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Strong capital inflows into the economy in the early months of 1998 were abruptly reversed into outflows in the second half of that year. As international investors sought less risky investment opportunities in the mature financial centres of the world, interest rate differentials between South Africa and the advanced economies widened perceptibly. Domestic demand and output in South Africa could not escape the short-term effects of a sharp rise in domestic interest rates — the downturn in economic activity since November 1996 was exacerbated and real gross domestic product fell sharply in the third quarter of 1998.


Since the fourth quarter of 1998 the situation in global financial markets has improved substantially. Interest rate reductions in the United States, the United Kingdom and in the euro area have helped to improve investor confidence and in most of the crisis-affected countries, financial markets have stabilised. There are good prospects of a strengthening in the current global economic recovery in the remainder of 1999 and in 2000.


In South Africa, the economy has regained some growth momentum over the past three quarters, supported by the recovery in the Asian economies, the continued strength of the United States economy and the general easing of domestic monetary conditions. Over this period the outlook for inflation deteriorated slightly as the rising cost of imported intermediate goods — following the depreciation of the rand around the middle of last year — and higher domestic production cost impacted on output prices. The inflationary effects of these cost pressures more than offset the deflationary influence of weak domestic activity. "Core" consumer price inflation and inflation in the prices of domestically produced goods have accelerated persistently since the second quarter of 1998.


The growth in real gross domestic product accelerated progressively from the fourth quarter of 1998 and reached an annualised rate of 1½ per cent in the second quarter of 1999 when it was boosted by a healthy increase in agricultural output. Among the main non-agricultural sectors of the economy it was the service-providing sectors, more particularly the telecommunications industry, that set the pace for output expansion. Despite the growth spurt in the second quarter, aggregate output in the first half of 1999 was about the same as in the first half of 1998, indicating negligible year-on-year growth in the first half of 1999. Considering the low levels of production in the second half of 1998, continuation of the current output recovery would take real gross domestic product in 1999 as a whole to a level higher than that in 1998.


Aggregate final demand (i.e. the total of household consumption expenditure, consumption expenditure by general government and fixed capital formation) declined in the second quarter of 1999. Despite gains in the real income of households and lower borrowing costs, consumer confidence was weak as memories of the asset price decline in 1998 lingered on and employment prospects remained poor. Household spending accordingly remained sluggish.


General government consumption expenditure declined in real terms, once again reflecting the resolve of the authorities to contain the growth in their recurrent expenditures. The weakness of the economy and some uncertainties about medium-term prospects effectively dampened the demand for new production capacity in the business sector. Capital outlays were probably also reduced by the unfavourable prices at which many types of capital equipment could be imported and the relatively high cost of finance.


The decline in final demand and the slight acceleration in domestic production contributed to a fairly significant increase in inventory levels. Industrial and commercial inventories declined slightly in proportion to the increase in output outside the agricultural sector, but elsewhere inventories were accumulated, giving the impression that stockbuilding might have been largely unplanned or involuntary. The net investment in inventories in the second quarter of 1999 — the first of its kind in ten quarters — was sufficient to turn the decline in total final demand into a strong rise in gross domestic expenditure.


A positive development in the first half of 1999 was an improvement in the gross saving ratio of the South African economy. If the steady rise in domestic saving could be sustained in the quarters ahead, this might strengthen overall fixed capital formation and economic performance in general. The corporate sector is nevertheless struggling to sustain historical saving ratios as growth in operating surpluses per unit of output has been gradually slowing since about 1995.

The slow growth in output during 1998 and the first half of 1999 was associated with weak demand for labour and declining employment levels in the formal sectors of the economy. The unemployment rate, judged by changes in the official employment statistics for the formal sectors of the economy, has probably increased in line with the weaker than expected growth in the economy. Productivity growth lost some of its capacity to contain inflationary pressures.


The value of merchandise and net gold exports declined in the second quarter of 1999 as some hesitancy occurred in the external demand for metals and minerals produced in South Africa. At the same time, the strengthening of aggregate domestic expenditure, particularly the accumulation of inventories, created a demand for imported goods, causing the value of merchandise imports to rise slightly. The consequent weakening of the trade account was countered somewhat by a slight improvement in net payments for services (including income of production factors and current transfers), but the current-account balance was still turned around from a surplus in the first quarter of 1999 to a small deficit in the second quarter.


The consolidation in the international financial markets led to an improvement in the financial account of South Africa with the rest of the world in the first half of 1999. Foreign direct investment into South Africa, which had briefly turned into net disinvestment in the fourth quarter of 1998, increased further in the second quarter of 1999. Attractive yields in the domestic bond market, the relative strength of the rand in the first half of 1999, and the need to diversify emerging-market portfolios continued to encourage strong inflows of portfolio capital into the economy.


