july 2018 - dec 2018

Bank competition in sub-Saharan African countries: Has anything changed in light of the 2007-2008 global financial crisis?

The Steinhoff Saga Management review - University of Stellenbosch Business School

July – December 2018

Bank competition in sub-Saharan African countries:
Has anything changed in light of the 2007-2008 global financial crisis?

Steve Motsi, Oluseye Samuel Ajuwon and Prof Collins Ntimc

  • OCT 2018
  • Tags Features, Finance

23 minutes to read

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Steve Motsi, Oluseye Samuel Ajuwon and Prof Collins Ntimc

Why increasing competitiveness among banks matters

How did the competitive behaviour of banks in sub-Saharan Africa change after the 2007-2008 global financial crisis?

To find out, three researchers examined the performance of 83 banks from six countries in the period from 2008 to 2013. They employed the Panzar-Rosse model of firm competition, and found that the degree of competition among banks in sub-Saharan Africa increased. This increase is due to the effect of reform or liberalisation policies, largely initiated in the pre-crisis era. The success that followed as a result of the development of banking systems nonetheless moderated at the onset of the 2007-2008 financial crisis. System instabilities, which are characteristic of a post-crisis period, exposed deficiencies in regulation and asymmetric incentives for bank management. A significant recalibration of prudential policies followed as regulators sought to restore system stability, which again impacted the competitive conduct of banks.

Why does increasing competitiveness among banks matter? There are a number of reasons for this:

  • It promotes effective financial intermediation, and explains the structure, stability, efficiency and performance of the industry.
  • It lowers interest rates and improves the production, quality and distribution of banking products.
  • It explains the level of access to financial services and the extent of external financing at household and firm level.
  • It improves the effectiveness of monetary policy transmission, supports real economy production efficiency, and promotes overall growth and development.

However, competition can also lead to aggressive conduct or excessive risk-taking by banks, which can have negative implications. These include the creation of asset-price bubbles, artificial credit growth and proliferation of opaque financial products, the deterioration of asset quality, excess leverage, and the build-up of systemic risk to the financial architecture.

A significant recalibration of prudential policies followed as regulators sought to restore system stability, which again impacted the competitive conduct of banks

Why was this study undertaken?

The first motivating factor stemmed from the sheer diversity of economies in sub-Saharan Africa, and their influence on the competitiveness in banking systems. The region had an estimated total GDP of USD 1.60 trillion in 2013, with an estimated 650 banks.

Historically linked to World Bank and IMF reform, the structure and size of economies and their banking systems reflect the extent of the deregulation of markets and trade, the promotion of private enterprise and innovation, and the ease of entry for foreign participants.

The Nigerian and South African economies, for example, have large, diversified and competitive banking systems. Medium-sized economies such as Angola, Kenya and Ghana also have competitive banking systems with significant foreign participants, while smaller island economies such as Mauritius and the Seychelles have, by comparison, first-class banks and sophisticated financial products and services. As such, the diversity of economies and banking systems in sub-Saharan Africa triggered an investigation into the competitiveness and performance of banks.

The second motivating factor was a desire to investigate how the 2007-2008 financial crisis triggered the poor performance of banks. This led to increased systemic risk to the financial architecture and the exposure of structural weakness in supervision and prudential policies. As banks faced problems stemming from adverse selection and moral hazard in their lending activity, the risk to small depositors, for instance, increased in the wake of the financial crisis. This risk materialised in the form of sequential service constraints, which created an incentive for depositors to verify the solvency of banks. To protect depositors, global recalibration of prudential policies followed.

The third motivating factor was limited literature on bank competition in developing countries, thus presenting an opportunity to provide additional insights.

The objectives of this study were therefore to:

  • Measure banking competition: Examine changes in banking competition in sub-Saharan Africa during a period of significant banking and economic reform that coincided with the 2007-2008 global financial crisis. Also examine the pricing behaviour of banks by applying the Panzar-Rosse model to compute a continuous measure of a static H-statistic. The computed value would then suggest the extent of the contestability of markets.

Add insight to existing literature: Contribute new insight to the current debate on competition and its impact on financial sector development strategy.

… competition can also lead to aggressive conduct or excessive risk-taking by banks

Structural approach to measuring competition

Firms apply various pricing strategies that influence competitive behaviour. The structural approach assumes a causal relationship between market structure and performance, and consists of two competing hypotheses – the Structure-Conduct-Performance (SCP) paradigm and the Efficient Structure Hypothesis. The SCP paradigm posits that a high concentration in an industry weakens the degree of competition and encourages collusive behaviour by organisations. In turn, collusive behaviour leads to abnormal profit at the expense of efficiency. Popular empirical tests are the Herfindahl-Hirschman Index and firm concentration ratio.

The Efficient Structure Hypothesis (ESH) indicates that a larger market share for an individual bank that leads to high industry concentration is the result of efficiency and lower input costs, as opposed to a low degree of competition. The hypothesis further argues that the SCP paradigm ignores economic, legal, technological and other barriers to entry and exit in an industry. In addition, it argues that the SCP paradigm does not account for firm efficiency. Therefore, an efficient bank will, over time, increase market share and market power, and ultimately drive superior performance relative to competitors.

Non-structural approach to measuring competition

The non-structural approach, on the other hand, is a modern view. It suggests that changes in input costs influence pricing behaviour and the performance of banks. This leads to prices being set equal to marginal costs. In addition, the non-structural approach argues against the notion of a causal relationship between market structure and performance. Popular empirical tests are the Panzar-Rosse model and Bresnahan model.

As banks faced problems stemming from adverse selection and moral hazard in their lending activity, the risk to small depositors … increaseed

More about the Panzar-Rosse model

The Panzar-Rosse model, which was applied in this study, assumes that the conduct of competing banks influences the performance of any individual bank. The idea is that banks employ dissimilar pricing strategies as they respond to changes in factor input prices. Competitiveness, therefore, is the extent to which changes in input prices reflect in revenues in a state of equilibrium. Assumptions of the model include a single product output and profit maximisation, where marginal revenue is set equal to marginal cost.

Using data at firm level, the test derives a measure called an H-statistic, which is a summation of the elasticities of revenue with respect to changes in input prices. In other words, an H-statistic is a continuous measure of the level of competition. When an H-statistic is less than or equal to zero, it implies monopoly or oligopoly pricing behaviour. When it is equal to unity, which implies perfect competition. Results for an H-statistic between zero and unity imply varying degrees of monopolistic pricing behaviour.

