South Africa: Selected Issues

South Africa’s macroeconomic policies face a complicated task of balancing between supporting domestic demand and maintaining stability. The Selected Issues paper for South Africa discusses economic development and policies. Although the opening output gap and declining employment do call for countercyclical fiscal and monetary policy easing, policymakers should also be mindful of the effects of such policies on external and internal macroeconomic stability. The combined package of monetary and fiscal policies has considerable effects on growth and employment.

Abstract

South Africa’s macroeconomic policies face a complicated task of balancing between supporting domestic demand and maintaining stability. The Selected Issues paper for South Africa discusses economic development and policies. Although the opening output gap and declining employment do call for countercyclical fiscal and monetary policy easing, policymakers should also be mindful of the effects of such policies on external and internal macroeconomic stability. The combined package of monetary and fiscal policies has considerable effects on growth and employment.

III. The Impact of Monetary Policy Shocks on Capital Flows in South Africa15

A. Introduction

29. The South African economy is largely open to international capital flows, and the country receives significant inflows of both bond and equity flows, although equity flows dominate (Table 4). These capital flows in turn might play an important role in financing the country's current account deficits. And as a result, large and sudden movements in international capital flows can have far reaching consequences for the South African economy.16 Thus, this policy note attempts to understand better the determinants of capital flows in South Africa, and in particular, the potential impact of monetary policy.

Table 4

Total Net Purchases of Equity and Bonds, Rand Billions

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30. While the South African Reserve Bank (SARB) sets monetary policy according to an inflation target, the most direct and immediate effects of monetary policy actions are usually on financial markets, making monetary policy a potentially significant determinant of equity flows in small open economies like South Africa (SA). That said, the transmission of monetary policy actions onto international equity flows can occur through a number of different and contrasting channels, and the net impact can be theoretically ambiguous.

31. International equity flows in part react to country specific asset prices such as the exchange rate and domestic stock returns. And by changing real interest rates, expected future dividends, or expected future stock returns, an unexpected increase in home interest rates is generally associated with a decline in stock values (Bernanke and Gertler (1999) and Bernanke and Kuttner (2005)). An unexpected increase in interest rates is also conventionally associated with currency appreciation. But the response of international equity flows to a decline foreign stock values or an appreciation of the domestic currency can depend on portfolio rebalancing considerations as well as on informational asymmetries between domestic and foreign investors.

32. In the case where international investors can only imperfectly hedge against exchange rate risk, portfolio rebalancing can be paramount. The intuition underlying this approach is that while there are diversification benefits to international (U.S.) investors from holding imperfectly correlated foreign equity, such holdings are also subject to Foreign Exchange (FX) risk. Thus, an appreciation of SA stock prices relative to U.S. markets increases FX risk, inducing portfolio rebalancing as U.S. investors sell, on net, SA equity, and repatriate capital. Conversely, after a monetary policy induced decline in SA stock prices, foreign portfolio managers may increase their exposure to SA assets by purchasing additional SA equity (Hau and Rey (2006)). This channel would produce a positive association between interest rates and net foreign purchases of equity.

33. However, in addition to differential equity market performance, exchange rate movements can also induce portfolio rebalancing. From an international investor perspective, an unexpected increase in SA interest rates that appreciates the rand, also increases the dollar share of assets in the SA market. The higher overall foreign exchange risk exposure for foreign (U.S.) residents may induce equity market outflows from South Africa, leading to a negative association between interest rates and net foreign purchases of SA equity (Hau and Rey (2002)).

34. Moreover, information asymmetries can also shape the reaction of international equity flows to monetary policy, as the information that is required to evaluate financial assets—such as knowledge of accounting practices, corporate culture, and the structure of asset markets and their institutions—is not straightforward and is often less available to international investors (Portes and Rey (2005)). In particular, if investors do not know the true returns of equities, but estimate them from past returns, then this informational asymmetry may make international investors' expectations of future returns especially sensitive to past returns (Griffin and others (2004)).

35. More so than SA investors then, foreign investors may buy SA equity following abnormally high domestic returns—trend chasing or momentum investing. And an interest rate increase that depresses stock prices could lead to a decline in net foreign purchases of SA equity, as foreigners revise their beliefs about future SA equity returns. Likewise, because rand appreciation increases SA returns expressed in home (U.S.) currency, trend chasing partially informed investors may purchase SA after unexpected rise in interest rates (Froot and others (2001)).

