The New Monetary Policy Framework

Our Understanding of the Changes and Potential Implications

In June this year, the South African Reserve Bank (SARB) began the process of transitioning to a new framework for implementing monetary policy in South Africa. The new monetary implementation framework is aimed at creating a monetary surplus by encouraging commercial banks to deposit cash reserves with the SARB. This is in contrast to the previous system which created a monetary deficit and required the SARB to provide liquidity.

BACKGROUND

Lingering COVID-induced supply chain disruptions, the war raging on in Eastern Europe and a cartel stubbornly restricting the supply of oil have all ensured that inflation continues to remain stubbornly high. Global central banks are scurrying to tame inflationary pressures, with many a central bank governor wearing a hawkish mask, perhaps in an effort to restore some semblance of credibility following the wide-scale ‘transitory inflation’ mantra proclaimed during the onset of the supply chain dislocations. With the spotlight now focused on monetary policy, and with our own central bank having recently transitioned to a new monetary policy implementation framework, we think it is worth running a refresher on monetary policy and digging a little deeper into the nuts and bolts of the new monetary policy implementation framework (MPIF).

MONETARY POLICY IN SOUTH AFRICA

In a country with an inflation-targeting regime such as South Africa, monetary policy is used primarily as a tool for maintaining price stability, which, in the local context, implies maintaining year-on-year headline consumer price inflation within a target range to 3-6%. The SARB achieves this by controlling the supply of money in the economy - either by increasing the supply of money in order to stimulate aggregate demand and place upward pressure on prices, or by decreasing the supply when price pressures become too elevated.

HOW IS THIS IMPLEMENTED?

Monetary policy is implemented by setting a short-term policy rate (repurchase rate) at a level which would either increase or decrease the growth in the supply of money. The repo rate affects the lending costs imposed by the banking and financial sectors. A lower-than-neutral repo rate would result in a lower lending cost and a higher likelihood of increased borrowing and spending. Similarly, a higher-than-neutral repo rate would make it relatively more expensive to borrow, which would likely curtail spending and soften price pressures.

Commercial banks and financial institutions use the repo rate to set their own lending rates, which are typically centred around the prime rate (repo + 3.5%). For monetary policy transmission to become effective, the SARB needs to create an incentive for commercial banks and financial institutions to use the repo rate as a base rate, given that they act as intermediaries in the monetary policy implementation framework by virtue of their role in extending credit to the broader economy. The SARB’s monetary policy committee’s decisions would have little effect on influencing the growth of money supply if commercial banks were to disregard using the repo rate as a base rate.

Figure 1: A strong relationship exists between the growth in money supply and the rate of inflation

Source: South African Reserve Bank (SARB), Futuregrowth 

CREATING AN INCENTIVE 

The SARB provides an incentive for banks to use the repo rate as a base rate by creating a monetary deficit. By draining cash from the money market, the SARB forces commercial banks to borrow from it, given its position as a lender of last resort. This impacts the ability of commercial banks to grow or shrink their balance sheets. The Bank does this via two key channels: 

1. Reserve requirement: Commercial banks are required to keep 2.5% of qualifying liabilities (e.g. customer deposits) in a reserve account held at the SARB. These reserve accounts drain cash from the monetary system and would prompt commercial banks to borrow against those reserves if and when demand for money increased. 

2. Open market operations (OMO): Here the SARB becomes a little bit more active in influencing the amount of cash in the market. The Bank has several tools it can use to drain or increase the amount of cash in the monetary system.  

3. SARB Debentures: A debenture is a type of debt instrument (similar to a bond) that the SARB issues to help it drain liquidity from the market. The uptake of debentures has historically been quite low, owing to market preference for more tradeable and competitively priced treasury bills.  

4. Long-Term Reverse Repos: Here the SARB sells bonds in terms of repo agreements in order to drain liquidity from the market. As with debentures, there has been a near non-existent uptake of these instruments, rendering them largely ineffective as a monetary policy tool. 

5. Public Sector Deposits: These are government cash accounts held at the Corporation for Public Deposits (CPD), which is a subsidiary of the SARB.  Like everyone else, the government needs cash on hand to manage the country’s day-to-day financial requirements. This cash is held at the CPD and invested in short-term money market instrument and special treasury bills. By holding an increasing amount of CPD funds in a SARB call account rather than placing them in the market, the Bank has been able to effectively drain liquidity. Having said that, absorbing CPD cash has been an expensive exercise for the Bank, given the excess rate the SARB call account has had to pay to secure the inflows. 

6. Foreign Exchange (FX) Swaps: These have been the SARB’s primary tool for creating a liquidity shortage in the market over the past few years. FX swaps are contracts in which one party borrows one currency from, and simultaneously lends another to, a second party. Each party then agrees to swap the currencies back at a future date, but at different exchange rates. The SARB sometimes uses FX swaps to temporarily drain liquidity from the market by swapping US dollars (USD) for South African Rands (ZAR), and generally uses FX swaps to sterilise inflows from international financial institutions. For example, during the height of the COVID crisis in 2020, the SARB had to sterilise a US$4.3 billion IMF loan by using FX swaps. The loan was transferred directly to the SARB in foreign currency, which the SARB then swapped into rands using the forward market. This created large distortions in the forward market, resulting in high and volatile FX-implied forward rates. As a result it had become increasingly expensive for non-resident investors to hedge their local currency positions.  

7. Direct intervention by purchasing or selling SA government bonds: This is a typically a measure of last resort and is used in times of severe illiquidity as was the case during the initial COVID-19 fallout (see figure 2). 

