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Annual Economic Report Introduction Economic activity had already been slowing down when the financial problems in Southeast Asia began to spread to South Africa in the first half of 1998. The contagion effects of the problems in Asia and the worsening economic situation in Russia confronted policy-makers in South Africa with two risks that had to be weighed against each other. On the one hand, with economic activity already slowing down and inflation expectations on the wane, there was the risk that a tightening of monetary conditions could compress domestic demand and weaken the prospects for a short-term cyclical recovery in the economy. On the other hand, the turmoil in the financial markets posed a threat to financial stability which, if not attended to, could impair the long-term growth capacity of the economy. In the end, the potential threat to financial stability and concern about the long-term well-being of the economy convinced policy-makers that steps had to be taken that would stabilise financial conditions with as little delay as possible. Interest rates accordingly rose over the full spectrum of maturities from April to August 1998. Business and consumer confidence wilted, and real output, which had been sluggish in the first half of 1998, fell in the third quarter of 1998 so that for the year as a whole, real gross domestic product rose by just ½ per cent. The downward adjustment in production volumes in the second half of 1998 was concentrated in the goods-producing or tradables industries. This slump in production had as much to do with the fall in external demand as with weak demand conditions in the domestic economy. The services sectors as a group, which are far less susceptible to changes in international trading conditions than the goods-producing industries, continued to grow throughout 1998 and the first half of 1999, albeit at a gradually slower pace. By the end of 1998 there were tentative signs that the worst of the international financial crisis was over. Economic conditions in Asia began to settle down. Output growth in that region gained some momentum and the demand for commodities and manufactured goods from South Africa picked up. As a result, real gross domestic production recovered somewhat in the fourth quarter of 1998 and increased further during the first half of 1999. There was also evidence that the downward trend in real value added by the manufacturing sector had flattened out in the first half of 1999. Despite the tightening of monetary conditions, growth in domestic final demand was fairly robust in the second half of 1998, due entirely to a surge in fixed capital formation by public corporations. All the other components of gross domestic expenditure either declined or increased at modest rates. By the first half of 1999, however, some of the expansion programmes of the public corporations had apparently run their course and aggregate real gross capital formation declined steeply, pulling real gross domestic expenditure down too. This decline in aggregate spending substantially improved the overall balance between aggregate supply and demand in the economy. The acceleration of capital spending by public corporations in 1998 lifted gross fixed capital formation as a percentage of gross domestic product to its highest level since 1991. Nonetheless, the 1998 ratio was still not high enough to raise long-term economic growth sustainably to levels which would absorb all new entrants to the labour market. The investment ratio was also below the investment rate in other fast-growing emerging-market economies. The gross saving ratio has improved slightly since the second half of 1998, mainly due to an improvement in general government finances. Household saving remained constrained by high levels of household debt and slow growth in real disposable income. Corporate saving was under pressure from slower growth in operating surpluses. Gross saving, which is meant to provide the wherewithal for capital formation, consequently remained too low to meet the growth needs of the South Afri