The monetary and fiscal response to the COVID-19 crisis

The monetary and fiscal response to the COVID-19 crisis

Sandy McGregor  - 27 May 2020

The Coronavirus pandemic has caused a massive disruption of global economic activity without peacetime precedent. In a presentation via Zoom webinar, Sandy McGregor examines governments’ responses and their impact on inflation. Watch the 21-minute recording here and key points are summarised below.

Information dries up

The market economy is not only a process through which goods and services are exchanged. It is also an information machine. Its success when compared to other economic models arises from using prices to provide the information needed to efficiently distribute resources through the economy. Collateral damage caused by the suspension of so many business activities due to COVID-19, is that the flow of information has significantly dried up. This introduces significantly more uncertainty as to what investment decisions are appropriate.

The response of the United States to the crisis

The US dollar is the world’s reserve currency. Accordingly, the response of the US to the crisis has been, and will continue to be, a key determinant of the pricing of financial assets, such as bonds and equities, throughout the global financial system. While most countries have responded with a combination of easier monetary policy and larger fiscal deficits, the scale and speed of the US response has been without precedent. Short-term interest rates have been slashed to zero. Since early March the US Federal Reserve (the Fed) has spent US$2.7 trillion buying money market assets and bonds. It has indicated that it is willing to spend a further US$1.3 trillion. The US Federal Government plans to increase its spending by about US$3 trillion. The Fed’s proposed intervention is equivalent to about 4.5% of the world’s annual GDP. As has been the case in previous money printing exercises during the past decade, the most visible consequence of the Fed’s actions has been a notable increase in equity and bond prices.      

Will this be inflationary?

There is increasing debate as to whether such massive money creation will reignite inflationary pressures. The optimists point to the contraction in spending, which will leave ample capacity to meet demand using the already existing capacity. The pessimists argue that the world’s supply chains have been fundamentally damaged and the efficiencies which were the drivers for decades of declining prices will no longer be there. The rising gold price is a barometer of increasing investor concerns.

Can South Africa fund a deficit equal to 15% of annual GDP?

Due to the lockdown of the South African economy, in the 2020/21 fiscal year tax collections will be about R300bn less than budgeted. This is equivalent to about 6% of annual GDP. The fiscal deficit is heading for R750bn or 15% of GDP. This is more than two times greater than the net borrowing requirement in 2019/20, which itself was a record. Funding this deficit poses a formidable challenge. Countries such as South Africa, which do not have an external surplus, cannot simply print the money as can the US, which has the inordinate privilege of the dollar being the world’s reserve currency. This would be to follow the path of Zimbabwe, Venezuela and Argentina into currency collapse and hyperinflation. Our deficit will therefore have to be funded by drawing on the domestic savings pool, and external funding from institutions such as the International Monetary Fund and New Development Bank, from which we have already entered loan agreements equivalent to R100 billion. This will be difficult, but not impossible, because the domestic savings pool is about R8 trillion, and regulations regarding offshore investments by asset managers and insurers could be adjusted to require a greater proportion of assets be held onshore. However, there will be huge demands on the domestic money market, which will keep longer-dated rates elevated.

The SARB cuts rates

Recently South African inflation has been benign, and this has given the Reserve Bank scope to cut interest rates more aggressively than it has done previously. The most recent cut of 0.5% was motivated by the need to give relief to borrowers, many of whom are under extreme pressure. However, it will be difficult to cut further given the need to maintain financial stability while funding the enormous fiscal deficit and remaining attractive to foreigners. 

To view the Q&A session from this webinar, click here.

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