Central Bank of Swaziland (CBS) Research Paper Commissioned by the Common Market for Eastern and Southern Africa (COMESA). Effects of Fiscal Policy on the Conduct and Transmission of Monetary Policy in Swaziland. Policy Research and Macroeconomic Analysis Division of the Central Bank of Swaziland Policy Research and Statistics Department 1 September 2015. Abstract The estimated VARs Johansen Cointegration approach are found to be stable and the Wald tests rejects all short run impacts of the fiscal balance on inflation and discount rate differential between Swaziland and South Africa. The fiscal balance has a long run significant impact on the inflation rate where a rise in the fiscal balance by a percentage point leads to a fall in inflation in the long run by 0.13 percent. The Fiscal Balance improvement leading to a fall in inflation widens the interest rate differential between South Africa and Swaziland lowering domestic interest rates in the process significantly in the long run. Fiscal shocks emanate from external factors with South Africa inflation having strong causality effects on the fiscal balance in the short run with a chi-sq. of 16.37 and a low p-value of 0.0003 in the Wald short run causality test. The fiscal balance is not financed through money creation in the short run where money creation has a chi sq. of 3.20 and p value 1 Prepared by: Simiso F. Mkhonta. Authorised for distribution by: 1
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Central Bank of Swaziland (CBS) Research Paper Commissioned by the Common Market for Eastern
and Southern Africa (COMESA).
Effects of Fiscal Policy on the Conduct and Transmission of Monetary Policy in Swaziland.
Policy Research and Macroeconomic Analysis Division of the Central Bank of Swaziland Policy Research and Statistics Department1
September 2015.
Abstract
The estimated VARs Johansen Cointegration approach are found to be stable and the Wald tests rejects all short run impacts of the fiscal balance on inflation and discount rate differential between Swaziland and South Africa. The fiscal balance has a long run significant impact on the inflation rate where a rise in the fiscal balance by a percentage point leads to a fall in inflation in the long run by 0.13 percent. The Fiscal Balance improvement leading to a fall in inflation widens the interest rate differential between South Africa and Swaziland lowering domestic interest rates in the process significantly in the long run. Fiscal shocks emanate from external factors with South Africa inflation having strong causality effects on the fiscal balance in the short run with a chi-sq. of 16.37 and a low p-value of 0.0003 in the Wald short run causality test. The fiscal balance is not financed through money creation in the short run where money creation has a chi sq. of 3.20 and p value of 0.20 as shown in the Wald tests but fiscal shocks would still lead to persistently high inflation and interest rates only to stabilise in the tenth year. The financial crisis and introduction of value added tax are found, tough insignificant, to reduce and increase inflation in the short run by 0.19 and 0.36 percent respectively and have no long run impact. The variance decomposition of inflation is mainly driven by the discount rate and fiscal balance in the long run.
This Research Paper should not be reported as representing the views of the CBS. The views expressed in this Research Paper are those of the author(s) and do not necessarily represent those of the CBS or CBS policy.
1 Prepared by: Simiso F. Mkhonta. Authorised for distribution by:
1. Introduction……………………………………………………………………………………………………………..4(a) Inflation and the Fiscal Deficit in 1980-2000………………………………………………………4(b) Inflation and the Fiscal Deficit in 2000-2015………………………………………………………5
2. Review on Fiscal Performance………………………………………………………………………………….63. Review on Existing Legal and Institutional Developments Discouraging and Promoting Fiscal
Dominance and Effective Coordination of Monetary and Fiscal Policy……………………..84. Challenges of Existing Fiscal Policy……………………………………………………………………………95. Key Features of the Operational Framework for Fiscal Policy, Monetary Policy and
Interaction between Fiscal and Monetary Policy……………………………………………………..116. Literature Survey……………………………………………………………………………………………………16
6.1 Theoretical and Empirical Literature on the Different Channels through which Fiscal Policy can affect Monetary Policy………………………………………………………………………16
6.2 The Impact of Fiscal Policy on Monetary Policy………………………………………………….166.3 Fiscal Policy Impact on Monetary Policy under Fixed Exchange Rate………………….16
6.4 Economic Mechanical Operation of Fixed Exchange Rate Regime…………..247. Methodology and Data……………………………………………………………………………………………..268. Econometric Results………………………………………………………………………………………………….27
8.1 Units Root Tests………………………………………………………………………………………………….278.2 The Long Run Inflation Estimation Equation and Diagnostic Tests……………………….298.3 The short Run Inflation Estimation Equation and Diagnostic Tests………………………388.4 The Long Run Discount Rate Differential Equation Estimation and Diagnostic
Tests…………………………………………………………………………………………………………….408.5 The Short Run Equation on Discount Rate Differential……………………………………….428.6 The Short Run Value Added Tax and Financial Crisis on Inflation Estimation
Equation……………………………………………………………………………………………………..469. Summary and Policy Implications…………………………………………………………………………….48
References
Figures
1. The Timeline for Growth and Fiscal Performance……………………………………………………62. Government Salaries and Capital Expenditure and Revenues………………………………….73. AR Root Stability Tests Equation 8(i)………………………………………………………………………334. Excess Liquidity………………………………………………………………………………………………………34 5. Impulse Response Function Equation 8(i)……………………………………………………………….356. Crude Estimation of the Trend for Velocity of Money…………………………………………….377. AR Root Stability Test Discount Differential Equation……………………………………………..428. Impulse Response Function; Discount rate Differential Equation……………………………449. Value Added Tax and Inflation………………………………………………………………………………..48
