Understanding Namibia’s Monetary Policy Dilemma

Back in 1993, when the Namibian dollar was introduced to replace the use of the South African rand in the country, the authorities made the decision to not break parity with the rand, unlike Botswana, instead opting to peg the currency to the rand at a rate of 1-to-1.

It is this fixed currency peg that underpins Namibia’s monetary policy framework. The purpose of monetary policy is to help keep prices stable and promote a healthy economy by encouraging people and businesses to spend, invest and save money in a balanced way. The Bank of Namibia (BoN) aims to achieve this through interest rate adjustments.

However, the fixed exchange rate regime means that the BoN is constrained by how much Namibia’s monetary policy can deviate from South Africa’s, which is why we often see the BoN mimicking interest rate decisions made by the South African Reserve Bank (SARB). In a small, open economy operating under a fixed exchange rate regime, like Namibia’s, the interaction between monetary policy and exchange rate policy is guided by the concept known as the “trilemma” or “impossible trinity”. This concept highlights that in such a system, it is not feasible to simultaneously achieve three objectives: a fixed exchange rate, free capital movement, and an independent monetary policy.

What the trilemma essentially means is that policymakers in a fixed exchange rate regime face a trade-off among these three goals. They can only prioritise two out of the three objectives at a time, while the remaining objective is inherently constrained. In Namibia’s case, we have a fixed exchange rate, and we have free flow of capital, meaning that our monetary policy cannot be fully independent. If interest rates in the country are materially lower than those in South Africa, large quantities of capital will flow out of Namibia, since higher returns are available elsewhere, which would place pressure on the currency peg as the agreement requires Namibia to keep foreign reserve holdings to an amount equal to or exceeding the amount of local currency in issue. To prevent the above scenario, the BoN usually keeps its repo rate above or in line with the SARB’s repo rate to safeguard the currency peg.

At this point it should be noted that the impossible trinity works on the assumption that financial markets operate under perfectly functioning conditions, where it is possible to immediately move capital between countries when there are even tiny differences in interest rates. In reality, capital movements are not instantaneous, costless or frictionless. Transaction fees are involved, convenience considerations need to be taken into account and capital is often already invested in fixed-term products, making capital movement difficult.

These market imperfections consequently mean that the BoN has some flexibility in its monetary policy decisions, and can deviate to some extent from the SARB’s rate decisions to control domestically induced inflation or support the domestic economy when needed. This brings us to the current situation.

We saw an example of this deviation in November last year, when the BoN’s Monetary Policy Committee (MPC) surprised the market when it announced that they would not be hiking the country’s repo rate by as much as its South African counterpart. The BoN delivered a rate hike of 50 basis points, versus a 75 basis point hike announced by the SARB.

The BoN’s rationale for the divergence at the time was that the central bank’s forecasts were showing that inflation would be levelling off over the short term, that oil prices were remaining muted, and that the rand had strengthened against the US dollar since the October MPC meeting. These were all signs that it would be safe for the BoN to slow their interest rate hiking cycle and start taking their foot off the accelerator.

The MPC further diverged from the SARB in April this year when it again announced a 25 basis point rate hike, compared to a 50 basis point rate hike in South Africa the month before. This increased the spread to half a percentage point. The last time Namibia’s interest rates were this much lower than SA’s was in 2009. BoN Governor Johannes !Gawaxab noted that the MPC was concerned that a bigger increase would constrict demand and crimp economic growth, and added that they are not seeing material capital outflows.

However, when the SARB delivered another 50 basis point hike in May, the spread widened to a percentage point, prompting the BoN to act in kind at its June MPC meeting. The governor stated that they have seen outflows of N$10.1 billion to South Africa during the first five months of 2023, and added, “What we need to do now is to close the gap before it becomes a bigger problem.”

The governor’s comments show that the central bank is somewhat caught between a rock and a hard place at present. The domestic inflation rate has been ticking down meaningfully since March, meaning that there is little reason to hike rates further at this point. However, should the SARB wish to continue protecting the value of the rand by hiking rates further over the coming months to “stay ahead” of more developed nations, the BoN will have little choice but to follow suit, despite it hurting indebted consumers and businesses at a time when it is not necessarily needed.

That being said, we are not questioning the currency peg arrangement and believe that the benefits continue to outweigh the costs. It just means that there will be short periods where monetary policy is not aligned to economic conditions and that this may cause some pressure on economic growth as a result.

Danie van Wyk – Head: Research