1. Macroeconomic background

The South African economy staged a remarkable recovery since the election of the Government of National Unity in April 1994. After a decade of virtual economic stagnation with average real growth of less than one per cent per year in gross domestic product, the economy rebounded strongly to expand at a seasonally adjusted annualised rate of 5,5 per cent in the second half of 1994.

In the first half of 1995, however, adverse climatic conditions reduced production in agriculture while a relatively sharp decline also occurred in gold-mining production. The result was that the total value added by the primary sector of the economy, declined by 18 per cent and the annualised rate of growth in overall production contracted to only 1 per cent. The secondary sector, however, and particularly manufacturing, continued with steady expansion and maintained overall growth of more than 5 per cent per annum. This was well supported by a continued expansion at a rate of about 3,5 per cent in the services sector.

Increased production was stimulated by robust domestic demand for goods and services as well as a further increase in the volume of merchandise exports. Private consumption expenditure has been on an expansion path for almost two years now, growing by a steady 3,5 per cent per annum. It is encouraging to note also that gross domestic fixed investment in all the major sectors of the economy, has made an important contribution to the current economic upswing. At this juncture, total gross domestic fixed investment is expanding at a rate of 8,5 per cent per annum. It is furthermore noteworthy to emphasise that current government consumption expenditure remains well constrained and has indeed in real terms declined slightly during the first half of 1995, creating more scope for continued private sector expansion.

The upsurge in domestic demand spilled over into imports with the result that the current account of the balance of payments moved into a deficit in the third quarter of 1994. Over the twelve months up to June 1995, the deficit amounted to R8 billion. In the second quarter of 1995, the current account deficit had risen to a seasonally adjusted annualised rate of R12,5 billion, equal to about 2,5 per cent of gross domestic product.

The growing current account deficit provided no foreign exchange funding problem as the net capital inflows over the past year surged to a total of more than R18 billion. Although this total capital inflow was more or less equally divided between short- and long-term funds, indications are that more medium- and long-term funds are now flowing in, particularly after international sovereign credit ratings for South Africa were established late last year and the Government and other public sector institutions re-entered the international capital markets for public issues.

With the net capital inflow exceeding the current account deficit, the official foreign reserves increased by more than R10 billion over the fifteen months from June 1994 to August 1995. At the present level of about R15 billion, the gross foreign reserves still account for only about six weeks' imports, and it remains an important policy objective to increase the foreign reserves further.

The exchange rate of the rand remained relatively stable over the past year. Against the background of rather volatile exchange rate changes amongst the currencies of the major industrial countries, the average weighted value of the rand against a basket of the currencies of South Africa's major trading partners depreciated by only 1,5 per cent from June 1994 up to August 1995. The rand remained remarkably stable after the abolition of the financial rand on 1995-03-13 and to the surprise of many observers, appreciated slightly by 1,0 per cent up to the end of September.

The improvement in overall economic conditions succeeded in reversing the downward trend in total employment in the formal sectors of the economy. During the last three quarters of 1994, total employment increased at an annual rate of 0,8 per cent. This rate of increase, however, still did not match the increase of 2,5 per cent in the economically active population last year, with the result that the number of people not employed in the formal sectors of the economy increased further. According to official statistics, no less than 43 out of every 100 economically active persons were either unemployed or involved in the informal sector in October 1994.

In order to maintain internal political and social stability, South Africa needs sustained economic growth at this higher level over the medium and longer-term. Now that a substantial part of the slack in the economy has been taken up, the prospects are good that more jobs will be created with continued steady growth in total economic activity. To achieve this objective, however, it is essential that overall financial stability shall be maintained.

2. Domestic financial developments

The expansion in real economic activity placed some pressures on the domestic financial markets, as reflected in a rising trend in interest rates. The tender rate on three-month Treasury bills, for instance, rose from 10,2 per cent in February 1994 to 12,7 per cent in December 1994 and to 14 per cent in August 1995. The monthly average yield on government stock with a maturity of ten years or more, rose by almost 5 percentage points from 12,2 per cent in January 1994 to 17 per cent in January 1995, before declining somewhat to 15,5 per cent in September 1995.

The demand for bank credit to support the rising trend in domestic expenditure, increased substantially and total bank credit extension to the private sector rose by 19,5 per cent over the twelve months ending in June 1995. Economic growth financed to an excessive extent with bank credit extension will, of course, not be sustainable in the longer term. It is fortunate that, over the past year, government succeeded in reducing its net indebtedness to the banking sector, partly offsetting the effect of the increase in credit extended to the private sector. Total bank credit extension therefore increased at a slightly lower rate of 15 per cent over the twelve months ending in June 1995.

The substantial increase in bank credit extension was the main cause of an equally unacceptably high rate of increase in the money supply. The broadly defined M3 money supply rose by 14,8 per cent over the twelve months up to the end of July 1995, which was well outside the guideline range of 6 to 10 per cent announced by the Reserve Bank at the beginning of the year as an acceptable rate of increase in the money supply over the calendar year.

