1. Balance of payments developments set the stage for monetary policy

Developments 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 attraction so much for the more serious longer-term investor. During the first nine months of 1996, foreigners remained net buyers of South African equities through the Johannesburg Stock Exchange for an amount of R5,8 billion, and also of South African bonds for an amount of R2,2 billion.

The outflow of short-term funds, however, reduced the overall net capital inflow to a figure of less than the current account deficit. Shortages of foreign exchange therefore developed in the foreign exchange market, which of course contributed to the downward pressure on the exchange rate of the rand. The Reserve Bank switched its policy from being a net buyer of foreign exchange in the market to become a net seller, and the Bank's own gold and foreign currency holdings declined from R15,7 billion at the end of 1995 to R10,0 billion at the end of September 1996. The Bank's policy was to ensure that sufficient liquidity would be available in the market at all times (for example to enable importers to meet their inter-national commitments), but not to try and fix the exchange rate at any predetermined level. The Bank was therefore leaning against the wind, as it did last year in the opposite direction, when the net foreign reserves of the country increased by R9,1 billion.

2. Domestic financial developments

Monetary policy in South Africa is to an important extent guided by developments in domestic financial conditions, that is, changes in the money supply, in the total amount of bank credit extension, the level and yield pattern of interest rates, the liquidity situation in the money market, the financial implications of budgetary policy, and, of course, by the rate of inflation. The objective of maintaining overall financial stability indeed culminates in the goal to keep inflation low.

Domestic financial conditions are obviously influenced by balance of payments developments, and the Reserve Bank's preoccupation with movements in domestic financial aggregates does not mean that it follows a policy of benign neglect as far as the balance of payments and the exchange rates are concerned. On the contrary, the attainment of the goal of stable domestic financial conditions is an important precondition for greater balance of payments and exchange rate stability.

The large net capital inflows over the past two years and the need for the Reserve Bank to intervene in the market for foreign exchange as a net buyer of foreign currencies, created an excess amount of rand liquidity in the domestic money market and contributed to an acceleration in the rate of increase in the money supply. It also prevented interest rates from rising sooner to a level where it would discourage the demand for credit and facilitated an unhealthy high rate of expansion in bank credit extension.

The rate of increase in the M3 money supply accelerated from 7 per cent in 1993 to 15 per cent in 1995 and has remained at this level throughout the first nine months of 1996. The rate of increase in bank credit extended to the private sector likewise accelerated from 9,7 per cent in 1993 to 17,6 per cent in 1995 and the first three quarters or 1996. Interest rates reflected the rising demand for credit and already started moving up in the second half of 1994, when the Reserve Bank also raised its Bank rate from 12 to 13 per cent.

Domestic financial conditions were abruptly affected by the sudden reversal in the inflow of short-term capital in February 1996. Interest rates moved up quite strongly. The yield on 91-day Treasury bills, for example, rose from 13,9 per cent in the middle of February to 16,2 per cent in August 1996. Liquidity in the banking sector was also gradually drained as the Reserve Bank's foreign reserves declined. The money market shortage increased from R6,1 billion late in February 1996 to R10,9 billion at the end of April 1996.

Despite some indication of a slow-down in real economic activity in 1996, the rates of expansion in the money supply and in bank credit extension remained at the relatively high levels reached in 1995. At best, both these financial aggregates lost some momentum and the growth rates are no longer on an accelerating path, but there is no firm confirmation yet that the necessary downward adjustments are in progress.

The rate of inflation was also adversely affected by the exchange rate and monetary developments over the past two years. The rate of increase in the consumer price index reached a twenty-four year low of 5,5 per cent over the twelve months up to April 1996, but has since then increased again to 8,4 per cent in September. The "underlying" rate of inflation, that is the change in consumer prices excluding the effects of changes in food prices, taxation and interest rate costs included in home-ownership, was less volatile but also rose from 6,6 per cent in April to 8,0 per cent in September 1996.

3. Implications for monetary policy

Developments in the balance of payments and particularly the depreciation of almost 20 per cent in the value of the rand since the end of last year, coupled with developments in domestic financial conditions, clearly demand a restrictive monetary policy at this stage. Monetary policy was indeed gradually tightened as the economic expansionary phase gained more momentum over the past two years. The Bank rate was increased in a number of steps from 12 per cent in September 1994 to 16 per cent at this stage. In recent months, the decline in the net foreign reserves of the Reserve Bank provided a further automatic tightening of monetary policy as liquidity was drained from the banking system (and not replaced through any domestic operations of the Bank).

