Role of the South African Reserve Bank

Money

This is the second article in the Government series of articles. The role of the South African Reserve Bank (SARB) is to “achieve and maintain price stability in the interest of balanced and sustainable economic growth in South Africa”. This is extremely broad, so I will delve into some of the most important things that the SARB does, why they do it and what effect it has on the economy. The first of these roles are specifying the prime lending rate.

1) Setting the prime interest rate

The SARB determines what the prime interest rate will be by adjusting the repo rate. The spread between the repo rate and the prime interest rate is 350 basis points, or 3.5%. At the time of writing, the repo rate is at 6.5%, which leaves the prime interest rate at 10%.

What is the effect of adjusting the prime interest rate?

Adjusting the prime interest rates has two major effects on the economy. When you cut interest rates the cost of debt becomes cheaper. This means that people have more money to spend and this money tends to flow into consumer products, which stimulates the economy. It also reduces the cost of debt for companies, which allows them to expand and employ more people. Increasing the prime interest rate has exactly the opposite effect.

As a secondary consequence, the government bond yield also comes down when you reduce the prime interest rate. In other words, the cost of debt for the government is also reduced. This makes bonds less attractive as an investment vehicle. As a result, money flows from bonds to share investments. Hence the demand for shares increase and the price, growing the share market.

Again increasing the prime interest rate has the opposite effect, but with one notable exception, the price of banking shares. This is because the interest that banks charge on their loans are directly related to the prime interest rate. You can read more about the fractional reserve banking business model in my article South Africa’s best savings interest rates.

Can we adjust the prime interest rate to 0%?

It might sound like there are only benefits to reducing the prime interest rate, however you can’t reduce the interest rate indefinitely. This is because the government won’t be able to get any debt if the returns for investors are too low.

This is especially true for foreign investors that need to achieve a decent return in foreign currencies. The bonds therefore need to outperform the rate at which the rand is weakening against other currencies. In theory, the rand should weaken against another currency by the difference between the inflation rates between the currency.

So if the inflation rate is on average 5% in South Africa and 2% in the United States, then our currency should weaken by 3% in the long-term. Speaking about the inflation rate, this is something that is also determined by the South African Reserve Bank.

2) Calculating CPI

The SARB is in charge of calculating the official Consumer Price Index (CPI), which is sometimes referred to as the inflation figure. This CPI figure just keeps track of the average cost increase per year of the typical products that South Africans would buy on a regular basis. At the time of writing, the CPI figure is 3.7%, which is much lower than it typically is. The long-term average from the sixties is 8.9%, with the average for the last 20 years being closer to 5%. The reserve bank targets a figure of 3% to 6%.

Calculating this figure is a complex and dynamic process. It includes items from various categories and the actual items change continually. This is because the items that we use also changes. A good example of this is the migration from floppy disks to compact disks and most recently flash drives. The categories used for this calculation can be seen below:

  • Food and beverages
  • Alcohol and tobacco
  • Clothing and footwear
  • Housing and utilities
  • Household contents, equipment and maintenance
  • Healthcare
  • Transport
  • Communication
  • Recreation and culture
  • Cost of education
  • Restaurants and hotels
  • Miscellaneous goods and services

The inflation figure is actually extremely important for investors. This is because you need to beat inflation throughout your investment career. Otherwise you are growing poorer, referred to as long-term under-performance. So, it is actually worth your time to keep an eye on this figure as a long-term investment benchmark.

Issuing currency

The SARB has the exclusive right to issue bank notes and coins. They are also in charge of the design of the notes, although it must still be approved. For printing the currency, they use the South African Mint Company.

The SARB does not care whether money is being circulated as cash or in electronic format. So it simply prints money based on demand from banks, as this will ensure that the cash is never more than the currency in circulation. Registered banks apply to the SARB head office to receive cash to replace old notes or put more currency in circulation.

The South African Reserve Bank also regulate banks

In extreme situations, the SARB provides liquidity to banks but most importantly the SARB regulates and supervises banks. To be compliant as a bank you need to adhere to a shitload of banking acts. If you would like to know more about this extremely boring but important role, you can read more about it here. The aim of the acts are to:

  • Protect banking customers
  • Maintain efficient and transparent markets
  • Ensure trust in the financial sector
  • Promote sustainable competition and transformation in the sector
  • Maintain financial stability

The South African Reserve Bank performs various essential tasks to ensure financial stability. We usually only hear about the interest rate going up or down since that is all we see affecting us. The next time someone asks you about the SARB you will know that they ensure economic stability and do economic data analysis.

Be safe out there,

Hendrik

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Endnote

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