Domestic indicators are not the full picture

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We will find out at 3pm today whether the repo rate and the prime rate will go up, go down or stay the same. Most agree that they won’t change.

The repo rate is the rate the Reserve Bank charges the commercial banks and the prime rate is the rate banks charge us.

Gill Marcus, the Reserve Bank governor, and her monetary policy committee are stuck between a rock and a hard place. Interest rates are the primary method to control inflation and whenever there is talk of changes in interest rates, it is the inflation rate that is stated as the driver and predictor of movements.

If inflation is high, it can be reined in by increasing interest rates and curbing demand for goods and services. If low, interest rates can be maintained or lowered to encourage spending and growth. This is the eternal balancing game that the central bank’s policymakers need to evaluate and decide on every time they meet.

But it’s not just inflation they need to be concerned about, but the portfolio investment inflows on the financial account – many of which are driven by South Africa’s high interest rates. This competitiveness is quickly being eroded by changes in the money market across the world.

A significant threat is the cutting back of the US quantitative easing policy and its central bank’s decision to buy fewer bonds from the market. The decrease in demand causes the price of bonds to decrease and interest rates to rise. The decrease in money supply and drop in US consumer demand have also sent shivers across the market, calming investor appetite for emerging market economies. Both lead to higher demand for portfolio investment in the US and less for the rest.

It’s not just the US that has become more competitive on interest rates. Brazil has increased its policy rate to 10.75 percent from 7.25 percent in April last year. Turkey recently raised its one-week repo rate from 4.5 percent to 10 percent.

Such violent movements in the money market result in violent movements in South Africa’s money. Net financial inflows on the financial account dropped from R79.9 billion in the third quarter of last year to R35.9bn in the fourth quarter.

Portfolio inflows alone changed from an inflow of R48.8bn to an outflow of R30.8bn over the same period – a total drop of R79.6bn in one quarter. This was made up mostly of interest-bearing debt and not shares, and is the largest quarterly outflow since the fourth quarter of 2008. In total, portfolio inflows decreased from R95.1bn in 2012 to R14.2bn in 2013.

If South Africa can’t attract money through portfolio and direct investment, it won’t be able to pay the huge difference between import expenses and export incomes. Positive flows on the financial account are crucial to finance the nearly R200bn deficit on the current account. If not, investor confidence in South Africa will drop, credit ratings will worsen and inflation will increase.

It is still likely that interest rates will not change today. To avoid future surprises, it is wise to look further than just inflation. South Africa’s financial market is ranked third best in the world, behind only Singapore and Hong Kong, and, as a result, experiences disproportionate financial flows in relation to the size of its economy. When deciding on monetary policy, Marcus is looking further than just domestic indicators, and so should we.

* Pierre Heistein is the convener of UCT’s Applied Economics for Smart Decision Making course. Follow him on Twitter @PierreHeistein


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