Effects of Fiscal Policy on the Conduct and Transmission Mechanisms of Monetary Policy

EFFECTS OF FISCAL POLICY ON THE CONDUCT AND TRANSMISSION MECHANISMS OF MONETARY POLICY IN ZIMBABWE

BY

WILLIAM KAVILA

DEPUTY DIRECTOR, ECONOMIC RESEARCH DIVISION

RESERVE BANK OF ZIMBABWE

ABSTRACT

This paper provides an analysis of the effects of fiscal policy on the monetary policy transmission mechanism in Zimbabwe under a dollarised environment. The analysis was conducted using an Unrestricted Vector Autoregressionmodel to identify shocks to fiscal variables and their impact on the monetary policy transmission mechanism. The variables analysed are interest rates, budget deficit, inflation, money supply and a proxy for economic activity over the period 2009 to 2014. The impulse response functions and variance decompositions are used to study the effects of identified shocks. The results suggest that nominal interest rates respond positively to a fiscal deficit shock. Furthermore, the results suggest that the response of inflation and money supply are muted, reflecting the limited role played by fiscal policy in influencing money supply and inflation under the dollarized environment.

Keywords: Structural VAR, Fiscal deficit, Monetary Policy, Transmission Mechanism

JEL classification: C32, E52, E62

Table of Contents

1.INTRODUCTION

2.TRENDS IN FISCAL PERFORMANCE IN ZIMBABWE

Revenue Performance

Expenditure Performance

Fiscal and Monetary Policy Interaction in Zimbabwe

3.LITERATURE REVIEW

Theoretical Literature

Empirical Literature

4.METHODOLOGY

Data and Estimation Method

5.EMPIRICAL RESULTS

6.CONCLUSION AND POLICY RECOMMENDATIONS

1.INTRODUCTION

The efficient coordination of fiscal and monetary policies is a pre-requisite for sustainable economic growth in the context of achieving both internal and external balance. Prudent macroeconomic management allows for mutually reinforcingobjectives of both fiscal and monetary policies. On the contrary, inefficient coordination give rise to sub-optimal economic outcomes. As highlighted by Balino and Enoch (1998), the necessary condition for effective coordination between monetary and fiscal policies is that each policy should be on a sustainable path. Even with effective coordination, unsustainability in one policy has negative spillover effects on the other, making the entire macroeconomic framework unsustainable. In addition, coordination also looks at the credibility of the overall policy mix. In this regard, the effectiveness of monetary and fiscal policies is dependentupon significant coordination.

The coordination of fiscal and monetary policy is crucial since the two policies operate in different time frames. Monetary policy can be adjusted more frequently and is normally used in fine tuning the economy. On the other hand, it takes a long time to change the fiscal stance. In this regard, the issue of coordination of fiscal and monetary policies had been prominent in the context of macroeconomic stabilization programmes (Niemann, 2008). The need for fiscal and monetary policy coordination has become pertinent especially given that most countries have established independent central banks. As a result, central banks around the globe have moved to primarily focus on price stability through inflation targeting (Sehovic, 2013). Central bank independence has resulted in increased disassociation between fiscal and monetary goals, implying that economic policy management increasingly focuses on the coordination of fiscal and monetary policies.

The importance of coordination between fiscal and monetary policy also came to the fore during the global financial crisis of 2008. The crisis showed that financial instability and weak fiscal policies can have a negative impact on each other. Crucially, the financial-fiscal feedback loop negatively affects the smooth operation of the monetary policy mechanism. The crisis highlighted that sound fiscal and monetary policies are critical for sustainable growth (European Central Bank, 2012). The coordination of fiscal and monetary policies also gained prominence as countries endeavoured to deal with the global financial crisis. Several countries carried out unconventional monetary and fiscal policies. Notably, monetary authorities turned to quantitative easing, while fiscal policies were highly expansive characterised by increased government spending and reduced taxes. Against this background, efficient coordination of monetary and fiscal policy becomes a necessity to ensure a sustainable policy mix in the aftermath of the crisis(Liborioa, 2011).

