Inflation Targeting: hearings

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Finance Standing Committee

01 March 2000
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Meeting Summary

A summary of this committee meeting is not yet available.

Meeting report

2 March 2000

Documents handed out :
Recent Economic Developments: Reserve Bank Governor's comments
Inflation Targeting: Reserve Bank Governor's comments
Overview and summary of Exchange Control Relaxations
Chamber of Mines
Black Business Council

The Governor of the South African Reserve Bank commented on recent economic developments both internationally and locally, inflation targeting and relaxation of exchange control. He then fielded questions from the committee.

The Chamber of Mines, Fedusa, Black Business Council, South African Chamber of Business and Idasa presented their comments on the Department's tax proposals and policies such as inflation targeting. Comments from the Minister of Finance concluded the meeting.

South African Reserve Bank
Tito Mboweni, Governor of the South African Reserve Bank, spoke on recent economic developments both internationally and locally, inflation targeting and exchange control relaxations (see presentations).

Mr Woods (IFP) noted that it was halfway through the Governor's term and the CPIX was at 7.7%. What would the governor do if he found that they were to find that they were not achieving their inflation target?

Mr Mboweni acknowledged that he was three years into his term said that he does not anticipate non-achievement. Inflation targeting depends on setting an achievable target and he is confident of this.

In answer to a question from Mr Andrew (DP) on well-coordinated policies and the maintenance of the Medium Term Expenditure Framework targets, Mr Mboweni said that budgets must follow policy and not the other way around. Departments have now been put into clusters and the government is determined to align policies. The maintenance of MTEF targets does not come out the Budget Review and this only comes out briefly in the Budget Expenditure Survey.

Mr Mboweni gave the example of the United States that has enjoyed 108 months of uninterrupted growth. He believes it is because of the following factors: they consistently aligned their economic policies, they took control of their fiscal policy and thus removed their huge budget deficit and replaced it with a $120 billion surplus, their massive development and application of technology and the large participation of their SMME sector. He concluded they are growing because their policies are talking to each other.

Mr Andrew asked is there pressure to defend the external value of the rand to keep inflation low. Secondly, is the repo rate dead?

Mr Mboweni said that it was "too expensive" to interfere in the foreign exchange rate. Defending the rand has in the past proved to be a useless exercise. He said that the repo rate is healthy and alive and "not in intensive care". The reason why it is so stable is Central Bank's assessment of the current state of the economy and a decision made based on factual analysis and not emotions.

Mr Bruce (DP) asked about the Reserve Bank's commitment to the target and stated that it was important to get the interest rate down and implement privatization to decrease government expenditure and reduce labour costs.

Mr Mboweni said that the alignment of policies was important. He stated that in New Zealand monetary policy decisions were the prerogative of the individual minister. He feels strongly that he does not want to take on the responsibility of making policy decisions on his own. It is important to achieve the target set in order to reduce premium risk, provide certainty and curb inflationary expectations. He also stated that the target has an influence on the collective bargaining process. The trend in the SA economy is for funds to flow into the financial markets.

Mr G Koornhof (UDM) questioned the economic impact of the inflation target. He mentioned that the real cost of capital is 13% compared to the UK (7%) and Australia (8%).

Mr Mboweni said that the South African economy is subjected to an environment that has resulted in high real interest rates. He mentioned that core inflation is at 8% and that the prime overdraft rate is 14.5%, and that the difference between the two is the real interest rate. He was convinced that it should not be so high and that the interest rate should be competitive so as to attract foreign trade. He said that the perception of investors is that they are not willing to invest in high inflationary countries. Inflation erodes the buying power of people and he is convinced that a low inflation rate would benefit poor people.

Dr Rabie asked Mr Mboweni to explain the econometric models on which inflation targeting is based.

Mr Mboweni said that the models are used to show the path of inflation and the econometrists from overseas are used to help develop the models. He stated that it would have been preferable to finish the models before the introduction of the inflation target, but had decided to proceed and use whatever capacity they have at present. He stated that central banking is about feeling the situation irrespective of technical influences, which the models might have.

Prof. Turok (ANC) asked if it was good to reduce inflation. He stated that SA's high cost of capital is driving SA companies abroad and he feels this is threatening to the economy. He asked where the ultimate test in the economy lies.

Mr Mboweni stated that the objective would be to remain below 6% in order to gain credibility and that it would be preferable to achieve the midpoint. He said that the eventual test of the economy's success or failure would be to bring down inflation and see if it translates into economic growth. He said that if the inflationary target should only be seen as a framework from which to work. He also stated that all the external factors that affect the decision-making process such as developments in the money market, need to be taken into account.

Prof Turok suggested that the Reserve Bank should simply print more money in order to assist the economy.

In response to this, Mr Mboweni said that the consequences of printing more money would lead to a hyperinflationary economy. He said that if the government wants to finance their deficit then they must go to the market and borrow money at the going market rate.

Ms Taljaard asked Mr Mboweni to comment on the role of the Monetary Policy Forum.

Mr Mboweni said that people's inflationary expectation is below 10 %. He said that the Monetary Policy Forum invites stakeholders to debate on issues arising out of the forum's approach and stance. He said that in addition to the Monetary Policy Forum meetings, they wanted to hold regional meetings in order to reach out to people.

Mr Feinstein (ANC) asked for an insight into the formal mechanism on how inflationary targeting will evolve between Mr Mboweni and the Minister of Finance.

Mr Mboweni said that it is government's prerogative to announce an inflationary target . He said that in accepting the target set by the government, the Reserve Bank and the government must communicate and cooperate together on all policies to ensure implementation. Mr Mboweni announced that he was not accountable to the Minister of Finance but to Parliament and that both the Minister of Finance and himself are accountable to the country.

Mr Andrew (DP) suggested that the Finance Committee members should observe the Monetary Policy Forum meetings to get a first-hand account of the issues being raised. He also asked Mr Mboweni to elaborate on the issue of international monetary flows.

Mr Mboweni stated that the Financial Stability Forum is part of an attempt to develop an understanding of what to do in times of a crisis. He noted that within the context of globalization that it was difficult to put up 'speed bumps' because of all the external factors that affect the decision-making policies. Mr Mboweni suggested that Finance Committee members attend the Monetary Policy Forum meetings in order to discuss technical details and mentioned that a quarterly bulletin on the state of the economy will be released in Parliament.

