Towards the end of 2000 the South African economy, probably because of its closer ties with the euro area, had not been seriously affected by the world economic downturn. However, by the end of the first quarter of 2001 it became clearer that the domestic economy would probably be affected adversely by the cooling down of economic activity in the big economies of the world.

The country's apparent isolation from the global slowdown ended when weaker international demand conditions affected export volumes in the first quarter of 2001. However, the fall in the value of the rand cushioned the full impact of the weakening of the global economy on the domestic economy, preventing a decline in the nominal value of exports.

The recorded decline in export volumes contributed to a slowing down in domestic economic growth from 3 per cent in the fourth quarter of 2000 to 2 per cent in the first quarter of 2001. Growth had already slowed down from 4 per cent in the third quarter of 2000 to 3 per cent in the fourth quarter, but that slowdown had essentially been restricted to the agricultural sector. In the first quarter of 2001 the weakness in the economy spread to other sectors of the economy, and the goods-producing sectors in particular were materially affected.

Aggregate domestic demand remained surprisingly strong and outstripped aggregate output in the first quarter of 2001. Consumption expenditure by households and general government continued to rise steadily, but the growth in real fixed capital formation and inventory investment accelerated, signalling a positive attitude among producers about future growth prospects for the South African economy. Unlike many previous recoveries when heightened investment activity had been concentrated in a few mega projects, growth in investment activity was spread fairly evenly over the various production sectors of the economy during this period.

There was a further shift in the distribution of income towards gross operating surpluses. Against the backdrop of slowing growth and evidence of wage moderation, it seems that some producers, at least, widened their operating margins.

Despite some improvement in gross saving, the national saving rate remained rather low in the first quarter of 2001. General government, focusing primarily on sound fiscal management and spending containment, made a positive contribution to gross saving, but the overall quantum of saving is still too low to sustain rapid growth in the medium term.

The benefits of the current recovery in domestic economic activity spread to the labour market when employment in the formal private sector, apart from agriculture, increased in the fourth quarter of 2000. This was only the third such increase in the past six years. By contrast, public-sector employment declined further as government organisations maintained their focus on decreasing the cost and improving the efficiency of public-service delivery. Regrettably, the decline in public-sector employment outweighed the small increase in employment in the private sector.

It is important to note that shrinking employment in the formal sectors of the economy does not necessarily imply a corresponding increase in the number of unemployed people. Some of those who are no longer employed in the formal sectors will have found work or created employment in the informal sector or in industries not captured in the employment statistics.

The growing under-utilisation of labour resources is steadily compressing a rise in the cost of labour. Salary and wage increases in the private sector during 2000 fell to rates last seen some thirty years ago. At the same time, the growth in productivity was at an exceptionally high level, in part due to the shedding of labour in the formal sectors and because of efficiency-enhancing investments in the business sector. Wage moderation and robust productivity gains jointly reduced growth in unit labour costs, especially in the manufacturing sector, to levels consistent with very low price inflation.

The relative stability of unit labour costs more than offset the upward price pressures emanating from the depreciation of the rand and high international petroleum prices. Quarter-to-quarter CPIX inflation fell to 6,1 per cent in the first quarter of 2001. Year-on-year CPIX inflation, which has to attain a level of below 6 per cent on average in 2002 in order to meet the inflation target set by government, fell by 150 basis points from August 2000 to April 2001, but was still some 70 basis points higher than the upper end of the inflation target range.

Furthermore, there are still some inflationary processes at work in the economy which may disrupt the gradual downward movement to lower inflation levels. For example, a consistently strong recovery in aggregate demand may disturb the current balance between aggregate supply and demand, and this together with stubborn administered prices would give fresh impetus to a rise in the currently waning inflationary process.

Demand for imports remained solid, reflecting the underlying strength of growth in gross domestic expenditure. But in this instance the pricing effects of the depreciation of the rand helped to avoid excessive growth in the volume of merchandise imports. Payments for imported goods rose somewhat but an abrupt fall in dividend payments to the rest of the world, ensured that the current account of the balance of payments remained decisively in surplus.

