Transcript Macroeconomic Theory and Policy

Macroeconomic Theory and
Policy
July 2015
By Kenneth Creamer
Overview
(1) Fiscal Policy
-
Spending = Tax Revenue + Borrowing (managing public
finances to promote investment employment and growth
in SA)
- Discussion
(2) Monetary and Exchange Rate policy
- ΔP = ΔM (managing money supply, interest rates,
inflation and exchange rates to promote
investment employment and growth in SA)
- Discussion
(1) Fiscal Policy
• Fiscal policy, more particularly a reconstructive fiscal policy,
is South Africa’s most important instrument for macro
economic management and for social and economic
transformation.
• A major long-term fiscal goal has been the reprioritisation
of expenditures away from race-based access to public
services, which were mainly reserved for the minority
white population under apartheid, towards more racially
equitable pattern of expenditure.
• Related to this has been a strong emphasis on the need to
improve the quality of spending and service delivery.
• Fiscal policy is heavily impacted upon by domestic and
international economic conditions, such as, fluctuations in
economic growth and in global commodity prices.
Key objectives of fiscal policy
• Counter-cyclical demand management, aimed at
stabilising demand and output when the economy is
being driven by the volatile forces of the business
cycle, AD = C + I + G + X - M
• Addressing inequities in income, in resourcing the
redistribution of assets and in eliminating unequal
access to basic services.
• Avoidance of inappropriately rising national debt.
Future generations will benefit greatly from resources
well mobilised but will suffer greatly if they inherit
fruitless debt and the burden of debt repayment (as
per Greek crisis).
• Driving infrastructure expansion and maintenance,
which in turn assists in shaping the structure of
opportunity and supply-side potential of the economy.
Role of infrastructure in socio-economic
transformation
• Due to macroeconomic circumstances – the current
challenge is to find:
– new forms of public-private cooperation and
– new ways to finance infrastructure expansion
• More than any other factor, the future of SA will be
built on such infrastructure expansion:
– economic infrastructure – which has the potential to
produce direct positive returns on investment – beneficial
circle of increased spending leading to returns and
revenues e.g. power and transport infrastructure
– social infrastructure – which is also uplifting and
transformative but which does not always shows a directly
linked return on investment e.g. education, municipal
services
5
Current drivers of inequality
• South Africa’s apartheid history has mean that our economy suffers
from high levels of unemployment and inequality, but there are also
current factors in the global capitalist system that are driving rising
inequality in South Africa and around the world:
– Some, such as Piketty (2013), have ascribed rising inequality to the
fact that the long-term dynamics of the capitalist system are such that
the return on assets held by the by the wealthy (r) is greater than the
rate of economic growth (g).
– Others, such as Brynjolfsson and McAfee (2011), have argued that the
recent ongoing wave of technological change is tantamount to a Great
Restructuring in which the acceleration of technology has negative
consequences for wages and jobs and that, while digital progress
grows the overall size of the economy, it does this while leaving the
majority of people in a poorer position.
– In the South African context, Burger (2015) has suggested that labour’s
falling share of income is due to financialisation and aggressive
returns-oriented investment strategies that have resulted in greater
investment in capital-augmenting labour-saving technologies.
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Role of infrastructure in socio-economic
transformation
• Infrastructure expansion is transformative – it can serve to push
back against SA’s unequal history and against some of the
economy’s current drivers of inequality.
• Infrastructure expansion is a necessary part of the solution, but to
be sufficient, it must also take into account:
– The fact that that there must be expanded access for the poor and
unemployed, as this majority of people cannot afford private services
– Increased public-private cooperation must serve to protect and
strengthen the quality of public services and not undermine them
– Quality, efficiency and return on investment are key tools in fostering
and managing economic development
• Such a programme of radical economic transformation is to be
judged on its radical impact in improving people’s lives, not on how
radical the instruments proposed seem to sound
• "It doesn't matter whether a cat is white or black, as long as it
catches mice.” – Deng Xiaoping
7
Key period’s in recent SA fiscal policy
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Phase 1 from 1994 to early 2000’s
Phase 2 from early 2000’s to 2008-09 crisis
Phase 3 from 2008-09 crisis to 2014
Current phase of fiscal consolidation from
2014-15
Expenditure, revenue and deficit trends 1990 2014
30
12
28
10
26
8
24
6
22
4
20
2
Defict/Surplus (% of GDP) RHS
Revenue (% of GDP) LHS
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
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1999
-8
1998
10
1997
-6
1996
12
1995
-4
1994
14
1993
-2 Expenditure (% of GDP) LHS
1992
16
1991
0
1990
18
Phases of SA fiscal policy
• First phase from 1994 to the early 2000’s, government prioritized fiscal
stabilization and put in place policies to reduce South Africa’s fiscal deficit.
