early warning signals of possible future trends in inflation, and guide central bank policy on its control over the money supply. It will be irresponsible for a central bank and, in the case of South Africa, indeed unconstitutional, to deliberately allow or encourage the creation of more money in a situation where all the available evidence points to higher inflation somewhere down-stream.
3. The present South African situation
The Reserve Bank has not in recent years been very successful in its efforts to keep the South African rate of inflation in line with that of the rest of the world. With the liberalisation of the South African financial markets, and the integration in world financial operations, the pressure on us to come more in line with global trends in inflation is growing.
What is of even greater concern is that most of the internationally recognised financial guidelines for monetary policy in South Africa moved in the wrong direction over the past two years, and now urgently demand corrective action. The money supply increased at a rate well in excess of the growth in the nominal gross domestic product, and there is now more money per unit of production available in the South African markets than ever before. Total bank credit extension increased at almost 20 per cent per annum for three years now, and the amount of bank credit outstanding as a percentage of gross domestic product is at a record level. The inverse shape of the yield curve indicates a strong expectation of higher inflation in the short term, and the depreciation of the rand last year caused the rate of inflation almost to double from April 1996 to April 1997.
And yet, the pressure on the Reserve Bank is increasing to use its power to create more money in an effort to bring interest rates down: against the trends of market forces. In the situation, the Bank's monetary policy committee, that is the Governor and three Deputy Governors, cannot be blamed for being cautious. We cannot, for the sake of short-term gains, place the medium- and longer-term economic development of South Africa now at stake. Any irresponsible action now can only have short-term advantages, if any, but will surely lead the economy into the dead-end street of higher inflation at some later stage.
The Bank is therefore keenly waiting for some clear indication from the markets that the underlying trends in the financial aggregates are changing. In light of the slowdown in real economic activity since the second half of last year, it can be expected that growth in the demand for bank credit will also be reduced, and that the rate of increase in the money supply will recede. To relax monetary policy before these signals are clear, however, could lead to a premature new upsurge in the demand for money that may easily end up in financial speculation and asset price inflation -- a dangerous development that created many problems for a number of otherwise well-managed economies in recent times.
The reasons for the growing pressure on the Reserve Bank to abuse its powers to create more money by people who do not share in the Bank's responsibility of protecting the value of the currency, can be understood. After three years of relatively strong expansion in gross domestic expenditure in South Africa, supported by large increases in bank credit extension, the market economy is now reacting to a fundamental disequilibrium that developed between the country's capacity to produce, and the desire to consume. In this situation, it becomes difficult to distinguish between what we would like to have, what would be good for our own personal interests, what is indeed possible or realistic, and what will be in the interest of sustainable longer-term economic development of the country as a whole. The Reserve Bank cannot support the view that a policy of deliberately creating more money in the present environment will be the right option. We would rather prefer to be patient and to endorse a decline in interest rates for the right reasons, and that will be a decline in the demand for bank credit and in the pressures for the creation of more money.
4. A search for instant solutions ("miracles")
Economists and business people, driven by the vested interests of their own sectoral or institutional involvement, often overlook the important macroeconomic relationships that regulate modern market economies. They often therefore make inconsistent demands on the monetary authorities and suggest unrealistic solutions to seek easy escapes from the disciplines of the market economy. These proposals also negate the basic task of the Reserve Bank, and the clear instruction given to the Bank by Parliament.
The Reserve Bank cannot, for example, continue to create an excessive amount of money and keep inflation in check. The Reserve Bank cannot let the value of the rand depreciate against other currencies, and reduce interest rates at the same time. The authorities cannot remove exchange controls, and maintain artificially low interest rates in South Africa. And yet, so often these conflicting demands are made on the Bank, at times even by the same critics who fail to distinguish between macroeconomic realities and microeconomic desires.
A recent prescription by the International Monetary Fund advised the Reserve Bank to reduce the outstanding amount of forward cover provided by the Bank to South African importers and other users of foreign finance, and to let interest rates rise in the process. This is at least a consistent prescriptive that makes sense in a macroeconomic context. It is a different question whether this will be the best policy to follow in the present short-term South African economic situation where there is so much pressure for an immediate reduction in interest rates. Here again, the monetary authorities in South Africa (the Reserve Bank and the Ministry of Finance) must use their discretion and apply a policy that will be in the interest of South Africa. Our advice is not to force the forward book down at this stage, but rather to do it gradually as and when underlying pressures on interest rates will decline in future. Even the Reserve Bank has some sympathy for the pain created by the high interest rates in our economy at this stage.
In South Africa, the International Monetary Fund directive for a reduction in the forward book was supported by many economists with acclaim. These same economists, however, continue with their pressure on the Reserve Bank to reduce interest rates. They certainly expect of our monetary authorities to achieve miracles in a rather difficult macroeconomic environment.
We in the Reserve Bank remain optimistic that the present monetary policy is succeeding in its task of restoring an equilibrium situation in the financial markets that will reduce inflationary pressures and lead to lower interest rates in due course. We can only beg of the South African public to remain patient with us in the full implementation of this frustrating corrective process. In the longer term, it will be in the interest of a more sound economy that will benefit all the people of South Africa.
The Reserve Bank also welcomes constructive participation in this on-going debate by the many interested private sector economists in South Africa, on condition that they divorce themselves from personal and professional interests and approach the problem in the wider perspective of a national economy that is trying to establish a foothold in a very competitive global financial environment. Personal and emotional attacks on the Governor of the Reserve Bank will not change the basic macroeconomic laws of demand and supply, or obviate the need for persistent financial discipline in an economy that is inclined to overspend and live beyond its means.