Mr. Stals reports on major economic developments in South Africa over the
past twelve months Address by the Governor of the South African Reserve Bank, Dr. C. Stals,
at the 77th Ordinary General Meeting of Shareholders of the Bank on 26/8/97.
Introduction
The turbulences in the South African market for foreign exchange from February
1996, and the subsequent destabilisation of the balance of payments, contributed to a weakening
of overall economic growth and to an upturn in inflation. The major task for monetary policy
over the past year has accordingly been to restore both external equilibrium and domestic
financial stability which are important preconditions for sustained investor confidence and
economic growth.
The process of restoring external economic equilibrium had to begin at home.
Many adverse factors converged to contribute to the sudden exchange rate shock of February
1996. Some were of a non-economic nature while others were rooted in macroeconomic
developments over the preceding two years. The problems caused by non-economic factors
diminished as concern about the finalisation of the Constitution of the Republic of South Africa,
the delay of local authority elections in certain provinces, and the political composition of the
Government of National Unity were fortunately allayed during the course of the past year.
Equally important has been the fact that the Minister of Finance, newly appointed in April 1996,
has stood the test of the markets with acclaim and soon established himself as an effective leader
of the country's overall financial policy.
Many of the disturbing economic problems which emerged last year were
addressed by appropriate policy responses, while the private sector has on the whole endured the
inevitable painful adjustments with much understanding. During both 1994 and 1995, growth in
real domestic expenditure by far outpaced growth in real domestic production. This was clearly
not a sustainable situation, and growth in domestic demand had to be curtailed to ensure a better
balance in the overall economy.
The untenable developments in domestic economic activity created a widening
deficit in the current account of the balance of payments which was being financed by an inflow
of volatile short-term foreign capital. When these short-term capital inflows switched into
outflows after February 1996, however, a downward adjustment in the rate of growth in overall
domestic expenditure, and therefore in the growing demand for imports, became imperative.
The divergent rates of expansion in domestic production and expenditure,
respectively, were also being financed to an increasing extent with domestic bank credit, or
simply the creation of additional money. With insufficient domestic saving and a sudden decline
in the inflow of foreign capital after February 1996, the pressure to accelerate the creation of
more money increased even further.
Assessed against this background, an untenable macroeconomic disequilibrium
was rapidly being perceived to be developing at the then level of the exchange rate of the rand.
Large foreign capital inflows in 1995, as well as the early weeks of 1996, exerted upward
pressure on the value of the rand. Within a floating exchange rate regime, the rand appreciated
in real terms, despite heavy Reserve Bank intervention to absorb part of the excess supply of
foreign exchange. The appreciation of the rand at the time was clearly irreconcilable with South
Africa's otherwise weak position in a very competitive world economic environment. A stronger
rand could not be sustained in the long term. Also instructive in this regard is that similar
experiences by other emerging economies over the past year proved that alternative exchange
rate systems, based on fixed or managed floating exchange rates, could also not cope with such
divergent economic trends. In some of those countries, even more painful economic adjustments
were required to restore financial stability than in the case of South Africa.
The monetary policy approach adopted by the Reserve Bank under the
circumstances was to let market forces take their course, with some short-term intervention by
the Bank only to support an orderly process of adjustment. The exchange rate was therefore
allowed to take its market-determined run while liquidity was drained from the domestic money
market, interest rates were guided in a gradual upward path, and the resultant adverse
consequences of the adjustment in real economic activity were accepted as essential to avoid
even greater disruption later on. Domestic financial stability had to be restored first and must
now be maintained in order to raise the production capacity of the economy to higher levels on a
sustainable basis.
These developments over the past year again exposed the urgent need for
longer-term structural economic reforms. In June 1996, the Government released a
Macroeconomic Strategy for Growth, Employment and Redistribution (GEAR). The full
implementation of this programme over the next few years will undoubtedly raise the potential
of the economy and enable South Africa to meet the vast basic social and economic needs of the
people of the country more adequately. It will also provide the economy with better armour to
withstand with more vigour similar adverse macroeconomic developments that may recur in
future.