The euro area sovereign debt crisis also showed that if fiscal and monetary policies are operating at cross purposes, the overall policy mix would be unsustainable. In the euro area, in particular, unsustainable fiscal policy including high debt levels, adversely impacted on the monetary policy transmission mechanism (ECB, 2012). In this regard, fiscal and monetary policy should be in harmony.The euro area crisis highlights that fiscal and monetary coordination should be an integral part of countries moving towards or are in a monetary union. In this regard, as theCommon Market for Eastern and Southern Africa(COMESA) strides towards a currency union it becomes imperative to review and examine the state of fiscal and monetary coordination in the respective member countries.

The need for fiscal and monetary coordination increases under monetary union arrangements. As highlighted by Suarez and Panico (2007), in a monetary union without fiscal federation, fiscal policy is the only policy instrument which can be deployed to deal with asymmetric shocks. Under a monetary union, the existence of only one monetary authority with several fiscal authorities requires significant measures to ensure adequate monetary and fiscal policy coordination. In a monetary union, coordination is required at two levels, that is, coordination among fiscal authorities of member states and in the coordination among monetary and fiscal policy authorities (Tirelli and Muscatelli, 2005).

It is against this heightened requirement for greater coordination of fiscal and monetary policy for countries moving towards or in a monetary union that it becomes imperative to assess the interaction of fiscal andmonetary policy in Zimbabwe. The assessment of fiscal and monetary coordination in Zimbabwe is, however, an interesting case since the country adopted the multicurrency system in 2009. In the multicurrency system, the country uses an array of foreign currencies, in which the principal currencies include the United States of America dollar (US$), British pound, South Africa rand, Botswana Pula and the Euro. It should be noted that while Zimbabwe is under a multicurrency system, the US$ is the unit of account and the majority of the transactions (over 90%) are in US$. All goods and services are priced in US$. The adoption of the multicurrency system resulted in the loss of monetary policy autonomy. This implies that the country is unable to use traditional monetary policy and exchange rate instruments to fine tune the economy. In this regard, the role of monetary policy has become limited, implying that the interaction between monetary and fiscal policies in Zimbabwe takes a different dimension. Fiscal policy is dominant under the multicurrency system, therefore there is need for the Zimbabwean Authorities to ensure that there is fiscal sustainability.

Historically, Zimbabwe faced significant fiscal challenges as exhibited by huge fiscal deficits averaging more than 9% of GDP for the period 1980 to 2008. The country adopted the multicurrency system in 2009 to stabilise the economy and this resulted in economic activity rebounding, on the back of an improved business environment. In this regard, growth in gross domestic product rebounded to an overage of 10.6% over the period 2009 to 2012, while annual inflation was below 5%. Fiscal performance also improved since the inception of the multicurrency system, with fiscal deficits averaging less than 3%. This was aided by the concomitant implementation of the cash budgeting framework since 2009.

In the absence of a local currency, the impact of fiscal policy on the smooth functioning of the monetary policy is expected to be minimal. It should, however, be noted that fiscal policy can affect monetary policy through its impact on interest rates andfinancial stability.Despite adopting a cash budgeting system in 2009, Government of Zimbabwe (GoZ) has since 2013 turned to domestic borrowing on the back of declining revenues. The increased recourse to domestic borrowing, may have resulted in higher market lending rates and the crowding out of private investment.

There are few studies on the interaction between fiscal and monetary policy in Zimbabwe and these have mainly concentrated on the impact of fiscal deficits on inflation. Most of the studies were done for the period prior to 2008. Makochekanwa (2011) examined the causality between government deficits and inflation and observed that there exists a causal link from the budget deficit to the inflation rate. He concluded that the monetisation of the budget deficit impacted negatively on inflation. Kararach et al (2010) also argued that the prime source of Zimbabwe’s hyperinflation was excessive money printing to finance huge budget deficits.

The rest of the study is organised as follows: Section II, provides an overview of trends in fiscal developments including institutional arrangements. Section III reviews theoretical and empirical literature, while methodological issues are addressed in Section IV. Section V analyses the results based on the empirical findings. Section VI proffers policy recommendations.