As far as the balance of payments is concerned, the Bank is prepared to make liquidity available on a regular basis to the market in foreign exchange to maintain orderly conditions, but is more concerned that the necessary adjustments will take place to restore equilibrium in the overall balance of payments. An increase in the net inflows of medium and long-term capital will, of course, reduce the need for reducing the deficit on the current account. A realistic and pragmatic approach at this stage should, however, be aimed at reducing the current account deficit -- a process which, by its nature, takes time, but is hopefully already in progress. This adjustment process is supported by:

the apparent slow-down since the beginning of the year in the rate of increase in gross domestic expenditure;

the depreciation of the exchange rate of the rand which has made imports more expensive and provided an incentive to exporters; and

the increasing effect of tight domestic financial conditions as reflected in the money market shortages and relatively high real rates of interest.

As far as domestic financial conditions are concerned, the latest available information begs the question whether monetary policy in its present form is restrictive enough. The Reserve Bank is eagerly awaiting confirmation that the rates of increase in bank credit extension and in the money supply are indeed slowing down. So far, there has been sufficient evidence that both these aggregates have now levelled out at relatively high rates of increase. Up to now, the monetary authorities were prepared to be tolerant, and to wait for further signals of an actual decline in the growth rates of these important anchors for monetary policy. Should new statistics contradict this assumption, there will be no alternative but to tighten monetary policy further.

4. Foreign exchange policies

The South African exchange rate is based on a floating exchange rate system and the exchange rate of the rand is determined basically by the demand for and supply of foreign exchange in the market. Total demand and supply are obviously influenced by many factors, including macroeconomic monetary policies and exchange controls. The Reserve Bank does not, however, try to fix the exchange rate at any predetermined level.

In general, the Bank accepts the need for exchange rate changes to reflect the inflation differential between South Africa and its major trading partners. In the South African context, a goal of exchange rate stability can only become realistic once the rate of inflation in South Africa is more or less in line with the average rate of inflation in the economies of our major trading partners.

Temporary fluctuations in the exchange rate of a currency can, of course, be ameliorated by central bank intervention in the foreign exchange market. This was illustrated in the case of the South African rand last year when the Reserve Bank intervened by buying foreign currencies when there was strong pressure for an appreciation of the rand. The low level of official foreign reserves restricts the Reserve Bank's ability to be effective with its intervention policy when the pressure is in the opposite direction, that is when a shortage of foreign exchange creates downward pressure on the exchange rate of the rand. In the longer term, South Africa must raise its foreign reserves to a more comfortable level that will enable the Reserve Bank to support a more stable exchange rate for the rand.

The Reserve Bank will continue to advise the Minister of Finance on the policy of a gradual relaxation in the remaining exchange controls. When South African residents are given permission to invest their rand savings outside of the country, there must be some reasonable assurance that it will be possible for them to convert rand assets into foreign currencies with which they can acquire foreign investments. With its low level of foreign reserves, the Reserve Bank cannot provide this assurance. In our situation, to act precipitately could create disaster. This is very well understood by a central bank that was forced to close the foreign exchange market in August 1985, and to introduce a moratorium on the repayment of established international commitments.

The Reserve Bank took notice once again of the International Monetary Fund's serious warning included in Mr Camdessus' eleven commandments for sound economic management, namely that countries should make "careful progress toward increased freedom of capital movements through efforts to promote stability and financial soundness". Managers of a number of large private sector funds and senior international bankers provided the same advice, and indeed requested from us a reconfirmation of our existing policies of gradual relaxation. People who create false expectations and unnecessary fears from time to time that South Africa will abolish all remaining exchange controls in a big-bang approach are only making the process more complex and more difficult. A more constructive policy of working with the authorities in the process of gradually getting rid of a system which, we all agree, is undesirable, will in the end be more productive.

5. Conclusion

Monetary policy in South Africa at this stage therefore has two important short-term goals:

Firstly, equilibrium must gradually be restored in the overall balance of payments that will ensure greater stability in the market for foreign exchange and will also support a more stable (but not fixed) exchange rate.

Secondly, the excessive increases in the money supply and in bank credit extension must be eliminated. It is possible that some structural changes in the South African economy influenced the increases in these aggregates over the past two years. In the longer run, no country can gain sustainable benefits from the creation of an excessive amount of money.