36. Since government behavior can also affect equity returns, and monetary policy actions contain information about policy preferences, foreign investors beliefs about future government policies can also affect the link between monetary policy and capital flows (Bartolini and Drazen (1997)). Specifically, our sample period begins with the adoption of inflation targeting in South Africa—and just seven years after the end of apartheid and the introduction of democracy. Thus, partially informed foreign investors may also use interest rate policy to update their beliefs about the credibility of the SARB’s monetary policy framework. And to the extent that interest rate increases signal a commitment to future price stability, and future policies that are favorable to investment, they can also attract equity inflows.

37. In sum, after a decline in stock returns and a currency appreciation due to an unexpected rise in interest rates, theories that emphasize portfolio rebalancing considerations predict:

  • Equity inflows, as foreign investors reallocate capital to the JSE to maintain portfolio exposure.

  • Equity outflows, as an exchange rate appreciation over weights the dollar share of SA assets.

38. After a similar event, models that emphasize information asymmetries predict:

  • Equity outflows, as trend chasing investors flee negative returns on the JSE.

  • Equity inflows if rand appreciation increases returns expressed in home currency.

39. In addition to the contrasting theoretical predictions, international equity flows, stock returns and the exchange rate are usually jointly and endogenously determined. Also, financial markets generally internalize policy announcements well before these announcements are actually made, and so, discerning the impact of monetary policy on these variables is especially difficult.

40. Therefore to make progress in understanding the relationship between monetary policy and equity flows, the analysis uses an event study approach. Monetary policy announcements in SA occur after meetings of the Monetary Policy Committee (MPC). These meetings are advertised well in advance, and of the 46 meetings during the sample period, only one interest rate change occurred outside of the regular schedule. Using data from the forward interest rate market the day before and right after each MPC meeting, this note decomposes monetary policy announcements into its expected and surprise elements, studying the impact of this decomposition on equity flows, stock market returns and the exchange rate.

41. The main results are:

  • A small positive relationship between expected interest rate movements and net purchases of equity by foreigners.

  • This is dwarfed by a much larger negative relationship between interest rate surprises and net purchases of equity by foreigners: an unexpected 50 basis point increase in rates is associated with a R 27 million or a 0.34 standard deviation outflow.

42. These results appear to operate primarily through the rebalancing channel after a rand appreciation:

  • First, an unexpected 50 basis point increase in interest rates is associated with a 1 percent decrease in stock prices, about a 0.74 standard deviation drop, and a 1 percent appreciation of the rand (versus the dollar).

  • But after controlling for the rand appreciation, the interest rate decomposition is not significant. Meanwhile, the rand appreciation is significantly associated with net capital outflows. The impact of stock returns is insignificant.

43. Thus, because South Africa has one of the most advanced financial markets among emerging markets, understanding portfolio rebalancing and FX risk exposure considerations among international investors seems key to discerning the transmission of monetary policy onto net purchases of equity by foreigners.

B. Data

44. Net purchases of South African equity by non residents can be large and volatile. From Table 1, while net R 66 billion flowed into the Johannesburg Stock Exchange in 2007, net outflows in 2008 were almost a similar magnitude. Daily flows also appear volatile (Figure 6). These flows are naturally closely related to stock returns and exchange rate movements, and Figures 7 and 8 plot respectively the daily changes in the Johannesburg Stock Exchange weighted index (JSE) and the rand dollar exchange rate—an increase is a rand depreciation. As with equity flows, there are periods when changes in both asset prices evince considerably volatility.

Figure 6.
Figure 6.

Net Purchases of South African Equity by Nonresidents

Citation: IMF Staff Country Reports 2009, 276; 10.5089/9781451841107.002.A003

Figure 7.
Figure 7.

Daily Change in the Johannesburg Stock Index

Citation: IMF Staff Country Reports 2009, 276; 10.5089/9781451841107.002.A003

Figure 8.
Figure 8.

Daily Change in the Rand Dollar Exchange Rate

Citation: IMF Staff Country Reports 2009, 276; 10.5089/9781451841107.002.A003

45. Monetary policy has also varied considerably over the sample period. The South African Reserve Bank adopted an inflation target of 3-6 percent in 2001—at the beginning of the sample period. And apart from a revision to this policy framework in December 2003, the framework has remained relatively constant throughout the sample period. Over the sample period, Figure 9 suggests three easing cycles, with the policy rate ranging from a maximum of 13.5 percent to a minimum of 7 percent.

Figure 9.
Figure 9.

