In the early months of 1998 there was good reason to believe that the economy was heading for a "soft landing" and that the downswing would probably not degenerate into a fully-fledged recession with a prolonged period of declining output. During the first four months of 1998 fiscal policy was consolidated further and placed on a sound footing, the growth in credit extension and money supply was slowing down, international reserves were increasing, capital market interest rates were declining, inflation was on the wane and expectations were high that interest rates would generally decline further in the second half of the year.

From about May 1998 economic developments in South Africa were adversely affected by the financial crises in Southeast Asian countries and by those that unfolded later in Russia and Latin America. When after-effects of these crises spilled over into South Africa and international portfolio capital flowed out of the domestic bond market, monetary conditions tightened rapidly. Short-term interest rates rose to high levels and this helped to preserve overall financial stability and ward off the danger of repetitive rounds of exchange rate depreciations and domestic cost and price increases.

The aftershocks of the international crisis triggered sharp declines in the interest-rate sensitive components of domestic demand, such as inventory levels, household spending on durable goods and private-sector fixed capital formation. Furthermore, the steep decline in output in the countries of Southeast Asia affected by the crises effectively reduced the demand for exports from South Africa directly, and indirectly through the impact of the decline on business conditions in the advanced economies of the world. Domestically, the downswing intensified and the real gross domestic product contracted in the third quarter of 1998 — for the first time since the first quarter of 1994.

The setback in the third quarter was nevertheless short-lived. Led by a return to positive output growth in the manufacturing sector and the continued expansion of the services sectors, overall economic growth recovered somewhat in the fourth quarter of 1998. This modest recovery was sustained in the first quarter of 1999 when aggregate gross domestic production expanded at an annualised rate of ½ per cent. Although the rate of growth was still rather muted, more of the main production sectors began to record increases in real value added.

During most of 1998, the high levels of capital spending by parastatals increased real gross domestic expenditure at a pace that exceeded overall economic growth, raising concern about the increase in external deficits. By the first quarter of 1999, however, some of the expansion programmes of the parastatals had apparently run their course and aggregate real gross capital formation declined sharply. Real consumption expenditure by private households and general government also declined and inventory levels were reduced once again.

The combined effect of the decline in real domestic spending and the small increase in output was an improvement in the domestic saving ratio in the first quarter of 1999. Gross domestic saving as a percentage of gross domestic product reached 15 per cent in the first quarter of 1999 — the highest ratio since the third quarter of 1995. This domestic saving ratio was still considered too low for sustained high rates of economic growth and employment creation.

Aggregate remuneration of labour continued to grow faster than the operating surpluses of business enterprises during 1998 and in the first quarter of 1999.

In an increasingly competitive environment, businesses experienced difficulties in recovering these additional costs through increases in their output prices. The reduction in the pricing power of businesses helped to contain production price inflation over the past three calendar quarters, but at the same time operating surpluses and therefore rates of return on invested capital came under greater pressure. However, it is not uncommon for operating surpluses to be compressed during downward phases of the business cycle when demand usually tends to be weak.

Employment in the formal sectors of the economy has been declining since 1989. This long-term decline in overall employment was aggravated by the current cyclical downswing in economic activity. In addition, government generally was committed to higher cost efficiency in public-service delivery and to this end, reduced the size of its workforce in the second half of 1998.

Nominal salaries and wages per worker in the non-agricultural sectors continued to increase in the second half of 1998. Although labour productivity increased at a fairly robust rate, this was not sufficient to prevent a more rapid rise in nominal unit labour costs during 1998. The impact of these and other cost-raising factors, such as higher agricultural prices and electricity tariffs, became discernible in a modest acceleration in the production prices of domestically produced goods in the first quarter of 1999. Overall consumer price inflation and core inflation nevertheless continued to slow down in the first quarter, signalling that the inflationary potential of the 1998 decline in the exchange value of the rand had been well contained so far.

Largely reflecting the sharp decline in gross domestic expenditure and the higher cost of imported goods, imports declined sharply in the first quarter of 1999. At the same time, exports rose strongly as the Southeast Asian economies began to recover and domestic producers expanded into export markets. These developments led to a quick transformation of the deficit on the current account into a surplus that was equivalent to about 1 per cent of gross domestic product in the first quarter of 1999.

