SOUTH AFRICA'S SURPRISE INTEREST RATE CUT

UNCLAS SECTION 01 OF 02 PRETORIA 001506

SIPDIS

DEPT FOR AF/S/KGAITHER; AF/EPS; EB/IFD/OMA
USDOC FOR 4510/ITA/MAC/AME/OA/DIEMOND
TREASURY FOR OAISA/BARBER/WALKER/JEWELL
USTR FOR COLEMAN
LONDON FOR GURNEY; PARIS FOR NEARY

E.O. 12958: N/A
TAGS: ECON EINV EFIN ETRD BEXP KTDB PGOV SF
SUBJECT: SOUTH AFRICA'S SURPRISE INTEREST RATE CUT



1. Summary. On April 14, the South African Reserve Bank
(SARB) announced a 50 basis point reduction in its
repurchase rate (equivalent to the U.S. federal funds
rate) much to the surprise of South African economic
analysts. SARB's justifications for reducing rates
include lower inflationary expectations, signs of weakness
in the manufacturing sector, and a benign inflationary
outlook over the next year. The rand closed at 6.25,
compared to 6.13 rands per dollar just before the SARB
announcement, as the real interest rate differential
between the United States and South Africa slipped to 4.65
from 5.15 percentage points. Tito Mboweni, SARB's
governor, reiterated the bank's goal of inflation
targeting rather than exchange rate or growth targeting.
Dropping interest rates now might signal SARB's growing
concern about sustaining South African growth in the midst
of a strong exchange rate. End Summary.

SURPRISE INTEREST RATE CUT
--------------


2. The South African Reserve Bank's (SARB) Monetary
Policy Committee reduced interest rates by 50 basis points
bringing the repurchase rate down to 7 percent, the lowest
level since 2000. Major banks followed with announcements
that they would also reduce their prime lending rates from
11 percent to 10.5 percent. Real interest rates in South
Africa are now 4.40 percent (i.e., the repurchase rate
minus February's consumer price inflation of 2.6 percent).
The real interest rate differential between the United
States and South Africa narrowed to 4.65 compared to 5.15
percentage points before SARB's announcement. The
reduction of the spread between real interest rates helps
explain the overnight depreciation of the rand via the
dollar.

Lower Inflation and Weakness in Manufacturing
--------------


3. In explaining the interest rate cut, Mboweni noted
evidence of slower economic activity in the manufacturing
sector as a result of the move by the rand to a higher
trading range over the past six months. In addition, he
cited recent evidence of slowing inflation and
inflationary expectations. The latest inflation
expectations survey conducted by the Bureau for Economic
Research (BER) at the University of Stellenbosch showed a
significant decline in inflation expectations. According
to the survey, CPIX inflation (consumer prices less
mortgages) expectations reached their lowest level since
the BER started the survey in 2000. For the first time,
survey respondents expected inflation to fall below the
upper end of the 3-6 percent inflation target band. On
average, CPIX inflation is expected to be at 4.5 per cent,
down from 5.5 per cent in the previous survey. CPIX
inflation is also expected to remain within the target
range for the next 3 years.

Immediate Reaction
--------------


4. The reduction in interest rates took most analysts by
surprise, as a Reuters poll of 15 economists done last
week predicted that the SARB would keep the repurchase
rate at 7.50 percent for the remainder of the year, with
any rise in 2006 limited to less than 50 basis points.
Standard Bank economist Monica Ambrosi asserted that key
inflation risk factors, such as the outlook for oil prices
and exchange rates, were more uncertain now compared to
February, when the majority of economists were expecting a
central bank interest rate reduction. The Council of
South African Trade Unions (COSATU) called for additional
interest rate reductions to weaken the rand and welcomed
Mboweni's announcement.

SARB CONCERNS ABOUT SUSTAINABLE GROWTH
--------------


5. Comment. The unexpected rate cut may signal that the
SARB is increasingly worried about the detrimental impact
of the strong rand on employment. Significant job cuts
have been announced in the mining and textile industries,
citing high rand costs of production. Recent deceleration
of growth in the manufacturing sector is also of
particular concern, as the manufacturing sector accounted
for 17 percent of real gross domestic product in 2004.
Manufacturing production growth sharply decelerated from
December 2004's 7.9 percent growth to 3.2 and 2.7 percent
in January and February 2005, respectively. Despite dim
prospects for manufactured exports, production still
increased over the past year due to robust domestic
consumer demand. Real domestic expenditures increased 6.3
percent in 2004. End comment.


FRAZER