Recent Economic Developments; Twin Peaks;SA Reserve Bank Annual Report 2012/13

Meeting report

Opening Remarks
The Chairperson welcomed the Governor of the SA Reserve Board (SARB), Ms Gill Marcus, and her delegation, and commented that the meeting was taking place at a time when the economic outlook was not very robust internationally or domestically. 

Opening Remarks by the Governor of the SA Reserve Bank
Ms Marcus said that after careful consideration, it had been decided to no longer produce an annual economic report, as the issues were largely covered in the quarterly bulletin, the monthly policy review, and the financial stability review.

SARB played a unique role in the economy.  It was not driven by a profit motive.  The initiatives and actions taken to address the impact of the global financial crisis had placed increasing demands and focus on central banks, and SARB was no exception.  Financial stability was now an explicit mandate. Regulatory reform of the prudential regulation of insurance and financial infrastructure had moved into the bank.  Increased responsibility for anti-money laundering and combating the financing of terrorism had expanded the demands on the bank.

Ms Marcus gave a brief overview of the annual report, referring to issues which would be covered in greater detail during the presentation.  The group financial statements indicated that there had been a loss for the group of R1.4bn after taxation, and R1.5bn for the bank itself.  The income of the bank was derived mainly from returns on investments of its foreign exchange reserves, and had been impacted by the low-yielding global environment. The losses were due to the unique nature of the bank, and arose from the performance of its function in the interests of the economy, and were not due to operational inefficiencies.  The major source of the losses emanated from the accumulation and management of its foreign exchange reserves, which needed to be increased to reduce the country’s vulnerability to large outflows of capital.  Great progress had been made in this regard, with gold and foreign exchange reserves rising from $8bn in 2003, to the current level of $50bn.  However, reserves were still on the low side.  Another contributory factor to the bank’s losses was the printing of the country’s new bank notes.  The notes in circulation exceeded R110bn, and increased at about 10% each year.  The losses had been met by drawing down from the bank’s contingency reserve, built up through previous years’ profits, and which now stood at R6bn.

Briefing on SARB Annual Financial Statements
Ms Naidene Ford-Hoon, Chief Financial Officer (CFO), SARB, presented the group’s annual financial statements.  The group was made up of the bank and four wholly-owned subsidiaries.  These were:

• The Corporation for Public Deposits (CPD), which accepts call deposits from the public sector, invests in short-term money market instruments, and transfers surplus profits to the government.
• South African Bank Note Company (SABN), which produces bank notes.
• South African Mint Company (SA Mint), which produces coins.
• SA Reserve Bank Captive Insurance Company (SARBCIC), which carries out short-term insurance business for the bank and its subsidiaries.

During the year, the Rand had depreciated from R7.67 to R9.20 to the US dollar, resulting in increases in the gold and foreign exchange holdings.  The gold price had increased from R12 793 per fine ounce in 2012, to R14 742, and gold holdings had risen by 2 246 fine ounces.  The SABN had been recapitalised through a subordinated loan or R1.1bn in order to finance its factory modernisation programme.  The SARB’s loss for the year was R1.5bn, compared to the previous year’s loss of R491m.  Operating costs had increased by R1.1bn, mainly due to higher staff costs as a result of an annual increment of 7%, an increase in the headcount needed to support the latest regulatory requirements, and a net increase in the post-employment benefit actuarial valuations.  The launch of the new Mandela banknotes had cost R890m, which was higher than the normal currency replacement cost.

Ms Ford-Hoon said it was important to note that the losses were incurred in the execution of the bank’s public duties, and did not reflect operational deficiencies or undue risks being taken.  The bank had a sound management framework, a disciplined budgeting process and prudent expenditure management.  Once the bank returned to profitability, it would need to rebuild the contingency reserve and reconsider the appropriate level, taking into account the losses incurred over the past three years.  The total assets of the bank had increased by R75bn (to R498.2bn), total liabilities had risen by R77bn (to R491.2bn), while the contingency reserve had decreased by R1.5bn (to R6bn).

Briefing on Twin Peaks Financial Regulatory Architecture in SA
Mr Lesetja Kganyago, Deputy Governor, SARB, said it did not look as if the end of the global financial crisis was yet in sight.  It had led to significant changes in the approach to regulation around the world.  South Africa had not had to make any major interventions to bail out its domestic financial institutions, thanks to a very robust regulatory framework.  However, areas for improvement had still been considered and in 2011 the Treasury had developed the “twin peaks” policy document, which captured the essence of what was to become South Africa’s new regulatory framework. There were three elements to one of the peaks – micro-prudential supervisors, market conduct regulators and macro-prudential regulators – which fell within the Reserve Bank, while the other peak – resolution framework – was in the market conduct regulator domain.  The process was being driven by the Treasury, the Financial Services Board (FSB) and SARB.  In 2014, legislation would be brought through to Parliament, and then the establishment of the “architecture” would take place.   The bank would be given an explicit mandate in law to deal with macro-prudential regulations.  The Global Financial Stability Board had captured the key attributes of a sound resolution framework, which South Africa would have to incorporate in its own framework, which would be created within SARB.

