1. Macro-economic consolidation in 1997

After a year of successful macroeconomic consoli-dation, the overall financial situation in South Africa during the first quarter of 1998 provided a promising base for some economic recovery during the course of the new year.

During calendar 1997, the growth in real gross domestic product slowed to 1,7 per cent, down from over 3 per cent in both 1995 and 1996. Simultaneously, however, growth in total real domestic expenditure also receded from 5 per cent in 1995 to only 1,4 per cent in 1997. With a better balance between growth in overall production and in total demand, pressures on the balance of payments were reduced. With a current account deficit of only R8,8 billion and a large net inflow of capital of more than R20 billion, the country's net gold and foreign exchange reserves increased by more than R11 billion; the gross reserves increased by even more as the Reserve Bank made use of short-term credit facilities to boost its own holdings of foreign exchange. At the end of 1997, the country's gross official gold and foreign exchange reserves held by the Reserve Bank and the private banks had risen to R36,6 billion, more than double the amount of R16,8 billion held at the end of 1996.

Although growth in important monetary aggregates such as the money supply and bank credit extension remained at relatively high levels throughout 1997, the Reserve Bank was prepared to ease monetary policy gradually. The rate at which the Reserve Bank makes loans available to banking institutions was lowered from 17 to 16 per cent in October 1997, and further to 15 per cent in March 1998, when a new more flexible system of daily repurchase transactions was introduced. This policy of an easing of monetary conditions was supported by a further encouraging decline in the rate of inflation. After peaking at 9,9 per cent in April 1997, the rate of increase in consumer prices, measured over a twelve months' period, declined to 6,1 per cent in December 1997.

2. Stage set in first quarter of 1998 for gradual economic recovery

In the first quarter of 1998, favourable conditions developed for an improvement in overall economic conditions. The current account of the balance of payments improved further. Measured on a seasonally adjusted annualised basis, the current account deficit declined from R14,1 billion in the fourth quarter of 1997 to R8,6 billion. A relatively large net capital inflow of more than R11 billion required further substantial intervention by the Reserve Bank in the market for foreign exchange to prevent an appreciation of the real effective exchange rate of the rand. The Bank's own gross gold and foreign exchange reserves indeed increased from just over R10 billion at the end of 1996, to R32,8 billion on 1998-03-31. With the further relaxation of exchange controls, private banking institutions also increased their holdings of foreign exchange, and at the end of the first quarter of this year, the country's total gross foreign reserves amounted to R45 billion, enough to cover about 3 months' imports.

These favourable developments in the overall balance of payments eased the financial situation in the country further. Purchases of foreign exchange by the Reserve Bank increased domestic liquidity. The amount borrowed by the banks from the Reserve Bank on an overnight basis declined from an average daily amount of over R11 billion in December 1997 to R4,6 billion in March 1998.

In the process, interest rates also declined. The rate on three months' negotiable certificates of deposit, for example, declined from 15,5 per cent at the end of 1997, to 13,2 per cent at the end of March 1998. The yield on long-term government bonds declined from an average of 14,2 per cent in December 1997 to 12,9 per cent in April 1998. Prime overdraft and mortgage lending rates similarly declined by about 2 full percentage points.

For monetary policy purposes, it was important that inflation continued on its downward trend. Consumer price inflation declined further from 6,1 per cent in December last year to 5,0 per cent in April 1998. The rates of increase in both the M3 money supply and bank credit extension to the private sector showed some signs of receding, although both stayed at a precariously high level.

3. What went wrong in May 1998?

This favourable macroeconomic situation changed suddenly and abruptly in May 1998 when an unexpected reversal in the net inflow of foreign portfolio investment, particularly in South African bonds, created shortages in the market for foreign exchange and in the domestic money market. These changes forced a depreciation of the rand and higher interest rates.

