Monetary Policy and the Economy in South Africa

Monetary Policy and the Economy in South Africa

Monetary Policy and the Economy in South Africa Mthuli Ncube African Development Bank Group, South Africa and Eliphas Ndou Reserve Bank of South Africa, Pretoria, South Africa

Mthuli Ncube and Eliphas Ndou 2013 Softcover reprint of the hardcover 1st edition 2013 978-1-137-33414-5 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No portion of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, Saffron House, 6 10 Kirby Street, London EC1N 8TS. Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The authors have asserted their rights to be identified as the authors of this work in accordance with the Copyright, Designs and Patents Act 1988. First published 2013 by PALGRAVE MACMILLAN Palgrave Macmillan in the UK is an imprint of Macmillan Publishers Limited, registered in England, company number 785998, of Houndmills, Basingstoke, Hampshire RG21 6XS. Palgrave Macmillan in the US is a division of St Martin s Press LLC, 175 Fifth Avenue, New York, NY 10010. Palgrave Macmillan is the global academic imprint of the above companies and has companies and representatives throughout the world. Palgrave and Macmillan are registered trademarks in the United States, the United Kingdom, Europe and other countries ISBN 978-1-349-46261-2 ISBN 978-1-137-33415-2 (ebook) DOI 10.1057/9781137334152 This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. Logging, pulping and manufacturing processes are expected to conform to the environmental regulations of the country of origin. A catalogue record for this book is available from the British Library. A catalog record for this book is available from the Library of Congress.

Contents List of Figures List of Tables Preface Acknowledgments List of Abbreviations viii xi xii xiv xv 1 Introduction: South African Monetary Policy Regimes 1 1.1 The exchange rate policy 2 1.2 Current account 3 1.3 Inflation and economic growth 3 Part I Output 2 Effects of Monetary Policy on Output 9 2.1 Introduction 9 2.2 VAR methodology 16 2.3 Data 17 2.4 Empirical results 20 2.5 Conclusion 23 3 Inflation Uncertainty and Output 25 3.1 Introduction 25 3.2 Theory 26 3.3 Literature review 28 3.4 Econometric methodology 29 3.5 Data and descriptive statistics 31 3.6 Empirical results 33 3.7 Conclusion 38 Part II Housing 4 Monetary Policy Transmission, House Prices and Consumption 43 4.1 Introduction 43 4.2 Consumption, housing prices and interest rates 46 v

vi Contents 4.3 The VAR model 48 4.4 Data 50 4.5 Results and discussion 51 4.6 Conclusion 61 5 Monetary Policy, Disposable Income and Consumption 65 5.1 Introduction 65 5.2 Data 67 5.3 VAR model 68 5.4 Results 70 5.5 Impact of oil price in the extended model 75 5.6 Counterfactual analysis 78 5.7 Variance decompositions 79 5.8 Conclusions 81 6 Mortgage Variables, Monetary Policy and Consumption 83 6.1 Introduction 83 6.2 Theory 88 6.3 What does international evidence conclude? 90 6.4 Data 91 6.5 Results 95 6.6 Examining the impact of US mortgage variables on South Africa 103 6.7 Conclusion 106 Part III Components of the Balance of Payments 7 Monetary Policy and Exchange Rate Shocks on South Africa s Trade Balance 113 7.1 Introduction 113 7.2 Literature review 115 7.3 VAR methodology 116 7.4 Data 119 7.5 Empirical results 122 7.6 Variance decomposition 136 7.7 Conclusion 136 8 Exchange Rate, House Price and Equity Shocks on the Current Account 139 8.1 Introduction 139 8.2 Review of findings in other countries 143 8.3 VAR methodology 144 8.4 Data 146

Contents vii 8.5 Empirical results 149 8.6 Conclusion 154 Part IV International Transmission 9 International Transmission of US Shocks into South Africa 159 9.1 Introduction 159 9.2 A review of previous empirical analysis 162 9.3 VAR methodology 164 9.4 Data 166 9.5 Results 168 9.6 Conclusion 175 Bibliography 177 Index 189

