1. Integration in the global financial markets

The political and social reforms in South Africa over the past few years were accompanied by equally important changes in South Africa's international financial relations. Important steps even preceded the election of the Government of National Unity in April 1994, when South Africa terminated the Debt Standstill arrangements of 1985 at the beginning of 1994. In terms of that decision, exchange controls on non-residents were partly lifted when restrictions on the repayment of certain blocked loan funds of foreign lenders were removed in terms of a final rescheduling agreement entered into with South Africa's foreign creditors.

After the election of the Government of National Unity, international sanctions and boycotts were removed, international restrictions on new loans and investments in South Africa were lifted, and South African banking institutions and importers and exporters gained access again to international money markets. The initial reaction was for a large inflow of short-term foreign capital into the country. In the third quarter of 1994, for example, the net inflow of short-term funds amounted to more than R4 billion.

The way was also opened for South Africa to re-access the capital markets of the world when Moody's and Standard and Poor's, and at a later stage Nippon Investors Service of Japan, gave South Africa international credit ratings which enabled South African borrowers to raise new funds through international public issues. In the fourth quarter of 1994, a net amount of R4,7 billion of long-term capital flowed into South Africa, to raise the total net inflow of funds from abroad in the second half of 1994 to just over R9 billion.

A third major event took place in March 1995 when South Africa abolished the financial rand system to remove the remaining exchange controls applicable to non-residents. This was followed by some substantial inflows of portfolio foreign investments in South African securities listed on the Johannesburg Stock Exchange, to add to the inflows of short-term bank and trade financing and also medium-term loan funds. A total net inflow of capital of almost R22 billion was established for the calendar year 1995, which included an inflow of just over R6 billion invested in South African securities through the Johannesburg Stock Exchange. The total net inflow of capital in the eighteen months from the middle of 1994 up to the end of 1995 therefore amounted to more than R30 billion.

2. Direct consequences of the capital inflows

These capital inflows had a few important con-sequences for the South African economy.

Firstly, after years of persistent net outflows of capital, South Africa could now again afford to let the domestic economy expand at a more rapid rate. Domestic expenditure in particular increased in real terms by 6,7 per cent in 1994, and by a further 5,6 per cent in 1995. As a result of the sharp rise in the demand for goods and services, imports from the rest of the world increased sharply, and the current account of the balance of payments moved into a substantial deficit of R12,7 billion in 1995. This, however, created no problem as the inflows of capital provided the required foreign exchange to cover the deficit.

Secondly, with the capital inflows exceeding the current account deficit, South Africa could, for the first time in years, again accumulate foreign reserves. At the time of the election in April 1994, the Reserve Bank held about R8½ billion in foreign reserves, but also had a similar amount of short-term foreign loans outstanding. At the end of 1995, the Reserve Bank's foreign assets amounted to R15½ billion, with zero foreign liabilities outstanding.

Thirdly, because of the capital inflows, the exchange rate of the rand remained relatively strong in 1995. In nominal terms, the average weighted value of the rand against a basket of the more important foreign currencies declined by only 3,6 per cent last year, which was less than the difference between inflation in South Africa and the average rate of inflation in the other countries.

Fourthly, banking institutions in South Africa now had easier access to foreign sources of finance and could supplement their domestic liquidity by borrowing short-term funds from their foreign correspondents, and from foreign financial markets. This enabled the banks to increase their total lending to the South African private sector by R47 billion, or more than 17 per cent last year. This contributed to an excessive rate of increase in the money supply and impeded the Reserve Bank's efforts to maintain overall financial stability.

Fifthly, the capital inflows enabled South Africa to further relax on the remaining exchange controls applicable to residents. In addition to abolishing all exchange controls on non-residents, applications from the South African corporate sector to acquire foreign direct investments were treated more leniently by the Exchange Control, institutional investors were given permission to diversify their investment portfolios through asset swap transactions with foreign investors, and the Reserve Bank substantially reduced its role in the forward foreign exchange market.

On balance, South Africa's gradual integration into the world financial markets already raised the growth potential of the South African economy to a higher level. South Africa now has access to foreign saving which can be used to supplement our own relatively low savings to finance economic development in the country.

3. Indirect consequences of the capital inflows

There are also certain disadvantages attached to this greater integration of South Africa in the global financial markets. I have already referred to the effects on monetary policy. Banking institutions in South Africa are no longer solely reliable on the South African Reserve Bank as their lender of last resort -- they can now also draw from foreign sources in a situation of a liquidity squeeze. The Reserve Bank is therefore forced now to take much more cognizance of the current situation in the international financial markets when domestic monetary policy decisions are taken.

There is also the disadvantage that the South African financial situation can easily be influenced by changes in other countries that are of no direct relevance for us. This was experienced at the end of 1994 when an international financial crisis struck Mexico and almost all the emerging economies were adversely affected by subsequent changes in capital market conditions. A loan issued by the South African Government in the global dollar bond market in December 1994 at a margin of 195 points above the ruling base rates at that time, traded at a discount in February 1995 to give an effective yield equal to 330 points above the base rates. These developments made it difficult for South Africa to raise further funds in that market until more stable conditions were re-established in the second half of 1995. Subsequently, the margin declined again and the bond is now trading at only about 143 points above the base rate.

