1. Exchange controls

The exchange controls applied in South Africa were introduced over many years and form part of a macro-economic structure that was distorted by political developments in South Africa, and by international actions against the country that had little to do with economic objectives or realities. These exchange controls, like many other policy components of the distorted economic structure, frustrated the implementation of conventional monetary policies, restricted the effective functioning of the market economy, and led to the incorrect pricing of important productive assets such as capital, labour and foreign exchange.

With the major political reforms introduced four years ago, it became a priority of the new South African Government to abolish exchange controls, together with many other unacceptable economic policies of the past. There were, however, good reasons why exchange controls could not be terminated immediately and had to be phased out gradually over an extended period of time. The main reason was, of course, a lack of foreign exchange reserves that would be required for the conversion of South African rand denominated assets into foreign assets. A further reason was that an overall economic system that became addicted to exchange controls over many years had to be prepared gradually to live and survive without the habitual narcotics of the past.

The new South Africa made sufficient progress in both these areas to phase out a major part of the exchange controls over the past few years. The programme of a gradual phasing-out created frustration for many people in the private sector who continued to urge Government and the Reserve Bank to move faster. Important steps were, however, taken from time to time without any major disruption of the overall financial stability of the economy. These steps were introduced only when the authorities were confident that the relaxations would not create an unserviceable demand for foreign exchange, and when sufficient progress was made with the reforms of the domestic financial markets, and with the reintegration of South Africa in the world financial system, to justify further relaxation.

Without going into the details of the relaxations already made so far, it is true to say that the emotion has now apparently been removed from this debate. The sincerity of the authorities with the commitment eventually to abolish all exchange controls is now accepted without question. The remaining controls are tolerated with more patience, and there is confidence that further steps will be taken as soon as possible to remove those that still remain.

The Reserve Bank is continuing to simplify rules and eliminate unnecessary administrative restrictions on international currency transfers. A stage has now been reached where, for the further phasing-out of the remaining controls, the attention is being focused on the diminishing number of transactions that are still subject to restriction, rather than on the growing list of exemptions. Up to now, any transfer of funds from South Africa was prohibited, unless permission was granted by the Exchange Control Authorities for such a transfer. Having passed the half-way mark with the phasing-out programme, we must now begin to think in terms of a system where all transfers will be free, unless specifically prohibited or restricted by Exchange Control. The Reserve Bank is now in the process of restructuring the Exchange Control Rulings on the basis of this new philosophy. This should lend support to a more orderly and more transparent phasing-out programme of the rest of the controls.

2. Monetary policy

It is fashionable, not only in South Africa, but also in many other countries, to become more critical of monetary policy in times of a macroeconomic slowdown. Many businesses, private individuals and even governments often over-indulge in an excessive utilisation of credit during the expansionary phase of the economy, and are forced in a subsequent retractionary phase to consolidate their position. Such a consolidation often proves to be a painful process and it is human to look for an extraneous scapegoat to blame for the dilemma, such as the Governor of the central bank.

In modern market economies, the interest rate represents one of the most potent self-regulatory disciplines of the market system -- indeed, one of the few self-regulated disciplines that is still allowed by most countries to operate in a relatively free market environment. Interest rates in most countries will normally rise and fall in line with underlying demand and supply conditions in the financial markets. With growing rigidities in other markets, for example in the markets for goods, services and labour, and particularly with an asymmetrical bias that tolerates increases in prices but not declines, the burden on the interest rate as an adjustment mechanism for macroeconomic disturbances has increased in recent times.

The South African economy provides no exception to this rule. Reflecting relatively rapid rises in real gross domestic expenditure in 1994, 1995 and the first half of 1996, the total amount of bank credit extended to the private sector rose by about 17 per cent per annum, that is at a much faster rate than the growth in nominal gross domestic product. By the end of 1996, a situation was reached where the total bank credit extended to the private sector as a percentage of total real gross domestic product reached a relatively high level of about 75 per cent.

The macroeconomic adjustment process over the past year, intended to bring growth in gross domestic expenditure more in line with the growth capacity of the production side of the economy, and to restrain the excessive use of bank credit (or money creation), was triggered by balance of payments developments when the net inflow of capital from the rest of the world suddenly subsided in February 1996. Economic forces beyond the control of the monetary authorities set in motion an adjustment process which included an unavoidable rise in domestic interest rates.

The market adjustment process also worked through the exchange rate mechanism, and the average weighted value of the rand depreciated by more than 20 per cent during the course of 1996. In a further process, the purchasing power of the South African community was reduced by an acceleration in inflation. Even inflation in certain circumstances becomes part of the self-regulatory mechanism of the market economy. Rising interest rates, rising prices and a depreciating currency indeed punished the South African community over the past year for having lived beyond its means for a period of more than three years, beginning already in 1994.

Interest rates rose over the whole spectrum of the yield curve. The monthly average yield on long-term government bonds rose from 14,10 per cent in February 1996 to 16,19 per cent in December 1996. The yield on three months bankers' acceptances rose from 14,10 per cent at the end of January 1996 to 17,00 per cent at the end of December 1996. The prime overdraft rate of banking institutions was raised from 18,50 per cent at the end of 1995 to 20,25 per cent at the end of 1996.

