1. The causes of the problem
The present financial crisis is, of course, not a South African crisis but a global one which affects many financial markets in many different countries. It is therefore wrong of so many South African analysts to seek for reasons within the South African economy for the affliction. Should the roots of the problem have been within the South African economy, it would have been easier to prescribe remedial action, and to apply appropriate policies that could guide the financial situation back to stability.
Reasons for the current crisis are debated very widely and very intensely in international financial fora. Since April this year, meetings within the International Monetary Fund, the World Bank, all the G-Groups, such as the G-7, G-10, G-22 and G-24, and the Bank for International Settlements were dominated by this issue. Many organisers of international conferences capitalise on the urgent need of participants in the financial markets for more discussion and analysis and for finding solutions to the problem. In the analyses, and with the advantage of hindsight, there is fairly general consensus that the origin of the present turmoil in global markets can be traced to the continuing weakness of the Japanese economy, and the exposure this brought of certain inherent structural weaknesses in the economies of a number of East Asian countries.
It is ironical now to realise that the spectacular economic successes achieved by a number of East Asian countries in the past few decades actually carried within the process of high and sustained economic development also the seeds of eventual collapse. Taking a longer-term perspective, the adjustments that are now taking place in those countries in the area of social, political and economic activity, are perhaps necessary to provide a new basis for a next wave of high economic development, provided the proven weaknesses will now be eliminated effectively from past policies, and from existing structures.
In his Chairman's Address delivered at the Annual General Meeting of the shareholders of the Bank for International Settlements, held in Basle on 1998-06-08, Governor Alfons Verplaetse summarised the East Asian situation as follows:
"The economic and financial drama unfolding in Asia over the last year or so has understandably puzzled and preoccupied both policy-makers and market participants. The deterioration in the economic fortunes of many of the affected economies has been extraordinary, particularly given the widespread belief that their earlier successes were based on sound fundamentals. Unfortunately, these earlier successes seem to have contributed as well to a climate of excessive optimism among both borrowers and lenders. As a result, inadequate attention was paid to the rapid build-up of domestic and foreign debt by domestic corporations. Also ignored was the significant threat this would pose to the stability of local banking systems should heavily managed exchange rate regimes come under pressure. Once difficulties emerged, a sharp and simultaneous reassessment of exposures to liquidity risk, market risk and credit risk then turned what might otherwise have been an orderly adjustment into a prolonged crisis. A more sober sense of realism is now influencing economic policy-making in the region. While the road ahead remains long and difficult, the courageous reorientation of policies in several countries deserve to be applauded. Indeed, confidence in the region is slowly being rebuilt".
The international prescription for the East Asian economies, spearheaded by the International Monetary Fund, covers a wide area of macroeconomic policies, financial structure reforms, improved governance in both private and public sector institutions and enhanced disclosure of information. Of particular importance is the very substantial foreign exchange support packages provided by the IMF, the World Bank, and the international banking community. South Africans, who remain critical about the modest assistance the South African Reserve Bank provided in the past for South African banks in distress, should take notice of the billions of dollars of assistance that central banks and governments now provide to re-capitalise ailing banks in Asian countries.
Taking account of all these programmes, as indicated by Alfons Verplaetse in Basle last week, "confidence in the region is slowly being rebuilt".
2. Effects of the Asian crisis on South Africa
It is true that the basic causes of the present financial crisis lay outside of South Africa and that we, as a small participant in the global financial environment, can do but little to change the situation. The South African financial markets, however, were in recent weeks severely affected by these developments. A first interesting question that should be asked at this stage is how contagion spreads in the present global environment of financial integration? How does the transmission mechanism work and what conduits are followed in the process of transferring problems from afflicted markets almost instantaneously to other markets?
In the case of South Africa, one obvious channel used in the past few months was the easily accessible bond market. During the first four months of this year, non-residents increased their holdings of South African bonds by R16,2 billion, that is by more than R4 billion per month. These large net purchases of South African bonds by non-residents increased the supply of foreign exchange in the market (although not all transactions represented cash flows); compelled the Reserve Bank to buy surplus dollars from the market in order to prevent an appreciation of the rand; increased liquidity in the domestic banking sector; and exerted downward pressure on both long- and short-term interest rates.
During May, however, in line with a major further deterioration in East Asia and in the global financial markets, non-residents reduced their holdings of South African bonds by R3,0 billion for reasons that had nothing to do with South Africa as such. In a major reassessment of their positions in emerging markets, many international fund managers decided to reduce their exposures in these markets. South Africa enjoyed the advantages of the large inflows of volatile portfolio investment in large amounts at the beginning of the year, and then reeled under the adverse effects of the subsequent withdrawal of some of these funds.
The changes in the underlying situation created new expectations, not only of higher interest rates, but also of a depreciation of the exchange rate. Investors with short-term objectives will obviously make use of such a situation to protect their own positions, and even to generate capital gains through speculative transactions. To achieve their goals, short-term investors could either transfer funds out of South Africa to a safer haven, or hedge transactions through the forward foreign exchange market. During May, confirming once again that the problem was not so much a South African country risk exposure, but much more a speculative exchange rate operation, the demand for forward cover soared, both at the level of the commercial banks and with the Reserve Bank. Refusal to provide in this demand would have led to much larger capital outflows, a greater shortage of liquidity in the money market, and much higher interest rates in the country.
Part of the international debate at this stage is whether countries such as South Africa should not rather revert to exchange controls to protect domestic markets more effectively against these volatile international capital movements. Our experience over the past four years provides sufficient evidence to prove that, over the longer term, there are more benefits than disadvantages attached to participation in the globalisation process, as an alternative to economic isolation.
