1. Developments over the past two years

With the establishment of the Government of National Unity in April 1994, the scene was set for the reinte-gration of South Africa in the international financial markets. International economic sanctions, trade boycotts, disinvestment campaigns and pressures for the withdrawal of foreign loans from South Africa were repealed. South Africa itself started with a gradual removal of exchange control restrictions, firstly of those applicable to non-resident investors and subsequently also others that restricted outward investment by South African residents.

Net capital outflows to the rest of the world placed an effective ceiling on the growth potential of the South African economy for a decade beginning in 1984. The capital outflows, however, suddenly switched into net inflows as from April 1994. After registering a net capital outflow of R15 billion in the balance of payments for 1993, net inflows of R5,4 billion and R22 billion occurred in 1994 and 1995, respectively. This reversal had a major impact on the growth potential of the economy, and last year's growth rate of 3,5 per cent was the best South Africa experienced since 1988.

Apart from gradually relaxing exchange controls, the Reserve Bank also started replenishing the country's depleted official gold and foreign exchange reserves. In April 1994, when the election for the Government of National Unity took place, the Reserve Bank had about R8,5 billion in foreign reserves, but also outstanding short-term borrowings of a like amount. The net foreign reserves therefore were at a zero level. At the end of January 1996, the Reserve Bank held R15,5 billion in foreign reserves, and had repaid all its foreign liabilities.

South Africa also negotiated for international sovereign credit ratings from Moody's, Standard & Poor's and Nippon Investor Service of Japan. These credit ratings were good enough to allow South Africa to enter the international capital market for public issues, and the Government made three successful issues in the global dollar market, the Japanese Samurai market, and the British Sterling market. A number of South African parastatals and private sector companies also raised funds from the international capital markets, through either loan or equity issues.

Foreigners became active investors on the Johannesburg Stock Exchange. The net inflow of foreign funds of R22 billion last year included no less than R6 billion of capital invested in South African bonds and shares purchased through the Johannesburg Stock Exchange. Total transactions by non-residents at times now account for as much as 50 per cent of the total turnover on the Johannesburg Stock Exchange.

Another interesting development is the emergence of a Eurorand market where non-resident institutions, mainly in Europe, raise funds through the issue of rand-denominated bonds sold to non-resident investors. These non-resident borrowers normally hedge their rand exposures by reinvesting the funds in South African bonds acquired through the Johannesburg Stock Exchange.

There are now more than ten foreign banks operating in South Africa through branch offices or subsidiaries, and more than fifty representative offices of foreign banks in South Africa. These foreign banks provide increased competition for South African banks, particularly in arranging and providing foreign finance for South African importers and exporters, and in raising foreign funds for South African borrowers.

South African banks in turn have established a number of branches and subsidiaries in the main financial centres of the world, and are now also operating through branches and subsidiaries in about 15 different African countries. South African banks at the end of last year had about R10 billion of outstanding short-term foreign liabilities, and were instrumental in arranging a further R10 billion of short-term foreign financing for their clients.

The turnover in the South African foreign exchange market, now amounting to between US $5 and $6 billion per day, provides further evidence of the opening-up of the South African financial markets for foreign participation, and for foreign competition. The Reserve Bank's influence over this market is declining -- the Bank is indeed being crowded out by the sheer size of the turnovers in the market. This market is gradually also taking over the function of providing forward cover for South Africans with foreign currency exposures -- the Reserve Bank's net oversold position in spot and forward foreign currencies declined from over US $20 billion at one stage to less than US $10 billion now.

2. Consequences of the integration in global financial markets

The integration of the South African financial markets in the global village has important implications for the monetary policy of the Reserve Bank.

Firstly, the Bank's influence on the liquidity of the banking sector is now less effective than before. The South African banks have access to an outside source of liquidity and have become less dependent on the discount window of the Reserve Bank. This makes it essential for the Reserve Bank to use more actively some of the other instruments available to it for the management of money market liquidity, such as open market operations, short-term swap facilities and variable cash reserve requirements.

Secondly, the level of interest rates in South Africa has an important influence on the capital flows into and out of the country. The Reserve Bank's interest rate policy must therefore take due account of the effect it will have on the balance of payments. Changes in interest rates in other countries can also have important effects on the South African monetary policy. The difference between South African interest rates and those in the major financial centres, adjusted for inflation differentials, provide an indication of the risk premium foreign investors demand for investment in South Africa -- a risk premium that must provide for political and economic risks, including the risk of exchange rate changes.

Thirdly, the money supply, which has been used since 1986 as an anchor for monetary policy in South Africa, is now a less reliable barometer of underlying inflationary pressures. Changes in the Reserve Bank's net gold and foreign exchange reserves can at times have an important influence on the total money supply. The Bank must therefore take account of the "statistical" causes of changes in the money supply when deciding on monetary policy actions. A rise in the money supply because of an increase in the foreign reserves may require a different reaction from an increase caused by more credit extension by banking institutions.

Fourthly, the exchange rate of the rand is more exposed to the whims of international investors and can easily be influenced by changed international perceptions of the South African political, social and economic situation. The fundamentals, such as purchasing power parity and the international competitiveness of a country, do not necessarily determine the equilibrium level of the exchange rate, particularly not in the short-term.

