A. RECENT ECONOMIC DEVELOPMENTS -- THE BUSINESS CYCLE

1. Real economic activity

Over the past two years, the South African economy performed reasonably well, that is compared to the preceding five years when the average rate of change in gross domestic product from 1989 to 1993 became negative and amounted to minus ½ per cent. In 1993 it turned positive and in 1994 increased to plus 2,7 per cent, and in 1995 to plus 3,3 per cent.

The performance of 1995 is even more encouraging if account is taken of the fact that total production in both agriculture and mining declined last year and sturdy growth of 7½ per cent in the manufacturing sector provided the main base for the expansion.

A similarly encouraging development on the demand or expenditure side of the economy was provided by a hefty increase of 10½ per cent in gross domestic fixed investment, which took place mainly in the private sector. Real fixed investment in the manufacturing sector was particularly strong: it rose by no less than 21 per cent in 1995. This augurs well for the future growth potential of the economy, and made an important contribution towards raising the production capacity of manufacturing, and therefore of the total economy, to a higher level.

Real private consumption expenditure also rose sharply in 1995, and increased by about 5 per cent on the preceding year. Because of this increase, which exceeded the rate of increase in personal disposable income, savings of households as a percentage of gross domestic product declined to the extremely low level of only 1 per cent. The "excess" consumer expenditure was financed by means of credit, and the ratio of consumer credit to personal disposable income rose from 23 per cent in 1994 to 25½ per cent in 1995.

It must be pointed out also that real consumption expenditure by general government last year increased by only ½ per cent which was considerably lower than the rate of increase of 4 per cent in the preceding year. The ratio of consumption expenditure by general government to gross domestic product declined slightly to 20½ per cent, which was still relatively high for an economy with a low savings ratio, as we have in South Africa.

In total, gross domestic expenditure last year increased by 5½ per cent, which outpaced growth in domestic production by more than 2 per cent. This is one of the more important characteristics of the South African economy that holds significant implications for the medium term programme on fiscal policy.

2. Balance of payments developments

As could have been expected with the strong rise in domestic expenditure, imports of merchandise increased sharply by 29 per cent last year. Linked to the extensive domestic real capital investment programme, pronounced increases were registered in the imports of machinery and electrical equipment, and also in vehicle and transport equipment.

Although exports of merchandise also did extremely well to increase by 24½ per cent, there was a decline in gold exports and an increase in net service payments to the rest of the world, with the result that the current account deficit rose from R2,2 billion in 1994 to R12,7 billion in 1995.

A large net capital inflow of almost R22 billion was sufficient to cover the current account deficit, and to add almost R10 billion to the country's foreign reserves. It also contributed to a relatively stable exchange rate of the rand, which depreciated in nominal terms by only 3,6 per cent from the end of December 1994 to the end of December 1995, that is, by less than the inflation differential between South Africa and its major trading partners. In real terms, the effective exchange rate of the rand indeed appreciated by about 1½ per cent.

The vulnerability of the South African economy for external shocks, particularly in the present situation where a relatively large current account deficit must be financed by a continued net capital inflow, was illustrated in the second half of February and during March 1996 when rumours and speculation led to an outflow of capital and large notional transactions against the exchange rate of the rand. In the longer term, South Africa must establish a stronger external position that will make it less prone to such disturbances. Fiscal policy will have to make an important contribution to this restructuring programme.

3. Domestic financial conditions

In the environment of the improved performance of real economic activity and an overall balance of payments surplus, the domestic financial situation remained relatively stable. The rate of increase in the overall consumer price index declined uninterruptedly from a peak of 15,3 per cent in 1991 to 8,7 per cent in 1995 -- the lowest rate of increase in any one year since the 6,1 per cent registered in 1972.

The Reserve Bank had some concern for the high rates of increase in the various components of the money supply, mainly because of the possible effects this could have on inflation at some later stage. The M3 money supply increased by 15,2 per cent from December 1994 to December 1995, and the M1 money supply by no less than 19,3 per cent over the same period. Changes in the money supply are regarded by the Reserve Bank as the most important signals of incipient inflation, and the Bank's guidelines for a tolerable rate of increase in M3 at this stage set an upper limit of not more than 11 per cent for last year. It should be noted that both in 1992 and in 1993, the M3 money supply increased at a rate of well below 10 per cent -- a factor which undoubtedly contributed to the declines in the rate of inflation in 1994 and in 1995.

