I have been asked to share my views with you today on where we are heading with monetary policy in South Africa in the years beyond 2000. Looking into the future on any matter is always a hazardous task. One can be inclined to be an optimist about the future like the American short-story writer Bierce Ambrose who said: "the future is that period of time in which our affairs prosper, our friends are true and our happiness is assured". On the other hand, one can also be inclined to be too pessimistic. I would rather fall in with the more realistic approach of another American writer, Tennessee Williams, who wrote: "the future is called perhaps ...".
In making predictions about the future, the best one can do is try to determine what important changes are currently taking place in the world and then attempt to deduce what implications this "perhaps" may have. In the time allotted to me I have therefore decided to concentrate on:
firstly, the major structural changes that have occurred recently or are still taking place in the international financial world;
secondly, the effects that these changes have already had on the South African financial sector; and
finally, the possible implications that these changes may have on monetary policy in the future.
2. STRUCTURAL CHANGES IN THE FINANCIAL SECTOR
Three major structural changes can in particular, be distinguished in the financial markets of the world, namely:
co-operation, convergence and integration.
World War I and the Great Depression of the 1930s left the world with highly regulated domestic capital markets and a disintegrated international financial system. It is therefore not surprising that the highest priority was attached to restoring multilateral payments and current account convertibility towards the end of World War II, which led to the Bretton Woods Agreement and the General Agreement on Tariffs and Trade. In the period immediately after the war, the emphasis was placed on the liberalisation of trade and payments. Progress with these reforms was relatively slow and only started to gain momentum from the early 1980s. An indication of the subsequent increasing orientation towards open economic systems is provided by the rising number of countries that accepted the IMF's Article VIII obligations of currency convertibility for current account transactions from 35 in 1970 to 137 in early 1997, or to 76 per cent of the total membership of the Fund.
In the 1980s, the authorities of the industrialised countries began to realise that with floating exchange rates capital mobility was not incompatible with the objective of stability in domestic economic conditions. They accordingly started with a process of liberalising financial systems, which was later also adopted by some of the emerging economies. At the beginning of this year almost 60 members of the IMF have accordingly already accepted both current and capital account convertibility.
The movement to more liberalised financial transactions gained further momentum with the negotiations in the World Trade Organisation to liberalise financial services. Discussions, which had already started a few years ago, are planned to be completed by the end of this year and finalised in formal agreements between the members of the World Trade Organisation. In principle the negotiations are directed towards obtaining both access to foreign financial markets and treatment in those markets that is equal to, or at least as good as, that afforded to domestic firms. In practice, this means reducing a wide range of barriers commonly faced by firms seeking to offer financial services across the border of countries or through the establishment of local branches or subsidiaries. Amongst the barriers that still exist in the world are: restrictive and discriminatory licensing for foreign firms, ceilings on permitted investments and restrictions on the kind of products that can be offered. The intention is to follow the present round of financial liberalisation with a further round in the year 2000.
Together with the process of financial liberalisation, globalisation have become a feature of the world economy, i.e. a growing economic interdependence of countries worldwide have become discernible through the increasing volume and variety of cross-border transactions and through the more rapid and widespread diffusion of technology. New technological advances have reduced transportation, telecommunication and computation costs, thus greatly increasing the ease with which national markets may be integrated at the global level.
The liberalisation and globalisation have resulted in a growing interdependence of national financial markets. Although these markets are still not forming a single global market, the degree of interdepence is already strong enough to have altered the environment in which monetary policy is conducted. In particular, it has affected the volume of international financial transactions. For example, the average daily turnover in the combined foreign exchange markets of the world has grown from about $200 billion in the mid-1980s to around $1,2 trillion at present.
These closely linked financial markets have changed the monetary transmission mechanism by enhancing the role of the exchange rates of currencies. Domestic interest rates may accordingly now have to adjust less to achieve the objectives of monetary policy, because a large part of the adjustment is achieved through changes in the exchange rate. Moreover, shocks that occur in one market may be more easily transmitted to other markets. The growth of the financial markets has also substantially increased the capital flows between countries, as well as the volatility in the movement of these funds between countries.