It would have been futile for the Reserve Bank in the prevailing circumstances to have resisted these price adjustments in the money and capital markets, or in the market for foreign exchange. The South African monetary authorities are indeed in retrospect now criticised by the International Monetary Fund for having intervened excessively in the foreign exchange market last year, particularly through the Reserve Bank's intervention in the forward foreign exchange market. This was prompted, however, by an acute shortage of foreign exchange reserves available both in the private banking sector and in the Reserve Bank at the time of the currency crisis.

The Reserve Bank agrees with the Fund that the Bank's role in the foreign exchange market should be reduced. But, as with the removal of the exchange controls, the macroeconomic environment must be prepared for such a withdrawal. Much progress has been made over the past few years, for example, in developing the spot and forward foreign exchange markets outside of the Reserve Bank. The average gross daily turnover in the South African market for foreign exchange now exceeds US $8 billion. It is estimated that the private banking sector now carries a forward book with gross purchases (and gross sales) of about $80 billion. A comparison of these statistics with the present level of the Reserve Bank's gross gold and foreign exchange reserves of only about $5 billion, and the Bank's net oversold forward book of about $18 billion equal to 22 per cent of the gross positions of the banking sector, indicates that the objective of a gradual reduction of the Reserve Bank's relative role in the foreign exchange market is already being achieved.

To give further impetus to this policy, the private banking sector will have to hold more foreign currency cash balances, partly to serve as cover for unmatched forward sales in respect of future foreign exchange commitments of the private sector. The exchange control limit that is still applied to the foreign currency holdings of South African authorised foreign exchange dealers will therefore soon be lifted.

In the mean time, it is interesting to note that, as at the end of June 1997, private banks already held almost one-third of the total gold and foreign exchange balances of R31 billion owned by the combined banking sector. In the process, the private banks are now providing some form of a shock-absorber between the Reserve Bank and the foreign exchange market. As this function of the private banking system will increase in future, South African interest rates will become more integrated in the international market structures, and must be allowed to reflect underlying movements in the external accounts with greater sensitivity.

The Reserve Bank's proposal for the introduction of a system of repurchase transactions on a tender basis between the Bank and its banking sector clients early next year represents a further important step in the continuing process of a gradual restructuring of the financial markets. The new proposed system will hopefully introduce greater flexibility in the money market, and will lead to the establishment of more realistic short-term interest rates. In the final situation, the decision of a private banking institution to do more business in foreign currency denominated assets and less in rand priced assets will be determined by interest rate or yield differentials.

3. A time for a more relaxed monetary policy?

The turbulences in the South African foreign exchange market continued from February last year up to October, but more stable conditions returned since November. The exchange rate of the rand first stabilised in November and December 1996, appreciated for three months up to March 1997, and then depreciated very slowly over the next five months. At the end of August 1997, the average weighted nominal value of the rand against a basket of the currencies of South Africa's major trading partners, was still up by about 4 per cent from the beginning of the year. The net capital inflows increased, and the net gold and foreign exchange reserves of the country rose by R12,5 billion to R31,1 billion as at 1997-06-30.

Market interest rates also peaked in the fourth quarter of last year, and the monthly average yield on long-term government bonds declined from 16,2 per cent in December 1996 to 14,1 per cent in August 1997. The interest rate on bankers' acceptances with a maturity of three months declined steadily from 17,0 per cent at the end of December 1996 to 15,1 per cent at the end of July 1997, to restore a more normal margin between the bankers' acceptances discount rate and the Bank rate.

Inflation peaked a few months later. The rate over twelve months in producer prices reached an upper turning point of 9,6 per cent in March 1997, before declining to 7,5 per cent in June. The consumer price index turned around at 9,9 per cent in April 1997, and amounted to 9,1 per cent in July 1997.

The adjustment process to restore better equilibrium in real economic activity is still continuing. After small declines in total domestic production and in expenditure in the first quarter of 1997, growth was resumed when both total gross domestic production and gross domestic expenditure increased again in the second quarter. It is not yet clear whether the recovery in the second quarter will be sustained throughout the third quarter and the rest of this year. Most short-term indicators point towards a continuation of slack economic conditions at this stage.

The Reserve Bank has up to now been reluctant to signal the beginning of a relaxation in the rather stringent monetary policy controls by also reducing the Bank rate. This reluctance is based mainly on a continuation, at least up to the end of June, of the expansion at a high level in domestic bank credit extension and in the money supply. To avoid inflation from escalating again at an early stage of a next economic recovery phase, the growth in the money supply must now be curtailed. A better equilibrium must be restored in the ratio of the total money supply to total gross domestic product through a lower rate of increase in M3 than in nominal gross domestic product for some time.

The timing of a change in the direction of monetary policy remains linked to changes in financial aggregates. It is normal in a market economy for trends in financial aggregates to follow with some time lag changes in the trends of overall real economic activity. On this occasion, the conventional time lag may have been stretched as a result of the continuing buoyant conditions in the South African financial markets. The money supply and bank credit statistics for July that became available only very recently, provided some further encouraging signs that this part of the macroeconomic stabilisation programme is now also beginning to show the desired results.

The Reserve Bank eagerly looks for confirmation of this observation from all the new economic data that become available on a current basis about present trends in the economy. It will be imprudent to relax monetary policy prematurely after the major pain of restoring financial stability has already been suffered over a protracted period of time since February 1996.