1. The objective of monetary policy

The main objective of the monetary policy of the South African Reserve Bank is to protect the value of the South African currency, that is, at all times to work against inflation. The Reserve Bank regards it as the most important contribution it can make towards economic growth and development. A stable financial environment is regarded as a precondition for sustainable economic development in the longer term.

South Africa has a long history of double-digit inflation behind it. From 1974 to 1992, that is for a period of 19 years, South Africa had double-digit inflation, ranging between 11 and 19 per cent per annum. A major breakthrough was made in 1993 when the rate of inflation dipped below 10 per cent for the first time to reach 9,7 per cent. In 1994, it declined further to 9,0 per cent and in 1995 to 8,7 per cent. Over the twelve months up to February 1996, the rate of inflation was equal to only 6,5 per cent.

To achieve its goal, the Bank concentrates mainly on developments in the financial sector of the economy. Monetary policy is anchored to the money supply, and for this purpose the Reserve Bank announces at the beginning of each year an acceptable rate of increase in the M3 money supply. At this stage, the guidelines are for a 6 to 10 per cent increase per year in the money supply. Last year, the actual increase in M3 was equal to 15,2 per cent, which explains the present rather restrictive monetary policy approach of the Bank.

Money is created in South Africa mainly through the extension of credit by South African banking institutions. To enable the Bank to control the money supply, the Bank must therefore at times reduce liquidity in the banking system through its open-market operations and through variable cash reserve requirements. Both these instruments were used over the past year to freeze surplus liquidity that developed within the banking system, mainly because of large inflows of capital from abroad. Total bank credit extended to the private sector nevertheless increased by more than 17 per cent.

The Reserve Bank can also influence the demand for bank loans through its interest rate policy. Against the background of an excessive rate of increase in both the money supply and domestic credit extension last year, the Bank encouraged interest rates to rise and to remain at a relatively high level. The prime overdraft rate of banking institutions at this stage is 18½ per cent, which is regarded by many as relatively high in real terms. If the average rate of inflation of 8,7 per cent of last year is deducted from the prime overdraft rate, it leaves an interest rate in real terms of about 10 per cent.

There were encouraging signs in recent months that the high interest rates have succeeded in arresting the excessive rates of increase in M3 and in bank credit extension. Certain interest rates, for example the yield on long-term government bonds, started to decline late last year, and reached a relatively low level in the middle of February this year (13,3 per cent).

On balance, South Africa succeeded in maintaining relatively stable financial conditions in 1995, with some concern for an excessive rate of increase in the money supply. A restrictive monetary policy, however, succeeded in exerting downward pressure on bank credit extension and on the growth in the money supply in recent months. The situation was, however, disrupted by the events in the foreign exchange market since the middle of February this year.

2. Monetary policy and the exchange rate

The South African monetary policy is anchored to an acceptable rate of change in the money supply, and is focused to an important extent on developments in domestic financial aggregates. The Bank does not, at the same time, target the exchange rate of the rand, which is determined on a floating rate basis by developments in the foreign exchange market. In the longer term, the exchange rate should also become more stable if the inflation rate can be constrained.

As secondary objectives, the Reserve Bank would like to increase the official foreign exchange reserves held by the Bank which now amount to only about R14 billion (equal to US $3,5 billion), and the Bank would also like to see relative stability in the foreign exchange market. Recent volatility in the foreign exchange market, which saw the rand depreciate from about R3,65 to the dollar to R4,25 to the dollar, is not conducive to the Bank's objective of maintaining financial stability in the South African economy. Against the background of large and unpredictable capital movements, which are influenced by economic and non-economic considerations, and the relatively low level of foreign exchange reserves at the Bank's disposal, it is not possible for the Bank to hold the exchange rate at any predetermined level.

At best, the Reserve Bank can at times lean against the wind and try to smooth out short-term fluctuations in the exchange rate of the rand. Over the past two months, the Reserve Bank therefore became an active seller of US dollars, both on a spot basis and in the forward foreign exchange market, in an effort to bring more orderly conditions into the market. During the last few days, it seemed as if the market has now found a new level for the exchange rate, and more stable conditions are returning.

3. Monetary policy and the financial markets

The Reserve Bank's monetary policy model works through markets -- the money market, the capital market, and the foreign exchange market. The Bank therefore has a vested interest in the existence of privately-owned financial institutions that are well-managed, and that can operate in well-functioning markets. Interest rates, financial asset prices and exchange rates must be determined by these institutions, operating in the markets, and these important financial prices must reflect underlying fundamentals.

It is South Africa's policy at this stage to synchronise its bank regulation and supervision rules with the international standards prescribed by the Basle Committee, and to allow foreign banking institutions to establish representative offices, branches and subsidiaries in South Africa to compete with local banks on a fair and equitable basis.

It is also important to encourage the development of well-functioning financial markets. The Bank therefore supports the changes that are now being introduced in the capital market, and are also in favour of the further development of the foreign exchange market.

In particular, the gradual relaxation of the remaining exchange controls will be supported by the Bank, provided it would not lead to an undue disruption of overall financial stability in the country.

4. Summary

In summary, the objective of monetary policy in South Africa is to maintain overall financial stability, in support of sustainable economic growth and development in the longer term. The most important element of financial stability is a persistently low rate of inflation, supported by a more stable exchange rate for the rand, and sound financial institutions operating in well-functioning financial markets.