This was achieved mainly through controlling government expenditure,
from around 28% of GDP to around 24% of GDP
• Second phase, in the early to mid-2000’s, fueled by a relatively rapid
economic growth and a global commodity boom, the budget balance
improved sharply, moving into a fiscal surplus position in 2006 and 2007,
when tax revenues exceeded expenditure. In this phase, both government
expenditure and revenue rose as a percentage of GDP, with revenue
growing more rapidly than expenditure. Tax revenues grew from around
22% of GDP in 2003 to just under 26% of GDP in 2008.
• The third phase began with the global financial crisis of 2008-09 and the
Great Recession that followed in its wake and continued until 2014-15
when the emphasis begun to fall on the need for fiscal consolidation.
During this third phase, South Africa’s fiscal policy played a strongly
counter-cyclical role, with the budget deficit rising sharply as growth
faltered, tax revenues fell and expenditure continued to rise.
Current phase of fiscal consolidation
• The primary reason for this change in fiscal stance is
that the economy is experiencing persistently low
levels of economic growth.
• Lower than expected economic growth has a number
of serious negative consequences for fiscal policy.
• It puts downward pressure on tax revenues, it prolongs and deepens budget deficits, raises the quantum
of related borrowing and pushes up the country’s
national debt.
• If the fall in tax revenues coincides with rising
expenditure, which has been the case in SA, then the
situation is exacerbated.
The problem of low growth in SA
• A clear indication that economic growth in South Africa has
since 2008-09 been performing worse than expected, is
given by the fact that in every budget presented by
government from 2008 to 2015 the projected GDP growth
rate has turned out to be an over-estimation, when
compared to the growth rate that actually has occurred.
• A typical example of this tendency to over-estimate growth
occurred along with the announcement of the 2012
budget, in which government projected that the GDP would
grow by 2,7% in 2012, 3,6% in 2013 and 4,2% in 2014,
whereas the actual GDP growth rates for those years
turned out to be 2,2%, 2,2% and 1,5% respectively.
• The fiscal authorities have displayed a tendency to overestimate future economic growth over the past ten years.
Growth rates lower than projected
6
Actual GDP Growth
5
Projection 2006-08
Projection 2007-09
4
GDP growth rate (%)
Projection 2008-10
3
Projection 2009-11
2
Projection 2010-12
Projection 2011-13
1
Projection 2012-14
0
2006
-1
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
Projection 2013-15
Projection 2014-16
Projection 2015-17
-2
Consequences of incorrect growth projections
• The the tendency to consistently overestimate future
economic growth rates, impacts negatively on the
budgeting process.
• It feeds into rising indebtedness, as:
– the overestimation of future growth rates results in an
overestimation of future revenues and
– an underestimation of future deficit size and borrowing
requirements.
• Overly optimistic forecasting also creates an unreliable
basis for planning future expenditure. This is a current
major weakness in South Africa’s budgeting process.
Cyclical and structural budget
components of budget deficit
• The budget deficit can be decomposed into two components – a
structural component and a cyclical component.
– The cyclical component is driven by the business cycle.
– The structural component reveals what size the budget deficit would
be if the economy was operating at full potential, being neither in a
boom phase or in a recession.
• In many countries, as economic growth quickens, tax revenues rise
and expenditures fall leading to a cyclically-driven reduction in the
size of the budget deficit.
• In South Africa, such a cyclical pattern occurs mainly due to the fact
that tax revenues and growth are positively related.
• South African expenditures are less cyclical as social security
payments, like old aged pensions and child maintenance payments,
are not highly correlated with economic growth, as are
unemployment benefits in certain other countries.
Structural and cyclical components of primary deficit
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26
9
24
22
6
Structural component (% of GDP) RHS
20
Cyclical component (% of GDP) RHS
Trend Revenue (% of GDP) LHS
18
3
Actual Revenue (% of GDP) LHS
Non-interest expenditure (% of GDP) LHS
16
14
0
12
10
-3
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
SA’s budget deficit is structural
• The previous figure shows an estimate of the structural
primary balance for South Africa for the period from
2000 to 2014 using a methodology whereby noninterest expenditure is subtracted from tax revenues
that have been cyclically adjusted.
• What this reveals is the fact that, during the period
from 2009 to 2014, South Africa has consistently begun
to run a primary structural deficit.
• Increasing expenditure has resulted in spending levels
in excess, not only of actual revenues, but also of trend
(or structural) revenues.
• As a result, the increased primary deficit has been
driven by an increased structural component rather
than a cyclical component.
Structural deficits are dangerous
• A typical Keynesian argument in favour of counter-cyclical
fiscal policy advances the view that an increased budget
deficit during times of reduced growth and falling
aggregate demand allows government to stimulate
demand, encourage growth and thereby preserve
investment and employment during a down-turn.
• The Keynesian argument is premised on the fact that it is
the cyclical component of the budget deficit that should
increase during a down turn in the economic cycle.
