Interpreting the November 2008 Monetary Policy Review
November 07, 2008
By Michael Kafe & Andrea Masia | Johannesburg
The SARB presented its bi-annual Monetary Policy Review (MPR) on November 4, 2008. This time around, the MPR offered little new information; and as usual, the panelists were guarded in their responses to questions from the floor. For us, the key issues are as follows:
First, the SARB warned that South Africa cannot expect to be immune to the global economic downturn: However, because the domestic banking system has remained relatively unaffected, and because there is a strong growth underpin from the government’s capital infrastructure program, the central bank noted that the impact of the global credit crisis on domestic GDP should be less severe than in other countries. This suggests that, unlike other countries where recession prospects have risen sharply, in South Africa the central bank does not feel compelled to engineer easier money with a view to averting a recession. If anything, we believe that the SARB is likely to preserve its credibility by continuing to prioritize the war against inflation (i.e., maintaining a tight monetary policy stance for as long as is warranted by domestic inflation risks), while allowing the fiscal authorities to address any growth concerns through counter-cyclical fiscal stimuli. Second, inflation prospects argue against policy easing in early 2009: The SARB reproduced the latest quarterly projections of its core inflation forecasting model as presented to the October 8-9 MPC meeting, with the associated fan chart showing a sharp drop in the projected inflation rate between 4Q08 and 1Q09. This is mostly due to the impact of the reweighting and rebasing of the inflation index, and it has CPI returning to the inflation target range in 2Q10. The SARB was, however, at pains to point out that there are numerous other risks associated with the inflation forecast, including but not limited to the recent deterioration in inflation expectations and related higher wage settlements, upside risks from recent developments in the exchange rate, and some downside risks from lower oil prices, a battered consumer, a widening output gap and softer wealth effects. From the inflation forecast fan chart presented in the review, we estimate the probability of CPI falling below the target ceiling by the close of 2008, 2009 and 2010 at 0%, 50% and 55%, respectively. In our view, these probability estimates are too low for the SARB to be confident enough to initiate policy easing early in 2009. Third, the panel suggested that future policy actions will hinge on changes in the balance of inflation risks: We believe that this refers to the metamorphosis of well-documented first-round food and energy price shocks into less conspicuous second-round inflation pressures in services inflation, at a time when the index is being reweighted to include more services (the weight of the services sub-index rises from 33.8% of the current CPIX index to 45.8% in the incoming CPI target index). Inflation in services such as healthcare, communications, recreation & entertainment, education and personal care is rising fast. And other subcomponents of the index, such as vehicles, which have been in deflation for the better part of the last half-decade, have now swung into positive territory and look poised to rise over 2009. Household operation costs have risen sharply too and will likely remain high in 2009/10 if the currency continues to trade on the back-foot. In response to a question from a journalist about whether the SARB will have enough leeway to cut rates as aggressively as suggested by the markets, at a time when the central inflation forecast clearly showed that inflation would remain far above the mid-point of the target band at the end of the policy horizon, the panel explained that it would depend on where the balance of risks lies at the time of each MPC meeting. Finally, we maintain for now our view that the SARB will cut rates by only 150bp in 2009, not the 300bp that the market expects. In response to a question on the risks posed by the country’s burgeoning current account deficit, the panel admitted that the current economic downturn is likely to place a ceiling on the price elasticity of South Africa exports, but held the view that import demand should be capped by the weaker ZAR. We beg to differ on the latter. We are of the opinion that lumpy public sector capital imports (which are relatively less sensitive to currency and interest rates) will be a key driver of import demand in 2009/10. As pointed out in earlier research (see South Africa Chartbook: Macro Cracks Widening, October 30, 2008), most of the 2010 FIFA-related infrastructure projects have rising import intensities over the build cycle, and we believe that import requirements are likely to rise as these projects mature. We therefore believe that the current account deficit will deteriorate, not improve, in 2009/10. This should exert further upside pressure on USD/ZAR, with commensurate inflationary implications that make it difficult for the SARB to cut rates as aggressively as is priced in by the market.
