Asking the right questions
The Monetary Policy Committee of the Reserve Bank will be asking this question of the economy today and tomorrow. They will be well aware that despite a severe decline in household spending (household spending declined at a real 4.9% rate in Q1 2009) net flows of capital to SA continued at near record rates, equivalent to 7% of GDP. All other things remaining the same, had spending growth been anything like normal, the flows of capital from abroad would have to have been even greater.
Avoiding the wrong answers
Perhaps it will be suggested by committee members that it would be unrealistic to expect capital flows of larger orders of magnitude – so limiting severely the scope for more household spending – and by implication the scope for lower interest rates that are urgently called for to encourage households to spend more and banks to lend more. We will argue that this would be the conclusion to draw from what is an inappropriate line of enquiry. Such thinking has caused the economy unnecessary distress in the recent past.
These are not normal times
Normally such a severe reduction in spending as occurred in Q1 2009, would have led to fewer goods and services imported, an improvement in the balance of trade and so less capital imported. The problem however was that the volume of exports declined at an even faster rate than real imports in Q1 – the result obviously of the global recession that reduced in particular demands for metals, minerals and motor cars from SA. The weaker trade balance dragged down GDP, which declined at a very depressing 6.4% rate in the quarter.
Spending in general held up in Q1 2009
However not all categories of domestic spending were in retreat in Q1. Surprisingly and somewhat anomalously, household spending on services actually grew at a brisk 7.5% rate amidst the consumer gloom – implying that spending on consumer goods will have declined at an over 12% annual rate. Gross fixed capital formation continued to increase, though at a very sedate pace compared to a year before, and government consumption spending also rose marginally.
Final demands, being the sum of household and government consumption spending and fixed capital formation, declined at only a net 1.5% rate. The disinvestment in Inventories of -R10.2bn, half the decline estimated for Q4 2008, meant that Gross Domestic Expenditure actually grew at a 2.2% annual rate in Q1 2009. (See the tables below sourced from the Quarterly Bulletin of the SA Reserve Bank June 2009)
Spending held up as did capital inflows and prices came down
Thus aggregate demand in general held up much better than aggregate output and this was made possible by robust capital flows. These capital flows also helped to strengthen the rand and by so doing lowered the rand prices of imported goods and services including capital goods. Without these more favourable trends in the prices of goods, particularly at the ports and the factory and farm gates, spending presumably would have been even weaker.
Guesses about the pace of capital flows have been wrong and may continue to be wrong
Trying to second guess the ability of the SA economy to attract capital and to set monetary and fiscal policy accordingly is in our view quite the wrong way to steer the SA economy. Yet such concerns have been an important and unhelpful influence on monetary policy in the recent past. They led to a much weaker rand in 2006-7 as higher interest rates came to threaten the growth outlook for the economy.
The guesses about the attractions of the SA economy to foreign capital are very likely to be wrong ones. Such guestimates have almost certainly underestimated actual capital flows to SA in recent years. They have not taken into full account the favourable feedback loop from faster growth to increased flows of capital into account. If growth can be kept going with sympathetic monetary policy settings, that emphasise the objective of sustaining growth, more capital can flow in to make that growth possible. And more capital means a stronger rand and less rather more inflation to accompany faster growth. That the SA economy could attract net foreign capital flows, at the rate equivalent to 7% of GDP in a recession as it did last quarter, would have been inconceivable to balance of payments model builders.
The conclusion the MPC should come to
The conclusion we believe the MPC should come to about its room for manoeuvre is to do all it can to revive household spending. Lower interest rates combined with quantitative easing is called for. If this should however mean a weaker rand because the extra foreign capital is not forthcoming this would mean a weaker rand and so be it. This would unfortunately mean higher prices and counter the stimulatory influence of lower interest rates.
Do not second guess the rand
The rand however should not be the objective of policy either directly, when the Reserve Bank intervenes in the currency market, or indirectly when it makes judgments about the sustainability of capital flows and sets interest rates accordingly. The rand should be allowed to find a value that is consistent with achieving a good balance between potential and actual domestic output. This is the only proper goal for fiscal and monetary policy with low inflation seen as a means to this end rather than an objective of policy itself.
The rand as we have indicated may well stand up well if faster growth were achieved and so more capital is attracted. The Reserve Bank should never feel constrained by fear of capital flows when encouraging domestic spending providing such spending is insufficient to the purpose of maintaining potential output and employment.
Realism called for
Yet the MPC will have to be realistic about how much influence it can have today on the economy. Any immediate revival in domestic spending growth is unlikely even with lower interest rates and quantitative easing. The confidence and wealth of SA households have suffered too much recent damage to expect any immediate response. Paradoxically even if the MPC does not share our view of the world the thought that spending is unlikely to revive soon will encourage the Committee to lower interest rates.
Therefore the relief for GDP growth is much more likely to come from exporting into a reviving global economy than from household spending. We expect the MPC to cut its repo rate by 50bps and by another 50bps in July. Any deeper cut now would be very welcome to us and the markets.