In retrospect, the economic policies of the past year contributed significantly
towards improving equilibrium when emerging imbalances threatened to frustrate the primary
objective of achieving sustainable optimum economic growth and development. Recent
improvements in the current account of the balance of payments, the firmer exchange rate of the
rand, the increased inflow of foreign capital, and the rise in official foreign exchange reserves,
provide sufficient evidence to the effect that the serious danger of a collapse in South Africa's
external economic relations a year ago has been successfully averted. Moreover, there are
encouraging, although as yet still only tentative, signs, emanating from both the production and
the expenditure sides, that the economy recovered slightly during the second quarter of 1997.
This preliminary indication is also confirmed by some hopeful signs that the
inflationary pressures which arose from the economic imbalances experienced last year are now
subsiding. At the same time, however, the overall financial situation still provides reason for
concern, particularly in view of the continued high rates of increase in bank credit extension and
in broad money supply. For reasons that will be explained in more detail below, the monetary
authorities must persist with their vigil against the threat of overall financial instability that can
only lead to stagflation in due course. There are many examples in the world today, both among
industrial and emerging economies, where this lesson is again being learnt the hard way after
years of reluctance to apply appropriate but unpopular short-term disciplinary monetary policies
in a timely fashion.
The Reserve Bank is not prepared to consider any short-term expediencies and
implement monetary policies that will in the long term lead to serious disruption of financial
stability. The country just cannot afford unsound monetary policies for short-term gain. Such
policies would gradually undermine the value of the rand and lead to an eventual collapse of the
financial system, with serious adverse implications also for the level of real economic activity.
Recent economic developments
The Reserve Bank's Annual Economic Report released this morning serves as a
background to the following brief summary of major economic developments over the past
twelve months:
A year of economic consolidation
The pattern of developments in real economic activity over the past twelve
months can best be described as the outcome of a necessary process of consolidation after three
years of positive growth. The rate of expansion in gross domestic product reached a seasonally
adjusted and annualised rate of 311⁄2 per cent in the second half of 1996, but then slowed down
to only 1 per cent in the first half of 1997, indicating a lower rate of growth for the full calendar
year of 1997 compared with that experienced during any one of the past two years.
During the first quarter of 1997, total gross domestic product actually declined by
1 per cent, setting off alarm bells of a pending recession. During the second quarter, however,
there was a distinct recovery when overall economic activity again turned to positive growth,
equal to an annualised rate of 211⁄2 per cent. With a continued decline in agricultural production
during the second quarter and only moderate growth in mining production, total value added by
the primary sectors declined by a further 1 per cent. Against this poor performance, however,
production in the rest of the economy was back on track with an expansion equal to 311⁄2 per
cent on an annualised basis. With growth of 7 per cent in manufacturing, 6 per cent in
electricity, gas and water, and 411⁄2 per cent in transport and communication, together with
positive growth in all the other sub-sectors, the fears of a pending recession must at least for now
have been allayed.
Gross domestic expenditure, on the other hand, remained fairly depressed. An
estimated small decline in total expenditure in the first half of 1997 contributed to the
consolidation process of restoring a better balance between total domestic production and
effective demand. Further declines in the growth rates of private consumption expenditure and
gross domestic fixed investment, coupled with a substantial reduction in total inventories, were
partly offset by a continued high level of expansion in general government consumption
expenditure, particularly at the level of provincial and local government.
During the second quarter of 1997 there was, however, a noticeable recovery in
demand when total gross domestic expenditure expanded again by 2 per cent, after having
declined by 1 per cent in the first quarter. Small increases from the first to the second quarter in
the rates of growth in private consumption expenditure as well as domestic fixed investment
were strongly supported by a further rise at an annualised rate of more than 511⁄2 per cent in
general government consumption expenditure. Excluding the effect of a substantial reduction in
inventories, total domestic expenditure actually increased by 211⁄2 per cent in the second quarter.
These disparate movements in real economic aggregates between the first and
second quarters of 1997 underline the importance of correctly interpreting short-term indicators
of current economic developments. The Reserve Bank will conscientiously analyse all economic
information that becomes available over the next few months with the necessary sensitivity to
the pressing needs of the country.
