Public Information Notice No. 00/19

Public Information Notice: IMF Concludes Article IV Consultation with South Africa

March 10, 2000

On February 14, 2000, the Executive Board concluded the Article IV consultation with South Africa.¹

Background

Financial market conditions have improved considerably since the last Article IV consultation. At that time, South Africa was experiencing serious foreign exchange market pressures, largely as a result of contagion from other emerging market economies, but also because of an adverse reaction by investors to the authorities' response to these pressures during May-June 1998. Starting in July, the authorities kept monetary policy consistently tight, refrained from intervention in foreign exchange markets to defend the currency, and maintained fiscal policy on course. As a result of these policies and an improved global environment, the authorities regained investors' confidence, which led to a resumption of capital flows.

The authorities have taken advantage of the improvement in market conditions since the fourth quarter of 1998, gradually reducing the repurchase rate from a high of 21.9 percent in September 1998 to 11.8 percent, and the net open forward position of the Reserve Bank (NOFP) from its high of US$23.2 billion in October 1998 to US$11.1 billion at end-February 2000. Following a depreciation of 18 percent against the U.S. dollar, the rand remained mainly within a range of R 6.00-R 6.20 during 1999. While headline inflation fell from 9.0 percent in December 1998 to 2.6 percent in January 2000, core inflation has remained at around 8 percent. There are clear signs of a cyclical recovery in economic activity, as quarterly rates of real GDP growth rose continuously during 1999, reaching 3.6 percent (annualized, seasonally adjusted) in the fourth quarter. However, the trend decline in formal private sector employment continued in 1998 and 1999, and the official unemployment rate, which was 22 percent in 1997, most likely increased further.

The stabilization of market conditions was also underpinned by a strengthening of the public finances. The overall budget deficit of the national government was reduced from 3.8 percent of GDP in 1997/98 (April-March) to 2.3 percent in 1998/99, about 1 percent of GDP below the original budget estimate, mainly as a result of higher-than-projected revenue. In addition, stronger expenditure management led to a turnaround in the overall balance of the provinces from a deficit of 0.9 percent of GDP in 1997/98 to a surplus of 0.4 percent of GDP in 1998/99. Thus, the overall deficit of the general government declined from 5 percent of GDP to 2.1 percent. For 1999/2000, the deficit of the national government is now projected to be 2.4 percent of GDP, over ½ of 1 percent of GDP lower than the original budget estimate.

The external accounts have improved significantly in 1999. The current account deficit fell from 1.6 percent of GDP in 1998 to virtual balance for the first three quarters of 1999, mainly reflecting a substantial contraction in imports and the completion of import-intensive investments by the public enterprises. The financial account of the balance of payments also improved, on account of the increase in portfolio investment following the return of investor confidence, the change in domicile of three large multinational corporations from Johannesburg to London, and a number of foreign currency bond issues by the government. Total external debt declined from US$39.2 billion in 1997 to US$38.8 billion in 1998 (29.1 percent of GDP).

Progress has been made on structural reforms: a free trade agreement with the EU is being implemented by South Africa since the beginning of 2000; the Southern African Development Community (SADC) trade protocol has been agreed upon and is expected to come into effect this year; privatization gained momentum with the sale of 20 percent of South African Airways in June 1999; and implementation of the measures to reduce unemployment arising from the October 1998 Presidential Jobs Summit has begun.

Executive Board Assessment

Executive Directors commended the authorities for the sustained pursuit of sound macroeconomic policies and the progress achieved thus far in the implementation of structural policies. These macroeconomic policies and the presence of a healthy and well-supervised financial system had contributed to the resilience the economy had demonstrated in weathering the recent emerging markets crisis. Directors emphasized that with confidence returning and broad-based economic recovery gaining strength, the urgent challenge facing the authorities is to raise South Africa's growth potential so as to facilitate job creation and improve living standards. Noting the extremely high level of unemployment in South Africa, they underscored that the key to generating high and sustainable output and employment growth lies in the pursuit of policies aimed at further lowering inflation and accelerating structural reforms that would help tap the large pool of unemployed and increase the skills of the labor force, increase domestic investment, attract foreign investment, and enhance efficiency. This challenge would require faster and deeper implementation of the reforms set out in the government's Growth, Employment and Redistribution (GEAR) strategy, most notably in the areas of labor market reform, trade liberalization, and privatization.

Directors commended the authorities on the conduct of monetary policy since the last Article IV consultation. They observed that during 1999 an appropriate balance had been struck between the need to stave off a recession in economic activity and the need to avoid a reemergence of financial market pressures. At the same time, the authorities had been successful in reducing the net open forward position (NOFP) of the Reserve Bank while containing inflationary pressures from the depreciation of the rand in 1998. Directors considered that the flexible exchange rate regime had again demonstrated its value in this crisis and that macroeconomic policies had been consistent with this regime. Looking forward, Directors stressed that monetary and exchange rate policies should continue to emphasize further reductions in the NOFP. They noted that, while the decline in interest rates to below pre-crisis levels has contributed to a sharp recovery in output, any further easing in monetary policy should be undertaken only as long as inflation continues to decline in line with the authorities' goal of reducing inflation to that of the level of South Africa's trading partners.

