Structural Changes in the South African Financial Markets
During 2002 and 2003, a number of structural changes occurred in the South African financial markets that removed significant imbalances and improved the robustness of the financial sector in general.
These developments include the transformation of the country’s huge negative open foreign currency position (NOFP) into a positive one, the return to a much more benign inflationary environment that enabled the South African Reserve Bank to significantly reduce interest rates during 2003, the removal of most of the structural liquidity surplus in the money market (which at its peak had threatened the Bank’s ability to implement interest-rate policy) and some consolidation in the banking sector after a turbulent period in 2002. These developments also coincided with a remarkable improvement in the external value of the South African Rand, despite significant relaxation of exchange control regulations. This article provides some background to these interesting and encouraging developments.
After the unprecedented decline in the Rand’s external value during the last quarter of 2001, which brought the depreciation in the exchange rate of the Rand against the US Dollar for that calendar year to 37.4 per cent, the Rand made an equally impressive turnaround, the extent of which surprised the majority of market participants. During 2002, a 39.6 per cent appreciation in the Rand’s value against the US Dollar was recorded, while the appreciation in the nominal effective exchange rate of the Rand, as measured against a basket of currencies of South Africa’s most important trading partners, amounted to 24.2 per cent. The appreciation in the Rand’s value continued during 2003 and by the end of November 2003, the Rand had appreciated by 88.7 per cent against the US Dollar since the end of 2001 and the nominal effective exchange rate has appreciated by 55.1 per cent. Never in the history of the Rand had it appreciated to this extent in such a short period.
This appreciation in the exchange rate of the Rand resulted from a combination of factors rather than from any single change in South Africa’s economic environment. However, a noteworthy change that accompanied this appreciation was that, whereas the Rand had previously been regarded as a one-way downward bet, for a number of actual and/or perceived reasons that had prevailed at the time, there is now a more balanced view towards the exchange rate of the Rand, allowing for both the possibility of a depreciation or appreciation. The first and perhaps the most obvious reason for the appreciation in the exchange rate of the Rand is that a correction in the Rand’s value was almost inevitable. During the last quarter of 2001, the Rand’s value fell by about 26 per cent against the US Dollar. Because this excessive and rapid depreciation was more than had been justified by underlying transactions relating to trade or investment flows, or by a significant change in economic fundamentals, the Rand was destined to adjust to a more appropriate level. It was generally recognised that the Rand had overshot its “equilibrium” value. However, the market remained uncertain about what an appropriate trading range for the Rand should be.
A second factor that contributed significantly to the appreciation in the Rand’s value against the Dollar, in particular, was the depreciation in the value of the US Dollar in the international currency markets. The US Dollar depreciated by 28 per cent against the euro from February 2002 to 20 November 2003. The US Dollar not only fell against the euro but also against the Yen, as well as against most other currencies in the world. A third factor that played an important role in the behaviour of the Rand during the past two years was commodity prices. The prices of gold, platinum, palladium and other commodities have increased significantly and thereby contributed to the appreciation in the Rand’s value. The contribution of the increase in commodity prices is also illustrated in the appreciation in the exchange value of other commodity currencies such as the Australian and Canadian Dollars over this time period.
Another factor worth pointing out in this condensed discussion is the interest-rate differential between South Africa and the rest of the world. Socalled “yield-hungry” investors have contributed significantly to the good performances of a number of higheryielding assets. Despite the interestrate reductions in the year to date, the Bank’s repo rate was still higher than comparable rates in the developed world, at 8.5 per cent at the end of November 2003.
Another factor that supported the Rand during 2003, which was also a major milestone for the South African Reserve Bank, in particular, was when the bank’s negative net open foreign exchange position (NOFP) turned positive in May 2003. The negative NOFP, which recorded a high of US$23.8 billion in September 1998, was largely an overhang of the bank’s attempts to stabilise the Rand’s exchange rate and ward off the spillover effects of the Asian crises in 1998. During that period, the bank had used its forward book to intervene in the foreign exchange markets. The NOFP at the time was regarded as a significant imbalance in the South African foreign exchange market, and the Bank’s efforts to turn it into a positive balance during that period established the market’s belief that the Rand was a one-way downward bet.
With the NOFP now positive, the bank’s next objective is to reduce its oversold forward foreign exchange book to zero, something that has almost been achieved, and thereafter to build its official foreign exchange reserves. Foreign exchange is currently bought in the market in moderate amounts with the purpose of strengthening the country’s reserves position, and not with the objective of influencing the exchange rate of the Rand.
As an aside it should be noted that the exchange rate of a country is a good barometer of investor sentiment towards the country. The South African economy has been performing fairly well, even during a period in which economic activity in the global economy was at relatively depressed levels. The country’s political framework is stable and fiscal and monetary policies are appropriate and prudently implemented, as had been evidenced by South Africa’s recent credit rating upgrade.
The Reserve Bank’s monetary policy framework is aimed at achieving its inflation target of between three and six per cent. In formulating monetary policy, the Bank’s Monetary Policy Committee (MPC) considers a wide array of domestic and international economic and financial developments and their possible impact on domestic inflation. The MPC’s decisions on interest rates are determined by the forward-looking probability that the CPIX inflation rate, which excludes interest rates on mortgage bonds, will fall within the target band. The Bank has only one operational variable with which to influence inflation, namely its repo rate, which in turn determines commercial banks’ lending rates.