3. The February 1996 turmoil in the foreign exchange market

The turmoil in the South African foreign exchange market over the past few weeks provided some further evidence of the consequences of becoming a participant in the global financial markets. Wild speculative rumours were thrown around about the possible causes of the turmoil. It is true that the combination of a number of unfounded rumours about the health of President Mandela, an imminent relaxation or even abolition of exchange controls, and a contentious assessment made by economist gnomes of the Bahnhofstrasse in Zürich about the exchange rate of the rand all contributed to the speculation and the consequent wide fluctuations in the foreign exchange market. In some circles, the Reserve Bank was even accused of engineering the slide in the exchange rate. The Bank was also blamed by others for not doing enough to support the exchange rate of the rand, and also for wasting the country's national reserves in our efforts to lean against the wind and provide some liquidity in a disorderly and uncertain market.

The rumours referred to above certainly triggered the events, although there were also some more fundamental reasons for the frenzy in the markets. Firstly, it must he noted that there were some nervousness, particularly in the capital markets, on a world-wide basis. Just during that time, investors in many countries and particularly in the United States of America, were disinvesting from fixed-interest bearing bonds, for example government stock. The yield on long-term government bonds in the United States for example rose from 5,62 per cent at the end of January 1996 to 6,07 per cent at the end of February. Taking account of the large amount of foreign investments made in South African bonds recently -- R3,1 billion in January and the first two weeks of February this year -- it can be understood that the global action of investors to become more liquid also affected South Africa.

Secondly, the South African rand appreciated from May 1995 to the middle of February 1996 by almost 6 per cent, mainly under the pressure of a persistent large inflow of capital during this period. The Reserve Bank intervened in the foreign exchange market and bought dollars from the market to prevent even a further appreciation of the rand. From the end of May last year up to the end of January 1996, the Reserve Bank's net gold and foreign exchange reserves indeed increased by R5,4 billion.

In a situation of large and persistent net capital inflows it is extremely difficult to decide what a correct exchange rate for the rand should be. The conventional definition of purchasing power parity becomes difficult to apply as the country can afford in this situation to run a permanent deficit on the current account of the balance of payments, and imports of goods and services can be allowed to exceed exports of merchandise and services on a permanent basis. The "correct" exchange rate in terms of macroeconomic theory must therefore be one that will give equilibrium in the overall balance of payments at a full-employment level of the domestic production resources. It is extremely difficult to calculate, from available macroeconomic statistics, what this exchange rate should be. Any calculation must be based on many subjective assumptions, for example how permanent is the net capital inflow into South Africa, and what will happen once exchange controls will be relaxed further?

It is because of such complexities that the Reserve Bank is reluctant to target the exchange rate, or to try and fix the exchange rate at any predetermined level. The Bank's intervention in the foreign exchange market is intended to promote orderly conditions, but not to fix the exchange rate. There are too many examples in the world, such as Mexico in December 1994, and even the United Kingdom in September 1992, to prove the risks involved in efforts by governments and central banks to hold exchange rates at a level not endorsed as realistic by the markets.

Taking account, however, of the relatively high rate of inflation in South Africa compared to the average rate of inflation in our major trading partners, and of current trends in the average unit labour cost of production in South Africa, an appreciation of the rand will not be sustainable in the longer term. It should also be noted that, after the adjustment of the exchange rate of the rand in February 1996, the average weighted value of the rand against the basket of currencies of South Africa's major trading partners, was more or less on the same level as at the end of May 1995, and was only 4,5 per cent down on its value as at the end of 1995. Measured in real terms, that is, adjusting for the inflation differential, the exchange rate over the longer term remained relatively stable.

The Reserve Bank, as all importers and exporters and foreign investors, do not like the abrupt way in which the adjustment took place in February. This, however, is part of the consequences of becoming more integrated in the global financial markets. The exchange rates between the major currencies of the world fluctuate quite widely in the presence of a global floating exchange rate regime, and smaller countries, like South Africa, must learn to cope with even wider fluctuations. As a foreign banker said to me in the last few days: "Welcome to the real world!".

In this environment, South Africa will be tested from time to time, and political, social, and economic developments in South Africa will have profound effects on the exchange rate of the rand. The Reserve Bank will have to increase its foreign reserves to a much higher level should it want to smooth out all fluctuations in the exchange market. The Bank will, however, have to be cautious not to lure international speculators onto the bandwagon, and not to create the impression that it would be willing to support the exchange rate of the rand at a level not perceived by the market to be sustainable.

4. The further relaxation of exchange controls

The recent disruption in the foreign exchange market, and the abrupt way in which the exchange rate of the rand was adjusted, vindicates the Reserve Bank's cautious approach in relaxing the remaining exchange controls, applicable to the outward investment by South African residents. The speculation that the next round of exchange control relaxations will lead to a major downward adjustment of the exchange rate of the rand, was presumptuous. If the Reserve Bank was of opinion that further relaxations could lead to a large outflow of capital, the Bank will not advise the Minister to proceed with the programme. This is indeed the main reason for the Reserve Bank's approach of gradualism in the phasing-out of exchange controls -- each step must be carefully considered not to lead to unstable financial conditions in the country. This includes, of course, the objective of maintaining relative stability in the exchange rate of the rand.

The Bank is still of the opinion, despite the recent developments, that some further relaxations of exchange controls will be justified during the course of this year. The phasing-out of the exchange controls is a longer term programme that should not be unduly upset by short-term gyrations in the market. The Bank will, however, as in the past, remain cautious and responsible in its advice to Government on the liberalisation of the foreign exchange market. It is clear that the market itself, and particularly South African participants in this market, needs time to adapt to the high-risk environment of the global financial market. Strong nerves will be required from time to time. We were severely tested over the last few weeks. I am sure we have all learned from this experience. All of us, including the Reserve Bank, will be wiser in the next round.