The guts of SA monetary policy (Part 1)

We live in a system of centralised money production where the central bank has sole right to create currency. Money is such a widely used good in the economy that we can basically say that government has a legislated monopoly on a hugely important economic good. This is one of the main reasons why saying we live a free market is so incorrect. Government controlling money production and the price of money is like government forcing itself into sole control of any major economic sector or the production of key goods that everyone uses all day, every day. This is the very definition of an un-free, inefficient, and morally compromised market.

Because of this legislative fiat, government, through its central bank, has the sole ability to set the price of money, restrict the use of other forms of money as legal tender, create new money out of thin air, and control credit creation. It is no surprise therefore that monetary policy is such a centrally important political issue, and in South Africa it has become one of the most important areas of economic and political discourse.

Monetary policy can take on a few forms, but by far the most significant way to pump new money into the economic system is through the creation of credit by commercial banks. In South Africa the Reserve Bank (SARB) and the commercial banks agree to create a money market shortage in the commercial banking system, with the SARB conducting open market operations using reverse repos and debentures to add or drain liquidity from the system to maintain an appropriate money market shortage among the commercial banks. In effect the SARB conducts open market operations, using instruments that primary commercial dealers are obliged to buy and sell, to ensure that the banks can only meet a substantial portion of their new funding requirements using the SARB borrowing facility.

As the SARB itself puts it,

“The Bank is in the best position to estimate the daily liquidity requirement, firstly, because it is the sole creator and destroyer of liquidity and, secondly, because it has the best overall market information about the factors influencing liquidity.”

How it works…
To fund the new credit provision to the private sector at the margin the commercial banks have to borrow from the SARB through the weekly repo facility, ‘selling’ government debt securities and SARB debentures to the central bank to ‘securitize’ the loans. Commercial banks pay interest on these loans, and the interest payments go back into the SARB’s balance sheet as a rise in cash balances, which are then used again for future loans to commercial banks. In this system the provision of new money through private sector credit is closely linked to the national debt, which is the stock of government bonds in issue in the system.

The banks pay down the ‘principal’ on these loans from the SARB by buying back the security that was offered as collateral, but then role over the same process every week, increasing the amount borrowed from the SARB as credit grows in the system. This means that over time, in an economy in which credit is ever-expanding, the money base keeps growing in the economic system through the commercial bank credit mechanism and funded by newly created currency from the SARB.

In other words, a lower repo rate over time (within a managed money market shortage) is really an incentive to the commercial banks to go and sell credit to the private sector and thereby expand the monetary base. The policy objective of such a stance is to get money into the system, supposedly making it easier for households and companies to get into debt and supposedly to increase overall economic growth and employment. These policy goals are admirable but can’t be achieved by this kind of policy… more in Part 2