The Asian financial problems, or the "contagion process", spread essentially through three channels to other economies:
- Firstly, investors in the main financial centres of the world, who had been investing vast amounts in the Asian economies during the 1990s, reassessed the risk associated with these investments and promptly reversed the direction of their capital flows, with little differentiation between individual emerging-market economies. Global investors began to seek "high-quality" investments in the advanced economies of the world, turning the Asian financial problems into a capital account shock for many emerging-market economies.
- Secondly, the sharp depreciation of the Asian currencies against the United States dollar and other currencies made the goods exported from these countries more competitive in export markets. This, together with the weak growth in Japan, had adverse consequences for the current-account balances of a number of emerging-market economies, including that of South Africa.
- Thirdly, because the Asian economies are large net importers of commodities, the slowdown in economic activity in Asia and the consequent weakness of aggregate demand led to a fall in the prices of internationally traded commodities. These lower prices weakened the prospects for a quick improvement in the current-account balances of many commodity producing economies.
The deficit on the current account of South Africa's balance of payments in 1997 and early 1998 was financed largely through inflows of portfolio capital, making the country particularly vulnerable to the after-shocks of the financial turbulence in Asia. The negative balance on the current account of the balance of payments widened abruptly in the second half of 1998 as the weak demand for exports and a sharp rise in imports of capital goods combined to exacerbate the deficit on the current account of the balance of payments. In addition, the strong inflow of non-reserve related capital in the first half of 1998 ceased and was followed by a small outflow in the second half of that year.
In response to these shocks, the exchange value of the rand and interest rates rose sharply in order to contain the growth in domestic demand and to contain capital outflows. The net outcome of these measures, along with the effects of increased labour market disruption and the slowdown of the global economy, curbed domestic production activity which had already been slowing before the effects of the international financial turmoil had been felt.
Real gross domestic production, which had been growing sluggishly in the second half of 1997 and in the first half of 1998, contracted in the third and fourth quarters as the fall in the exchange value of the rand and the sharp rise in interest rates weakened business and consumer confidence. The output declines in the second half of 1998 reversed the small advances made in the first half of the year, reducing output in the whole of 1998 to a level that was roughly equal to that of 1997, i.e. no meaningful economic growth was achieved in 1998.
The output declines were particularly pronounced in the primary and secondary sectors of the economy. By contrast, real value added in the tertiary sector continued to grow at about the same rate as in 1997. For this reason the increasing orientation of the South African economy towards the production of services received further momentum from the slowdown in growth in 1998.
Unlike the decline in real gross domestic production, real gross domestic expenditure continued to expand in the second half of 1998, albeit at a considerably lower rate in the fourth quarter than in the third quarter. The main reason for the expansion of domestic expenditure was the solid growth in domestic fixed investment, largely attributable to the investment activity of public corporations which appeared to be unperturbed by the high interest rates.
These capital outlays had a high import content which contributed to the weakening of the current-account deficit in the second half of 1998.
Consumption expenditure by households on durable goods, especially on motor vehicles, declined sharply in the second half of 1998. Meanwhile, general government successfully curtailed the growth in their consumption expenditure to far more sustainable levels. Destocking continued in the last two quarters of 1998, albeit at a slower rate than before.
Domestic saving relative to gross domestic product remained low and even tended to deteriorate in the second half of 1998. At its current level, the saving ratio is even more insufficient for the development needs of the country than a few years ago. If such a low saving ratio persists it will constrain long-term economic growth, unless domestic resources are augmented by strong inflows of direct investment capital from abroad.
The inability of the supply side of the economy to respond in a way that would create new jobs in sufficient numbers to reduce unemployment continued to be a major structural weakness in South Africa's economic performance. The employment situation deteriorated further during 1998 as both the private sector and the public sector reduced employment opportunities. These movements signalled a relative slackness in the labour market with the supply of labour substantially exceeding the demand for labour.
Increases in average remuneration per worker generally outpaced consumer price inflation and production price inflation in 1998. In the third quarter of 1998, however, the growth in nominal remuneration per worker declined from the high levels attained in the second quarter. This, together with a further increase in output per worker, slowed the rise in unit labour costs during the third quarter of 1998 and helped contain domestically generated inflation in the fourth quarter.
The sharp rise in the prices of imported goods in the middle quarters of 1998, along with the increase in home mortgage rates, which caused a strong rise in the cost of home-ownership, resulted in a one-off rise in the aggregate price level. Disinflationary forces at work in the economy, especially the moderation of the growth in unit labour costs and the reduced margins of domestic producers, quickly arrested the upward pressure on prices and prevented a price spiral from developing. The gradual easing of monetary conditions and declining home mortgage rates make the prospects for smaller increases in the general price level during 1999 promising.
As mentioned before, the deficit on the current account of the balance of payments widened substantially from the first half of 1998 to the second half. A sizeable decline in net service payments to the rest of the world nevertheless led to a modest shrinking of the negative balance on the overall current account from the third to the fourth quarter of 1998. This followed a progressive weakening of the current-account balance in the first three quarters of 1998.