List of Figures 1.1 South African current account and trade balance as percentage of GDP 4 1.2 South African GDP and inflation rates 5 2.1 Linkage between financial conditions, monetary policy and real economy 10 2.2 South African financial conditions indices 11 2.3 Components of the financial conditions index during its expansionary phase in 2004 12 2.4 Components of the financial conditions index during its contractionary phase in 2008 13 2.5 Quarterly GDP growth rates and money market interest rates 13 2.6 Trends of all variables 18 2.7 Shaped posterior distribution of impulse responses 19 2.8 Dynamic responses 20 2.9 GDP growth versus estimated monetary policy shocks 22 3.1 Plots of output and inflation rate 32 3.2 Generalized impulse responses: inflation uncertainty and inflation 37 3.3 Generalized impulse responses: inflation uncertainty and output growth 38 4.1 Loan to value ratios 44 4.2 Loan to value ratios according to large mortgages books 45 4.3 Relationship between interest rate, housing and consumption 46 4.4 Plots of variables 52 4.5 Impulse responses to the interest rate and house price shocks 55 4.6 Impulse responses to the interest rate from the alternative model 59 4.7 Impulse responses to house prices from the alternative model 60 5.1 Trends in variables 66 5.2 Plot of variables 69 5.3 Responses to monetary policy shocks 72 5.4 Responses to house price shocks 73 5.5 Responses to disposable income shocks 74 viii

List of Figures ix 5.6 Responses to inflation shocks 76 5.7 Responses to oil price shocks 77 5.8 Consumption paths after shutting off disposable income at different dates 79 6.1 Components of commercial bank finances (%) 85 6.2 Bond amounts according to institutions (billion rands) 86 6.3 Values of primary and secondary bonds in South Africa 86 6.4 Average values of bonds (million rands) 87 6.5 Debt to household income ratios and costs of servicing debt 87 6.6 The housing monetary transmission mechanism channel 89 6.7 Plots of all variables 93 6.8 Monetary policy shocks 96 6.9 Mortgage lending shocks 97 6.10 Housing price shocks 99 6.11 Residential investment shocks 101 6.12 US residential investment shocks 104 6.13 US house price shocks 105 7.1 Real imports and exports as percentage of gross domestic product 114 7.2 Plot of variables 121 7.3 Exchange rate appreciation and monetary policy shocks 123 7.4 Main shocks in the second specification 126 7.5 Main shocks using OECD data 127 7.6 Main shocks using OECD data in the second model 128 7.7 Main shocks on exports and imports in the main model 130 7.8 Main shocks on exports and imports in the second model 131 7.9 Main shocks, private absorption and equity appreciation shocks 134 7.10 Main shocks, private absorption and supply shocks 135 8.1 Current account as percentage of GDP and asset prices 140 8.2 Current account and net portfolio flows 140 8.3 Current account and other variables 142 8.4 Plots of variables 148 8.5 REER, equity appreciation and housing shocks 150 8.6 Main shocks and monetary policy shocks 152 8.7 Main shocks and private absorption 153 9.1 South African exports to main trading partners 160 9.2 Bilateral US and South African investment positions 160 9.3 US recession and South African growth 162 9.4 Plot of all variables 167 9.5 Effects of US M2 expansion shocks 169

x List of Figures 9.6 Effects of US contractionary monetary policy shocks 171 9.7 Effects of US output shocks 172 9.8 Effects of negative trade shocks 173 9.9 Effects of portfolio shocks 174

List of Tables 2.1 Contractionary monetary policy shock 17 3.1 ARCH and unit roots tests 32 3.2 Accumulated effects of inflation uncertainty on inflation 34 3.3 Results 36 4.1 Descriptive statistics 51 4.2 Decomposition of variance for series (%) 56 4.3 Decreases in consumption in the sixth quarter (%) 58 4.4 Unit root test 63 5.1 Variance decomposition of consumption variables in five-variable VAR (%) 80 6.1 Descriptive statistics 92 6.2 Variance decomposition of shocks (%) 102 6.3 Forecast variance error decomposition of South African variables (%) 108 7.1 Benchmark VAR 118 7.2 Modified benchmark VAR identification 119 7.3 Descriptive statistics 120 7.4 Augmented VAR identification 132 7.5 Variance decomposition of various shocks (%) 136 8.1 Benchmark VAR identifications of shocks through sign restrictions 145 8.2 Descriptive statistics 147 8.3 Variance decomposition of various shocks (seven-variable VAR) 154 9.1 Description of the variables 166 xi

