South Africa’s surprise rate decision aligns with global prioritisation of inflation over the risk of a financial crisis

31 Mar 2023

The South African Reserve Bank joins the ranks of other central banks that are keeping a watching brief on the banking crisis while maintaining their dogged fight against inflation. For now, it’s not expected to become another global financial crisis, but the search is on for other unseen liabilities that could set in motion a self-fulfilling financial crisis.

South Africa’s decision to raise rates by another 50 basis points (bps) is another monetary policy decision that highlights that central banks are doggedly committed to prioritising fighting inflation over the potential financial and economic fallouts from a year of steeply rising interest rates.

Over the past two weeks, five other central banks have raised interest rates by a combined 175 bps. These include the Federal Reserve, Bank of England and Norway (all raising rates by 25 bps), as well as the Swiss National Bank, European Central Bank and the SA Reserve Bank (SARB), who increased their rates by 50 bps.

Central banks have indicated they will maintain a watching brief over the trajectory of the banking crisis, and financial markets took the Fed and ECB’s removal of reference to ongoing increases as an indication that some dovishness had crept into their stances. Fed chair Jerome Powell also indicated that the impact of the banking crisis could equate to a percentage point increase in the Fed Funds rate.

The Blackrock Investment Institute sees the trade-off for central banks – between fighting inflation and protecting both economic activity and financial stability – as “now clear and immediate”. Based on recent events, it thinks the Fed and ECB will “go as far as possible to distinguish their inflation-fighting campaigns from measures to deal with bank troubles and safeguard the financial system”.

The global banking fallouts received a brief mention in the SARB Monetary Policy Statement on Thursday, with governor Lesetja Kganyago saying the Bank will continue to closely monitor funding markets for stress. So far, the stresses and strains in US regional banks have had little impact on South Africa’s financial markets or banking sector – and the rand rallied in the wake of the surprise rate hike, reflecting that it was positively received in financial markets.

Read more in Daily Maverick: Global central banks endorse Switzerland’s Credit Suisse-UBS deal

But the stresses and strains at the US regional banks do require that we look under the hood to see if there are any other problems that may set a much bigger financial crisis in motion, sweeping South African financial markets into the mayhem.

At the heart of the problem in the US banking sector is that the smaller banks are struggling to match their assets, namely interest-paying loans, with their liabilities, the interest they have to pay on customer savings. Meanwhile, some banks have found themselves with fixed-rate loans that are locked in at the lower levels that they can’t adjust to reflect the higher fundings costs of the bank. Some banks are also reluctant to increase their interest rates in lockstep with the central banks because of the threat of defaults.

Then, to attain liquidity levels required by post-Global Financial Crisis regulations, many banks invested disproportionately in government bonds, traditionally considered riskless assets, when interest rates were low, and as interest rates have risen, the market value of these assets has tanked. The problem is that, should they need to sell these assets, as in the case of Silicon Valley Bank, they stand to suffer huge losses.

‘Unseen’ risks

These risks are described as “unseen” or “hidden in plain sight” because in the US banks don’t have to account for these potential losses if they were to be sold at market prices at any point in time. The result is that most haven’t seen the need to hedge these portfolios against rising yields. Yields reflect a decline in bond prices. Silicon Valley Bank, for instance, sold $21-billion of its bond portfolio at a $1.8-billion loss, which triggered its demise.

But that’s history in the minds of the market, and analysts are already focusing on how we can expect this banking crisis to pan out. The main question being asked is: do the events of the past few weeks lay the ground for a financial crisis that equates to the global financial crisis in 2008? If so, the ongoing hawkishness of central banks, including the SARB, could be extremely risky when the other impacts of higher interest rates have yet to be felt too.

Blackrock predicts that there will be no 2008 redux but that the banking crisis has made a recession likely. It says the Credit Suisse problems had long been known and banking regulations in general are much stricter, and banks’ assets of the Globally Systemic Banking Institutions (GSBI) are of much higher quality. The world’s largest asset manager doesn’t see a repeat of 2008 when the downfall of Lehman Brothers spiralled into a global financial crisis. But it does believe that a longer-term solution is needed “to avoid leaks in the financial system’s global plumbing”.

Oxford Economics Lead Economist Adam Slater considers how likely the banking crisis is a reprise of the GFC. “Unlikely, in our view, at least a crisis emanating from residential real estate and a collapse in confidence, as occurred back in 2008. Yes, instability caused by a combination of sharp policy rate rises and excess liquidity is a problem. But vulnerability in the wider real economy is less so.” It cites financially stronger borrowers and banks in a better position, with stronger capital adequacies and more stringent lending standards, as economic forces that would preclude a more severe financial crisis akin to the 2008 financial market meltdown.

Read more in Daily Maverick: Bank crisis metastasises into the next, more damaging, phase

But it does expect commercial real estate, which gets most of its funding from smaller regional banks, to be a bigger, though manageable, source of vulnerability and more banking sector upheaval and consolidation is considered inevitable.

This time the banking crisis dissipated quickly as a result of the measures the government and the Fed put in place to prevent a self-fulfilling cycle being set in motion by the massive withdrawals of deposits from the US regional banks and Credit Suisse. The Fed guaranteed all deposits in SVP and Signature Bank even though bank deposits of more than $250,000 are usually uninsured.

It also prevented the crisis from spreading globally by participating in coordinated action to assure access to sufficient dollars to prevent a financial liquidity crisis in Europe by giving greater access to the network of US dollar liquidity swap line arrangements.

However, as Slater warns: “That the banking system has become so dependent on – and more sensitive to – more frequent and bigger government interventions is a problem that the global markets will have to deal with in the years to come.”

GMO believes the Federal Reserve has blood on its hands and needs to do more: “These banks were acting rationally by investing in long-duration assets when the Fed was erroneously signalling that rates would stay low in the face of ‘transitory’ inflation.”

But central banks are evidently still unassailable in their commitment to maintaining high interest rates for as long as it takes to get inflation down to 2% in the developed countries and within the 4% to 6% target range in South Africa.

But the banking crisis has undoubtedly made the course of monetary policy, including quantitative easing programmes, even less certain than the uncertainty that prevailed before the first US regional bank, SVP, fell in mid-March. Given the determining role consumer and investor sentiment usually play in financial crises, this makes anything possible. BM/DM

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‘Unseen’ risks