The third important structural change is the strong movement towards closer international co-operation, convergence and integration. Many regional economic co-operation arrangements have been formed or are under consideration which could perhaps be seen as a transitionary phase of globalisation, but which could have serious implications for the monetary and other economic policy measures of the authorities.
Of particular importance for the financial sector is the formation of the economic and monetary union in Europe. The European Monetary Union will consist of an area whose economic potential will be comparable to that of the United States. With the establishment of the European Monetary Union, one of the largest government bond markets in the world will be created by denominating all new government bonds of member countries in euro. Given the size of the euro market, it is also to be expected that the euro will play an important role as an international currency. Experience has shown that the development of the euro into a major international currency will probably be gradual, starting off in those countries which at present have close links with Europe. However, together with the US dollar and to a lesser extent the Japanese yen, the euro is later likely to be used extensively as an invoicing and reserve currency.
3. EFFECTS ON SOUTH AFRICA'S FINANCIAL SECTOR
These changes in the rest of the world had little effect on South Africa's financial sector during the 1980s and the beginning of the 1990s, i.e. in a period in which South Africa became increasingly isolated from the rest of the world as a result of trade boycotts, embargoes and financial sanctions. The subsequent transition to a new political dispensation and the normalisation and expansion of the country's international relations, completely changed this situation. In these new circumstances, the South African financial sector was forced to move from a relatively isolated position into a world that in many instances looked completely different from the time when our financial institutions were still actively involved internationally.
To cope with the challenges of this new environment, it became imperative to bring about structural adjustments to the country's financial sector. In this regard it was particularly important to improve the functioning of the domestic financial markets, including the enhancement of transparency and liquidity. In addition, the re-entry of South Africa in an integrated international financial community led to the decision by the authorities to abolish exchange control. The country's limited foreign exchange reserves prevented the immediate removal of all exchange control measures, and the authorities therefore opted for a gradual relaxation of capital account transactions.
The restructuring of the financial sector, together with the normalisation of South Africa's international relations, led to a sharp increase in non-residents' participation in the domestic financial markets and enabled domestic banks to branch their activities out to other countries. The establishment of subsidiaries and branches of foreign banks increased the competition in the so-called domestic wholesale banking business, especially in the provision of foreign financing. Moreover, non-residents' transactions on the Bond Exchange started to increase rapidly, while they continued to be heavily involved in the Johannesburg Stock Exchange. Not only did this participation of non-residents contribute to a substantial increase in the turnover of these two markets, but it also led to greater volatility in long-term interest rates because investors quickly altered their positions with changes in domestic as well as international conditions. Moreover, prices on the Johannesburg Stock Exchange became more susceptible to changes in the prices on the stock exchanges of major financial centres.
The large movements in foreign portfolio investment and trade finance were also responsible for the increased volatility in capital flows that South Africa experienced over the past three years. A nearly consistent net outflow of capital of R48,3 billion in the period from the beginning of 1984 to the middle of 1994, was turned around with the reintegration of the country in the world economy to a net inflow of capital not related to reserves amounting to R8,7 billion in the second half of 1994. This was followed by a further exceptionally large inflow of capital of R19,2 billion in 1995, before a number of adverse developments reduced this inflow to R3,9 billion in 1996 and led to severe pressures on the foreign exchange holdings because the current account deficit could not adjust at the same pace.
Large and volatile capital movements seem to have become a characteristic of most emerging economies. Despite considerable efforts that have been made to make South Africa a more investor-friendly country, it can safely be assumed that volatile capital movements will continue to be an important feature of our economy in the future. This volatility will not only be influenced by domestic developments, but also by events in other countries. The crisis in Mexico during 1994 is a good example because it affected the capital flows and financial markets of most of the developing countries. The fact that South Africa's capital outflow in the first quarter of 1996 coincided with a sharp rise in interest rates in the United States also seems to be more than mere coincidence.
The volatile capital movements brought about sharp fluctuations in the nominal exchange rate of the rand. These fluctuations already became discernible from the beginning of 1993, i.e. before the termination of the financial rand. The turbulence in the market for foreign exchange had important other effects, such as
leads and lags in the payment and repatriation of foreign exchange, which put additional downward pressure on the spot exchange rate;
a substantial increase in the volume of transactions on the foreign exchange market from a daily average net turnover of R3,5 billion in 1992 to R6,0 billion in 1996;
larger margins between foreign exchange selling and purchasing rates; and
sharp fluctuations in the Reserve Bank's net open foreign currency position.
