What would an optimal SARB equity transfer approach look like?

The South African Reserve Bank’s (SARB) Gold and Foreign Exchange Contingency Reserve Account (GFECRA) has accumulated a little under R500 billion in revaluation profits. The existence of this account creates a communication challenge for SARB as it can create pressure for these unrealised profits to be realised and used for other government purposes.

The SARB’s approach to accounting for reserve gains and losses is unusual by international standards and raises several complex questions about the optimal approach to macroeconomic risk management in South Africa.

Let’s start with some background about South Africa’s foreign exchange reserves. South Africa’s foreign reserves have increased from under USD2 billion in the mid-1980s to over USD60 billion currently. Foreign reserves are a potential buffer in the event of external shocks since the rand value of these reserves tends to increase during global risk events (as occurred during the COVID-19 pandemic). South Africa’s foreign reserves stand at around 16% of GDP, at a comparable relative level to Brazil and India, but slightly below the IMF’s adequacy metric.

A key policy question remains as to what the appropriate role of SARB’s foreign reserve management policy is in the context of the nation’s deteriorating sovereign financial position. Should South Africa accumulate more reserves as the IMF suggests, or pay off its debt more quickly, given how steep South Africa’s yield curve is?

As the amount of reserves South Africa holds has risen over time, so has the implied holding cost of our reserves. Since our inflation tends to be higher than in our trading partners, the rand tends to depreciate over time and our interest rates have tended to be higher than in advanced economies. This has meant that the implied cost of carrying FX reserves has been relatively high in South Africa. Rand depreciation over time has also seen an accumulation of profits on South Africa’s foreign reserve holdings accrue to the SARB’s GFECRA account.

A back-of-the-envelope calculation suggests that the carrying cost of South Africa’s foreign exchange reserves have been in the ballpark of 0.5% of GDP per year since 2005, compared to valuation gains of around 1% of GDP per year. Foreign reserve holdings act as a counter cyclical buffer, with profits accumulating profits during good times, but with some potentially large losses accumulating following shocks such such as the global financial crisis and the COVID-pandemic. Still, it is hard to know whether locking in expenditure of around 0.5% of GDP on reserves as an insurance policy offers value for money or not, given how hard it is to assess South Africa’s external vulnerabilities.

But the returns from the reserves have been lower than the cost of financing government debt, so some argue it would be better for reserve profits to be transferred from the buffer account to government, to be used for other purposes, such as paying off debt.

It is important to note that realising reserve profits is not costless. It either requires selling some FX reserves, which would leave South Africa with lower buffer levels and cause liquidity fluctuations that SARB would need to manage, or require the monetisation some of the unrealised profits. Regarding the latter, the introduction of a new monetary policy implementation framework in June 2022 has made it possible for SARB to use remunerated reserves to drawdown the GFECRA account instead of selling reserves. But since SARB has to pay the policy rate on these reserves, this would imply offsetting liquidity management costs so government would not get the full amount of any GFECRA drawdown.

Another option proposed by authors from Amia Capital and a student from the LSE is for a profit transfer rule to be created through a change in the SARB Act that governs GFECRA. They argue that the current approach is sub-optimal, and estimate that savings of between around 0.25% and 1% of GDP per year might be possible if buffer levels are reduced and a profit transfer rule introduced. Such a rule would also de-politicise the process around transferring profits to government though, as they note, changes to the SARB Act would need to preserve SARB’s operational independence to deal with potential costs or losses associated with its management of GFECRA.

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