Mr. Stals comments on the need for greater financial flexibility in a volatile global financial environment  (Central Bank Articles and Speeches, 5 Nov 98)
Central bank: sarb | Type: speech | Date: 1998-11-05

Mr. Stals comments on the need for greater financial flexibility in a vol global financial environment Address by the Governor of the South African Reserve Bank Dr. Chris Stals, at the Annual Dinner of the Institute of Bankers in Cape Town on 5/11/

## 1.

Increasing volatility in financial marketsDevelopments in the global financial markets over the past year focused attention on the ability of countries to adapt to rapidly changing conditions in a volatile global environment.

With a strong trend towards globalisation and the wo integration of financial markets that swept through the world economy over the past most countries of the world, big and small, have now become more exposed to volatile inflows and outflows.

The cross-border (and therefore cross-currency) transfers of huge of investment funds disrupt domestic and foreign currency markets in many countries al a regular basis.From the experience of the past year, it is clear that many of the smaller with rapidly expanding domestic economies and emerging financial markets find it incre more difficult to maintain domestic financial stability and remain within the environment of an integrated global financial market.

The amounts involved in volatil transfers are too large for the smaller economies to absorb.

Countries find it diffi internal situations to sudden and unpredictable turnarounds in the flow of funds that place from time to time.A second major problem that surfaced during this year of financial turmoil c around the diverse economic needs of many countries that find themselves at different economic development, different phases of the business cycle, and pursuing different o with their overall economic strategies.

The integrated global financial markets set hig based on the needs and norms of the more developed economies, being the main source o supply of funds.

Ambitious fund managers, seeking to maximise the yield on invest managed on behalf of demanding clients, have little loyalty to the needs or the circum the countries where they make their investments.

There is, indeed, little diversifica thinking or in their computer programs when they invest in the global markets -- all markets are, for example, treated as just one group of countries.Given the environment of volatile capital movements, a third deficiency present system has been identified, and that is the lack of a global 'lender of las 'discount window facility' that can serve to provide temporary assistance in times o outflows of capital from a country.

The resources of the International Monetary Fund t to be completely inadequate in the present volatile environment.

Even after the complet current round of increases in the quotas of the Fund, the IMF will not be in a positio the needs of its member countries in times of serious global financial crises.

Many over the past year of IMF assistance are also of the opinion that the conditionalitie IMF loans are no longer appropriate for the present world environment.

Disrupti international financial markets are no longer created by structural or temporary imb international trade, but rather by volatile international capital inflows and outflow conditionalities are still directed, however, to the restoration of equilibrium in account of the balance of payments.A fourth conclusion from the developments of the past year is that the p international financial system of floating exchange rates and free capital movementsincreasing incentives for speculators and short-term profit explorers to exploit wea individual countries, often at the cost of the impoverished and the poor people of the

## 2.

A Hobson's choice for the emerging marketsSmaller countries such as South Africa can do little to change the world f system, but may still be able to isolate themselves from the volatility of the world e This will, however, require comprehensive restrictive exchange controls on both resid non-residents in respect of all international capital transactions.

In the process, moves in this direction will most probably be excluded from the ongoing process of f globalisation, and will be barred from access to international capital markets.A few countries recently nevertheless opted for this alternative and preferred the route of isolation to the continued exposure of their economies to fic fund managers and international currency speculators.

In the case of Malaysia, it was j the country's high domestic savings rate will generate sufficient funds to provide for future economic development.

In the case of Russia, the government had no other choice close its financial markets after a major collapse in the public and private sect systems.South Africa, with its low level of domestic saving and massive needs for economic development, has no choice.

Unless this country can rely on some regular subs inflow of capital from the rest of the world, its economic growth rate will not creat jobs for the already large number of unemployed and the annual addition to the labour provide the resources needed for the social upliftment of the population.

South Afr therefore remain part of the global financial markets, and must pursue macroeconomic and introduce structural adjustments regarded as necessary to make the country attra foreign investors.It is not precluded that some important changes may be introduced to the financial system over the next few years.

South Africa will, to the extent that it pa this debate in various international fora, press for the introduction of measures tha the volatility of the markets.