Chamber Of Mines
The Chamber of Mines support the Budget announced by the Minister of Finance and stated that the net effect of the move on the tax base on various groups should be neutral. The Chamber of Mines expressed their willingness of trying to fulfil the wish of the Minister of Finance that more taxes come from the mines. The speaker mentioned that there are a number of scenarios that show that the amount of tax would decrease in the future because of major mining expansion programmes, but that in the long term this would improve. He stated that the contribution from the mining industry was not substantial at the moment due to the recent expansion programmes and hope to inject a lot into the economy in the future.

Note: SACOB presentation was not minuted, only the discussion period. Here is their press release:
SACOB believes that the budget represented a partial shift towards improving economic conditions for growth by inducing productive investment. SACOB expressed serious concern about the lack of certainty concerning inflation targeting. Although the Minister indicated a 3 - 6 % target range he qualified this by indicating that this range would be targeted by the end of 2002. This is not acceptable as targets for this year and next year are not available.

The budget deficit was still firmly under control while capital expenditure received the required boost to stimulate infrastructure delivery. The reduction in personal and small business taxes will enhance disposable income of individuals and additional impetus for small business. However, the introduction of capital-gains tax is not an incentive for investment. The budget is a watershed for tax reform as it moves from source-based taxation to (world wide) resident-based taxation which could inhibit investment trends.

SACOB expressed disappointment that there was not the required shift from personal and company tax (direct) to value added tax (indirect) which could have widened the tax net in addition to removing investment hurdles.

The inflation targeting range, if implemented immediately, is an unrealistic attempt at incrementally chipping away at inflationary pressures. Should interest rates increase as a result of inflation targeting, growth and investment will be encumbered. Real interest rates in South Africa are still higher than its trading partners and the international average. The private sector therefore requires the targets for both 2000 and 2001 as soon as possible.

The exemption on interest income was only marginally increased and therefore the non-savings culture in South Africa would probably be sustained.

References to privatisation and definite commitments to this process are marking the beginning of a new era for foreign direct investment matched by debt reduction and social development for the poor.

All in all the budget represents consistency in terms of the medium term plan but will be stifled by uncertainty relating to inflation targets.

Adv Abri Meiring of SACOB suggested that the government apply the findings of the Katz Commission . He added that the SARS be asked to do a full analysis of the implications of the capital gains system. He concluded by saying that the government should do away with taxation on pension funds since it affects the ordinary citizen.

The Chairperson asked the SACOB delegation to give an idea of tax

Mr Bill Lacey gave the example of the shipping industry where government
is imposing labour levies (RSC levies) and this gives the impression that the Minister tends to finance his aims through levies.

Dr Woods (IFP) asked why business was not buying into the vision of the
minister . He added that business should be a bit more concessive on issues regarding the economy . He noted that there was not too much positive feedback in their submission . He went further on to say that their submission was more intellectual and not constructive with regards to helping the Finance Committee.

There was no reply to this.

Mr Andrew (DP) stated that one of the problems is that there is not enough domestic fixed investment and he asked what was SACOB's perspective as
to the inadequacy of this investment .

Mr Bill Lacey replied by saying that had business seen GEAR implemented
in its totality, there would have been more investment . Labour is a contentious issue, since rigid legislation exists surrounding this facet and this is one of the major stumbling blocks preventing domestic fixed investment .

The Chairperson stated that the Minster of Finance has done a terrific job and asked from where the growth stimulus is lacking. This question, she said could better be engaged in at a later stage .

Mr Mokgoro (ANC) asked how equity could be increased other than through
the Capital Gains Tax system.

Adv. Meiring replied by saying that the CGT system was fulfilling a
"wicket-keeper" duty . He added that addressing the equity problem
through a "wicket-keeper" wearing "golden gloves" is not suitable for
tax gains .

Black Business Council
Members of the Black Business Council (BBC) praised the budget as being one of the best that the country has been presented with for decades. They felt that although the budget reflected significant progress in terms of low inflation targets, the degree of transparency in communication between the Department of Finance and the Reserve Bank needed more attention. In addition to the presentation, Mr Mondi (BBC representative on Macro-economic Policy) and Mr Waja (BBC representative on Taxation and Business Policy) highlighted the following:
The inflation targeting environment is riddled with supply shocks such as the floods in Mpumalanga. The inflation band must be complemented by forecasts.

The R9.9bn tax savings envisaged in the budget will result in an increase in consumer spending. There are welcome tax breaks in the SMME sector but the government is silent on the other facets affecting SMMEs . In the previous budget the effective company tax rate was decreased and this was interpreted as encouraging corporatisation and the discrimination against personnel service companies was an issue still unattended .

Dr Koornhof (UDM) asked for the BBC's view on how big business could aid the SMME sector in their endeavour to flourish.

Mr Waja replied that not enough research had been done with regard to this particular relationship between big business and the SMME sector .

The Minister of Finance, Mr Trevor Manuel, asked the BBC to give a clear definition of personnel employment companies

Mr Waja replied by saying that these were companies which had been set up in response to the increasing trend in business to outsource certain services for limited periods.

Ms Gretchen Humphries representing FEDUSA, stated that the budget was a welcome relief for workers in South Africa . However the budget left a lot of challenges unanswered. Further to her submission, she touched on the following issues :

Tax Proposals
She commended the South African Revenue Service for their efficiency. She welcomed the tax proposals since the larger portion of tax relief would be enjoyed by people in the lower income group . However there were concerns that the tool allowance (currently R75) has not been sufficiently upgraded to meet current economic demands.

Retirement Fund Taxation
FEDUSA does not support this type of taxation.

Capital Gains Tax
FEDUSA strongly rejected this type of taxation stating that it would impact negatively on the retirement fund industry.

Job Creation
FEDUSA expressed their concern over the current unacceptable jobs loss situation. They suggested that SMME 's should enjoy tax holidays (the more jobs created and maintained, the greater the benefits)

Parliamentary Committee
FEDUSA expressed their dismay at the lack of participation by civil society in the budgetary process and they further alluded that the Portfolio Committee had become the rubber stamp of the ministry.

Inflation Targeting
FEDUSA expressed no views on inflation targeting .