Despite the weakening of the current-account balance and large net sales of bonds by non-resident investors, there was only a relatively small decline in international reserves during 1998. Import cover, i.e. international reserves expressed as a ratio of the value of imports of goods and services in a certain period, remained virtually unchanged from the fourth quarter of 1997 to the fourth quarter of 1998. Despite the capital account shocks of 1998 there was still a net inflow of long-term capital into the economy for the year as a whole.
Furthermore, persistent outflows of short-term capital in the first three quarters of 1998 were followed by an inflow of this type of capital in the fourth quarter. In part, this inflow was due to the delayed repatriation of foreign currency earnings by exporters who had taken advantage of the lengthening of the repatriation period allowed by the exchange control authorities in March 1998 from 30 days to 180 days.
The rand came under strong downward pressure between May and August 1998, but has recovered some of its losses since then. This was to a certain extent a consequence of the capital inflows of the fourth quarter, but was also assisted by the unwinding of short positions held by international hedge funds and other currency speculators who were left with their positions at a loss-making exchange rate or at a less profitable exchange rate than they had generally expected.
The growth in the M3 money supply remained relatively strong during 1998, despite the sharp rise in interest rates and the slowdown in the economy. The M3 guideline had been overshot throughout 1998 and it was only in the fourth quarter that the quarter-to-quarter growth in the money supply subsided to a rate roughly consistent with the objectives of the monetary authorities.
The growth in M3 during 1998 was fuelled by persistently strong and increasing growth in credit extension to the private sector. The fastest growing component of credit extended to the private sector was "other loans and advances" by banks, which is utilised to a large extent by companies and other business concerns. The credit categories used mostly by households, such as mortgage loans and instalment sale agreements, increased at more modest rates than those used by the corporate sector.
Money market conditions eased considerably from the third quarter of 1998 along with the return of some stability to the global financial markets. This allowed the Reserve Bank some leeway in the conduct of monetary policy.
From about the middle of October 1998 the daily liquidity needs of the private banks were fully met and money market rates, which had risen sharply in the second quarter, were allowed to decline steadily. Apart from a brief period in January 1999 when the problems in Brazil threatened to unsettle financial conditions in many emerging markets, the downward trend persisted well into the first quarter of 1999. The private banks took the cue of the money market and lowered their prime overdraft rates in a series of six steps by a total of 550 basis points from October 1998 to early March 1999.
Bond yields moved sharply higher between May and August 1998 when non-residents became net sellers of bonds, but since then they have retraced about three-quarters of their earlier rise. Foreign participation in the domestic bond market remained lively throughout 1998. Aggressive selling of bonds by non-resident investors in the last eight months of 1998 makes it less likely that there will be further large sales of bonds in early 1999.
Capital raised in the primary debt market by public-sector bodies subsided in 1998 to levels well below those recorded during the previous year. This limited the potential for crowding out private-sector participation from the primary fixed-interest market. The private sector nevertheless eschewed participation in the domestic debt market because of the high interest rates and showed a clear preference for equity financing. Reflecting these financing preferences of the domestic corporate sector, capital raised in the primary equity market rose sharply in 1998.
Share prices fell drastically between May and September 1998. The share market recovered somewhat in the final months of 1998 and the early months of 1999; however, it was still some 5 per cent lower in February 1999 than in December 1997. The sector that performed worst was the commercial sector where prices declined, on balance, by 20 per cent from the end of 1997 to February 1999.
The rise in interest rates in the middle quarters of 1998 and the slowdown in the economy motivated the Minister of Finance to revise the budget deficit target in November 1998 from an original deficit of 3,5 per cent of gross domestic product for the 1998/1999 fiscal year to 3,9 per cent. Fiscal policy would nevertheless still emphasise fiscal consolidation, the reprioritisation of government expenditure and the broadening of the tax base with the aim of ultimately lowering statutory tax rates. Surprisingly strong revenue growth, which exceeded the original budget expectations, is expected to bring the eventually realised deficit ratio closer to the originally projected ratio. In fact, when the Budget for the fiscal year 1999/2000 was tabled in Parliament, the Minister estimated the outcome to be 3,7 per cent for the fiscal year 1998/1999.
Besides the general strengthening of the finances of the Central Government, the financial positions of the broadly defined public sector improved even more impressively. Provincial governments, in particular, were successful in turning large financial shortfalls in fiscal 1997/1998 into financial surpluses in fiscal 1998/1999. Unlike the previous year when provincial governments borrowed fairly extensively from the banking sector, they reduced their bank indebtedness during the first nine months of fiscal 1998/1999 and in the meantime also accumulated deposits with the private banks.
By the beginning of 1999 the slowdown in the global economy that had been engendered by the financial problems of emerging markets seemed to have abated. The worst of the crisis appeared to be over and many emerging-market economies are recovering from the turmoil of 1998. The recovery in the South African economy will, among other things, be determined by