Panzar and Rosse (1987) showed that for a profit-maximising monopolist, an H-statistic cannot be positive, since an increase in input raises marginal cost. This, they say, leads to an output restriction and therefore lower revenues. For perfect competition where an H-statistic is equal to unity, individual firms incur an increase in marginal and average costs without altering equilibrium output.

Developing two hypotheses

It has been indicated that the competitive structure of a banking system could change over time due to the process of reform/liberalisation and deregulation. From that view, a calculated H-statistic explains the pricing behaviour of firms. By measuring the sum of elasticities of revenue to factor input prices, an H-statistic equates to unity where there is perfect competition/contestability, implying that an increase in factor prices would not alter bank output. A calculated result, which is less than unity but above zero, would suggest an alternative view of monopolistic competition or partial contestability, which implies that changes in factor input prices affect bank pricing of output. Therefore, the hypothesis follows:

H1. There is a statistically significant positive association between unit factor input prices (market power) for a bank and the extent of competitive behaviour.

Following from the empirical theory on banking competition, the validity of the competition parameter is sufficient only when the banking system is observed in general market equilibrium. As such, an E-statistic, calculated to explain that general market equilibrium exists where the factor input prices of funds, labour and capital expenditure do not influence banking returns, is statistically equivalent to zero. The hypothesis therefore follows that:

H2. Market equilibrium exists where returns on bank assets are not associated with factor input prices.

How was the study conducted?

This study drew a sample of 83 banks from six countries which represented three sub-regions in sub-Saharan Africa: East Africa (Kenya and Uganda), Southern Africa (Mauritius and South Africa) and West Africa (Ghana and Nigeria). The selection criteria for the sample included data availability, economic and financial development, advanced legal frameworks, good corporate governance and disclosure, and the use of IFRS reporting standards. Data was mainly sourced from a public database called African Financials and from bank websites. Data on macroeconomic variables were sourced from the World Bank.

To protect depositors, global recalibration of prudential policies followed.

Dependent variables

In 2009, REV (ratio of interest income to total assets) increased to its highest level of 14.53% from 11.82% in 2008, intuitively suggesting that banks’ pricing behaviour altered to reflect increasing risk to lending activity in light of the financial crisis. Countries that experienced trade vulnerabilities, mainly due to declining commodity prices, would have likely reacted to a deterioration in loan quality by raising interest rates. As expected, bank performance was negatively affected by changes in the operating environment, resulting in a mean ROA of 1.41% for 2009, which was the lowest over the observed period, as some banks reported losses.

Independent variables

Not surprisingly, PF (unit price of funds or average cost of funds is the ratio of interest expense to total customer deposits) increased to its maximum of 10.74% in 2009, reflecting the rising cost of funds associated with the general loss of depositor confidence, capital flight, low liquidity and increased leverage. Years later, however, PF declined as regulators tightened prudential policy and directed banks to increase capitalisation levels. In the wake of the financial crisis, banks sought to improve the quality of risk management and general operations, which increased the wage rate as skilled talent was acquired. However, as alternative methods of distribution such as branchless banking evolved, pressure on the wage rate diminished. Banks, instead, focused on upgrading information technology infrastructure, driving PK to its highest levels in 2010.

Bank-specific control variables

Despite the negative effect of the financial crisis on asset quality in many banking systems in sub-Saharan Africa, a bank-specific control, RISKASS, did not rise significantly. The average was 3.41% in 2008, but declined to 1.89% in 2011. This implied that some banking systems where insulated from the impact of the crisis, or had sufficiently strong risk management infrastructure to avert a banking crisis. Other banking systems either wrote off or sold non-performing loans.

Interestingly, lending activity as measured by CREDIT remained relatively stable, with a mean of 50.60% over the observed period. The extent of financial intermediation in banking systems in sub-Saharan Africa pre- and post-crisis was constrained as a result of poor credit information, a lack of collateral and financial illiteracy, such that banks traditionally preferred to lend to larger and less-risky corporate customers or alternatively held cash and government securities. Therefore, and as expected, there was no significant level of deleveraging that occurred post-crisis.

However, in view of the crisis regulators took precaution by instigating a recapitalisation of banking systems. In essence, average EQUITY increased to 15.01% in 2010, and to 15.11% in 2013, as profitability of banks improved.

Country-specific control variables

GROWTH also followed a positive trend, from 4.24% in 2009 to 6.40% in 2011, due to a recovery in commodity prices, additional resource discoveries and exploitation, and rising domestic demand. However, growth rates tapered off in 2012 and 2013 as uncertainties over stability in the global economy increased, and risks of faltering demand from emerging economies such as China materialised. Average inflation did not indicate any trend, owing to differences in pass-through to domestic prices from associated local currency depreciation. In 2008, as commodity prices peaked, average inflation for the representative sample reached a high of 14.61%, but subsequently declined to 6.59% in 2010.

Analysis of the correlation matrix

The correlation matrix mainly indicates positive signs for the coefficients. There was a statistically significant positive association between REV and the main independent variables PF and PL, with correlation coefficients of 0.62 and 0.64 respectively. PK, on the other hand, had a negative sign, but the relationship with REV was statistically weak as the coefficient was only 0.10. RISKASS and CREDIT had similar correlation coefficients with REV, of approximately 0.40 respectively, indicating a positive relationship between lending activity and risk management in the determination of interest rates. The higher the risk associated with granting each loan, the higher the lending rate.

Likewise, the association of RISKASS and CREDIT to PF was relatively strong, indicating that the cost of funds played a role in determining the quantity of risk and extent of lending activity assumed by each bank. Further, the correlation coefficient between RISKASS and CREDIT was positive with a correlation coefficient of 0.60. Notably, the correlation coefficient between PL and RISKASS of 0.41 indicated that bank wage rates were partly influenced by the acquisition of specialised talent in risk management in the wake of the financial crisis. PL and INFL had a coefficient of 0.39, but the positive sign highlighted the effect of inflationary pressures on the wage rate.

Lastly, the relationship between ASSET and GROWTH had a correlation coefficient of 0.49. Significantly, the positive sign was associated with the notion of a causal link between financial sector development and economic growth.

In the wake of the financial crisis, banks sought to improve the quality of risk management and general operations, which increased the wage rate as skilled talent was acquired.

What did the study find?

Firstly, the outcome of testing for H2 indicated sufficient conditions of market equilibrium. Secondly, H1 was regressed and the conditions of monopolistic competition identified were consistent with previous studies.