Dr Rabie (NNP) asked Ms Humphries what were acceptable tax levels on retirement funds.

Ms Humphries replied that ideally there should be no tax levied on retirement funds. Realistically the tax levy should be below 10 % but the current tax levels were too high.

The Chairperson, Ms Hogan, asked if it was fair that civil service workers have a prior say on how government should spend its money and she further asked if FEDUSA had applied its mind to the budgetary process in terms of more public participation.

Ms Humphries said that the government had reneged on an agreement in 1996 concerning the collective bargaining process which resulted in the major Public Service strike in 1999 . What FEDUSA is actually calling for is for the budgetary process to be incorporated into the collective bargaining process.

Mr Mofokeng (ANC) asked on what basis does the union demand to have
prior negotiation before the budget is drafted.

Ms Humphries replied that what FEDUSA was looking for was some co-ordination through the forum of the Bargaining Council and the Collective Bargaining Process.

Mr Albert van Zyl, representing IDASA, praised the Department of Finance for the improvement in budget documentation. However, the budget raised concerns in not addressing sufficiently the poverty situation.

Factors contributing to Poverty
These were outlined as being income insecurity and the non-development of human resources skills. Income security included protecting the poor from macro-economic shocks. The current tax system is structured in such a way that it impacts negatively on poor people. Mr van Zyl stressed that housing and land are the key assets in alleviating poverty. He further suggested that programmes executed by government should be catalysed and better facilitated e.g. Land Reform Programme.

Mr Leeuw (ANC) asked IDASA if inflation targeting was not a mechanism to reduce the risk in income.

Mr van Zyl answered that he was not an expert in macro-economics and that their submission had not done enough research on this aspect.

Mr Andrew (DP) asked whether unemployment was not a central theme in looking at the poverty problem and he further stated that the budget had catered for this quite adequately.

Mr van Zyl replied that what is needed is an interim measure to be executed until such time that the government's social security strategy is implemented.

The chairperson of the Finance Committee, Ms Hogan, asked whether inflation
targeting should be linked to pension funds or not.

Mr van Zyl replied by saying that this area needed to be developed further
and that he had no comment at present.

Concluding Remarks by the Minister of Finance
In his concluding remarks the Minister urged parliamentarians to take seriously their responsibility to assist and give timeous input on the budget. He felt that one of the sad features of the present hearings was the fact that there was so little comment on the medium term expenditure plan which had been drawn up. He also felt that the trend lines which were shown up to 31/3/2003 need to be continually debated and discussed otherwise the parliamentary system is undermining the process of collective bargaining and preventing the flourishing of democracy.

Mr Manuel felt that the main question which people should be asking is how does Parliament seek to engage the Medium Term Expenditure Framework? He stated strongly that people are not discussing enough this very important "monitor" of the progress of the budget's implementation. He reiterated that if people were to see a democracy flourish, Parliament would need access to quality information and it would in turn need to give quality feedback.

Inflation targeting
He believes that price stability is important especially for those people who did not have so much money to be able to adjust for inflation and still live above the breadline. The idea of implementing inflation targeting was borne from a deep concern for the poor.

Th three possible approaches which he and his advisors considered in implementing inflation targeting were:
Using a band e.g. between 3-4%
Using a target e.g. 3%
Using a ceiling e.g. inflation will not reach above 3%

After discussions between the Department and the Reserve Bank the band method was decided on. A time span of two years was given because responses to monetary policy usually take more than a year to manifest themselves in the economy.

It was kept in mind that a jump in inflation would not be advisable as it would mean running the risk of hiking up interest rates or trying whatever means to achieve a certain level of inflation figure. Thus the Department was not looking for a point and chose rather to use a band which would be monitored on an annual basis as the Department felt its way and its modelling capabilities improved.

Labour Market
On this issue Mr Manuel merely asked IDASA what rigidities in the market were they talking about in their presentation.

Here Mr Manuel wanted to know from Parliament what they thought the value of the expenditure incidence analysis was as a way to deal with poverty alleviation. He reminded parliament that they needed to compare "apples with apples " - South Africa with other middle-income countries rather than upper-income countries.

On the housing figures raised by IDASA Mr Manuel said it was necessary to consider the number of houses to be built in terms of the backlog of houses required especially in rural areas. If there were a move towards urbanisation then the building of houses would need to be adjusted in line with that.

He said that poverty relief would come mainly from the unemployment relief program which has been instituted.

On this issue he said that the push to privatise "everything" was unrealistic. He called on people to be careful and understand the inequalities prevalent in the South African economy and also to try and learn from the mistakes of others who had rushed into privatisation. He said that it should be common knowledge that government is not making any promises with respect to privatisation so that when it does not happen no one can say to the Government "you promised that it would happen!"

For the mining sector he felt that the move from the double to the single taxation was not much tax relief but it was something.

On capital gains tax he said that some cost benefit analyses had been done and they had found that at a cost of R100 million, R900 million in taxes would be collected from this form of taxation. He said he felt that this was not such a bad ratio. He said efforts would be made to try and draft less complicated legislation on the topic.

On personal income tax he pointed out that more money was being put back into the consumers' pockets. SITE meant that the Receiver of Revenue had fewer forms to process, thereby freeing up its capacity to do more effective revenue collection.

The South African VAT system has world-wide recognition for being equitable as the basket of zero-rated goods target the poor well so that the poor spend less on VAT and thus income inequalities continue to be addressed.

Small and Medium Sized Enterprises
On this issue he acknowledged the points raised by the Black Business Council and said the Department will try and make an exemption to black SMMES in an attempt to increase employment.

Finally Mr Manuel reiterated his previous point that discussions should now be centred on the trends and the medium term expenditure program detailed in the budget. By June this year he would like to receive a letter from his colleagues in the Cabinet detailing any deviations that they had noticed from the medium term expenditure framework. In order to get there though, he reminded people that they would need to have progressive discussions so that if the baseline was wrong it could be noticed and corrected early. The budget, he said, should a "continually changing animal".

Appendix 1:
Recent Economic Developments
Statement by Mr T.T. Mboweni, Governor of the South African Reserve Bank

1. International economic conditions

Economic prospects in industrial and emerging-market economies improved materially during 1999. At the beginning of the year most international forecasters expected growth to be generally subdued. As the year progressed it became increasingly apparent that world economic growth was much more robust than originally expected. Current estimates now show that world output expanded by approximately 3 per cent in 1999.