South African Reserve Bank's Policy Rate

Citation: IMF Staff Country Reports 2009, 276; 10.5089/9781451841107.002.A003

46. By influencing stock returns and exchange rate movements, domestic monetary policy can shape international equity flows. And to illustrate some of the basic correlations in the data, Table 5 turns to a simple first order ARCH model. Consistent with the literature on equity flows, there is evidence of persistence, as the autoregressive coefficients up to five days are significantly different from zero (column 1).17 But there is also evidence that conditioned on past flows, changes in the policy rate appear significantly related to capital flows.

Table 5.

Dependent Variable: Daily Net Purchases of South African Equity18 Autoregressive Conditional Heteroscedasticity (1,1)

Table 5.1 The Change in the Policy Rate

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Table 5.2.

Including Domestic Stock Prices and the Exchange Rate

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Table 5.3.

Including Domestic Stock Prices, the Exchange Rate, Commodities and U.S. Stock Prices

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47. But consistent with the prediction that monetary policy might shape these flows through stock returns and exchange rate movements, including these variables changes the sign of the interest rate variable (column 2). In this case, a 50 basis point increase in the interest rate is associated with a decline R 55 million decline in net purchases of equity three days later—about a 0.08 standard deviation drop. There is also significant evidence that past returns on the stock exchange positively affects subsequent equity flows—trend chasing. But conditioned on the past behavior of equity flows and stock returns, exchange rate depreciations are negatively linked to subsequent flows. These basic correlations persist even after controlling for other potential factors such as commodity prices and international equity returns (column 3).

48. The correlations in Table 5 suggest that the transmission of monetary policy onto equity flows might operate through movements in the exchange rate and domestic stock prices. However, because financial markets are unlikely to respond to policy actions that were already anticipated, the correlations in Table 5 are only suggestive. Indeed, since expectations of future equity inflows might also shape both the rand and domestic stock prices, it is difficult to causally interpret the correlations in Table 5. Using daily data and conditioning on other asset prices is a useful step in addressing these biases, but the limited variation in the policy rate at a daily level can hinder inference.

C. An Event Study Approach

49. This subsection uses an event study approach to understand the impact of monetary policy on international equity flows in South African. As part of its inflation targeting framework, interest rate decisions are made at regular MPC meetings—usually six meetings in a calendar. The schedule of these meetings are usually announced several months in advance, and there has only been one instance—January 15th, 2002, during the rand crisis of 2001-2002—when interest rate policy was changed outside of the regular schedule. Using the relative predictability and transparency of this policy framework, we are thus able to study the behavior of asset prices around these interest rate announcements.

50. That said, the very predictability and transparency of the monetary policy framework would make it likely that asset prices reflect anticipated policy announcements in advance of the MPC dates. Therefore, we use data on forward interest rate contracts around the time of the MPC meetings to extract information about market participants interest rate expectations. This allows us to decompose policy changes into its expected and surprise elements. In particular, the interest rate quoted in a forward rate contract on date t, itf is for a 3 month contract, with a fixed interest rate, beginning 30 days from datet,it+303month

51. Thus, on any date t, the interest rate in the forward market reflects market expectations about the short term—three month—interest rate that is likely to prevail on date t+30, as well as a possibly time varying risk premium, nt:

itf=E(it+303month|t)+nt

And if changes in the policy rate are fully anticipated prior to an MPC meeting, then policy announcements after the MPC meeting are unlikely to engender any change in the 30 day forward rate. Unexpected policy announcements are however likely to precipitate revisions in the forward market rate. To see this, let t*denote for example the day of a MPC meeting, then the change in the forward rate around this meeting can be written as:

Δit*f=E(it*+303month|t*)+nt*E(it*-1+303month|t*1)nt*1

52. If MPC dates do not systematically coincide with other news, so that daily changes in the risk premium are relatively small, then ni-nt-1≈0, and the revision in expectations after a policy announcement is:

Δit*f=E(it*+303month|t*)E(it*1+303month|t*1)

Hence, any change in the forward rate after an MPC announcement are likely to be attributable to a revision of interest rate expectations, and can help measure the surprise component of interest rate policy.

53. The sample period begins in April 2001 and ends in December of 2009, and contains 46 MPC meetings. Although relatively short, this sample period contains considerable variation in interest rate policy (Figure 9). The variation in the interest rate occurred via 22 discrete changes in policy; there were no policy changes announced after the other 24 MPC meetings (Table 6). Table 6 also shows that while 50 basis point changes are the most frequent, large policy changes have occurred during the sample period: there are seven instances of a one percentage point changes in the policy rate, and two cases of 1.5 percentage point changes.

