South Africa’s macroeconomic policies face a complicated task of balancing between supporting domestic demand and maintaining stability. The Selected Issues paper for South Africa discusses economic development and policies. Although the opening output gap and declining employment do call for countercyclical fiscal and monetary policy easing, policymakers should also be mindful of the effects of such policies on external and internal macroeconomic stability. The combined package of monetary and fiscal policies has considerable effects on growth and employment.

Abstract

South Africa’s macroeconomic policies face a complicated task of balancing between supporting domestic demand and maintaining stability. The Selected Issues paper for South Africa discusses economic development and policies. Although the opening output gap and declining employment do call for countercyclical fiscal and monetary policy easing, policymakers should also be mindful of the effects of such policies on external and internal macroeconomic stability. The combined package of monetary and fiscal policies has considerable effects on growth and employment.

I. Between Scylla and Charybdis: Demand Management Policies to Support Growth and Maintain Stability in South Africa 1

A. Introduction and a Brief Model Description

1. The global crisis has seriously affected South Africa. Output is falling as slumping external demand and falling commodity prices reverberate through the economy. At the same time, inflation is stubbornly high and the current account deficit remains sizable, keeping the economy vulnerable to sudden shifts in capital flows.

2. In this environment, macroeconomic policies face a complicated task of balancing between supporting domestic demand and maintaining stability. While the opening output gap and declining employment do call for countercyclical fiscal and monetary policy easing, policy makers should also be mindful of the effects of such policies on external and internal macroeconomic stability. Sizable deterioration in measures of stability like the external current account deficit and inflation could prove counterproductive to the objective of output stabilization if, for example, they weaken investor confidence and thus raise the risk of a sudden stop of capital inflows.

3. This note analyzes the role of announced and expected fiscal and monetary policies in South Africa in balancing between these objectives. We first simulate the dynamics of the economy under the negative external demand and commodity price shocks brought on the South African economy by the global crisis, and then apply a package of fiscal and monetary policies consistent with the authorities’ announcements and market expectations. These policies affect measures of economic activity—growth and employment, and measures of macroeconomic stability—the trade balance and inflation. We find that policies that raise output and employment also lead to higher inflation and higher trade deficit. This trade-off, however, seems broadly favorable, as the “losses” in terms of higher inflation and trade deficit appear modest relative to the “gains” in terms of higher output and employment.

4. The analytical tool we employ is the IMF’s Global Integrated Monetary and Fiscal Model. Built from extensive microfoundations, the model is particularly suitable for policy analysis owing to its rich structure, flexible and realistic menu of policy instruments, and endogenous interaction between fiscal and monetary policy. 2 Fiscal policy has strong and persistent effects on economic activity through realistic features such as (i) the presence of liquidity-constrained households, along with intertemporally-optimizing (overlapping-generations) ones, which presence strengthens and accelerates the impact of fiscal policies; 3 (ii) finite planning horizon for the intertemporally-optimizing households, which emphasizes the effects of current policies at the expense of future ones; and (iii) distortionary taxes on consumption, capital, and labor that affect saving, investment, and labor supply decisions. Various nominal and real rigidities (e.g., sticky prices and wages, habit persistence in consumption, and adjustment costs in investment and trade) contribute to a realistic description of the interaction between monetary policy and the real economy as well.

5. In accordance with South Africa’s policy framework, we have chosen fiscal and monetary policy representations that aim to smooth the economic cycle and maintain stability. We model fiscal policy as strongly countercyclical, aiming to stabilize the budget balance around a chosen structural target; cyclically higher/lower revenue thus lead to higher/lower target headline balance. The description of fiscal policy objectives in government documents of recent years tends to support such representation.4 For the purposes of this note, the public sector is calibrated to include both the general government and the state-owned enterprises, as the latter implement the main part of the public sector investment program. Monetary policy operates in an inflation-targeting framework, guided by an inflation-forecast-based rule, where the policy rate responds to expected inflation and the output gap. As the financial sector is in good shape, the monetary policy transmission—which in South Africa is strong and fast—remains fully operational. Moreover, the flexible exchange rate—an integral part of the monetary policy framework—can usefully serve as a shock absorber without harmful side effects owing to the lack of significant balance sheet exposures in foreign currencies.

