1. Phase One: Preamble to the adjustment

The course of the South African economy, and especially of the balance of payments, during 1995 paved the way for the recent adjustment that took place in the exchange rate of the rand.

Against the background of increasing domestic spending, the current account of the balance of payments has shown an increasing deficit. During 1994 this deficit was equivalent to only R2,2 billion. During the course of 1995 the quarterly deficit, seasonally adjusted and calculated at an annual rate, showed the following trend:

First quarter ... R 8,7 billion

Second quarter ... R14,8 billion

Third quarter ... R12,2 billion

Fourth quarter ... R15,0 billion

For the year as a whole, the deficit was equivalent to R12,7 billion. The course of the current account of the balance of payments was, however, not exceptional when seen against the background of the business cycle. It is normal for imports to rise steeply during strong increases in domestic spending, as happened last year. In fact, total domestic spending already increased in 1994 by 6,7 per cent, and in 1995 by an additional 5,6 per cent. An increase of 10,4 per cent in the total gross domestic fixed investment in particular led to a sharp increase in the importation of capital goods such as machinery and equipment.

This deterioration in the current account of the balance of payments did not, however, like so often in the past, give rise to any pressure on the country's gold and foreign exchange reserves, or on the exchange rate of the rand. On the contrary, owing to an exceptionally large net inflow of capital from abroad, the official foreign reserves continued to rise. In total, the country's official foreign reserves increased by R9,1 billion, which was distributed as follows over the four quarters of the year:

First quarter ... R 3,1 billion

Second quarter ... R 1,1 billion

Third quarter ... R 0,5 billion

Fourth quarter ... R 4,4 billion

The increase in the fourth quarter, when the deficit on the current account was at its highest, was particucularly large. The increase in the foreign reserves was of course made possible by an unexpectedly large net inflow of capital from abroad. The net inflow totalled R21,7 billion and was distributed as follows over the year:

First quarter ... R 5,5 billion

Second quarter ... R 5,0 billion

Third quarter ... R 3,8 billion

Fourth quarter ... R 7,4 billion

The net inflow was particularly large in the fourth quarter and throughout the year exceeded the deficit on the current account. The total net inflow of funds last year included, among others, an inflow of R6 billion through the Johannesburg Stock Exchange. A further amount of R4 billion flowed into the country in this way during January and February 1996.

Owing to these trends in the most important balance of payments aggregates, the exchange rate of the rand was exceptionally firm during 1995. However, it is interesting to note that the average weighted value of the rand during the first five months of 1995, i.e. from 1994-12-31 to 1995-05-31, dropped by as much as 7,6 per cent. After this, however, from 1995-05-31 to 1995-12-31, it increased by 4,4 per cent. During January 1996 it increased by an additional 1,4 per cent, pushing the total increase in the value of the rand over the eight-month period from June 1995 to January 1996 to more than 6 per cent.

It was difficult, on the basis of the underlying economic situation, to justify this increase in the value of the rand. The Reserve Bank intervened in the foreign exchange market throughout this period by buying large amounts of foreign exchange -- hence the increase of more than R9 billion in the country's foreign exchange reserves during this period. In this way the Bank prevented a further appreciation in the exchange rate of the rand.

The action of the Reserve Bank in the foreign exchange market made it difficult for the Bank to abide by its monetary policy goal of controlling the money supply. As and when the Bank bought foreign exchange, it naturally augmented the liquidity of the banking system by creating new rand balances for the local banks. This is one of the reasons why domestic bank credit extension increased by more 17 per cent last year, and the money supply by approximately 15 per cent.

The Reserve Bank could therefore hardly do more to prevent an appreciation in the exchange rate, without risking an eventual rise in the rate of inflation.

2. The second phase: The adjustment

The predictable adjustment in the exchange rate of the rand took place very unexpectedly and very sharply when the exchange market practically collapsed in the middle of February 1996. From 1996-02-16 to 1996-02-29 the average weighted value of rand dropped by 5,1 per cent. The exchange rate of the rand against the dollar dropped rapidly from R3,65 to close on R4,00.

The Reserve Bank changed its intervention policy immediately, to become a net seller of foreign exchange to the market. From 1996-02-16 to 1996-02-29 the Reserve Bank in fact sold R5,3 billion worth of US dollars to the market to ensure that the adjustment of the rand to a lower level would be as smooth as possible. The Bank's opinion was that it would be wrong to try and keep the exchange rate at any particular level. In a system based on floating exchange rates, where exchange rates all over the world are continually changing and large international capital movements dominate the foreign exchange markets and the determination of the exchange rate, central banks are hardly in a position to determine what exchange rate is "right" or the "most desirable" for a country's currency.