Despite the substantial increase in the total amount of bank credit extended to the private sector, the banking sector remained fairly liquid, supported mainly from time to time by relatively large increases in the Reserve Bank's net foreign reserves. The extent to which South African banking institutions availed themselves of easier accessible foreign sources of finance is illustrated by the total amount of the foreign liabilities of the banking sector, including the on- lending of foreign funds to clients, which rose from R10,8 billion at the end of 1992 to R24,7 billion at the end of May 1995. South African banks are now less dependant on the discount window facilities of the central bank than during the days of the country's economic isolation, which has brought an interesting new dimension to monetary policy, and the management of the money supply.

During the course of the past year, there also developed some unwelcome new upward pressures on inflation. The rate of increase over twelve months in the production price index accelerated from 5,4 per cent in October 1993 to 11,5 per cent in April 1995 before receding again to 9,0 per cent in July 1995. The rate of increase in consumer prices likewise accelerated from a low of 7,1 per cent in April 1994 to 11,0 per cent in April 1995, before coming down again to 7,5 per cent in August 1995.

Although the expectations are that the average rate of inflation will be below 10 per cent for the third year in succession over the calendar year 1995, the underlying upward pressure on inflation remains of great concern to the Reserve Bank. The South African economy retains a strongly built-in bias towards inflation and, unless checked by the implementation of a persistent restrictive monetary policy, inflation can easily accelerate again. Just a slightly more lax approach, as applied during the difficult year of political transition in 1994, can easily lead to the re-emergence of double digit inflation, with all its adverse consequences for sustainable economic growth at an optimum level in future.

3. Restrictive monetary policy essential for sustaining financial stability

A restrictive monetary policy is seldom popular in any country. In South Africa, there are now again increasing signals of the unwillingness of particularly certain private sector pressure groups to understand, to accept and to adhere to the financial disciplines of the market economy. To give credit to the Government of National Unity, it must be admitted, however, that the pressures for unhealthy monetary stimulation at this stage, emanate mainly from the private sector, and mainly from sources with a vested interest in inflation. Within government, there is good understanding of the need for maintaining overall financial stability in support of sustainable real growth in the longer term.

Taking account of the longer-term objective of maintaining overall financial stability and, more in particular, of gradually forcing inflation down to a lower level, the Reserve Bank is, at this juncture, concerned about:

the unacceptably high rate of increase in the money supply which must, as a first priority, be guided back into the guideline range of 6 to 10 per cent expansion per annum;

the sharp increase over the past year in the total amount of bank credit extended to the private sector. There is obviously always some scope for further growth in the total amount of bank credit outstanding, but economic expansion that becomes overly dependent on the creation of more money cannot be sustainable;

the excessive amount of liquidity that remains available within the banking system. If the Reserve Bank must accumulate more foreign reserves by absorbing surplus foreign exchange from the market, more effective monetary policies, for example more aggressive open market operations, will have to be used to neutralise domestic liquidity created by the capital inflows;

the obstinate inflationary psychosis remaining within the minds, plans and projections of the South African community. South Africans, unlike the people of so many other countries, still believe in the outplayed theory of a trade-off between inflation and growth;

the rising pressure for excessive wage and salary increases. Such increases must inevitably lead to more unemployment which will be even more detrimental if it should be allowed to reach this unavoidable destination via the route of inflation; and

severe pressure on fiscal policy. Not only the deficit before borrowing in the budget, but also the level of total government expenditure as a percentage of total domestic expenditure and the total tax burden are all on the verge of increasing total inflationary pressures in the economy, particularly if allowed to increase to higher levels.

For all these reasons, monetary policy in South Africa will have to retain its present stance of a rather restrictive approach. The Reserve Bank believes that not only should the current disciplines of the market economy, and particularly the relatively high level of real rates of interest, be tolerated and endured, but, where possible, these market forces will even have to be reinforced by deliberate restrictive monetary policy actions. These will include more aggressive open market operations and, where justified by any further improvement in the overall balance of payments position, also by further relaxations of the remaining exchange controls.

4. The exchange rate policy of the Reserve Bank

The South African government has decided already in the early eighties that in the post-Bretton Woods era of fixed par values, South Africa will adhere to a floating exchange rate regime. The South African Reserve Bank, as part of its mandate from Government, has been tasked with administering the system, and with the responsibility of intervening in the foreign exchange market from time to time at its discretion.

In its intervention operations, the Reserve Bank does not fix the exchange rate, neither does it set any predetermined target or target range for what the exchange rate should be. The Bank's monetary policy model is anchored to money supply guidelines and is based on the premise that, provided reasonable overall financial stability can be maintained within the domestic economy, the exchange rate of the rand should be left to find its own level. Any intervention by the Reserve Bank should be intended only to smooth out undue short-term fluctuations in the exchange rate.