2.TRENDS IN FISCAL PERFORMANCE IN ZIMBABWE

This section reviews fiscal trends in Zimbabwe since independence in 1980. In addition, the section also analyses the observed relationship between fiscal and monetary variables as a prelude to the econometric analysis of the effects of fiscal policy on the conduct and transmission mechanism of monetary policy in Zimbabwe.

Zimbabwe’s fiscal performance was largely poor over the last 3 decades, starting in 1980, with fiscal deficits averaging well above 5% of GDP.The high fiscal deficits were mainly attributed to elevated Government expenditures. Figure 1 shows developments in Government revenues, expenditures and deficits since 1979.

Figure 1: Developments in Government revenue, expenditure and fiscal deficit as a % of GDP from 1980 to 2014.

Source: Ministry of Finance and Economic Development, Zimbabwe (Various Publications)

Revenue Performance

Government revenue averaged 26% of GDP between 1980 and 2014. Value-Added Tax (VAT) dominated the revenues, accounting forabout 30% of the total revenue collected between 1980 and 2014. Equally important were individual and corporate taxes which also contributed about28% of total revenues over the same period.

In a bid to improve revenue collection, GoZ made several institutional changes. Notably, the GoZ established the Zimbabwe Revenue Authority (ZIMRA)in 2001 a semi-autonomous institution, which merged the former Department of Taxes and Department of Customs and Excise. This resulted into a leaner organisation and boosted revenue collections.

To increase the contribution of indirect taxes as well as to expand the tax base, the countryintroduced value-added tax(VAT)in 2004. The introduction of VAT at a 15% standard rate improved the performance of indirect taxes. Over the years, the GoZ has been introducing and refining tax policy with the view to improve revenues. In light of the increasing informalisation of the economy, government introduced presumptive tax to cater for business that do not keep proper books of accounts such as informal and cross border traders, transport operators, hair dressing saloon operators and small scale miners.

Government also introduced the Large Client Office in 2010 aimed atproviding a one-stop-shop service to large clients in the administration of Income Tax, Pay As You Earn (PAYE) and Value Added Tax (VAT). In the same year, the GoZ also introduced VAT fiscalisation process for operators with a certain threshold. This involved theconfiguration of fiscal devices to enable them to record sales and other tax information on the read-only fiscal memory at the time of sale for use by the tax authorities in Value Added Tax (VAT) administration.

Expenditure Performance

Government expenditures have been elevated, averaging about 36% of GDP between 1980 and 2014. Recurrent expenditure has dominated Government spending since 1980, with expenditure on social spending and employee compensation accounting for an average of 80% of total expenditure. The huge recurrent expenditures crowded out productive capital expenditures such as spending on infrastructure.Figure 2 below shows the composition of government expenditure since 1980.

Figure 2: Composition of Government Expenditure: 1980-2014

Source: Ministry of Finance and Economic Development, Zimbabwe (Various Publications)

Salaries and wages have been the largest single expenditure head since 1980. The wage bill increased from around 39% of total expenditures in 1980 to about 70% in 2014.Figure 3 below shows the proportion of employee compensation to recurrent expenditure.

Figure 3: Employee compensation versus other Government expenses

Source: Ministry of Finance and Economic Development, Zimbabwe, (Various Publications)

With government spending dominated by recurrent expenditures, capital expenditure received low allocations, impacting negatively on infrastructure development over the years.Government expenditure performance has also been affected by expenditure overruns by respective line Ministries.With a view to control expenditure overruns, Government set up the Implementation and Control of Expenditure Unit which validates expenditure requests from line Ministries and also ensures that the ministries do not overshot their budgetary allocations.

In 2009, Government adopted the cash budgeting system in a bid to foster fiscal discipline among line Ministries. This went a long way in reigning in expenditures by line Ministries and resulted in lower deficits. While adoption of multicurrencyin 2009 improved revenue collection,it did not alter Government’s spending pattern, as expenditure remained tilted towards employee compensation. Wages and salaries have remained the most dominant component of expenditure from 2009 to 2014.

