28 Jun 2017

Opinion piece: The importance of maintaining core institutional strengths (such as inflation targeting) to avoid further credit rating downgrades

Annabel Bishop

Chief Economic

The importance of maintaining core institutional strengths (such as inflation targeting) to avoid further credit rating downgrades.

Many high income economies, and also middle income economies seeking to transition to high income economies, employ inflation targeting. South Africa is a middle income economy and this means that it is able to afford social welfare payments and other social services that low income economies typically would struggle to do so on their government earnings (taxes) alone, and so these countries rely on international donor aid or access to employment in neighbouring countries, amongst other supports, such as Zimbabwe.

In seeking to protect the value of the rand (by preventing high inflation) the SARB is seeking to maintain macro-economic drivers fundamental to a stable economic system, and not an economy that is heading to junk status - ultimately a failed state which is unable to make social welfare payments to the poor. Indeed, it is the poor who are most rapidly afflicted by sharply rising prices (the removal of inflation targeting), particularly the prices of food and other necessities as they spend the bulk of their income on these items, often going without. A high inflation environment, where inflation targeting is abandoned, would mean a rapid (likely double digit) rise in the cost of living, which the poor would not be able to afford, and would have to increasingly go without.

When the question of economic growth versus inflation targeting is introduced, then the answer is somewhat different, and indeed the US, a highly successful, high income economy, balances a dual mandate of seeking both low unemployment (employment creating growth) and low inflation. How the US differs from SA though, is that its unemployment rate, in low, single digits is not comparable to SA’s high rate, officially now close to 30% (27.7%), in that South Africa’s unemployment rate contains a large structural element (which we estimate up to 22%). This means that even if we cut interest rates substantially, despite high, and expected high, inflation (abandon both inflation targeting and the independence of the South African Reserve Bank), these interest rate cuts would not reduce unemployment to below 22%. Instead what is needed to do that is strong, persistent and inclusive economic growth.

Indeed, strong, inclusive economic growth that continues (economic growth which ensures the socio-economic wellbeing of all the countries citizens) is the only sustainable solution to sustainably radically reducing unemployment to single digits, eliminating poverty and radically dropping inequality. We estimate reducing unemployment to single digits in SA would take continuous real GDP growth of above 6% from current levels for at least 10 years, along with strengthening (not weakening) SA’s institutions. That is, real GDP growth of above 6% from current levels every single year for at least 10 years driven by the private business sector. Without strong economic growth of this magnitude there will be insufficient incentive to employ the number of individuals needed to drop SA’s unemployment rate sharply to single digits.

Government has run out of borrowing capacity (if it wishes to retain investment grade credit ratings), and its debt is now instead in the process of being downgraded to sub investment grade, with negative outlooks on its key credit ratings that remain investment grade (negative outlooks mean the next move will be a credit rating downgrade). Government can no longer borrow to pay current expenditure (which includes public servants’ remuneration), as it has done in part, resulting in a primary deficit. Indeed, what is happening now is that the credit rating downgrades risk further downgrades and a lower growth environment as business and consumer confidence falls.

Already depressed confidence levels have seen the South African economy tip into recession after a slow steady decline in economic growth since 2009. Business confidence has been depressed since 2009. Why? Initially as a legacy issue from the global economic crisis, but then, after the global economy saw growth lifting, South Africa followed a different growth trajectory. Key institutional strengths are necessary in any successful economy that improves the standard of living for all its citizens (provides socio economic transformation). No country has sustained successful socio economic transformation to higher living standards if it erodes key institutional strengths like Central Bank independence

Clearly it is not the role of the SARB to achieve meaningful socio economic transformation, not only is it impossible for just one entity to do, but the key problem in SA is a radical loss of confidence in the macro economic outlook. Meaningful socio economic transformation can only be achieved by fast sustainable GDP growth, which in turn can only be achieved by strengthening and maintaining core institutions (such as inflation targeting, Central Bank independence, judicial independence, private sector property rights (including intellectual property), eliminating corruption and wasteful government expenditure, reducing unnecessary regulation, ensuring transparency and consistency of government policy making, low costs of crime and violence, strong auditing and reporting standards, efficacy of corporate boards and investor protection). Crucially, government policies need to be balanced with support for robust, broad based private business sector activity (an environment where risk and return can be priced with near certainty) if lasting, meaningful socio economic transformation is to occur.

The private business sector has always been the growth engine of any economy, and with fiscal stimulation having run out of steam in SA as government finances are now very constrained, monetary stimulation (monetary policy accommodation) has naturally come under scrutiny. However, unlike the robust debate which takes place between the SARB and the private business sector (as the latter generally prefer lower interest rates); public sector threats to the constitutional independence of the SARB are unhelpful as the SARB cannot bring about, let alone achieve meaningful socio economic transformation. The best the SARB can do is balance regulation on the financial services industry with care to underpin sustainable positive activity (and so employment) in it, while ensuring a workable inflation environment, as businesses also cannot operate successfully in a high inflation environment, particularly one that is at risk of runaway inflation.

Tinkering with the cornerstones of economic success that are encapsulated by the strengths of core institutions listed above (the global norms for successful economies), historically results in unsustainable socio economic transformation, and so the socio economic transformation proves not to be meaningful (does not last), except for the politically connected few. The wheel cannot be reinvented successfully when it comes to the formula for inclusive economic success, and so socio economic transformation.

Rapid growth of the private business sector is the key, as only it has the capacity to absorb all the unemployed in the long-term, but it is currently hamstrung in South Africa by weak demand and the gradual (actual and attempted) weakening of core institutions. The latter has depressed the business sectors confidence to invest and employ, and increased its fear of failing through expanding/overstretching in a weak economic environment. Private sector businesses need to be able to ensure their continued existence, as failure means job loss (increased unemployment), loss of capital and economic hardship for all involved.

Central Bank independence and inflation targeting/low inflation are key underpins to high credit ratings, and indeed remaining positives which have been identified for SA by the credit rating agencies. If SA’s Central Bank is no longer independent, and is mandated by government/parliament to cease inflation targeting and take up a new mandate, SA will very likely lose its remaining key investment grade credit ratings, which are already on a negative outlook (in line to fall into sub investment grade).

A migration from investment to sub-investment grade for a sovereign invariably means higher borrowing costs for that country, particularly when a season of global risk on wears off (these seasons are never permanent in the financial markets). Pressure is put on the whole maturity spectrum and interest rates in the short end rise too. While the South African Reserve Banks’ repurchase (or repo) rate will not escape this pressure, it will also be under pressure to increase following rand weakness and a resultant rise in inflation. Scuppering inflation targeting wouldn’t remove the upwards pressure on financial market interest rates for a sub-investment grade sovereign, but it would remove the pressure on the repo rate for hikes from higher inflation.

The advent of a blanket sub-investment grade sovereign rating for SA would, we estimate weaken the rand substantially, and quickly towards R19.00/USD. Such radical depreciation of the domestic currency would push up living costs for South Africans substantially, transforming their living costs as food price inflation is influenced by the exchange rate, as are transport costs. Doing away with, or diluting the inflating targeting mandate, would not stop the negative impact on living standards, and this socio-economic own goal would hurt the poor most.