We know from experience, however, that proposals for c the global financial architecture can take a long time to find consensus, and changes probably only be introduced gradually.In the meantime, South Africa will be exposed from time to time to vol capital movements, and the domestic economy will remain vulnerable to external distur that may in the short term force macroeconomic policies inconsistent with domestic ec objectives.

The question remains, what can, or should, South Africa do to make sure domestic economy will, over the medium and longer term, be better protected again disadvantages of international financial market volatility and still gain maximum advan international capital inflows?

## 3.

The need for financial flexibilityGlobalisation is about markets.

It is markets that are being integrat worldwide system of unrestricted capital movements, and markets that are being opened participation by investors from all around the world.

Acceptance of any country in t financial markets therefore requires a recognition of the principles of the market ec an adherence to the rules of the game.One of the basic rules of the game in a market economy is that governments allow market forces of demand and supply to determine prices.

Intervention by governme the markets for whatever purpose, if necessary, must always work through the markets, suspending or restricting the forces of demand and supply.

The price mechanism indeed p the core discipline of the market economy, and through price changes, markets signal m and activate automatic adjustment processes intended to hold demand and supply in equilIn the context of international capital flows, the exchange rate is, of c most important price.

It is important for the smaller countries therefore to ensu adjustment processes for exchange rate changes in the environment of a volatile global environment.

It is almost impossible to maintain a fixed exchange rate for any curre large amounts of capital start flowing out of or into a country.

Efforts to maintain unrealistic exchange rate in such circumstances will only entice speculative transactio eventually exacerbate the problem.This does not mean, however, that the authorities may never intervene i foreign exchange market, for example to maintain orderly conditions, to smooth out sh fluctuations, or to provide liquidity to the market.

Such interventions, which must always be conducted through the market system, are often confused with a policy of fi exchange rate through more direct means of control.In South Africa, there is a misguided perception that the Reserve Bank intervene in the foreign exchange market to prevent any appreciation of the rand, but m from intervention whenever the rand comes under pressure for depreciation.

Such a poli of course, create a one-way bet for speculators and will encourage short-term investo positions against the rand and then force the exchange rate down to generate capital themselves.

The Reserve Bank prefers to intervene in the market on a discretionary work discreetly through the market forces of demand and supply, and to keep specu guessing on what the Bank's next step will be.South Africa adheres to a policy of a floating exchange rate system.

As lon still maintain exchange control restrictions on the foreign assets that South African r hold, the Reserve Bank will have to continue to intervene in the foreign exchange mar time to time, both as a buyer and as a seller of foreign exchange.

As in the past, th exercise cautious discretion, will respect the underlying forces of demand and supply accept the need at times for a depreciation and, in different circumstances, al appreciation of the rand.

In other words, we believe the present South African excha policy has sufficient flexibility built into the system to accommodate the vicissi globalised financial market system.Another very important price that must be flexible and adjustable in th world financial environment is the interest rate.

Interest rates are prices: the pricfunds with different maturities and different risk exposures.

As is the case with all o a market economy, interest rates are determined by forces of demand and supply. authorities do not want to accept interest rates as determined by market forces, t preferably work through the markets to either reduce the demand for funds (for exam reducing government expenditure), or increase the supply of funds (by creating more through the central bank).

This latter course may reduce interest rates in the short te the danger of higher inflation, and therefore also higher interest rates, in the longerIn March this year, the Reserve Bank moved away from the conventional fix Bank rate for its loans to banking institutions and introduced the more flexible d system for repurchase transactions, where the effective lending rate of the Reserve determined on a day-to-day basis through a process of the interaction of demand and sup repo rate is now more closely linked to movements in short-term market interest r determined by overall demand and supply conditions in the money market.

Short-term in rates can adjust very quickly to changes in underlying conditions.

The repo rate can be by the Reserve Bank by changing the amount of central bank funds supplied to the market process, the basic principle of the market mechanism is adhered to.Here once again there is a misguided perception in South Africa that the R Bank should intervene more actively in the markets to prevent interest rates from ri when there is a fundamental shortage of funds, but should not prevent interest ra declining in times of increases in the supply of funds.