3. The South African reaction
Many South Africans looked for malignant ulcers within the South African system that were supposed to have caused the problem in the financial markets. The Government and the Reserve Bank were blamed for creating the situation, and all kinds of petty incidents were dramatised in the media. And yet, developments in South Africa followed the course of the international markets that affected even stable economies such as those of Australia and New Zealand in a similar way.
Although South Africa could not change the course of events in the global financial markets, we had to react to the unexpected and disrupting effects on the South African economy of these developments. South Africa was particularly concerned about its domestic economic situation which certainly did not need a series of depressive shocks at this stage. It is, however, not possible to separate the domestic economy entirely from international developments and, at the same time, participate in the advantages of international market integration.
As in the past, the Reserve Bank let itself be guided by the principles of a market economy, and by rational market adjustments to reflect changes in underlying conditions. With a decline in the overall net capital inflow, and possibly a deficit in the overall balance of payments in May 1998, the exchange rate had to depreciate, domestic liquidity had to be drained out of the banking system, and interest rates had to rise. The policies applied by the Bank during this period provided an overall strategy for simultaneous changes in these aggregates to encourage adjustment in the capital market, the money market and the market for foreign exchange, on a consistent basis.
Critics of elements of the policy often overlook the inter-relationship that exists between all the financial aggregates, and real economic activities, in a market economy. They also sometimes overlook the longer-term financial policies of the country, and ignore developments that preceded the latest changes. The Reserve Bank is, for example, criticised for having used part of 'our' foreign reserves to provide liquidity to the foreign exchange market. Should the Bank then also refrain from buying dollars in the market during times of surplus supply, for example as the Bank did during the period January to April 1998? Will it be ethically defendable to foreign investors to absorb dollars in the official foreign reserves in times of capital inflows, but refuse to make dollars available when they decide to disinvest?
The Bank is criticised for having once again supported the market in forward foreign exchange during the past six weeks. The Bank would also like to get out of this market, but must take the needs of the domestic economy into account. By providing forward cover, the Bank prevented a larger capital outflow, a bigger decline in the cash foreign reserves, higher interest rates, and more depreciation of the rand. Reducing the Bank's role in the forward foreign exchange market is part of the longer-term strategy of financial liberalisation, which should be implemented with caution, and with due regard of adverse implications for the domestic economy.
Some critics believe that the Reserve Bank should not have intervened in the foreign exchange markets at all, and should have allowed the rand to depreciate more. Were they of the same opinion when intervention went in the opposite direction over the preceding 16 months and the Bank increased its net foreign reserves by R13,2 billion? Or do they believe that a country can follow their proposed asymmetrical intervention policy and still become part of the global financial system?
Critics who believe that the rand is 'overvalued' and should be allowed to depreciate more and take their cue from what countries such as Australia and New Zealand did recently, must take into account that these countries allowed their exchange rates to appreciate from time to time, and therefore have a greater capacity to accommodate depreciation at other times. Over the period of more than six years from 1992 to May 1998, the real exchange rate of the rand against the US dollar depreciated by more than any of the currencies of Mexico, Australia or New Zealand. Compared with Australia and New Zealand, it is no wonder that South Africa over this period had a higher rate of inflation and a lower economic growth rate, partly because of our asymmetrical policy on exchange rate adjustments which supports a permanent inflationary bias.
The depreciation of the exchange rate provides no panacea for the domestic economic growth problems of South Africa. This was reconfirmed as recently as in 1996, when the rand depreciated by more than 20 per cent, and inflation almost doubled from 5½ per cent in April 1996, to almost 10 per cent in April 1997. More depreciation has more of an inflationary effect, and therefore requires a more restrictive monetary policy with higher interest rates than less depreciation. This is well-illustrated by the so-called 'monetary conditions index' used by the Bank of Canada which indicates that a 4 to 5 per cent depreciation of the Canadian dollar must be accompanied by a 1 per cent increase in Bank rate to maintain the same monetary policy stance. Supporters of more depreciation in South Africa must therefore be consistent, and also be supportive of higher interest rates in the country.
Finally, nobody likes the recent rise in interest rates in South Africa, except perhaps the few silent savers we may still have hidden somewhere in the country. But, once again, the recent adverse changes in the capital account of the balance of payments left us with no alternative -- we either had to accept a rise in interest rates now, or allow the deterioration in the balance of payments to be perpetuated indefinitely. Eventual adjustment would then have become more painful and more costly. Although calls were made on fund intermediaries such as the commercial banks to delay general interest rate increases for as long as possible, each institution operating in the market must judge its own position and decide its own interest rate policy. We should not, by forcing banks to keep interest rates artificially low, force a weak financial system on our economy. So far, the soundness of the financial system distinguished South Africa from many of the East Asian economies with their vulnerable banking structures.
4. Concluding remarks
The recent adverse developments in the financial markets affected the South African economy negatively, at a stage when we were of opinion that the time was right for a relaxation of monetary policy. It would have been foolish, however, to pretend that the unfavourable developments did not take place, and to have continued on a course of monetary restimulation.
Foreign investors will judge South Africa on this occasion, not so much on what we do to correct dis-equilibrium in our own economy -- that was already done during 1996 and 1997. Collectively, however, they will judge us on how we handle this rather difficult and embarrassing situation where there is a clear conflict between our domestic and international objectives.
We in the Reserve Bank believe we have so far followed policies in the best interest of the country to cope with a difficult situation. As stability will return to the international financial markets, the South African economy will be well-placed to resume a new upward phase of the business cycle.