Table 6.

Distribution of Changes in the Policy Rate

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Forecasting interest rates

54. The event study approach based upon the 30 day forward market rests on the idea that the forward market is rational and efficiently forecasts future interest rate changes. Otherwise, if differences between policy rate announcements and market expectations—surprises—are systematically correlated with economic information available to the market prior to the announcement, then this economic information contained in the surprise could also affect capital flows, biasing the results from the event study approach.

55. Defining the interest rate surprise as the difference between the announced policy change and that expected in the forward rate market the day before the announcement, Figure 5 suggests that the forward market may underestimate interest rate increases. To evaluate the rationality of the forward market in predicting the policy rate more systematically, we regress the policy change announced after each MPC meeting, Δi*t, on the expected change as imputed from the forward market the day before the change:E(Δit|t1)=it1fit1:

Δit*=α+βE(Δit|t1)+εt(2)

56. From column 1 of Table 7, the expectations derived from the forward market the day before MPC meetings are significantly and positively correlated with the subsequent policy change. Errors are common however. Expectations explain only about 65 percent of the variation in the subsequent policy changes, and the coefficient is less than one, suggesting, as in Figure 8, that big movements in the policy rate tend to surprise the market. Indeed, consistent with the idea that the forward market may systematically under predict policy changes, the constant term is positive and significant.

Table 7.

Forward Market Forecasts, OLS19

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Table 9.

Net Purchases of Equity, Expected and Unexpected Interest Rate Announcements Dependent Variable: Net Purchases of Equity

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Robust standard errors in parentheses. *,**,*** denotes significance at the 10, 5 and 1 percent levels respectively.

57. That said, the remaining columns of Table 4 strongly suggest that expectations in the forward market are efficient. Conditioned on expectations, information contained in a number of key asset prices before the MPC meetings do not predict the policy change. Specifically, South Africa is the world's major exporter of precious metals, and fluctuations in the prices of platinum and gold, can have a big impact on the domestic economy. Column 2 includes the daily changes in these prices up to three days prior to the MPC meeting in order to ascertain whether information contained in commodity price fluctuations help predict policy rate changes.

58. Conditioned on the forward market expectations, the commodity price variables are individually and jointly insignificant. Similarly, column 3 shows that stock returns and changes in the exchange rate up to three days prior to each meeting also do not contain any independent information. Likewise, column 4 suggests that international equity and bond flows do not appear to anticipate systematically changes in the policy rate. Thus, while there is some evidence that the forward market is systematically surprised by large rate changes, there is little indication that policy rate surprises are predictable given the available information.

Interest rates and equity flows

59. This subsection examines the impact of interest rate changes on equity flows. These flows are usually highly persistent, and the correlations in Table 4 suggest they might react with some lag to policy announcements. Thus, building on the earlier results, we first examine the impact of monetary policy changes on equity flows both on the day of the announcement, as well as up to five days later:

Ft+i=α0+α1Δit+et fori=0,1,2,3,4,5

60. Using the raw change in the policy rate, the evidence in Table 8 indicates that an increase in the interest rates can have a small positive impact on equity inflows two days later. A 50 basis point increase is associated with a R 9 million increase in equity flows—about a 0.12 standard deviation increase based on the behavior of daily flows over the sample period.

Table 8.

Net Purchases of Equity and Interest Rate Announcements Dependent Variable: Net Purchases of Equity

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Robust standard errors in parentheses. *,**,*** denotes significance at the 10, 5 and 1 percent levels respectively.
Ft+i=α0+α1Δits+α2ΔitE+etfori=0,1,2,3,4,5

61. However, decomposing the interest rate change into its surprise, Δits, and expected, ΔitE, components suggests a more nuance reaction. An expected increase in interest rates is associated with a small increase in capital flows, observed two and three days after the policy announcement. But the coefficient on the unexpected component of the interest rate change is significantly larger and negative (column 4). A surprise 50 basis point increase is associated with a R 27 million or a 0.34 standard deviation decrease in equity flows three days later.