Better equilibrium in the balance of payments
The salutary effects on the balance of payments of slower growth in total
domestic expenditure are clearly reflected in the rapid decline in the deficit of the current
account. On a seasonally adjusted and annualised basis, this deficit declined from R13 billion in
the second quarter of 1996 to only R3.5 billion in the second quarter of 1997. In unadjusted
figures, the negative balance declined from R5.5 billion in the first half of 1996 to R3.0 billion
in the second half of last year, and R2.4 billion in the first half of 1997.
Both imports and exports of merchandise responded to the depreciation of the
rand last year. In the second quarter of 1997, the level of merchandise exports at current prices
was 25 per cent higher than in the second quarter of 1996, whereas the value of imports
increased by only 11 per cent. This was, however, not all due to the price effect of the
depreciation of the rand. Growth in the volume of imports also slowed down as a result of the
decline in gross domestic expenditure. In the case of the value of exports, an increase of 25 per
cent was already experienced in the year prior to the depreciation, partly as a result of the
removal of international sanctions, which no doubt continued to affect exports in 1996 and the
first half of 1997.
The improvement in the current account was supported by a larger net inflow of
funds reflected in the capital account of the balance of payments. The pressure on the exchange
rate of the rand, which continued from February to October 1996, subsided again after October,
almost as suddenly as it had appeared. During the first three quarters of 1996, the net capital
inflow amounted to only R585 million, but this was followed by a net inflow of R3.3 billion in
the fourth quarter, and by no less than R16.7 billion in the first half of 1997.
After the rand had depreciated by as much as 23.5 per cent in nominal terms
between 14 February 1996 and the end of October 1996, it appreciated by 10 per cent over the
next five months. From the end of March to the end of July 1997, however, the rand depreciated
again by 3.6 per cent to give a net increase of 6.0 per cent in the external value of the currency
from November 1996 to the end of July 1997. It should be noted, however, that the average level
of the exchange rate of the rand over the first seven months of 1997, compared with its average
value over the same period in 1996, showed a depreciation in nominal terms of 8.4 per cent.
Although the initial appreciation after October 1996 was accepted as a partial
correction of an over-reaction, the Reserve Bank nevertheless, already in November 1996,
started to intervene again in the market as a net buyer of foreign exchange. The country's gross
foreign reserves held by the consolidated banking sector indeed increased by R17.2 billion over
the past three quarters to reach a level of R31.1 billion at the end of June 1997. This was
sufficient to cover about 911⁄2 weeks of imports of goods and services.
Currency depreciation as a means to achieve greater international competitiveness
only has a chance to succeed in countries where inflation is not sensitive to depreciation. The
events of the past year proved once again that in South Africa inflation reacts with a time lag of
only about six months to major changes in the exchange rate. The quarter-to-quarter increase in
the seasonally adjusted and annualised rate of change in the production price index for imported
goods escalated from 6.0 per cent in the first quarter of 1996 to no less than 18.1 per cent in the
fourth quarter, before it declined again to 12.4 per cent in the first quarter of 1997. In the second
quarter of 1997, that is approximately six months after the turnaround in the trend of the
exchange rate in November 1996, the production price index for imported goods actually
declined by 10.7 per cent.
Monetary aggregates slow to respond
Over the past two years, the Reserve Bank has on various occasions advanced
reasons why changes in the M3 money supply may have lost some of its usefulness as a reliable
anchor for monetary policy. At this juncture, the Bank regards changes in M3 only as one among
several important financial indicators. It no longer bases its monetary policy decisions
automatically on any rigid formula linking actual changes in M3 to the predetermined money
supply guidelines issued by the Bank at the beginning of each year. In 1996, for example,
monetary policy was aimed more directly towards the restoration of external financial stability.
More recently, the Bank has become more concerned about the excessive increase in domestic
bank credit extension, not only because of its influence on the money supply, but also for other
reasons. There has, for example, been growing anxiety about the over-extension of the private
sector's indebtedness relative to disposable income, and the increasing vulnerability of the
banking sector to adverse developments in a possibly less favourable future macroeconomic
environment.