Tables
2
1. ADF Statistics for Testing for Unit Root……………………………………………………………….28.
2. Lag length Criterion………………………………………………………………………………………………29
3. Johansen Unrestricted Cointegration Rank Test (Trace)…………………………………………30
4. Johansen Unrestricted Cointegration Rank Test (Maximum Eigenvalue)………………..31
5. Diagnostic Tests for Inflation Equation…………………………………………………………………..32
6. Wald Causality Test……………………………………………………………………………………………397. Diagnostic Test for Discount Rate Differential Equation……………………………………..418. Discount Rate Differential Equation Stability Test……………………………………………….429. Wald Causality Test Discount Rate Differential Equation…………………………………….4510. Diagnostic Results Value Added Tax and Financial Crisis Equation……………………….47
Appendix I Definitions and Sources of Variables……………………………………………………………..50
Appendix II Tables and Figures……………………………………………………………………………………....50
SACU % Change The Fiscal Deficit as % of GDPGDP growth Change in Government Expenditure
SACU
% C
hang
e
Global Fin-ancial Crisis-low growth-low SACU growth
Asian Fin-ancial Crisis & Dot Com bubble-low growth-low SACU growth
SACU wind-fall -high oil pricesrecovered growth
high growth -low SACU growth (low base) -defcit
Boom Period
SACU recovers
Source: Central bank of Swaziland
The high economic growth rates recorded in the 80s resulted in government running a
surplus of 5.9 percent. Government expenditure increased in the 1990s as recurrent
expenditure increased buoyed by the good GDP growth emerging from the 1980s. The high
inflation rate of 20.3 percent in 1987 and 14.1 percent in 1990 contributed to the high
increases in Government expenditure. Government expenditure again increased
6
substantially in the year 2000 where the expenditure was mostly driven by millennium
projects capital expenditure. Government expenditure saw another substantial in
expenditure in 2004 when the salary review exercise was implemented. The SACU receipts
picked up reaching a peak of close to 70 percent of total government revenue in the years
2006, 2007 and 2008, before sliding, starting from 2009, down to a low of 38 percent of
Government revenue in 2010 due to the global financial crisis. As a consequence the
government ran deficits as high a deficit as 9.5 percent in 2010 financing the deficit through
treasury bills and, bonds and through money creation which was quickly reversed in 6
months to shield the monetary regime from collapsing. Swaziland Government expenditure
in general is driven by high revenues and high inflation which needs to be compensated to
keep Government operations stable. Government has no appetite to set aside funds in
periods of high government revenue because of a level of employment that has officially
been above 20 percent.
Figure 2 Government Salaries and Capital Expenditure and Revenues
19801983
19861989
19921995
19982001
20042007
20102013
0
5
10
15
20
25
30
35
40
45
Government Salaries and Wages percent of GDP as % of GDPCapital Expenditure percent of GDP as % of GDPGovernment Revenue and Grants as % of GDPGovernment Expenditure as % of GDP
perc
ent
Source: Central bank of Swaziland Quarterly Reports
This points to the fact that the government and the central bank do coordinate to shield the
monetary regime as stated by the Central Bank Order of 1994. The limit on Central bank
borrowing displays that there is an implicit limit put on fiscal policy by monetary authorities
Sargent and Wallace (1981)thus Swaziland can be viewed as a monetary dominant
monetary-fiscal policy set up even though the limits are on the high side In figure 2
government expenditure has steadily increased with increases in revenue. When
government revenue fell in 2010 and 2011 due to the financial crisis expenditure did not
7
adjust commensurate to a fall in revenue resulting in a huge deficit. The expenditure
remained high due to statutory commitment and resistance by the authorities in
implementing fiscal reforms of cutting recurrent expenditure but instead the capital
programme was cut compromising long term growth. The SACU receipts shock result in a
huge deficit as they account for a significant part of the revenue and coupled with a sticky
down ward wage bill.
In a nutshell the economy ran deficits in the early 80s after independence to include more
of the population in the Government budget. The was a short cut in economic growth as
the country experienced floods in 1984 but the increased expenditure after independence
and the location of firms in the economy as it was then a comparatively conducive
environment for investment in a politically turbulent Southern African region saw the GDP
growth rates rising to reach above 10 percent in 1990. The Asian financial crisis and the
Dotcom bubble in the late 90s and early 2000 saw the government being driven to a high
deficit as revenues fell. The oil price boom saw an upturn in SACU in 2005 only to experience
the global financial crisis in 2009, 2010 and 2011 where SACU receipts fell and recovered to
normal levels in 2012.
3. Review on Existing Legal and Institutional Developments Discouraging and Promoting Fiscal Dominance and Effective
Coordination of Monetary and Fiscal Policies.
The Government of Swaziland in the quest to promote monetary and fiscal coordination
with the interest of not impinging negatively on monetary policy in terms of excessive
credit promulgated Act No. 7 of 1994 providing for the issue of Treasury Bills and
Government Stock setting a limit of SZL/ZAR300 million. The act was amended in 2010 at the
height of the global financial crisis to a limit of 25 percent of GDP, which still is a limit
commensurate to the state of the economy, as a means to instil fiscal discipline though the
limit could be considered on the high side. Sargent and Wallace (1981) note along the lines
of the development of the limit that the demand for bonds place an upper limit on the stock
of bonds relative to the size of the economy and the creation of money on the other hand is
determined by who sets the limits between the monetary and fiscal authorities. Does the
monetary authority set by how much base money should grow or the fiscal authorities set it
8
by running any level of deficit with no ceiling on base money growth. Once the limit has
been reached the principal and interest due on the bonds already sold to mob up liquidity
and fight inflation must be finance at least in part by seignorage, requiring the creation of
additional base money which would ultimately defeat the initial disinflationary intentions of
setting the limit. Raising interest rates by the Central bank is no option under the fixed
exchange rate regime more in particular because of the resultant effects it would have on
growth. Thus setting the limits on government domestic credit by legislation would not need
the Central bank to sell bonds to fight inflation by mopping up liquidity. The Central bank
avoids a situation where it will have no option but to create more money to pay off the
principal interest on the bonds and treasury bills. The monetary authorities would have the
option of rolling over the debt till there is enough growth to absorb the excess liquidity
resultant from financing the principal interest rates on bonds through seignorage. Sargent
and Wallace’s model does not look at the options of rolling over debt as growth emerges
because they constructed a monetarist economy model.
