Address by Dr Chris Stals, Governor of the South African Reserve Bank, at a Conference on South African Financial Markets arranged by Standard Corporate and Merchant Bank, Johannesburg. 1. Balance of payments developments set the stage for monetary policyDevelopments in the South African balance of payments during the course of 1995 and 1996 made it extremely difficult for the Reserve Bank to achieve its objective of maintaining overall financial stability. These devel-opments reconfirmed the continuing presence of the traditional balance of payments constraint that so often in the past provided an early-warning signal of the need for a slow-down in an economic expansion phase. They also provided South Africa with a first experience of the risk exposures involved for a relatively small economy in being part of the global financial market system. International investors conform to multinational rules and norms that can, at times, be very unsympathetic for the individual country with its own restricted national goals.Judged against past experiences, developments in the current account of the balance of payments over the past two years came as no surprise. With increases of 6,7 per cent in 1994 and 5,6 per cent in 1995 in real gross domestic expenditure, which included an increase of about 10 per cent in real gross domestic fixed investment last year, imports were bound to rise very rapidly. Mainly because of the need to import capital equipment required in support of large investments in the manufacturing sector, the volume of imports increased by about 20 per cent during each of the past two years. In 1995, the total value of merchandise imports was 64 per cent up from 1993. With more modest but still encouraging increases in exports, dampened slightly by a decline in gold production, the current account of the balance of payments deteriorated from a surplus of R5,8 billion in 1993 to a deficit of R12,7 billion (equal to 2,6 per cent of gross domestic product) in 1995.The normal deterioration in the current account of the balance of payments in concurrence with domestic expenditure trends was, however, veiled temporarily under cover of a large net capital inflow. On a net basis, the capital account of the balance of payments switched from an outflow of R15 billion in 1993 to inflows of R5,4 billion in 1994 and R21,7 billion in 1995. During each of the past two years, the net capital inflows exceeded the current account deficits, with the result that the official gold and foreign exchange reserves increased from an almost zero level early in 1994 to about R18 billion at the end of 1995.The inflows, particularly in 1995, included some short-term funds that capitalised on the opportune circumstances of high interest rates in South Africa and a relatively stable exchange rate of the rand, to yield relatively high returns for foreign investors. As it turned out to be, the flaw in the situation was the stable exchange rate which could, in the longer term, not be sustained. Based on economic fundamentals such as inflation differentials, purchasing power parity and international competitiveness, the rand could not appreciate on a permanent basis as happened during the latter half of last year.When a combination of a number of adverse international and domestic economic developments, and internal political changes in February 1996 brought this reality back to the markets, the exchange rate of the rand came under severe pressure. A large part of the opportunistic capital inflows of last year flowed out of the country and reduced the overall net capital inflow from R11,2 billion in the second half of 1995 to only R2,7 billion in the first half of 1996. Short-term capital (that is capital with an original maturity of less than 12 months) showed a net outflow of R4,6 billion during the first two quarters of this year, whereas a net inflow of medium and long-term capital amounting to R7,2 billion continued to cover the current account deficit of about R7 billion over this period.In the circumstances, South Africa did not lose its attra