1. Introduction

Investor confidence is based on many unquantifiable concepts such as stability, security, credibility, consistency and success. These perceptions apply not only to the economy of a country, but also to the political, social and cultural environment in which the investor has to operate.

Monetary policy is but one element of total economic policy, albeit a very important component of the total macro-economic strategy. As such, sound and good monetary policy on its own cannot guarantee new investment, neither by domestic nor by foreign investors. Sound monetary policy is, however, an important precondition for investor confidence.

The main objective of the South African monetary policy is to secure overall financial stability. The goal of monetary policy is therefore not an end in itself, but rather an intermediate objective intended to provide a financial environment that will be conducive to the attainment of the ultimate objective of optimum economic growth and development. The best contribution monetary policy can make towards the achievement of this final goal is to provide a stable financial environment. The ultimate measure of overall financial stability is a low (or should it be a zero?) rate of inflation. The task of monetary policy therefore is to protect the value of the currency, and to work against inflation all the time.

2. The South African record of inflation

South Africa's record on inflation is not that good. For a long period of time, that is from 1974 to 1992, the rate of inflation stayed in the double digit range, with an average annual rate of increase in the consumer price index of about 14 per cent. In both 1993 and 1994, however, the rate of inflation declined to slightly below the level of 10 per cent, with average prices rising by 9,7 per cent in 1993 and by 9 per cent in 1994. Over the twelve months ending in July 1995, average consumer prices again rose by 9 per cent.

There is some misplaced complacency now in South Africa that this is good enough. It is argued that, as long as the rate of inflation can be constrained to below 10 per cent, it will be sufficient. This view is partly based on the generally discredited perception of a socalled "trade-off" that is presumed to exist between inflation and growth. It is even believed by some of the proponents of this approach that a little bit of inflation may be good for growth. Empirical results throughout the world refute this belief. There is overwhelming evidence that, over the longer term, countries with low rates of inflation achieve better results with economic growth and development than countries with high inflation. The trade-off theory may have had more validity in the decades of the sixties and early seventies when exchange rates were fixed in terms of the Bretton Woods System, and inter-national capital flows were much smaller. Today, the principle of rational expectations supported by sophisticated forecasting methods based on electronic data processing techniques lead to much quicker reactions in markets, and in market prices.

Over the past year, there were some threatening signals that inflation in South Africa was creeping up again into the double digit range. After bottoming out at a level of 7,1 per cent in April 1994, the rate of increase in consumer prices accelerated again to 11 per cent in April 1995. Since then it has, fortunately, receded again to 9 per cent over the twelve months up to July 1995.

The battle against inflation has clearly not yet been won. The slightest relaxation in the vigil of monetary policy against this evil leads to quick revival, and to the resurfacing of the many underlying inflationary pressures still present in the system. This was proven over the past eighteen months when some lax monetary policies allowed the rates of increase in the amount of bank credit extension and in the money supply to accelerate again to an untenable level of between 15 and 20 per cent.

A high and increasing rate of inflation in South Africa obviously holds many risks for the investor, particularly for those investors, be they resident or non-resident, acquiring South African assets with values denominated in rand. In an environment of rising inflation, the investor will demand an additional compensation in the form of a risk premium built into the yield on his investment. Higher inflation therefore not only demands higher nominal interest rates, but also higher real rates.

To inspire more investor confidence, South Africa must therefore continue to work against inflation. After the success of the last few years in establishing a new base of just below 10 per cent for the rate of inflation, a next major and concerted effort is now required to push it down even further. It must be regarded as a national objective in the next phase to bring the average rate of inflation down to a level more or less in line with the average experienced in the major trading partners and competitors of South Africa. That will require inflation of below the 5 per cent level -- an objective which is not unrealistic, but will require active support from Government, organised business and commerce, trade unions and the general public. The Reserve Bank is determined and ready to lead the way.

3. Changes in the money supply

The continued usefulness of the money supply as an anchor for monetary policy is open to doubt. Quite a few countries in the world that previously used this model for monetary policy has since abolished money supply targeting and switched to some other basis such as the exchange rate, the level of interest rates or domestic credit extension for their monetary policy decisions. So far, the South African experience with money supply targeting has been relatively rewarding. In 1988, when the M3 money supply was rising at a rate of more than 27 per cent,the rate of inflation was almost 16 per cent (over the twelve months up to June 1989). The rate of increase in the money supply was then gradually reduced to only 8 per cent in 1992 and 7 per cent in 1993. As already mentioned, the rate of inflation declined to below 10 per cent for the first time in more than twenty years in 1993, and stayed at this lower level throughout 1994.

It would therefore seem as if changes in the money supply had some effect, with an explicit time-lag of more than twelve months, on changes in the rate of inflation. It must still be seen whether this relationship will continue to hold in the new environment with a greater exposure for the South African economy to international capital movements, and to developments in the global economy.

In particular, the relatively large increase of about 16 per cent in the M3 money supply over the twelve months up to July 1995, signals some danger for inflation in 1996. On this occasion, different from past experience, a large net inflow of capital from the rest of the world, which partly ended up in an increase in the net foreign reserves of the Reserve Bank, contributed to the increase in the money market liquidity, and also in the money supply. Will this perhaps have a different impact on inflation?

The Reserve Bank's monetary policy model is, however, not a rigid money rule. Full discretion remains with the Bank on the application of the operational instruments of monetary policy such as open market operations, discount window activity and changes in minimum cash reserves of banking institutions. The Bank is also not only guided by changes in the money supply, but also by other factors such as the rate of increase in the total amount of private sector indebtedness to the banking sector.

