Mr Stals looks at South Africa's financial and economic prospects for the next five years  (Central Bank Articles and Speeches, 27 Jan 99)
Central bank: sarb | Type: speech | Date: 1999-01-27

## Mr Stals looks at South Africa's financial and economic prospects for the next five yeaAddress by the Governor of the South African Reserve Bank, Dr Chris Stals, at confe organised by Omega Investment Research (Pty) Ltd held in Frankfurt on 25/1/99 and Zuri 27/1/99.This

overview of the South African economy is presented in three parts.

Firstly developments in the economy and the current situation are summarised to provide a back for possible future developments.

Secondly, the more important structural economic adju that are now in progress and that will have an important influence on the course developments are referred to.

Thirdly, a longer-term view is taken of developments over recent past two five-year periods, supplemented with a forecast for the next five years.

## 1.

Recent developments and the current situationThe year 1998 turned out to be a very frustrating one for the South African economy.

Du first quarter, encouraging signals of an imminent improvement in underlying cond emerged.

Substantial amounts of foreign capital flowed into the country, mainly in th portfolio investments in South African bonds and equities.

The country's foreign increased sharply; there was upward pressure on the exchange rate of the rand; domestic increased; and interest rates declined.At that stage, there was some optimism that the fairly depressed conditions in real activity since the second half of 1997 would be turned into a new upswing during the c 1998.

Growth in real gross domestic product, which had declined from a level of about cent per year in 1995 and 1996 to below 2 per cent in 1997, was predicted to rise againHowever, the South African economy was severely shocked when the large inflows of for funds in the form of portfolio investment in South African bonds were suddenly reversed 1998.

Non-residents increased their holdings of South African bonds by R16 billion du first four months, but then became net sellers, and reduced their holdings of South Afr by R26 billion over the next eight months.

It is interesting to note that, throughout l residents remained more positive about investment in South African equities and increa holdings of shares acquired through the Johannesburg Stock Exchange by R42 billion ov year as a whole.

Despite the large disinvestment in bonds, non-residents still incr overall holdings of South African securities by R32 billion.The abrupt change that took place in May in the Bond Exchange nevertheless had far-re effects for the South African financial situation.

The yield on long-term government b example, rose from a monthly average of 12.9 per cent in April to over 18 per cent in S and fluctuated widely on a daily basis to peak at over 21 per cent at one stage.

T effects of the net selling of bonds by non-residents quickly spilled over into the foreign exchange.

Pressures in this market led to an eventual devaluation in the nomina exchange rate of the rand of 16.4 per cent from the end of April 1998 to 31 December 19 country's net gold and foreign exchange reserves, which increased by almost R19 billion fifteen months that ended in March 1998, then declined again by R12½ billion over the l quarters of last year.

At the end of 1998, the total official reserves of the country about R31.6 billion, the equivalent of about two months' imports.These changes in the capital account of the balance of payments, which were obviously linked to the worldwide dispersion of the East Asian crisis, forced the Reserve Bank toa more restrictive monetary policy.

The interest rate on the Reserve Bank's daily r transactions with banking institutions increased from below 15 per cent in early Apri almost 22 per cent in August.

In light of the declining amount of liquidity in the ban and the rising rate for Reserve Bank accommodation, banking institutions raised the lending rate from 18 per cent in April 1998 to over 25 per cent in August.With these adverse developments in the financial markets, the outlook for an early impr in real economic activity faded.

On the contrary, overall economic activity slowed down In the third quarter, total real gross domestic product indeed showed an annualised rat of 2½ per cent.

It is estimated that, on balance, total gross domestic product in 19 much different from that of 1997.The negative developments in the global financial and commodity markets had some adv effects also on the current account of the balance of payments.

The deficit indeed incr a level of about R7 billion in the first half of the year to a level of about R18 billi half.

Special imports, however, contributed to this increase in the negative bal indications are that the growth in imports is now slowing down in line with the more d domestic demand, whereas certain exports are beginning to react positively to the depre the rand last year.Short-term developments in the South African economy were therefore very much affecte the turmoil of the past year in the global financial markets, and by negative devel international commodity markets.

The current situation creates frustration for the authorities, who have an understanding of the need for some stimulation of domestic d but also an obligation to protect overall financial stability in an unfriendly international financial environment.The strong link between internal economic developments in South Africa and changes i international situation was illustrated clearly when global financial markets became m towards the end of last year and in the early weeks of 1999.

The strained South African situation simultaneously eased to such an extent that the exchange rate of the rand a from about R6.30 to the United States dollar in August 1998 to R5.70 early in Januar Domestic interest rates declined by about 3 full percentage points from the extremely h reached last year.In the past ten days, however, negative developments in the Brazilian situation on created new pressures in the South African market for foreign exchange, and put some br the declining trend in interest rates.

In the short term, the fate of the South Afric now to an important extent determined outside of the country.

Should the international stabilise and improve during the course of 1999, the South African economy will be follow.