62. Figure 11 plots the conditional correlations reported in column 4 (Day 3). Standard outlier detection statistics suggests that the MPC meetings on January 15, 2002 and again on the December 11th 2003 are likely to be influential. The meeting on January 15, 2002 is the only unscheduled meeting in the sample, and a 1 percentage point increase in the interest rate was announced in response to the rand crisis of 2001-2002. The December 2003 date was equally noteworthy, as it marked a shift in the definition of the inflation target from an annual average to a continuous inflation target of between 3 and 6 percent for inflation measured over a period of twelve months.

Figure 10.
Figure 10.

Density of Interest Rate Surprises

Citation: IMF Staff Country Reports 2009, 276; 10.5089/9781451841107.002.A003

Figure 11.
Figure 11.

Conditional Correlation between Net Purchase of Equities and Interest Rate Surprises.

Citation: IMF Staff Country Reports 2009, 276; 10.5089/9781451841107.002.A003

63. As a robustness exercise, column 1 of Table 10 uses a dummy variable to absorb the potential impact of these two dates. The estimates are slightly smaller, but remain robust at the 5 percent level. “Surprises” in the forward market appear rational, but to check whether our results are driven by a trend in capital flows that unexpectedly coincides with interest rate policies, column 2 includes capital flows the day before the announcement as a control variable. The results remain robust.

Table 10.

Net Purchases of Equity, Stock and Exchange Rate Movements, and Interest Rate Announcements

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Robust standard errors in parentheses. *,**,*** denotes significance at the 10, 5 and 1 percent levels respectively. All specifications include a constant, and a dummy variables for meetings on January 15th, 2002 and again on the December 11th 2003.

64. Stock prices and changes in the nominal exchange rate are key channels through which monetary policy might affect international equity flows. And to understand better these results, we now turn to these variables. In particular, using the same event study methodology, column 3 of Table 10 examines the impact of interest rate changes, decomposed into its expected and unexpected components, on JOSÉ stock returns. While expected movements in the interest rate do not have a significant impact on stock returns, an unexpected 25 basis point increase in the interest rate is associated with a 0.5 percent decline in stock prices, about a 0.37 standard deviation drop. Column 4 turns to the exchange rate. An unexpected 25 basis point rise in interest rates is associated with a 0.50 percent appreciation. Moreover, unlike stock prices, monetary policy announcements explain about twenty two percent of the variation in exchange rate movements.

65. Thus, in order to assess the role of stock market returns in explaining equity flows, column 5 includes stock returns on the day of the MPC announcement. Returns on the JSE are not significantly related to subsequent equity flows, and there is little change in the interest rate variables. The results are however dramatically different when including the change in the rand dollar exchange rate (column 6). In this case, the interest rate variables lose significance, and their magnitudes decline by about 75 percent. In contrast, the interest rate variable is positive and significant at the 10 percent level. A one standard deviation appreciation—about 1.2 percent decrease in the rand dollar exchange rate—is associated with a R175 million outflow three days later. Table 11 shows that these results are driven by simple valuation changes, as the impact of the exchange rate remains robust when equity flows are measured both in terms of U.S. dollars. It is also robust when equity flows are deflated by the market capitalization of the Johannesburg Stock Exchange in order to yield a unit free metric of flows.

Table 11.

Additional Robustness Checks

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Robust standard errors in parentheses, *, **, *** denotes significance at the 10,5 and 1 percent levels respectively. All specifications include a constant, and a dummy variables for meetings on January 15th, 2002 and again on the December 11th, 2003.

66. In sum, these pattern of correlations are consistent with a portfolio rebalancing explanation. An unexpected increase in the interest rate is associated with a significant appreciation of the rand, increasing the dollar share of assets in the SA market. The higher overall foreign exchange risk exposure for home (U.S.) residents may induce equity market outflows, leading to a negative association between interest rates, rand appreciation and net foreign purchases of SA equity.

15

Prepared by R. Ramcharan.

16

Calvo and others (2008) surveys the link between fluctuations in capital flows and current account adjustment.

17

A variety of market microstructure models predict that traders with private information reach their desired positions slowly, in order to mitigate transaction costs. Thus, the order flow of informed traders is conditionally, and positively, auto correlated. Institutional factors can also give rise to flow persistence. For example, structural shifts in asset allocation can be undertaken on a phased basis to reduce transaction costs (Froot and Donohue (2004)).

18

Robust standard errors in parentheses. *,**,*** denotes significance at the 10, 5 and 1 percent levels respectively. (ti) denotes the ‘i’ lagged value

19

Dependent Variable: Announced Change in Policy Rate “L” is the lag operator. Robust standard errors in parenthesis.

South Africa: Selected Issues
Author: International Monetary Fund