COVID-19: What policymakers can and can’t do

Pandemics like COVID-19 invoke behavioural responses amongst economic agents that cannot be controlled by government stimulus packages. But, there is still a lot macroeconomic policymakers can do. The South African Reserve Bank can keep the wheels of the economy oiled amidst tighter financial conditions, which includes cutting the policy interest rate.

Money needs to be directed to the right areas
Fiscal policy is especially important as government expenditure must be redirected to the right areas. The clear message from the experience of countries that have borne the brunt of COVID-19 to date is to test as widely as possible and isolate as early as possible. This “upfront” strategy will have an economic cost. Not only does testing require funding, but self-isolation or quarantine implies small and medium enterprises close. Jobs are lost temporarily or even permanently. However, early action on the right response should go some way towards lowering the cost associated with the inevitable economic fall-out.

SA was already fiscally weak before COVID-19
The problem is COVID-19 has hit South Africa at a time when it is in a weak fiscal position and the economy is heading into an even deeper downturn. The murky picture of a week ago has become clearer as more and more of our trading partners shut down economic activity. Existing domestic recessionary conditions can be expected to intensify, led by a global downturn.

Global confidence will likely remain depressed, destroying wealth
Even though China is expected to return to full production in the months ahead its economy has taken a big hit, while the shock to the global economy is likely to intensify in the months ahead, initially in Europe and the US. As the number of reported cumulative infections and deaths around the world and ultimately locally spikes exponentially, dwarfing the number of recorded cases to date, confidence levels are likely to remain depressed, while social distancing gains momentum. At the same time, the fall in financial asset prices will have negative wealth effects.

South Africa cannot escape
At some point depleted precautionary savings levels are likely to encourage a return to economic activity and social engagement, probably in a piecemeal pattern. But, in the near term a material disinflationary slump in demand is likely following the March 2020 stockpiling-driven bounce. We must be prepared for the risk that the economic downturn is more intense than currently feared.

We cannot ignore the impact of a weaker economy on government revenue, given a likely negative real GDP growth outcome this year and a decline in tax buoyancy. Even if government redirects existing spending to accommodate COVID-19 related expenditure, the shock to its revenue base implies that absent a change in the current fiscal policy stance the Main Budget deficit is likely to widen markedly further to around 9% of GDP in the current fiscal year. At the same time, the government’s debt level is expected to lift to around 80% of GDP in three years’ time.

A rising Budget deficit and debt levels complicate interest rate decisions
This is an additional complication for the Reserve Bank as it prepares its response on Thursday, 19 March 2020. The US Federal Reserve’s aggressive monetary policy loosening strategy, a domestic recession and likely downward revisions to local inflation expectations and forecasts (at least in the near term, partly driven by the collapse in the oil prices), are pointing to an interest rate cut – perhaps a large one. However, through history powerful inflation shocks worldwide have more often than not reflected fiscal failure. If fiscal policy unravels, the usual inflation models break down. In such a scenario the argument that surplus capacity is containing inflation would be invalid.

Time to overhaul the Budget?
Given unfolding events, the Budget for 2020 is out of date. Long bond yields are in double digit territory, but inflation is low and real GDP growth is expected to be negative this year. Given these dynamics a shift towards a material primary Budget surplus is required over time to stabilize the debt ratio. But, we are heading towards an increasingly large primary Budget deficit of around -5% of GDP this year. The key question now is whether we are in a position to address the fiscal situation sufficiently to make the fiscal maths add up. The answer to this will have an important bearing on monetary policy decisions.