The framework was being adopted to fulfil inter-dependent policy objectives.  The first of these was market conduct, which involved consumer protection, access to finance and the integrity of markets.  Then there was prudential regulation, which referred to the safety and soundness of financial institutions, and finally the issue of financial stability, involving the mitigation of systemic risk.   All three of these objectives were interconnected.  The “twin peaks” architecture had a “prudential” peak, on the one hand -- dealing with banking, insurance, and the supervision of conglomerates, anti-money laundering, combating the financing of terrorism, and financial market infrastructure – and a “market conduct” peak on the other, which dealt with consumer protection and fairness, financial inclusion, markets’ integrity and financial literacy.  Treasury was drafting the legislation for the establishment of the architecture in 2014, while it was estimated that the consolidating regulatory powers aligned to the twin peaks framework, would be implemented in 2016.

Briefing on recent economic developments
Mr Brian Kahn, Advisor to the Governor, presented an updated review of SARB’s annual economic report, which had been issued some time back.

Looking at the international scene, there appeared to be a multi-speed recovery in the global economy.  There were signs of recovery in the United States, but there had been a sharp fiscal contraction earlier in the year, and there was now the budget impasse and debt ceiling issues, and if they were not resolved quickly, they would have serious implications for the global economy.  Another “headwind” was the possible withdrawal of monetary stimulus, which would lead to long-term interest rates rising, slowing down growth.  The Eurozone had emerged from recession, but growth was expected to remain weak for some time, which was bad for South Africa, given our strong trade links with the region.  The UK was showing signs of improving, but the Japanese outlook was uncertain.  Growth in emerging markets was slowing, including the BRICS countries, but the outlook for Africa was generally positive.  The US was talking about a slowing down in the pace of expansion of liquidity.  However, the reaction had been as if they had been proposing the tightening of monetary policy, and one had seen a major withdrawal of capital from the emerging markets.  The impact was enormous.  Other international factors were the downward trend in prices for a wide range of commodities in 2013, while oil prices had remained high, reacting to the growth outlook and tensions in the Middle East.

Turning to the South African situation, Mr Kahn said the problem was that growth in demand was exceeding growth in domestic output, and this implied a current account deficit, or that savings were insufficient to finance investment.  Growth in the first quarter of 2013 had been an anaemic 0.9%, and a recovery in the manufacturing sector had seen the second quarter improve to 3%.  However, the full-year growth forecast was 2%, as the third quarter had been adversely affected by strike action.  A growth rate of 3% was required to retain employment at its current levels, but 5% was needed to bring unemployment down.

Domestic consumption expenditure, which had driven growth between 2010 and 2012, was now moderating, and investment expenditure remained weak.  Due to a lack of confidence and the fact that there was under-utilised capacity, the private sector was growing fixed capital formation by only 2.7%.  The consumer confidence index had fallen to its worst level in ten years, slowing households’ consumption expenditure, although household indebtedness remained high.  Domestic saving had declined, with the government dis-saving as part of its cyclical policy in response to the recession.  Bank credit extension remained moderate, and there had been a sharp drop in the rate of unsecured lending, which would affect the household expenditure outlook. 

Employment growth was a source of concern, with employment growing by only 0.1% in the private sector (or only 7 000 workers), and had it not been for the public sector, there would have been a net decline.  At the same time, real wages had been increasing, but the impact had been partly softened by the higher output per worker.

Since May last year, the Rand had depreciated significantly against a basket of currencies.  Up until this stage, the Rand had moved very much in line with the currencies of other emerging markets, and the exchange rate had been driven mainly by external factors. However, there had been the widening deficit on the current account, followed by the fallout from the Marikana tragedy and other domestic issues, and the Rand had delinked from other currency groupings.

The current account deficit had been widening since the third quarter of last year.  The reason was that real imports had been increasing, while exports had declined during the recession and South Africa had not been able to recover to the extent that other emerging markets had.  The country was exporting less, and prices were also falling.  This pointed to the need for South Africa “to get its export story right.”   Reducing imports would affect capital equipment required for infrastructural development.

