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Colombia Stronger Still South Africa South Africa Slaps 10% Tariff on Wheat Imports View GEF Archive

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The Case for a Rate Cut

The central bank argued that its decision to cut rates was based on four factors: better-than-expected actual inflation; falling inflation expectations; a new set of internal forecasts that shows inflation within target range in 2010 and 2011; and a large output gap that dampens inflation pressure.

First, actual inflation data have been benign.  Since November, inflation in Colombia has remained near the lowest levels in nearly six decades.  Indeed, March's reading of 1.83% annual inflation was the lowest since November 1955.  And despite accelerating economic recovery, inflation had dipped below 2% after bumping around that level for the previous three months.  Indeed, inflation since last October has been below the central bank's new 3% target and in March has dipped below the 2% lower bound.  The central bank argues that this benign inflation data allow for a more expansionary monetary policy stance.

Second, inflation expectations continue to fall.  After peaking in 4Q08, one-year-ahead inflation expectations have been steadily declining and have hit the historical low of 3.6% in April.  The central bank's statement accompanying last week's rate decision further highlights that inflation expectations are within the target range and thus shows that the new target is gaining credibility.

Third, the central bank's forecasts show inflation within the target range in 2010 and 2011.  The central bank's models forecast that economic activity will be in the 2-4% range this year.  In addition, they forecast inflation below the 4% upper bound of the target range both in 2010 and 2011.  Indeed, the central bank expects inflation to reach the 3% target by end-2011.

Fourth, the central bank argues that a wide output gap should keep a lid on inflation pressure this year.  The central bank acknowledges that economic recovery, particularly domestic demand, has been stronger than expected.  Indeed, in 4Q GDP grew at a sequential annualized pace of 4.7%, largely due to strong domestic demand that grew at a sequential annualized pace of 6.5%.  But despite recovering activity and the central bank's expectation that growth will be in the 2-4% range this year, the authorities signaled that the output gap remains wide and that this should dampen inflationary pressure.  Last year Colombia's economy grew 0.4%, below any reasonable estimate of Colombia's potential, and thus an output gap did open up.  The authorities argue that this gap is sufficiently large that it allows them to move to a more expansionary policy stance without jeopardizing price stability.

Underestimating Inflation Risks?

While the central bank argues that inflation pressure in Colombia is limited, we are concerned that the inflation picture is much less benign.  Our concerns are three-part:

First, the pace of inflation appears to be worse than the annual readings suggest.  While it is true that the recent annual inflation readings are near the lowest in more than five decades, the authorities have moved to a more aggressive inflation target of 3% with a 1% tolerance band, committing to keeping inflation near historical lows on a sustained basis.  But if recent pace of inflation is any guide, the central bank may miss the inflation target this year.  Sequential monthly inflation in the three months through March is running at 0.6%, or 7.3% annualized.  Of course, January and February were exaggerated by weather-driven food inflation spikes.  But in March inflation came in at 0.25%M or an annualized pace of 3%.  That may seem like good news but for the fact that inflation would breach the upper level of the target if monthly inflation remains at the March level for the remainder of the year.  Indeed, projecting forward the March pace of inflation would yield 4.1% annual inflation in December.  Thus, the authorities need to see inflation slow to a pace below 3% simply to meet the target this year - that is likely to be more challenging, in our view, given the acceleration we are seeing in activity.

Second, rebounding activity may start generating inflation pressures before year-end.  The authorities argue that a lack of inflation pressure despite a dynamic rebound shows that price pressures are limited.  But while we agree that Colombia still has some slack in the economy, we suspect that it may be less than what is necessary to justify a more expansionary stance.  Estimating potential growth is notoriously tricky, so we use average growth over five, ten and fifteen years to create an index of ‘potential' GDP.  But under any of those scenarios our calculations suggest that the output gap would close in 3Q10.  That, in turn, may produce inflationary pressure and an uncomfortable surprise for the central bank.