Analysing the general market equilibrium

H2 was tested for a sample of 83 banks in sub-Saharan Africa to determine whether banking competition exists under conditions of general or long-run market equilibrium. Based on the literature, this could also be stated as ROA is not influenced by factor input prices in the long run, with a computed E-statistic equalling zero. The outcome was that the computed value of the E-statistic was 0.003, with a p-value of 0.407. Therefore, the null hypothesis that unit factor input prices were equivalent to zero, was not rejected. This implies that banking competition was observed in a state of general equilibrium.

The results of the empirical test for H2 were consistent with findings from previous studies, where, in the long run, factor input prices did not influence bank returns. These findings were also consistent with the theoretical literature, which states that, in equilibrium, the zero profit constraint holds constant at market level.

… policymakers should continue to draw up policies aimed at the development of financial intermediation and improved competitive conduct of banks in sub-Saharan Africa

Test of competition using the Panzar-Rosse approach

Having satisfied the conditions of general market equilibrium, H1 was tested for the same sample of 83 banks to determine whether there is a statistically significant relationship between changes in market conditions/power and the extent of competitive conduct. Specifically, a regression of the Panzar-Rosse model was used to compute a continuous measure of an H-statistic that had a value of 0.57. The results confirmed that the H-statistic was significantly different from both unity and zero at the 1% level of significance. The findings suggested that the banking system is characterised by monopolistic competition, as opposed to perfect competition or pure monopoly. Both null hypotheses were strongly rejected, allowing for heterogeneity among the banks.

Similarly, the results of monopolistic competition were consistent with outcomes of previous studies since changes in factor input prices (market power) incurred by a specific bank influenced changes to its revenue. Under conditions of perfect competition, on the one hand, an increase in input prices would have raised marginal costs and total revenue by the same amount, where an H-statistic is equal to unity. Under pure monopoly, on the other hand, marginal costs would have increased but equilibrium output would have declined, such that the H-statistic is less than zero.

What are the implications of this?

Consistent with the outcome of monopolistic competition, is has been suggested that reform/liberalisation and prudential policies would likely have influenced pricing behaviour of individual banks and market discipline. The findings, therefore, supported H1, namely that there is a statistically significant positive association between the effect of market conditions (banking reform) and the extent of competitive behaviour.

Unexpected, bank-specific control variables largely carried no statistical significance (RISKASS, ASSET and CREDIT), while RISKASS had a negative sign. EQUITY, however, had a strong statistical significance, with a positive sign on the coefficient, implying that higher capital levels led to strong pricing power. This was expected in view of the impact of prudential policies which followed the 2007-2008 financial crisis, where a significant number of banks in sub-Saharan Africa increased capital via mergers and acquisitions, initial public offerings and/or the capitalisation of reserves.

What are the policy implications of this?

The findings of this research impacted policy design in the financial sector. This was mainly due to the linkage between the extent of competition, technological advancement, efficiency of financial intermediation, access to financial services, performance and stability.

  • The impact of policies on revenue and cost: It is clear that reform/liberalisation and prudential policies impacted the revenue and cost functions of the banking systems. As such, market players would likely continue to alter their conduct to ensure profit maximisation. For example, interest rate liberalisation could increase the cost of funds as banks compete for market share of deposits. In turn, banks could increase lending rates to expand their net interest margin.
  • Recapitalisation leading to increased market power: The policy-driven recapitalisation of banks resulted in increased market power in the pricing of loan output.
  • Higher contestability of markets leading to increased risk taking: Higher contestability of markets, owing to unrestricted/universal banking approaches and the deregulation of formal barriers, drove excessive risk-taking by banks in order to defend or expand market share. For example, excessive risk-taking by banks in Nigeria, via the provision of ill-fated margin loans, triggered regulatory responses to the ensuing crisis.
  • The rise in foreign bank participation: Foreign bank entry impacted the contestability of markets, technological advancement, the recalibration of risk management frameworks and capital flow. In East Africa, for example, where formal regulatory barriers were largely withdrawn as a part of policy design, there were a number of implications. These included a rise in foreign bank participation, significant cross-border capital flows and strong technological innovation, which enhanced the competitive conduct of banks.
  • Increased access to finance: Policy implications on the provision of credit to the private sector indicated a trend towards promoting access to finance, enhancing competitive conduct and performance among banks. Although findings on lending activity were statistically insignificant, banks made progress in extending their markets to low-income households and SMEs.
  • More robust banking systems: The study found that policy helped to foster the development of banking systems and efficiency of financial intermediation in the real economy, which ultimately influenced economic growth.

 

  • The original article was published in 2018 the SPOUDAI Journal of Economics and Business, 68(1), 59-83. Find the link here. https://www.researchgate.net/publication/326065383_Bank_Competition_in_Sub-Saharan_African_Countries_Has_Anything_Changed_in_the_Light_of_2007-2008_Global_Financial_Crisis
  • Steve Motsi and Oluseye Samuel Ajuwon are involved with the Department of Development Finance at the University of Stellenbosch Business School.

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2008 US financial crisis

Using an intervention approach to analyse the 2008 US financial crisis

The Steinhoff Saga Management review - University of Stellenbosch Business School

July – December 2018

Using an intervention approach to analyse the 2008 US financial crisis

2008 US financial crisis

Katleho Makatjane, Edward Molefe and Roscoe van Wyk

  • OCT 2018
  • Tags Features, Finance

16 minutes to read

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Katleho Makatjane, Edward Molefe and Roscoe van Wyk

How did the 2008 US financial crisis impact the real exchange rate in SA?

This study investigated the impact of the 2008 United States financial crisis on the real exchange rate in South Africa. The data used in this empirical analysis covers the period from January 2000 to June 2017. The seasonal autoregressive integrated moving average (SARIMA) intervention charter was used to carry out the analysis.

Where did this all start?

The 2007-2008 worldwide financial crisis was an astonishing and multifaceted process. The financial crisis came as a result of surplus liquidity as the Federal Reserve Chairman Ben Bernanke had excess savings that were used in global financial markets and US mortgage markets. In addition, insufficient assets and liability and the risk management practices of financial organisations resulted in the advancement of the 2007-2008 financial crisis. The crisis had spill-overs that affected various areas of the economy – such as financial markets and commodity markets.

Researchers have shown that from 2007 to 2008, the US national government initiated endeavours to avoid disturbing mortgage markets. That is why the crisis went through five stages:

  • Stage 1: The US experienced a housing bubble boosted by significant mortgage lending.
  • Stage 2: Other types of assets were also impacted by the crisis. This stage also impacted mortgage companies, investment banks and other banks worldwide.
  • Stage 3: This stage was characterised by the colossal addendum of liabilities from exposed banks which prompted the international liquidity crisis. This triggered anxiety about possible credit contagion of the same risk on the universal scale.
  • Stage 4: This stage was characterised by the disintegration of investment product structures which eliminated the comprehensive liquidity provisions into an article of trade, causing the bubble effect in this area.
  • Stage 5: A peak was reached in September 2008 with a massive shifting of funds into risk-free securities. Lehman Brothers filed for bankruptcy protection and the US investment banking system faced its ultimate demise.