The Central Bank of Swaziland Order of 1974 addresses the limits to money creation as
means to finance government deficits. The order states that the extension of credit to
government by the central bank shall at no time exceed twenty percent of the average
annual revenue of Government. The Order further states that from time to time
Government in respect of temporary deficiencies of current budget revenue, subject to
repayment within six months following the end of the financial year of the Bank in which
they are granted can borrow from the Central Bank. When calculating 20 percent of
Government revenue in 2013 the limit runs up to slightly above E1.8 billion which is above
the board, more in particular because Swaziland is in a fixed exchange rate regime. Krugman
(1979) observe that when government is no longer able to defend a fixed parity because of
the constraint on its actions, there will be a “crisis” in the balance of payments. Though
there is a constraint set by the order on Government seignorage financing it is deemed to be
on the high side because an increase of E1.8 billion in base money for the year 2013 for
example would translate into an increase of over 250 percent, which would obviously not
auger well for monetary policy and the economy at large.
The Governor in consultation with management and the monetary policy coordination
committee decides on interest rates. The monetary policy coordination committee is chaired
9
by the governor with part of bank management and stakeholders’ representatives from
outside the bank as members..
4. Challenges of Existing Fiscal Policy
The most pressing challenge for fiscal policy in Swaziland is the fact that on average with
data from 1980 to 2013 revenue from SACU has been above 50 percent of total revenue.
The fears were confirmed in 2010 during the height of the global financial crisis where
Swaziland experienced a negative shock in SACU receipts to the tune of 49 percent resulting
in a deficit of close to 10 percent. The government has been working on diversifying the
sources of revenue and has also restructured the collection of taxes by forming the
Swaziland Revenue Authority (SRA) and introducing value added tax in 2012.
The highest wage bills in sub-Sahara Africa at 15 percent of GDP on average from 2006-2010
and rising to 17.5 percent of GDP in 2014’is Swaziland’s other fiscal challenge. Olivier
Basdevant (2012) observed that the risk of a significant loss of SACU revenue calls for fiscal
reforms. Wage bills have become a frequent element of conditionality in IMF programs
with 17 out of 42 Poverty Reduction and Growth Facility (PRGF) programs (13 of 24 PRGF
programs in Africa) from 2003-2005 alluding to some form of wage bill ceiling. Basdevant
further notes that Botswana, Lesotho, Namibia and Swaziland shock on SACU receipts may
emanate from at least three structural factors: (i) a slowdown in global economic activity,
which would affect the SACU revenue pool; (ii) a reduction in the common external tariff
rates as a result of trade liberalization; (iii) the creation of the South African Development
Community (SADC) customs union and the fourth not mentioned in the paper would be the
loss of fiscal autonomy as SACU creates a development fund. Basdevant probably does not
mention this because it can swing either way depending on how each countries campaigns
for a share in the development fund which would be established by SACU.
The underlying bloated recurrent and non-discretionary expenditure, notably on the wage
bill, do not auger well in the event of a government revenue shock, which would highly likely
emanate from SACU receipts. There is therefore an urgent challenge to lower the wage bill
so that the budget can absorb shocks so as to avoid dire economic consequences coupled
with revenue diversification.
10
5. Key Features of the Operational Framework for Fiscal policy,
Monetary Policy and interaction between Fiscal and Monetary
Policy.
Paul Hilbers (2005) observes that the most important objective of central bankers is price
stability, but he further notes that there are others like economic development and growth,
exchange rate stability and safeguarding the balance of payments, and maintaining financial
stability. He notes that key variables in monetary policy include interest rates, money, credit
supply, and the exchange rate. Monetary and fiscal policies implementation by
independent of each other monetary authorities and fiscal authorities respectively is in itself
far from being independent. The implementation of one influences the other. It is therefore
essential that a consistent monetary-fiscal policy mix be pursued.
Hilbers in his 2005 paper presented at the IMF Seminar on Current Developments in
Monetary and Financial Law highlights both direct and indirect channels through which
fiscal policy affects monetary policy. Figure 1below aids the expression of both indirect and
direct channels of fiscal policy in affecting monetary policy.
(a) Excessive fiscal deficits may tempt government to finance the deficit by printing
thus leading to expansionary monetary policy which fuels inflationary pressures
and leads to a real depreciation of the currency. Depreciation of the currency
may lead to balance of payments crises.
(b) Even when deficits are not financed by money creation there is the concern of
the private sector being crowded out of the credit market by government
through high interest rates and outright non availability of credit funds for the
private sector, compromising economic growth and development in the process.
(c) Too much dependence on foreign funding of the deficit could result in exchange
rate and/or balance of payments crisis which would be worrying for the Central
bank as it also has direct implications for the maintenance of a healthy level of
reserves.
(d) A more direct way fiscal policy can affect Central bankers is by raising revenue
through increases or imposition of indirect taxes where a once off increase can
11
lead to a wage-spiral, depending on labour market forces, leading to
permanently high inflation and inflationary expectations.
(e) Confidence in the economy is compromised by large and persistent deficits which
may lead to the collapse of the monetary regime as noted by Makoto Richard
and Ndedzu Desmond (2012) in the case of Zimbabwe.
(f) Forward looking agents raise savings and reduce consumption in the light of
perceived unsustainably fiscal deficits leading to contractions in the economy
and ineffectiveness of expansionary monetary policy in resuscitating the
economy. This could be viewed as a fiscally induced liquidity trap which can be
reversed by changes in the nature of government expenditure.Fiscal
restructuring in general could help restore confidence in the economy and
resuscitate private spending.
(g) Expansionary fiscal policy will affect the Central bank whether the Central Bank is
independent or not. As expansionary fiscal policy may lead to inflation and as a
result Central banks hike interest rates straining the economy, attracting hot
money and increasing currency risks. Sterilization becomes costly for the Central
bank leading to inflationary pressures and at a later stage the reversal of the hot
money due to external factors. This may ultimately lead to a depreciation of the
currency inviting more inflationary pressures. Turkey in 1994 and 2001 and
Mexico in 1994 are relevant cases.
(h) The desire to develop financial markets with the aim of achieving economic
growth and development, funding deficits and debts and proper management of
liquidity with more flexible interest rates also results in the interaction of
monetary and fiscal policies.
