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We cover the latest research paper by the South African Reserve Bank (SARB) in which they take a look at South Africa's fiscal multipliers after the financial crisis of 2008/2009. What follows in the article is as obtained from the South African Reserve Bank research paper.
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Abstract
South Africa’s fiscal position has deteriorated considerably over the last 10 years, with debt levels reaching historical highs in the post-apartheid period. National Treasury’s intentions for fiscal consolidation have again drawn attention to the fiscal multiplier literature. We use an econometric model to calculate the fiscal multipliers over the past decade. Our estimates take account of the specific fiscal conditions for each year, in particular the changing relationship between debt and the sovereign risk premia as well as the impact of tax increases. The model suggests that the fiscal multiplier declined from 1.5 in 2010 to around zero in 2019 as the debt levels became progressively more unsustainable and large tax increases muted the aggregate demand effects from higher government expenditure. The low fiscal multipliers suggest that fiscal consolidation will be less costly in terms of growth forgone than generally perceived.
Introduction
Despite higher tax rates, South Africa’s fiscal position has deteriorated considerably over the last 10 years. Large structural deficits have been accompanied by rising risk premia and slowing economic growth (Loewald, Faulkner and Makrelov 2020). National Treasury’s intentions for fiscal consolidation to stabilize debt and avoid a debt crisis have focused attention on the fiscal multiplier literature. The fiscal expenditure multiplier reflects what happens to the rest of the economy when government changes its spending. If a fiscal multiplier is 1, gross domestic product (GDP) changes by exactly R1 for every extra R1 of government spending. If it is more than 1, extra spending by government crowds in even more domestic output. If it is less than 1, activity does not rise as much as the spending increase, perhaps because of import leakage, capacity constraints or crowding-out effects.
The relationship between government debt and the risk premium is particularly important for our analysis. The economic literature suggests a strong non-linear relationship. At low debt levels, the risk premium remains unchanged and it can even decrease if the fiscal policy intervention is temporary and targeted. At high and rising debt levels, the risk premium starts to increase more exponentially. 3 This study makes use of a small quarterly macro econometric model (QMM) that is specifically designed to capture the relationships between government and the real economy
The relationship between government debt and the risk premium is particularly important for our analysis. The economic literature suggests a strong non-linear relationship. At low debt levels, the risk premium remains unchanged and it can even decrease if the fiscal policy intervention is temporary and targeted. At high and rising debt levels, the risk premium starts to increase more exponentially. 3 This study makes use of a small quarterly macro econometric model (QMM) that is specifically designed to capture the relationships between government and the real economy
Estimates of fiscal multipliers in South Africa
The recent South African literature presents a wide range of fiscal multipliers depending on the methodology used and the different impact channels incorporated in the estimates. 4 In one of the more comprehensive studies, Jooste, Liu and Naraidoo (2013) calculate expenditure multipliers for South Africa using a calibrated Dynamic Stochastic General Equilibrium (DSGE) model, a structural vector error correction model and a time-varying parameter Vector Autoregressive (VAR) model. They generate multipliers smaller and larger than 1 depending on the methodology and assumptions regarding the business cycle, the share of Ricardian households and the import intensity of the economy
Understanding the limitations and assumptions of each approach supports the appropriate use of the different estimates. Results, which assume that South Africa is a closed economy, are clearly inappropriate for policy use as the country is a small open economy. Using multiplier estimates generated under conditions of sustainable government debt is not useful when the government debt trajectory is perceived as unsustainable.
Large calibrated or econometric models provide estimates based on the assumed structure of the model. These are useful as laboratories to show how different channels and assumptions affect the size of fiscal multipliers. The estimates need to be interpreted in the context of the assumed model structure. For example, does it make sense to assume that government and household consumption are substitutes
Understanding the limitations and assumptions of each approach supports the appropriate use of the different estimates. Results, which assume that South Africa is a closed economy, are clearly inappropriate for policy use as the country is a small open economy. Using multiplier estimates generated under conditions of sustainable government debt is not useful when the government debt trajectory is perceived as unsustainable.
