SOUTH AFRICAN MONETARY AUTHORITIES EXPECT INFLATION

UNCLAS SECTION 01 OF 02 PRETORIA 001956

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SIPDIS

DEPT FOR AF/S/MTABLER-STONE; AF/EPS; EB/IFD/OMA
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E.O. 12958: N/A
TAGS: ECON EINV EFIN ETRD BEXP KTDB PGOV SF
SUBJECT: SOUTH AFRICAN MONETARY AUTHORITIES EXPECT INFLATION
WITHIN TARGET RANGE ALTHOUGH RISKS REMAIN


1. Summary. At the May 11th semiannual Monetary Policy
Forum meeting, officials from the South African Reserve Bank
(SARB) briefed members of the economic community on the
justification of leaving interest rates unchanged so far in

2006. Citing lowered inflation expectations since November
2005 and inflation having been within the 3%-6% target range
for the past 31 consecutive months, the SARB expects
inflation to remain within its target range over the next
several years. However, risks to inflation remain the same.
Increasing current account deficits, rising oil prices,
strong consumer demand and increasing household debt levels
still worry the SARB as potential harbingers of accelerating
inflation. Recent statements by the SARB Governor Mboweni
and Finance Minister Manuel suggest that future SARB action
may lean towards interest rate increases to curb
inflationary risks. The SARB also presented research that
suggested South Africa's current growth potential (non-
inflationary growth) was slower than what would occur if
government's economic targets were met or if South Africa
attained the average competitive performance of emerging
markets. End Summary.

So far, Inflation Under Control
--------------


2. Targeted inflation, i.e., consumer prices without
mortgage costs, has remained within the 3%-6% range for the
past 31 consecutive months. Since the last Monetary Policy
Forum in November, inflationary expectations have steadily
declined, and thus the SARB has steadily lowered its
forecasted peak inflation rate over the next two years. In
October 2005, SARB thought inflation would peak at 5.8%; its
current inflation peak is 4.9% occurring in the first
quarter 2007, and then receding to just over 4.5% throughout

2008.

South Africa Faces Same Inflationary Risks Over Past Year
-------------- --------------


3. The inflationary risks facing South Africa have not
changed over the past year. High and volatile oil prices,
widening current account deficits, strong consumer demand
and increasing household debt levels have provided SARB with
enough reasons to be cautionary about rising inflation in
the future. So far, none of these risks have translated
into substantially higher inflation.


4. The relative strength of the rand has tamed the impact
of rising oil prices denominated into dollars. Little
evidence exists to suggest rising oil prices are causing
increased secondary inflation. The strong rand did
encourage cheaper imports, with imports increasing by 10.1%
in 2005 compared with export growth of 6.7%. However,
cheaper imports provide more competition to domestically
produced goods and limit possible price increases.


5. Rising disposable income along with relatively low
interest rates mean that increased debt is still relatively
affordable. Even though household debt reached 65.5% of
disposable income during the last quarter 2005, debt service
costs are 7% of disposable income, less than half the 1998
level.

Jawboning Attempts to Reduce Inflationary Risks
-------------- --


6. Recent statements by both SARB Governor Mboweni and
Finance Minister Manuel on the dangers of incurring
additional debt in the face of possible interest rate hikes
underscore the importance of moral suasion in trying to cool
strong credit and consumer demand. Over the past two years,
household consumption growth supported strong growth in GDP,
with strong growth in household spending on durable and semi-
durable goods.


7. SARB's most recent Financial Stability Review (March
2006) warned about recent changes signaling that borrowers
might be facing repayment problems. Mortgage loans overdue
(those that are more than 180 days overdue and either
inadequately secured or uncollectible) increased by 5.5% in
the year to February 2006, while the ratio of overdue

PRETORIA 00001956 002 OF 002


mortgage loans to total mortgage advances increased from 1%
in the third quarter 2005 to 1.2% in the fourth quarter.
Both Mboweni and Manuel have warned about possible impacts
of increasing interest rates on consumers, saying what goes
down must come up.

Interesting Asides
--------------


8. For every Monetary Policy Review, the SARB publishes
separate sidebars that highlight recent topics of research.
This issue featured three topics, one of which generated
great discussion and had implications for government
policies. The May issue of the MPR featured bank research
on household indebtedness, comparing affordability indices
across countries; a discussion on global trade imbalances
and summary of research on measuring South African potential
output. Given the South African government's emphasis on
achieving accelerated growth, discussion on potential output
raised questions.


9. Potential output is the maximum sustainable level of
output consistent with stable inflation. It can never be
observed, but most econometrically estimated macroeconomic
models estimate potential output by using production
functions that use total factor productivity, desired
capital stock and a natural rate of unemployment (frictional
not structural unemployment).


10. SARB's research posits four scenarios: status quo,
utopia, government targets, and international benchmarks.
SARB's discussion does not make it precisely clear which
value of the natural unemployment rate each scenario uses.
The status quo uses some positive value (not specified).
Utopia scenario uses 0, which assumes there is neither
structural nor frictional unemployment. Government targets
scenario assumes unemployment is halved in 10 years, savings
to GDP ratio reaches 22% and the foreign direct
investment/GDP ratio reaches 1.3%. International benchmark
scenario assumes that South Africa achieves the average
performance of emerging markets, where the unemployment rate
is 12%, FDI to GDP is 4% and the savings to GDP ratio is
25%.


11. The results are illuminating. The status quo scenario
yields 4.1% growth in potential output, utopia shows 6.9%
growth, the government target scenario's growth of potential
output is at 5.1%, and the international benchmark scenario
reaches 6.5%.


12. Comment. Only the results were presented at the
presentation without explanation of the assumptions behind
each scenario. Several questions arose concerning the
relatively low growth of potential output in both the status
quo and government target scenarios. SARB representatives
stressed that the analysis was intended as contributions to
current research and not serve as the SARB's opinion of
South Africa's current growth potential, or what would occur
if the government's economic targets were met. End comment.

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