Directors noted that further cuts in the NOFP would help reduce the risk premium on South Africa's assets and thereby lower long-term interest rates on a sustainable basis. In this context, they welcomed the public statements by the monetary authorities reaffirming their intention to progressively reduce the NOFP with the intention ultimately of dismantling the forward book, as market conditions permitted. Some Directors observed that limited and cautious external borrowing could operate as a supplement to this strategy. The authorities were also urged to maintain a transparent approach in their strategy for reducing the net open forward position.

Directors agreed that exchange controls should continue to be liberalized cautiously, and where appropriate replaced by prudential regulations.

Directors agreed with the authorities that the adoption of a formal inflation-targeting framework for monetary policy in 2000 was feasible and desirable. They noted that South Africa satisfied the main prerequisites for inflation targeting and that such a framework would help impart greater transparency and credibility to monetary policy and the process of inflation control. Directors welcomed the authorities' intention to hold discussions with civil society in order to explain the inflation-targeting framework so as to increase the support for its implementation later in the year.

Directors welcomed South Africa's participation in the pilot program of Financial System Stability Assessments (FSSA). They noted that the financial system appeared robust and that the regulatory framework covering both banks and other financial institutions was sound. It was noted that even after netting out cross shareholdings, South African banks remained well capitalized. Moreover, South Africa's practices with regard to transparency and supervision were, with a few exceptions, in line with best international practices. Directors observed that the FSSA report had made some suggestions to strengthen the financial system, including by expanding on-site inspections of financial institutions, netting out cross shareholdings of financial conglomerates to estimate properly the bank capital and to improve their supervision, and improving the procedures for resolution of problem banks. Directors also noted that the authorities had already taken appropriate remedial actions in most of these areas, and welcomed their intention to set up a deposit insurance scheme and introduce new money laundering legislation.

Directors commended South Africa's strong fiscal performance during 1998/99, which had included a substantial turnaround in the provincial finances. They noted that the authorities had shown continued fiscal discipline in implementing the 1999/2000 budget and in setting out its medium-term budget framework. In addition, modifications to the tax system had been made that would reduce distortions to investment incentives and help stimulate private saving. In this regard, Directors looked forward to the final report of the commission on tax reform and consideration by the authorities of its recommendations on further improving the tax system. On the expenditure side, Directors noted the reorientation of spending toward health, education, welfare, housing, and crime prevention, reflecting the importance attached to the goals of reducing poverty and raising living standards, while at the same time strengthening management of public resources. Directors supported the authorities' intention of improving the delivery of government services by rationalizing the size of the civil service and improving its wage structure.

Directors welcomed the initiatives that came out of last year's Job Summit but underscored the need for more fundamental changes in certain aspects of the labor market policy to encourage job creation for the unskilled. In particular, they pointed to the importance of implementing two measures proposed in the GEAR that had not yet been carried out: the scaling down of wages for young trainees and the granting of more discretion to the Minister of Labor to limit the extension of centrally negotiated wage agreements.

Directors commended the authorities on the substantial progress that had been made in trade liberalization in recent years, noting the strong international evidence linking trade liberalization to higher productivity growth—a link that is also evident in South Africa. They also emphasized the benefits to the South African economy of the free trade agreement with the EU, which they hoped would be fully adopted as quickly as possible, and the decision by the authorities to implement unilateral tariff cuts on trade with other Southern African Development Community (SADC) members once agreement had been reached on a code governing rules of origin. Directors encouraged the authorities to continue the process of trade liberalization and, in particular, urged that the tariff regime be further simplified, that less use be made of discretionary tariff increases, and that protection for the so-called sensitive sectors be lowered. In addition, there is a need for greater cooperation between the various regional initiatives, including the Cross-Border Initiative and SADC, in order to ensure consistency of objectives and strategies while avoiding duplication of effort.

Directors noted that public enterprise restructuring and privatization have moved slowly and stressed the importance of accelerating the detailed program under preparation. This too would contribute to higher productivity growth. They commended the authorities' intention to use privatization revenues to reduce debt.

The authorities' commitment to satisfy in full the requirements of the Fund's Special Data Dissemination Standard was commended. While reported data were generally comprehensive and of high quality, labor market statistics needed major improvements as they were currently published with limited frequency and long lags. The need for improvements in the timeliness of data on external debt and in the quality of financial data reported by the provinces and local authorities was also noted.