Large calibrated or econometric models provide estimates based on the assumed structure of the model. These are useful as laboratories to show how different channels and assumptions affect the size of fiscal multipliers. The estimates need to be interpreted in the context of the assumed model structure. For example, does it make sense to assume that government and household consumption are substitutes
Changing fiscal dynamics
In 2008/09, South Africa’s debt-to-GDP ratio stood at 26%, hardly unsustainable. The fiscal policy decisions in the 10 years prior to the global financial crisis created the space for a strong fiscal response. While the initial post-crisis response was justified, the stimulus deviated from two key conditions. It was not temporary and it was not well targeted as a rising portion of expenditure was spent on wages rather than on investment. Strong real growth in spending was achieved, with growth averaging almost 4% per year over the entire period, and increased by more than 7% in 2019/20. Attempts at fiscal consolidation were done through taxes rather than expenditure, which contributed to lower economic growth
Figure 1 indicates that the ratio of expenditure to GDP increased from 27% in 2008/09 to 33% in 2019/20. Initially, fiscal deficits were funded by debt issuance at very competitive rates as South Africa benefitted from the quantitative easing policies in advanced economies. This suggests that the expenditure multipliers were large. However, government started using tax increases to fund expenditure, which raised the tax-to-GDP ratio by 2 percentage points, from 23.9% in 2010/11 to 25.9% in 2016/17, muting the positive aggregate demand effects from higher government expenditure. Tax increases were also accompanied by large tax shortfalls, suggesting substantive negative impacts on GDP. The South African risk premium, as measured by the Emerging Markets Bond Index Plus (EMBI+) measure, decreased in the period immediately after the global financial crisis (Figure 2). A large part of the decline was driven by domestic factors, suggesting that at the time fiscal policy was perceived as sustainable and having a positive impact on economic activity.
Figure 1 indicates that the ratio of expenditure to GDP increased from 27% in 2008/09 to 33% in 2019/20. Initially, fiscal deficits were funded by debt issuance at very competitive rates as South Africa benefitted from the quantitative easing policies in advanced economies. This suggests that the expenditure multipliers were large. However, government started using tax increases to fund expenditure, which raised the tax-to-GDP ratio by 2 percentage points, from 23.9% in 2010/11 to 25.9% in 2016/17, muting the positive aggregate demand effects from higher government expenditure. Tax increases were also accompanied by large tax shortfalls, suggesting substantive negative impacts on GDP. The South African risk premium, as measured by the Emerging Markets Bond Index Plus (EMBI+) measure, decreased in the period immediately after the global financial crisis (Figure 2). A large part of the decline was driven by domestic factors, suggesting that at the time fiscal policy was perceived as sustainable and having a positive impact on economic activity.
Figure 3 presents a simple proxy indicator of the fiscal expenditure multiplier. It shows the incremental-government-expenditure-to-output ratio. This has more than doubled since 2015, 8 indicating that the growth of government expenditure over the period saw a much smaller increase in output compared to previous periods.
Methodology
We employ a macro econometric model similar to the Reserve Bank’s core econometric model and the Bureau for Economic Research (BER) econometric model.7 The structure of the economy is represented by a set of econometric equations and identities based on economic theory and the relationships in the system of national accounts. Long-term dynamics are represented by a set of co-integrating relationships while the methodology also allows for deviations in the short-run from the long-run equilibrium. The economy is continuously bombarded by a range of shocks, which are transmitted via changes in prices (exchange and interest rates and consumer prices) affecting income and in turn decisions to invest and consume. The adjustment by economic agents to these shocks occurs over several periods, depending on the particular shock and the specific characteristics of the sector. The model has more than 20 estimated equations and roughly 100 identities. The model incorporates five major tax rates, endogenous risk premia and a lending spread. These model characteristics are particularly important for our analysis. This type of model has been subject to the Lucas critique (Lucas 1976). Yet it has remained the workhorse of many central banks and ministries of finance due to its ability to incorporate more channels relevant to a particular policy question than other macroeconomic models, its better fit with the data and its flexibility to create different economic scenarios. It is for these reasons that we have chosen to develop and use an econometric model.
Non technical description of the model
The QMM models the behaviour of firms, households, policymakers (both monetary and fiscal) and the rest of the world. The QMM structure captures the key expenditure and income relationships reported in the National Accounts. Figure 4 provides a diagrammatic representation of the model. Firms hire labour and invest in capital to produce goods and services in the economy. Over the long run, the costs of additional workers are compensated by the extra revenue they generate, implying that the pace of growth in real wages cannot exceed the growth in labour productivity. There is a homogenous relationship between growth and employment such that employment growth only exceeds output if it is accompanied by reduced real wages. However, over the short(er) term, prices and wages are ‘sticky’ so labour can temporarily make relative gains (losses) against firms through higher (lower) real wages or employment. The growth in nominal wages is a function of real wage growth and inflation expectations.