The Reserve Bank's policy of supplying US dollars on a forward basis was also adjusted according to the new circumstances. In 1995 and the first few weeks of 1996 the Bank reduced its participation in the foreign exchange market fairly rapidly. The Bank's net sales of foreign exchange, which at one stage amounted to well over USA $20 billion, retreated to only some $8 billion at the end of February 1996. The book has since increased again by approximately $4 billion up to the end of April 1996.

3. A third phase: Consolidation

Although the rand continued to depreciate until early March 1996, a more stable situation then followed and the exchange rate of the rand for a period of about three weeks fluctuated between the levels of R3,90 and R3,95 per US dollar. The Reserve Bank continued to lend support to the market by selling dollar in the spot market and also entering into further forward cover transactions. The Bank's gold and foreign exchange reserves therefore dropped in March by R724 million, while the total amount of net forward sales of foreign exchange increased by USA $374 million.

The total depreciation of the rand from 1996-01-01 to the end of March 1996 amounted to 8 per cent. The Reserve Bank did not regard the depreciation up to that point to be excessive, especially if the appreciation of approximately 5 per cent during the last seven months of 1995 is taken into account. In real terms, i.e. after adjustment for the inflation differential between South Africa and its major trading partners in the world, the value of the rand showed very little change on a net basis from 1994-12-31 to the end of March 1996. Seen in the longer term, the objective of maintaining a fairly stable real value of the exchange rate of the rand was still achieved.

4. A fourth phase: Overreaction

A fourth phase began in late March and during the first two weeks of April 1996 with the occurrence of an overreaction in the exchange market. From 1 to 30 April, when the exchange rate of the rand moved to levels between R4,35 and R4,39 per USA dollar, the average weighted value of the rand dropped a further 9,2 per cent. From 1996-01-01 up to and including 1996-04-30 the total net depreciation of the rand in nominal terms was therefore equivalent to approximately 15,6 per cent.

The large inflow of funds through the Johannesburg Stock Exchange also dried up at this stage. This came to only R235 million in March 1996, and in April a net outflow of R1,9 billion took place.

The Reserve Bank is of the opinion that the market overreacted at this stage, and that the rand is now undervalued. However difficult it may be to determine the "correct" value of the exchange rate, the size of the cumulative adjustment that has now taken place since the middle of February this year in the exchange rate of the rand can no longer be justified on the grounds of underlying economic fundamentals. The Reserve Bank is therefore hoping that the markets will now act more rationally and that the exchange rate, with the necessary support by the Reserve Bank, will now at least stabilise.

5. The causes of the exchange rate adjustment

It is clear from the preceding analysis that there were various good reasons why the exchange rate of the rand had to adjust to a lower level from the abnormally strong level at the beginning of the year. It is unfortunate that this adjustment took place so suddenly and so steeply over such a short period.

The adjustment of the exchange rate was to a certain extent caused by unjustified rumours and speculative transactions. It was not always clear whether the exchange rate adjustments caused the rumours, or vice versa. An adjustment of the exchange rate based merely on unfounded rumours would in the longer term not have been sustainable. It is therefore important to draw a distinction between fundamental and perceived causes.

As far as the perceived causes or rumours are concerned, time will tell which were correct and which were incorrect. It has already been proved that there was no truth in the rumours that Mr Mandela was seriously ill, or that the Governor of the Reserve Bank was supposedly going to resign. It turned out to be true that Minister Chris Liebenberg resigned and that he was replaced by Mr Trevor Manuel. Mr Manuel has already shown himself to be strongly in favour of financial and monetary disciplines, and has also indicated that he has no intention of making sudden and drastic changes to the broad economic policy approach of the past few years. Mr Manuel emphasised, for example, that further exchange control relaxations will only be introduced gradually, and will not be allowed unduly to disrupt the financial markets.

This leaves the fundamental causes of the depreciation still to be considered. It is true that the South African inflation rate is substantially higher than the average of our major trading partner countries, and competitors, in the international trade. It is true that in many instances South African organisations cannot act competitively in the international markets. Important improvements in respect of the productivity of labour, capital and management in South Africa are vitally important. It is also necessary to further liberalise the international trade and foreign exchange markets. This will, however, in keeping with accepted policy, be done gradually.

Taking account of all these fundamental deficiencies, South Africa cannot, and is not, a candidate for an appreciating currency. There will be continuous pressure on the exchange rate of the rand in the longer term for as long as these fundamental or structural problems are not rectified. Hopefully, however, we are moving in the right direction with all of these. In the meantime,I want to believe that the adjustment of the exchange rate over the past few months went too far -- and that we are in fact now, as far as the exchange rate is concerned, a few steps ahead of the "fundamentals".

This offers us new challenges, for instance to prevent this "excessive" adjustment of the exchange rate from causing an escalation in the inflation rate. It also offers us new opportunities to enter the export markets with increased aggression. Let us take these challenges and opportunities in hand in the correct way.