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The US Federal Reserve System has lowered official short-term interest rates on seven occasions over the past eight months – one of the most aggressive easings in monetary policy in history. Yet the latest releases of economic statistics still paint a mixed picture. The US economy may still avoid moving into a period of declining output, but hopes of a quick rebound have faded. Simultaneously, a weaker American economy, together with declines in international crude oil prices from earlier peaks, have reduced the risk of inflationary pressures worldwide.


Growth prospects weakened in several emerging-market economies and some of them experienced serious financial crises in the first half of 2001. Turkey, Argentina and Brazil had to take stern measures to stabilise their financial systems and to limit the spread of their problems to other economies. Argentina implemented an austerity fiscal package in order to balance the national budget. In all three countries the International Monetary Fund played a role by offering policy advice and by making additional resources available under the existing standby facilities.


The weakening of the international economy contributed to a slowdown in output growth in South Africa during the first quarter of 2001. But unlike the slowdown in global economic activity which apparently intensified in the second quarter of 2001, growth in the domestic economy picked up from an annualised rate of 2 per cent in the first quarter of 2001 to 2½ per cent in the second quarter. The resilience of the South African economy in the first half of 2001 could be attributed, among other things, to the flexibility of the exchange rate of the rand and the fact that the potential benefits of the recent depreciation of the rand were not eroded by higher inflation as so often happened in the past.


Domestic real final demand remained relatively buoyant in the second quarter of 2001, even though growth in final consumption expenditure and fixed capital formation slowed down somewhat. By contrast, inventory investment fell sharply, forcing real gross domestic expenditure in the second quarter of 2001 to fall too. The decline in inventory levels might well be an indication that domestic producers feel less confident about the strength of future growth in aggregate income and demand.


The domestic saving ratio declined in the second quarter of 2001, mainly because of weaker saving by the corporate sector. Despite an appreciable increase in the share of operating surpluses in total factor income, companies preferred to step up their dividend payments rather than retaining profits in the firm. To a certain extent, this corporate behaviour could have been a reflection of available excess capacity in the domestic economy.


The long-term decline in employment in the non-agricultural formal sectors of the economy continued in the first quarter of 2001. Partly reflecting this pattern of utilisation of available labour resources, wages in the private sector continued to increase at modest rates in the first quarter of 2001. Moderate wage increases, combined with strong productivity growth which is also partly related to the reduction in employment, resulted in a further slowdown in the growth of nominal unit labour cost. In the medium to longer term this may contribute to an improvement in the international competitiveness of domestic producers, and consequently to stronger growth in exports, employment and the economy in general.


The slower growth in nominal unit labour cost together with lower international oil prices were reflected in lower year-on-year price inflation in the first half of 2001. Price pressures at the production level have started easing in recent months and consumer price inflation has also started declining. However, there were signs of an acceleration in endogenously generated inflation from the first quarter of 2001 to the second quarter. For example, production prices of domestically produced goods and the prices of non-food consumer goods rose more rapidly in the second quarter of 2001 than in the first quarter. The growth in overall inflation indicators was curbed mainly by smaller increases in the prices of imported goods and a decisive slowdown in the prices of consumer services.


The current account of the balance of payments, which moved into a surplus in the fourth quarter of 2000, fared reasonably well in the second quarter of 2001, despite the slowdown in the international economy. Merchandise export volumes recovered somewhat from the slight weakness of the first quarter of 2001 and, bolstered by the domestic price-raising effect of the depreciation of the rand, overall nominal export earnings increased quite impressively.


The increase in import prices that followed the depreciation of the rand over the past two years, helped by a decline in inventory investment, discouraged the importation of goods into the country and reinforced the trade surplus in the second quarter of 2001. This healthier trade balance was offset by a considerably higher deficit on the services and income account, essentially reflecting the steady accumulation over the past eight years of non-residents' ownership of shares in domestic companies. As a consequence, the surplus on the current account of the balance of payments fell back slightly in the second quarter of 2001.


The restructuring of the corporate relationship between De Beers and the Anglo American Corporation contributed materially to a surplus on the external financial account of the country. The international reserves of the country strengthened further, but despite these favourable conditions the rand remained under persistent downward pressure, largely owing to non-economic factors originating outside the country. Nonetheless, the flexibility of the exchange rate has contributed appreciably to the recent strengthening of the current-account balance at a time when the international economy has been losing its growth momentum.


