1. Historical background

Over many years, the South African balance of payments represented a major constraint on the economic growth potential of the country. In many countries the balance of payments will emit early warning signals of an emerging overheated economy, that is, an economy that wants to expand faster than can be justified by the available resources of the country, and by the ability of the people of the country to use the resources actively for the production of the goods and services they need. In South Africa, these signals are often emitted at a relatively early stage of an economic upswing and need careful interpretation lest we shall kill a recovery phase already in the bud.

Over the decade from 1984 to 1993, persistent net capital outflows from South Africa, inspired by non-economic considerations, aggravated the normal constraint of the balance of payments. During this period, South Africa had to accommodate a total net capital outflow of more than R50 billion, which amounted on the average to about R5 billion per annum. To generate the necessary foreign exchange needed for funding this outflow, the country had to run a surplus on the current account of the balance of payments of more or less a similar amount per year over the whole ten-year period. In particular, at no time could South Africa afford any sudden upsurge in the imports of merchandise, for example machinery, from the rest of the world.

During this extended period of time, the domestic economy therefore had to be restricted to a running speed well below its real potential in order to ensure a continuous current account surplus -- domestic demand had to remain depressed to keep imports low, and, at the same time, to release as much as possible of domestic production for export.

South Africa succeeded in meeting this challenge and the aggregate surplus on the current account of the balance of payments over the ten years from 1984 to 1993 also exceeded R50 billion to match the net capital outflows. Over the ten year period as a whole, the total current surplus was slightly less than the accumulated net capital outflow with the shortfall being covered from available official foreign reserves. The process, however, depleted the net official foreign reserves of the country to a zero position in early 1994 when the Government of National Unity was elected. It also left South Africa, after a decade of low economic growth at an average rate of less than one per cent per annum, with massive unemployment.

The only advantage left to the economy by the decade of balance of payments suffering was a relatively low level of foreign debt for the country. In the middle of 1994, the foreign liabilities of South Africa denominated in foreign currencies amounted to only US $16,7 billion, equal to 14 per cent of the country's gross domestic product, and 57,0 per cent of the annual exports. These are low ratios in terms of recognised world standards, particularly if compared to the developing economies of the world.

2. The changing pattern of international economic relations

The political and social reforms of the past five years culminated in the democratic elections of April last year, and in the inauguration of the Government of National Unity in May 1994. These developments initiated the withdrawal of the international economic actions against South Africa, and led to a gradual normalisation of South Africa's international economic relations. The United Nations and all its members withdrew the economic punitive measures previously introduced, and most countries repealed the boycotts, sanctions, disinvestment and withdrawal of loans campaigns against South Africa. Over the past year, South Africa has:

re-established normal relationships with multi- national organisations such as the United Nations and the International Monetary Fund and the World Bank Group;

obtained various international credit ratings which re-opened the way for accessing the international money and capital markets;

raised a substantial amount of new funds on the international capital markets through the issue of shares, debentures and convertible notes by private corporations, and through loan issues by the Government and parastatals, either in the form of public issues or private placements and syndicated loans;

abolished the financial rand system and removed virtually all exchange controls applicable to non-residents;

committed itself to a scheduled reduction of import tariffs in an agreement with the World Trade Organisation;

joined various international regional arrangements such as the Organisation for African Unity and the Southern African Economic Development Community (SADEC); and

entered into negotiations for the establishment of new economic relationships with the European Union and the African Development Bank.

Many of these new initiatives will only hold advantages for South Africa in the longer run, but there has already flowed some real benefits to the South African economy in the form of major changes in the underlying balance of payments structure.

3. Changes in the balance of payments

The large net outflows of capital from South Africa continued throughout the first half of 1994. During the first two quarters of last year, the net capital outflow amounted to R3,7 billion, following upon a net outflow of about R15 billion in 1993.

The situation, however, changed dramatically after the Government of National Unity took over and, in the second half of last year, there occurred a total net capital inflow of almost R9 billion. In the beginning, a substantial part of the net inflow took the form of short-term capital, representing mainly short-term interbank financing arrangements and trade financing linked to import and export transactions. In the fourth quarter of 1994, however, more long-term capital in the form of loans and other financial issues boosted the capital inflow into the country. This trend was continued in the first quarter of 1995 when a further net inflow of about R5 billion was registered.

The capital inflows into the country enabled South Africa for the first time in more than ten years to accommodate a deficit on the current account of the balance of payments. A substantial rise in the country's imports of merchandise not only eliminated the surplus on the current account, but created a deficit which amounted to R2,5 billion in the second half of last year. In the fourth quarter, the gap between total imports of merchandise and services and total exports had widened to a deficit equal to a seasonally adjusted annual rate of about R7 billion, which increased further to about R8 billion in the first quarter of 1995.

The changes in the current account over the past year reflected the rising demand for goods and services in South Africa, and formed part of the cyclical upswing in total domestic economic activity. The economic growth rate escalated during the course of last year from -3,7 per cent in the first to +2 per cent in the second, +4 per cent in the third and +6 per cent in the fourth quarter.

Two components of domestic expenditure that increased particularly sharply last year, were net fixed investment, especially in manufacturing, and also investment in inventories. Both these types of investment normally have a high import content and it therefore came as no surprise that imports rose by 27½ per cent last year, and by even a higher rate in the first quarter of 1995.

The deficit that emerged on the current account so far gave no reason for concern, as it was more than adequately covered by the net capital inflows. Over the past nine months, that is since the middle of last year, the total accumulated current account deficit amounted to less than R5 billion. This was about R8 billion smaller than the cumulative net capital inflow of approximately R13 billion over the same period, with the result that the country's net foreign reserves increased to a more comfortable level over this period.