Non-residents increased their holdings of South African bonds by R16,3 billion during the four months January to April 1998. In the month of April alone, the net increase amounted to R6,2 billion. In May, however, non-residents reduced their holdings of South African bonds by R3 billion, followed by a further net outflow of R4 billion in June and R6,3 billion so far in July.

It is interesting to note that this sudden reversal in the investment attitude of non-residents did not affect investment in equities in the same way. The increase in the net amount of South African equities held by non-residents amounted to R19,4 billion in the first four months of 1998, that is, an average of R4,8 billion per month, and to R11,3 billion (average of R3,8 billion) in the subsequent three months May to July 1998. The total net inflow through the two markets together, however, declined from R13,3 billion in March and R12,8 billion in April, to only R500 million in May, and less than R100 million in June. In July, on balance, there was a net outflow of funds.

The changed situation immediately created a shortage of foreign exchange in the market, and exerted downward pressure on the exchange rate of the rand. The initial depreciation of the rand was fairly modest -- from the end of April to 1998-06-04, the nominal effective exchange rate of the rand depreciated by only 1 per cent. Subsequently, however, when perceptions became fairly general that the rand would depreciate further, the nominal effective exchange rate declined by a further 22 per cent up to 1998-07-06. Since then, markets became more stable, and the rand recovered some of the lost ground with an appreciation of 1 per cent. On balance, since  1997-12-31, the rand has depreciated by 20 per cent against a basket of the currencies of South Africa's major trading partners.

In retrospect, it is clear that the initial pressures created by the switch in the portfolio capital flows adversely influenced expectations of future movements in the exchange rate, and encouraged a substantial outflow of short-term capital (normal "leads and lags"). Further pressure on the exchange rate at that stage for obvious reasons enticed foreign investors to take speculative positions against the rand, which added to the exchange rate pressures.

Against the background of these volatile inter-national capital movements, domestic money market conditions also became very unstable. In the situation, interest rates had to rise, and with greater flexibility in the money market introduced with the Reserve Bank's system for daily repurchase transactions, the upward adjustment in interest rates followed a rather erratic route. The Reserve Bank's effective lending rate to banking institutions moved from 14,80 per cent on 1998-05-16, to 24 per cent on 22 June, but then declined again to stabilise at a level of just over 20 per cent at the end of June. Since then, it increased in a steady way to its present level of 21,3 per cent.

Liquidity in the banking sector was also substan-tially reduced through the events of the past three months. At the end of March 1998, the banks borrowed only R4,4 billion from the Reserve Bank. By 26 May, this amount had increased to R16,7 billion. During July, the total liquidity need of the banks fluctuated around the R10 billion level per day.

Short-term market interest rates in general rose by about 5 full percentage points over the past three months. The prime overdraft rate of banking institutions at its present level of 24 per cent is at its highest level since 1985/86.

4. Prospects for the future

The depreciation of the rand of about 20 per cent since the beginning of this year will bring some advantages to South African exporters, and to local manufacturers competing with imported products. A depreciation in any situation indeed provides a monetary stimulus to the economy, and can benefit the balance of payments under certain conditions. There is, however, always the risk that the major stimulatory impact of the depreciation will fall on prices, and not on real production. After the depreciation of the rand in early 1996, inflation in South Africa doubled from 5,5 per cent in April 1996 to 9,9 per cent in April 1997. On that occasion, fortunately, inflation then peaked and declined again to the recent low point of 5,0 per cent.

It is a further challenge therefore for monetary policy to make sure that, on this occasion, inflation will not in the wake of the latest depreciation of the rand be relegated on a more permanent basis to a higher level. This will require great caution with the implementation of monetary policy for the next twelve months.

The financial developments of the past three months will, in the short-term, have some adverse effects on real economic activity, particularly in developments in the components of real expenditure that have become unduly dependent on bank credit extension. In the longer term, the adjustments can be beneficial to economic growth, provided financial stability will be restored and maintained with appropriate restrictive monetary and fiscal policies.