• In Keynesian-terms, it is not a desirable situation for the
structural component of the budget deficit to be rising as it
implies that even if the economy were to no longer be in
low growth conditions, there would continue to be a
sizeable, structural primary budget deficit.
• This leads to a problem of rising national debt.
If low growth is the new normal
• If low growth is the new normal, then South
Africa will have to make adjustments to its fiscal
policy in order to avoid rising indebtedness.
• This has motivated South Africa’s recent
commitment to fiscal consolidation, including:
– marginally increased tax rates for higher income
earners and
– plans to a slow down real government expenditure
growth, as announced in the 2015-16 Budget.
Debt scenarios
• National debt is driven higher by a combination of govt borrowing,
low growth and high interest rates - Δb = d + (r – Δy)b
• The diagram indicates the impact which low economic growth has
on the projected level of the national debt between 2015 and 2025.
– In the initial scenarios, with no fiscal consolidation, the primary
budget deficit is assumed to equal 2% of GDP and a real interest rate
of 2% is assumed.
– In the low growth scenario, with a real GDP growth rate of 1.5%, the
national debt rises to 60,3% of GDP by 2025.
– In the high growth scenario, with a real GDP growth rate of 4,5%,
national debt rises to 51,3% of GDP by 2025.
• If it is assumed that the country’s fiscal position is successfully
consolidated and that the primary deficit is reduced from 2% to
zero, that is, where non-interest expenditure is fully funded by tax
revenues, then:
– under the low growth scenario (1,5% GDP growth) national debt
would rise only marginally, from the 2014 actual level of 47,1% of GDP,
to 48,3% of GDP by 2025.
– Under the high growth scenario (4,5% GDP growth), fiscal
consolidation would see national debt fall to 41,6% of GDP by 2025.
Impact of growth on SA’s national debt projections
65
60
55
50
Actual national debt (% of GDP)
45
"Low growth Scenario with 2% primary defict
(%of GDP)"
40
"High growth scenario with 2% primary deficit
(% of GDP)"
35
Low growth scenario with primary balance (%
of GDP)
30
High growth scenario with primary balance (%
of GDP)
25
20
15
199019921994 19961998200020022004 20062008201020122014 2016201820202022 2024
SA’s debt rise needs to be halted
• SA’s debt to GDP ratio is not particularly high as compared to other
country’s. Of concern is the fact that the trajectory of South Africa’s
national debt is rising more sharply than for most other countries
• South Africa’s national debt as a percentage of GDP has been rising
much more sharply than that of other BRICS countries, comprising
Brazil, Russia, India, China and South Africa. In fact, the national
debts levels of India and Brazil have been falling over the period.
• A consequence of South Africa’s rising debt levels is that each year
increasing amounts of government spending has to be allocated to
repay interest on government debt.
• Interest repayments have begun crowding out expenditure on other
items as they rose nominally from around R56-billion in 2009 to just
over R110-billion in 2014, or from 8,1% to 10% of all government
spending.
Comparative national debt positions for BRICS
countries
90
80
70
China's debt (% of GDP)
60
50
40
Brazil's debt (% of GDP)
South Africa's debt (% of GDP)
30
20
India's debt (% of GDP)
10
Russia's debt (% of GDP)
0
Politics of fiscal consolidation
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SA’s move towards fiscal consolidation is not based on an ideological commitment
to austerity or small government, rather it is a prudent and pragmatic adjustment
necessary to preserving the country’s long-run fiscal potential.
It is an approach that can be fully reconciled with the broader vision of the need to
build an effective developmental state in South Africa.
It is not possible to know with any degree of certainty whether South Africa’s
recent low growth performance should be regarded as the ‘new normal’ (some
argue that the world is entering a period of secular stagnation, but SA has also
been effected by specific problems such as power shortage and prolonged labour
disputes
Growth could return to SA e.g. if there is a future upswing in global commodity
prices or there is successful implementation of the country’s National
Development Plan.
It is such uncertainty about South Africa’ future growth path, which makes it
incumbent on government to consolidate its fiscal position and take steps to
reduce the country’s structural deficit.
It would not be prudent to continue to run fiscal policy on the mere hope that
growth will be higher in the future. It is better to consolidate with the knowledge
that the fiscal stance can be altered again in future if and when higher levels of
growth are sustainably achieved.
Challenges associated with fiscal consolidation
• Fiscal consolidation will limit the resources available for infrastructure
expansion, for welfare and for the remuneration of government
employees.
• A key risk is that during fiscal consolidation, employment costs will crowdout social programmes and the plans for infrastructure investment that
are so-crucial to transforming the supply-side potential of the South
African economy.
• The 2015 Budget envisaged that for the period from 2014/15 to 2017/18
capital should be the fastest-growing item of non-interest spending over
the medium term (with planned growth of 8,9% a year in nominal terms).
• It also envisaged that employee compensation would grow at 6,6% a year
and expenditure on goods and services would grow at 5,1% a year. The
need for consolidation is clearly indicated by the fact that interest
payments were projected to grow at 9,4% a year over the same period.