The adoption of fiscal rules play an important role in avoiding large and persistent deficits
which may affect monetary policy, through variables like inflation, interest rates and
balance of payments. Transparency in monetary and fiscal policies is also vital in ensuring
that monetary and fiscal policies are coordinated effectively as promoted by the
International Monetary Fund (IMF). Most importantly, the stance of the fiscal and monetary
policy mix and the magnitude of the effect of fiscal policy on monetary policy are
determined by the nature of dominance between fiscal and monetary policy. A
12
fiscal/monetary dominant set up as espoused by Thomas J. Sargent and Neil Wallace (2012)
is as follows;
(a) where a fiscal dominant scenario exists the monetary authorities face the constraints
imposed by demand for government bonds and there is a great tendency for fiscal
authorities to run deficits that monetary authorities will be unable to control either
through the growth rate of base money or inflation forever. As put by Sargent and
Wallace (2012) the monetary authority’s inability to control inflation permanently
under these circumstances follows from the arithmetic’s of constraints it faces
emanating from how the deficit is financed.
(b) where a monetary dominant scenario exist , the fiscal authorities then face the
constraints imposed by demand for bonds, since it must set its budget so that any
deficits can be financed by a combination of seignorage chosen by the monetary
authority and bond sales to the public. Under this scenario monetary authorities can
permanently control inflation.
Therefore the severity of the effects that the fiscal deficit could have on monetary policy is
basically determined by whether a fiscally or monetary dominant scenario is obtained.
Under a fiscally dominant scenario the effect on monetary policy are detrimental to the
economy and pronounced, Makoto Richard and Ndedzu Desmond (2012) and Jean-Claude
Nachega (2005) found this to hold for Zimbabwe and the Democratic Republic of the Congo
(DRC) respectively.
The framework therefore outlines the different possible conduits through which fiscal policy
can affect monetary policy. The possibilities it should be stated are not exhaustive but are
those that have been cited in literature. They are not rigid but vary from economy to
economy depending on the disposition of monetary and fiscal policy and the underlying
economic and political dynamics. Ndezu and Makoto (2012) and Jean-Claude Nachega
(2005) found that the deficits and their monetisation were brought about by political
dynamics.
13
Figure 2 Organogram Frame work for Fiscal and Monetary Policy Interaction
14
Fisc
al D
efici
t
finance through domestic credit
market
high interest rates lead to;- crowinding out of the private
sector and weak economic growth-attract hot money and risks of
reversal of hot mney and balance of payments crisis. The prevailing
high interest rates though with more capital into the ecomnony still exclude the private sector
-ricadian equivalence
development of financial markets
proper management of
liquidity
economic growth
financed through monetisation
-inflationary pressures-balance payments
crsis/currency crisisweak economic growth
ricadian equivalence
indirect tax impostion wage-spiral and permanetly high inflation
financed through international credit market
balance of payments crisis/currency crisisricadian equivalence
Transparency
Fiscal Rules
Fiscal/Monetary Dominance
6. LITERATURE SURVEY
6.1 Theoretical and Empirical Literature on the different
Channels through which Fiscal Policy can affect Monetary
Policy.
6.2.1 The Impact of Fiscal Policy on Monetary Policy.
The relationship between budget deficits and inflation has been investigated extensively for
both industrial and developing countries with mixed results. The debate on the desirability
of deficits came to the fore front and developed primarily into two camps during the epoch
of the Great Depression with eminent scholars like Keynes stirring the debate. Deficits got
extensive attention during the period between the Great Depression in the 1930s and post-
World War II in the 1950s. John Maynard Keynes (1936) popularised the need for
governments to run deficits during recessions to compensate for the shortfall in aggregate
demand but should run surpluses in boom times so that there is no net deficit over an
economic cycle. Keynesian approach is therefore not likely to be inflationary owing to the
fiscal discipline entrenched in Keynesian thought though Keynes appreciates the advantages
of monetization at least to a certain limit. Fiscal discipline is defined as the capacity of
government to maintain smooth financial operation and long-term fiscal health; it branches
into (1) multiyear perspective on budgeting and (2) mechanism to maintain fiscal health and
stability over business cycles Yilin Hou (2003). An inflationary deficit cannot be seen to bring
fiscal discipline as resultant inflation would lead to higher real fiscal deficits according to
Aghevil and Khan (1977). The neo-classicalist on the other hand, the Chicago school of
economic and Australian school of economics among others believe deficits are a bad thing
in that they are inflationary. They argue that this is because governments pay off debts by
printing money, increasing the money supply and creating inflation. Jean-Claude Nachega
(2005) found that the degree of institutional structure linking budget deficits to money
creation has changed over time in that in the period from 1965 to the mid-1970s the DRC
was characterised by relative political stability, resulting in lower monetization of the deficit
15
and lower inflation. Nachega’s conclusion point to the fact that the nature of deficit
financing determines the impact of the budget deficit on inflation where monetization of
the budget deficit was found to be inflationary in the DRC compared to periods where the
budget deficit was less monetized. From Nachega’s conclusion the Fiscal Dominance
hypothesis which is central in the study of the impacts of budget deficits on monetary policy
can be appreciated.
It has often been argued that high inflation in developing countries is a result of persistently
high monetised deficit. The FD hypothesis that high inflation is a result of fiscally dominant
government with large and persistent deficits financed through money creation is found to
hold for developing countries. Apheous Ncube, Jackie Kitiibwa and Jean-Baptiste
Havugimana (2013) cite fiscal policy as one of the impediments in implementing monetary
policy in developing countries. It has also been observed in developing countries that
nonfiscal real disturbances or high inflation may lead to lower real tax revenues hence
higher real deficits rendering the deficit and money supply endogenous to the inflationary
process Nachega (2005).
Early studies confirm the FD hypothesis since Agheveli and Khan (1977). Agheveli and Khan
first showed that the growth in the money supply and inflation are linked in a two-way
relationship in Brazil, Colombia, the Dominican Republic and Thailand over the period 1961-
74. They ultimately found out that fiscal deficits play an important role in the inflationary
process, and that increases in these deficits are largely owing to the differences in lags of
government expenditures and revenues.