The recovery in global economic conditions was supported by the improved conditions in international financial markets. The greater financial stability supported continued high growth in the industrial countries. Sustained rapid growth was recorded in the United States, but the economies in Europe also fared well. Only the Japanese economy appears to have lost momentum as the year progressed, probably related to the increasing strength of the yen.

Most stock markets in industrial countries approached record levels towards the end of 1999, while bond prices generally fell sharply. Signs of a build up of inflationary pressures began to appear, which led many of the larger economies in the world to pursue restrictive monetary policy measures, resulting in higher short-term interest rates. Large imbalances continued to be reported in the external balances of industrial countries, with the United States in a large deficit and Japan and the Euro zone in surplus.

Further favourable economic conditions are projected for the industrial countries in 2000. Although economic growth is expected to slow down somewhat in the United States, its level should remain high. In the European Union and Japan the growth in real gross domestic product should accelerate. This higher economic growth is expected to be achieved under relatively stable economic conditions. Inflation rates could increase somewhat, but should remain at low levels. Current forecasts generally show sustainable external account balances, while unemployment is expected to decline in the advanced economies.

Economic conditions in emerging-market countries improved in 1999. The recession in Latin America seems to have bottomed out, and economic growth in most of the emerging Asian economies recovered considerably. With the return to stability, capital flows to emerging-market economies took off again, resulting in higher share prices, lower interest rates and more stability in foreign exchange markets. The recovery has been particularly pronounced in Korea, but the growth rates of Hong Kong, Singapore, Malaysia and Thailand were also high.

Economic forecasts for Africa have generally been revised upwards. The year 1999 may be the fifth consecutive year in which production grew faster than the population of Africa, and the International Monetary Fund is expecting the real gross domestic product of Africa to increase by almost 5 per cent in 2000. Unfortunately, this positive economic performance was not shared evenly across the continent, but was mainly concentrated in North and Central Africa.

In Sub-Saharan Africa output growth was low and the average per capita income remained depressed. Although many of these countries were not directly affected by the turmoil in financial markets, the decline in international trade and commodity prices had a severe impact on their economic performance. Considerable success has, however, been achieved in improving institutional and legal frameworks, the liberalisation of goods and services markets and the achievement of macro-economic stability in Sub-Saharan Africa. These structural reforms bode well for future economic development, so much needed to relieve poverty. Sub-Saharan African economies should also benefit during 2000 from the expected generally favourable world economic conditions.

2. Real economic conditions in South Africa
In tandem with the improvement internationally, a gradual strengthening of economic conditions became apparent in South Africa during 1999. Four consecutive quarters of positive growth was reported in the country's total output. Moreover, the seasonally adjusted and annualised change in real gross domestic product accelerated consistently from ½ per cent in the fourth quarter of 1998 to 2 per cent in the second quarter of 1999, slightly more than 3 per cent in the third quarter and 3½ per cent in the fourth quarter. Despite the recovery during the course of the year, the average growth rate in real gross domestic product amounted only to about 1 per cent in 1999 as a whole.

The acceleration in output growth during 1999 was mainly propelled by a rise in real private consumption expenditure, the accumulation of inventories and an increase in agricultural production. To a large extent, the outcome was the result of a reduction in interest rates, the demutualisation of life assurance companies, good agricultural conditions and the run down in inventories to very low levels in the preceding year.

Real fixed capital formation continued to decline during 1999, but the rate of decline in fixed investment by the private sector appears to have flattened out and a slight increase occurred in the fourth quarter. Currently the economy is still functioning way below full production capacity, which is not conducive to an increase in capital formation. New investments in 1999 were therefore directed mainly towards the maintenance of existing production capacity or the implementation of new technologies.

Disconcerting was the low growth in South African exports during 1999, but the export performance seems to have improved somewhat during the second half of the year. The volume of exports fluctuated around a more or less horizontal trend in the eighteen months up to the third quarter of 1999. South Africa's non-gold export volumes accordingly increased by merely 2½ per cent during the past year. Growth in export volumes is regarded as a precondition for the sustainability of the current economic recovery.

Despite the recovery in economic activity, the total number of people employed in the non-agricultural sectors of the economy declined by 80 000 in the first nine months of 1999. Sharp decreases were recorded in employment in the mining, manufacturing and construction sectors.

The average year-on-year rate of increase in nominal salaries and wages per employee was 7,6 per cent in the first three quarters of 1999. The increase in wages per worker was countered to some extent by an acceleration in the growth of labour productivity from a year-on-year rate of 1,9 per cent in the first quarter of 1999 to 3,6 per cent in the third quarter. As a result, nominal unit labour costs rose at a year-on-year rate of only 4,7 per cent in the first three quarters of 1999. This alleviated upward pressure on the prices of domestically produced goods.

3. Domestic monetary developments
The relatively small increase in nominal unit labour costs was an important contributing factor to a moderation in consumer price inflation from 8,6 per cent in 1997 to 6,9 per cent in 1998 and 5,2 per cent in 1999. This was the lowest level of inflation in consumer prices since the late 1960s.

Core inflation (i.e. the change in the overall consumer price index excluding the prices of certain food products, changes in mortgage lending rates, value-added tax and property taxes) rose from 7,5 per cent in 1998 to 7,9 per cent in 1999. This increase resulted largely from a steep rise in the prices of petrol and motor vehicles. These price increases were also responsible for an increase in the average annual change in the production price index from 3,5 per cent in 1998 to 5,8 per cent in 1999.

The growth rate in the broad money supply (M3) measured over twelve months slowed down from a peak of 19,4 per cent in June 1998 to below the upper boundary of the money supply guidelines of 10 per cent from February 1999 and to a lower turning point of 5,3 per cent in August 1999. It then increased again to 10,2 per cent in January 2000. This acceleration in the growth of M3 was concentrated in notes and coin, and cheque and call deposits.

The growth in total bank credit extension measured over a period of twelve months more than halved from 18,5 per cent in December 1998 to 8,4 per cent in December 1999 before rising again to 10,1 per cent in January 2000. The reduction in the growth of bank credit extension was mainly due to slower growth in credit provided to the private sector, especially in the form of mortgages, instalment sale credit and leasing finance. Although the rate of increase in other loans and advances (including overdrafts) also slowed down, it remained on relatively high levels because of credit extended to the corporate sector in South Africa.