Fiscal and Monetary Policy Interaction in Zimbabwe

The GoZ’sfiscal deficits reached peaks of 20% and 22%, of GDP in 1998 and 2000, respectively. The deficitswere difficult to address since the main expenditure head was in the form of salaries and wages. During the 1980s and 1990s the budget deficit was financed through both domestic and external sources. As a result, the country contracted huge domestic and external debt. Government faced challenges in meeting external debt obligations since 1999,resulting in the country accumulating external payment arrears.

Faced with huge budget deficits and limited financing options, the GoZmade recourse tothe monetisation of fiscal deficits. The excessive recourse to bank finance by the fiscus fuelled money supply growth, which led to an upsurge in inflation. The recourse to central bank financing impaired the smooth functioning of monetary policy, with the central bank recording significant losses as a result of financing fiscal deficits. Kovanen (2004) and Kramarenko (2010) found the prevalence of fiscal dominance in Zimbabwe prior to 2008.Munoz (2007) highlighted that as a result of money printing central government losses reached 75% of GDP in 2006. The negative impact of the fiscal deficits on monetary policy were more evident during the period 2000 to 2008, when inflation reached a peak of 231 million per cent in July 2008.

The GoZ’s failure to service its external debt led to the accumulation of external payment arrears, which wereestimated at 86% of public and publicly guaranteed debt in 2012. The perceived unsustainability of fiscal policy and debt could have had a negative impact on the credibility and confidence in monetary policy and the overall policy mix. In 2007 and 2008, the lack of confidence in monetary policy manifested itself through unofficial dollarisation and the emergence of a parallel market for foreign exchange which affected the efficiency of monetary policy. The lack of confidence in monetary policy also negatively impacted on financial stability.

The adoption of the multicurrency system in 2009 subordinated the role of monetary policy to fiscal policy. Under the multicurrency regime GoZ can no longer seek recourse tocentral bank financing. This effectively means that the government has to finance its deficits by borrowing from other financial institutions other that the central bank and from non-bank domestic sectors.

Since 2009, Government has been pursuing cash budgeting in a bid to nurture fiscal discipline. Cash budgeting was critical for fiscal consolidation between 2009 and 2011, when the economy was recovering at a fast pace. The cash budget system, however,exhibited greater vulnerabilities as the economy slowed down in 2012. Reflecting the slowdown in the economy, the GoZ increased borrowing to finance fiscal expenditure overruns.

The limited fiscal spacethat characterised the study period forced Government to seek alternative sources of finance such as issuance of TBs to finance deficits. The issuance of TBs impacts on monetary policy variables such as interest rates. In this regard, there is need for close coordination between fiscal and monetary authorities to ensure that fiscal deficits are financedon a sustainable basis.

3.LITERATURE REVIEW

Theoretical Literature

Fiscal and monetary policies are the traditional tools used by governments to achieve macroeconomic stability. Fiscal policy refers to the control of government revenue collections and expenditures to influence economic activity. Monetary policy on the other hand refers to the control of money supply or interest rates by the central bank to achieve stated macroeconomic objectives. Monetary and fiscal policy are implemented by two different bodies and, therefore, coordination of the policies is required.

A change in either fiscal or monetary policy will influence the effectiveness of the other, thereby, affecting overall policy direction. Fiscal policy affects the conduct of monetary policy through several channels, notably interest rates and exchange rates. Under fiscal dominance, for example, fiscal policy sets the general environment in which the central bank conducts monetary policy. Fiscal dominance implies that even when the central bank is independent, monetary policy can be severely limited by the stance of fiscal policy.

Sargent and Wallace (1981) focused on the impact of fiscal indiscipline on monetary policy. They argued that monetary policy and price level stop being exogenous when the fiscal deficit is predetermined and unsustainable. In this regard, fiscal sustainability is a precondition for monetary stability. The authors also introduced the concept of fiscal dominance, a scenario in which an extreme case of fiscal indiscipline has significant negative implications for monetary policy. In a broad sense, fiscal dominance occurs when it is the fiscal authorities whodetermine the extent to which budget deficits are financed through bond issuance and seignorage. In the face of fiscal dominance monetary authorities lose their ability to control inflation,whenever the real interest rate exceeds the growth rate of the economy(Sargent and Wallace 1981).