The 2007-2008 financial crisis affected economies all over the world. Most economies started to recognise the effect of this crisis in March 2008.

The 2007-2008 financial crisis affected economies all over the world. Most economies started to recognise the effect of this crisis in March 2008. Therefore, the rationale of this study was to evaluate whether the 2007-2008 financial crisis had a transitory or long-term effect on the South African economy utilising the SARIMA intervention procedure. This intervention model is used to assess the patterns and duration of the financial crisis on the real exchange rate of South Africa. The study also wanted to assess whether the crisis had a transitory or permanent effect on the country’s economy. The empirical analysis used in this study is divided into three stages:

  • Firstly, the SARIMA model was used as benchmark to describe South Africa’s exchange rate.
  • Secondly, an intervention analysis was performed to appraise the effects of the 2008 financial crisis. This will assist the Monetary Policy Committee of South Africa to understand the linear co-movement of the country’s exchange rate.

Thirdly, a comparative analysis was done to determine whether the intervention analysis successfully represents the waves of 2008 financial crisis contrasted with SARIMA.

What other research has been done in this field?

The structural breaks in the data can be examined exogenously by assessing their impact with an ARIMA model that is developed on the basis of a time series. The difference between the actual data and the data without the bearing is known as the degree of the power of an exogenous event.

The number of data fluctuations that is more than or less than expected is based on the data trends before the intervention event.

The intervention is therefore used to determine the statistical influence of an exogenous intervention on a given time series and to measure the magnitude of the impact, if any.

Various researchers have used the intervention model to analyse time series prone to structural breaks. This includes Coshall (2003) who examined the impact of the September 11 terrorist attacks on international travel flows. Lai and Lu (2005) quantified the decline in the demand of air transport passengers in the US after the terrorists attack on September 11. Eisendrath and his co-researchers (2008) measured the waves of the September 11 terrorist attack on the Las Vegas Strip’s gaming volumes. Min and his co-researchers (2011) used an intervention model to analyse the consequence of Severe Acute Respiratory Syndrome (SARS) on Japanese demand for travel to Taiwan. Zheng and his co-researchers (2013) examined the impact of the 2007 recession on US restaurant stocks by employing an intervention model.

The SARIMA model with the intervention was also used by Ebhuoma, Gebreslasie and Magubane (2017) to model the outcome of the re-introduction of dichlorodiphenyltrichloroethane (DDT) on confirmed monthly malaria cases in KwaZulu-Natal. Results revealed both a sudden and a perpetual monthly decline in malaria. The cause of this decline was the aftermath of implementing an intervention policy to curb malaria. The long period of low malaria cases shows that the continued use of DDT did not act as an insect repellent as predicted. Therefore, the feasibility of reducing malaria transmission to zero in KwaZulu-Natal requires other reliable and complementary resources.

The study also wanted to assess whether the crisis had a transitory or permanent effect on the country’s economy

How was the study conducted?

Two models were proposed for this study, namely the SARIMA intervention model and SARIMA model. The SARIMA model served as benchmark model to show that the multiplicative SARIMA model denoted by SARIMA follows a certain mathematical form.

There should be no common factors between the seasonal autoregressive (SAR) polynomials and seasonal moving average (SMA). Also, SAR polynomials should correspond with the characteristic equation of SARMA because that is the role of the SAR model.

Because the 2008 financial crisis was unique, the intervention variable Zt symbolised some discrete event in which Zt=1 denotes the international financial crisis while Zt=0 denotes otherwise.

How the SARIMA model was developed

The SARIMA model was developed in three stages:

Step 1: The unit root test and the identification of the order of difference help to reduce the variance of the data and make the time series ready to be modelled by a stationary S (ARIMA) model. The Augmented Dickey-Fuller (ADF) test is usually applied for the unit root test. For model selection, the Akaike information criterion (AIC) and Schwartz Bayesian criterion (SBC) were employed in this study. The study also used the AIC for the lag length selection of the ADF model.

Step 2: Next, the parameters of the intervention function and SARIMA were estimated and determined. The autocorrelation function (ACF), partial autocorrelation function (PACF) and cross-autocorrelation function (CACF) were used to tentatively identify the parameters of the model. Nonetheless, statistical measures generally provide outstanding proof of an appropriate intervention function. The theoretical characteristics of the ACF and PACF for a stationary SARMA process were also presented.

Step 3: A residual or noise diagnostic check was done. The correlogram of Q-statistics based on the ACF and PACF of the residual was used for the residual analysis. Statistical tests such as the Jarque-Bera test for the normality of residuals and the Lagrange multiplier for the heteroscedasticity of the residuals were also used. The Breusch-Godfrey test was used to test the correlation of the residuals.

This will assist the Monetary Policy Committee of South Africa to understand the linear co-movement of the country’s exchange rate.

Empirical analysis

To execute the analysis, the study used a time series of real exchange rates for the period January 2000 to June 2017 obtained from the South African Reserve Bank database. The 2008 financial crisis is hypothesised to be a significant event influencing exchange rate movements in South Africa. The series showed upward and downward trends in conjunction with seasonal components. This implies that the real exchange rate in South Africa was not constant over the sampled period.

The Kruskal-Wallis (KW) statistic test was used to determine the presence of seasonal components. It provided significant evidence that the exchange rate holds seasonal properties as the KW test rejected the null hypothesis of no seasonal components over the alternative of seasonal components in the exchange rate series. Next, the researchers applied the SARIMA and SARIMA intervention models.

The results of applying the SARIMA model

The Augmented Dickey-Fuller test was applied to the time series. This provided sufficient evidence that the exchange rate series contained unit root with both seasonal and non-seasonal differencing of order one. Using the ADF model, a stationary time series was achieved.

While diagnosing the estimated ARIMA, all the estimated parameters are significant at 1%, 5% and 10% level of significance. The estimated Q-statistics provided significant evidence that the estimated model is a white noise process. Model parameter estimates must preferably be less than one to deem them sufficient and significant.

The results of applying the SARIMA intervention model

The intervention model used the 2008 financial crisis as intervention period. This crisis reached South Africa in March 2008. Before the estimation of an intervention model, the ADF test was applied to provide evidence that the pre-intervention time series had no unit root. The intervention model was estimated by firstly identifying the order of intervention parameters by applying various tests. Finally, the diagnostic checks for the noise proved that this was a white noise process, showing the estimated model to be valid.

