Mr. Stals discusses the current economic situation and factors influencing monetary policy in South Africa in 1999  (Central Bank Articles and Speeches, 3 Nov 98)
Central bank: sarb | Type: speech | Date: 1998-11-03

## Mr.

Stals discusses the current economic situation and factors influencimonetary policy in South Africa in 1999 Address by the Governor of the South African Reserve Bank, Dr. C.

Stals, at an International Conference arranged by ABN AMRO Bank Kagiso Financial Services, held in Johannesburg, on 3/11/98.

## 1.

Domestic economy dominated by international developmentsDuring the past six months the South African economic scene was dominated developments in the international financial markets.

The East Asian financial marke which already started with pressures in Thailand's foreign exchange market in June 19 some time before it spread to other emerging markets outside of the East Asian region, to the smaller industrial countries of the world.

More recently, financial markets industrial countries also became contaminated.In the case of South Africa, the contamination took place through disinvestment of foreign funds from the South African Bond Exchange.

During the firs months of 1998, non-residents increased their holdings of South African bonds by R16.3 During the next five months, from May to September 1998, they reduced their holdings of African bonds by R22.4 billion.

This major switch was directly linked to a reassessment foreign investors during April/May 1998 of their investment positions, and the decision their exposure in fixed-interest bonds of the emerging market economies.It is interesting to note that non-residents continued to increase their in South African equities.

After increasing their investment in South African shares through the Johannesburg Stock Exchange by R19.4 billion in the first four months of 19 added a further R17.3 billion during the following five months.

The reversal in the i trend on the Bond Exchange was, however, sufficient to change drastically the outlook South African economy, and some promising economic developments in the first quarter o year were promptly aborted.

## 2.

Adverse financial developments lead the downward trend in the economyThe sudden switch of foreign investors' sentiments had far-reaching effects South African financial markets:- The immediate effect of the withdrawal of investment funds from the Bo Exchange was a sudden and sharp increase in the yield on long-term bon The average monthly yield on long-term government bonds rose from 12.9 p cent in April 1998 to 18.3 per cent in September.- The withdrawal of foreign investments created pressure in the for exchange market and the average effective exchange rate of the rand agai basket of currencies depreciated by 21.4 per cent from 22 May 1998 to August 1998, to bring the cumulative decline in the external value of th from the end of last year to 24.6 per cent.- The depreciation of the exchange rate encouraged further capital outflo the form of negative 'leads and lags', and also led to speculative po taken against a further depreciation of the rand.

In the end, a net ou more than R13 billion in the form of private sector short-term capital additional pressure in the foreign exchange market.- The outflow of capital reduced liquidity in the banking sector and forc banks to borrow more from the Reserve Bank on a day-to-day basis.

Th estimated daily liquidity needs of the banks increased from about R2 bil the beginning of May to more than R13 billion in early June 1998.- Other interest rates followed the yield on long-term government bonds o strong upward surge.

The rate for repurchase transactions from the Res Bank increased from 14.78 per cent on 12 May 1998 to 24 per cent on 22 J 1998, before it settled early in July at a level just above 21 per cent institutions raised their prime overdraft rate from 18.25 per cent at t April 1998 to 25.5 per cent on 28 August 1998.- In order to provide liquidity to the drained foreign exchange market Reserve Bank drew about R8 billion on foreign loan facilities and increas outstanding hedge facilities in respect of future international bal payments commitments from US$ 17.5 billion at the end of April 1998 US$ 25.3 billion at the end of June 1998.- Having risen by 32.3 per cent from December 1997 to an all-time high in 1998, the average monthly level of share prices listed on the Johanne Stock Exchange declined by 38.7 per cent between May to September 1998.Although the financial conditions started to stabilise again in early July situation remained extremely sensitive throughout the next three months, up to Septembe Exchange rates, yields and interest rates and share prices reacted to rumours, s transactions and adverse international developments, and most of the financial ag showed great volatility.

## 3.

Adverse financial conditions brought negative developments in real economic activityThe adverse developments in the financial markets had a negative effect already fragile real domestic economy.

The GDP growth rate remained subdued at a lev ½ per cent in the first two quarters of this year.

All indications are that it became in the third quarter, and there may even have been some decline in the level of total prA much smaller decline in inventories during the second quarter of this caused some improvement in the level of gross domestic expenditure from the first quart domestic final demand, however, declined marginally to a rate of expansion of 3 per ce second quarter.

Indications are that the expansion in demand may have been maintained level throughout the third quarter.The current account of the balance of payments recently also showed the stra the adverse international conditions.

The main reason for a substantial weakening in t account balance from the first two quarters of 1998 into the third quarter lay unexpectedly sharp rise in total imports whereas total exports, at least in volume ter from the second to the third quarter.As could have been expected after the depreciation of the rand, inflation upwards.