No central bank can, of course, disregard developments in the money supply or in
bank credit extension, even if such developments can be explained as temporary distortions
caused by major structural economic reforms. Although changes in M3 and its shorter-term
components should be interpreted with circumspection in the present South African
environment, they cannot be discarded or ignored. The relationship between the money supply
and nominal production, or the velocity of circulation of M3, may be changing, but new
relationships are being established in the process of transformation. Over the longer term, it
remains true that inflation cannot be sustained indefinitely unless it is fuelled by continuous
excessive money creation.
Throughout 1996, the annual rate of increase in the M3 money supply fluctuated
within a narrow range of between 13.6 and 16.1 per cent. By January 1997 it reached a peak of
16.8 per cent, and then declined gradually to 12.7 per cent in June 1997. As a guideline the
Reserve Bank currently regards a rate of increase of not more than 10 per cent per year in the
M3 money supply as consistent with the prime objective of reducing inflation gradually to a
level that will be more in line with the average rate of inflation in the economies of South
Africa's major trading partners.
The increase in M3 has now consistently exceeded the rate of growth in the
nominal value of gross domestic product for more than three years, with the result that the ratio
of the total amount of money in circulation to gross domestic product has risen to 58 per cent,
which is the highest level since 1980. A lack of availability of money can therefore hardly be
advanced as a reason for the slowdown in real economic activity over the past eighteen months.
The relatively high level of the money supply or, inversely, its low level of
velocity of circulation, holds a potential danger for future inflation. Although a substantial part
of the excess amount of money in circulation may at this stage be confined to the financial
sector, possibly contributing to financial asset inflation, the Reserve Bank will have little control
over the situation once holders of financial assets decide again to divert their spending to the
acquisition of goods and services. Central bank policy must therefore always be forward-looking
and attempt to pre-empt the danger of overspending or rising inflation at some future
inopportune stage.
Total bank credit extended to the private sector likewise continued to increase at a
high rate throughout 1996, and fluctuated between a peak of 18.9 per cent in July and a low of
16.1 per cent in December. During the first six months of 1997, it peaked at 17.4 per cent in
April, and then declined only marginally to 16.3 per cent over the twelve months up to June. As
in the case of the money supply, the total amount of bank credit outstanding has risen as a
percentage of gross domestic product over the past few years. At the end of June 1997, it
amounted to 75 per cent of gross domestic product, compared with 67 per cent at the end of
1993.
Bank credit is, of course, not only extended for the purpose of financing
purchases of goods and services. Indeed, particularly in recent months, a substantial amount of
the additional bank credit created may have been linked to the explosive increases in the volume
of transactions in the financial markets, particularly in the equity and bond markets.
Nevertheless, all forms of bank credit create money, and the initial reason for which money is
created is only of limited significance for monetary policy purposes. Once the money has been
created, it becomes part of the amorphous pool of the total money supply and, depending on the
strength of the multiplier effect, is available to be used a number of times over, and for many
purposes other than its first application.
Many explanations can be offered for the persistently high rates of increase in
bank credit extension and in the money supply, despite the slowdown in real economic activity
over the past eighteen months. It could partly be linked to a switching of international trade
financing from foreign to domestic sources, or partly to the financing of summer crops in the
agricultural sector that are being harvested late this year. It is also known that bank credit
extended to local authorities increased by no less than R2.7 billion from 31 December 1996 to
30 June 1997. These explanations, however, do not detract from the need for a curtailment of the
excessive rates of increase in these important monetary aggregates at this juncture.
In light of the unfavourable experiences of a number of other countries in recent
years, ranging from a well-developed country such as Japan to an emerging economy such as
Thailand, central bankers elsewhere are increasingly concentrating on restricting the provision of
bank credit for investment in financial assets and property. In a bull market, even at high interest
rates, borrowers will continue to borrow funds to buy assets that are rapidly appreciating in
value; and banks will continue to lend because the value of their collateral is rising. This could
easily cause a speculative bubble that, should it burst, can create major difficulties for both
lenders and borrowers. In such a situation, it is not unusual for the money supply to continue to
rise, in conflict with the objectives of the monetary authorities, and often also in contrast to the
slowdown in real economic activity. South Africa is hopefully not yet in such a position. In the
implementation of monetary policy more than in anything else, prevention is almost without
exception less costly in terms of a possible temporary loss of production and employment that
can in any case not be sustained, than the sacrifices that will eventually be required to fight high
inflation once it has become entrenched.
