1. Introduction

Article 3 of the South African Reserve Bank Act defines the primary objectives of the Bank as follows:

"In the exercise of its powers and the performance of its duties the Bank shall pursue as its primary objectives monetary stability and balanced economic growth in the Republic, and in order to achieve these objectives the Bank shall influence the total monetary demand in the economy through the exercise of control over the money supply and over the availability of credit".

This assignment has been repeated in Sections 195 to 197 of the South African Constitution in terms of which the Reserve Bank must protect the internal and external value of the rand. The Bank must exercise these duties as an independent institution and in regular consultation with the Minister of Finance. In the final situation, the Bank is accountable to Parliament for the implementation of its duties.

In the mandate given to the Bank by the South African Parliament the emphasis falls clearly on "monetary stability", "balanced economic growth" and "the protection of the value of the rand". In terms of the Act, the Bank must pursue these objectives by influencing "the total monetary demand in the economy" and this must be done through "control over the money supply and over the availability of credit".

2. The institutional framework

It is generally accepted today that the central bank of a country should have a major say in the making and implementation of monetary policy. To achieve the objective of monetary stability, it is often necessary to implement unpopular measures that may not be reconcilable with the short-term objectives of politicians or of governments. Governments will, for example, be very reluctant to introduce a more restrictive monetary policy in a period shortly before an election. In such a situation, it will suit the politicians to be able to pass the responsibility for the unpopular measures to an independent central bank.

The power of central banks to control the money supply and the availability of credit is a very potent one. If not managed with great responsibility, it can lead to a breakdown in the financial system, to hyper- inflation and a final rejection by the people of the country of the total money and banking system. This will, in the longer term, not be in the interest of economic development and will frustrate all other efforts to improve the standard of living of the people in general. Governments and politicians are at times very short-sighted and may be prepared to sacrifice medium and longer-term financial stability, and therefore economic growth, for short-term expediencies. Monetary policy, on the other hand, must be applied consistently over time in order to achieve its objectives.

The South African Reserve Bank is a relatively independent institution, owned entirely by the private sector and managed by a relatively independent Board of Directors. Seven of the Board members are elected by the shareholders and seven are appointed by Government. Board members may not be members of Parliament and may also not serve in the board of any private banking institution.

The Bank is also sufficiently autonomous to take independent decisions on matters of monetary policy such as interest rates, discount facilities, open market operations, minimum cash reserve requirements and bank regulation and supervision. The Reserve Bank manages the country's official gold and foreign exchange reserves on behalf of Government, and also implements exchange controls and the exchange rate system as an agent for the Minister of Finance.

In all matters, the Bank works very closely with the Minister of Finance. The Bank also submits an annual report on all its activities, including its monetary policy decisions, to Parliament. The Governor from time to time appears before the Parliamentary Joint Committee on Finance. Useful discussions take place within this Forum on the objectives and implementation of monetary policy.

3. Why is financial stability important?

The question may be asked why financial stability is of such great importance? Changes in the value of money and particularly declines in the value of money, are normally regarded as a sign of financial instability. The rate of inflation is generally used to indicate changes in the value of money. The main task of the Reserve Bank therefore is to keep inflation low, or to keep the value of money as stable as possible.

The instruction to the Bank in the Act is not to keep the value of money constant, neither does the Constitution confer on the Reserve Bank a responsibility to keep both the internal and external value of the rand constant or fixed at any predetermined level. Read together, the Act and the Constitution require of the Bank at all times to work for financial or monetary stability. Some discretion is left to the authorities on what "stability" really means in this context. It is assumed, nevertheless, that a high degree of monetary stability is needed to support "balanced economic growth" in the country.

High inflation, or financial instability, has many disadvantages for the economy. Modern economies based on the functioning of the market system are indeed very dependent on sound and stable money. People must trust money, otherwise they will not be prepared to accept money as remuneration for their services. If money does not have a stable value, it will no longer be acceptable in exchange for goods or services and the country will have to revert back to the complex and inefficient system of barter trade. In the extreme case of hyper- inflation, a foreign currency, for example the United States dollar, effectively becomes the measure of value and even the means of exchange.

High inflation also distorts the allocation of resources and often directs the efforts of entrepreneurs and investors into hedging operations, instead of productive activity. High inflation discourages saving - - people rather spend money now than saving it for future consumption when its value will be much less. High inflation discriminates against the fixed salaried workers, pensioners and low-income people that cannot protect themselves sufficiently against the erosion in the value of money. It not only makes the country in total poorer, but also leads to an even more unequal distribution of wealth and income -- the poor gets poorer faster than the rich because of inflation.

In the global economy, where the markets for capital, goods, services and also labour get more integrated, countries with high inflation are punished severely. It is extremely difficult for a country with a high rate of inflation to remain competitive in a global environment where more and more countries are successfully reducing the rate of inflation in their economies to a relatively low level (of between zero and five per cent).

Finally, if a country, or at least its central bank, is not permanently on guard against a decline in the value of its currency, the ever-present inflationary forces in the economy will almost inevitably lead to a gradual escalation in the rate of inflation until it gets completely out of control. Inflation is like cancer -- it feeds on itself and reproduces more inflation cells at an increasing speed, unless violently opposed by the central bank.