• The litmus test will be whether government is able to meet these
ambitious plans to improve the composition of fiscal expenditures.
Promoting investment
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A key economic intervention of the developmental state in South Africa has been
via significantly expanded public-sector-led investment.
The basic vision being that state borrowing, and borrowing by state owned
companies sometimes backed by government guarantees, would be used to fund
investment in infrastructure and people, which in turn would ‘crowd-in’ further
investment, stimulating growth, increasing tax revenues and thereby avoiding
rising debt.
As per the diagram, it can be seen that investment by state owned companies,
such as Eskom and Transnet, rose sharply from 2009 onwards.
Investment by general government rose, but not as sharply as the rise in
investment by public corporations.
Private sector investment has not been growing as sharply as envisaged. In 2014
private sector investment remained the largest contributor to overall investment.
The state-led public investment programme provides a strong stimulus to growth
and employment, but it is not of sufficient magnitude to uplift the whole economy.
In order for to achieve the National Development Plan’s goal of lifting overall
investment from the current level of around 20% of GDP to 30% of GDP, it will be
necessary that public-sector investment should serve as a catalyst to facilitate or
‘crowd-in’ private sector investment.
Significant increase in investment by public
corporations
450.0
400.0
80
70
350.0
60
General government investment (LHS 2000
=100)
300.0
250.0
50
200.0
40
150.0
State owned companies investment (LHS 2000
=100)
Private sector investment (LHS 2000 =100)
30
100.0
50.0
0.0
20
Total Investment (RHS as % of GDP)
10
Impact of fiscal consolidation on investment
• There is a risk that fiscal consolidation could impact negatively on
such plans – as reduced pubic resources would be available for
investment.
• On the other hand, there could be a positive impact, as successful
fiscal consolidation has the potential to contain, or even reduce, the
cost of borrowing for state owned companies, as the cost of such
borrowing is usually linked to the credit ratings which rating
agencies stipulate for South Africa as a whole and for certain
specific state owned companies.
• It is likely that a successful fiscal consolidation phase will halt the
phase of credit rating downgrades that South Africa has recently
been experiencing, and possibly even reverse course allowing for
positive re-ratings in future.
• Such re-rating would lower the cost of borrowing and potentially
stimulate increased investment in the economy more widely.
Impact on social protection
• Another possible risk posed by fiscal consolidation is that it could
reverse gains that have been made in reducing poverty in South
Africa.
• Significant increases in public expenditure on social security,
education, health, electricity and sanitation services have been
shown to have reduced multidimensional poverty in the country.
According to one study, in 1993, 37% of South Africa’s population
could be defined as falling under a multidimensional poverty line.
By 2010, the proportion of people living below the same multidimensional poverty line had fallen to 8% once expanded access to
social security, education, health, electricity and sanitation services
had been taken into account.
• Using a money-only metric, one which does not take into account
the effects of increased access to public services, those living below
the poverty line had only decreased from 37% in 1993 to 28% in
2010.
Impact on social protection
• A 2015 World Bank report broadly supports the finding that South Africa’s
fiscal policy has been effective in reducing poverty and income inequality.
• Although South Africa remains one of the world’s most unequal societies,
as result of the country’s fiscal system:
– 3,6 million people in 2010 were lifted above the poverty line of living on less
than USD2,50 per day (PPP adjusted).
– Fiscal transfers also reduce inequality to a point where the incomes of the
richest decile were reduced from being over 1000 times higher than those in
the poorest decile to where they were 66 times higher.
– The Gini coefficient fell from 0,77 before taxes and social spending were taken
into account, to 0,659 after such transfers were taken into account.
– The Gini coefficient declines further, to 0,59 (indicating greater equality), if the
monetised value of health and education spending is included. The inclusion
of such expenditures is controversial, though, as such inclusion would imply
that increasing expenditure on such items as teachers’ and health workers’
salaries would, by definition, play a role in reducing income inequality.
Fiscal consolidation is a political challnge
• SA fiscal policy is at a cross-roads – consolidation or debt
• Fiscal consolidation will put pressure on South Africa’s programme
of poverty alleviation and will limit the resources available for the
kind of infrastructure expansion and maintenance that have been a
key driver of investment in recent years.
• Such pressure may result in political problems for a government if it
fails to successfully face many of its challenges in service delivery
and in building effective administrative capabilities and anticorruption and good governance structures.
• If these pressures and contradictions prove to be overwhelming and
the path of fiscal consolidation is not followed, this will lead to
serious financial problems entailing even more politically, socially
and economically costly adjustments in future.
Discussion
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What is fiscal policy consolidation?
What are its benefits?
What are its risks?
How best should we respond to the political
challenges associated of fiscal policy
consolidation?
Monetary and exchange rate policies
• Background: In 1999 South Africa announced the adoption of an inflationtargeting framework to guide the conduct of its monetary policy.
