1. The objectives of monetary policy
The main objective of monetary policy in South Africa is to establish a stable financial environment in support of sustainable real economic growth over the medium and longer term. The South African Reserve Bank believes that financial stability may not provide a guarantee for economic growth, but it certainly is an important precondition for the maximum employment of the resources of the economy, including the labour force.
Although low (or even zero) inflation is regarded as the ultimate measure of financial stability, the monetary policy model in South Africa targets the intermediate objective of changes in the money supply. For this purpose, guidelines are set by the Reserve Bank at the beginning of each calendar year for an acceptable rate of growth in the M3 money supply. For 1995, guidelines of 6 to 10 per cent were decided on with the intention of providing for real growth in the economy of between 3 and 4 per cent, and the recognition of a rate of inflation of 9 per cent in 1994. The intention was therefore that monetary policy should exert further downward pressure on inflation during the course of 1995.
Money is created in South Africa mainly through the extension of credit by banking institutions. In setting guidelines for an acceptable rate of growth in the money supply, the Reserve Bank indirectly provides indicative limits for the growth in the total claims of the banking sector on the private sector or, viewed from a different angle, for the increase in the total indebtedness of the private sector to the banking sector. The monetary model as applied in South Africa therefore gives the Reserve Bank a vested interest in the total credit extension of the banking sector.
The Reserve Bank can influence the amount of bank credit extension either by influencing over-all liquidity in the banking sector, that is, by influencing the supply of credit, or by influencing the demand for credit emanating from the private sector. Liquidity in the banking sector can be influenced through various operational instruments such as changes in minimum cash reserves for banking institutions, open market-operations and short-term money market interventions through swaps and repurchase transactions.
The demand for bank credit is to an important extent interest rate driven. By influencing the general level of interest rates, the Reserve Bank can exert some influence on the total demand for credit, and therefore on the money supply. The main operational instrument in this case will normally be the Bank rate, that is the rate at which the Reserve Bank is prepared to make loans to banking institutions at the discount window.
In pursuing its money supply objectives, the Reserve Bank must of course also take account of fiscal policy, and in particular of the magnitude of the deficit before borrowing in the budget of the government sector, and in the sources used for funding the deficit. Money supply targets can easily be frustrated by inflationary financing of the budget deficit. In South Africa, good co-operation between the Reserve Bank and the Treasury is constantly on guard against this danger.
The monetary policy model is influenced in various ways by the international financial relations of the country. Changes in the gold and foreign exchange reserves have a profound influence on the liquidity of the banking sector; net inflows or outflows of capital link South African interest rates to rates in the rest of the world; and the stability of the exchange rate of the rand presents an alternative measure for the value of the currency. The Reserve Bank therefore also has a vested interest in the level of and changes in the official foreign reserves and in the exchange rate of the rand, and in changes in international interest rates, particularly in the case of countries with whom South Africa maintains close financial relationships.
This monetary policy model does not establish a rigid monetary rule for the implementation of policy in South Africa, but leaves an important degree of discretion to be applied by the authorities. The correct timing of decisions is, for example, of great importance as there are unavoidable time lags between actions and reactions of the various components of the monetary policy model. Changes in interest rates will obviously only affect changes in the amount of bank credit extension with a time lag of perhaps more than six months, and changes in the money supply could even take longer to work through to total spending and to prices.
It is also recognised that changes in the money supply as an anchor for monetary policy may lose its effectiveness as more substitutes for money are being introduced in the credit economy, and as the South African financial system becomes more integrated in global money and capital markets. The Reserve Bank therefore is now adopting a more holistic approach and regards changes in all major financial aggregates to be important indicators for its decisions on monetary policy changes. Changes in the money supply still serve as the anchor for monetary policy, but does not solely determine all policy decisions.
Overall financial conditions are therefore assessed regularly by monitoring:
changes in all the components of the money supply, ranging from M0 to M3;
the causes of the changes in the money supply (for example, the growing importance of the effect of changes in the net foreign assets of the Reserve Bank is of vital importance for taking appropriate decisions);
changes in total bank credit extended to the private sector and to government, and also the purposes for which credit is extended;
the level of interest rates, and also the structure of the yield curve, and trends in interest rates in international financial markets;
changes in the net gold and foreign exchange reserves; and
movements in the exchange rate of the rand as measured by the average weighted value of the rand against a basket of the currencies of the country's major trading partners.
