Tuesday, 23 November 2010

Reserve Bank cuts again, but will it matter?

Last week, Reserve Bank governor Gill Marcus announced yet another rate cut, bringing the repo rate down to 5।5% and prime down to just 9% - the lowest rate the country has seen since 1974.

The move was not unexpected. Inflation has been close to or within the 3-6% target range for about a year (see chart) and has for several months surprised on the downside, while growth remains somewhat feeble, as illustrated by recent weak manufacturing data. In addition, the rand continues to display Schwarzenegger-like strength against the dollar (see chart), and, as Ireland teeters on the verge of a debt meltdown, the global economy looks more and more risky.

Against this backdrop, then, the decision to cut rates was not a surprise। It is an open question, however, whether or not the cut will have the kind of beneficial economic effects that many hope for.

In general, rate cuts tend to have two stimulating effects on the economy. First, they encourage households and businesses to borrow (and hopefully spend and invest) more, and second, they tend to weaken the currency and thus to stimulate exports. But will either of these things come to pass in South Africa, given the current context? Let's look at each in turn.

It's highly questionable whether the latest rate cut will have much effect on consumer or business borrowing.

On the consumer side, people just don't have much capacity to borrow. As the FNB Property Barometer noted last week, "The most recent Reserve Bank Quarterly Bulletin indicates that household levels of indebtedness remain stubbornly high, with the debt-to-disposable income ratio for the 2nd quarter (of 2010) at 78।2%, not far below the all-time high of 82%.

This would suggest that households as a group are not able to aggressively grow their borrowing off such a high base."

Given this, it's unlikely that the latest rate cut will boost borrowing; more likely, South Africans will try to pay down their debt as their monthly repayments decrease.

This isn't written in stone, of course। After all, last week's retail sales numbers showed that sales rose by 0.4% month-on-month in September, and 6.1% year-on-year. This growth soundly beat analysts' forecasts of around 4.7%, and suggests that South African consumers are still willing to spend.

But being willing to spend is not the same as being able to borrow and it looks like South African households are still too deep in hock to think of taking on more debt just yet। Backing up this view, last week's FNB/BER consumer confidence index reported a slight fall in the fourth quarter. Overall the index has been stuck between 14 and 15 this year, suggesting that consumers are no more upbeat now than they were at the beginning of the year, and making major new borrowing unlikely.

On the business side, there's nothing to suggest that South African businesses will borrow more at lower rates। Businesses borrow primarily when there are opportunities available for them to profitably invest in, and the current climate of uncertainty is not encouraging of such investment.

When it comes to weakening the currency, it's again not clear whether or not the rate cut will help. There's no doubt that the government is keen to see the rand weaken against the dollar; finance minister Pravin Gordhan announced measures to weaken the currency during his recent Budget speech, including further exchange control relaxation and the further accumulation of foreign exchange reserves, and economists have speculated that a general push to weaken the rand was behind last week's rate cut, although Marcus was adamant that this wasn't the case।

Either way, however, it seems very unlikely that South Africa can actually do much about the level of the rand. As Marcus noted, "Since the previous meeting of the Monetary Policy Committee [in September], the rand has appreciated by over 3% against the dollar. This has been despite lower domestic interest rates and the higher pace of reserve accumulation."

In large part the problem is that even after 650 basis points in cuts, South Africa's interest rates are still high by global standards (see table), and will doubtless continue to attract hot money (foreign money from investors looking for better yields), which will keep the currency strong।

In addition, a lot of rand/dollar volatility is actually just dollar/euro volatility in disguise, and so events in the US and Europe, which South Africa can do nothing about, are often the major drivers of the currency। Overall, then, it's unlikely that a 50 basis-point cut in domestic rates will have much effect on the rand.

What, then, can we conclude about the latest rate cut? While the reasons behind it are obvious, solid, and sensible, it remains an open question whether or not it will pay off। Given current circumstances, there seems to be no easy way for the cut to boost the economy through currency weakness or increased borrowing. Only time will tell if we can cut our way to faster growth.

Write to Felicity Duncan: felicity@moneyweb.co.za

*This article first appeared in Discovery Invest

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