South Africa shoots itself in the foot

South Africa’s wide inflation target that ensures costs in the economy increase faster than those of its trading partners reduces its competitiveness and limits its economic growth. 

To get prolonged lower interest rates and improve the competitiveness of South African exporters, the country’s inflation target should be lowered to 3%. 

This is feedback from researchers at the South African Reserve Bank, Christopher Loewald, Rudi Steinbach, and Jeffrey Rakgalakane. 

These researchers published a white paper on the impact of lowering the country’s inflation target to 3% amid reports that the discussions to lower the target between the National Treasury and the Reserve Bank are in advanced stages. 

The National Treasury sets the inflation target range, which the Reserve Bank then uses its tools, such as interest rates, to meet this target. The range is currently 3% to 6%. 

In the paper, the researchers showed that inflation targeting has vastly improved the control of inflation in South Africa and is highly credible. 

However, they said that in the long run, inflation in South Africa has proven to be far higher than that of the country’s major trading partners. 

“Ultimately, better control of inflation should achieve stronger macroeconomic outcomes for South Africa,” the researchers said. 

“Inflation remains well above that of trading partners and the inflation premium in short-term and long-run interest rates is far too high, undermining investment.” 

The researchers explained that South Africa’s price level increases faster than that of its trading partners, making its exports relatively more expensive and, therefore, less competitive. 

To make up for this declining competitiveness, the rand weakens, making South African exports relatively cheaper in the global market. 

This results in a weaker currency, which significantly increases the cost of importing goods, in turn, increasing inflation and eroding purchasing power. 

The researchers estimate that a lower inflation target of 3% can result in additional GDP growth of over 0.25% per year within five years and 0.4% within a decade due to improved economic competitiveness. 

These estimates are conservative, with the benefit set to be greater as lower interest rates ease the government’s debt-servicing costs and increase productive investment. 

The graph below illustrates how South Africa’s inflation rate has consistently been higher than that of its emerging market peers. 

It is significantly higher than that of some of its largest trading partners, such as the United States and the European Union, which target 2% inflation. 

Additional benefits

A major benefit of a lower inflation target is a stronger currency in the short term, which translates into lower inflation in the long term. 

This should, over time, result in lower interest rates, which will boost the local economy and attract investment to the country. 

The researchers explained that South Africa’s high interest rates typically reflect the economic risk of lending to a country with weak growth and high debt levels. 

In this scenario, significant benefits would be achieved by ‘de-risking’ the country with lower sovereign credit risk, they said. 

However, this has to be coupled with expanding the economic growth reforms currently underway to ensure maximum benefit. 

The clearest path to reducing risk is to increase domestic savings, providing more local funds for investment. 

This cannot be accomplished with larger public deficits when spending multipliers are very low, nor through allowing inflation to tax incomes. 

Higher inflation increases real growth and tax revenue only if it is unanticipated and temporary, and even then, it shortens investment maturities and increases interest rates, both of which are negative for investment and the fiscal position.

As a result, lower inflation should translate into faster economic growth by encouraging lending into the country through lower interest rates. 

This will also benefit the government financially by reducing its debt-servicing costs, which are growing at a rate faster than nominal GDP. 

Another major benefit is that sustained lower inflation should help maintain the purchasing power of households over time, particularly low-income households. This is vital for economic and political stability.