Address by Mr T.T. Mboweni, Governor of the South African Reserve Bank, at the South African Bond Market Conference organised by the Debt Issuers Association, 5 October 2006 Honoured guestsLadies and gentlemen 1. Introduction Thank you for giving me the opportunity to open this conference on the South African Bond Market. There are several reasons for developing debt markets. The most fundamental reason is to make financial markets more complete by generating market interest rates that reflect the opportunity cost of funds at each maturity. This is essential for efficient investment and financing decisions. If bond markets do not exist, firms may have to finance the acquisition of long-term assets by short-term debt, and investment policies may be biased in favour of short-term projects. Furthermore, debt markets can help the operation of monetary policy as prices in the long-term bond market give valuable information about expectations of likely macroeconomic developments and about market reactions to monetary policy moves. In my opening remarks today I will touch briefly on monetary policy and bond market issues. 2. Monetary policy developments As you are all no doubt aware, monetary policy does not determine bond market yields. Nevertheless, monetary policy and the bond markets do impact on each other in important ways. Expected monetary policy developments are reflected in bond yields and we, in turn, get a lot of information from the bond market about market expectations concerning future monetary policy, inflation and growth. More recently, the development of the inflation-linked bond market has provided us with further insights into longer-term inflation expectations in the market. Not surprisingly, the change in the monetary policy stance in recent months has been felt in the local bond markets. The repo rate had been unchanged for 14 months, but in June of this year, the Monetary Policy Committee decided to raise the repo rate by 50 basis points, and this was followed by a further increase of the same amount in August. Although capital market rates reflect expectations, these expectations are not always correct. At the time of the first increase, these changes were not fully reflected in bond yields, but we have seen a significant adjustment since then. Although our actions took many by surprise, for some time we had been sounding warnings that we perceived the risks to inflation to be on the upside. Our warning remains the same today, as we still see significant upside risk to the inflation outlook. Our major concern remains the growth of household consumer demand which grew at an annualised rate of 8 per cent in the second quarter of this year. This expenditure is still being driven by credit extension growth in excess of 25 per cent, and household debt as a proportion of disposable income has risen to an historically high level of 70 per cent. Despite the obvious dangers of such developments and the recent hikes in interest rates, there are no indications of any meaningful change in consumer behaviour. It is hard to imagine that such trends, if unchecked, will not have inflationary consequences. Another area of concern has been the current account deficit, which although narrowing from the 6,4 per cent of GDP registered in the first quarter of 2006, still stood at a high of 6,1 per cent of GDP in the second quarter. As we have noted in the past, current account deficits are not in themselves inflationary. There is however a possible risk to the exchange rate if the deficits are perceived by the markets to be unsustainable, particularly if the deficits are reflecting higher consumption expenditure. On numerous occasions we have pointed out the possible implications of the deficit for investor sentiment and for the rand. The recent exchange rate reaction to the higher deficit is indicative of this, but it is also part of the adjustment process. Nevertheless the adjustment in the exchange rate has reached levels which may pose a further threat to the inflation outlook. Fortunately it is not all doom and gloom, a