The cross-autocorrelation function (CACF) showed that the 2008 financial crisis directly distressed the South African exchange rate, which caused a significant drop in import and export goods and services in the country the month after the event. The intervention effect is computed as an asymptotic change of 17%. This implies that the effect of the intervention caused a drop of 17% in the exchange rate. The same decline happened in the South African economy.

The next task was to determine which model best mimicked the data and produced fewer forecasts. This study applied four error metrics – a mean error, mean absolute error, mean percentage error and mean absolute percentage error – to measure the performance of each model. The results indicated that the model with intervention had the smallest values of all the proposed error metrics.

… the application of SARIMA intervention model can indeed explain the dynamics and impact of interruptions and changes in time series

What did the study find?

The US financial crisis was triggered in July 2007. However, the effect of the global financial crisis only reached South Africa in March 2008, with immediate and alarming consequences. Among others, it significantly impacted the exchange rate. It also led to a dramatic decline in the country’s output value since March 2008, which continued throughout 2008 and 2009 before reaching a steady state. During this period, resources were downgraded, companies were shut down causing unemployment rates to accelerate, and economic growth slowed down.

The study has found that the SARIMA model with intervention outperformed the SARIMA model, and that the application of SARIMA intervention model can indeed explain the dynamics and impact of interruptions and changes in time series.

Also, the study has shown that a seasonal time series that is interrupted by policies during a financial crisis can be modelled by the SARIMA intervention model. Going forward, scholars can also extend this empirical analysis to multivariate modelling by using the determinants of the exchange rate and the SARIMAX model with intervention to gain a better understanding of the linear relationship and co-movement of the exchange rate in South Africa.

The results of this analysis provide practical information for the Monetary Policy Committee of South Africa to make informed policy decisions on exchange rate movements. It also underlines the value of the intervention model in modelling interrupted time series such as exchange rates.

  • Original article: Makatjane, K. D., Molefe, E. K., & Van Wyk, R. B. (2018). The Analysis of the 2008 US Financial Crisis: An Intervention Approach. Journal of Economics and Behavioral Studies, 10(1), 59-68, Doi: https://doi.org/10.22610/jebs.v10i1.2089
  • Roscoe Van Wyk is from the University of Stellenbosch Business School.

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share based incentives

Do share-based incentives allow executives to obtain undue economic gain?

The Steinhoff Saga Management review - University of Stellenbosch Business School

January – June 2018

Do share-based incentives allow executives to obtain undue economic gain?

share based incentives

By Ms Gretha Steenkamp and Prof Nicolene Wesson

  • Nov 2018
  • Tags Features, Leadership

19 minutes to read

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Ms Gretha Steenkamp and Prof Nicolene Wesson

What share-based incentives are supposed to do
Long-term share-based incentives to executive directors have become commonplace, both abroad and in South Africa. Most stakeholders in a listed company would view these incentives as a beneficial way to align the interests of shareholders and executives. Share-based incentives can motivate executives to focus on aspects of importance to the shareholders and to the company. These incentives can also be used as a retention tool because of their long vesting periods and, in respect of equity-settled share-based incentives, can save the company a cash outflow.

Share-based incentives comprise a significant portion of executive remuneration. Critics say that these incentives could allow rent extraction – obtaining economic gain without giving any benefits in return. To enable proper governance, stakeholders (both shareholders and regulators) need to be aware of the characteristics of share-based incentives.

Although share-based incentives can be an effective way of remunerating executives, they are not without risks. Incentives might be structured incorrectly or executives might be enriching themselves without the shareholders being aware of this as share-based remuneration is difficult to understand and measure, and is often poorly disclosed. Share-based incentives could also be a motivation for executives to manipulate certain metrics to earn the remuneration associated with it.

In South Africa, with its high income inequality, more and more questions are being raised about the appropriateness of the large amounts of remuneration paid to executives of listed companies. Yet, there is no comprehensive understanding of these executive share-based incentives.

Critics say that these incentives could allow rent extraction – obtaining economic gain without giving any benefits in return.

What did this study investigate?
The aim of this study was to evaluate the trends relating to executive share-based incentives, as well as the reliability of available data sources on these incentives in South Africa.

Firstly, a trend analysis was done for companies listed on the Johannesburg Stock Exchange between 2002 and 2015. Share options were the most popular share-based incentive until 2008, but were then replaced by share appreciation rights (SARs) and later by full quantum schemes (performance and restricted shares). Compared to global evidence, SARs were popular for longer and full quantum schemes became prevalent later in South Africa. Increased use of full quantum schemes in later years signal improved alignment of executive/shareholder interest (in line with the agency theory).

Secondly, this study commented on the reliability of the IRESS financial database in recording share-based incentives, when compared to the annual financial statements (AFS) of companies. Numerous discrepancies in IRESS detracted from its usefulness as a sole data source when evaluating executive share-based incentives. Also, different disclosure practices in the AFS increased the risk that executives in South Africa could be utilising share-based incentives to extract rents from companies. Therefore, an assessment of the reliability of IRESS will help regulators to address current disclosure practices to ensure that reliable information on executive share-based incentives is available to shareholders – irrespective of the data source used.

Although share-based incentives can be an effective way of remunerating executives, they are not without risks.

More about share-based incentives to executives
A share-based incentive to an executive is defined in the International Financial Reporting Standard 2 (IFRS 2) as a payment made by a company to an executive to remunerate the executive for services rendered, where the value of the payment is based on the share price of the company. The payment can be settled in company shares or in cash.

Share-based incentives can be granted annually as a part of the executive’s package or only granted if certain performance targets are met. A vesting period follows (which usually has vesting conditions attached, e.g. the executive must stay employed or the earnings per share figure should increase by 5%) and then the incentive will vest in the name of the executive. The incentive is either immediately exercised on the vesting date or later based on the executive’s discretion.

Share-based incentives could also be a motivation for executives to manipulate certain metrics to earn the remuneration associated with it.