The extent to which government deficits/government debt affect, interest rates, money
supply, inflation and the balance of payments hence reserves and the exchange rate has
been studied by authors like Jean-Claude Nachega(2005), Ieva Sakalauskaite (2010), Michael
Kumhof ,and Douglas Laxton(2009) and lately Olivier Balanchard (2004) though in different
approaches and contexts. They invariable found that fiscal dominance or rather persistent
and high deficits led to a change in the conduct of monetary policy due to its effects on
interest rates, when interest rates respond to government debt Michael Kumhof , Ricardo
Nunes and Irina Yakadina (2008) and when interest rates make government debt more
attractive Olivier Balanchard (2004). Further studies looked at money supply and inflation
16
including Jean-Claude Nachega (2005), and money supply(monetary policy) on exchange
rate in Ieva Sakalauskaite (2010) and inflation under three central bank monetary
accommodation scenarios; excess, net and statutory central bank credit to government in
Makoto Richard and Ndedzu Desmond (2012).
Jean-Claude Nachega (2005) in his study on the Democratic Republic of the Congo (DRC)
argues that an increase in the budget deficit leads to increased seigniorage and the money
creation begets inflation. He found out that the degree of the institutional structures linking
budget deficits to money creation changed over time. The DRC experienced different epochs
defined by political changes that had varying effects on money creation. During period of
high political instability public finances put pressure on monetary policy leading to
monetization of the deficits hence higher inflation. The empirical results show a strong and
statistically significant long-run relationship between budget deficits and seignorage, and
between money creation and inflation. The long run inflationary impact of the deficit stays
its course even when the model takes into account output growth or velocity. Mokoto
Richard and Ndedzu Desmond (2012) did a study along similar lines and found government
deficits to be highly inflationary under excess Central bank credit to government in the case
of Zimbabwe. They concluded that when modelling fiscal dominance-monetary
accommodation hypothesis as a Vector Autoregressive model the inflationary worries are
not present if government settles its debt procured through money creation and if the
government restricts institutional credit.
The external balance appears as a variable of interest for the monetary authorities as it
features in the frame work for fiscal-monetary policy mix in figure 1. Foued Chihi and Michel
Normandin (2008) found that the covariance of the external and budget deficit is
numerically positive for 24 developing countries examined and is statistically significant for
almost all cases. They also found similar results from the estimated correlation between
external balance and budget deficits, and the estimated slope coefficient obtained by
regressing the external deficit on a constant and the budget deficit to ascertain causality,
which may not be concluded firmly from covariance analysis.
17
Raghbendra Jha (2007) observes that with poor credit and bond markets and downwardly
inflexible fiscal expenditures, some of the financing of the resultant deficit spills over onto
the external sector and the central bank.
From the manipulation of the national accounts two gap model one can deduce that fiscal
policy has indeed an impact on the external position where;
Thus if government saving fall S will fall and it will be reflected in the external account,
more so if the reduction in savings are a result of a draw down in foreign reserves.
Therefore a government deficit is likely to have a negative impact on the external sector.
Olivier Blanchard (2004) looks at fiscal dominance when fiscal dominance has been
instigated by increased interest rates that make government debt more attractive. He
argues that if increased government debt due to increased interest rates increases the
probability of default on the debt then this may lead to a real depreciation in the exchange
rate and higher inflation. Therefore Olivier concluded that this could have dire
consequences for inflation targeting in Brazil. He ultimately concluded for Brazil in 2002 and
2003 that an increase in the real interest rate in response to higher inflation leads to a real
depreciation and the real depreciation leads in turn to further increases in inflation. Olivier
presents a model between the interest rate, the exchange rate, and the probability of
default, in a high-debt high-risk-aversion economy such as Brazil in 2002 and 2003. Jean
Nachega (2005) noted that in the case of the DRC. Beaugrand (1997) and Akitoby (2004)
estimated the fiscal deficit-inflation relationship in a single equation and failed to account
for potential feedback from inflation which is taken care of by Nachega (2005) by using a
VAR with inflation feedback effect which Blanchard (2004) explained through increased
interest as responding to deficit driven high inflation. As the interest rates respond to
18
inflationary pressures the deficit increases all the more with high interest rates as
government debt is made more attractive leading to a vicious cycle.
Sargent and Wallace (1981) present a dynamic analytical mathematical framework showing
the interactions that shows that even in an economy that satisfies monetarist assumptions 2,
if monetary policy is interpreted as open market operations then monetary policy cannot
permanently control inflation. The extent to which inflation can be controlled depends on
the way fiscal and monetary policies are coordinated. Sargent and Wallace consider two
extreme forms of coordination; one where monetary policy dominates fiscal policy by
independently setting policy such as announcing growth rates for base money for the
current period and all future periods. The monetary authorities therefore determine the
amount of revenue it will finance the government deficit through seigniorage. The fiscal
authorities are then left with the bond financing ceiling imposed by the appetite for
government bonds of the public. Under this coordination the monetary authorities can
control inflation permanently because it can choose the growth of the money base which is
closely linked to inflation under the monetarist assumptions.
But in an instance where fiscal policy dominates monetary policy; that is; the fiscal authority
independently sets its budget, announcing all future deficits such that they are determined
by how much they are going to finance the deficit from either sale of government bonds or
seignorage. Sargent and Wallace observe that under this set up the monetary authorities
face the constraints imposed by the demand for government bonds, for it must try to
finance with seignorage any discrepancy between the revenue demanded by the fiscal
authorities and the amount of bonds that can be sold to the public. Under such
circumstances there is highly likely to be runaway inflation as monetary authorities are
helpless in controlling inflation with monetary policy being ultimately determined by fiscal
policy.
6.2.2 Fiscal Policy Impact on Monetary Policy in Fixed Exchange Rate Regimes
Under a fixed exchange rate regime fiscal policy tends to be restrictive and therefore
eliminates the money creation route of deficit financing. By 1973, most major world 2 The monetarist assumptions of a monetary economy are that: the monetary base is closely connected to the price level, and the monetary authorities can raise seignorage, which is revenue raised through money creation.