Inflation had been within the targeted 3% to 6% range for 14 months, but had moved above 6% during the past two months.  It was expected to return to the target band during the fourth quarter, and remain there until the end of 2015.  The repo rate had been kept at 5%, which was lower than inflation, pointing to a monetary policy which was relatively accommodative.  However, there were upside risks to inflation, which posed a dilemma for the bank, with the biggest risk coming from the exchange rate depreciation.  The upside risks included labour costs, food prices and administered prices, such as fuel, which had been consistently above the inflation target.

Discussion
Mr D Ross (DA) said that the Committee appreciated the frank comments on the state of the economy.  With the growth rate at 2% and inflation above 6%, stagflation was a real problem.  How could this be addressed?  Nersa’s curbing of electricity prices increases showed that progress had been made in containing administered prices, but he was concerned that the proposed nuclear plants might result in higher prices, with an adverse effect on the economy and job creation. He shared the concerns of SARB over the crisis in the mining sector, and the problem of unemployment. He referred to the lack of confidence on the part of the private sector to invest, and asked whether this was because of the high electricity and water costs, and over-regulated labour issues.  Taking into account the group’s loss of R1.4bn, and the contingency reserve standing at R6bn, what did SARB consider to be the desired level?  The Committee supported the “twin peaks” approach to regulation, as it was important to retain South Africa’s world class banking status.  There needed to be an in-depth discussion on so-called “property (Ponzi) schemes” which had resulted in thousands of people losing money.

Ms Marcus said that the SARB was looking at ways to address the group’s losses, but did not want to adopt options which would add costs to the economy.  The situation was likely to get worse, because of the changing yield on bonds, and factors beyond the control of the bank.  It was difficult to determine an ideal level for contingency reserves, but SARB’s strategy was to build them up gradually when it was profitable again. 

The best way to deal with Ponzi schemes was to recognise that they were often driven by greed, so SARB had embarked on a campaign to make the public aware that “if something sounded too good to be true, it usually was”

The challenge of slow growth and rising inflation was not unique to South Africa, but affected other emerging economies. Advanced economies, such as the US and Japan, were concerned about deflation, and were trying to achieve some inflation. This meant there were a variety of policy challenges. Growth of 2% was certainly not good enough, and this was linked to the lack of domestic confidence.  There would be no investment if there was an excess of capacity and no demand. The depreciated currency presented some opportunities to recover export markets, but this was being hindered by sluggish growth among the country’s main Eurozone trading partners. However, the region was growing, and South Africa’s exports into Africa were increasing, to offset the overseas decline.

Ms Marcus said that there had to be certainty of energy supply. Eskom’s build projects were taking longer to complete than expected, but there had been significant gas finds in Mozambique and Namibia – two of South Africa’s neighbours – and this provided an opportunity for a diversified approach to the energy mix.

SARB’s concern was that if wages increased without a corresponding increase in productivity, there would be further job losses.  The move to mechanisation was not just a local issue, with unemployment in Europe averaging 12%.  The challenge was to create sustainable jobs on the scale that was required to reduce unemployment, taking into account the nature of the available labour and the impact of technology.

Mr Kganyago said that the SARB would welcome a discussion on the property schemes, bearing in mind that what the bank regulated was deposit-taking activities. It was a complex issue, and the main problem was when the scheme was uncovered, it was usually too late to take effective action to protect the people who had already lost money.

Ms Z Dlamini-Dubazana (ANC) noted that the International Monetary Fund (IMF) had indicated a certain range for South Africa’s foreign exchange reserves, and asked whether SARB was comfortable with the range specified.  Could it lead to another downgrade?  Would the increase in money in circulation over the Christmas season affect the country’s economic stability?  Was there additional risk involved in switching from short-term to long-term bonds in order to finance government debt?  It was worrying that while China had an increased demand for iron ore, it had been reported that South Africa could not deliver because it lacked the skills to do so. How could household expenditure be moderated so that domestic saving could improve?