Such an asymmetrical approa unfortunately, not be tolerated by the disciplines of the global market economy.

In turmoil in the international financial markets, a number of smaller countries experi vengeance of the international market forces when they tried to keep exchange rates o rates fixed at artificial levels not associated with the underlying market fundamentals.A third area where greater flexibility in the price-fixing process has be more importance in the situation of global financial integration is in the determina prices of financial assets such as share and bond prices.

A decision by the Hong Kong Authority recently to buy shares in the stock exchange when sales by non-residents push down was exploited by speculators, but nevertheless contributed to some stabilisatio authorities operated mainly through the market mechanism of demand and supply.

As wit other interventions by the authorities in the financial markets, buying or selling of financial markets should be done with discretion, and should not prevent normal marke from continuing to function effectively.

For a country such as South Africa, it is important to encourage well-functioning, efficient and flexible financial markets whe can adjust quickly to changes in the underlying demand and supply conditions.Many other examples of a need for greater flexibility in the process o determination can be conjectured, for example, prices of commodities, of financial ser of labour.

Without flexible prices in all markets, smaller countries will find it difficult to survive in an integrated worldwide economy.

## 4.

South Africa's experience with global financial volatilityOver the past six months, South Africa has experienced the full force uncontrollable volatility of the international financial markets.

A few statistics wil impact these forces had on the South African economy:- During the first four months of 1998, non-residents increased their hold South African bonds by R16.3 billion.

During the next five months, th from May to September, non-residents reduced their holdings of South Afri bonds by R22.4 billion.- The exchange rate of the rand, which was relatively stable throughout 199 the first four months of 1998, depreciated by 21.4 per cent from 22 May to 31 August 1998.

Since then, the rand has appreciated slightly but is this stage, on average about 16 per cent down from the beginning of the y- The yield on long-term government bonds rose from below 13 per cent in Ap 1998 to 20.09 per cent on 28 August 1998, and then declined again to belo per cent at this stage.- The prime overdraft rate of banking institutions was raised from 18.25 pe at the end of April 1998 to 25.5 per cent on 28 August 1998.

During the few weeks, the major banks have reduced their prime overdraft rates aga 23.5 per cent.- The average prices of all shares listed on the Johannesburg Stock Exch increased by 32.3 per cent from December 1997 to an all-time high in 1998, but then declined by 38.7 per cent to the end of September 1998. the end of September, the all-shares price index of the Johannesburg Exchange has increased again by about 19 per cent.These erratic movements in major financial aggregates created many problems the authorities, financial institutions, businesses, private individuals, and indeed economy.

And yet, nobody can be blamed for it.

It is part of the globalisation of markets, and of South Africa's participation in this process.

South Africa went through experience in 1996.

On both occasions, that is in 1996 and so far in 1998, we succ restoring financial stability in a relatively short period of time, but not without pai and a high social cost in terms of low economic growth.There is no guarantee that somewhere down the road our economy will not tested again by the increasing volatility of an integrated world financial market s therefore important that we shall all learn from the two experiences of the past thre shall prepare our economy to prosper even within the environment of volatile inter capital movements.We have learnt that sound macroeconomic policies at all times make it eas absorb the fluctuations in the financial markets.

Countries that do not appl macroeconomic policies are punished more severely during times of international cu turmoil.We have learnt that flexibility in domestic financial and other markets m easier to absorb the shocks of the periodic global financial market disturbances.

In pa have learnt that prices as determined by market forces must be allowed to respond qui decisively to changes in underlying market conditions.We have learnt that government policies are important, but that govern actions alone cannot solve the problem once it has infiltrated into our markets.

The di the market economy must be allowed to function in a flexible way.We have learnt above all that sound, well-managed, and healthy banki institutions can form a major bastion against total economic collapse in a situatio capital outflows.

In a number of East Asian countries, the economies collapsed com because weak banking systems could not survive in the adverse climate of sudden large o of capital.South Africa must be grateful for the strength of our banking system, and protect it to make sure that we shall also be able to withstand the future storms o global financial market environment.

Weak banking systems lead to weak economies.