## 2.

Structural economic adjustmentAs already explained, cyclical developments in the South African economy turned negat 1997 and remained depressed throughout 1998.

The business cycle will hopefully swing positive again as the international financial situation becomes more stable (in the se this year?).

There are, however, a number of fundamental or more basic deficiencies economy which were identified by Government in its Macroeconomic Strategy for Growt Employment and Redistribution (GEAR), published in June 1996, and which also nee attention.In the GEAR document, Government recognised that the most important economic proble facing South Africa at this juncture is the large and growing unemployment in the coun problem not only provides a serious economic challenge for macroeconomic policy, but contributes to adverse socio-political developments.

For example, the seriously disrupt and violence situation in the country can be linked directly to growing unemployment.

I the crime and violence makes economic recovery more difficult.

The country is therefore in a vicious circle of growing unemployment, more crime and violence, lower economic gr and, therefore, more unemployment.The Government's GEAR programme supports its earlier Reconstruction and Development Programme (RDP), providing for the social upliftment of the South African commun particularly of the disadvantaged groups of the past.

The RDP focused the attentio demand side of the economy, that is on the huge and legitimate needs of millions o Africans that still live in poverty.

It is understood by Government, however, that th provide for RDP can only come from increases in the production of goods and service disappointing past performances of the supply side of the economy must therefore be ad in order to make it possible to meet the accumulated pent-up demand by producing more and services in the country.The main strategies in the GEAR programme provide for the following:- a fiscal deficit reduction programme to contain debt service obligations, counter in free resources for investment;- a reduction in tariffs to contain input prices and facilitate industrial restructuri- a commitment to moderate wage demands, supported by an appropriately structur flexibility within the collective bargaining system;- an exchange rate policy to keep the real effective rate stable at a competitive level- a consistent monetary policy to prevent a resurgence of inflation;- the gradual relaxation of exchange controls;- the restructuring of state assets (privatisation);- tax incentives to stimulate new investment in competitive and labour-absorbing proje- a strengthened levy system to fund training on a scale commensurate with needs.South Africa is in a process of gradually implementing the GEAR strategy, although Gover is often criticised for moving too slowly, particularly with the privatisation programm the introduction of more flexibility in the labour market.

The adverse cyclical devel the past eighteen months, and the dismal performance of the economy in the short encouraged the critics of GEAR to condemn it as a failure.

There are therefore strong within the country for Government to relinquish the strategy and to replace it wit populist approach.Government, however, remains committed to the gradual restructuring of the economy wit objective of raising the economic growth potential to at least 5 per cent over a six-yeis admitted that some of the strategies provided for in the 1996 GEAR document may need revision in light of recent economic developments, but the essence of the strategy retained and must be pursued and implemented with determination.In a recent study of the South African economy, economists from Goldman Sachs of New Y concluded as follows: 'The GNU (Government of National Unity) successfully led the co through the first phase of the transition (1994-98) from the apartheid era.

The GNU co program of structural reforms, including progressive current and capital account libe committed to respect the independence of the SARB (South African Reserve Bank), announced a development strategy emphasizing gradual fiscal consolidation.However, a second round of structural reforms to address structural rigidities on the of the economy are required if real GDP growth and employment are to be boosted significant and sustainable way.

These reforms include liberalization of labor completion of the trade reforms, completion of capital account liberalization, and fur sector reform -- including an aggressive privatization program'.

## 3.

Longer-term developments in the South African economyTurning to the longer-term developments in the South African economy, it is interestin that some remarkable improvements did take place in parts of the economy over the pa years.

An analysis of a few selected key economic indicators of developments over the years (see Table 1 attached to this document) reveals the following:- The rate of growth in real economic activity as reflected in changes in gross domest increased from a yearly average of 0 per cent in the first period (1989 to 1993) t in the second period (1994 to 1998).

Similarly, the rate of growth in real gross expenditure changed from minus ½ per cent to positive growth of 3 per cent per a Greater confidence was also reflected in a substantial improvement in gross domest investment, which declined by 2½ per cent per year from 1989 to 1993, but then incre 7 per cent per year from 1994 to 1998.

One of the emerging weaknesses in the econ reflected in the decline over these two periods in gross domestic saving as a perc gross domestic product, from an annual average of 19 per cent in the first, to 16 the second period.- Where the economy failed most was in the creation of jobs.

Total employment in declined by an average annual rate of 2 per cent from 1994 to 1998, which was even than the average decline of 1.3 per cent in the preceding period of five years.

D further increase in unemployment, the annual rate of increase in average real wa salaries more than doubled, from 1.7 per cent in the first, to 3.9 per cent in the s- A further positive development was a dramatic switch-around in the net capital flo abroad -- from persistent outflows before 1994 to a cumulative net inflow of more t billion over the next five years.

The relatively large capital inflows made it tolerate a deterioration in the current account of the balance of payments -- fr surpluses in the first, to continuous deficits in the second period, reflecting increase in total domestic expenditure at a rate that outpaced the rate of grow domestic product.