Third, inflation expectations remain elevated.  The authorities signaled that falling inflation expectations were an important ingredient in their decision to cut rates, but the one-year-ahead expectations remain elevated.  While it is true that inflation expectations remain within the target range, at 3.6% in April, they remain significantly above the 3% target.  Indeed, given that historically inflation expectations have risen with actual inflation and given that observed inflation is likely to rise in the months ahead, we are concerned that the recent fall in inflation expectations may not be sustained. 

Given the data on activity, inflation and expectations, we suspect that the prudent decision would have been to keep rates on hold.  Given the pace of actual inflation, elevated expectations and rebounding activity, we find it difficult to justify a rate cut.  In particular, given the recovery in activity, it is, in our view, hard to argue that the economy needs more monetary stimulus.  Indeed, the authorities themselves signaled that they continue to see activity rebounding stronger than they had expected.  Under such conditions, we suspect that the market expectation of rates on hold at 3.50% would indeed have been the prudent policy choice.  What then to make of the decision to cut interest rates this past week?

Currency or Inflation Targeting?

We suspect that the decision to cut rates may be due to the central bank's concerns about the currency rather than inflation.  The rate cut was combined with a decision to halt TES bond sales that are used to sterilize the central bank's reserve accumulation.  Unsterilized interventions tend to be more effective (and potentially more inflationary) and so the central bank's impact may be more meaningful in the currency market in the near term.  And this decision is in line with history: Colombia's central bank has a track record of trying to fight currency appreciation and even at the risk of more inflation as seen in 2007 and 2008.  Indeed, on March 3 of this year the authorities announced that they would intervene in the currency market by purchasing $20 million per day through the end of May, amounting to a total of $1.26 billion.  But the intervention has so far proved ineffective as the exchange rate has barely budged: from 1,927 on March 3 to 1,956 on April 30.  The decision to cut rates and to stop sterilizing the intervention may be aimed at more effectively weakening the currency.

But the renewed focus on fighting currency appreciation raises inflation risks.  After all, not sterilizing the declared intervention alone may expand the monetary base by near 2-2.5% per month.  And the rate cut may mean a more expansionary, and thus potentially inflationary, monetary policy.  Indeed, we are concerned about upside inflation risks, particularly as the rebound in activity erodes the slack in the economy in 2H10.

Indeed, we are revising our inflation and interest rate forecasts for 2010 and 2011.  We are revising our inflation forecast for 2010 to 4.4% (from 4.1% previously) and for 2011 to 4.1% (from 3.9%).  And we now expect the central bank to delay hikes until 4Q10 and then to have to catch up as inflation begins getting out of hand.  Consequently, we are moving our interest rate forecast for 2010 to 4.25% (from 5.50%) and for 2011 to 6.50% (from 6.00% previously).

Currency Appreciation Ahead

But the central bank's shifting focus to fighting currency appreciation may prove an uphill battle as we see significant fundamental support for a stronger peso.  Indeed, after an initial reaction to the new measures, we suspect that currency appreciation should continue in the months ahead.

In fact, we are upgrading our forecast for the Colombian peso for 2010 and 2011. We are moving our Colombian peso exchange rate forecast for 2010 to 1,850 (from 1,950) and for 2011 to 1,800 (from 1,950).  There are three factors driving our forecast for a stronger Colombian peso:

First, we expect strong trade-based dollar inflows.  Since Colombian exports bottomed out in the middle of last year, there has been a steady trade-based net inflow of dollars.  And in recent months this inflow has intensified as exports to the US and China have accelerated.  Indeed, in the three months through February, exports to the US (Colombia's main trading partner) grew over 60%Y and exports to China were up near 420%.  Indeed, while many have focused on the impact of the trade friction with Venezuela, that country has fallen to fourth place, behind China, as an export destination for Colombian goods.  In sum, we suspect that trade, particularly with the US and China, will continue to be a driver for currency appreciation in the months ahead.