Financial flows continued to leave the economy on a net basis. There was some inward foreign direct and portfolio investment as foreign firms and investors bought into South African companies, but these were effectively swamped by an outflow of funds committed by resident economic entities to the accumulation of assets offshore. In the end, the country's net international reserves declined slightly, largely explaining the generally weaker exchange rate of the rand during the first quarter of 2001. Over the past eighteen months or so, the depreciation of the rand has exceeded by a substantial margin the inflation differential between South Africa and its major trading-partner countries, boosting the competitiveness of domestic producers in export markets.

Broad money growth accelerated quite noticeably in the first quarter of 2001, reflecting the relative strength in aggregate nominal domestic demand. By contrast, aggregate domestic credit extension by banks slowed down, especially banks' claims on the private business sector, which eased from the high levels recorded in the fourth quarter of 2000. But there were signs of renewed vigour in private households' demand for bank credit, and mostly for asset-backed lending such as mortgage financing, leasing and instalment sales financing.

The Monetary Policy Committee of the Reserve Bank decided to keep the Bank's official rate on repurchase transactions unchanged at 12 per cent throughout the first five months of 2001. The official rate was last raised by 25 basis points in October 2000. Other money-market interest rates broadly moved in tandem with the repurchase rate and similarly displayed a fair degree of stability over the past quarter. Nine-month interest-rate futures contracts have recently signalled that markets now expect the official repurchase rate to fall later in the year.

Long-term interest rates, measured by rates at the ten-year horizon, generally fell during 1999 and 2000, with further reductions since the beginning of 2001. Also, estimates of long real yields fell virtually in tandem, reflecting an improved outlook for the balance between domestic saving and investment.

Prominent among the reasons behind the steady decline in real long-term interest rates is the decline in the public-sector borrowing requirement over the past seven years or so. The reduction in the market for bond financing by the public sector was only partly filled by corporate borrowing. The demand for equity financing dwindled too in the early months of 2001, adding further to the better balance between aggregate saving and investment.

Price developments in the international securities markets, especially in the markets for equities, influenced the movements in prices on the JSE Securities Exchange SA. Fairly volatile price movements in the international markets were reflected in domestic share price movements. Non-residents participated eagerly in these lively trading conditions, pushing their share in total turnover on the domestic equity market to 40 per cent in the first few months of 2001 from an average of less than 30 per cent in 2000. Simultaneously, investors increasingly sought protection against capricious market behaviour, and turnover in the derivatives market boomed in the first quarter of 2001.

Sound management at the macro level continued to characterise the public finances during the 2000/01 fiscal year. Actual expenditure by national government for the full fiscal year was very close to the spending total projected by the Minister of Finance in February 2000. National government revenue, once again, exceeded earlier expectations by a considerable margin, reducing the absolute size of the budget deficit to a level well below that which had been expected when the original budget proposals were presented to Parliament. Growth in public-debt servicing costs was also well contained and the primary surplus of national government (i.e. the fiscal balance recalculated by excluding interest expenses) increased relative to gross domestic product, effectively allaying any lingering fears that public finances might become caught in a debt trap.

Overall there are grounds for optimism about the future growth prospects of the South African economy. Reasons for optimism are that

• the economy has been in a recovery phase of the business cycle since about the third quarter of 1999, yet it has not developed any of the usual imbalances (e.g. balance-of-payments problems and renewed inflationary pressures) so typical, in the past, of economic expansions;
• inflation has been moderate and appreciably lower than during previous recoveries, as has been the growth in unit labour costs;
• the levels and growth of asset prices (equities, fixed-interest securities and real-estate) are evidently not excessive;
• the balance sheets of banks and other financial intermediaries are sound;
• the exposure of the corporate sector to external debt does not pose any serious threat;
• the financial position of the household sector is far healthier than in previous expansions and bankruptcies of individuals have fallen sharply;
• private fixed-capital formation is rising but there is apparently no danger of creating excess capacity;
• the deficit on the current account of the balance of payments was turned into a surplus, most notably by the expansion in export earnings; and
• the exchange rate of the rand has fallen to a level where domestic producers can compete aggressively in export markets.

Even though the outlook is positive, there is still the danger that a global economic slowdown could harm domestic economic activity. Inflation has abated, but is still higher than in trading-partner countries and higher than the upper end of the target range set by government for 2002. Proactive steps to minimise the risk of slower economic growth have to be carefully balanced against achieving enduringly lower inflation.