In the present situation, the Reserve Bank feels that a cautious monetary policy
stance remains justified. This has been the approach throughout the past year and undoubtedly
has had a major influence on developments in the money market. The shortage of funds in this
market, as reflected by the amount of accommodation required by banking institutions from the
Reserve Bank, first increased from a daily average of R4.9 billion in January 1996 to R10.6
billion in March 1997, before it declined to R7.3 billion in July 1997. As the recovery in the
balance of payments recently gained momentum, the Reserve Bank has been prepared to allow a
natural downward adjustment in the money market shortage, paving the way for a gradual
decline in money market interest rates.
The Reserve Bank raised its lending rate to banking institutions, the Bank rate,
from 15 per cent at the end of 1995 to 16 per cent in April 1996, and then to 17 per cent in
November 1996. The rate on three-month bankers' acceptances first increased sharply from 14.6
per cent at the end of December 1995 to 17.0 per cent a year later, but has since declined
gradually to 15.0 per cent in the middle of August 1997.
As the South African financial markets are being integrated more in the global
financial system, the comparison between South African and international interest rates takes on
greater significance. Too low a level of interest rates locally will eventually be reflected in a
weak currency, and lead to a further depreciation of the rand. Too high a level, on the other
hand, will attract speculative short-term capital from abroad, and lead to an undesirable
appreciation of the currency, and/or an unhealthy expansion of domestic liquidity.
The sharply inverted shape of the yield curve in South Africa makes the
comparison of the level of local interest rates with the international markets more difficult. At
the long end of the spectrum, the yield on long-term government bonds in South Africa seems to
be on the low side in real terms. Short-term interest rates, and particularly bank lending rates at
the other end of the yield curve, seem to be high in South Africa, reflecting negative
expectations on inflation, high risks involved in more short-term lending to an already
overborrowed community, and a relatively high demand for funds.
The conservative monetary policy measures applied by the Reserve Bank over the
past eighteen months have paid off by containing the increase in inflation to below 10 per cent,
despite the pressures arising from the depreciation of the rand last year. Measured over a period
of twelve months, the rate of increase in the overall production price index rose from 5.3 per
cent in April 1996 to 9.6 per cent in March 1997, but then declined to 7.5 per cent in June 1997.
Movements in the consumer price index followed a similar path and the increase
in consumer prices, measured over twelve months, rose from 5.5 per cent in April 1996 to 9.9
per cent in April 1997, before declining to 8.8 per cent in June 1997. At the time of the
depreciation of the rand in 1996, a much higher rate of inflation was predicted on the basis of
previous experience.
There is, however, no reason for complacency. As long as the South African rate
of inflation remains significantly higher than that in the major countries of the world, the
integration of South Africa into the global financial markets will be slow and turbulent. In view
of the complex interaction between the level of interest rates, the rate of inflation, and the
exchange rate in the process of financial globalisation, disruptive adjustments will be demanded
from time to time. This will continue to complicate decisions for investors and cross-border
traders. Participation in the process of financial globalisation ultimately requires a high degree of
convergence between countries in these basic financial aggregates. The domestic levels for
interest and exchange rates can no longer be determined by governments or central banks in
isolation. These financial prices will indeed increasingly be driven by international market
consensus.
At this stage, the international market imperative requires of South Africa to bring
its rate of inflation gradually in line with the rest of the world. Alternatively, the country's drive
towards greater participation as an important borrower of funds in the world financial markets
will be constrained.
Furthermore, what is even more important is that the existing imbalances of
income and wealth in the domestic economy will further deteriorate in an inflationary
environment. It is relatively easy for those more fortunate members of society to protect
themselves against inflation as they have easy access to credit and can spend more in today's
terms, hoping to repay with depreciated money sometime in the future. Less fortunate members
of the society find that wage increases do not keep up with inflation, especially run-away rising
inflation, and their savings and buying power deteriorate continuously.
Financial market reforms pay dividends
The major reforms in South Africa's financial markets over the past few years
paid good dividends in the form of substantial increases in the volume of business done through
these various markets. Structural improvements introduced by the Johannesburg Stock
Exchange, the Bond Exchange of South Africa, and the South African Futures Exchange
(SAFEX), were also boosted by the further relaxation of exchange controls.