It should also be noted that, with the removal of international b sanctions against South Africa after 1993, both merchandise imports and exports expanding at a much higher rate.- A further important improvement in the economy is reflected in the decline in the annual rate of inflation, which was still in double digit territory during the fir stayed comfortably below the 10 per cent level in the second.It is obvious from an analysis of the macroeconomic statistics that, in the process o adjustment, South Africa must, over the next five years, succeed in its stated object around the trend of the past ten years for total employment to decline consistently.

T the most daunting challenge for the South African economy.The forecast for possible developments over the next five years provided in Table 1 i economic forecasts, based on past trends, and on discretionary assumptions about possib developments.

For the purpose of this forecast, it was assumed that Government will con implement the GEAR strategy and will retain disciplined fiscal and monetary policies.

It assumed that South Africa will be able to attract a fairly substantial amount of foreig funds over the next five years -- an amount at least equal to the total net inflows of years, with hopefully a greater part of it in direct instead of portfolio investment.A further requirement for the strategy to succeed is that monetary policy will rem restrictive, and interest rates will be retained at a relatively high level.

It als further reduction in the deficit on the Budget of central government from about 4½ pe gross domestic product this year to 2½ per cent in the near future.It should, furthermore, be remembered that, apart from the shortcomings of the economy to above, South Africa also offers many advantages that provide a strong basis fo economic development.

These include a well-developed infrastructure, sound and well-man financial institutions, sophisticated and modern financial markets, and highly-develo and experience in areas such as engineering, architecture, the legal professions, medic business management.

Add to this the possibilities that are being opened up for an exp South Africa's economic relations with the rest of Africa, and there are many reasons optimistic about the economic potential of the country.On the assumptions made about the implementation of macroeconomic policy, and on condi that the existing advantages present in the South African economy will be protected an expanded, the following forecast for possible developments in the South African econom the next five years does not seem to be unrealistic.- The capacity of the economy to produce goods and services will be raised gradually t a level of 5 per cent by the year 2004.

This will give an average annual rate of gross domestic product of about 3 per cent over the next five years.- Net capital inflows into the country at a rate of more than R10 billion per annum it possible to maintain growth of at least 3 per cent per annum in gross domestic ex also rising gradually to about 6 per cent per year by 2004.- This will include a continuous growth in gross domestic fixed investment at an aver of 4 per cent per annum.- The current account of the balance of payments will remain under pressure, and a deficit will require more capital inflows.

Positive steps will have to be taken (in GEAR strategy) to attract more direct foreign investment into the country.- Inflation will decline gradually and will come in line with the level of inflation industrial countries of the world.- The process of gradually removing exchange controls will be completed, and South A will become even more integrated in the world economy.- South Africa's leading economic role in Southern Africa will be firmly established SADC, and will gradually expand beyond the Southern Africa region.It must be expected that the path of economic development in South Africa over the n years will not be a smooth one.

The structural economic reforms, further integration in economy, and the continuing socio-political reforms in the country will all at tim destabilising effect on the domestic economy.

It will be extremely difficult at th provide any sensible year-to-year forecast of possible developments in the economy.

The to take a longer-term perspective covering the next five years, therefore, makes more seThe forecast also indicates that total employment in the country should soon start risi it will still require a major effort to make up for existing backlogs.

## 4.

ConclusionBased on a short-term analysis, the South African economy is rather depressed at this is very dependent on some improvement in the international economic environment sustainable recovery.An analysis of developments in a few important macroeconomic aggregates reveals signi improvements in the performance of the overall economy over the past five years, b exposes a few structural weaknesses that must be addressed urgently in order to raise production capacity.Finally, if well-managed, the South African economy has the potential of making furthe progress over the next five years to reach the objective of at least 5 per cent growth and of creating more jobs.Should the country want to achieve more ambitious targets in the next five years, and I even that would be possible, we shall, in the words of the Goldman Sachs economists, ha apply the same strategies, but with less timidity, and more aggression.

## Table l: Selected Key Economic Indicators(Average annual percentage changes, unless otherwise indicated)expenditure investmentsaving to gdp workerbillions)8.

Merchandise banks (level)| 1989 | 1994 to 1998 | 1999 to 2003* ||------------------------------------------------------------------|----------------|-----------------|| Real gross domestic product | +2 | +3 || Real gross domestic expenditure | +3 | +3 || Real gross domestic fixed investment | +7 | +4 || Ratio of gross domestic saving to gdp | 16 | ...

|| Employment | -2.0 | +1 || Real salaries and wages per worker | +3.9 | 1.5 || Balance of payments (R billions) | | || +R | -R 7.9b | -R 9b || * Current account (average) * Capital account (cumulative total) | +R50.9b | ...

|| Merchandise | | || * Imports | +9.2 | +7 || * Exports (including gold) | +6.4 | +5 || Consumer prices | +8.1 | 5.5 || 10.

Prime overdraft rate of banks (level) | 18.9% | 15.5 || 11.

Central Government Budget deficit as % of gdp | 5.1 | 2.5 |*Forecast