The main reason for the increase in the money supply aggregates in 1995 was a relatively sharp increase of 17,5 per cent in the amount of bank credit extended to the private sector. A substantial part of the increased economic activity in the country was therefore financed through the creation of more money. Domestic saving, supplemented by a large net inflow of capital, was not sufficient to finance the increase of 5½ per cent in real gross domestic expenditure. Even if the rate of inflation is also taken into account, bank credit extension was still high relative to the nominal expansion in total demand. It not only accommodated last year's rate of inflation of about 9 per cent, but provided some stimulus for future inflation.

The strong demand for credit, emanating from both the government sector, to finance budget deficits, and from the private sector, to finance investment and consumption, exerted upward pressure on money and capital market interest rates. The yield on 91-day Treasury bills for example, rose from 10,2 per cent in January 1994 to 14,2 per cent in December 1995 and the yield on long-term government stock from 12,2 per cent at the beginning of 1994 to 17 per cent in May 1995, before it declined again to 14,6 per cent in December 1995.

In light of the financial developments, the Reserve Bank had to retain a relatively restrictive monetary policy throughout the past eighteen months. The Bank's own lending rate, the Bank rate, was raised gradually from 12 per cent in the middle of 1994 to 15 per cent in June 1995, and has remained at this relatively high level for the past nine months. The policy succeeded in preventing a further escalation in the money supply, but has so far not yet succeeded in bringing monetary expansion within the accepted guidelines which are regarded to be compatible with the longer-term objective of maximum sustainable real growth, with price stability.

B. LONGER-TERM PROSPECTS FOR THE ECONOMY -- STRUCTURAL ADJUSTMENT

The cyclical or business cycle developments in the economy over the past few years were encouraging, but also provided further evidence of certain structural deficiencies of the South African economy. A medium term fiscal plan cannot ignore the implications of the business cycle for government revenue, expenditure and borrowing requirements, but must be aimed more purposefully to the gradual elimination of the structural deficiencies of the system. Major fiscal policy reforms, and particularly thorough structural reform of government expenditure policies, can normally be done only in a medium-term framework.

It is also true that over-emphasis on the cyclical performance of the economy often mask the real underlying structural deficiencies. Government revenue, for example, will normally be higher at, or shortly after, the peak of the cycle, and government expenditure relatively lower during this phase. The fiscal deficit, measured as a ratio to gross domestic product, for example, may therefore in this situation be lower than the real or underlying deficit.

Fiscal policy in general has, of course, a major impact on the macro economy. Although relationships are not always direct and consistent, fiscal policy as a whole will affect the level and composition of aggregate demand, the national savings rate, the growth of monetary aggregates and inflation, and the balance of payments and the exchange rate. Through all these inter-relationships, fiscal policy in the final situation is indeed the most important determinant of economic growth, employment and the standard of living of the total community.

In framing fiscal policy in South Africa, the existence of three major macroeconomic gaps must be taken into account, namely the saving/ investment gap, the imports/exports gap, and the growth potential/labour supply gap.

4. The saving/investment gap

Economic developments over the past few years again exposed the serious problem of insufficient saving by South Africans. In 1995, total gross domestic saving by companies, individuals and government amounted to R81 billion, and R12 billion of the inflow of capital from the rest of the world also became available for financing economic development (the rest went into foreign reserves). A total amount of R93 billion was therefore available for "non-inflationary" financing of economic activity.

However, of this amount, R66 billion was required for maintaining the existing production capacity of the economy, that is for depreciation, to leave only R27 billion for the financing of an expansion of production capacity. The deficit on the budget of the consolidated general government, however, in its own right required R28 billion, and net investment by the private sector in fixed capital and in inventories a further R27 billion.

Without analysing the complex financial flows involved in the balancing act, it can be understood why the demand for credit from the banking sector was relatively large, and why the M3 money supply eventually rose by R37 billion, partly to finance also the rising consumer demand for goods and services.

This saving/investment gap is, unfortunately, not only a temporary phenomenon that created financial strains and exerted upward pressure on interest rates in 1995, but it represents one of the major constraints on the economic growth potential of the country for the future. Fiscal policy is part of the problem, and part of the solution. Total consumption expenditure, including that of government, must be constrained; total saving, including that of government (which at this stage is negative), must be raised; and total real investment in the economy must be increased if South Africa should want to reach its longer-term economic goals.