Despite continued foreign asset accumulation by South African companies and individuals, a sizeable surplus was recorded on the financial account with the rest of the world, which also translated into an overall surplus on the balance of payments during the second quarter of 1999. The net international reserve holdings of the country accordingly improved further. Under these favourable conditions the exchange value of the rand held up well and even appreciated somewhat over the second quarter. The economy's vulnerability to exchange rate shocks was further diminished by a substantial reduction in the net open position in foreign currency of the Reserve Bank.


The broad monetary aggregate (M3) expanded relatively slowly during the first seven months of 1999. Year-on-year growth in the M3 money supply remained in the lower half of the 6 to 10 per cent guideline range indicated by the Reserve Bank as acceptable monetary growth in the medium term. The growth in M3 was partly held back by a rise in the income velocity of circulation of the broad money supply. Private households and businesses seemed to have allocated an increased share of their saving flows to equities and non-depository type interest-bearing assets, and reduced their net bank indebtedness.


The growth in the private banking sector's assets slowed down too, mainly due to a deceleration in the growth in their claims on the domestic non-bank private sector. The growth in the demand for credit by the private sector decelerated because of households' weak spending on durable consumer goods, and declines in the business sector's fixed capital formation. Weakness in the demand for working capital by the corporate sector and the shifting of trade financing from domestic to offshore sources of credit when the rand strengthened against the US dollar in the second quarter, could also have contributed to the slowdown in the banks' claims on the domestic private sector. In the aggregate, the growth in credit demand by the private household sector slowed down considerably more than the growth in the corporate sector's demand for credit.


Liquidity conditions in the money market tightened considerably in the second quarter of 1999 as the Reserve Bank drained liquidity from the market in order to raise the private banks' dependency on central bank money. Declining overall consumer price inflation and a greater sense of stability in the financial markets nevertheless created circumstances conducive to declining money market rates. The Reserve Bank endorsed the downward movement of short-term interest rates and at times even encouraged an acceleration in the speed of decline in the rate on repurchase agreements. The yield curve consequently assumed a fairly steep positive inclination over shorter maturities, but remained rather flat over maturities beyond three years. The positive slope of the curve inside the five-year interval could indicate expectations of an imminent decline in inflation, whereas the horizontal slope in the area beyond five years may indicate some scepticism about a sustained move towards lower inflation in the long term.


Bond yields generally moved in a narrow range around a steadily rising trend from the beginning of the second quarter of 1999. Yields responded, among other things, to the market's perceptions of the likely impact of foreign economic difficulties on the domestic financial markets, changes in interest rates in the United States, the fall in the gold price and the gradual accumulation of domestic inflationary pressures. Investor sentiment was more positive in the share market where prices rose over the first seven months of 1999. The prices of gold-mining shares, by contrast, remained under downward pressure as central banks and international organisations indicated their intentions to sell gold from their international reserve holdings.


The primary bond market was still dominated by public-sector organisations. Virtually all capital raised in the first half of 1999 through issues of fixed-interest securities was intended for the financing of public-sector organisations. When private-sector companies wished to raise capital in the primary markets, their activities were almost exclusively confined to the equity market.


The high levels of activity in the securities markets extended to the formal derivatives markets and the turnover of options and futures contracts in the formal markets remained lively. Activity in the real-estate market, which had been severely affected by the financial turbulence of 1998, recovered slightly from the low levels of the first quarter of 1999, but was still much more subdued than activity in 1997 and the early months of 1998.


The increase in national government expenditure in the first four months of fiscal 1999/2000 was about on a par with the increase envisaged in the Budget for the full fiscal year. At the same time, national government revenue ran well ahead of budgetary projections. At this early stage of the fiscal year, prospects are good that government will meet, or be well within, the declared deficit objective for the full fiscal year. At the level of provincial governments, surpluses on the financial accounts are being maintained, albeit at a somewhat lower level than in the first three months of the 1998/99 fiscal year.


Furthermore, the consolidation of fiscal discipline at national and provincial government levels would be extended to include local authorities.

Sound fiscal and monetary policies have contributed to the relatively rapid improvement in overall economic performance after the financial turbulence of 1998. Budgetary restraint at national and provincial government levels has helped to improve domestic saving and permitted the monetary authorities to reduce interest rates to lower levels than would otherwise have been possible.


This policy mix, and sustained progress towards lower inflation, will in due course foster clear price signals, more efficient utilisation of productive resources, strong business investment and significant advances in employment, productivity and real compensation of employees.