The large increases in the turnover in financial markets also contributed to a continued strong momentum in the monetary expansion. Both the money supply and the total amount of bank credit extension to the private sector continued to grow at exceptionally high rates. From the beginning of 1995 the rate of increase in the M3 money supply has fluctuated within a narrow band around a level of 15 per cent, and only recently began to show signs of subsiding. The rate of increase in total bank credit extended to the private sector fluctuated around an even higher level of 17 per cent over the same period. This continued high demand for money and credit extension was, however, not only related to the changed conditions in financial markets. Another important contributing factor was the transformation process in the labour force where a large number of older people with a high savings propensity were replaced by younger people in relatively senior positions with a high propensity to consume and a greater willingness to make use of bank credit to finance these transactions. On the supply side banks actively promoted the use of bank credit and a large number of retail outlets introduced in-house credit cards to encourage consumption expenditure.
Finally, the reintegration of South Africa in the changed world economy has led to a sharp growth in the eurorand bond market. Borrowing in rand on this market occurred for the first time in September 1995. This was followed by a further 22 issues, before the depreciation of the rand from the middle of February 1996 caused the interest in this market to disappear. When the exchange rate of the rand became more stable from the end of October 1996, the eurorand bond market again began to expand at a rapid rate. At the end of July 1997, the total eurorand issues outstanding amounted to R23,7 billion. The remarkable growth in this market can mainly be ascribed to the fact that it provides the opportunity to separate credit risk of corporate issuers from the currency risk represented by borrowing in rand. The growth in the eurorand market has contributed to the inflow of capital to South Africa, because many of the corporate issuers have hedged their rand exchange rate risk in the South African market.
4. IMPLICATIONS FOR MONETARY POLICY
The liberalisation, globalisation and integration in the world has therefore already had significant effects on South Africa's financial sector and will in the years beyond 2000 become even more important. In the coming years monetary policy decision makers will always have to remember that the internationalisation of investment decisions implies that capital, by being transferable abroad, can easily be removed from national political influence. Careful consideration should accordingly be given to the factors responsible for capital movements.
The two primary forces that drive investor interest in developing countries are the search for high returns and the opportunities for risk diversification. In making these decisions, investors are influenced by domestic as well as external influences. Investments in any developing or other country may be affected by economic conditions in other countries, such as the level of interest rates, exchange rates and asset prices, and expected changes in these aggregates. There is ample evidence that changes in external conditions played a role in the large capital flows to emerging economies in the late 1980s and early 1990s. Two of the most important developments were the drop in interest rates and lower economic growth in industrial countries.
Domestic factors may, however, be even more important in attracting and keeping capital in a specific country. Apart from socio-political circumstances, the creditworthiness of a country on the economic front depends, inter alia, on the level of development of the country, the availability of resources, the infrastructure, the pace of economic growth, labour costs and laws, the overall balance of payments position, the level of foreign reserves, the size and growth of public and foreign debt and overall macro-economic management. According to a recent study of the World Bank, countries are generally "likely to suffer a loss of investor confidence when the real exchange rate is perceived to be out of line, the government's debt obligations are large in relation to its earning capacity and external reserve position, fiscal adjustment is perceived to be politically or administratively infeasible, or the country's growth prospects are bleak".
Be that as it may, the changed financial environment has made it imperative that the monetary authorities achieve the objective of price stability. The pursuit of price stability in the rest of the world and the success achieved by many countries in bringing their inflation rates down to low levels, has left South Africa with no alternative than to bring its inflation in step with that of the rest of the world and to keep it there. If this is not achieved in the coming years, market adjustments to compensate for inflation differentials are inevitable. Such adjustments could include large disruptive capital outflows, a depreciation of the rand and high interest rate levels.