6. We have further adapted the model to the South African environment. First, we changed the model to exempt liquidity-constrained households from labor tax, as workers at the bottom half of the income distribution (who are more likely to be liquidity-constrained) typically do not pay personal income tax in South Africa. Moreover, they do not receive a share of the dividends paid by corporations as opposed to the higher-income households, and we calibrated the model to that effect. These features would tend to reduce the effect of personal income tax changes on consumption and employment. Second, to account for the existence of a large pool of underutilized labor, willing to work at the prevailing wage rate should labor demand pick up, the labor supply elasticity of liquidity-constrained households with respect to wages has been raised significantly above that of the nonconstrained ones. This parameterization allows large response of employment of liquidity-constrained workers to small changes in wages, approximating absorption of excess labor supply at close to prevailing wages when labor demand picks up. Finally, the risk premium on international borrowing has been linked to the terms of trade, in addition to being related to the current account deficit as in Kumhof and Laxton (2007). This allows changes in prices of exported commodities to affect the risk premium on external borrowing (i.e., the spreads on international bonds and CDS contracts), an empirically relevant feature for South Africa. 5 The model is calibrated to South Africa’s national accounts data for 2008 and fiscal data for FY 2008/9.

B. Policy Scenarios and Results

7. The baseline scenario explores the impact of a negative external demand shock and a drop in export commodity prices under a standard (pre-crisis) policy response (Figure 1). The external demand shock is calibrated to broadly correspond to the IMF’s trade-weighted projections for output and import demand dynamics in South Africa’s trading partners in 2009-10; the commodity price shock corresponds to projections for a trade-weighted index of export commodity prices. The policy response incorporated in this scenario is governed solely by the pre-crisis fiscal and monetary policy rules, i.e., it reflects the play of automatic stabilizers on the fiscal side and some monetary easing as implied by the monetary policy rule, but there are no discretionary fiscal or monetary policy actions.6 The model is calibrated at quarterly frequency; the shocks can be thought of as emanating in the fourth quarter of 2008.

Figure 1.
Figure 1.

Baseline (External Demand Shock and Commodity Price Shock With Standard Policy Response)

Citation: IMF Staff Country Reports 2009, 276; 10.5089/9781451841107.002.A001

Source: IMF staff calculations.Note: Simulations are reported over 5 years; each tick mark corresponds to one quarter. The abbreviations OLG and LIQ denote the overlapping-generation (higher-income) consumers and the liquidity-constrained (lower-income) ones.
Figure 2.
Figure 2.

The Effects of Expected Monetary Policy in 2009 Relative to the Baseline

Citation: IMF Staff Country Reports 2009, 276; 10.5089/9781451841107.002.A001

Source: IMF staff calculations.Note: Simulations are reported over 5 years; each tick mark corresponds to one quarter. The abbreviations OLG and LIQ denote the overlapping-generation (higher-income) consumers and the liquidity-constrained (lower-income) ones.
Figure 3.
Figure 3.

The Combined Effects of Announced Fiscal Policy in 2009-11 and Expected Monetary Policy in 2009 Relative to the Baseline

Citation: IMF Staff Country Reports 2009, 276; 10.5089/9781451841107.002.A001

Source: IMF staff calculations.Note: Simulations are reported over 5 years; each tick mark corresponds to one quarter. The abbreviations OLG and LIQ denote the overlapping-generation (higher-income) consumers and the liquidity-constrained (lower-income) ones.

8. We then consider three policy scenarios and their effects:

  • The first policy scenario combines the baseline with a monetary policy interest rate path consistent with policy actions in December 2008-March 2009 and market expectations (as of April 2009) for Q2-Q3 of 2009, after which monetary policy reverts to its pre-crisis rule. This path implies some “discretionary” easing on top of the easing implied by the policy rule. Figure 2 shows the effects of such monetary policy on the main macroeconomic variables relative to the baseline.

  • The next scenario adds discretionary fiscal policy measures for 2009-11 (as announced in Budget Review 2009) to the previous scenario. On the expenditure side, policy is introduced as the planned increases in public investment (including State-Owned Enterprises), transfers, and government consumption relative to GDP. As no major tax initiatives were announced, tax policy is modeled as maintaining the average effective tax rates on the main taxes unchanged. As revenues adjust endogenously in line with the dynamics of their tax bases, these fiscal policy assumptions for 2009-11 incorporate the effects of both automatic stabilizers and discretionary measures. Figure 3 illustrates the effects of the combined monetary and fiscal policies relative to the baseline.