It should be noted that the Reserve Bank has a predetermined target, or guidelines, for only one of these variables, and that is for the M3 money supply. If rigidly pursued, consistent and appropriate levels (or rates of change) for all the other aggregates will be determined automatically by the enforcement of the money supply guidelines. If growth in the money supply can be restricted to a rate more or less in line with growth in the real economy, inflation should over time be constrained, and the exchange rate should then also remain relatively stable. This will normally require positive real rates of interest at all times, although the level of the real rates will fluctuate, depending on the current state of underlying market conditions.
2. The importance of overall financial stability
The Reserve Bank believes that overall financial stability will:
lead to a better balance between consumption and saving that will make more resources available for investment purposes;
reduce distortions in the economy created by the inflation of the past, and by the perverse reactions of savers, consumers and investors to this fatal economic disease;
facilitate the implementation of the Reconstruction and Development Programme intended to meet the basic needs of all South Africans, as well as fostering high and sustainable economic growth; and
contribute towards an investor friendly environment that will attract foreign investors to the country.
The Reserve Bank's commitment to this monetarist approach is often criticised for being too narrow-minded or unimaginative, and not appropriate for the development needs of the new South Africa. Critics of the Bank, however, fail to consider the possible consequences of the alternative of a more expansionary monetary policy aimed more directly at the provision of more funds at lower costs for the many social and development needs of the country. Such a policy of excessive money creation will with little doubt sooner or later lead to higher inflation, with all the adverse consequences this could have for social and political stability in the country. Poverty cannot be relieved by the creation of more money.
3. Recent developments in the financial aggregates
In both 1992 and 1993 the M3 money supply increased at rates below 10 per cent per annum and remained comfortably within the guidelines set by the Reserve Bank. During the course of 1994, the rate of increase in the money supply accelerated again to exceed 15 per cent which was well above the target range of 6 to 9 per cent set for that year.
The year 1994 was an extremely difficult one for South Africa with the introduction of major political and social reforms, and with the appearance of volatile capital movements in the balance of payments. During the first half of the year, a net outflow of capital of R3,7 billion reduced the net foreign reserves by R3,2 billion. This was then followed by a net capital inflow of R8,9 billion and an increase in the foreign reserves of R6,3 billion in the second half.
In the circumstances, the choice for the monetary authorities was either to allow the exchange rate to depreciate sharply in the first half of the year, and then to tolerate a sharp appreciation in the second half, or to intervene in the foreign exchange market to stabilise the exchange rate, but then with the risk of not meeting the money supply targets. Pragmatism within the Reserve Bank in the implementation of monetary policy moved the Bank to deviate temporarily from the established model and in 1994 to pursue exchange rate stability as a first priority, instead of controlling the money supply. The Bank accordingly intervened quite heavily in the foreign exchange market, first by selling foreign exchange partly to cover the outflow of capital and then, from May onwards, by buying foreign exchange from the market.
This policy contributed to a more stable adjustment in the exchange rate of the rand but did not fix it at one level. The effective exchange rate still depreciated in nominal terms by about 12 per cent in the first seven months, and then appreciated by about 3 per cent in the last few months of the year.
As indicated above, the net gold and foreign exchange reserves declined in the first half, and then increased by more than R6 billion in the second half of last year, to be followed by a further rise of R4,2 billion in the first six months of 1995 when the depreciation of the rand was restricted to less than 4 per cent.
The Bank thus succeeded in supporting relative stability in the exchange rate of the rand over the past eighteen months, whilst at the same time increasing its net foreign reserves by more than R10 billion. In the process, however, the Bank's intervention transactions contributed to a large increase in the overall liquidity of the banking system, and to excessive increases in the money supply. The additional liquidity furthermore provided a basis for a substantial increase in the extension of bank credit to the private sector, which rose by no less than 17 per cent in 1994, and by 19,5 per cent over the twelve months up to June 1995.
