Debt-financed fiscal stimulus in South Africa

Abstract

Levels of government debt-to-GDP have been rising substantially for over a decade in emerging market economies such as South Africa, which has led to much debate around the implementation of large-scale debt-financed fiscal stimulus programs in response to the economic fallout of the global covid-19 pandemic. Debt-financed fiscal policies directly stimulate aggregate demand through government expenditure or tax cuts, but their effectiveness is highly dependent on direct crowding-out of private sector expenditure, spill-over effects to the private sector through a higher risk premium on interest rates, and the interaction between fiscal policy and monetary policy. Using an open-economy dynamic stochastic general equilibrium model for South Africa, we identify the effect of six different fiscal policy instruments on short-term and long-term interest rates. These disaggregated expenditure and revenue shocks raise long-term real yields between 18 and 29 basis points, but there are non-negligible differences in the dynamic responses to each fiscal instrument. Our main findings suggest that, in the context of fiscal sustainability, an investment-driven debt-financed fiscal stimulus programme would reduce the government debt-to-GDP ratio, especially in periods of economic slack when monetary policy would typically be more accommodative. In fact, since the global financial crisis, monetary policy has reduced the burden of fiscal adjustment in response to rising debt and a rising risk premium. But further shocks to the risk premium could offset any gains from the current stance of monetary policy (for example, a credit rating shock raises the long-term government bond rate 155 basis points).