ERSA’s Fiscal Futures webinar series (IV)

23 October 2020

In this brief we present the participant’s views on the credibility of South Africa’s financial institutions and complacency risk. Brief one introduced you to the themes, the participants and then the first two topics: first Treasury and the South African Reserve Bank’s Response to COVID, and second the fiscal deficit and fiscal sustainability. Brief two covered debt, including a presentation made by Treasury, brief three discussed economic growth, and brief five covers the policy reforms which South Africa needs to make.

INTRODUCTION

All of the participants agreed that the internationally respected credibility of South Africa’s financial institutions is an asset to the country. They disagreed, however, on how that credibility should be used. One camp argued that the credibility of the South African Reserve Bank (SARB) should be used to temporarily provide financial support to Treasury and the economy, while others argued that it should not be used for this as it would result in the erosion of credibility. The points raised by the former camp will be covered first.

At the end of the brief we will cover the points made by the international speakers who believe South Africa faces complacency risk – with regards to its financial position – and the response from a South African counterpart, who argued that this was not the case but instead policy coordination is the real issue.

USE SARB’S CREDIBILITY TO PRINT MONEY

Investment in South Africa is reliant on foreign savings and they are attracted by growth. The context of this crisis is that we have a large output gap (actual is lower than potential GDP) and economic logic says we must do something. What we must do is to fund growth, which we can do at no cost to the country by SARB temporarily printing money to be pumped into the economy. However, SARB wants to protect its reputation with regards to what it considers sound monetary policy at a cost to the economy, even though there is no inflation which allows us the opportunity to print money.

We must separate short-term needs (alleviating the effects of the crisis) from long-term reforms, which are reforms we all agree on, and SARB’s good reputation should be used for temporary relief. However, the existing high interest rates on government’s long-term bonds implies that SARB policy is not great, and that we will be printing money whether we like it or not.

What’s the point of credibility of we do not use it? Furthermore, credibility is relative and if everyone else is printing money why can’t we? There is, however, the risk that the politicians do not see it as temporary.

PROTECTING SOUTH AFRICA’S FINANCIAL CREDIBILITY

South Africa’s “assets” are its low inflation and deep financial system. We must not lose credibility, which is endogenous and relies on fiscal and monetary factors, because no country has ever developed after losing its credibility.

No fiscal expansion pays for itself and unsustainable fiscal deficits lead to inflation. Furthermore, the nature of the COVID crisis is not typical. It is a supply shock and throwing money at it may not have the desired impact, because people cannot work and may have no way to spend it, adding to the inflationary risk. A typical Keynesian response (increased government expenditures to stimulate demand) does not apply.

True, when facing a shock you want a full policy mix with monetary and fiscal policy expansion creating space for each other. However, quantitative easing[1] (QE) is unconventional policy and expands the reach of monetary policy beyond its traditional role.

The general idea behind the central bank involvement in financing government through QE is that the only cost is increased consumer price index (CPI) inflation, but that is not the case. Once the central bank starts financing government you use up the important stock of credibility, which is extremely risky. It also generates asset price inflation, in the stock-market for example, and asset bubbles cause major issues. If QE does cause CPI inflation to become unanchored we will lose SARB’s credibility. Foreign investment is needed so the credibility of SARB is very important.

Another danger with QE is interest rate yield curve control, and buying bonds to get the rates you want requires full coordination between a country’s reserve bank and treasury, which signals a regime change, i.e. the loss of reserve bank independence. In the late 1940s into the 50s the United States Federal Reserve headed in this direction with the government saying it was an emergency given the Korean War. In the dispute that ensued between the Fed and the politicians, the Fed finally won and ended yield curve control, thereby maintaining its credibility. In South Africa which is an emerging market there is an even larger risk of losing credibility.

The fundamentals in South Africa are far worse than after the previous crisis. Our yield curve is about the steepest in emerging markets and we ignore that at our own peril. If we use the SARB to bring it down it will hasten the loss of credibility and worsen the situation.

South Africa currently has a negative feedback loop which requires increased debt to pay-off debt costs and it is slowly spiralling. Losing monetary credibility will accelerate that.

At the end of the day it is unclear whether QE actually increases aggregate demand in an economy. Some economic theory might say we need the stimulus and also interest rate targeting because there is an output gap. But why should we take risks with monetary and fiscal policy before getting the basics right, like fixing Eskom, the network industries, etc?

South Africa’s fiscal credibility, on the other hand, is not great even though our tax revenue to GDP ratio is higher than other emerging markets. This is because Treasury has persistently been pushing out the self-imposed fiscal ceiling/limits on government spending.

The question is what must be done in order to finance fiscal expenditure? We must avoid the temptation of inflation or prescribed assets[2] which will destroy fiscal credibility. Argentina tried this and its local debt market was destroyed by inflation. We also need to avoid distortionary tax revenue collection policies which reduce the net social gain from imposing the taxes.

Fiscal discipline leads to persistent growth. QE is only temporary in countries with fiscal space and low interest rates, e.g. Chile and Colombia. South Africa on the other hand has neither of these and we must decrease expenditure and execute reforms for growth to happen.

It is important to think of how to meet the country’s financial needs while upholding credibility. First, for liquidity it is a no-brainer to tap the World Bank and IMF first for support, which should also help bring down interest rates. Second, a reform strategy is required.

COMPLACENCY RISK

The international speakers from South America and Belgium felt that South Africa currently faces complacency risk with regards to its financial position. They stated that South Africa has a credible reserve bank, low inflation, large financial sector and operates in rands, so therefore has a lot to work with, but that we take these for granted despite a worsening economy. This complacency risk is serious because South Africa has never defaulted and we think we can finance our way out of the crisis through foreign finance.

Latin American countries thought “maybe we should test monetary policy”, and the risks are not only to credibility but it will also test the strength of the country’s institutions.

Argentina was complacent about its fiscal deficit during the term of the pro-market government, which proved costly when a new government was elected in 2017-19 and real wages decreased 70%. It is therefore very important for business and government to figure out how to decrease the deficit.

A South African participant responded that it is not correct to categorise South Africa’s risk as complacency. Instead, he said, we have had five years of tough budgets and are at risk of further endogenising low growth through our austerity measures, with the major problem being a co-ordination problem between fiscal policy and the mix of investment and and sequence of investment.

By Charles Collocott, Researcher, HSF, 23 October 2020

[1] Quantitative easing (QE) is a form of unconventional monetary policy in which a central bank purchases longer-term securities from the open market in order to increase the money supply and encourage lending and investment. Buying these securities adds new money to the economy, and also serves to lower interest rates by bidding up fixed-income securities. It also expands the central bank's balance sheet. https://www.investopedia.com/terms/q/quantitative-easing.asp

[2] Prescribed assets is a policy whereby government forces investment and pension funds to invest a predetermined percentage of their funds into government assets.