Over the past eighteen months, the Reserve Bank intervened quite heavily in the foreign exchange market, first by supplying the market with a substantial amount of foreign exchange when large net capital outflows that occurred before the election in April 1994, threatened the stability of the financial system, and, subsequent to the election, by buying a substantial amount of foreign exchange from the market when a large net capital inflow developed. The country's net gold and foreign exchange reserves accordingly declined by R12,3 billion in the fifteen months from January 1993 to May 1994, but then increased again by R10,6 billion over the twelve months from June 1994 to May 1995.

Because of the intervention by the Reserve Bank, the real exchange rate of the rand remained relatively stable over this extended period of more than two years, taken as a whole. Over the past year, however, the intervention in the foreign exchange market with the objectives of replenishing the foreign reserves and at the same time preventing the exchange rate from appreciating, clashed to some extent with the Reserve Bank's commitment to its monetary policy model, based on controlling the money supply. The more the Bank intervened in the foreign exchange market to absorb surplus foreign exchange, the more domestic liquidity was created, and the more difficult it became to restrict the growth in bank credit extension and in the money supply.

The Reserve Bank's model for monetary policy and the Government's preference for a floating exchange rate regime clearly call for only a restricted role for the Reserve Bank in the foreign exchange market. It is for this reason that the Reserve Bank has recently started to reduce its participation in the forward foreign exchange market.

The Bank will be fully satisfied if a successful domestic monetary policy will lead to the stabilisation in the value of the rand, as reflected in low or zero inflation, and if the exchange rate will then also become relatively stable to reflect the domestic financial stability. To enable normal market forces to work towards this kind of overall financial equilibrium, it will be necessary for South Africa to abolish or substantially reduce the remaining exchange controls.

5. Foreign exchange control policy

The current foreign exchange controls were introduced by South Africa since 1961, mainly to protect the domestic economy from the adverse effects of capital outflows inspired by non-economic factors. Now that South Africa's internal and international political and economic relations are being normalised again, there is general agreement that the remaining exchange controls should be removed.

At this stage South Africa has no exchange controls on current account transactions, that is on payments for goods and services, and the country complies fully with Article VIII status in terms of the Articles of Agreement of the International Monetary Fund.

On 1994-01-01, South Africa reached agreement with its foreign creditors on a final rescheduling arrangement and on the removal of all exchange control restrictions on the repayment of maturing foreign loans. On 1995-03-13, the financial rand or dual exchange rate system was terminated and South Africa now has no exchange controls on non-residents. Foreign investors are therefore completely free to introduce foreign funds in whatever form into the country and to transfer funds out of the country in the form of capital, dividends, income or profits.

It is the official attitude of the Reserve Bank and of the Minister of Finance that the remaining exchange controls, applicable to the outward investment of capital by South African residents, should be removed on a step- by-step basis, that is gradually instead of in a once only 'big bang' application. The reason for this approach of gradualism is, firstly, that the amount of the official foreign reserves was fully depleted by years of continuous net capital outflows and is still at a level that will not allow the authorities to provide meaningful assistance for a smooth transition to the new system.

Secondly, after years of restriction, large backlogs accumulated with South African investors who may now for good reason want to acquire a substantial amount of foreign assets in order to diversify some of their existing portfolios into foreign currencies. Without sufficient foreign reserves to support this demand, the conversion problem could easily create a new foreign exchange reserve crisis, to the detriment of South Africa's foreign trade and all the foreign investors who now hold about $28 billion of investments in foreign currency claims on South Africa, and in rand denominated investments in the country. A new foreign exchange liquidity crisis is the last kind of dilemma that South Africa as a re-emerging economy can risk at this juncture.

Thirdly, many distortions were created by the exchange controls of the past, for example in financial asset prices, in the exchange rate, interest rates, wages and salaries and in international competitive positions of South African producers. These distortions must be corrected but it is questionable whether it will be socially and politically tolerable to force the necessary painful adjustments on the system in a short period of time with a 'big bang' removal of all the protective and distortive exchange controls.

The approach therefore has been adopted to subdivide South African residents, for exchange control purposes, on an institutional basis in a few groups and to start relaxing the controls gradually within these groups. For a few years now, South African corporates were enabled to acquire direct investments outside of the country with the prior approval of the Exchange Control. Since the middle of 1995, institutional investors in South Africa are also granted permission under certain circumstances to make portfolio investments in foreign assets, particularly through swaps from their existing portfolios. At a later stage, the controls on private individuals and on former residents (emigrants) will hopefully also be relaxed.

The tempo at which the remaining exchange controls will be removed, will be determined mainly by developments in the overall balance of payments, and particularly in the foreign reserves position. South Africa is nevertheless determined to continue with the programme of a gradual abolition of the remaining exchange controls, but with the retention of the overriding objective of maintaining overall financial stability in both the domestic financial and in the foreign exchange markets.

Financial stability is, after all, the most important contribution that monetary policy can make towards sustainable real economic growth in the longer term.