  • Finally, Figure 4 demonstrates the effects of a scenario that rebalances the fiscal policy mix in years two and three in favor of investment at the expense of consumption and adds a cut in the tax on capital (see paragraph 12).

Figure 4.
Figure 4.

The Effects of Rebalanced Fiscal Policy in Years Two and Three Relative to Announced Policies

Citation: IMF Staff Country Reports 2009, 276; 10.5089/9781451841107.002.A001

Source: IMF staff calculations.Note: Simulations are reported over 5 years; each tick mark corresponds to one quarter. The abbreviations OLG and LIQ denote the overlapping-generation (higher-income) consumers and the liquidity-constrained (lower-income) ones. The rebalanced fiscal policy package consists of higher public investment and lower taxation of capital relative to the announced policies, with lower consumption and higher public enterprise revenue keeping public sector balances at the announced target levels.

9. In the baseline, the external demand shock and the commodity price shock lead to significant drops in output, employment, and inflation. The sharp decline in partner country demand cuts the volume of South Africa’s exports (leading to output and employment decline), while the drop in export commodity prices further reduces the value of exports and, through the terms of trade effect, raises the cost of external borrowing.7 Consumption and investment, however, fall more slowly than output, as intertemporally-optimizing consumers try to smooth the income shock over time, and the fall in investment is cushioned by the falling real interest rate and the real exchange rate depreciation (which stimulates investment in the tradable sectors). The trade deficit initially widens, as the negative external shocks outweigh the positive impact of the notable real exchange rate depreciation. 8 From a saving-investment perspective, the overall saving rate falls as government dissaving—spurred by the strongly countercyclical fiscal rule—more than offsets the moderate increase in private saving, while investment rises a little relative to GDP. Inflation declines, as the effect of the opening negative output gap dominates the effect of the depreciated exchange rate. This allows monetary policy to ease and remain accommodative for some time. Over time, private investment begins to rise, motivated—with a lag—by the lower real interest rate, the real exchange rate depreciation, and by the recovery in partner countries. This leads to output recovery in South Africa as well. The trade balance improves as the public sector deficit is quickly reduced in the wake of the output pick-up.

10. The monetary policy path expected by the market alleviates the effect of the shocks on output and employment early, when they are at their worst. Its seems to work mainly through its effect on investment, which is more sensitive to interest rate changes, although consumption also improves.9 As the monetary easing in the first year after the shocks is more aggressive than the one suggested by the pre-crisis policy rule, it also results in somewhat higher inflation. The extra easing over the baseline suggested by this path affects the exchange rate, the external risk premium, and the trade balance only moderately.

11. The combined package of monetary and fiscal policies has considerable effects on growth and employment with only moderate increases in inflation and the trade deficit relative to the baseline. The text figure to the right shows the average annual increases in the four main macroeconomic variables of interest in the first two years after the external shocks under the two policy scenarios: a monetary policy response only (see Figure 2) and the same monetary policy response augmented with the fiscal policy measures announced in Budget Review 2009 (see Figure 3). Fiscal policy appears more powerful than monetary policy largely because the presence of liquidity-constrained consumers (who cannot borrow and therefore do not benefit from the monetary easing) reduces the effect of monetary policy. The combined package of fiscal and monetary easing can raise output by about 1¾ percentage points and employment by almost 2½ percentage points at the expense of raising inflation by about 2¼ percentage points and the trade deficit by ½ percentage point of GDP (all relative to the counterfactual baseline of no discretionary policy reaction).10 We view this as broadly encouraging, especially given that the nontrade component of the current account deficit has already begun shrinking, thus offsetting some of the projected increase in the trade balance. In addition to the higher inflation, another side effect is, however, that the fiscal expansion raises the real interest rate, which tends to crowds out private investment mildly for a few quarters. A note of caution: these results cannot be extrapolated for a much larger than planned fiscal expansion, as it would lead to rising interest rates that would diminish and eventually eliminate the output and employment gains.

uA01fig01

Average Annual Effects 2009-10

(in percent; trade deficit in percent of GDP)