Classification of share-based incentives
The following types of share-based incentives were taken into account in this study:

  • Appreciation scheme – share options: Share options have been used extensively from the 1990s and provided large earnings for executives in the bull market which followed. The prominence of share options was due to companies incorrectly viewing them as ‘cheap’ or ‘free’ since they were unrecognised in the financial statements before the effective date of IFRS 2 (December 2005) and did not cause an outflow of cash. What is commonly called a ‘share option’ is actually a purchased call option for the executive of the company. Such an option conveys to the holder thereof (the executive) the right – but not the obligation – to buy shares in the company at a certain exercise price at a pre-determined date or period in the future. The executive has to stay employed in the company during the vesting period. After the vesting date, the share options may be exercised at the executive’s discretion, but options need to be exercised before the expiry date. The executives share in profits to be earned on the shares, but not in the losses.
  • Appreciation scheme – share appreciation right (SAR): A SAR is basically a cash-settled version of a share option (where the increase in share price from grant date to vesting date is paid out in cash), conditional upon the executive staying with the company. Some SARs are net-settled in shares (where the number of shares equals the value of a would-be cash payment), but the majority are cash-settled. The use of appreciation schemes (share options and SARs) is declining globally.
  • Full quantum scheme – restricted shares: Shares equal to a certain rand-value are allocated to an executive. These shares will vest in the name of the executive once an employment period has been completed. On the vesting date, the executives receive the shares at no cost.
  • Full quantum scheme – performance shares: Performance shares are similar to restricted shares, but also have performance vesting conditions attached. The shares accrue to the executive (at no cost) after a certain time period (usually three to five years) has been completed and certain performance targets have been met.
  • Full quantum scheme – phantom shares and other cash-settled plans: A phantom share entitles the owner thereof to a cash payment equal to the share price on exercise date. A share is effectively granted (similar to restricted and performance shares), but it is settled in cash to avoid dilution of the current shareholders’ interest. Other cash-settled plans may also occur where cash is paid, based on performance measures.
  • Full quantum scheme – deferred bonus: A deferred bonus scheme is where executives choose to defer a portion of their short-term cash bonus into shares of an equal value. The executive is rewarded for this deferral with the receipt of shares of an equal value at no cost, if the executive is still with the company at the vesting date.
  • Hybrid scheme – share purchase: A share purchase scheme is a type of hybrid between appreciation and full quantum. An executive purchases the shares at the ruling market price, but only has to pay the purchase price at a future date. The value that the executive receives is the appreciation in share price. However, the executive is exposed to downside risk.

Shareholders are often unaware of these rent-extraction activities.

What does the literature say about share-based incentives?
A literature review was undertaken to shed light on the theoretical perspectives underpinning executive share-based remuneration.

Most studies concur that executive share-based incentives originated as a result of agency theory. Executives are seen as agents of the principal (shareholders) and should be incentivised to act in the best interest of the shareholders. Share-based incentives were developed as a financial incentive to align the interests of the executives with those of the shareholders, as they enable exposure to similar risks (increase or decrease in the share price).

In recent years, there has been increased awareness that share options and SARs (appreciation schemes) are not ideal in aligning executive and shareholder interests, as appreciation schemes award for increases in the share price but do not expose executives to a down-side risk. As a result, full quantum schemes have been gaining ground because the risks and rewards of shareholders and executives are more appropriately aligned.

Over the years, additional theories on share-based incentives were developed. This includes institutional theory which proposes that corporate governance requirements, accounting treatment and the economic climate would influence the share-based incentives being paid to executives. Institutional theory also proposes that executive remuneration in emerging economies could be different to those in the developed world.

The managerial power or rent-extraction theory proposes that executives could use share-based incentives to extract undue remuneration from companies. Shareholders are often unaware of these rent-extraction activities.

Some view share-based incentives as a governance measure in itself – in that it aligns the financial interests of executives with those of shareholders. Most, however, believe that share-based remuneration should be governed appropriately to reduce opportunities for rent-extraction and manipulation.

Some view share-based incentives as a governance measure in itself – in that it aligns the financial interests of executives with those of shareholders.

How the research was conducted

This quantitative study used longitudinal secondary data from the IRESS financial database as well as the annual financial statements (AFS) of companies. Firstly, a trend analysis was done, which evaluated the characteristics of share-based incentives earned by the executives of 32 JSE-listed companies. To address the measurement problem relating to share-based incentives, a number of measurement bases were employed for share-based incentives. These bases included the type of schemes employed and granted, and also the realised gain on exercise of share-based incentives (instead of the grant date fair value). Secondly, the reliability of the IRESS database in respect of share-based incentives to executives was assessed by comparing IRESS data and AFS data.

The study period was from 2002 to 2015. In 2002 remuneration data first became available on IRESS (the effective date of King II). For each company, the following steps were followed per year:

  • Determine who the CEO was in that specific year
  • Extract from IRESS the data for the CEO (total remuneration as well as data regarding share-based incentives, such as type of scheme, vesting conditions and number granted)
  • Evaluate data from IRESS for possible discrepancies or incompleteness.

Both the IRESS data and AFS data were transposed and cleaned to enable analysis using various techniques and tests. Among others, the study determined the following trends:

  • There was a switch from share options to SARs in the 2000s, owing to changing accounting regulations (the expensing of share options become mandatory from December 2005 onwards). As SARs grants were replacing share options, companies were now employing two schemes (previously granted share options and the SARs).
  • In the period 2002 to 2015, share options were still the favoured share-based incentive, with more than half of the company years having a share option in use. The only other share-based incentive that was widely used was SARs.
  • From 2002 to 2004 only share options were being granted, but the number of companies granting share options decreased substantially from 2009 onwards. SARs came into use from 2006 and increased in popularity over the years 2008 to 2013, with many companies still employing them in 2015. Performance shares have been used since 2008, but only gained momentum from 2013 onwards.
  • South Africa decreased share option usage at the same time as the rest of the world (after the effective date of IFRS 2). However, SARs were more prevalent in South Africa than in the rest of the world, and for a longer period of time. The move to full quantum schemes, correspondingly, occurred only later for South Africa. Moving to full quantum schemes could be viewed as improved compliance with the agency theory, as full quantum schemes ensure improved alignment of shareholder and executive interests. Possible reasons for the prolonged use of SARs and delay in introducing full quantum schemes include the fact that South Africa was less affected by the financial recession than developed countries and that the country’s corporate governance requirements developed or were implemented at a slower pace.
  • The mean gain on share-based incentives was at a minimum of R232 258 in 2002, but rose to R1 882 471 in 2006. After 2006 the mean gain on share-based incentives decreased to a low point in 2009 (during the financial recession). After 2009 the mean gain on share-based incentives rose again to its maximum mean of R2 151 880 in 2015. It would seem that a financial recession either decreases the likelihood of executives exercising share-based incentives, or decreases the actual gain made on exercise (due to depressed share prices). Overall, the large gain made by executives on the exercise of share-based incentives could be an indication of managerial power or rent-extraction. The potential for such rent-extraction is increased due to IFRS 2 accounting for equity-settled share-based payments to employees at the grant date (rather than exercise date) fair value, and also due to divergent practises applied by companies when disclosing the gain realised on exercise − which negatively affects the data-collection process of IRESS.
  • The gain on share-based incentives was also compared to the guaranteed package of a CEO. The guaranteed package comprises salary plus other guaranteed benefits (such as pension), but excludes incentive payments (such as annual bonus and share-based incentives). Winsorised gain on share-based incentives was correlated to guaranteed package and it was found that larger companies, which are more likely to pay higher salaries, also remunerate in share-based incentives to a larger extent. From 2002 to 2015 the mean guaranteed package of a CEO increased steadily from R1 497 258 to R7 510 750. Inflation over this period was approximately 5.56% per year, which would have resulted in R1 497 258 increasing to only R2 579 776. The fact that the growth rate exceeded inflation substantially highlights the large increase in executives’ guaranteed package over the period.

