DR C.L. STALS, GOVERNOR OF THE SOUTH AFRICAN RESERVE BANK, AT THE SEVENTY-SIXTH ORDINARY GENERAL MEETING OF SHAREHOLDERS OF THE BANK, 27 AUGUST 1996-08-27  1. INTRODUCTIONIn last year's Chairman's Address, the attention was focused on monetary policy and net foreign capital movements. The following warning notes were then sounded about the large capital inflows experienced at that time. The net capital inflow in excess of the current account deficit exerted upward pressure on the exchange rate of the rand and reduced the international competitiveness of the domestic economy. A sudden reduction in the capital inflow would demand painful adjustments and cause major disruptions.The overall balance of payments surplus created surplus liquidity in the banking system and stimulated an undesirable and excessive expansion in domestic credit extension.The inflows concealed underlying structural weaknesses of the economy.The large net capital inflow destabilised the domestic financial system and reduced the reliability of indicators such as the money supply aggregates, money market shortages, short-term interest rates and the yield curve as a basis for monetary policy decisions.In retrospect, these warnings proved to be very timely. The most important change in the macroeconomic scene over the past year was the substantial decline since February 1996 in the total net capital inflow from abroad. This sudden deceleration changed the overall balance of payments position, the foreign exchange market, the domestic financial situation, the local business mood as well as foreign investors' assessment of South Africa as an emerging market economy where sound high-yielding investments could be made.The smaller net capital inflow from February 1996 onwards led to an overreaction in the foreign exchange market, and triggered a downward adjustment in the exchange rate of the rand which continued with intermittent pauses during the subsequent six months. From the middle of February 1996 to the middle of August 1996 the average weighted value of the rand against a basket of currencies of South Africa's major trading partners depreciated by 20 per cent. At this juncture, it continues to need coolheadedness from both policy makers and currency traders to restore stability to the foreign exchange market.Not only the external economic relations of South Africa, but also domestic economic activity changed significantly from 1995 to the first half of 1996. Although the rate of overall real economic expansion has been retained at last year's level of about 3½ per cent, the primary sectors of production, and particularly agriculture and non-gold mining, have since replaced manufacturing and the services sectors as the prime movers of the economy.The growth in overall expenditure, however, continues to outpace growth in total production with the result that large imports of goods and services are required to maintain equilibrium between overall demand and supply. The current account of the balance of payments therefore remains in deficit and, in light of the decline in the net capital inflow, it has now become a matter of concern from a macroeconomic policy point of view.The maintenance of the expansion in domestic demand continues to depend heavily on the extension of more bank credit which not only contributes to an unacceptably high rate of increase in the money supply, but also leads the country towards an untenable debt position where an unduly high share of the current income of both government and households will be claimed for debt servicing. This dangerous prospect holds a serious warning for the banking sector to apply greater caution in their lending operations. It also dictates the need to continue with a restrictive overall monetary policy. Despite growing pressure from different sources for the relaxation of monetary policy, the Reserve Bank, in the interests of medium-term financial stability and longer-term sustainable economic growth and development, must persist on its current course of responsible monetary restraint. RECENT ECONOMIC D