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Euro Wreckage? A Remix
November 07, 2008
By Joachim Fels | London
Some themes are like U-boats. They linger beneath the surface most of time, but when they emerge occasionally, they provoke much fear and can cause serious damage. One such theme is the potential break-up of the euro, which has become popular again recently with the deepening of the financial turmoil. Euro break-up was first widely discussed ahead of the introduction of the euro ten years ago, when commentators such as Harvard economist Martin Feldstein argued that the single currency might even lead to civil war in Europe. When that didn’t happen immediately and the euro introduction went smoothly, the theme submerged, only to make a comeback in 2004/05 when fiscal deficits rose and the fiscal stability pact was broken and had to be rewritten. Then as now, sovereign yield spreads between EMU member states widened and the euro weakened as markets were pricing in a rising probability of some sort of break-up. How seriously should one take the break-up risk in general? And how do the current financial turmoil and its consequences alter the risk assessment? To answer the first question, let’s revisit some arguments we published on this issue almost five years ago (those interested in more detail and a reply by Nobel laureate Bob Mundell to our piece back then may want to refer to Euro Wreckage? January 22, 2004 and Debating ‘Euro Wreckage?’ February 9, 2004). The following points made back then remain valid today, in our view: • First, the fact that the Maastricht treaty doesn’t contain any provisions for the break-up of the euro doesn’t mean that it cannot happen. If a sovereign member state really decided to secede from the single currency, it would be impossible for other members to prevent this. • Second, the political and economic costs of leaving the euro are sufficiently high to make secession unlikely, especially for a country that wants to leave in order to devalue its currency. For this country, borrowing costs would likely rise as investors would demand a currency risk premium. Also, while contracts between parties in the seceding country could by law simply be redenominated in the new currency, re-denomination would not easily apply to cross-border contracts. Foreign creditors could still demand to be repaid in euros (‘continuity of contract’). Thus, a country that secedes and devalues would still have to repay its foreign debt in euros and would thus face a rising debt burden. • Third, the economic rationale for leaving would be stronger for a country that wanted to secede in order to revalue, i.e., introduce a stronger currency than the euro. In this case, the country’s borrowing costs would go down rather than up. Therefore, a more credible break-up scenario would be one where rising fiscal deficits and a politicisation of the ECB would lead to higher inflation and a weaker euro, inducing countries with a high preference for stability (say, Germany and some of its neighbours) to leave. Again, we do not think that a break-up is a likely outcome, but we think it is more likely that countries would want to leave to introduce a stronger currency than to introduce a weaker currency. • Fourth, despite the high economic and political costs of leaving the euro, the technical and practical hurdles to secession are fairly low. National central banks (NCBs) in the member states still exist and are fully operational. For example, the liquidity operations are still conducted in a decentralised fashion by the NCBs. Further, the bulk of the foreign exchange reserves still sit with the NCBs. And finally, euro notes and coins are issued by the NCBs rather than the ECB and can still be traced by some of their characteristics (the letter before the serial number on the notes, and the backside of the coins) to their respective national origins. Thus, a country that wanted to reintroduce a national currency would not have to immediately print and provide new notes and coins, but could use the euro notes and coins issued by its NBC as sole legal tender in the meantime. Back then we concluded that while a break-up of the euro was unlikely due to the high political and economic costs associated with it, it was definitely not unthinkable, and long-term-oriented investors should factor in this risk. Looking at where sovereign risk spreads are today compared to four years ago (much wider), we think we gave the right advice. However, markets may now actually have gone too far in factoring in euro break-up risks. This is because in some respects the current financial turmoil should make it less likely that the euro will fall apart in the foreseeable future. Here’s why: • Without the euro, Europe would have been even harder hit by the financial turmoil. This is because the banking sector stress would very likely have led to a currency turmoil within Europe, with peripheral currencies coming under pressure. The fate of Iceland, Hungary and some others where the financial stress sparked a currency turmoil is a case in point. Even the Danish krone, which is firmly pegged to the euro, has come under pressure, which has forced the Danish central bank to raise interest rates in recent weeks despite the ongoing recession. These examples suggest that the costs of being outside the euro when a major crisis hits are even higher than previously thought. • Consequently, the current turmoil makes it more likely that euro membership will grow rather than shrink in coming years. Several euro accession candidates will likely make an effort to join sooner than previously planned. Pasquale Diana thinks that the most likely dates for entry for Poland and Hungary are now 2012 and 2013, respectively, both a year earlier than seemed likely six months ago. Also, Oliver Weeks thinks that the Baltic states could now enter a year earlier than previously thought in 2012. And Elga Bartsch points out that Denmark has become a real euro prospect, with the turmoil making it more likely that the traditionally eurosceptic Danes will vote in favour of membership in the referendum which the government now wants to hold as early as next year. • The financial turmoil has also served to illustrate how interconnected the global financial system is. Euro secession by one or several countries would lead to major currency mismatches in the financial system and in the non-financial sector and could even have systemic consequences. This raises the hurdle for a country to leave the euro and also makes it more likely that the other members would ‘induce’ a country to stay in, in order to prevent a major financial crisis. • Last but not least, the ECB’s aggressive and unconventional response to the turmoil in the form of massive liquidity provisions and a change in the collateral framework make it a ‘tested’ institution that has shown its determination and ability to deal with adverse circumstances. Once the dust settles, we believe that this will enhance the ECB’s reputation as a crisis manager in the eyes of both the euro members’ governments and the public at large. This will make it more difficult for any future government to argue that life could be better outside of the euro’s and the ECB’s umbrella, in our view. Don’t get us wrong. We are not arguing that a euro break-up is impossible. In fact, we warned about this possibility already four years ago, when hardly anybody was willing to entertain the idea. However, the experience of the current financial stress should make it, at least for the foreseeable future, less palatable for any member country to venture secession. Hence, we believe that the U-boat named euro wreckage is likely to submerge again soon. More prosaically, while there are good reasons to believe that sovereign risk spreads within the euro area will remain wider than they used to be, they may have widened too much on speculation that the euro may break apart.
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