Money market interest rates eased considerably during the course of 1999 in accordance with the direction determined by the Reserve Bank. The predominant prime overdraft rate of banks was reduced by 11 percentage points from 25,5 per cent in October 1998 to 14,5 per cent in January 1999. Bond yields at first declined much more moderately from a monthly average yield of 16,4 per cent in December 1998 to 15,0 per cent in October 1999. It then decreased somewhat more rapidly to 14,0 per cent in December 1999 and 13,5 per cent in January and February 2000. The country and currency risk premiums of investment in South Africa decreased sharply in 1999.

Activity on the bond and share market remained buoyant throughout 1999. Trading activity on the bond market reached R8,8 trillion in 1999, i.e. slightly higher than the R8,5 trillion in 1998. The value of shares traded on the Johannesburg Stock Exchange rose to R448 billion in 1999, which was 40 per cent more than the previous all-time high in 1998. The overall share price index recovered markedly from September 1998, and in January 2000 it was 79 per cent above this previous lower turning point. In February 2000 the monthly average all-share price index fell back by some 3 per cent.

4. The balance of payments and foreign exchange market

The current account of the balance of payments moved into a deficit from the second quarter of 1999 despite the still low level of economic activity in South Africa. The shift from a surplus to a deficit in the current account balance mainly reflected a deterioration in South Africa's terms of trade which was partly offset by a decline in the volume of imports. As already indicated, the volume of South Africa's merchandise exports responded rather modestly to the improved world economic conditions.

The financial account of South Africa with the rest of the world was characterised by a large net inflow of portfolio investments amounting to about R5,5 billion in 1999. As was the case in 1998, this consisted largely of non-resident purchases of South African shares. In 1999 non-residents increased their equity holdings by more than R50 billion, compared with about R46 billion in 1998. Non-residents were also net purchasers of South African bonds to the amount of R14,3 billion in 1999, compared with net sales of bonds of R9,8 billion in 1998.

In contrast to these large portfolio investments by non-residents in South Africa, their direct investments averaged only about R2 billion per quarter in 1999. This is, of course, the kind of investment that South Africa needs to improve its economic performance in the long run. It is important that a more investor friendly environment is created to encourage these types of capital flows into the economy.

The net inflow of portfolio and direct investment capital was employed to reduce the outstanding foreign short-term loans of South Africa and to allow residents to geographically diversify their investments. In addition, the inflow of funds to South Africa allowed the Reserve Bank to strengthen its foreign reserves from a level of R31,6 billion at the end of 1998 to R46,4 billion at the end of January 2000. The overall balance of payments surplus further enabled the Reserve Bank to reduce its net open position in foreign exchange from US$22,5 billion to US$11,5 billion over the same period.

Owing to the overall favourable balance of payments position of the country, the nominal effective exchange rate of the rand increased by 0,6 per cent in 1999. This implies that the real effective exchange rate of the rand increased at a higher rate, because South Africa's production prices on average increased more rapidly than those of our major trading partners and competitors. Although the price competitiveness of South Africa was therefore reduced during 1999, the level of the real effective exchange rate is still relatively favourable in view of the sharp depreciation of the rand in 1996 and 1998.

5. Economic prospects for South Africa in 2000
The generally favourable world economic conditions should support economic growth in South Africa during 2000. The international commodity prices for many mining products have already started to rise. An increased demand for goods should also lead to an increase in exports from South Africa. Import growth will, however, be stronger due to higher expected aggregate domestic demand. The deficit on the current account of the balance of payments could therefore increase to about 1½ per cent of gross domestic product. At this level the current account transactions of South Africa with the rest of the world should not impose any constraint on economic growth.

The rise in South Africa's exports and an increase in low inventory levels could contribute to higher economic growth of about 3½ per cent in 2000. Although this will be a considerable improvement when compared with the low growth in total output during 1998 and 1999, it is still too low to have any significant effect on the creation of employment opportunities. The higher growth could lead to an increased demand for investment to replace obsolete machinery and equipment, but will probably not bring about any large expansion of the production capacity of the country. Serious attention will have to be given to improve the economy's ability to grow at a more rapid and sustainable rate in order to reduce unemployment.

The expected higher growth in real gross domestic product during 2000 should be obtained under relatively stable economic conditions. Although inflationary pressures may increase somewhat over the short term, the inflation outlook over the medium to long term is still promising, provided that it is not disrupted by international economic shocks and that monetary discipline is maintained.

Appendix 2:


Inflation Targeting: Reserve Bank Governor's comments

1. Introduction
The Minister of Finance has announced in the Budget the implementation of a formal inflation targeting monetary policy framework for South Africa. The objective is to bring inflation within a target band of 3 to 6 per cent by 2002. This document briefly describes the rationale for the decision to formalise the current informal inflation targeting monetary policy framework.

2. The previous monetary policy framework
The mission of the South African Reserve Bank is defined in the Constitution of the Republic of South Africa, which specifies that it is the task of the Reserve Bank to protect the value of the currency in the interest of balanced and sustainable economic growth in the country. The Reserve Bank must therefore establish and maintain a stable financial environment, because that is the only way in which monetary policy can contribute to continued high economic growth. Although financial stability does not guarantee that the economy will perform at maximum capacity, it is an important precondition for the attainment of the economic growth potential.

A low inflation rate and a sound financial system are normally regarded as synonymous with stable financial conditions. The objective of monetary policy is therefore to bring the inflation rate down to a level where it will not materially affect economic decisions. To achieve this objective, the Reserve Bank adopted an informal inflation targeting framework to bring the domestic inflation rate gradually more in line with the average rate of inflation in the country's major trading partners and major international competitors. Based on expected future inflation trends in the rest of the world, an informal inflation target of between 1 and 5 per cent per annum (to be obtained over the medium to longer term) has thus far been the economic objective of the Bank.

In order to provide advance notification of the likely stance of monetary policy and because the growth in money supply is regarded as a vital element in the propagation of inflation, specific money supply guidelines were announced by the Reserve Bank early in each calendar year. The most recent average rate of growth in the broadly defined money supply (M3) of between 6 and 10 per cent for 1999 was regarded to be consistent with the objective of keeping inflation under control and to accommodate an increase in real production of up to 5 per cent per year.