It is for these reasons that the Act of the South African Reserve Bank, the Constitution of the Republic of South Africa and also the White Paper on the Reconstruction and Development Programme so unequivocally instructed the Reserve Bank to:

"maintain the value of the currency, to keep inflation relatively low, and to ensure the safety and soundness of the financial system".

4. How can inflation be contained?

Inflation is to an important extent a monetary phenomenon. "Too much money chasing too few goods" is a popular description of what inflation is about. It is for this reason that the fight against inflation, at least as far as the Reserve Bank is concerned, is aimed at controlling the money supply. The money supply should preferably not increase faster than the increase in the volume of goods and services produced in the country -- some tolerance can be allowed as more money may become necessary for use in the ever-growing financial activities, but even this need for more money should not be accommodated too generously.

Inflation, however, has many causes, some of which fall completely outside of the influence or control of the central bank. Inflation can, for example, be imported because of rising prices in the rest of the world. Inflation can be caused by excessive increases in Government expenditure, particularly if financed through the banking system. It can also be caused by real wage increases in excess of productivity rises, and by monopolistic price exploitation. In practice, it is extremely difficult for the central bank to resist all these inflationary pressures, or to counter them by an even more restrictive monetary policy. These "non- monetary" inflationary pressures in themselves exert pressure on the banking system to create more money, and to accommodate rising prices in the process.

Control over the money supply, however, remains one of the major anti-inflationary measures that any country can harness in its efforts to protect the value of money. The non-monetary inflationary pressures will harm the economy in their own right but should, as far as possible, not be allowed to have secondary adverse effects through escalating inflation.

In a country like South Africa, where there are many inflationary pressures at work at all times, a heavy burden falls on monetary policy. The Reserve Bank can never relax in its vigil against inflation and must almost always "lean against the wind" with a relatively restrictive monetary policy.

5. Can the Reserve Bank control the money supply?

The broad definition of the money supply includes, in addition to banknotes and coin, also cheque deposits with commercial banks and other deposits with banking institutions that can easily be converted into cash. As at the end of 1994, banknotes and coin accounted for only about R12 billion out of a total M3 money supply of R244 billion, that is for 5 per cent of the total.

The major part of the money supply therefore consists of bank deposits, and bank deposits in turn include genuine saving by the public and also new money created by banking institutions in the process of making loans to their clients. The task of controlling the money supply is therefore to an important extent dependent on the ability of the Reserve Bank to influence the amount of bank credit extended by banking institutions.

The ability of banking institutions to give more credit to their clients depends on the amount of liquidity available to the banks. The Reserve Bank's operational instruments used to influence the money supply are therefore firstly directed to the management of the amount of liquidity (cash) available in the banking system. This can be reduced, for example, through selling Reserve Bank assets such as Government stock to the market in exchange for cash, or by increasing the minimum amount of cash that banks must hold in their deposit accounts with the Reserve Bank.

The amount of bank credit that will be extended, is also a function of the demand in the private sector for more credit. This demand is influenced amongst other things by the level of interest rates. If an excessive amount of bank credit is being extended, it can be restrained by a rise in interest rates. The Reserve Bank has an important influence on interest rates through its own Bank rate -- that is the rate at which the Reserve Bank is prepared to make loans to banking institutions. When the Reserve Bank raises Bank rate, banking institutions will normally also raise their lending rates which will then reduce the demand for credit.

The Reserve Bank can therefore through the monetary policy instruments at its disposal influence both the supply of and the demand for bank credit, and thus also the amount of new money that will be created by banking institutions through their lending operations. In practice, it is not always as easy as the theory may suggest.

There are, firstly, time lags involved in changes in monetary policy and the application of monetary policy instruments, and in the desired reactions in the market place. Open market operations may, for example, reduce the liquidity of the banks immediately, but may take some time before it affects the amount of bank credit extended.

The reaction of lenders to changes in interest rates are, secondly, not always the same and can be very inconsistent. In times of buoyant economic conditions, it may be necessary to raise interest rates quite strongly before the demand for credit will subside.

There are, thirdly, long time lags involved in changes in the money supply and in total spending, and also in changes in spending and changes in inflation. If the central bank waits until prices start to rise before it takes any restrictive monetary policy measures, it will already be too late.

Monetary policy can therefore not be applied on the basis of a defined mathematical formula -- there is always a lot of discretion involved in the implementation of monetary policy. This makes it so easy for economists, business people and the general public to criticise monetary policy. Good central bankers learn to ignore the praise they sometimes get, and also not to be too sensitive about the criticism there will always be. The success of the policy will be tested by the results -- that is, by the rate of inflation, or by their ability to keep inflation low despite all the inflationary pressures in the economy.

6. The present stance of monetary policy in South Africa

Over the past year:

total bank credit extended to the private sector increased by 17 per cent;

total M3-money supply rose by 15,7 per cent; and

the rate of inflation as measured by changes in consumer prices increased from 7,2 per cent over the twelve months up to April 1994 to 9,6 per cent over the twelve months ending in January 1995.

Against this background, the Reserve Bank increased its Bank rate from 12 to 13 per cent in September 1994 and to 14 per cent in February 1995. The minimum cash reserves for banking institutions was also recently raised from 1 to 2 per cent and the Reserve Bank is now geared to follow a relatively restrictive monetary policy for the rest of this year.