South Africa Needs A Gold-Price Rule Currency Board

The recent slide of the South African Rand against the US dollar and the euro provides the latest evidence that the African nation should end its commitment to its "inflation-targeting" monetary regime and institute a currency board that follows a gold-price rule.

In the past year, the South African rand has weakened significantly against the US dollar with 8 South African rand presently exchanging for 1 US dollar as compared to 6 rand exchanging for 1 US dollar in January of 2000.

And the rand's fall against the US dollar is not a new phenomenon - in January of 1996 it only took 4 rand to purchase 1 US dollar and in the 1st quarter of 1992, 3 rand exchanged for 1 US dollar.

And in just the short tine period from November 9, 2000 until last week, the rand has fallen from an exchange rate of 7.7650 to the dollar to 8.01 to the dollar.

Inflation-targeting is a monetary regime whereby the central bank uses various monetary policy instruments to achieve a certain rate of inflation as measured, in South Africa's case, by a consumer price index.The basic ingredients of inflation-targeting include the announcement of a target for future inflation at some low level or range; subsequent monitoring of the expected rate of inflation; and the use of various monetary policy instruments in order to keep the inflation rate estimates in line with the inflation target which the government has publicly announced.

On February 23, 2000 South Africa's Finance Ministry announced that the government had decided to set an inflation target range of 3 to 6 per cent for the year 2002.

The goal of "inflation-targeting" is price stability. And the Governor of the South African Reserve Bank (SARB), T.T. Mboweni has stated, "Price stability is achieved when changes in the general price level do not materially affect the economic decision-making process."

If one accepts that definition of price stability, then South Africa's "inflation-targeting" monetary regime has failed to, is currently, and will continue to fail to achieve its stated goal.

The reason why South Africa will continue to fail in its efforts to achieve price stability is because it is aiming at the wrong target. It is aiming at an inflation index when it should be aiming at a unit of account or monetary standard. Contrary to conventional wisdom, inflation begins with a decline in the monetary standard and not with a rise in the general price level. In other words, inflations occur when the monetary standard - the definition of the value of a paper currency in terms of another currency or commodity - declines or weakens in value.

You can only truly "target" inflation by controlling the rate at which the monetary standard declines. You can only target a 3- 6% increase in the general price level by targeting a 3-6% decline in the monetary standard. As an example, in South Africa, you could only achieve a 3% to 6% increase in consumer prices if you allowed the South African unit of account - defined in terms of a weight of gold - to decline by 3 to 6 percent. This would mean that 1 South African rand would purchase 3% less gold than it previously did. Or, with a lesser chance of success, the same could be achieved if the value of a 1 South African rand decreased by 3 to 6 percent against a stable US dollar.

Then that inflation or decline in the monetary standard would spread throughout the South African economy.

But the decline of the rand in terms of gold or the US dollar precedes the appearance of inflation that will show up in a South African consumer price index.

The reason why "inflation-targeting" fails is because it focuses on the effect (increased consumer prices) and not the cause (a decline in the monetary standard).

Attempting to control the rate of inflation by using a consumer price index is about as effective as driving a car through the rear-view mirror - taking events that you have already passed as your guide.

This was most obvious in the time period from January 1996 to September 1999 when the price of gold dropped from $416 per ounce to $256 per ounce. This dramatic drop in the "monetary standard" foreshadowed the movement of a massive deflation train that would eventually carry prices downward in farm commodities, oil, real estate, goods and services and wages.

Today the price of gold is $264 an ounce.

By comparison, the price of gold has gone from 1,500 rand in January of 1996 to 2,000 rand per ounce today.

Interestingly, Alan Greenspan did not publicly consider the possibility of a monetary deflation until two years after the price of gold dropped. At that time he and the Federal Reserve, like South Africa's Reserve bank today, were driving while looking in the rear view mirror - managing the economy by watching a consumer price index and other variables as opposed to looking at the most monetary of all commodities - the price of gold.

The gold price is especially important for gold and commodity producing countries like South Africa whose mining sector has been devastated by the lower price of gold and other commodities on international markets.

And there exists another problem with inflation-targeting in South Africa, and that is the preferred monetary policy instrument of the SARB, used to manage the economy - the repurchase rate, commonly referred to as the "repo rate".

Repos occur when the monetary authorities repurchase assets which they had previously sold to the market. Because repos effectively are open market purchases, they inject liquidity into the market. Repos and reverse repos are ideally suited for offsetting fluctuations of a short-term nature that affect bank reserves. They also help to offset large shifts in liquidity that are caused by capital inflows and outflows.

However, in South Africa the repo rate itself actually feeds into the inflation rate forecasts.

Banks in South Africa are so sensitive to the repo interest rate that any movement in the repo rate upward or downward is soon mirrored in the banking sector's prime lending rate to its best customers. And this affects mortgage rates.

Higher interest rates which raise the borrowing expenses of entrepreneurs, small businesses and corporations, are passed along to consumers resulting in higher prices or "inflation" that would be picked up in consumer price indices.

In 1998 South Africa's annual inflation rate of 9% as measured by the consumer price index, was largely a result of higher interest rates which caused a marked increase in the mortgage cost component of South Africa's CPI.

The very mechanism that South Africa is using to control inflation actually produces inflation.

Simply put, the SARB's reliance upon managing the country's monetary policy via the repo rate has an overall negative rate on the country's economy.

