Economic conditions have improved substantially in South Africa during the past three years. The peaceful political transition paved the way for the reintegration of the country into the world economy and opened up new opportunities for economic development and growth. Considerable success was achieved in this regard, but difficult challenges will have to be faced in the coming years to reach the full growth potential of the country, to reduce unemployment and to bring about a more equitable distribution of income and wealth.

Recent economic developments

After having contracted at an average annual rate of 0.5 per cent in the period 1989 to 1993, real gross domestic product increased on average by 3 per cent per year over the last three years. This output growth was fairly broadly based and occurred in all the main sectors of the economy, with the notable exception of the gold mines. The production of gold continued with its secular decline, which had already started in the early 1970s.

The main impetus to this better economic performance came from the removal of trade and financial sanctions against the country, which boosted exports, led to an inflow of capital and took away the need to maintain a surplus on the current account of the balance of payments.

This recovery in aggregate domestic output growth lost momentum in the first quarter of 1997 and real gross domestic product declined at an annual rate of 1 per cent. Although this decline was primarily caused by a substantial decrease in agricultural output from the exceptional high levels of the preceding year, growth in the non-agricultural sectors also slowed down noticeably in the first quarter of 1997. The growth in output measured over one year nevertheless still amounted to 2.5 per cent in the first quarter of 1997.

The contraction in domestic production in the first quarter coincided with a further decrease in real gross domestic expenditure, which has been evident since the second half of 1996. Inventory levels were reduced in the first quarter of 1997 and the growth in both real private consumption expenditure and real fixed investment expenditure decelerated sharply to low levels. In contrast, real government consumption expenditure increased strongly at an annualised rate of 5.5 per cent.

Despite the low growth in capital formation, fixed investment as a ratio of gross domestic product amounted to 17 per cent in the first quarter of 1997 - that is considerably higher than the 15 per cent in the second half of 1995. However, this level is still well below the ratio of 25 per cent, which research has shown is needed for a sustainable high rate of economic growth that will be able to absorb the increase in the economically active population, and reduce unemployment.

Employment growth responded slowly to the higher level of economic activity and aggregate non-agricultural employment is still 7 per cent below its level at the beginning of the 1990s. A growing number of unemployed persons are thus depending on a shrinking number of workers in the formal economy for their livelihood. According to surveys undertaken by the Central Statistical Service nearly one-third of the economically active population is unemployed in South Africa.

A decline in the nominal unit labour costs supported by a counter-inflation monetary policy and lower inflation expectations, led to a decline in the rate of inflation below 10 per cent in the past four years, compared with a higher turning-point of nearly 19 per cent in 1989. A recent acceleration in inflation during the second half of 1995, was arrested in the first quarter of 1997 and the rate of inflation was kept at single-digit levels by an appreciation of the rand and slower growth in nominal unit labour costs.

Despite a good performance of merchandise exports, the current account of the balance of payments deteriorated quickly with the higher economic growth and a surplus was changed into a deficit. As could be expected, the rise in the domestic needs for capital and intermediate goods led to a sharp increase in imports. The current account deficit, however, remained manageable and as a ratio of gross domestic product never exceeded 3 per cent. In the first quarter of 1997 this ratio amounted to only 1.5 per cent.

This switch in the current account of the balance of payments occurred against the background of the normalisation of South Africa's international financial and trade relations and coincided with a large net capital inflow to the country of R30.8 billion from the middle of 1994 up to December 1995. At the same time, it made the country more vulnerable to the vagaries of international capital flows. Sharp fluctuations in capital movements led to volatility in the exchange rate of the rand. From the middle of February 1996 to the end of October the nominal effective exchange rate of the rand decreased by no less than 23.5 per cent. Changes in international as well as domestic sentiments then brought about a reversal in the capital movements and caused the nominal effective exchange rate of the rand to increase again by 8 per cent up to the end of May 1997.

The high level of domestic expenditure in conjunction with a substantial rise in the value of transactions on domestic capital markets and other structural changes in financial markets, led to an increase in the money supply to levels fluctuating around 16 per cent, that is to levels well in excess of the money supply guidelines of 6 to 10 per cent. The main counterpart of the growth in money supply was an increase in bank credit extension to the private sector. In view of these developments and with the objective of overall financial stability in mind, a conservative monetary policy stance was pursued by the authorities.

The primary objective of fiscal policy was the achievement of fiscal sustainability in the medium term, including the reprioritisation of government expenditure in order to increase allocations for social services, capital expenditure and the other objectives of the economic upliftment of the population. The Government accordingly applied considerable fiscal constraint to contain the growth in government expenditure. As a ratio of gross domestic product, the Budget deficit was brought down from nearly 8 per cent in fiscal 1992/93 to 51/2 per cent in fiscal 1996/97, and it is projected to decline further to 4 per cent in fiscal 1997/98.

Economic challenges

The main economic challenge facing South Africa is the need for employment- creating economic growth to reduce the current high level of unemployment and create opportunities for the upliftment of a large segment of the population. High economic growth is a precondition for the effective attainment of other economic objectives such as the relief of poverty, socio-economic reform and the sustained improvement of living conditions in general. At the same time, it is essential that the economic growth should create employment opportunities. Only when the bulk of the work force has been absorbed into the formal sectors of the economy, will the problem of poverty, crime and violence be reduced. The tax base will then also be sufficient to enable the Government to address the question of income redistribution.

High long-term economic growth is dependent on the expansion of production capacity and the improvement of productivity. In addition to increases in employment, expansion in production capacity requires additions to the country's capital stock in the form of net fixed investment. Depending on various assumptions, it has been estimated that the net investment requirement should amount to about 8 per cent of gross domestic product to achieve high and sustainable economic growth. This will, in turn, require financing to the tune of 24 per cent of gross domestic product.

At present, the domestic savings ratio of the country is equal to only 16 per cent of gross domestic product, indicating a considerable gap between the financing requirement for higher economic growth and domestic savings. Part of this gap can be met by removing dissaving of government, and by the encouragement of private saving. A substantial part of the financing requirement will nevertheless still have to be met by funds obtained abroad. Considerable progress has been made to make South Africa a more investor-friendly country to attract foreign investment by measures such as the abolition of exchange controls on the inward and outward movement of capital by foreigners, the gradual removal of exchange controls on residents and the termination of non-resident shareholders tax as well as the tax payable by foreigners on interest earned in South Africa.

The other factor necessary for high economic growth - that is productivity growth - will depend on the efficiency with which inputs are applied to produce outputs, or rather on technological progress, investment in human resources and a competitive industrial structure. Well-educated and well-trained workers are better equipped to raise productivity. Considerable attention is accordingly provided in the macro-economic strategy of the Government to improve the education system in South Africa and to the in-house training of workers. To promote effective competition, the tariff wall behind which South African organisations operate has been lowered, changes are under consideration in the laws affecting competition and large conglomerates have been encouraged to reduce economic concentration.

A precondition for the attainment of all these challenges standing in the way ofsustainable high economic growth is the maintenance of financial stability. This means that monetary policy must continue to provide a stable financial environment with low inflation to guard both the domestic and external value of the rand. Sustained strict monetary and fiscal discipline are therefore essential. Monetary policy will aim to maintain real interest rates at positive levels to encourage savings and investment and to attain long-term real effective exchange rate stability. In this process, the authorities will also continue to gradually remove the remaining exchange controls.