M3 was the money supply aggregate used for this purpose because it had the most stable relationship with domestic demand of all the aggregates and was unaffected by deposit shifts between different maturities. M3 is a comprehensive aggregate consisting of all banknotes and coin in circulation plus all deposits of the domestic private sector with banking institutions.

The term money supply "guidelines" was used rather than the more common term "targets" to indicate that no rigid or overriding "money rule" was pursued by the authorities. Instead, the monetary authorities applied the guidelines in a flexible and low profile manner and did not leave interest rates and exchange rates completely free to find their own levels at all times. The Reserve Bank continued to exercise discretionary judgement in deciding what combination of money growth, interest rates and exchange rates to aim at in any given set of circumstances.

To restrict money supply to a level not exceeding 10 per cent, it was important that the amount of total bank credit extension did not increase by much more than 10 per cent. Higher rates of increase in the demand for bank credit would put upward pressure on domestic interest rates. As a further intermediate objective of monetary policy, the Reserve Bank accordingly strived to keep the growth in total bank credit extension below 10 per cent.

In view of the growing complexity of functional relationships between the various financial variables, the Bank did not rely only on these two variables to determine its monetary policy stance. It also monitored other economic indicators, such as developments in price indices other than consumer prices, the level of interest rates, the shape of the yield curve, changes in nominal and real salaries and wages, nominal unit labour cost, the gap between potential and actual national output, money market conditions, the overall balance of payments position, the gross gold and other foreign reserves and the public sector borrowing requirement.

3. Inflation Targeting
In contrast to this flexible framework to achieve price stability, inflation targeting is a much more concise approach in which a pre-commitment to an inflation target is made. In an inflation targeting monetary policy framework the central bank of the country is given an explicit mandate to achieve the inflation target. The target becomes the overriding objective of monetary policy. The need for intermediate targets, such as the exchange rate or the growth in money supply, falls away.

In an inflation targeting framework the central bank has to determine directly what the likely path of inflation will be. For this purpose econometric models are applied and changes in economic circumstances are carefully analysed to determine how inflation could be affected. The prediction of likely developments in inflation becomes a serious matter because it has a direct impact on adjustments in the monetary policy instruments, i.e. it affects the monetary policy stance of the authorities.

Inflation targeting therefore relies heavily on forecasting. In view of the relatively long time lags involved between a change in monetary policy and its impact on the inflation rate, any monetary policy framework has to rely on forecasts. If the objective of the central bank is the attainment of financial stability, it will always have to decide on how its current policy stance will affect future price movements, whatever monetary policy framework it decides to pursue. The difference between inflation targeting and other monetary policy frameworks is that inflation targeting makes forecasting explicit and transparent.

Although the achievement of the inflation target becomes the overriding objective of monetary policy under this approach, it does not mean that the central bank must apply definite rules and is not left with any discretion. If the central bank ignored current economic developments completely and only concentrated on containing the rate of inflation, this could lead to serious distortions in the economy over the short-term, with probably serious implications for the inflation rate over the long-term. For example, if the import prices of a country increase substantially due to international developments, keeping inflation close to the long-run target could be very costly in terms of lost output. In such cases, some discretion must be applied.

It is, however, also important that not too much discretion is applied by a central bank. The objective of the exercise is after all to hit the target. Missing the target consistently with wide margins could lead to lost prestige and credibility, an important factor on which inflation targeting relies. An inflation-targeting monetary policy framework can only be successful if the public is certain that the central bank is serious about containing inflation. The benefits of inflation targeting depend on whether wage and price setting are responsive to the inflation target of the authorities.

4. The reasons for introducing Inflation Targeting
Considerable success has been achieved in the application of informal inflation targeting in South Africa and the inflation rate was brought down to levels last attained at the beginning of the 1970s. In these circumstances it is not unreasonable to ask why a formal inflation-targeting framework is being introduced.

Basically four reasons can be given for this decision. Firstly, the system of informal inflation targeting at times created uncertainties about the monetary policy stance adopted by the authorities. For example, the growth in money supply and bank credit extension was above the guidelines of the authorities for a considerable time. A rise in interest rates should have been the normal response to these developments. However, in analysing the situation the authorities realised that the high growth in the monetary aggregates was mainly due to structural changes in the economy resulting from the re-entry of South Africa in international markets and the liberalisation of the financial system. Contrary to general expectations they did not apply more stringent monetary policy measures, which was difficult for the general public to understand. The announcement of the inflation target reduces uncertainty about the future course of monetary policy. Inflation targets therefore make policy transparent. They make the central bank's intentions clear in a way that should improve the planning of the private sector.

Secondly, inflation targeting can improve the co-ordination between monetary policy and other economic policies depending on the way the target is set and provided that the target is consistent with other policy objectives. The setting of the inflation target was therefore a joint decision between government and the central bank. Inflation targeting will be most effective when all economic policies are well co-ordinated. This better co-ordination in an inflation-targeting monetary policy framework in comparison with other frameworks can be achieved by the structured decision-making process of the framework. Inflation targeting is usually a formalised co-ordinated approach defining precisely the co-ordinated effort needed to contain inflation in pursuit of the broader economic objectives of sustainable high economic growth and employment creation.

Thirdly, inflation targeting helps to discipline monetary policy and strengthens the central bank's accountability. Clear targets are set which the central bank must meet. If the actual inflation rate deviates from these targets, the central bank has to explain the outcome. This places more discipline on the central bank in reaching the agreed targets. It also leads to a better understanding on the part of the public on what basis monetary policy decisions are made.

Finally, the introduction of inflation targeting could affect inflation expectations and promote a further reduction in inflation. If inflation targets are perceived to be credible, they should form a benchmark against which price and wage adjustments can be compared. Inflation targets, in theory, should therefore influence the growth in the operational cost of enterprises as well as their price setting.

