Monetary Policy and the Economy in South Africa


Sep 23rd 2013

In the recent book I co-authored with Eliphas Ndou (Economist at the South Africa Reserve Bank Research Development), entitled “Monetary Policy and the Economy in South Africa”, we discuss some of the different empirical and pertinent monetary policy questions in South Africa. Using a Bayesian VAR approach the book assesses the linkage of monetary policy with various economic variables.

The evolution of the South African monetary policy has been remarkable. From the “direct controls” regime in 1970 to the “liquidity asset ratio-based system” between 1960 and 1981, to the most recent monetary policy adopted in 2000 – the “inflation targeting framework” – the South African monetary policy system has been able to adapt to economic and development challenges both domestically and abroad. The inflation targeting is a monetary policy framework in which the Central Bank announces an explicit inflation target and implements policy to achieve this target directly. In fact, the inflation targeting framework provides full operational autonomy to the South African Reserve Bank (SARB), which can elect the use of any available monetary policy instrument in its pursuit of targets. Although there were some periods of fallout (e.g. 11.5 per cent in 2008), the SARB managed to bring inflation within the three to six per cent band.

As we investigated the effects of an unanticipated contractionary monetary policy shock on output in South Africa, we found that it reduces output, suggesting that unanticipated monetary policy has significant nominal effects, with price levels significantly reduced. With regard to the relationship between output and inflation, we were able to support Friedman’s hypothesis that increased inflation uncertainty reduces the information function of price movements and hinders long-term contracting, thus potentially reducing real output growth.

A contractionary monetary policy shock also impacts consumption expenditure in South Africa. We notice that an increase in the interest rates reduces consumption by lowering the amount of disposable household income available after mortgage payments have been made. Monetary policy tightening (e.g. to 9.8 per cent) impacts both household wealth and credit, which reduce the level of consumption. We investigated further by adding four consumption variables: non-durable, durable, semi-durable and total consumption goods (including effects of oil prices). We found that as the interest rate increases, the real house prices, real disposable income, as well as real non-durable and services consumption expenditure decrease. Adding the oil price inflation variable, the negative effect on all real consumption, real disposable income and real house prices becomes stronger.

According to the South African Reserve Bank, the country recorded a Current Account deficit of 216,202 million ZAR in the second quarter of 2013, while the Trade Balance deficit reached 14,205 million ZAR. South Africa’s trade balance as a percentage of gross domestic output has widened since 2003 (Q4). Those trade deficits are best explained by the deterioration in commodities exports and high imports of fuel and high value added goods. The fluctuation of the currency exchange rate regime and its impact on the country’s competitiveness is equally worth noting. From 1972 until 2013, the rand-dollar exchange rates (USD-ZAR) averaged 4.6900 reaching an all-time high of 12.4500 in December of 2001 and a record low of 0.6700 in June of 1973. In our book, we compared the effects of contractionary monetary policy and exchange rate appreciation shocks on the trade balance in South Africa. Using a Bayesian sign restriction approach, we found that trade-weighted exchange rate appreciation shocks worsen the trade balance for longer periods than contractionary monetary policy shocks.

In analyzing the effect of both the exchange rate and monetary policy shocks on the trade balance through imports we also investigated the significance of house prices and equity price appreciation shocks on the South African current account balance. By using the sign restriction VAR approach in an open economy framework (to account for the international transmission mechanism), we compared the impact of the Real Effective Exchange Rate (REER) and asset prices (i.e. house and equity prices) on current account movements. Our results show that, compared to asset prices, the REER shocks tend to worsen the current account for longer periods, thus suggesting that REER fluctuations drive the main adjustments of current account imbalances.

Another important element that the book analyses is the international spillover effects, more particularly the transmission of macroeconomic shocks in the United States to the South African economy, in light of the global financial crisis. By using the SVAR model, the book investigated the channels and the extent to which the macroeconomic fluctuations in South Africa are influenced by US shocks. The spillover effects of the interconnectedness between South African and US economies are numerous. We found that a US monetary expansion had positive spillover effects on South African output, stock prices, the exchange rate and M2, monetary supply. The results confirm that the South African economy is indeed vulnerable to external shocks.


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Mthuli Ncube

Professor Mthuli Ncube is the Chief Economist and Vice President of the African Development Bank, and holds a PhD in Mathematical Finance from Cambridge University, UK, on “Pricing Options under Stochastic Volatility”.

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