Some estimate that a decision by the SARB to raise the repo rate by .25% would influence South African banks to raise their prime-lending rate by .50%. That would leave South Africa's commercial banks with a prime-lending rate of 14.50 which could make new financing too expensive for those looking to expand their business operations and who are in need of new working capital.

This has a negative effect on economic growth.

In addition, according to the SARB, changes in interest rates in South Africa generally take from 18 to 24 months to have a material influence on the underlying rate of inflation.

This alone makes one wonder how the SARB can target an annual rate of inflation through the use of a monetary policy tool that takes more than a year to have an impact.

Another fallacious argument used by those in South Africa who support inflation-targeting is that it is somehow possible for inflation targeting to dampen the volatility in capital flows and sharp swings in the nominal exchange rate. These inflation-targeting advocates argue that by making it clear to the financial markets that a certain rate of inflation is the target, speculators will be discouraged from "attacking" the rand.

In fact the total opposite is the case as currency speculators and investors can easily determine that a country's publicly-announced inflation targets lack credibility and cannot be achieved. This would immediately cause these individuals and investors to sell their rand holdings and move into safer currencies or assets.

Another flawed aspect to this argument is that it does not take into account that investors move capital in and out of a country based upon their confidence in a government's policies as well as due to developments inside of financial markets.

As an example the rand's most recent fall coincided with three rumors that caused individuals to not want to hold the rand.

The first rumor was that the country's long-awaited efforts to privatize its telephone company were delayed. The second rumor was that South Africa's Finance Minister, Trevor Manuel, was resigning to take a position at either the International Monetary Fund (IMF) or World Bank. The third rumor was that the South African government was considering instituting currency controls that would alter the movement of currency in and out of the country.

Though all of the rumors were denied by government officials, they do indicate that any efforts to promote price stability have to include efforts to increase demand for the rand.

To accomplish this the principal lever at the government's disposal is fiscal policy and the lessening of regulations that stifle production, impede the transfer of earnings into assets, and which inhibit risk-taking and entrepreneurial development.

In many respects, South Africa has done a credible job in this area. With personal income taxes, rebates were increased in order to raise tax thresholds by the projected rate of inflation. This was done in order to prevent tax bracket creep, the process by which inflation causes people's nominal wages to increase to the point where they are pushed up into a higher income tax bracket where they are taxed a higher percentage for earnings that are worth less.

In addition, South Africa lowered marginal tax rates applicable to those with incomes of R 46,000 - R70, 000 from a range of 39-43 percent to a range of 30-40 percent.

And corporate tax rates were slashed from 35 percent to 30 percent making South Africa competitive, in this area, with the international community.

However, some of the positive impact of these measures was counteracted by the decision to institute a capital gains tax in South Africa where there previously had been none and by the increase in several indirect taxes.

South Africa should pursue more aggressive fiscal policies that encourage investment and which empower and encourage South African small businesses and companies to shoulder the burden for creating economic growth, a burden currently being carried disproportionately by the country's public enterprises.

If South Africa can continue to institute fiscal policies that are not regressive and which unleash the productive capacity of its people and existing enterprises, it ensures a supportive and complimentary environment for monetary policy.

South Africa should embrace such a fiscal policy and discard its "inflation-targeting" exercise in favor of a currency board which fixes the rand to either the dollar or euro as long as the dollar or euro price of gold stays within a certain range.

The right combination of fiscal and monetary policies ensures that the appropriate supply of a stable rand is matched by a strong domestic and international demand for the rand.

A straight orthodox currency board, independent of a gold price rule is not enough as in and of itself a currency board does not reveal whether the monetary policies of the Federal Reserve or European Central bank are inflationary or deflationary in nature.

If South Africa were to tie the rand to the dollar, for example, when the Federal Reserve was inflating the value of the dollar, South Africa would unfortunately import that inflation.

We suggest that South Africa fix to the dollar as long as the gold price stays within the range of $250 and $280 an ounce.

But the optimal scenario would be if the SARB could somehow manage to obtain a commitment from the Federal Reserve that the US central bank would pour desperately-needed liquidity into the market place until the price of gold reached $310 per ounce (a price level recommended by 1999 Economics Nobel Prize Winner Robert Mundell) , South Africa could wait until that price level is reached and fix to the dollar at that rate.

A dollar gold price of $310 that was maintained for some time would indicate a break in the now 4-year old world-wide deflation.

An orthodox currency board that follows a gold-price rule makes the maintenance of a monetary standard the only priority of the central bank. And it eliminates the failed practice of managing the economy through interest rate manipulation.

Monetary policy is then on auto-pilot and free from the politics and corruption that has discredited central banks in emerging economies throughout the developing world.

Honesty and trust increase under a currency board regime and faith in the stability of the unit of account is firmly established as each day, citizens, consumers, producers, laborers, corporations and banks know that for every rand that is in circulation, the SARB has to have at least 100% foreign currency reserve backing in order to honor the fixed rate of exchange.

Under a currency board the central bank literally has to display its balance sheet to the public every day.

In the 1990s every country that has instituted a currency board has seen its annual rate of inflation and commercial interest rates drop, in addition to experiencing a dramatic rise in their foreign reserve holdings.

By establishing a gold-price rule currency board, South Africa would find not just an "inflation target" but also the price stability that it so desperately has been seeking.

Cedric Muhammad

Tuesday, January 16, 2001