5. Disadvantages of Inflation Targeting
Taking these advantages of inflation targeting into account, it may seem as if the introduction of this framework could only be beneficial for South Africa. However, inflation targeting could also have disadvantages. One of the major problems encountered in the implementation of inflation targeting is that it relies heavily on forecasting. A country applying this monetary policy framework should accordingly have well-developed forecasting techniques on which they can rely in the determination of the monetary policy stance. Notwithstanding this limitation, it can be argued that all monetary policy frameworks should be forward looking. The difference between inflation targeting and these other frameworks is that the views of the central bank about future developments in the economy are more clearly stated where the authorities apply inflation targeting. If regular inaccurate forecasts are made by the central bank it could therefore seriously affect the credibility of the authorities.

Another possible disadvantage of inflation targeting is that it may not always allow sufficiently for the effects of external economic shocks on the economy, thus leading to inefficient output stabilisation. As already indicated, inflation targeting places a discipline on the monetary authorities to achieve the targets. If an external economic shock occurs, such as a serious drought or a large change in the terms of trade of a country, the monetary authority may not take enough cognisance of the effects of such an occurrence and apply too stringent policy measures to achieve the stated inflation targets. These actions of the central bank will result in lower inflation, but at a high cost to the economy. To allow for this possible disadvantage of inflation targeting, so-called escape clauses are usually included in inflation targeting agreements providing for more flexibility in the implementation of this monetary policy framework.

6. Inflation Targeting and Employment
The mission of the Reserve Bank as determined in the Constitution of the Republic of South Africa has as a point of departure a firm belief that there is no long-run trade-off between inflation and unemployment. This belief is founded on influential theoretical work done by prominent international economists, as well as a host of empirical findings. In fact, some evidence exists that over the long term a higher growth in employment can be obtained with a low rate of inflation. This seems to be substantiated by the recent experience in the United States where lower inflation has been accompanied by sustained high growth.

The correlation that seems to exist between low inflation and sustained high growth is also not a surprising result considering all the disadvantages of inflation. High inflation distorts the allocation of resources and favours investment in non-productive hedge assets. Highly skilled people then apply their talents to realising inflation profits, instead of concentrating on improving production methods and creating employment opportunities.

High inflation also discourages saving and leads to higher consumption. The tax system further complicates this issue. In particular, inflation induces a preference for debt financing by businesses and individuals. The risks faced by shareholders increase with rising corporate debt ratios. Debt financing by individuals reduces household saving and increases the chances of future financial default. The low domestic savings ratio makes the country dependent on foreign capital to finance development programmes and to create employment. This dependency on foreign capital places a serious balance of payments constraint on economic development.

Some of the other disadvantages of inflation will also have an impact on employment. For example high inflation erodes the competitiveness of manufacturers and leads to unfair redistribution of wealth by penalising the poor more than the rich. This will probably also result in lower growth, fewer jobs and an increase in unemployment.

Having determined that the establishment and maintenance of financial stability is an important precondition for sustained employment creation, the question can be asked what would be the most efficient way that this objective can be achieved. In view of the advantages of inflation targeting, the Reserve Bank is of the opinion that this framework should minimise the social and economic cost of achieving price stability. Inflation targeting sets a scene in which longer-term agreements on prices and wages can more easily be based. The reduced uncertainty and friction should enhance planning the expansion of production capacity and job creation. The inflation targeting framework therefore facilitates a smooth running of the economy, which is positive for job creation.

7. The implementation of Inflation Targeting in South Africa
The Minister of Finance announced in his Budget Speech that we had agreed on a target band of 3 to 6 per cent. Although a fixed-point provides the best focus for inflation expectations and avoids the disadvantage of a band or ceiling (which tends to concentrate expectations towards the upper boundary), a band or ceiling provides more flexibility in the case of unforeseen price shocks. A fixed-point target is also much more difficult to hit than a band or a ceiling.

Since the time horizon over which the target is set could affect its credibility, it was considered prudent to set a time horizon of almost three years to allow sufficient time to bring inflation into the target range. If the target had been set over a too long period, the public's interpretation may have been that the authorities are not serious about combatting inflation. In view of the time lags between policy decisions and their impact on inflation it was also important to ensure that the time horizon is not too short.

In all inflation targeting countries the practice is to specify the target in terms of the consumer price index, or some variant thereof. The index should preferably include a range of products fully describing the domestic cost of living and generally accepted by the public. The CPIX (i.e. the headline consumer price index excluding the effects of changes in the mortgage rate) has been chosen to ensure that the Bank is targeting the most appropriate measure of inflation. The CPIX will have the advantage that it will be a more understandable index for the public than the core price index and that it excludes any effects that the Reserve Bank could have on prices.

8. Conclusion
There were definite advantages in replacing the informal inflation targeting monetary policy framework with an explicit inflation targeting framework. Furthermore, the implementation of such a framework will not materially affect the operational procedures applied by the authorities in monetary policy implementation, but can lead to a more efficient co-ordination of policy measures. In applying this new monetary policy framework the Reserve Bank will apply modern state-of-the-art forecasting techniques and proper allowance will be made for the effects of external economic shocks on domestic prices.

Appendix 3:
Overview and summary of Exchange Control Relaxations

The present exchange control system in South Africa is used primarily to control movements of capital by South African residents. South Africa has, however, now reached the stage where there are no exchange controls on the movement of funds of non-residents and effectively no controls on current account transactions. Resident corporates, financial institutions and private individuals all have limited scope to make some investments abroad. This situation has been achieved by government following a policy of gradually phasing out exchange controls. Government is, therefore, committed to the removal of exchange controls.

Since 1994 significant progress has already been achieved:
- A first major step was the abolition of the Financial Rand in March 1995, which had been re-introduced in 1985. No capital controls are, therefore, applied to non-residents who may freely invest in and disinvest from South Africa. This applies to portfolio investment as well as foreign direct investment into South Africa.

- South African corporations have been allowed to make increasingly large offshore investments and to raise foreign capital against their domestic Balance Sheets. On approval local corporates may transfer up to R50 million abroad for a new investment. For an approved investment into the SADC region an amount of up to R250 million may be remitted for a new investment.

- Qualifying institutions i.e. long term insurers, pension funds and the unit trust industry as well as fund managers are allowed to participate in asset swaps. They may also invest a portion of their earnings into portfolio investments offshore. The present limit for such portfolio investments has been increased to 15% of their South African assets.

- Exchange Control restrictions on foreign investments by private individuals resident in South Africa were lifted in July 1997 and the current limit stands at R500 000 per individual.