The thrust of monetary policy under circumstances of volatile cross-border capital movements therefore seems to be clear: inflation expectations and consequent hedging and other evasive actions can be minimised only by a consistent counter-inflation monetary policy stance. Fortunately the South African monetary authorities have already for a number of years followed this course and has achieved some success in bringing the inflation rate in South Africa down to lower levels. In future, with globalised financial markets it will be even more important that a consistent counter-inflation policy be pursued, despite pressures which may be placed on the central bank.
It should, however, also be realised that such a policy stance does not provide unconditional protection against capital outflows, which may also be sparked off by a change in a country's relative position to other countries. For example, inflation expectations in other countries may disrupt domestic economic conditions. Policy makers therefore have to take such developments into consideration in deciding on their own actions. It can, nevertheless, be expected that volatility in the exchange rate of the rand will inevitably become a feature of the South African foreign exchange market. Although monetary policy makers cannot stand idly by in the event of such disruptions, they must also be aware of the fact that they cannot prevent it completely. In the long run, realistic capital market interest rates and exchange rates, which are ultimately decisive in investment and other decisions, are beyond the control of the central bank. The only approach that can be followed by any central bank is a consistent counter-inflation policy stance so that it can forestall uncertainties and avoid excess volatility.
Unfortunately, the pursuance of price stability has been made more difficult by the fact that the transmission mechanism has become more complex due to the changed conditions in the world. The relationship between changes in interest rates, money supply and the inflation rate has become more obscured under liberalised conditions in comparison with the period when South Africa was sealed off from external influences. As a result of international capital flows, the effects of changing interest rates are being transmitted to a greater extent through exchange rates and participants' expectations of possible economic developments. Longer time lags are accordingly at times discernible between policy changes and their desired impact on the real economy.
These changes in the transmission mechanism of monetary policy have affected the credibility of the money supply as an intermediate guideline of policy. The money supply has become a less reliable indicator of underlying inflation and therefore also a less reliable anchor for monetary policy, because it is influenced by international capital flows and developments in domestic financial markets which obscure these relationships. The South African Reserve Bank has accordingly started to use a broader range of economic indicators for the determination of policy actions. Many other central banks in the world have shifted to direct inflation targeting in their monetary policy strategy. In the years beyond 2000 South Africa may also have to adopt such a strategy, provided that the markets for other production factors are restructured to reflect underlying demand and supply conditions.
Large fluctuations in international capital flows also create problems in the management of domestic liquidity. With the increased integration of financial markets, South African banking institutions can more easily obtain funds from external sources when they are squeezed by a tight domestic liquidity situation, i.e. they do not solely have to rely on the Reserve Bank as lender of last resort. This has contributed further to already insensitive money market interest rates. Short-term interest rates have become relatively rigid, and only show pronounced changes when Bank rate is changed. Under tight money market conditions banks prefer to adjust their asset and liability positions rather than changing their interest rates. Increased interest rate flexibility is an important prerequisite for proficient liquidity management to cope with volatile international capital flows, exchange rate changes and financial asset price movements. The new financial environment will therefore require that the monetary instruments that are applied in South Africa are adjusted in order to improve the flexibility of domestic financial markets.
In addition, the globalised financial markets of the future will provide new challenges in the field of banking supervision. The experience in a large number of other countries has clearly indicated that with globalised financial markets and large international capital flows there are a real danger of bank failures. Economic and financial expansion are bound to lead to higher asset prices and a deterioration in the loan portfolio of banks. If asset prices start to decline after a period of credit growth, the danger of default and large bad debts become imminent. Continued attention will accordingly have to be given in South Africa in the coming years to sound risk management and the devotion of even more resources to the supervision of financial markets.
In conclusion it can be stated that although the liberalisation, globalisation and integration of financial markets will bring about many advantages to South Africa, it will also force more discipline on the management of the economy. In an integrated world economy, international investors will judge the appropriateness of broad macro-economic policy. If they feel that unsound policies are being pursued, this will become apparent in their investment decisions. Ill-judged economic policy measures of government authorities could accordingly lead to painful adjustments forced on economies through the actions of the participants in the markets. In these circumstances a consistent counter-inflation monetary policy stance is the best course that the central banks, including the South African Reserve Bank, can follow. If such monetary policy measures are taken in close co-operation with other forms of macro-economic management we cannot but be successful in South Africa in the coming years.