Mr T Harris (DA) took the SARB to task for implementing a 7% increase for staff, although it had set a 3% to 6% inflation target. What sort of example did this set?  The Governor had suggested that the country’s foreign exchange reserves were too high, at R50bn – at what level should they be?  Would SARB be open to more competition from the banking sector?  From an economic growth point of view, South Africa was out of step with the rest of the world – 1% below the world average, and below the average for emerging countries and African nations.  What was the reason for this?  The de-linking of the Rand from other emerging currencies had started with the labour unrest at Marikana, and strikes were again to the fore.  How could this annual “economic lockdown” be avoided?  The decline in the Rand had two effects – it enhanced exports, but made imports more expensive.  Which effect was currently stronger in South Africa?  Africa was increasingly buying manufactured goods, but South Africa was not taking advantage of this.  What could it do to start benefiting from this trend?  The report showed that unsecured lending increased significantly to R441bn in 2012, and a newspaper article had quoted a bank spokesman as saying that “unsecured loans helped keep heads above water.”  This was an extremely dangerous sentiment. What level of unsecured lending would require a change in action from SARB?  Another major concern related to the maintenance of an exchange control regime. Did this not represent a vote of no confidence in our economy by the government?  The original intention had been to scrap exchange controls gradually – was this still the policy?

Ms Marcus said that one needed to distinguish between the contingency reserve, which the bank builds up to use as a buffer, and the reserves of the country, which currently stood at $50bn. The IMF report stated clearly that they think the country should build up more reserves, as they stood at the lower end of the range the IMF had proposed. While the SARB did not disagree, it was difficult to determine what an ideal level was, and it was hugely expensive to economies to build up reserves when a currency was depreciating. The level of reserves should be considered on a global basis.

More bank notes would be in circulation in the December period, as people used cash more at this time. There was a view that the use of plastic (bank cards) would reduce the use of notes and coins, but this was not happening.

Households were under pressure to moderate their expenditure levels owing to a wide range of issues. There were higher costs for electricity and water, education and health care, but the most immediate transmission to people was the cost of petrol. This was where the exchange rate had a major impact – and global oil prices were rising. The knock-on effect was higher transport costs, which also affected food prices. With Christmas approaching, people should try to reduce their current debt levels through moderating their expenditure, and should recognise that interest rates will not remain at their current low levels when committing themselves to long-term credit for capital purchases.

Ms Marcus agreed with the comments about above-inflation salary increases, but pointed out that the bank was moving to a significant portion of the increase that was performance related. The bank wanted to set an example by staying within the inflation target range, and both the executive members and the board had taken no increase this year. Part of the problem was that the increases covered a 15-month period, as allowance had to be made for a three-month “window” for performance evaluations, which had moved the increase date from April to July.

There was no doubt that everyone at the bank agreed there should be more competition, but the question was where that competition should come from. There was vigorous competition in the corporate investment banking side, with all the international players present. On the retail side, there was not the same level of competitiveness from outside the country, because it was felt the local banks were very well covered. SARB’s approach was to look at different requirements, and trying to encourage dedicated banks – cooperative banks – to focus on engaging with the market at a grass roots level.  This would involve considering whether one could have a differentiated approach that would allow a different capital requirement if certain risks were not taken. SARB’s role would be to assist in enabling this development.

Industrial relations could be improved if the parties involved “talked to each other.” This applied as much to employers as it did to labour. If the labour force did not understand the business of the company, in the sector and the global environment, they would not be aware of the implications of their actions. She gave an example of a platinum mine, where management went underground to understand the dynamics better, and the workers did not know what they were digging out, or what it was used for. One needed to have an informed work force, which understood the company and its plans, and what the threats and risks were.
Labour relations in South Africa were generally not good, and this applied equally to employers.  A strike should be a last resort.  The right to strike did not mean a duty to strike.

Looking at the Rand exchange rate, South Africa’s problem was not the depreciation, but the volatility. One needed to be able to plan ahead, and take advantage of market opportunities which depreciation offered. South Africa had in fact increased its exports of manufactured goods into Africa, from 22% to 38% of production, in a very short period, and this was a huge change. Future growth would depend on infrastructure development, and this was a challenge for the SADC countries. The SARB’s role, in collaboration with other central banks, would be to provide a framework to make things happen, such as a common payment system and the harmonisation and integrity of data.

Unsecured lending was coming down quickly, but one needed to recognise that banks were not available in rural areas. There were eight million people who were clients of two banks which focused on unsecured lending, so giving it a bad name did not help, as it provided financial inclusion to a great number of people. What had to be considered was how it was managed, was it ethical and what the product was. It addressed a huge need in society, but had to be well managed and needed sound regulation. Financial inclusion was a goal of government.

Mr Hlengani Mathebula, Head: Group Strategy and Communications, SARB, said the reason that peak levels of currency in circulation occurred in December was the result of the free movement of people at this time, and the Rand circulated freely in South Africa’s neighbouring countries. Those returning home during this period took Rands with them, which in due course would be repatriated to South Africa.

Mr Kganyago said the switching of bonds was the preserve of the Treasury, and SARB acted as an agent of the Treasury. Switching took place to minimise the risks involved in refinancing one’s debt in the future.

