An increase in fiscal deficits by one percentage point may lead to a 1.3% currency depreciation risk, especially if the share of debt denominated in foreign currency is sizeable or if foreign holdings of sovereign debt are high, a study by the Bank for International Settlements (BIS) suggests.
The findings by the Swiss-based institution speak to how changes in fiscal deficits affect near-term inflation in emerging markets. It is important for SA, whose consolidated fiscal deficit is expected to widen against government forecasts as the country faces weaker revenue growth due to the lack of real GDP growth while spending pressures increase.
BIS principal economist Ryan Banerjee said that while a fiscal expansion typically leads to a currency appreciation, which partly offsets the inflationary impact of smaller economic slack, it is not the case with emerging markets.
“If a fiscal expansion is expected to significantly worsen the fiscal accounts, it might lead to an erosion of investors’ confidence and a currency depreciation, which then magnifies the initial inflation response,” Banerjee said.
Understanding the channels through which fiscal policy might affect inflation has therefore gained greater prominence lately. Fiscal expansion contributes to increasing domestic aggregate demand, he said.
The BIS findings can be considered in accordance with the latest warning by Fitch Ratings, which on Monday said a further big increase in the debt-to-GDP ratio by the government due to persistent large fiscal deficits will lead to a negative rating action.
Fitch expects SA’s consolidated fiscal deficit to widen to 4.5% of GDP in 2024, from 4.2% in the current financial year, against a government forecast of 4%.
Depreciation
The US-based ratings agency forecasts zero real GDP growth in 2023, against 1.9% growth in 2022, due to severe power shortages in recent months, which are likely to weigh heavily on GDP. It should be followed by a modest recovery to 0.9% growth in 2024 and 1.3% in 2025.
It expects inflation in 2023 to remain above the Reserve Bank’s 4.5% target at 6.4% on average, mainly due to the continued depreciation of the rand of about 15% against the US dollar and the cost of load-shedding for businesses, which is likely to be passed on to consumers. Inflation averaged 7% in 2022.
Inflation is forecast to decline to 5.5% in 2024 and 4.5% in 2025, enabling the Reserve Bank to start easing monetary policy.
Regarding rising government debt, Fitch said it expects gross loan debt to reach 76.9% of GDP in 2026, up from 72.3% in 2023, against a government forecast of 73.6%.
Fitch said it expects the Eskom debt transfer to increase SA’s debt-to-GDP ratio by about three percentage points and for the country’s current account deficit to widen to 2.4% of GDP in 2023, 3.6% in 2024 and 3.5% in 2025, from 0.4% in 2022, due to low global demand, logistic sector difficulties constraining export volume and rising imports driven by a fixed-capital formation recovery.
The issue of increasing debt is also highlighted by the Wits Public Economy Project in a fiscal paper “Austerity Without Consolidation”, which states that SA’s debt ratio will not stabilise at 73% by 2025, from 71% now, as the National Treasury has forecast, but will be about 80% by 2025.
Banerjee said that while higher deficits lead to exchange rate depreciations, BIS research shows that the effects of deficits on inflation and exchange rates are smaller if an economy is pursuing a policy of inflation targeting.
“We find that the effect of higher deficits on inflation is considerably weakened in inflation targeting regimes,” Banerjee said. “The frameworks and constraints on monetary policy matter strongly for the deficit-inflation link.”
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