5. The imports/exports gap

In 1995, South Africa's total imports rose quite sharply to open up a deficit of R12½ billion on the current account of the balance of payments. Last year, the problem arose mainly from the relatively sharp increase in total gross domestic expenditure, but it is nevertheless true that South Africa not only has a relatively high marginal propensity to import, but also a relatively high average level of imports as a ratio of gross domestic expenditure (the import penetration ratio is high). An unmanageable balance of payments deficit therefore often develops long before the full employment level (of labour) has been reached in the domestic economy. For the time being, this makes economic development in South Africa very dependent on sustainable capital inflows from the rest of the world, not only to supplement the insufficient level of domestic saving, but also to provide the foreign exchange reserves needed for the payments for imports.

Fiscal policy planning must obviously also take this structural deficiency of the South African economy into account. Not only must undue pressures on domestic resources be avoided by keeping public sector expenditure under control, and by non-inflationary financing of government deficits, but an investor friendly environment must also be supported to keep South Africa attractive for the foreign investor. This by definition rules out the option to raise taxes indiscreetly.

6. The growth potential/labour gap

The most important economic challenge for the South African authorities remains to provide more jobs for the many unemployed people in the country. Throughout the economic upswing of the past few years, no progress was made towards solving this daunting problem. In the twelve months up to the middle of 1995 -- the latest statistics available -- only 40 000 employment opportunities for new jobs were created in the non-agricultural private sector, against an increase of approximately 350 000 people in the economically active population. Unemployment therefore continued to increase.

And yet, in the public sector, even at this juncture, there is a need for rationalisation and for a reduction in total employment. To cut the public sector wage bill by withholding wage increases can become counter-productive -- any prolonged disparity between public and private sector wages may result in a loss of high-quality staff. Cutbacks in civil service numbers are often a more appropriate reform, but one that is not easy to apply in an environment of high unemployment and massive poverty, as we have in South Africa.

As with many other economic restructuring programmes, this course of fiscal expenditure adjustment may at first have a negative impact, before total employment will benefit from greater buoyancy in the private sector. The J-curve effect makes it extremely difficult to medicate with the correct treatment a patient that is already fatally sick.

C. CHALLENGES FOR FISCAL PLANNING

A medium term fiscal plan must therefore take account of:

Firstly, the current phase of the business cycle. South Africa is now in the fourth year of the current upswing phase. No spectacular heights were reached in this economic recovery phase, although economic growth has been of a better quality, and quantity, than for many years. In 1995, relatively good growth was achieved in the non-primary sectors, the overall balance of payments remained in surplus and relatively stable conditions were retained in the domestic financial situation. Little progress was, however, made in creating more jobs. These favourable conditions will not last forever -- sooner or later, the business cycle will go into a downward phase again which will make it more difficult for fiscal policy to achieve the overall macroeconomic objectives.

Secondly, the South African economy is burdened with many structural deficiencies. Fiscal policy can, and must, play an important part in seeking solutions for these structural problems. In particular, domestic saving must be encouraged, and consumption at all levels be restrained. The external economic relations must be strengthened -- the current account deficit must be restricted to the level of a reasonably sustainable net inflow of capital from the rest of the world. Such an inflow of capital will be dependent on the maintenance of a stable and sound investor friendly environment. This requires persistent monetary and fiscal discipline. Policies must be pursued that will encourage the employment of more people. Economic growth may be a precondition for more employment, but provides no guarantee for such employment. This was clearly illustrated by the events of the past two years.

It is no easy task to design a framework for a fiscal plan that will meet all these macroeconomic goals at the same time. It is no easy task to reconcile the major elements of the fiscal plan, concentrated on the revenue side (tax issues), the expenditure side, the borrowing requirements, and the management of the public debt, in one consistent plan. It is however, of crucial importance that fiscal policy must not aggravate the problem by embarking on a course that will discharge more inflationary pressures in the economy, that is, a programme that will reduce saving; or will contribute to an increase in external disequilibrium, that is increase the current account deficit of the balance of payments; or will lead to a further entrenchment of the employment/ growth paradox in the economy.

To find the optimum combination of fiscal policy measures, together with the right mix between monetary, fiscal and other macroeconomic policies, in this environment is the challenge we have to face. The realities of structural deficiencies in the South African economy cannot be ignored or disregarded for much longer. Otherwise, too many expectations of the people of South Africa will never be fulfilled.