A country’s biggest asset was not its money in the bank, but its ability to collect taxes in the future. For this reason, most countries preferred to borrow in local currency, and minimise their foreign currency debt.  South Africa’s foreign currency-denominated debt was small.

He supported the Governor’s contention that the local financial market was highly competitive, and said it should not be forgotten that when the World Economic Forum had released its report, South Africa was ranked No. 1 in the regulation of its financial markets, No. 1 in the regulation of its auditing and accounting professions, and No. 2 in the regulation of its banking sector and the quality of the banking system.  All of this bore testimony to the importance of competition in the financial market, as it was the only way to discourage bad practice in the sector.

Mr Kganyago highlighted that the country was still on track to remove exchange controls.  When the process to gradually liberalise the regulations started, the International Monetary Fund (IMF) in 1996 had suggested a “big bang” approach.  Two years later, the IMF had come back and said the country was moving too fast, and in 2010 it had said there was merit in South Africa retaining some measure of exchange control.  Regulations which had been found to be unconstitutional would be changed within 18 months, but the Act itself had not been ruled unconstitutional.

Ms J Tshabalala (ANC) said that if there was an upside risk of inflation, what steps could be taken to maintain the integrity of the local economy, and ensure it did not affect the workers and the poor. The issue of unemployment was worrisome, and measures needed to be taken to achieve the required 5% growth rate. There were discussions around subsidies and incentives, while the confidence of investors relied on a stable economic policy – and uncertainty appeared to be part of the problem.  It was important for business to invest and create employment, and one could not have a growing economy where the public sector was the biggest employer. The private sector was sitting back and waiting for things to improve, and this was not good for the economy.  With the Rand declining, this could be a good time to become involved in investing in infrastructure for sub-Saharan Africa with a view to improving exports and imports.  She referred to the E-tolling issue, and said the government needed to fulfil its side of the bargain to ensure payment to Sanral – how would the rest of the world view the way South Africa honoured the contracts it entered into?

Ms P Adams (ANC) referred to a passage in the SARB annual report, which indicated a sub-standard batch of coins had been produced at the SA Mint. What steps had been taken to remedy the situation?  She added that many elderly people were the victims of pyramid schemes, and asked if modern technology could not be employed to warn people about these schemes.

Ms Marcus said the problem at the mint had involved only a small number of coins, and the processes at the entity had been reviewed to ensure it did not recur.

In the case of Sanral, there was an agreement and a contractual obligation, and this had to be met.   Just as was currently happening in the US, the government could not default on its debt – if there were issues, it had to sort them out.

Regarding the effect of depreciation on imports and exports, the effect on imports such as petrol was that they had an immediate impact on the economy. A significant proportion of imports were capital expenditure on government infrastructure, which were made more expensive by a weaker Rand. But in the end, this expenditure was about improving economic efficiencies over time. The decline in exports was not because there were no products to export, but because we did not get them to the markets. This was the challenge.

The level of job creation in the private sector was related to a range of issues, such as excess capacity, a growing economy, or technological innovations.  The strategy of the National Development Plan was to focus on those areas where most jobs could be created, and this was in the primary sector, such as agriculture.

If the upside risks to inflation persisted, and if inflationary expectations remained at the upper end of the band, the tool of SARB was the interest rate. The bank’s tolerance was intended to reduce the impact a rate increase would have on the country’s growth rate. In the end, however, the bank’s primary responsibility was to curb the rate of inflation, and it would take action when this was necessary.

Mr Mathebula said pyramid schemes were both worrying and painful. The SARB had decided, in collaboration with the FSB, the National Consumer Commission and the National Credit Regulator, to launch a campaign to close the loopholes and create public awareness. The basic problem was the greed of those who became involved in the schemes, and the best form of defence was to have an informed public.

Ms Marcus said the meeting had formed an important part of SARB’s role of being accountable to Parliament, and she extended an invitation to the Committee to visit the bank’s headquarters in the new year.

The Chairperson thanked the Governor and her delegation for their presentation.  The message he had received was that there were challenges which South Africa had to deal with itself. Why was capital not being invested in the country? Why were companies sitting on their cash in the banks?  Outsiders needed to derive confidence from those already operating within South Africa. There was a serious, violent polemic between business and labour – they were poles apart – and a key question was whether the National Economic Development and Labour Council (NEDLAC) was the right forum to deal with these issues. It was up to Parliament, and not SARB, to come up with suggestions on how things could be improved.  There was a need to focus on the positives, and not dwell on the negatives.

The meeting was adjourned.