South Africa is facing greater financial risks, including recent ones of its own making, but deviating from current monetary policy could prove to be the biggest risk of all.

In its first Financial Stability Review for 2023, the South African Reserve Bank warns that global and local risks to South Africa’s financial stability have increased. They include two new risks that might impact the local markets over the medium term: a surge in capital outflows and the possibility of sanctions imposed by the West following allegations of South Africa supplying weapons to Russia.

The global risks we’ve known about for some time: persistent global inflation over the last 18 months leading to sharply increasing interest rates, which are causing concerns around global growth, including the possibility of a recession.

Compounding these are the new risks identified by the SARB that uniquely affect South Africa. First, there is the risk of capital flight and declining market liquidity. Foreign holdings of South African government bonds have declined from around 45% in 2018 to 27% this year. Regulatory changes have also meant that South African retirement funds are now able to invest more offshore. So, you’re left with the local banks as the primary buyers of government bonds. In a risk-off type of environment, where everyone is rushing for the door at the same time, the lack of liquidity can see yields rise sharply.

The other new risk highlighted by the SARB is the possibility of sanctions amid heightened geopolitical polarisation around Russia. This creates significant risk to our current account, because the US and its Western allies are some of our main trading partners.

The release valve for many of these risks is ultimately our currency, which, through depreciation, can adjust the current account deficit, but there is a pass-through impact on inflation.

Given the current growth outlook together with cost-push inflation, many are questioning if the SARB’s policy of continuing to hike rates is appropriate. Through the lens of financial stability, I believe that it is the lesser of two evils. One just has to look around at our emerging-market peers, because in the fight for global capital, relative attractiveness is important.

In 2019 we had some of the most restrictive monetary policy among peers such as Brazil, Mexico, and Hungary. However, in this hiking cycle, while our base rate has increased quite materially, many of these peers are now sitting with rates in double digits. So one could argue that, on a relative basis, our policy is really not that restrictive.

It’s interesting to draw parallels with Turkey, where similar risks have materialised. This, alarmingly, is a path South Africa could take if US sanctions were imposed together with continued capital outflows and the SARB changes tack, cutting rates into elevated inflation.

A single party has been ruling for more than 20 years, but with a grip on power that is starting to slip. With a leader who has plenty of time for Moscow, whilst antagonising the West, Turkey was first subjected to US sanctions in 2018. Tighter secondary sanctions followed in 2020. They’ve seen significant capital outflows, and, in the face of high inflation and a depreciating currency, they decided to dramatically cut interest rates, which, in retrospect, has exacerbated their problems.

Since 2018 the Turkish lira has gone from 3.7 to 20.7 lira to the dollar – effectively a 37% depreciation year-on-year. Inflation has been running at 29% per year. This is what could happen if some of the risks identified by the SARB end up eventuating. Whilst the medicine of higher interest rates may be tough to swallow, we can be thankful that the SARB diligently adheres to its mandate of price stability in the face of mounting pressure – because the biggest risk to South Africa’s financial stability could be cutting rates in the current environment.

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