… the large gain made by executives on the exercise of share-based incentives could be an indication of managerial power or rent-extraction

Taking note of the risks of share-based incentives

Share-based incentives to executives are increasingly used by listed companies in South Africa. Such incentives should align the interests of executives and shareholders and, as such, incentivise executives to increase shareholder value. However, share-based remuneration can also provide executives with an opportunity to extract rents from the company if these incentives are not properly governed and disclosed. The global debate on the justification of large amounts spent on executive share-based incentives has increased, but research has been meagre owing to the variety and complexity of such incentives as well as the poor disclosure thereof in annual financial statements.

The extent of the gain when exercising share-based incentives, combined with the fact that IRESS significantly understates the magnitude thereof, highlights the risk that executives in South Africa could be using share-based incentives to extract rents from companies.

 

  • The original article was published in the South African Journal of Accounting Research, 32(1), 46-70. Find the link here.
  • Prof Nicolene Wesson lectures in Management Accounting (Financial Analysis) at the University of Stellenbosch Business School. She is also the academic head of the Postgraduate Diploma in Business Management and Administration (PGD BMA). Ms Gretha Steenkamp is from the School of Accountancy at Stellenbosch University, where she lectures Financial Accounting. Ms Steenkamp is a PhD student USB.

 

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food prices

The impact of food prices on the welfare of households in South Africa

The Steinhoff Saga Management review - University of Stellenbosch Business School

July – December 2018

The impact of food prices on the welfare of households in South Africa

food prices

Roscoe van Wyk and Cliff Dlamini

  • OCT 2018
  • Tags Features, Finance

18 minutes to read

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Roscoe van Wyk and Cliff Dlamini
About food prices, affordability and food security

It has been shown that a 1% increase in food prices can reduce household welfare by over 20%. This confirms a negative correlation between food prices and welfare.

The global food price surge of 2006 to 2008 has negatively impacted South African households. In addition, ever-increasing food prices and lack of access to finance make it difficult to strengthen food security among households in this country.

Global trends suggest that food prices will increase year on year, affecting the welfare of households – in particular poorer households. The instability caused by price hikes is not a short-term problem. In fact, it can have a lasting effect on poverty. Whether consumers are poor or wealthy, the contents and quality of a consumer’s food basket depend on its affordability relative to the consumer’s income.

It has been shown that a 1% increase in food prices can reduce household welfare by over 20%

According to the World Bank, rising food prices affect macroeconomic stability as well as the welfare of net buyers of food. This has a significant impact on poorer households that use a larger proportion of income for food. In South Africa, rising living costs force households to use their income for consumption expenditure rather than savings.

The overall aim of the study was therefore to establish the relationship between household welfare and food prices in South Africa between 1990 and 2015, and to determine what measures can bring about sustainable food prices. The secondary objectives were to:

  • Examine the relationship between food prices and household welfare in South Africa by determining how real household welfare responded to a shock in food prices
  • Analyse the long-run relationship between food prices and household welfare in South Africa by determining how real household welfare responded to a shock in food prices
  • Provide recommendations for a conceptual framework mitigate the impact of high food prices on households in this country.

In South Africa, rising living costs force households to use their income for consumption expenditure rather than savings

Taking a closer look at food prices and food insecurity

Clarity on the causes of market failure by policymakers is important. It is critical for the government to understand the correlation between market and price behaviour in times of food crises. The government is the custodian of policymaking and implementation, and thus needs to support remedial action in order to address the welfare impact of rising food prices.

Some researchers say food insecurity should be included as a market failure as it occurs when free markets are seen to be socially inefficient, when the market outcomes prove social benefits to be below the costs of society in respect of that outcome, or when benefits are not fully utilised via social resources. Hence, the market clearing variables do not maximise net social benefits. The presence of public goods and negative externalities are the two most important causes of market failure in food security.

The relationship between relative and nominal prices forms the causal nature of changes in food prices and can be attributed to relative demand and supply conditions of both non-food and food commodities, resulting in a net increase in relative food prices. Rising food prices increase the risk faced by lower-income households and subsequently transfer real income from lower-income consumers. Rising food prices have an adverse effect on purchasing power. Poor households spend most of their household income on food, making food prices an important factor in their well-being.

Food prices are influenced by, among others, supply and demand, inventories, macroeconomic factors, exchange and interest rates, global economic activity, oil price volatility, global weather patterns, financial investment and agricultural policy.

Approximately 70% of the global poor population reside in rural areas and are dependent on agriculture for the possibility of improving their livelihoods, welfare and decreasing poverty rates.

South African urban households spend more on food than do rural households. One study from 2001 has shown that rural households’ food expenditure was approximately 23% of their total household expenditure whereas urban households’ food expenditure was approximately 15% of their total household expenditure. The difference between urban and rural food expenditure can be expected, as rural households may supplement their food with subsistence farming or own food production.

The government is the custodian of policymaking … and thus needs to support remedial action in order to address the welfare impact of rising food prices

The impact of rising food prices in other countries

How do other countries respond to rising food prices and how effective are their reforms?

To find out, a literature study was undertaken to gain a clearer understanding of food security and food prices in Ghana, India and the USA. These countries differ in terms of income distribution, poverty levels and food security. However, each country has developed policy reforms and programmes to enhance food security and the welfare impact associated with food prices.

In 2008, Ghana imposed import duties on yellow corn, rice and wheat in an effort to lessen the burden on consumers from the adverse impact of further increases in food prices. One study in Ghana suggested that the current policy reform of protecting domestic rice producers by means of import taxation did not contribute to the reduction of national poverty, as there is a tendency for rice growers in Ghana to remain poor. It is challenging for Ghana’s government to implement an effective policy due to tight market conditions for important agricultural commodities. For the government to make sound policy decisions, it needs to understand the causes and implications of rising food prices, and how members of society are impacted by these. An understanding of these variables will allow governments to improve decision-making which contributes to effective policy formation.