Indeed, we are upgrading our forecasts for the trade balance and the current account for this year and next.  We are upgrading our forecasted trade surplus in 2010 to $6.6 billion (from $0.1 billion) and in 2011 to $4.7 billion (from -$0.8 billion).  And the better trade balance results in a better current account balance as well.  We are moving our current account forecast in 2010 to 0.7% of GDP (from -2.3% of GDP) and in 2011 to 0.0% of GDP (from -2.6% of GDP).

Second, we expect strong foreign direct investment (FDI).  FDI has been an important source of strength for Colombia's economy, ensuring supportive external accounts.  And our latest tally of investment projects slated for this year shows that Colombia could receive at least $11.5 billion, or near 4.1% of GDP, in inward FDI.  That's up from our previous estimate of $7.8 billion (see "Colombia: Beyond Venezuela", This Week in Latin America, March 8, 2010).  The strong FDI inflows may be an additional factor behind the coming currency appreciation.

Finally, rising commodity prices should provide a boost to the currency via a positive shock to the terms of trade.  Colombia's exports are mainly commodities like oil, coffee, coal and some metals.  The bumpy but steady rise in commodity prices since early last year has boosted Colombia's terms of trade: the ratio of the price of exports and imports.  And historically rising terms of trade have been associated with currency strength.  Given futures prices for commodities and given the forecast of supportive global growth from our global economics team (we expect 4.6% global growth in 2010 and 4.0% growth in 2011), the risks are that commodity prices may continue to rise further over the next 18 months, further fueling currency appreciation pressure in Colombia.

While economic fundamentals suggest that the peso should continue to appreciate, the greatest homegrown risk to the currency remains the prospect of further policy action, as well as the risks surrounding a much more competitive (and uncertain) presidential election process than was expected just a few weeks ago.  While we are assuming that there will be no major policy shift regardless of the outcome of the presidential race, the uncertainty as the front-runner's status has now been called into question could contribute to greater peso volatility in the run-up to the May 30 election.  While only about a month ago the elections were largely written off as a shoo-in for a former member of the outgoing president's cabinet, in recent weeks the polls show that a new front-runner has emerged.  The new front-runner is a relatively little known figure with much of his career in academia, but for two stints as mayor of Bogota.  Should he get elected, he has signaled that his presidency would represent a break from the past by emphasizing human rights and strict enforcement of the rules.  What is not clear is whether his economic and security policies would maintain the framework built during the previous administration.  After all, Colombia's economic progress over the past few years is principally due to the security dividend and the orthodox economic policies followed by the Uribe administration.

Bottom Line

The central bank's decision to cut rates may be a signal that the authorities are focusing more on fighting currency appreciation and may have to pay the inflation costs of such a policy shift.  Indeed, we suspect that the central bank may be slow to tighten monetary policy this year.  But ultimately we fear that the central bank's focus on fighting currency appreciation will prove ineffective as supportive global conditions drive Colombian peso strength.  The principal consequence of the recent surprise interest rate cut is unlikely to be any meaningful change in the direction of the currency, but it may come at a cost to monetary policy as economic agents ultimately demand that the central bank do even more on the rates front to reaffirm its inflation-fighting credentials.

South Africa
South Africa Slaps 10% Tariff on Wheat Imports
May 05, 2010

By Michael Kafe & Andrea Masia | Johannesburg

South Africa's Wheat Industry

Wheat farming in South Africa is the country's second-largest field crop, trailing closely behind the maize industry. Some 98% of the Southern African Customs Union (SACU)'s wheat is produced in South Africa - mainly in the Free State and Western Cape regions. Total SACU demand for wheat is in the region of 3 million tons per annum, of which some 40-50% is imported from countries like Canada, the US, Germany and Australia. South Africa also exports some 120,000 tons of wheat to other African countries such as Kenya, Uganda, Malawi and Mozambique. The bread industry accounts for 70-80% of total human wheat consumption.

Local wheat producers often complain about high input costs - particularly in the procurement of fertilisers, where competition is grossly imperfect and the supply curve is relatively steep. Also, the lack of significant competition in the product market - e.g., the milling and baking industries, where there is hardly any import competition - has often been cited as a reason for low profit margins in wheat production. Third, South African wheat farmers face unfair competition from developed countries that have well-established and significantly generous agricultural subsidy schemes.