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economies had migrated to freely floating exchange rates against the dollar. The transition
to freely floating exchange rates was characterized by plummeting stock prices, skyrocketing
oil prices, bank failures and inflation. Buchanan and Wagner (1977) argued that deficits are
inflationary under an interest-rate pegging monetary policy for industrialised countries. This
is due to the non-flexibility of the interest rates where the Central bank in the desire to hold
down interest rates and thus peg at a low point under prevailing economic conditions
purchase government bonds and in the process increase base money.
The smaller economies continued with the pegged exchange rate system for various reasons
including the size and openness of their economies to trade and financial flows, the
structure of production and exports, stages of its financial development, its inflationary
history, and the nature of the shocks they faced. Industrialized economies adopted explicit
inflation targeting, along with floating exchange rate systems in the 1990s and the policy has
spread to emerging and developing economies and the industralised economies have
moved further to an ultimate fixed exchange rate system under a monetary union.
Ieva Sakalauskaite (2010) found empirical evidence to the fact of inferior public balances in
countries operating under currency pegs, and the argument that the changes in economic
conditions after a fixed exchange rate regime is established may create expansionary
temptations for politicians, resulting in lower surpluses. Ieva (2010) in his research though
finds that rigid exchange rate arrangements are conducive to delivering fiscal discipline,
while the effects of currency boards do not differ significantly from those of regular pegs. As
earlier pointed out developing countries opted for fixed exchange rate regimes for many
reasons one of which was historically high inflation figures which were to be tamed by fixed
exchange rate regimes in instilling fiscal discipline and importing low inflation. Typical the
country/currency chosen to be pegged to ought to exercise both fiscal and monetary
discipline hence low and stable inflation.
Swaziland has been on a fixed exchange rate system since 1974 on the establishment of the
Central Bank and issuance of the first notes and coins of the local currency, the Lilangeni.
Swaziland is a small landlocked country with an open economy and South Africa is her
dominant trading partner, and has a low level of financial development such as the low level
of activity in the stock exchange which factors have contributed to Swaziland adopting a
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fixed exchange rate system. Countries with open unbiased economies and developed
financial markets as earlier observed opted for floating exchange rate systems.
Swaziland’s membership to the Common Monetary Area agreement cements the
commitment by Swaziland to exercise monetary and fiscal disciplines.
Ieva Sakalauskaite (2010) observed for 10 Central and Eastern European transition countries
over the period 1992-2008 that rigid exchange rate arrangements are conducive to
delivering fiscal discipline, while the effects of currency boards do not differ significantly.
The first generation model following the seminal work of Paul Krugman (1979) and Maurice Obstfeld (1986). A standard first-generation model of a small open economy in log notations
* indicates lag order selected by the criterion LR: sequential modified LR test statistic (each test at 5% level) FPE: Final prediction error AIC: Akaike information criterion SC: Schwarz information criterion HQ: Hannan-Quinn information criterion
Figure3. AR ROOT Stability Tests
Money supply is and gross international reserves are dropped from the estimation to render
the model stable and the following results are obtained from the Johannes Cointegration
estimations.
Table 3. Johansen Unrestricted Cointegration Rank Test (Trace)
Hypothesized
No of CE(s)
Eigen value Trace
Statistics
0.05
Critical Value
Prob.**
None* 0.917752 164.9246 95.75366 0.0000
At most 1* 0.719539 89.98402 69.81889 0.0006
At most 2* 0.557740 51.84440 47.85613 0.0201
At most 3 0.423246 27.36865 29.79707 0.2203Trace test indicates 3 cointegrating eqn(s) at the 0.05 level*denotes rejection of the hypothesis at the 0.05 level**MacKinnon-Haug-Michelis (1999) p-values
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The likelihood ratio (LR) value is greater than the 5 percent critical value where it gives 3
cointegrating equation. The trace statistics therefore shows three cointegrating equations at
the 0.05 level. The Max-egen value test indicates 2 cointegrating equation at the 0.05 level.
Table 4 Johansen Unrestricted Cointegration Rank Test (Maximum Eigenvalue)
Hyphothesis No. of CE(s)
Eigenvalue Max-Eigen Statistics
0.05Critical Value
Prob.**
None* 0.917752 74.94055 40.07757 0.0000
At most 1* 0.719539 38.13963 33.87687 0.0146
At most 2 0.557740 24.47575 27.58434 0.1190
At most 3 0.423246 16.51016 21.13162 0.1964Max-eigenvalue test indicate 2 cointegrating eqn(s) at the 0.05 level*denotes rejection of the hypothesis at the 0.05 levelMacKinnon-Haug-Michelis (1999) p-values
Since all values in the table 4(i) are not significant they then all do not have a short run
relationship. Which means the deficit, exchange rate, base money, South Africa inflation and
the discount rate do not granger cause inflation in the short run or rather they are weakly
exogenous. Inflation, South Africa inflation and the discount rate granger cause the fiscal
balance in the short run through high repayments in with higher discount rates, and higher
real deficits through higher South Africa and domestic inflation in the short run.
The fiscal balance, the exchange rate, base money, South Africa inflation and discount rate
do not have a short run impact on inflation. Inflation, South Africa inflation and the discount
rate all have short run impact on the fiscal balance.
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8.4 THE LONG RUN DISCOUNT RATE DIFFERENTIAL ESTIMATION EQUATION AND DIAGNOSTIC TESTS.
The monetary authorities conduct monetary easing by lagging the discount rate from that of
South Africa particularly when domestic growth prospects are grim. The below vector
autoregressive model estimates the impact of the deficit and other variables to discount
rate differential from that of South Africa.
The likelihood ratio (LR) value is greater than the 5 percent critical value where it gives 2
cointegrating equations. The trace statistics show two cointegrating equations at the 0.05
level. The max-eigen value test indicates 2 cointegrating equations at the 0.05 level.