South Africa in its own right also recently experienced the effects of adverse changes in the attitude of foreign investors to a specific country in the environment of globally integrated financial markets. A change in perceptions of foreign investors on the creditworthiness of a country can easily lead to a major disruption of financial stability. Such changes may be inspired by events that are completely external to the affected country, for example, at the time of the Mexican crisis of 1994/95, many other emerging economies were also affected. But more often it will be linked to internal political, social and/or economic developments within the country itself. This leads to the conclusion that a country that has become part of the global village, that adheres to the world-wide system of floating exchange rates, and that is open to large in- and outflows of foreign capital, has become subject to the disciplines, the whims and the preferences of the international financial markets.

4. Recent events in the South African foreign exchange market

The large capital inflows during the post-1994 election period prepared the way for the recent disturbances in the South African foreign exchange market. These capital inflows, which continued during the first six weeks of 1996 when almost R5 billion of new foreign investments entered the Johannesburg Stock Exchange, not only enabled South Africa to cover a large deficit on the current account of the balance of payments, increase the official foreign reserves, and relax on the exchange controls, but also put upward pressure on the exchange rate of the rand.

The South African rand, which in recent years depreciated gradually to reflect the difference between the South African rate of inflation and the average rate of inflation in the economies of our major trading partners, appreciated by no less than 6 per cent from May 1995 up to the end of January 1996. This created the misconceived perception with some foreign investors that the South African market was offering extremely high real interest rates with a relatively low risk factor. It also led to a belief in some circles that the rand was moving into an overvalued situation, and that some adjustment will have to take place sooner or later.

The events are now history -- the adjustment did take place, but in a very abrupt and disruptive way. The average weighted exchange rate of the rand declined by 5,1 per cent during the last two weeks of February 1996, and by a further 3,7 per cent in March. The anomalous gains in the value of the rand during the eight months preceding 1996-02-15 were therefore wiped out again during a matter of six weeks. By the end of March 1996 the exchange rate of the rand, adjusted for the inflation differential, was more or less back at the level that applied at the end of 1994. The unjustifiable increase in the real purchasing power of the rand during 1995 was therefore cancelled by the exchange rate adjustments of February/March 1996.

Markets, however, often overreact. The further depreciation of the rand during the first two weeks of April pushed the value of the rand too far in the opposite direction. There is therefore a growing belief that, at the current level, the exchange rate of the rand is now undervalued.

However, it must be pointed out once again, in an environment of large international capital flows it is extremely difficult to define a correct exchange rate for any currency. Such a rate cannot be based entirely on purchasing power parity principles, as this would ignore the effect of capital flows. In the real world, and particularly in the short-term, capital flows are dominant in the foreign exchange markets, and the level of the exchange rate is more dependent on volatile capital movements than on the more stable underlying fundamentals reflected in the international trade accounts of countries.

5. Consequences of the depreciation of the rand

Various reasons for the abrupt adjustment in the exchange rate can be proffered -- some based on fundamentals such as purchasing power parity, relative competitiveness in world markets, political and social risk differentials, and the relatively high rates of inflation in South Africa; others, based on unfounded rumours such as the health of the President, possible resignations of public officials such as the Governor of the Reserve Bank, and the abolition of exchange controls.

Be that as it may, the rand has depreciated and it is unlikely that it will return to its previous level, although some lost ground may be recovered. The South African economy will be affected in various ways by this depreciation. Firstly, the capital inflows into South Africa may be more subdued in the rest of 1996 than what was experienced in 1995 and the early weeks of this year. More in particular, the speculative and more volatile inflows, seeking a higher return in the short term, may be discouraged. In the longer term, this may turn out to be a blessing in disguise.

Secondly, South African exporters and local manufacturers competing with importers will benefit from the depreciation of the rand, provided their cost of production will not increase proportionately, or even by more than the depreciation in the near future.

Thirdly, it could be expected of prices of most imported goods to rise as a result of the depreciation. This can easily start a new bout of overall inflation. It is therefore almost self-evident that the post-devaluation situation calls for even more cautious monetary and fiscal policies, and for constraint on wage increases and other upward price adjustments in the country. Only then shall South Africa find any lasting economic advantages from the depreciation of the past two months.

6. Conclusion

South Africa has therefore now gained some useful experience of being part of the global financial markets. We have seen the importance of being on our guard for unexpected changes in international market conditions over which we have no control. We have learned to be cautious about excessive speculative capital inflows into the country, and how important it is to take account of the effects of such flows on domestic monetary policy. We have experienced the abruptness of changes in the direction of capital flows, and the consequences thereof for the exchange rate of the rand. We have learned how important it is to remain flexible in times of essential adjustment, and to respect the forces of the global market.

The next test we now are confronted with, is the handling of the post-exchange rate adjustment period. Can we use this opportunity afforded us by the depreciation of the rand also in the interest of longer term economic development in South Africa? The answer will be yes only if we shall be prepared to apply the economic disciplines I already referred to. Otherwise the exchange rate adjustment will only lead us back into a new period of high inflation which will, in the end, cause lower growth, more unemployment, and greater poverty.