• This decision was against the backdrop of the emerging market contagion
that followed the so-called Asian crisis of 1997-98, which had lead to a loss
of confidence in emerging market economies and related sharp currency
depreciations in these economies.
• In the heat of the crisis (SARB) burnt its fingers in attempting to prop-up
the value of the Rand by purchasing Rands with about USD25-billion
worth of forward borrowed funds and sharply increasing the interest rate,
to over 20 percent, in order to promote capital inflows with the ultimate
objective of strengthening the rapidly depreciating Rand.
• At the time the SARB followed an eclectic monetary policy mandate,
pursuing a range of goals including low inflation, economic growth,
targeting the growth in monetary aggregates and intervening in the
currency market.
• Against this background, inflation targeting provided an alternative
framework, focused primarily on achieving an inflation target and which
explicitly excluded interventions to target a particular value of the Rand.
Debates on inflation targeting
• Advocates of the inflation-targeting framework argue that
the policy effectively facilitates the kind of low-inflation
macro-stability, which leads to low short-term and longterm interest rates, and which encourages the investment
required to stimulate growth and employment creation.
• Critics of the inflation targeting argue that the framework’s
narrow focus on low inflation is not appropriate,
particularly given South Africa’s high unemployment rate.
They argue that the framework will result in unnecessarily
high interest rates and will lead to low levels of economic
growth.
• The data comes down on the side of advocates of inflation
targeting
Interest rates and investment
• As per the next diagram it can be seen that the inflation-targeting
framework heralded in a period of sharply reduced long-run
interest rates.
• Such lower long-run rates are a key factor in reducing borrowing
costs and promoting new investments.
• Although non-interest rate factors have also proven to be important
in shaping investment decisions.
• Non-interest factors include the economic growth rate, the
existence of appropriate infrastructure and logistical systems, as
well as the general level of business confidence.
• Furthermore, the retention of high cash holdings by South African
companies, which enables companies to fund investments, not by
borrowing but from their retained earnings, may also have
contributed to a reduced interest rate sensitivity of investment
decisions.
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1990/01
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1991/05
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Long term interest rates
20
18
16
Govt 0-3 year bonds
Govt 3-5 year bonds
10
Govt 5-10 year bonds
Govt 10+ year bonds
8
6
4
Growth and unemployment
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South Africa’s unemployment rate has remained stubbornly high throughout the
inflation-targeting period,
But it would be misplaced to blame inflation targeting for persistent
unemployment.
Monetary policy is chiefly an instrument capable of bringing price stability in the
medium to long run this contributes to higher levels of growth and investment.
A correlation exists between an increased growth rate and decreased
unemployment rates, for example in the growth period from 2003 to 2007, the
unemployment rate fell by close to 5 percentage points.
To the extent that lower inflation, and lower interest rates, facilitate increased
investment, monetary policy can assist in fostering long-run growth and
employment.
Any attempt to boost the economy with ongoing monetary expansion will serve
only to fuel inflation and, beyond a short-run stimulus, will not assist in promoting
economic growth and employment creation in a sustainable manner.
In fact, at some point, attempts at sustained monetary stimulus will become
counter-productive, risking high levels of inflation that are detrimental to
economic growth, or even hyper-inflation.
Unemployment rate and GDP growth rate
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13
26
11
24
9
22
7
Official unemployment rate LHS
20
5
18
3
16
1
14
-1
12
10
-3
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Real GDP growth rate RHS
Exchange rate policy
• A more pertinent critique of South Africa’s monetary policy
framework has been that it leaves the country vulnerable to the
vagaries of currency volatility
• The argument has been made by South African exporters that there
is a contradiction between government’s stated commitment to
export promotion and the tendency for prolonged periods of Rand
strength and Rand volatility.
• In terms of the well-known ‘open economy trilemma’, only two, of
three, beneficial policies can be pursued simultaneously. Under the
inflation targeting framework, the two favoured policy objectives
are free capital flows and monetary policy independence.
• As a result the SARB’s freedom to target a more competitive value
for the Rand has been limited.
Open economy tri-lemma
Policy constraints – A tri-lemma
•
In terms of the open economy tri-lemma, only two out of three of the following policy options may
be pursued at once:
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•
•
to have an open capital market, in which foreign finance can flow freely into and out of the economy;
to have monetary policy autonomy, where interest rates are set by the Central Bank based on the conditions
and goals of the domestic economy rather than based on the interest rate decisions of another country’s
monetary authorities, and
to peg or manage the country’s exchange rate, that is to set the exchange rate at a competitive level to
promote a country’s exports and avoid exchange rate volatility.
Hong Kong has chosen a fixed exchange rate and free movement of capital, therefore its interest
rate is determined by factors outside of the Hong Kong economy, which as a result is not capable of
an independent monetary policy. If Hong Kong tries to increase interest rates due, for example, to a
scenario where it interest rates which are linked to US interest rates are deemed to be too low and
thus promoting a bubble of increasing prices in Hong Kong’s property market, then capital will flow
into the economy and capital will have to be blocked, or the exchange rate will strengthen and will
no longer be fixed.