In order to counter the secondround effects of the depreciation of the Rand on CPIX inflation, which rose from 5.8 per cent in September 2001 to 11.3 per cent in October 2002, the Bank increased the repo rate by 100 basis points in January 2002. This increase was followed by further increases of 100 basis points each time in March, June and September 2002. In total, the Bank raised its repo rate by 400 basis points over eight months. Inflation has subsequently become much more benign, and moved back within the Bank’s target range in September 2003. The decline in inflation since September 2002 has enabled the Bank to reduce its repo rate by 500 basis points between June and October 2003, with at least a further 100 basis points still priced into money-market rates. The stronger Rand and low interest rates globally remains supportive of an environment of low inflation and interest rates, which partially provides a counter for the adverse effects of a strong Rand on South African exporters and economic growth.
In addition to the success in reducing inflation, there has also been a noteworthy achievement on a more technical level that removed another structural imbalance, namely a substantial reduction in the excessive amounts of surplus liquidity that existed in the South African money market. The Bank’s monetary policy implementation framework is based on a liquidity deficit system, in terms of which banks borrow from the Bank at the repo rate, which is fixed by the MPC. Currently, the size of the liquidity requirement is around R13 billion, which commercial banks borrow from the central bank through repurchase transactions conducted at the repo rate.
The Reserve Bank levies a cash reserve requirement that banks should maintain interest free in accounts at the Bank. Theoretically, the liquidity drained from the market in this way should be adequate to maintain a liquidity requirement in the money market through which the Bank can, by means of its refinancing operations, implement monetary policy. However, South Africa has for some time now suffered from a structural excess liquidity in the money market. This has necessitated the use of openmarket operations by the Bank, which were rolled on a continuous basis to maintain a liquidity requirement in the market. For example, the Bank conducted longer-term reverse repos, issued its own debentures and conducted foreign exchange swaps to withdraw additional surplus liquidity from the market. At one stage, the combined amount of these operations was close to R70 billion. The main cause of the structural liquidity surplus in the money market was losses that were realised on the Bank’s forward foreign exchange book, which injected significant amounts of Rand liquidity into the domestic money market. The sharp depreciation of the Rand during 1998 and 2001 augmented the amount of losses made on the Bank’s forward contracts.
Although it never materialised, there was a threat at the time that the Bank would not be able to roll its open-market operations. Under these circumstances, the Bank would not have been able to maintain a liquidity requirement in the money market. This could have resulted in losing control over money-market rates and an inability to implement its monetary policy effectively. In a concerted effort between the Bank and the National Treasury, the structural surplus in the money market has been reduced to the point where it no longer poses a threat to the effectiveness of the Bank’s monetary policy implementation framework. The process was also assisted by the Bank’s oversold forward book generating profits as the Rand recovered, which drained liquidity from the money market.
The decline in the structural liquidity surplus will enable the Bank in future to conduct its open-market operations more appropriately to smooth liquidity conditions. The Bank now also has more flexibility with regard to the way in which it manages liquidity in the money market.
South Africa currently has 39 banks, of which 25 are domestic banks, two are domestic mutual banks and 14 are local branches of foreign banks. In addition, there are 47 approved local representative offices of foreign banks in the country. Since the beginning of 2002, in particular, there has been considerable consolidation in the South African banking sector. The first half of 2002 was characterised by turbulence resulting from the demise of a number of small and mediumsized banks. However, stability has returned, and South Africa currently has fewer, but probably more solid banks. The main achievement in this regard has probably been the way in which the contagion effect of problems at some of the smaller banks has been managed and contained. This indeed suggests that the financial sector is resilient in the face of notinconsiderable shocks.
Despite the decline in the number of banks operating in South Africa, the size of the banking sector as measured in terms of total assets is still growing. At the end of January 2002, South African banks had combined assets of R1,034 trillion; these have grown to R1,363 trillion by the end of September 2003. The banking sector also remains well capitalised, with an average riskweighted capital-adequacy ratio of 12.8 per cent at the end of September 2003, compared with 12.6 per cent at the end of 2002 and 11.4 per cent at the end of 2001, well above the statutory requirement of 10 per cent.
South Africa has virtually no exchange control restrictions for non-residents. A gradual approach is being followed to remove the remaining exchange controls on residents and during 2003 further progress was made with this process. For example, the amount that institutional investors are allowed to invest, on approval, is currently 15 per cent of total assets for long-term insurers, pension funds and investment managers and 20 per cent of total assets for collective investment schemes. In addition, the limits for foreign direct investments by South African corporates into Africa and elsewhere in the world have been increased to R2 billion and R1 billion per investment, respectively. The use of both these limits were expanded to include not only new investments but also “top-up” funding for the financing of expansions of existing foreign direct investments. Progress is also being made with regard to the release of the remaining emigrants’ blocked funds.
In February 2003, the Minister of Finance introduced an exchange control amnesty and accompanying tax relief programme, in terms of which residents who have transgressed exchange control regulations in the past can declare their foreign assets, against the payment of a once-off levy. Numerous other relaxations were also announced in 2003 with regard to travel allowance limits, maintenance transfers, monetary gifts and loans and alimony allowances.
The year 2003 was a remarkable year for the South African financial markets, and, in particular, for the Reserve Bank. During this year, a number of structural imbalances that had existed for a number of years as legacies of past practices have been removed, paving the way for a new era in central banking. In the absence of these imbalances, the Bank will find it easier in future to maintain its focus on its core functions, namely achieving its inflation target on a continuous basis, effectively implementing monetary policy, building up and effectively managing its gold and foreign exchange reserves and contributing to the effective functioning of the financial markets. By ensuring financial stability in this manner, the Bank creates an environment that is conducive to economic growth and development.