- Since July 1997 resident individuals may retain foreign earned income abroad.

Further relaxations include the following:
- the removal of controls on the level of foreign exchange holdings by authorised dealers in foreign exchange i.e. South African banks;

- the licensing of foreign exchange bureaux;
- the ability of non-residents of the CMA to maintain foreign currency denominated deposits with South African banks.

- the abolition of separate travel allowances for neighbouring countries and other foreign countries

- the establishment of United States Dollar/South African Rand futures contracts through the South African Futures Exchange for non-residents and Authorised Dealers in foreign exchange

- allowing immigrants to repatriate funds brought into the country;

- South African gold producers are no longer required to market their gold through the South African Reserve Bank;

- permission for foreign firms to list on the JSE to raise capital up to a maximum of R250 million for projects anywhere in the SADC region;

- permission for the issue of SADC Depository Receipts in South Africa for companies listed in the SADC region;

- the requirement to repatriate foreign currency earnings within 30 days of accrual has, in respect of businesses utilising customer foreign currency accounts, been extended to 180 days;

- restrictions on the opening and operation of customer foreign currency accounts by businesses making profits or commission on foreign transactions have been removed, subject to the 180 day limit for the repatriation of funds;

- the non-resident ownership level at which foreign controlled resident entities become subject to the limits on local borrowing has been raised to 75%;

- a relaxation in the capital structure requirements of foreign-controlled South African resident entities;

- the extension of loans to foreign shareholders by such companies in lieu of dividend transfers;

- current account payments and receipts are generally unrestricted;

- permission for corporates, who utilise customer foreign currency accounts, to off-set foreign import commitments against export proceeds; and

- limits in respect of discretionary expenditure such as travel allowances are reviewed on an annual basis.

- In line with international practice and to accommodate permissible foreign currency payments for small transactions e.g. imports over the Internet, South African residents are allowed to make such payments via credit/debit cards. Payments are limited to R20 000 per transaction. This arrangement does, however, not absolve cardholders from complying with the requirements imposed by the Customs authorities or ad valorem excise and customs duties.

Remaining Exchange Controls

A) Corporates
i) Foreign investment - Corporates are allowed, on application, to transfer up to R250 million from South Africa per new approved investment in the Southern African Development Community ("SADC") provided a longer term benefit to South Africa can be demonstrated. In respect of investments elsewhere in the world, corporates are limited to the transfer from South Africa of up to R50 million per new approved investment subject to the same criteria requirements.

For more costly investments corporates may, on application, raise foreign finance facilities on the strength of their South African Balance Sheet provided the facility is for a minimum period of two years, during which two year period there can be no recourse to South Africa.

ii) Foreign loans - All loans from outside the Common Monetary Area require prior Exchange control approval. Approval is normally granted provided the interest rate charged is market related.

B) Institutional investors
i) Asset swaps - Qualifying institutional investors, i.e. long term life insurers, registered pension funds, unit trusts through unit trust management companies and registered fund managers, may on application acquire foreign portfolio assets of up to 15% of their total South African employed assets by way of an asset swap with a foreign counter party. The transaction must be foreign exchange reserves neutral and should be structured through an exchange of portfolio assets and or cash.

ii) Cash flow transfers - Qualifying institutional investors could, on application, during 1999 acquire portfolio investments on SADC stock exchanges of up to 10% of their net cash flows generated during the 1998 calendar year. In addition, a further 5% of their net cash flows generated during the 1998 calendar year could, on application, during 1999 be utilised to acquire portfolio investments elsewhere in the world. Such transfers formed part of the overall 15% asset swap limit and were made at a cost to South Africa's foreign exchange reserves.

C) Foreign controlled entities
i) "Affected persons" - South African registered entities who are 75% or more foreign controlled are restricted in the amount of local financial assistance they may avail of. Dividend / profit / income distributions are, however, freely transferable in proportion to the percentage shareholding / ownership provided the relative distribution will not cause the entity to be placed in an over borrowed position in terms of formula requirements.

D) Individuals
i) Foreign investment - May invest up to R500 000 per individual for any purpose outside the Common Monetary Area provided the party is over 18 years old and a registered tax payer in good standing.

ii) Foreign loans - All loans from outside the Common Monetary Area require prior Exchange Control approval. Approval is normally granted provided the interest rate is market related.

iii) Travel allowances - R120 000 per calendar year per person 12 years or older. R35 000 per calendar year per child under 12 years of age.

iv) Foreign study allowances - R120 000 per calendar year per single student. R240 000 per calendar year per student accompanied by a spouse.

v) Holiday travel allowances for students studying abroad - R35 000 per calendar year per single student and R70 000 per calendar year for a married student accompanied by a spouse.

vi) Gifts and donations to non-residents - R10 000 per applicant per calendar year.

vii) Maintenance payments to non-residents - R4 000 per month to direct family members.

viii) Emigrants - Persons emigrating to any country outside the Common Monetary Area qualify, at the time of their emigration and after all their assets have been brought under the control of an Authorised Dealer, to be accorded the following facilities:

- a settling-in-allowance of R400 000 per family unit or
! a settling-in-allowance of R200 000 in respect of single persons
- a travel allowance applicable to each member of the family unit subject to the limits laid down under point (iii) above
! household, personal effects and motor vehicles to the value of R1 million may be exported on a Form N.E.P.

Various restrictions remain on the use of blocked funds in South Africa.

E) Authorised Dealers/Administrative controls
i) Import transactions - Payment by Authorised Dealers on behalf of South African importers may be effected against certain prescribed documentation. Sales of foreign currency by Authorised Dealers in amounts of R50 000 and above must be supported by a Form A.

ii) Export transactions - Authorised Dealers diarise and control the receipt of export proceeds from outside the Common Monetary Area. The foreign currency proceeds must be sold to an Authorised Dealer within 30 days from accrual. In respect of all consignments of R50 000 and above a Form F178 is completed. Purchases of foreign currency by Authorised Dealers in amounts of R50 000 and above must be supported by a Form E. A Form N.E.P. is completed in respect of goods exported for which no payment will be received.

iii) Other - Authorised Dealers may effect payment on behalf of their clients in respect of current account transactions with parties outside the Common Monetary Area against the production of documentary evidence confirming the amounts involved.


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