China, on the other hand, has chosen a fixed exchange rate and independent monetary policy,
therefore China cannot allow free movement of capital. If China tries to allow free movement of
capital, as it may wish to do in order to assist in facilitating the countries geo-political ‘rise’ through
extending the power of its financial system, then capital is likely to flow into the economy thus
strengthening the exchange rate, which could no longer be fixed. Alternatively, if China wished to
keep a fixed exchange rate it might need to lower its interest rate to avoid a currency appreciation
and thus lose its ability to have an independent monetary policy.
Space to manage the exchange rate
•
•
More recently, the strict interpretation of the trade-off implied by the ‘open economy trilemma’
has been tempered somewhat.
IMF researchers have suggested that, with careful application, two targets can be pursued using
two separate instruments.
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–
•
•
•
Firstly, the interest rate can be used as the instrument aimed at achieving low inflation, which is regarded as
the primary target.
Secondly, sterilised foreign exchange market interventions can be used as an instrument to ameliorate
volatile currency movements, but such amelioration of currency movements must be clearly understood to
be a secondary target.
In terms of the approach outlined by the IMF researchers, if the Rand appreciates and the
authorities regard it as misaligned, then they can intervene in the foreign exchange market by
buying foreign reserves. The buying of foreign reserves will increase the supply of Rands and
weaken the currency. As a result of the increased supply of Rands there is a risk of increased
inflation, so the foreign exchange market intervention must be sterilised by selling bonds and thus
decreasing the money supply.
The limitation being that if inflation persists, and it is the primary target, then interest rates may
have to rise in order to reduce future inflation, even though raising the interest rate is likely to have
the effect of strengthening the Rand.
If, on the other hand, the Rand depreciates too sharply and the authorities wish to attempt to
strengthen the Rand, they will intervene in the foreign exchange market by buying Rands with the
foreign reserves which they hold. Clearly, this strategy is limited by the finite quantity of foreign
reserve holdings which the authorities possess.
Managing the exchange rate
• During periods when the Rand strengthened sharply, such as, by
7,8% in 2009 and by 12,3% in 2010,
• The SARB begun to responded with an active policy of building up
South Africa’s holdings of foreign exchange reserves in order to
maneuver against what was perceived as excessive Rand strength
• This would have the effect of reducing the competitiveness of South
Africa’s exports and putting pressure on local industry as imports
became relatively cheaper.
• A letter written by the then Minister of Finance to the SARB
Governor in 2009 in which the government’s mandate to the SARB
was clarified to explicitly include to objective of balanced and
sustainable economic growth, and thus made the inflation targeting
framework more flexible and open to the secondary objective of
influencing the level of the exchange rate.
Real effective exchange rate of the Rand
120
80
70
100
60
50
80
Real effective exchange rate of the Rand (RHS
% change)
40
60
30
20
40
10
0
20
-10
-20
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
0
Real effective exchange rate of the Rand (LHS
Index 2010 = 100)
Alternative approaches
• Certain other approaches to targeting the exchange rate have been
mooted. For example, some have argued that volatile short-run inflows
and outflows of capital have the potential to be highly disruptive, distort
the economy towards debt, consumption and financialisation and lead to
periods of excessive currency strength.
• One policy prescription of this approach is that short-term financial flows,
or so-called ‘hot-money’ flows, should be more highly regulated, through
interventions such the levying of small taxes on capital flows, the so-called
Tobin tax, or through stipulated minimum time-limits for investments
which aim to prevent rapid flow reversals.
• The theoretical arguments regarding the pro-cyclical distortions of
unfettered capital flows are attractive
• But in practice the structural characteristics of the South African economy,
with its persistent current account deficit and capital account surplus,
mean that limitations on capital inflows are likely to have serious negative
consequences and would come with significant adjustment costs.
South Africa’s Balance of Payments
6
4
2
Current account balance (% of GDP)
0
-2
-4
-6
-8
Capital account balance (% of GDP
SA is dependent on capital inflows
•
•
•
The imposition of restrictions on capital inflows would almost certainly result in a sharp
depreciation of the Rand and would raise the specter of a balance of payments constraint on
economic growth – as South Africa’s exports do not earn sufficient foreign currency to pay for
imports and growth would have to be slowed in order to reduce the demand for imports (a
situation not altogether dissimilar the position that the apartheid state found itself in during the
1980’s, when financial sanctions were intensified).
Capital scarcity and exchange rate pressures would also likely lead to sharp interest rates hikes,
which would further raise the cost of investment and suppress growth and employment in the
economy. A significant slow-down in capital inflows would also probably be disruptive to the
financing of South Africa’s current phase of infrastructure expansion, in key cross-cutting network
sectors, such as, energy and transport infrastructure, and this too would have wider negative
consequences for economic growth and employment.