Private investment follows the investment accelerator approach by modelling investment as a function of GDP (Jorgenson 1963). In addition, we capture the effects of higher borrowing costs on investment. The household sector consumes imported and domestically produced goods and services. Household consumption spending is driven by permanent real after-tax income, consistent with the permanent income hypothesis. Monetary policy decisions affect household consumption via commercial banks’ effective lending rate, which is a function of the repo rate. The long-run equilibrium for real export volumes is determined by a foreign demand (income) variable and a competitiveness (price) indicator. Rand-denominated export commodity prices and domestic producer input determine export competitiveness in the model. Import volumes react to the equilibrium level of domestic demand as the income variable and a competitiveness indicator in the form of import prices (i.e. the rand equivalent of foreign inflation and oil prices) relative to the GDP deflator. Positive and negative output gaps also affect import volumes over the short term. When the output level is above potential, the import propensity to GDP increases.
Interest rate movements vis-à-vis the United States (interest parity condition) determine the exchange rate along with the balance of the current account. The exchange rate feeds into the export and import prices of South African goods and services. QMM distinguishes between government consumption (split into wages and non-wages), transfers (mostly to households), subsidies and the interest payments on government debt. These are all exogenously determined and subject to discretionary fiscal policy.
Government expenditure is financed by tax revenues and/or issuing of bonds. The model provides for five major taxes, namely personal and corporate income taxes, value-added tax (VAT), fuel levies and custom receipts, which are modelled as exogenous effective rates on the relevant tax base. The role of monetary policy is to anchor prices at the mid-point of the target range. Headline inflation is modelled as a function of demand pressures captured by the output gap and the producer price index (PPI). The latter captures both demand and supply factors affecting the cost structures of firms. These factors include unit labour costs and import prices.
The QMM uses a calibrated Taylor rule, with the policy interest (repo) rate reacting to changes in the foreign equilibrium real interest rate (referenced by the US Fed rate), South Africa’s risk premium, the output gap and the deviation of inflation from the target. The risk premium is measured by the JP Morgan EMBI+ measure8 for emerging markets. The real repo rate in the model increases in response to a higher risk premium, a more positive output gap or inflation expectations exceeding the target level. Inflation expectations are adaptive in the model. This specification is supported by Kabundi and Schaling (2013) and Crowther-Ehlers (2019), who find that expectations formation tends to be more adaptive in South Africa.
Real long-term interest rates reflect the trend in the real short-term policy (repo) rates and the fiscal balance (as % of GDP). The risk premium enters the long-run interest rate equation via the repo rate. By affecting output and the cost of borrowing, fiscal and monetary policy decisions impact income and the real cost of capital, which in turn affects economic activity.
In QMM the output gap is derived from the difference between actual and potential GDP – with the latter informed by a Hodrick–Prescott filter. This is in contrast to the SARB core model where the output gap for all periods is calibrated to the estimates generated by Botha, Ruch, and Steinbach (2018). For the most recent years, we use estimates produced for the Monetary Policy Committee. The model framework tries to capture how the financial sector tends to amplify economic shocks through changes in the aggregate lending spread. We define the lending spread as the banks’ weighted effective lending rate minus the repo rate. The spread is driven by changes in the JSE All-Share Index and South Africa’s risk premium. A deterioration in the global and domestic environment affects equity prices and risk premia, increasing the risk aversion of the financial sector and leading to a higher lending spread. This mechanism captures some elements of the theoretical models of Borio and Zhu (2012) and Woodford (2010)
Interest rate movements vis-à-vis the United States (interest parity condition) determine the exchange rate along with the balance of the current account. The exchange rate feeds into the export and import prices of South African goods and services. QMM distinguishes between government consumption (split into wages and non-wages), transfers (mostly to households), subsidies and the interest payments on government debt. These are all exogenously determined and subject to discretionary fiscal policy.
Government expenditure is financed by tax revenues and/or issuing of bonds. The model provides for five major taxes, namely personal and corporate income taxes, value-added tax (VAT), fuel levies and custom receipts, which are modelled as exogenous effective rates on the relevant tax base. The role of monetary policy is to anchor prices at the mid-point of the target range. Headline inflation is modelled as a function of demand pressures captured by the output gap and the producer price index (PPI). The latter captures both demand and supply factors affecting the cost structures of firms. These factors include unit labour costs and import prices.
The QMM uses a calibrated Taylor rule, with the policy interest (repo) rate reacting to changes in the foreign equilibrium real interest rate (referenced by the US Fed rate), South Africa’s risk premium, the output gap and the deviation of inflation from the target. The risk premium is measured by the JP Morgan EMBI+ measure8 for emerging markets. The real repo rate in the model increases in response to a higher risk premium, a more positive output gap or inflation expectations exceeding the target level. Inflation expectations are adaptive in the model. This specification is supported by Kabundi and Schaling (2013) and Crowther-Ehlers (2019), who find that expectations formation tends to be more adaptive in South Africa.