A new pattern of a persistent net inflow of capital emerged after the election of the Government of National Unity in April 1994. The net inflow of R8,9 billion in the second half of last year was followed by a further net capital inflow of R9,8 billion in the first half of 1995. The persistent capital inflows enabled the Reserve Bank to re-focus the attention of monetary policy again on the control of the money supply and the Bank switched to a more restrictive stance with monetary policy late in 1994. The Bank rate was raised on three occasions from 12 per cent in September 1994 to 15 per cent in June 1995, minimum cash reserve requirements for banks were raised early in 1995 and the Reserve Bank gradually implemented more aggressive open market operations to sterilise at least part of the additional liquidity created by the capital inflows.
The increasing demand for credit and the more restrictive monetary policy contributed to relatively sharp increases in interest rates. The yield on long- term government bonds for example, rose from about 12 per cent in the beginning of 1994 to 17 per cent in January 1995.
The more restrictive monetary policy succeeded in arresting the acceleration in both the money supply and the bank credit extension to the private sector. The rate of increase in M3 peaked at 16,8 per cent in June 1995 before declining again to 15,1 per cent in August. The rate of increase in bank credit extension to the private sector also declined slightly from a peak of 19,5 per cent in June to 18,6 per cent in August 1995. The yield on long-term government stock has also come down from a peak of 17 per cent to a level of just over 15 per cent at this stage.
Against the background of the developments in the financial aggregates and the unstable conditions of 1994, the rate of inflation increased from 7,1 per cent over the twelve months up to April 1994, to 11 per cent in April 1995. Consumer prices were, however, affected to an important extent by a temporary rise in food prices and the rate of inflation subsequently declined again to 7,5 per cent in August 1995.
Although the more restrictive monetary policy stance adopted after September 1994 began to deliver the desired results in the past few months, the danger of an increase in inflation back to the double-digit range has not been fully averted. It remains a first priority of the Reserve Bank to force the growth in the M3 money supply back into the target range of 6 to 10 per cent set for 1995. Monetary policy must therefore remain relatively restrictive for the time being.
4. Monetary policy and exchange controls
As already indicated, the Reserve Bank does not set predetermined targets or guidelines for the exchange rate of the rand. The exchange rate regime decided on by the South African government since the breakdown of the fixed par value system is based on a free floating exchange rate, determined by the forces of demand and supply in the foreign exchange market, and influenced from time to time by Reserve Bank intervention. The intention of Reserve Bank intervention should only be to smooth out temporarily and reversible short-term fluctuations. In retrospect, the intervention by the Bank in 1994 was, for example, relatively successful.
The exchange rate of the rand is, however, still being determined under the umbrella of exchange controls applicable to the outward investment of capital by residents. It is the intention of the South African government gradually to remove all remaining exchange controls and good progress was made in this regard over the past eighteen months:
At the beginning of 1994, the debt standstill arrangements were terminated.
In March 1995, the financial rand system and the two-tier exchange rate for the rand was abolished.
Various concessions were made to enable South African corporates to make direct investments outside South Africa.
In June 1995, a first step was taken to enable South African institutional investors to acquire portfolio investments in foreign securities.
The Reserve Bank is now in a process of gradually withdrawing itself from the forward foreign exchange market and is encouraging the private banks to participate more actively in this market.
In the light of the relatively low level of the official foreign reserves, which now amount to about R15 billion or the equivalent of six weeks' imports, the Reserve Bank and the government remain of the opinion that a gradual abolition of the remaining exchange controls is the only responsible route to follow.
At this stage, real economic growth in South Africa is proceeding at a steady rate of 3 to 4 per cent per annum and the indications are that the more important financial aggregates such as the money supply and bank credit extension are gradually returning to more acceptable rates of growth. A deficit of more than R10 billion in the current account of the balance of payments, equal to about 2,5 per cent of gross domestic production, is being covered with a relatively large net capital inflow which is indeed large enough to permit some increase in the foreign reserves. The exchange rate has been relatively stable over the past year and inflation, after a temporary hiccup, is back to the relatively low level of about 7,5 per cent attained early in 1994.
Projections indicate that steady economic growth with financial stability and without any undue pressure on the balance of payments can be maintained throughout 1996. This should provide South Africa with the opportunity to continue with essential structural economic adjustment, such as the implementation of the Reconstruction and Development Programme and further relaxations in the exchange controls, needed to raise the economic growth potential of the country to a higher level.