These balance of payments developments hold the promising prospect of an improvement in the longer-term economic growth potential of the country, although they provide no guarantee for permanent growth at the higher level. It should firstly be remembered that, in all market-oriented economies, economic development is a cyclical process -- periods of recovery turn into overheated economies, and eventually lead to a downturn in the business cycle, albeit in preparation for the next recovery phase.

Secondly, the balance of payments strength at this juncture is based entirely on the presumption that the net capital inflows of the past year will be sustained. With foreign reserves still at an uncomfortably low level, sufficient to cover only about six weeks' imports, South Africa cannot sustain a current account balance of payments deficit for any lengthy period of time without a simultaneous net inflow of capital into the country. And this will depend on how well we manage the South African economy. We have to compete with many other countries in the world for the scarce savings of the richer nations and, unless we can make South Africa more or, at the minimum, as attractive as many other successful emerging economies, we shall not be able to attract foreign capital for ever.

4. The new balance of payments situation and foreign exchange controls

The changed balance of payments situation not only raised the prospects for economic growth, but also created opportunities for a liberalisation of the foreign exchange market. Already by the beginning of 1994, South Africa was able to enter into a final debt rescheduling agreement with its foreign creditors on the debt affected by the 1985/86 Interim Debt Rescheduling arrangements.

This was followed by the abolition of the financial rand and dual exchange rate system in March 1995. This major step was, of course, made possible by the reversal in the net capital outflows and in the rise in the official foreign reserves over the past year. The market place indeed provided the necessary signals needed to encourage the authorities to take this final plunge.

There is a lot of pressure now on the authorities also to abolish the remaining exchange controls applicable to residents. The Reserve Bank agrees that, eventually and in the longer term, South Africa should liberalise its foreign exchange market as far as possible, and should leave the determination of both the spot and forward foreign exchange rates of the rand to be determined by market forces, unhampered by exchange controls. There is little difference of opinion on what the ultimate objective should be.

The Bank is, however, as with the abolition of the financial rand, convinced that South Africa should tread with caution on the road of exchange control liberalisation. The sequencing of events needs careful planning, and the timing of successive relaxations should be well- considered. It will not be in the interest of South Africa to take steps that will cause undue disruption in overall financial stability, neither will it be wise to introduce relaxations from which we may be forced to retract again. The Reserve Bank's approach of cautiousness is based on the presumption that we must first ensure more stability in the underlying market forces before we entrust the determination of important prices such as the exchange rate, interest rates and the prices of domestic financial assets to the market forces.

At this juncture, the Reserve Bank believes that high priority should be given to the transfer of the responsibility for the determination of forward foreign exchange rates from the Reserve Bank to the market. As a further step, we should also enable institutional investors to diversify some of their existing portfolios into foreign assets. Both these steps carry inherent risks for macro-economic financial stability that should not be underestimated. They therefore deserve careful and well-planned management, as did the extended programme of the lifting of exchange controls on non- residents.

5. The new balance of payments situation and the exchange rate of the rand

The new balance of payments situation has also created a new environment for the determination of the exchange rate of the rand. In the present situation we have an international monetary system based on:

floating exchange rates for many currencies, including the South African rand;

relatively free capital movements without exchange controls; and

a globalisation of or world-wide trend towards the integration of money and capital markets.

In this environment, exchange rates are determined in relatively free foreign exchange markets by the overall demand for and supply of foreign exchange. The old theory of purchasing power parity based on current account surpluses or deficits, is breaking down, at least in the short-term. Exchange rates are now being determined by volatile capital flows, and not by the relative competitiveness of domestic producers. In a number of countries exchange rates are appreciating despite growing deficits on the current account of the balance of payments, just because of massive capital inflows. Should the developments in the South African balance of payments over the past year be perpetuated, we may have to face a similar situation.

These developments force countries to place more emphasis on the adjustment of their domestic economies in times of disequilibrium. The solution for a country that has lost its international competitiveness, does not lie in changing its exchange rate, but rather in correcting the deficiencies of its domestic economy. It is an illusion to believe that structural shortcomings in an economy can be overcome just by changing relative prices.

It is also important that the exchange rate, and also domestic interest rates and financial asset prices, shall be sensitive to sudden large capital inflows or outflows. Efforts by central banks and governments to maintain interest rates, exchange rates or financial asset prices at artificial levels could easily lead to large-scale speculation, as Mexico experienced in 1994. In the present world financial system, speculators can easily win against authoritarian decisions -- they can never win against markets.

6. Concluding remarks

The world financial environment is changing. Markets are beginning to play a more important role in the economic decision-making process and are encroaching on the powers of central banks and of governments to take their own independent decisions. National authorities can no longer ignore the dictums and the disciplines of the global market place.

South Africa is gradually becoming one more village of the global market place. We cannot afford to ignore the dictums of the global markets where investors, lenders, creditors and bankers are looking for the tested and tried disciplines of effective financial management. More than ever before, fiscal, monetary, trade and other economic policies are now being exposed to continuous international observation. The international markets punish unsound economic policies very severely.

It will depend on us whether we can remain a net importer of foreign capital in the years to come, and whether the present economic upswing will be sustainable over a relatively long period of time. In the foreseeable future, the two will go together -- without a regular net capital inflow, South Africa will be destined to grow at a level determined by its own savings. At this juncture, such growth will not be sufficient to solve our problems of massive unemployment.