Real long-term interest rates reflect the trend in the real short-term policy (repo) rates and the fiscal balance (as % of GDP). The risk premium enters the long-run interest rate equation via the repo rate. By affecting output and the cost of borrowing, fiscal and monetary policy decisions impact income and the real cost of capital, which in turn affects economic activity.
In QMM the output gap is derived from the difference between actual and potential GDP – with the latter informed by a Hodrick–Prescott filter. This is in contrast to the SARB core model where the output gap for all periods is calibrated to the estimates generated by Botha, Ruch, and Steinbach (2018). For the most recent years, we use estimates produced for the Monetary Policy Committee. The model framework tries to capture how the financial sector tends to amplify economic shocks through changes in the aggregate lending spread. We define the lending spread as the banks’ weighted effective lending rate minus the repo rate. The spread is driven by changes in the JSE All-Share Index and South Africa’s risk premium. A deterioration in the global and domestic environment affects equity prices and risk premia, increasing the risk aversion of the financial sector and leading to a higher lending spread. This mechanism captures some elements of the theoretical models of Borio and Zhu (2012) and Woodford (2010)
Results
We calculate the fiscal multipliers for each calendar year. Figure 8 shows the impact multipliers, calculated as the change in GDP divided by the change in real government consumption expenditure. The fiscal expenditure multiplier is time-varying and ‘state dependent’. It also takes into account how expenditure is funded. Initially, the expenditure multiplier increases to 1.5 after the global financial crisis, but then gradually declines towards zero as the fiscal situation deteriorates and South Africa is faced with a series of supply shocks. We now briefly explain how these results are generated in our framework. The first period is characterised by low government-debt-to-GDP ratios, large output gaps and significant capital inflows. During this period, an increase in government spending does not translate into higher risk premia or higher policy rates. There are no crowding-out effects and the higher levels of economic activity support the stock market, leading to lower lending spreads. This amplifies the initial positive impact on output.. At the same time, government consumption expenditure does not crowd out government investment, which provides further support to the growth accelerator mechanism in the model. The import leakage is also relatively small due to the large output gap supporting a higher multiplier
Figure 9 shows the impact on household consumption and investment. During the first period the response is strong and positive. 23 In the second period, post-2010, the dynamics change. The economy is hit by a series of transitory and permanent supply-side shocks. These include falling commodity prices and binding electricity constraints, particularly for export- and electricity-intensive sectors such as mining and manufacturing. The output gap is no longer large and negative. The structural factors from the first period have started to reverse. The import leakage is higher now as the supply constraints and the previous recovery in the economy require a greater degree of importation. The fiscal shock now leads to a higher policy rate and risk premium (equation 3). The real long-term yield and the lending spread increase, following the dynamics outlined in equations 2 and 4. The response of private investment relative to the first period is muted, reflecting a much smaller positive growth accelerator effect and also higher borrowing rates in the economy. Government spending is less efficient in its efforts to stimulate economic activity. In addition, the expenditure shock is accompanied by tax shocks that increase the effective PIT rate, negatively affecting household consumption. The tax-to-GDP ratio increased from 23.9% in 2010/11 to 25.9% in 2016/17. The average impact on investment is still positive but very small and on consumption it is negative (Figure 9).
In the last period, post-2014, the negative dynamics are exacerbated. The response of the risk premium to rising debt is now stronger. The tax increases are higher, including a VAT increase. The supply constraints become even more binding. Long rates and lending spreads increase by more than in period 2. Under these conditions, household consumption and investment decline relative to the baseline (Figure 9). These dynamics generate small and in some years even negative multipliers
Conclusion
Our results show that the space for generating strong positive growth effects from a fiscal expansion has long gone. The multiplier was close to zero by 2015. Yet, government has been growing expenditure, increasing taxes and growing debt. The outcome of this policy has been declining growth and limited fiscal space to respond to the COVID-19 crisis. Our results suggest that the costs of fiscal consolidation will be less harmful to growth than generally perceived as the multiplier is currently very small. Our results compare favourably to previous estimates.12 Our multipliers are similar to those calculated by Schröder and Storm (2020) but also to Mabugu et al. (2013) and Jooste, Liu, and Naraidoo (2013). What we illustrate is that changing fiscal conditions as well as structural shifts in the economy can materially change the size of fiscal multipliers. Generating multipliers under one economic state and assuming that they apply under different economic states is an incorrect approach, which will generate large policy errors