The value of bonds traded in the Bond Exchange of South Africa increased by 51
per cent in 1996 to exceed the R3,000 billion level. In the first half of 1997, the total turnover in
this market already exceeded R1,700 billion. These higher values included a substantial increase
in transactions effected by non-residents in the market.
The value of shares traded in the secondary share market increased from R63
billion in 1995 to R117 billion in 1996, and to R92 billion for the first half of 1997. As in the
case of the Bond Exchange, non-residents also made an important contribution to the increase in
business transacted through the Johannesburg Stock Exchange. The turnover in options and
futures contracts traded through SAFEX performed likewise, showing sharp increases over the
past eighteen months.
The importance of the formal capital markets for the economic development of
South Africa can be clearly illustrated by two basic statistics. Firstly, over the eighteen months
from the beginning of 1996 up to the middle of 1997, the amount of new capital raised through
issues on the Stock Exchange and net issues of fixed interest-bearing securities in the primary
bond market amounted to approximately R50 billion. Secondly, over the same period, net
purchases by non-residents of South African securities listed on the exchanges amounted to
about R34 billion.
Supportive fiscal policies
The Minister of Finance applied further disciplines in his Budget proposals for
1997/98 with a commitment to reduce both government dissaving and the deficit before
borrowing during the current fiscal year. In the preceding year net dissaving by government was
equal to 3.1 per cent, and the budget deficit equal to 5.6 per cent of gross domestic product. The
deficit for the current fiscal year is expected to be reduced to 4.0 per cent of gross domestic
product.
The Government also made an important contribution to the official foreign
reserves of the country by way of two bond issues in international capital markets during June
1997. The total proceeds from these two loans amounted to R3.8 billion.
A few smaller and one major privatisation transaction - the sale of an equity stake
of 30 per cent in Telkom - raised more than R6 billion over the past year. Part of these funds
was used to contain total government debt to a level of about 56 per cent of gross domestic
product.
The better harmonisation of monetary and fiscal policies over the past year made
a major contribution to the success achieved with the objective of restoring overall financial
stability after the foreign exchange market disruption of February last year.
Financial co-operation in Southern Africa
The Committee of Governors of the Central Banks of the twelve members of the
Southern African Development Community (SADC) met twice during the past twelve months to
discuss matters of financial co-operation. The Secretariat of the Committee within the Reserve
Bank has made good progress in the compilation of a computerised data base of financial
statistics of the region and information on the functions and responsibilities of the twelve
participating central banks.
Officials from all the central banks participated in a number of courses presented
by the Reserve Bank's Training Institute, and a course was again presented for bank regulators
and supervisors in the East and Southern Africa Banking Supervisors Group (ESAF). A special
study is being undertaken with the support of the World Bank on the development of national
payment and clearing systems with a view to the eventual establishment of a cross-border
payment and settlement system for all SADC countries.
Over the next year, the co-ordination of financial co-operation in the region will
be extended also to include the activities of commercial (private) banks and stock exchanges.
A need for more flexible monetary policy operations
Developments over the past year revealed a need for greater flexibility in the
market for short-term funds. The transformation in the South African financial markets since
1994, and in particular the further integration into the global financial system, will in future
require more prompt action and decisive direction for movements in financial asset prices,
interest rates and exchange rates.
Part of the explanation for the rigidities in the South African money market lies
with the present system used by the Reserve Bank to provide accommodation to banking
institutions at the discount window. Banking institutions have unlimited access at the Bank rate
to overnight loans from the discount window, provided they have at their disposal acceptable
collateral. The Bank accepts Treasury bills, Land Bank bills, South African Reserve Bank paper
and Government bonds, all with an outstanding maturity of less than 91 days, as security for
such overnight loans. A second-tier facility is also available, but at a penalty rate of 75
percentage points above the Bank rate against similar securities as collateral, but with
outstanding maturities of between 91 days and three years.
The Bank rate is, of course, changed from time to time to adapt to changes in
underlying financial market conditions. To make the system work effectively, the market must
react with sensitivity to changes in underlying demand and supply conditions, and must also
emit clear and comprehensible signals to the authorities. For exampl