Figure 2: Simplified shortage-based monetary framework

Source: South African Reserve Bank (SARB) 

Figure 3: Direct interventions by the SARB (sovereign bond purchases) 

Source: South African Reserve Bank (SARB), Futuregrowth 

IMPLICATIONS OF ECONOMIC UNCERTAINTY 

Simplistically, commercial banks source cash via deposits from account holders and other banks. They subsequently use this cash to issue loans to businesses and individuals in the form of business, vehicle, home and personal loans. During times of economic stress, commercial banks may wish to take on less risk and, in turn, issue fewer loans. This often results in commercial banks accumulating excess cash.  

The accumulation of excess cash leaves the banks with three options. Firstly, they can reduce cash by continuing to extend loans, but at the risk of seeing an increase in defaults. Alternatively, they could choose to not extend any loans, but to hold on to the cash and earn no interest. Thirdly, they could deposit the excess cash at the SARB and earn a rate between repo and repo -1%. The latter option often makes sense, given that interest will be earned and that the SARB itself can be considered a risk-free borrower in the local market.  

FACTORS LEADING TO THE POLICY FRAMEWORK CHANGE 

During the COVID-19 fallout, banks chose to de-risk their balances sheets by pulling back on extending credit and instead accumulated cash. The excess cash was transferred to the commercial banks’ respective reserve accounts at the SARB, earning repo -1%, resulting in the effective repo (which is the effective rate banks earn on their deposits at the SARB), decoupling from the official repo rate set by the SARB.   

Figure 4: Effective repo rate versus actual repo rate 

Source: South African Reserve Bank (SARB) 

The liquidity vacuum created by the banks forced the SARB to respond by injecting cash into the system by purchasing government bonds and increasing the size and duration of repo facilities to the banking sector. Although this response was appropriate and based on maintaining a functional and stable financial market, the SARB struggled to revert back to its pre-crisis shortage position once the market had stabilised. 

For its transmission mechanism to function efficiently, the SARB must be able to create a shortage in the money market in order to compel the commercial banks to borrow from it. It has become increasingly difficult and costly for the SARB to drain liquidity from the system, especially during times of economic shock, so it made sense for the SARB to consider moving from a shortage to a surplus monetary regime.  

TRANSITIONING FROM A MONETARY SHORTAGE TO A MONETARY SURPLUS SYSTEM 

Domestic monetary policy had been implemented using a cash reserve or shortage system since 1998. Although the system functioned reasonably well initially, many of the monetary tools used to drain liquidity in order to create the monetary shortage eventually became either redundant or very expensive.  

The transition to the new surplus system started in June this year. Phase 1, a 12-week transition in which the existing monetary shortage of R30 billion was converted to a surplus of R50 billion, was completed at the end of August.  

An important feature of the new framework is the quota applied to banks on their excess reserves. The quota acts as a cap on the level of reserves on which banks can earn the policy rate. Any level of reserves over this cap would earn a punitive rate of repo less 100 basis points. There is a risk that in a system where all commercial banks are flush with liquidity, there would be no need for banks to borrow or lend to or from each other, since no individual bank would ever have a shortage of cash. However, the surplus liquidity target of R50 billion has been divided amongst the banks, with each bank receiving a quota (or “tier”) based on its individual size. This should ensure that there is never too much liquidity in the system as a whole, which could force banks to systematically earn punitive rates on their reserves. The punitive rate on excess reserves should also encourage interbank lending since banks with excess levels of reserves would be willing to lend these reserves at a rate in excess or repo -100 basis points to banks with cash shortages. This tiered-floor system is therefore aimed at avoiding the hoarding of cash by banks under times of economic stress as well as during times when markets are functioning normally.  

The transition was done gradually in order to acclimate the market to the new system. Banks in particular were required to gradually increase their levels of reserves held over the period in order to align to their individual quotas. The transition has gone according to plan and monetary policy continues to function normally. The monetary policy committee still sets interest rates as they did prior to the transition, and the inflation target band remains at the current range of 3-6%. The focus now is for the SARB to continue to manage the level of surplus liquidity in the market.  

EXPECTED LONG-TERM STRUCTURAL BENEFITS OF A SURPLUS MONETARY SYSTEM: 

1. Better transmission between policy rate and market rates. International experience indicates that in a tiered-floor system, interbank rates generally become more aligned to the central bank’s policy, implying a more effective transmission mechanism; 

2. Less of a need to use expensive monetary tools for draining liquidity such as FX swaps; 

3. During times of crisis, commercial banks tend to de-risk by not extending credit and hoarding cash instead. This creates illiquidity which, in turn, triggers market dysfunction. By starting off with a liquidity surplus, there should be less of a need for the SARB to actively create liquidity during episodes of aggressive market de-risking; and 

4. The new system will be simpler - given less of a need to use complicated liquidity draining tools - and more resilient to shocks. 

POSSIBLE MARKET IMPLICATIONS OF THE NEW SURPLUS SYSTEM  

We see the migration to a surplus tiered-floor system as a positive development for the yield curve.  

Potentially lower and more stable implied FX yields could see a resumption of foreign demand, given the lower cost of hedging rand-denominated local bond exposure. This should encourage yield curve compression over time. 

Furthermore, excess liquidity should act as a buffer in times of economic shock, lessening the need for direct SARB intervention. This should hopefully act as a buffer against market illiquidity and could imply less yield curve volatility.  

Ultimately, a more liquid market, with lower funding costs should lead to more efficient price discovery, but the proof will always remain in the pudding. Although South Africa’s fiscal and economic fragility remains elevated and is ill-positioned to withstand another crisis, we will only be able to see the true efficacy of the new monetary policy implementation framework when we find ourselves under bouts of market stress.