Referring again to the unstable financial conditions of the late 1980's, total bank credit extended to the private sector increased by almost 30 per cent in 1988, but then gradually subsided to 8,7 per cent in 1992 and 9,7 per cent in 1993, just before inflation on its downward trend broke through the magical 10 per cent barrier. Bank credit extension to the private sector remains one of the main sources of money creation, and efforts to keep the growth in the money supply in check must therefore also be directed towards controlling the rate of increase in total bank lending.

This requirement introduces the Reserve Bank's interest rate policy into the model. The demand for bank credit is to an important extent interest rate driven, and a high level of interest rates provides one of the most portent discouragements to borrowing from the banking sector. It is for this reason that the Reserve Bank endorsed and even encouraged the rising trend in interest rates over the past year when the total amount of bank credit extended to the private sector rose by almost 20 per cent. The Reserve Bank raised its Bank rate on three occasions from 12 per cent in September 1994 to 15 per cent at the end of June 1995. Most of the more market related short-term interest rates also rose by between 3 and 4 percentage points over the past year. The Reserve Bank is at this stage firmly committed to a more restrictive monetary policy, and is determined to bring the rates of increase in both the money supply and in bank credit extension back into line with its consistent programme for overall financial stability. It is questionable whether measures taken so far will be sufficient to achieve this objective -- if not, more restrictive measures will have to be applied in the months ahead. If South Africa wants to retain the confidence of investors, the country will have to maintain a relatively stable overall financial environment.

4. The exchange rate and the management of the foreign reserves

South Africa has no predetermined target for the exchange rate. A floating exchange rate regime was adopted by Government after the demise of the Bretton Woods system of fixed par values and the Reserve Bank has a mandate to intervene in the foreign exchange market at its discretion, mainly to smooth out short-term fluctuations. The exchange rate is determined primarily by a number of authorised foreign exchange dealers operating in a market where the total average daily gross turnover now exceeds US $6 billion. All the activities in this market, including the determination of the exchange rate, take place under the umbrella of the remaining exchange controls applicable to the outward investment of all South African residents. The level of the exchange rate is therefore affected by these direct controls, which will hopefully gradually be removed in future.

Over the past two years, the Reserve Bank intervened quite heavily in the foreign exchange market, first by selling foreign exchange to the market when large capital outflows exerted downward pressure on the exchange rate, and then, from the middle of 1994, by buying foreign exchange when the capital outflows were reversed and large amounts of particularly short-term money flowed into the country. The result was that the Reserve Bank's net gold and foreign exchange reserves declined by R9,6 billion from the end of 1992 up to the end of April 1994, and then increased again by R9,9 billion in the subsequent 16 months up to the end of August 1995.

Despite this intervention by the Reserve Bank, the effective nominal exchange rate of the rand against a basket of the currencies of South Africa's major trading partners depreciated by 14,4 per cent from the end of 1992 up to the end of April 1994, and by a further 6,2 per cent from the end of April 1994 up to the end of August 1995. Were it not for the Bank's intervention, the depreciation would have been much more severe in the first period, and there would have been some appreciation in the second. The Bank's actions therefore at least contributed to a more stable exchange rate over the period as a whole.

Even after an increase of more than R10 billion over the past year, the level of the country's total foreign reserves, now estimated at about R15 billion, is still uncomfortably low. At this level it is indeed sufficient to cover only about six weeks' imports. It therefore still remains an important priority of monetary policy to increase the foreign reserves to a more satisfactory level.

5. Foreign exchange control policy

South Africa has no restrictive exchange controls on current account transactions and complies fully with the Article VIII requirements of the International Monetary Fund. Over the past few years, the Debt Standstill Arrangements of 1985 were finally renegotiated and the financial rand system was terminated to remove all the remaining exchange controls on non-residents.

As far as residents are concerned, the Reserve Bank, acting as the agent for the Minister of Finance, has for some years now applied a more flexible policy for the outward direct investment by South African corporates. Since June this year, the mandate to the Bank was also extended to enable South African institutional investors to make portfolio investments outside of the country. This new programme started off with a scheme for the exchange of South African assets for foreign assets by institutional investors, with the intention to make some further concessions if permitted by further improvements in the overall balance of payments position and in the foreign reserves.

The Reserve Bank has also recently started to reduce its support for the forward foreign exchange market. It is the intention that the private banks in South Africa will gradually take over the function of providing forward cover for both buyers and sellers of foreign exchange on a forward basis.

The Minister of Finance and the Reserve Bank are in agreement that the remaining exchange controls should be lifted, but only on a gradual and step-by-step basis. The lifting of the exchange controls should not lead to any serious disturbances in the overall financial situation, which we regard as of prime importance for the encouragement of foreign investment in the country.

6. Concluding remarks

The main objective of monetary policy is therefore to maintain overall financial stability. This is the best contribution that monetary policy can make towards the encouragement of Investor Confidence in South Africa.

The experience of the past decade provides sufficient evidence to believe that the Reserve Bank's monetary policy model, anchored to changes in the M3 money supply, still serves to achieve the objective of overall financial stability. We should therefore not try to fix something that is not broken. The Bank is, however, conscious of the major changes in the financial markets, particularly because of South Africa's reintegration into the international financial markets. This will be further enhanced by the removal of the remaining exchange controls. A more pragmatic approach with a greater degree of discretion may therefore be required with the implementation of monetary policy during this transition period. The main objective must, however, remain to preserve overall financial stability, that is to reduce inflation further from whatever level it may achieve.