On the balance of evidence, it would appear that the benefits of unregulated capital inflows
outweigh the costs, and that both the benefits and the costs are fairly substantial.
–
–
•
On the benefits side, continuing access to foreign financial flows assists in freeing South Africa from a
balance of payments constraint and contributes a steady flow of foreign savings which means that interest
rates are lower than the would be if only the domestic pool of savings was available.
On the costs side, allowing unregulated capital inflows will lead to increasing levels of foreign ownership of
South African assets, which in turn will lead to future dividend outflows. A further problem is that such
inflows can distort the economy towards consumption and financialisation and away from production and
industrialisation. Unregulated capital inflows are also associated with higher levels of exchange rate
volatility and potential currency misalignment, which can put pressure on export industries if the Rand overappreciates.
Lastly, the adjustment costs, if South Africa were to attempt to change policy and begin to regulate
capital inflows costs, would be significant, probably including a sharp currency depreciation and
higher interest rates.
Macro-prudential regulation
•
•
•
•
Another line of critique against the inflation-targeting framework is that under the
framework the monetary authorities fail to properly monitor and act against the
development of non-inflation macroeconomic instabilities, such as, asset price
bubbles and over-leveraging in the financial system.
A flaw with the inflation targeting framework, revealed very clearly by the 2008-09
financial crisis, is that it is possible that during periods of inflation moderation the
seeds of macroeconomic instability will be sown. This phenomenon, described in
Minskian terms as the ‘paradox of credibility’, arises when there is a general
economy-wide perception of reduced risk, inducing economic actors to behave in
such a way as to make the system riskier.
Central banks are responding to this weakness in erstwhile orthodox monetary
policy by taking on new responsibilities and developing new instruments which
will assist them in the task of macro-prudential management.
A particular focus is on housing prices, as in certain economies, like the United
States and the United Kingdom where home ownership is very widespread, a
financial cycle can be discerned whereby housing prices bubbles have led procyclically to crises in the banking sector.
Macro-prudential policy in SA
•
•
•
In line with this, the SARB has begun to place more emphasis on the need for
improved macro-prudential surveillance and regulation. In addition to monitoring
the compliance of South African banks with minimum capital requirements, such
as, those outlined in the Basel II and Basel III accords, the SARB has sought to
involve itself in interventions aimed, not just at achieving its inflation target, but
also those aimed at trying to avoid the build up of potentially dangerous
imbalances in the financial sector.
An example of the types of interventions that the SARB will undertake, if it detects
an emerging bubble in housing prices, would be to decrease the permissible loan
to value ratio for those borrowing money to fund house purchases, say from 100%
to 80%. This will mean that home buyers will need to pay a 20% deposit, which
will have an effect in subduing house prices and in decreasing household leverage
ratios. Another instrument in this regard is the setting of credit standards, such as
those which stipulate the maximum percentage of monthly income that can be
used to fund monthly bond repayments.
There is some risk that an effect of Basle III will be to limit resources available via
the commercial banks for long term investment (a double-whammy in the context
of fiscal consolidation)
Current monetary policy challenges
• In the current phase, South Africa continues with interest rates that are
low by historical standard. This is in line with the global situation, as since
the 2008-09 Great Recession most countries have experienced historically
low interest rates for a pro-longed period of time, and Japan for even
longer, see diagram
• In fact, with nominal interest rates being at, or very close to, the zero
lower-bound, countries such as the United States, Japan and the United
Kingdom, and the Euro-zone countries have adopted unconventional
monetary stances,
• Such as the massive purchase of bonds and other financial assets in
secondary markets, in a process known as quantitative easing (QE), with
the aim of lowering longer-run interest rates (as short-term nominal rates
can go no lower then zero.
• An important objective of such unconventional approaches is to use lower
long-term rates to try and stimulate investment and other elements of
demand and thereby also introduce a degree of inflation expectations
back into economies that are flirting with deflation.
-5
1/1/15
5/1/14
9/1/13
1/1/13
5/1/12
9/1/11
1/1/11
5/1/10
9/1/09
1/1/09
5/1/08
9/1/07
1/1/07
5/1/06
9/1/05
1/1/05
5/1/04
9/1/03
1/1/03
5/1/02
9/1/01
1/1/01
5/1/00
9/1/99
1/1/99
5/1/98
9/1/97
1/1/97
Comparative 90-day short-run T-Bill rates
45
40
35
30
United States
25
United Kingdom
20
Brazil
15
South Africa
10
Japan
5
0
Risk of deflation
• Deflation is regarded as a significant
macroeconomic threat.
• Falling prices would have the effect of subduing
and delaying consumption and investment
demand.
• Deflation would also put the financial system at
risk, as debt and debt repayments are typically
fixed in nominal terms, so these repayments
would rise in real terms, as prices and wages fell,
leading to the likelihood of widespread default
and financial distress, particularly for the banks.