Existing Tariff Dispensation

Under the existing tariff dispensation for wheat, which was originally introduced in 1999, discarded after a few years and re-introduced a decade later in December 2008, a 10-year moving average of the US No. 2 HRW Gulf settlement price (the world reference price) is used as the relevant benchmark price off which protection is calculated. If the 3-week moving average of this reference index (calculated weekly, FOB) shows a variance of more than US$10/ton from its benchmark price level for three consecutive weeks, an adjustment to the tariff is triggered, and a new duty is calculated, resulting in a base price reset. The resulting dollar duty is converted into ZAR at the prevailing USDZAR rate on the day the adjustment is triggered.

New Tariff Dispensation

Citing the need to transit from a practically irrelevant 10-year history of the rand-equivalent international reference price of wheat that was failing to keep up with the rising input costs and limited pricing power faced by South African wheat producers, Grain South Africa (GSA) - a non-profit organisation representing some 6,000 commercial grain producers that produce nearly 80% of South Africa's wheat harvest - lobbied the Department of Trade and Industry in October 2009 to move to a 5-year moving average benchmark price that better captures the structural changes in the wheat industry since 2004/05.  The GSA also requested an additional protection - the Producer Subsidy Equivalent (PSE) of US$24 or 10.27% of the domestic dollar-based reference price - to compensate for distortions introduced by overseas producer subsidies. This further raised the implied reference price to US$260/ton and pointed to an effective 33% ad valorem tax on wheat, given that the actual 3-week moving average price of wheat was some US$196/ton at the time. 

After considering the application, the government agreed that the existing dollar-based reference price of US$157/ton had been fixed at that level for too long, although it was of the opinion that the proposed increase to US$260 was too steep, and could have a major impact on the price of bread and other wheat-based products. The International Trade Administration Commission of South Africa (ITAC) subsequently considered the application and recommended that the benchmark price be raised to an effective landed price of US$215/ton - some US$45 less than the US$260/ton requested by GSA.

The awarded increase was based on the 5-year FOB moving average of the world reference price (US$236/ton) as requested; plus the US$24/ton margin to compensate for global subsidies as per the OECD producer subsidy equivalent for agriculture; less an estimated 5-year moving average freight cost (average ocean transport costs of wheat to a South African port) of US$45/ton. To our knowledge, this is the first time that a transport component has been introduced into the formula, and is likely to go unchallenged by GSA. According to ITAC, however, the approved price support should place South African wheat producers on the same competitive footing as their overseas counterparts.

Given a 3-week moving average spot of US$196/ton in the world reference price as at the first week of October 2009 implies an immediate duty of US$19/ton (US$215/ton base price less US$196/ton).  This is an effective 10% ad valorem tax.  

Impact on Fiscus and Inflation

First, assuming full pass-through, ITAC estimates that the approved tariff increase would lead to a moderate increase of around 2.5% in the price of bread. The overall impact on inflation should therefore be minimal - bearing in mind that bread (1.56% of CPI index) and other wheat-based products (1.18% of CPI index) together account for only 2.74% of the CPI index. At the margin, we expect a significant offset from the 26% decline in yellow maize prices (yellow maize is a key input in meat and dairy products, which together account for a much larger 6.4% of the CPI basket) and from the 31% fall in white maize prices.

Second, from a medium term perspective, we also believe that the lower-than-requested tariff outcome is yet another demonstration of the government's commitment to reining in runaway inflation in public goods and services. The most recent examples were the tariff awards to the Airports Company of South Africa (40.7% versus 132% requested), Transnet (6.1% versus 51.3% requested) and Eskom (25% versus 35% requested).

Third, using a spot exchange rate of USDZAR7.40, and an aggregate wheat import estimate of 1.5 million tons, we calculate that this tax is likely to rake in an additional R0.2 billion to the fiscus (US$19/ton * R/US$ 7.41 * 1.5 million tons).

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