The long-run equation estimation
Discount differential =Dd
Fiscal Balance = FB
GDP growth = GDPGr
INF =Inflation
Monetary base=Mb
The variables are cantered and lodged.
Unrestricted Cointegration Rank Test (Trace)
Hypothesized No. of CE(s)
Eigen value TraceStatistics
0.05Critical Value
Prob.**
None* 0.880858 140.1625 69.81889 0.0000At most 1* 0.612328 76.33921 47.85613 0.0000At most 2* 0.529998 47.91133 29.79707 0.0002At most 3* 0.433321 25.26077 15.49471 0.0013At most 4* 0.239717 8.221919 3.841466 0.0041Trace test indicates 5 cointegrating eqn(s) at the 0.05 level*denotes rejection of the hypothesis at the 0.05 level**Mackinnon-Haug-Michelis (1999) p-values
Unrestricted Cointegration Rank Test (Maximum Eigenvalue)
39
HypothesizedNo. of CE(s)
Eigenvalue Max-EigenStatistics
0.05Critical Value
Prob.**
None* 0.880858 63.82329 33.87687 0.0000At most 1* 0.612328 28.42788 27.58434 0.0389At most 2* 0.529998 22.65057 21.13162 0.0303At most 3* 0.433321 17.03885 14.26460 0.0177At most 4* 0.239717 8.221919 3.841466 0.0041Max-eigenvalue test indicates 5 cointegrating eqn (n) at the 0.05 level*denotes rejection of the hypothesis at the 0.05 level**Mackinnon-Haug-Michelis (1999) p-values
The fiscal balance has no short run impact on interest rate differential between South African and
Swaziland but the performance of GDP and base money impact on the interest rate differential.
44
Swaziland usually keeps its discount rate lower than that of South Africa if GDP is not performing
well. Increases in base encourage a close in the differential to avoid capital flight.
8.6 THE SHORT RUN VALUE ADDED TAX AND FINANCIAL CRISIS ON INFLATION ESTIMATION EQUATION.
Due to the short time series not all variables can be run on a vector error correction model
thus a single equation is estimated to assess the impact of the financial crisis and
introduction of value added tax on inflation.
The financial crisis was preceded by a rise in inflation which saw interest rates rising and the
collapse of the housing subprime. The resultant fall in aggregate demand saw inflation fall.
The dummy variable for the financial crisis and value added tax have no cointegrating
relation with the other variables and can therefore not be included in the Johansen
procedure of estimation employed above hence their effect on inflation is investigated
through the estimation of a single equation below.
Table 10 Results of the Financial Crisis and Value Added Equation.Dependent Variable: DCLNINFMethod: Least SquaresDate: 09/14/15 Time: 09:11Sample (adjusted): 1984 2013Included observations: 30 after adjustments
R-squared 0.707487 Mean dependent var -0.043255Adjusted R-squared 0.553533 S.D. dependent var 0.460908S.E. of regression 0.307970 Akaike info criterion 0.758946
45
Sum squared resid 1.802065 Schwarz criterion 1.272719Log likelihood -0.384193 Hannan-Quinn criter. 0.923306F-statistic 4.595444 Durbin-Watson stat 1.768183Prob(F-statistic) 0.002121
DIAGNOSTIC TESTS
Table 10 Diagnostic Results Value Added Tax and Financial Crisis Equation.
Diagnostic Test H0 F-Statistics ProbabilitySerial Correlation No serial Correlation 0.23914 0.7899
nR2 Chi-sq
Heteroskedasticity
Breuch-Pagan-
Godfrey
No Heteroskedasticity 1% 17.59929 23.20925
No Heteroskedasticity 5% 17.59929 18.30704
H0 Jarque-Bera Probability
Normality Residual are normally distributed 0.218220 0.896632
Durbin Watson 1.82˞
The single equation has an R2 of 70 percent and a durbin Watson statistics of approximately
2. The Breusch-Pagan-Godfrey test shows that there is an absence of heteroskedasticity
since the nR2 value of 17.6 is lower than the 1% critical chi-sq value of 23.20925, even the
5% critical chi-sq value of 18.30704 we fail to reject the null hyphothesis of no
heteroskedasticity. The presence of serial correlation is also rejected with p values of
greater than 5 percent recorded. Multicollinearity is solved by centering the variables.
Figure 11 -Value Added Tax and Inflation
46
Jan-05
May-05
Sep-05
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May-07
Sep-07
Jan-08
May-08
Sep-08
Jan-09
May-09
Sep-09
Jan-10
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Sep-10
Jan-11
May-11
Sep-11
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-4-202468
10121416
Swaziland-inflation Polynomial (Swaziland-inflation)South Africa-inflation Polynomial (South Africa-inflation )Series3
The government of Swaziland in 2012 introduced value added tax which did not result in
change in the trajectory of inflation but instead the deviation of local inflation from that of
South Africa was a bit pronounces. The inflation did not experience a shock that resulted
prior to the financial crisis. The value added tax resulted in a temporal upward movement
in inflation of 0.428 percent in 2012 and the financial crisis on the other hand resulted in a
fall in the inflation rate by 0.121 percent.
9. RECOMMENDATIONS AND POLICY CONCLUSIONS.
The significantly negative long run impact the fiscal balance has on inflation suggests that
persistent fiscal deficits would be inflationary. The persistently high deficits would further
result in persistently higher discount rates which would not auger well for economic growth.
A healthy fiscal balance would ease pressures on tight monetary policy and the domestic
discount rate would fall below that of South Africa. The Swaziland monetary authorities
pursue a fixed exchange rate regime where they generally track discount rate in South Africa
in their conduct of monetary policy. The authorities have a tendency of keeping the
domestic discount lower than that of South Africa when there is a pressure for an
accommodative monetary policy due weak growth. The fiscal balance which relies on South
African Custom receipts for a healthy position deteriorates to push up inflation and the
discount rate in the long run compromising economic growth prospects. Exchange rate
deterioration also worsens the fiscal balance and results in a deficit which leads to higher
47
long term inflation. The monetary authorities should therefore discourage the government
from running persistent fiscal deficits by advocating a fiscal restructuring trimming the
bloated recurrent expenditure in particular the wage bill. The implementation of an
accommodative monetary policy is difficult under a huge budget deficit and the healthier
the fiscal position the better will be the long run discount rate trajectory. Fiscal shocks
should therefore be avoided by basically reducing the recurrent budget in particular the
wage bill and diversifying sources of revenue away from heavy reliance on SACU recipients.