Citation: IMF Staff Country Reports 2009, 276; 10.5089/9781451841107.002.A001

12. A moderate rebalancing of the fiscal policy mix could deliver even stronger and long-lasting growth and employment results without compromising the performance of inflation and the trade balance (Figure 4). This policy scenario—motivated by the need to strengthen private investment, recently weakened by the drop in international commodity prices and the decline in capital inflows—uses as a baseline the policy package used in the simulations in Figure 3 (i.e., the dynamics shown in Figure 4 are relative to the effects in Figure 3). It maintains the same monetary policy stance and rebalances the fiscal policy mix. Specifically, public investment is raised further by ¼ percentage point of GDP in years two and three of the simulations (broadly corresponding to South Africa’s FY 2010/11 and 2011/12), while the envisaged increase in public consumption is reduced by similar amounts. In addition, to improve incentives for private investment, the average effective tax rate on capital is reduced permanently by one percentage point from year two onwards, financed by an increase in the “other” revenues (i.e., other than the three major taxes-on labor, capital, and consumption).11 As private investment responds to both the tax cut and the increase in government investment (which increases private capital’s productivity), this rebalancing results in moderately (but permanently) higher output and employment without measurable costs in terms of higher inflation and/or higher trade deficit.

C. Conclusions

13. While the impact of the global shocks on South Africa appears strong, demand-management policies can provide considerable relief at moderate cost. We have analyzed the effects of the announced fiscal policy and expected monetary policy on the South African economy hit by adverse external demand and commodity price shocks. We found that the negative impact of the shocks on the economy could be worryingly strong, but active policy measures can support output and employment to a considerable extent at relatively moderate cost in terms of higher inflation and higher trade deficit relative to the counterfactual baseline scenario of no discretionary policy actions.

14. As the economy adjusts to the shocks, the need for external financing may be greater than thought. The model makes two unconventional predictions: (i) the trade deficit will widen considerably in 2009-10 relative to 2008 under the influence of the adverse shocks, even though expected policies do not contribute significantly to this widening; and (ii) inflation will remain elevated for a while (here the contribution of policies is more notable, but still moderate). While the specific quantitative estimates are mainly illustrative and do not take into account all relevant factors (e.g., the effects of positive supply shocks on inflation or the reduction in the nontrade component of the current account deficit), the direction of these changes gives food for thought. These results indicate that the economy adjusts only gradually to the external shocks—with positive implications for growth and employment—but they also imply that it may need larger than currently expected amount of external financing going through the adjustment process. The resumption of portfolio inflows since February 2009 is therefore most timely.

1

Prepared by Nikolay Gueorguiev.

2

For a detailed description, see Kumhof and Laxton (2007).

3

Throughout the note, we will use interchangeably the term pairs intertemporally-optimizing (overlapping-generations)—higher income households, and liquidity-constrained—lower income households.

4

See Budget Review 2009, pp. 52-53, Budget Review 2008, p. 47, and the Appendix to Medium Term Budget Policy Statement 2007, all available at http://www.treasury.gov.za/.

5

As the model has only one commodity sector, which we have chosen to represent South Africa’s exported commodities (mainly platinum group metals, gold, and coal), oil price changes do not directlly reflect the terms of trade.

6

These rules should be viewed as describing broadly the systematic mode of reaction of fiscal and monetary policies to economic developments rather than as strict rules eliciting automatic policy response.

7

The higher premium on external borrowing is also one way of accounting for the effects of the large portfolio outflows in late 2008.

8

We focus on the trade deficit rather than the current account deficit for expositional clarity and because South Africa-specific factors make modeling the dynamics of the non-trade part of the current account difficult.

9

The immediate effect of the interest rate easing on consumption is limited to consumers with significant net debt. Although household debt exposure is significant, it seems concentrated in upper-income households. A survey shows that consumers with mortgages accounted for only 14 percent of aggregate consumption in 2007.

10

As South Africa follows an inflation-targeting framework, we let monetary policy respond endogenously to the rise in inflation created by both fiscal and monetary easing (relative to the counterfactual baseline) after the fourth quarter of the simulations.

11

These “other” revenues can represent, e.g., environment-friendly levies or higher user fees for services provided by the public enterprises, allowing them to recoup part of their investment costs.

South Africa: Selected Issues
Author: International Monetary Fund
  • View in gallery

    Baseline (External Demand Shock and Commodity Price Shock With Standard Policy Response)

  • View in gallery

    The Effects of Expected Monetary Policy in 2009 Relative to the Baseline

  • View in gallery

    The Combined Effects of Announced Fiscal Policy in 2009-11 and Expected Monetary Policy in 2009 Relative to the Baseline

  • View in gallery

    The Effects of Rebalanced Fiscal Policy in Years Two and Three Relative to Announced Policies

  • View in gallery

    Average Annual Effects 2009-10

    (in percent; trade deficit in percent of GDP)