Although net international capital flows into South Africa declined strongly during 1998, there was still a net inflow of capital into the economy for the year as a whole. A further inflow occurred in the first quarter of 1999. Net international capital inflows diminished in 1998 as inward foreign direct investment flows subsided and eventually developed into some disinvestment in the fourth quarter, while outward direct investment by South African organisations continued at a high level. Outward portfolio investment by resident institutions, mainly through the asset swap mechanism, also gathered momentum in 1998. In the first quarter of 1999, inward portfolio investment flows strengthened appreciably and there was a resumption of direct investment flows into the economy. As a consequence, there was a healthy surplus on the international capital transfer and financial account in the first quarter of 1999.

Together, the surpluses on the current and financial accounts of the balance of payments occasioned a sizeable increase in the country's international reserves. This contributed to a reduction in the net open position in foreign currency of the Reserve Bank, in this way lowering the exposure to risk that might arise from fluctuations in the exchange rate. Despite a strong increase in turnover in the market for foreign exchange, which often corresponds with exchange-rate weakness, the nominal effective exchange rate of the rand remained relatively stable during the first five months of 1999.

The growth in M3 slowed down quite perceptibly from the third quarter of 1998 as the general public reduced their liquidity preference and lengthened their expectations of a recovery in the economy. As a result the growth in M3 moved within the guideline range indicated by the Reserve Bank. The growth in bank credit extended to the private sector, particularly that to the private corporate sector, slowed down to levels far more compatible with expectations of low inflation. This positive development, from a perspective of inflation reduction, was probably a delayed response to the sharp rise in the cost of bank credit in the second and third quarters of 1998.

Money market conditions eased considerably during the first four months of 1999. Liquidity emanating from an increase in the Reserve Bank's net foreign assets and from transactions of the Bank in the forward foreign-exchange market, occasionally reduced the private banks' dependency on central bank funds to low levels. With an eye to managing changes in short-term interest rates, the Reserve Bank used various methods to drain liquidity from the market in April and May 1999.

In the second half of May 1999, the Bank also signalled that a pause in the decline of money market interest rates might be warranted as problems in Russia were once again threatening the financial stability in emerging markets and because of some nervousness in the markets ahead of the elections in South Africa. At the same time, the price of gold went into steep decline, threatening to revert the current account of the balance of payments to a deficit.

Bond yields moved decisively lower in the first three months of 1999. Pre-election nervousness, together with the weak gold price and events in other parts of the world, caused yields on long-term government bonds to move gradually higher towards the end of May 1999. Share prices strengthened, on balance, in the first four months of 1999, but fell back in May when adverse developments in the bond market echoed in the share market. Despite the price fluctuations in the bond and equity markets, non-resident investors maintained a strong presence as net buyers of bonds and shares in the domestic securities markets throughout the first five months of 1999.

Substantial progress has been made over the past fiscal year in strengthening fiscal policy by reducing the national government's budget deficit and the overall public-sector borrowing requirement. The outcome of the national government's actual deficit in fiscal 1998/99 was well below the targets indicated by the Minister of Finance when the Budget was presented to Parliament in March 1998. The public-sector borrowing requirement was reduced, equally impressively, from 9,4 per cent of gross domestic product in fiscal 1993/94 to 3,7 per cent in fiscal 1998/99, thus removing earlier concerns about unsustainable public-sector debt growth and the concomitant potential for crowding out of the private sector from the domestic capital markets.

Government's commitment to sound fiscal policy was further demonstrated by the curbing of growth in public-sector expenditure in the face of a downswing in general economic activity.

Towards the middle of 1999 a substantially better balanced macroeconomic situation has been attained. Further positive factors are that the prospects for the global economy have improved since the second half of 1998. Strong growth has continued in the United States economy and the euro area is expected to respond in due course to the easing of monetary conditions and the depreciation of the euro. The implementation of reform measures in many emerging-market economies has also strengthened global economic performance. Trends in total economic activity have turned around or appear to have bottomed out in the Southeast Asian economies and in Japan. Economic growth on the African continent is also expected to be relatively strong in 1999.

Because investor sentiment towards emerging markets generally has improved, the South African economy is likely to continue to benefit from capital flows from the mature financial markets of the world. All these hold the promise of a stronger recovery in the second half of 1999. This will probably spill over into the new millennium, resulting in a rate of economic expansion which is likely to be stronger in 2000 than in 1999.