India has one of the highest rates of rising food prices in the developing economies. Researchers have shown that from 2006 to 2013, India experienced food inflation at an average rate of over 9%, which was nearly double than during the previous decade. Given that the poor households in rural India spend large portions of their total income on food, they are unable to divert additional resources to suppress the impact of rising food prices. This increases food insecurity in the country.

Three patterns can be distinguished in India’s food price trends:

  • The first pattern of inflated food prices emerged when global food prices increased in 2005 to 2007. The rate at which food prices were inflated was significantly lower in India at the time.
  • The second pattern saw India’s food prices decrease from 2007 to 2008 compared to 2006 to 2007, which is when global food prices significantly increased.
  • The third pattern illustrated that global food prices declined at the end of 2008, but India’s food prices escalated during this time. This indicated that global food price increases had a marginal impact on India as a result of less exposure.

The Indian government has adopted a wide range of policy instruments to combat rising food prices. From 2007 to 2008, the Indian government divided its intervention measures into two categories: economic policies (which included pricing policies, trade policies, stock management policy and public distribution) and social programmes. The social programme policy instruments included cash transfers, food for work, food rationing, school feeding schemes and rural employment schemes. The programmes and policies targeted trade and consumption, with little emphasis on a supply response. According to the World Bank, high rising food prices turned the political economy of food into an important catalyst for short-term economic policy in South Asia and highlighted the transformation of food security into an important strategic tool for policymakers.

The USA relies heavily on food subsidies and tariffs for food security. Empirical evidence illustrates that more than 22% of children living in the USA live below the official poverty line. Also, half will be on food stamps before they reach the age of 20. Food subsidies are included in price supports by the government, which guarantees a price for a farmer’s crops because the state would purchase the excess crops. The USA Farm Bill of 2002 introduced payments for certain crops that are independent of price, also known as direct payments. The USA has experienced lower food tariffs on fruit and vegetable imports and higher tariffs from food-exporting countries around the world. As a result, export growth did not keep pace with import growth. The increase in imposed tariffs could impact food prices, which in turn will impact food security and the welfare of citizens of the USA.

The poor are vulnerable to food price hikes. However, policymakers can alleviate the burden suffered by the poor.

What is the role of policy interventions in alleviating the plight of the poor?

The poor are vulnerable to food price hikes. However, policymakers can alleviate the burden suffered by the poor.

Market information is a key factor when trying to correct price instability, especially in food markets. Without market data on the value of the damage caused by price hikes to markets, the state cannot determine its effect on households.

Researchers have different opinions on the causal relationship between food price increases and the adverse impact on households. Some studies have indicated a positive correlation between food price increases and adverse welfare effects on the poor. However, literature has also indicated that long-term price increases support agricultural development, which in turn impacts positively on employment and poverty relief.

Literature confirms that prices in agricultural food markets are much more inclined to volatility than in other industries. This is due to the supply of food commodities being inelastic in the short term, the demand for food being price inelastic and the unpredictability of food supply due to climate change. In 2008, South Africa had a projected total transfer cost, inclusive of agricultural subsidies, of between 2% and 4.5%. This means a substantial proportion of gross domestic product (GDP) is allocated to help alleviate the burden suffered by the poor. Literature suggests that approximately 80% of South African rural households are unable to afford a basic basket of nutritional food, which would cost approximately R262.00 per person per month.

Today, policymakers are increasingly using innovative mechanisms and legislation to accommodate rising food prices. This includes demographical or geographical targeting in order to direct limited resources to households whose welfare is largely impacted by food price shocks.

Globally, the current economic environment is characterised by sharp increases in food prices. Policymakers have attempted to lower food prices while also limiting the signalling of higher global prices to domestic markets. Since the 1980s, governments have tried to manage risks without affecting the prices of food commodities, which has an effect on variables such as crop insurance, future markets and the trade behaviour of food commodities.

There is a desperate need for government intervention to curb seasonal food insecurity that affects the rural poor by deepening and widening social safety net programmes. Policymakers require strong legislation and policies to assist the poor in this regard. The state must intervene when there is a lack of credibility in food market liberalisation due to a shortage of effective policies to protect the poor. Policies should build confidence in global markets and develop positive relationships between private and public agents.

long-term price increases support agricultural development, which in turn impacts positively on employment and poverty relief

How was this study conducted?

A deductive and/or inferential approach to research was used in this study. The study employed annual time series data derived from secondary sources such as the World Bank and the Organisation for Economic Co-operation and Development, covering the period 1990 to 2015. Due to the lack of welfare measurement in South Africa, the study employed household disposable income as a proxy. The Vector Error Correction Modelling (VECM) econometric approach was used to analyse the relationship between household welfare and food prices in South Africa. The study also performed stability and diagnostic tests, and the variance decomposition and General Impulsive Response Function to detect the behaviour of shocks in the variables used to determine household welfare in South Africa.

What did the study find?

In essence, the study found that a 1% increase in food prices would reduce household welfare by 21.3%. The study, therefore, confirms a negative correlation between food prices and welfare.

… approximately 80% of South African rural households are unable to afford a basic basket of nutritional food

Similar studies in other countries came to the same conclusion. This includes several studies on the decline in household welfare in Ethiopia due to excessive increases in food prices.

The policy options in the short run to address the impact of food prices on household welfare in South Africa could include:

  • Subsidising staple food baskets for households in South Africa
  • Reducing the prices of staple foods through the reduction of food tariffs
  • Reducing household expenditure on basic needs through subsidisation.

These policy options could lessen the burden on households when there is a rise in the prices of staple foods and therefore improve household welfare. Long-run policy recommendations include:

  • Improving the unemployment rate in South Africa
  • Improving access to finance and credit for South African households.

By addressing rising unemployment rates, improving access to finance and credit through job creation and improving micro-credit strategies, an environment can be created where South African households can improve their disposable income.

There is a desperate need for government intervention to curb seasonal food insecurity that affects the rural poor

The successful implementation of policy options – such as food subsidies and tariffs for staple food sources – by the South African government will help to provide the country’s households with:

  • Sustainable food prices
  • The improvement of household welfare by reducing staple food prices
  • The reduction of total household expenditure.

The government is hesitant to engage in projects that will take up large amounts of fiscal resources. However, agriculture and food security are government priorities within the National Development Plan. Hence the recommendations of this research provide a provisional strategy to create an environment for sustainable food prices in South Africa.

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