The heavy reliance of government revenue on SACU receipts renders the fiscal balance
Table A112 COINTEGRATING RESULTS OF DISCOUNT RATE DIFFERENTIAL LONG RUN EQUATIONDate: 12/04/15 Time: 14:49Sample (adjusted): 1984 2013Included observations: 30 after adjustmentsTrend assumption: Linear deterministic trendSeries: CSASDDIFF CDEFICIT CGDPGR CLNMBLags interval (in first differences): 1 to 2
Unrestricted Cointegration Rank Test (Trace)
Hypothesized Trace 0.05No. of CE(s) Eigenvalue Statistic Critical Value Prob.**
None * 0.806249 92.38297 47.85613 0.0000At most 1 * 0.494547 43.14747 29.79707 0.0008At most 2 * 0.379475 22.67847 15.49471 0.0035At most 3 * 0.243278 8.362798 3.841466 0.0038
Trace test indicates 4 cointegrating eqn(s) at the 0.05 level
54
* denotes rejection of the hypothesis at the 0.05 level **MacKinnon-Haug-Michelis (1999) p-values
Unrestricted Cointegration Rank Test (Maximum Eigenvalue)
Hypothesized Max-Eigen 0.05No. of CE(s) Eigenvalue Statistic Critical Value Prob.**
At most 2 * 0.379475 14.31567 14.26460 0.0491At most 3 * 0.243278 8.362798 3.841466 0.0038
Max-eigenvalue test indicates 1 cointegrating eqn(s) at the 0.05 level * denotes rejection of the hypothesis at the 0.05 level **MacKinnon-Haug-Michelis (1999) p-values
Unrestricted Cointegrating Coefficients (normalized by b'*S11*b=I):
P values for the Chi-square is 0.0592 and is greater than 0.05 therefore the deficit has no short run impact on the discount rate differential between South Africa and Swaziland.
P value for the Chi-square is 0.0556 and is greater than 0.05 therefore the GDP growth has no short run impact on the discount rate differential between South Africa and Swaziland.
P value for the Chi-square is 0.9658 and is greater than 0.05 therefore the Money supply (M1) growth has no short run impact on the discount rate differential between South Africa and Swaziland.
P value for the Chi-square is 0.8081 and is greater than 0.05 therefore the GDP growth has no short run impact on the discount rate differential between South Africa and Swaziland.
The deficit has no short run impact on discount rate differential between South Africa and Swaziland as the p value for the chi-square is greater than 0.05.GDP growth has a short run impact on the discount rate differential between South Africa and Swaziland as the p value for the chi-square is less than 0.05.Money Supply M1 has a short run impact on the discount rate differential between South Africa and Swaziland as the p value for the chi-square less than 0.05. This is basically driven by the perception taken by economic agents on an increase in the debt stock as government procures debt through the issuance of bonds. Or there fall in domestic credit to the private sector as reflected in M1 encourages the monetary authorities to lag effect a lower domestic discount rate to that of South Africa. Jointly Money Supply has a short run impact on the discount rate differential. The fall in credit to the private sector in
Monetary base Mb has no short run impact on the discount rate differential between South Africa and Swaziland as the p value for the chi-square is greater than 0.05.
TableAII 5 VAR heteroscedasticity test Results.VAR Residual Heteroskedasticity Tests: No Cross Terms (only levels and squares)Date: 08/04/15 Time: 15:42Sample: 1981 2013Included observations: 31
TableA116. Short run Inflation Equation (VECM) Vector Error Correction Estimates Date: 09/15/15 Time: 15:01 Sample (adjusted): 1984 2013 Included observations: 30 after adjustments Standard errors in ( ) & t-statistics in [ ]
TableA117 FINAL VAR STABLE FOR INFLATION EQUATIONDate: 11/12/15 Time: 09:53Sample (adjusted): 1984 2013Included observations: 30 after adjustmentsTrend assumption: Linear deterministic trendSeries: CLNINFL CDEFICIT CLSAINFL CLNDR CLNEXRATE CLNMBLags interval (in first differences): 1 to 2
Unrestricted Cointegration Rank Test (Trace)
Hypothesized Trace 0.05No. of CE(s) Eigenvalue Statistic Critical Value Prob.**
None * 0.917752 164.9246 95.75366 0.0000At most 1 * 0.719539 89.98402 69.81889 0.0006At most 2 * 0.557740 51.84440 47.85613 0.0201At most 3 0.423246 27.36865 29.79707 0.0929At most 4 0.291963 10.85849 15.49471 0.2203At most 5 0.016552 0.500726 3.841466 0.4792
Trace test indicates 3 cointegrating eqn(s) at the 0.05 level * denotes rejection of the hypothesis at the 0.05 level **MacKinnon-Haug-Michelis (1999) p-values
62
Unrestricted Cointegration Rank Test (Maximum Eigenvalue)
Hypothesized Max-Eigen 0.05No. of CE(s) Eigenvalue Statistic Critical Value Prob.**
None * 0.917752 74.94055 40.07757 0.0000At most 1 * 0.719539 38.13963 33.87687 0.0146At most 2 0.557740 24.47575 27.58434 0.1190At most 3 0.423246 16.51016 21.13162 0.1964At most 4 0.291963 10.35776 14.26460 0.1895At most 5 0.016552 0.500726 3.841466 0.4792
Max-eigenvalue test indicates 2 cointegrating eqn(s) at the 0.05 level * denotes rejection of the hypothesis at the 0.05 level **MacKinnon-Haug-Michelis (1999) p-values
Unrestricted Cointegrating Coefficients (normalized by b'*S11*b=I):
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