30 Jan 2014 What is the reason for the surprise interest rate hike?
The only reason for the rate hike that I can understand is if it is part of a concerted EM action. We know that most of the emerging markets increased rates recently: Brazil, India, Russia, Turkey, etc. With interest rates in the US and Europe likely to stay this low until H2 2015, higher yields across all emerging markets will again attract foreign flows, especially after the currency depreciations it is less risky and more attractive to invest now than before the slide. It might well work and we can see inflows again. Yields in the US and Europe are too low and Treasury yields need to increase before they become attractive as an asset class in my opinion. There is also an unlikely chance that the hike is politically motivated to put more pressure on the ANC conservative core (as Max du Preez called it) to oust Pres. Zuma who is the real reason for the Rand weakness, plus strikes of course. I don’t think we have ever seen an interest rate hike just before an election in SA, or even in other countries. I am pretty confident that the Rand will strengthen if No1 is recalled before or soon after the elections.
Nothing else makes sense. I read and reread the press release from Governor Marcus. Every argument can be found in most of the MPC press releases since we breached the 6% in H2 2011. Every time the argument of high inflation breaching 6% was balanced by the weak economy and lack of demand. Nothing has really changed. We are likely to breach the 6% again with a high of 6.6% expected, sounds very familiar to 2011, 2012, 2013 and now 2014. The economy is as weak or weaker than in the last 3 years. Using interest rates to combat inflation caused by an external force like a depreciating currency is like using a blunt letter opener to do a heart transplant on a sick patient. You will get the heart out after a long struggle, but the patient will probably be dead by then. Interest rates are very effective to combat inflation caused by excessive demand in the economy, but it is a very blunt instrument to lower cost-push inflation. The prices of imported goods will simply not come down because interest rates go up. We will consume less, but economic growth will be negatively affected in a time where we are already battling a weak economy. Today’s M3 (6.15%) and Private Sector Credit Extension (6.14%) release confirms the lack of demand.
It is also a fallacy that our Central Bank can stop the slide in the currency by increasing interest rates. That argument only holds true for stable currency countries like the US and Euro where investors will move big amounts invested in deposits if interest rate differentials change. It does not work for SA. If the interest differential on money markets between SA and the US is a healthy say 6%, the investor’s profit quickly becomes a loss if the currency moves more than 6%, which in SA can happen in less than a week. He cannot protect against currency moves in the forward market either because forward cover costs exactly the interest rate differential plus profit for the Bank. Foreign investors do not invest in our money market in a big way, they invest in our Bonds and equities. That is why an interest rate hike many times lead to a weakening of the currency and not a strengthening, as we saw yesterday when the Rand weakened sharply after the MPC announcement. Listen to the podcast of Chris Hart on Radio 702 last night where he reiterated that foreign investors are growth investors, not deposit investors.
What about our huge BOP deficit? If higher interest rates push us into a recession imports will decline, but at what cost? The main reason why our Current Account has not improved with the weakening Rand is because we are not producing exports as a result of strikes. Rand weakness will eventually cause imports to decline and exports to grow without the need to kill the domestic economy with high interest rates. In 1998 the Rand plunged and the SARB responded by increasing the prime rate from 18% to 25%. It did not stop the slide because the rates killed economic growth and caused more foreign investors to flee. Nobody was prepared to invest in the massive interest rate differential because of currency volatility. Unfortunately the SARB also tried to defend the indefensible Rand in the forward market. The result was a loss of R130bn on the forward book which constrained economic growth for years and put the fear of hell in foreign investors as we battled to wind down the forward currency exposure. The Rand never fully recovered and the economy battled. South Korea took a different approach in 1998. Their domestic economic growth was not excessive and did not need an interest rate hike, so they left rates unchanged and let the currency slide, more than 50%. Despite a spike in inflation, within 18 months foreign investors returned to take advantage of the cheap currency and solid economic growth, the currency recovered to where it was and the economy kept growing.
The only reason for the hike that makes sense to me is the first one, concerted Emerging Market action. The other arguments were present since 2011 and nothing much changed, we even had a decrease in 2012. We will pay a heavy price in economic growth with very little success in propping up the Rand and reducing the BOP deficit. I hope this is the last attempt to use this blunt and ill-equipped instrument on a disease caused mainly by labour anarchy and political ineptitude. Stop strikes and our exports will reduce the BOP deficit and lure foreign investors back which will lead to a stronger currency and reduce inflation.
Head Sanlam iTrade.