The rate of increase in consumer prices measured over a twelve-month period in from 5.0 per cent in April 1998 to 9.1 per cent in September, and the rate of incre overall producer price index rose from 2.3 per cent in March 1998 to 4.3 per cent in SeIn this environment, the rates of increase in bank credit extension and money supply remained on a high level.

Together with the external strains, the situatio very restrictive monetary policy approach on the Reserve Bank in order to restore financial stability to the South African financial markets.The overall South African economy is now going through a cycle that is led strongly by developments in the financial markets.

The recent decline in real economic was directly caused by the adverse developments in global financial conditions.

The Ea crisis had started already in the middle of 1997, but had a delayed effect on the So financial markets, which deteriorated badly, particularly during the second quarter of Trends in the real economy followed the downward trend in the financial markets with short time lag.

## 4.

More stable conditions return to financial marketsAlthough the underlying conditions in the South African financial markets already become more stable in early July, conditions started to improve noticeably on September and early October.

Just as the initial negative impact on South Africa was linked to adverse developments in the international financial markets, the recent rec followed an improvement in international financial conditions that gained momentum duri after the 1998 Annual Meetings of the International Monetary Fund and the World Bank.The improvement in the South African financial market conditions was refle in:- A decline in the net sales of South African bonds by non-residents.

Th outflow in October declined to less than R1 billion and was the smalle the past six months.- An easing in the overall liquidity position of banking institutions.

T liquidity requirement at month-ends declined from R12.2 billion in Jun R7.2 billion in September and R5.9 billion in October.- A decline in long and short-term interest rates.

The yield on long government bonds declined from 20.09 per cent on 28 August 1998 to belo 16 per cent at this stage.

The rate on repurchase transactions from the Bank declined from 21.85 per cent on 13 October to 20.45 per cent to Banking institutions reduced their prime overdraft and mortgage lending by 1 full percentage point during the past few weeks.- An appreciation of the rand from the very low level reached in July.

D the month of October the average effective exchange rate of the appreciated by 3.9 per cent to reduce the cumulative depreciation sin beginning of the year to about 17½ per cent.- A significant slowdown during September 1998 in the rates of growth of b the M3 money supply and bank credit extended to the private sector.Conditions in the financial market will hopefully continue to improve furth to lead real economic activity into recovery in the course of the current business cycle improvements in the South African financial market conditions should therefore hopeful to an improvement in real economic activity, and particularly in gross domestic pro during the course of next year.The tight monetary conditions, high interest rates and restrictive monetar in 1998 were forced on South Africa by adverse developments in the international fi markets.

In the situation, monetary policy had to carry a heavy burden in restoring stability to the South African financial markets.

Unpopular measures, such as a reducti liquidity and high interest rates, had to be embraced in order to avoid more serious such as a foreign reserves crisis, or a breakdown in the banking system.Provided the encouraging recent trends towards greater stability in international financial markets continues, monetary conditions in South Africa sho gradually become easier.

From the point of view of real economic activity this is, of most desirable development at this stage.There are a number of reasons why any deliberate actions taken by the mone authorities to relax monetary policy should be implemented with caution.Firstly, not all problems in the international markets have been resolv world is still holding its breath on the vulnerable situation of the Japanese banking systems; Brazil is still lingering on the edge of a dangerous cliff with its internat relations; weaknesses recently surfaced in the financial markets of a few industrial c the secondary effects of the financial market crisis are only gradually filtering th form of a decline in global real economic growth.Secondly, the recent financial turmoil left the South African scene with additional scars that need time to heal.

The depreciation of the rand forced inflation level and even more out of line with the rest of the world; the weakening of the curre of the balance of payments in the third quarter provides a further warning for caution; stimulation may easily increase demand without increasing production; and the continu level of the country's official foreign reserves do not provide much scope for man unless large foreign capital inflows will again supplement the supply of foreign exchangStructural deficiencies in the South African economy that restrict the c economic growth potential to a relatively low level place an almost permanent obliga monetary policy to remain relatively restrictive.

A relaxation of monetary policy would stimulate demand and, unless production responds flexibly and quickly to increa expenditure, monetary stimulation is inclined to lead either to an unsustainable overal payments deficit and/or an unacceptably high rate of inflation.

The monetary policy tar Government's Strategy for Growth, Employment and Redistribution (GEAR) cannot be achiev unless all the other goals for structural adjustment are also achieved at the same timeIn view of the depressed real economic situation in the country at this sta is, however, some room for a responsible relaxation of monetary policy, provide international and domestic financial conditions continue to improve further.

The Reser will move cautiously with and not against any improvement in the underlying condition will allow market forces to exert normal pressures on important prices such as the exc and domestic interest rates.