Preface This book is made up of four parts covering output, housing, components of the balance of payments, and international transmission. Different VAR approaches are applied to data in order to assess monetary policy conduct in South Africa. The book uses two Bayesian VAR approaches in the form of sign restrictions and Minnesota priors, in addition it estimates over identified and precisely identified SVARs. Part I examines output in South Africa. Chapter 2 investigates three questions relating monetary policy to the business cycle using a VAR sign restriction approach, dealing in particular with the effect of contractionary monetary policy shocks on output, and the proportions of fluctuations due to contractionary monetary policy shocks relative to other shocks. This chapter also shows some of the actual monetary policy activities that are captured by the approach. Chapter 3 assesses the importance of price stability as a mandate for monetary policy authorities. It assesses the relationships between inflation, inflation uncertainty, output growth uncertainty and output growth variables. This involves testing the impact of inflation uncertainty on inflation to determine whether the central bank pursues stabilization policies (as suggested by Holland 1995) or goes out of its way to be unpredictable and engineer higher inflation, hoping for output gains (Cuikerman and Meltzer 1986). In addition, the study looks at the indirect channel through inflation uncertainty on both real output growth (Friedman 1977) and its uncertainty, which is expected to be negative, according to Taylor (1979), or positive, according to Logue and Sweeney (1981). Part II deals with the real estate sector. Chapter 4 estimates an SVAR and quantifies the percentage decrease in consumption expenditure, attributed to the changes in household wealth, due to a contractionary monetary policy shock in South Africa. This compares the significance of indirect effects relative with direct effects. The indirect channel operates through changes in the interest rates on household wealth, the rising interest rates directly reducing current consumption. The direct channel refers to the effects of interest rates on consumption. Chapter 5 assesses the role of disposable income, inflation and house prices on various categories of consumption. The analysis is extended to assess the impact of oil inflation shocks on real variables. Chapter 6 investigates the role xii

Preface xiii of the mortgage market and the impact of spillover effects from the US housing market on the South African economy. This particularly searches for any evidence of a directional push effect from developments in the US housing market on South African counterparts. Part III focuses on the trade balance and current account. Chapter 7 examines the differential effects of contractionary monetary policy and exchange rate appreciation shocks on the trade balance. In addition, the analysis further examines the channels through which monetary policy affects the trade balance. Chapter 8 investigates the economic significances of the exchange rate, house prices and equity price appreciation shocks in explaining current account fluctuations, and seeks to find the dominant shock between the real effective exchange rate, house prices and equity price appreciation shocks in terms of the effect on the South African current account balance. Part IV deals with international spillover effects. Chapter 9 focuses on the transmission of macroeconomic shocks in the United States to the South African economy. This chapter particularly investigates the extent to which macroeconomic fluctuations in South Africa are caused by US shocks. The objective is to demonstrate South Africa s vulnerability.

Acknowledgements We would like to thank our colleagues and friends in the South African Reserve Bank research department for their patience and for supplying us with data used in this book. We thank Nombulelo Gumata and Thabo Mokoena at the South African Reserve Bank, and Professor Alain Kabundi, Professor Chris Malikane, and colleagues at the African Development Bank for their helpful comments in reviewing some of the chapters. We also thank the Journal of Housing and Scottish Journal of Political Science for their permission to reproduce the graphs. We are grateful to Tom Doan at Estima for his help with programming and e-course material. We thank colleagues at the European Central Bank, especially Alberto Musso, for his assistance with programming, and at the University of the Witwatersrand. xiv

List of Abbreviations ADF AGOA Alsi BFGS BIS CPI-X E-GARCH EMU FAVAR FFR GARCH GARCH-M GDP IFS IMF KPSS MFD MMR MPC NEER NGP OECD OLS PCE PP RBC REER repo SARB SVAR SVECM VAR VECM Augmented Dickey Fuller test African Growth and Opportunity Act All Share Index Broyden Fletcher Goldfarb Shanno algorithm Bank of International Settlements consumer price inflation, excluding mortgage rates exponential generalized autoregressive conditional heteroscedasticity European Monetary Union factor augmented vector autoregression federal funds rate generalized autoregressive conditional heteroscedasticity generalized autoregressive conditional heteroscedasticity-in-mean gross domestic product international financial statistics International Monetary Fund Kwiatkowski Phillips Schmidt Shin test Mundell Fleming Dornbush money market interest rate marginal propensity to consume nominal effective exchange rate New Growth Path Organisation for Economic Co-operation and Development ordinary least squares personal consumption expenditure Phillips Perron test real business cycle real effective exchange rate repo rate or repurchase rate South African Reserve Bank structural vector autoregression structural vector error correction model vector autoregression vector error correction model xv