Risks when interest rates rise in the rest of the world
•
•
•
•
•
It is much anticipated that monetary policy will ‘normalise’ at some stage in the future and that the current global
period of historically low interest rates will come to an end, but there is a high degree of uncertainty as to the
likely timing of such an eventuality. It is also possible that ‘normalisation’ will not occur in a simultaneous and
coordinated manner and that, for example, the United States will begin rising interest rates before the Euro-zone.
South Africa is highly linked into the global interest rates cycle. When the United States indicated that it would
begin tapering-back on its QE in 2013, this resulted in a flow-back to the of United States of QE-generated
liquidity, which had sought returns worldwide and which was then attracted back to the United States by the
prospect of future interest rate increases.
South Africa, along with other developing countries, experienced significant exchange rate weakening. Due to
currency deprecations and related inflationary pressures, these countries also had to face the related possibility of
their own interest rate hikes, even if demand in their domestic economies remained weak.
At the G20 Summit in St Petersburg in 2013 South Africa raised a concern that developed-world economic policy
makers should take greater cognizance of the effects of their macroeconomic policies on the economic situation in
developing countries.
President Zuma warned the G20 Summit of “increased turbulence in global financial markets, which has been
brought about by speculation that the US Federal Reserve will soon cut back on the $85 billion it has been
pumping into the financial markets every month. Emerging economies like South Africa have benefitted from the
actions of the Federal Reserve, as foreign investors have bought huge amounts of South African government
bonds at fairly low yields and equities. Therefore, the prospect that the Federal Reserve will cut off these flows of
funds has resulted in emerging market currency volatility, which has been yet another reminder of the risks and
the potentially destabilising and negative effects that policies and shocks in major economies can have on other
countries and regions.”
Near-term future interest rates in SA
• Rey (2013) has empirically challenged the characterisation
offered by the ‘open economy tri-lemma’ and has
suggested that the true open-economy characterisation
faced by countries is a ‘dilemma’, that is, a choice of either
free capital flows or monetary policy independence,
regardless of whether the exchange rate is fixed or floating.
• Rey argues that due to the existence of a global financial
cycle, where asset prices in emerging markets and
developed economies move together, countries like South
Africa, which allow relatively free movement of foreign
capital in and out of the country, are tightly bound to the
global interest rate cycle and do not enjoy a significant
degree of monetary policy independence, despite having a
free-floating exchange rate.
Near-term future interest rates in SA
•
•
•
All these factors indicate that South Africa is likely in the not too distant future to
enter an upward phase in its interest rate cycle. Despite the fact that the country
is planning to enter a phase of fiscal consolidation, which will have a disinflationary
effect, it is likely that international factors, rather than domestic factors, will serve
as the main prompt to pushing up interest rates. This process will be re-enforced if
the raising of interest rates in the United States, and other relevant countries,
leads to an outflow, or reduced inflow, of capital resulting in Rand weakness and
imported inflation pressures.
The main domestic driver of inflation will be on-going sharp increases in electricity
prices, which are required in order to fund expanded power generation
infrastructure. It is unlikely, though, that the SARB would take action as a result of
the first-round effects of rising electricity prices. Analogously, to oil price shocks
experienced by South Africa in the past, the SARB is likely to focus on containing
second-round inflationary effects resulting from the electricity price increases.
In other words, it is understood that no amount of interest rate increases will
impact directly on the electricity price, but if South African consumers respond to
the rising electricity price by seeking higher wages and adjust their overall
spending upwards, then it is the inflationary effects of such developments that
monetary policy is better equipped to deal with.
Risk of stagflation in SA
•
•
•
Given South Africa’s low growth prospects and the effect of likely external and
internal drivers of inflation, South Africa may begin to be faced with a ‘stagflation’
scenario, where inflation rises above its target, but where growth remains low or
below potential. Such a scenario will present a dilemma for South African policy
makers, as the SARB will be mandated to contain inflation by raising interest rates,
despite the fact that rising interest rates will impact negatively on short-run
growth prospects.
The problem is best resolved by separating short-run and long-run effects. In the
short-run, high interest rates will impact negatively on growth and demand, but in
the long-run it is to be expected that the maintenance of low inflation will
contribute positively to the investment climate and that this will foster higher
levels of growth.
The alternative approach of allowing inflation to rise significantly, and so avoid
interest rate increases in the short-term, is less attractive, as in order to avoid the
growth-inhibiting effects of ever-rising prices, inflation will, at a later stage, need
to be brought under control. This will result in larger future increases in interest
rates and the even higher costs to output and employment associated with such
disinflationary interventions.
Discussion
• What is the role of monetary policy in SA?
• How best should the SA Rand be managed?
• What wil be the impact of rising interest rates
in SA on government and the private sector?
• Are there any other questions about
macroeconomic policy issues in SA?