Confident that inflation prospects would not be jeopardised by an upturn in the growth of aggregate demand in the second half of 2001 and in 2002, the Reserve Bank lowered its interest rate on repurchase transactions by 100 basis points in June 2001. This step brought the repurchase rate down to 11 per cent and the prime lending rate of the private banks to 13,50 per cent – the lowest rate since March 1986. A one-off administrative adjustment to the margin between the Reserve Bank's repurchase rate and the interbank call rate was made by lowering the rate on repurchase transactions further by 100 basis points. This adjustment was made purely for operational purposes and was not meant as a change in monetary policy. All of these rate adjustments were consistent with the policy objective of lowering inflation to within the upper region of the 3 to 6 per cent target range in 2002.


Since the introduction of inflation targeting, the growth in M3 has no longer been used as an intermediate target for monetary policy purposes. Nevertheless, money supply and credit continue to provide useful information about prospective spending plans and inflationary pressures. Recent trends have been encouraging. M3 growth has accelerated noticeably, but this was largely a result of strong growth in longer-term deposits. This might have been influenced more by fears of losses on equity investments than by intentions to spend in the future.


Bank credit extension to the private sector also continued to rise briskly. The greater part of this credit expansion was extended to the corporate sector where fixed capital formation, which lays the foundation for future economic growth, has been growing at a solid pace over the past year. The smaller part of credit extension to the private sector reflected a reasonably buoyant consumer demand. The net claims of the banking sector on the government sector declined quite sharply in the first half of 2001, slowing down the growth in total bank credit extension to a very low rate.


The secondary bond market has continued to perform well in 2001 and yields have fallen by about 220 basis points from December 2000 to August 2001. Unlike previous rallies in the bond market, the declines in bond yields during 2000 and 2001 were mainly driven by domestic institutional and other investors. Non-residents have continued to sell bonds on a net basis in the domestic market in the first eight months of 2001.


Sound macroeconomic fundamentals, coupled with the well-regulated environment in which the domestic markets operate, probably contributed most to a substantial decline in the sovereign risk premium on South African government debt. Furthermore, the inflation-adjusted yield on long-term bonds has declined to its lowest level since 1994. Short-term interest rates broadly followed the repurchase rate of the Reserve Bank downwards in June 2001, but when the repurchase rate was lowered as part of the changes made to the functioning of the money-market refinancing system, other short-term rates remained unaffected.


The repurchase-based refinancing system in the money market was introduced in March 1998 when it replaced the old system which allowed for overnight borrowing by private-sector banks from the Reserve Bank at a pre-announced fixed Bank rate. Under the repurchase system, the Reserve Bank announced the maximum amount of funds available each day and banks had to bid for those funds, effectively determining the cost of central bank borrowing at the auction.


Although the system worked reasonably well, a number of shortcomings became apparent. To eliminate these inefficiencies, some modifications to the system were proposed after in-depth research and widespread consultation with domestic money-market participants and experts at other central banks and multilateral agencies. Among these changes was the partial closing of the margin between the repurchase rate and the interbank call rate. As indicated above, money-market interest rates were left unaffected by this adjustment.


The decline in yields in the bond market was influenced by steadily waning inflation expectations and also by a decline in the supply of public-sector fixed-interest securities. As the overall public-sector borrowing requirement was under control and government gave preference to funding in the international capital markets, and in addition more funds were expected to be released by the scheduled restructuring of government assets, there were excess funds available in the domestic debt market. Bond prices were bid higher and so the cost of funds declined below banks' lending rates, causing activity in the primary corporate bond market to pick up. Cash holdings of non-bank financial intermediaries also increased appreciably.


The uncertainty about growth prospects together with the recent volatility in share price movements dampened the demand for new capital in the market for equity issues. In the secondary share market, activity was bolstered by the De Beers/Anglo American transaction. Share prices generally rose by about 8 per cent in the first eight months of 2001, underpinned by the strong performance of gold-mining shares, but they were simultaneously held back by a decline of 64 per cent in the prices of information-technology shares.


The increase in real-estate prices started to slow down in the first half of 2001. This may weigh down on future household final consumption expenditure, potentially dampening the business mood in coming months. By contrast, share prices may be bolstered when part of the cash overhang of non-bank financial intermediaries finds its way to the share market, counteracting the negative sentiment that may follow the rather lacklustre price movements in the property market.


The government's fiscal strategy of broadening the tax base and rationalising public spending is being implemented successfully. The budget deficit in fiscal 2000/01 undershot the initial target for the year and a healthy primary surplus was achieved on the accounts of national government. Especially among provincial governments the principles of good governance were firmly established – the aggregated net indebtedness of provincial governments to private-sector banks declined noticeably over the past year or so.


Emphasis on foreign borrowing for financing the budget deficit of national government contributed substantially to the decline in the overall cost of capital in the economy. The consolidation of public finances has now reached a stage where it is providing scope for infrastructural spending in areas such as roads, education and water supplies. The government has also reduced corporate tax rates to make South Africa a more internationally competitive investment destination.