Taming the tides of high inflation: Policy options for South Sudan
The Republic of South Sudan emerged in 2011 from decades of conflict as the world’s newest independent country, with huge state and peace building challenges, and extreme institutional and socio-economic deficits. Six years after independence, South Sudan remains one of the world’s most conflict-affected and fragile countries, unable to emerge from cycles of violence. The escalation of the war generated large displacements of population – most notably since November 2016. The famine declared in February 2017 underscores the severity of the humanitarian crisis. By July 2017 about 6 million (about 50 percent of the population) had been food insecure, 1.9 million had been internally displaced, and 2 million had fled the country.
By August 2016, South Sudan displayed all the signs of macroeconomic collapse, with output contracting, and inflation and parallel exchange market premium spiraling. While the lack of reliable information makes it difficult to assess the current state of the economy, GDP is estimated to have contracted by about 11 percent in FY2016/17 due to conflict, oil production disruptions and below-average agriculture production. On the demand side, exports and household consumption declined, while government consumption increased due to spending on defense and security operations.
The fiscal deficit remained high, although its exact magnitude is difficult to estimate given the lack of real time data. Based on the 2016/17 budget, the fiscal deficit is estimated at about 14 percent of GDP. The 2016/17 budget allocated about 42 percent of the total domestically financed budget to salaries, 19.5 percent to operating and capital expenditure, 19 percent to transfers to states and counties, and about 14 percent to peace and security.
The financing situation is dire. Not only is the government financing itself through accumulated arrears to civil servants – many of whom have not been paid for months and are probably no longer working; moreover, the government has accumulated large contingent liabilities on its balance sheet. Sources of deficit financing have dried up. Deficits associated with the war and security spending are requiring the government to cover its costs by printing money, driving inflation.
Monetization of the fiscal deficit explains to a large extent the high inflation, although there are some indications that borrowing from the Bank of South Sudan had been limited in recent months. The annual Consumer Price Index (CPI) increased by 480 percent in 2016 and by 155 percent during July 2016-June 2017, according to the latest official statistics. Notwithstanding the recent downward trend, the very high inflation continues to put many households in both urban and rural areas in a very difficult position, as they are unable to afford the minimum food basket.
The current account deficit is estimated to have narrowed to about 1.6 percent in FY2016/17 from about 6.1 percent of GDP in FY2015/16. Export revenues decreased due to declining oil prices and lower oil production. Oil production is estimated to have decreased to about 120,000 barrels per day in 2016 down from 165,000 barrels per day in 2014, itself less than half of the peak production before independence in 2011. However, imports also decreased by more than exports, narrowing the current account deficit.
The South Sudanese Pound (SSP) continued to depreciate. Following the move to a more flexible exchange rate arrangement in 2015, the South Sudanese Pound (SSP) depreciated on both the official and the parallel market. On the parallel market, it depreciated from SSP 18.5 per dollar in December 2015 to SSP 70 per dollar by August, 2016 and SSP 172 per dollar by August 2017. Political events drove the volatility of the SSP: the pound initially appreciated on the parallel market when the Government of National Unity came into place, but it later depreciated steadily, in particular after the new fighting erupted in July 2016. It has continued to depreciate steady since as instability across the country continues.
Restoring peace, including reform of the security sector, followed by efforts to rein in public sector borrowing to levels that avoid printing money are necessary preconditions for any stabilization program. The only way to halt the economic devastation is to put in place a consistent and credible macroeconomic program, with transparent administration and external support both for financing and credibility purposes.
The FY17/18 National Budget aims to restore macroeconomic stability, but lacks credibility. It puts special emphasis on controlling public expenditure, increasing non-oil revenues, encouraging investment and economic diversification and removing subsidies to the national oil company (Nilepet). The Budget also aims at refraining from borrowing from the Bank of South Sudan to bring down inflation and prevent further depreciation of the currency. Although the FY17/18 Budget foresees a two-fifth cut in expenditure in dollar terms compared to the 2016/17 budget, it is unlikely that enough cash will be available to execute all budgeted items. While it is difficult to predict the prioritization of expenditures, it is likely that the government will continue to protect security spending and core executive functions. Thus, the population will become even more dependent on humanitarian relief and donor funded development projects for access to services. Even if the economy showed some recovery starting in 2018, projections suggest that poverty will continue to rise through 2019 as economic growth is likely to be surpassed by population growth.
Taming the tides of high inflation: policy options for South Sudan
A key policy priority for South Sudan is to curb inflation. What can the country do in this regard? Countries have historically tamed extreme inflationary situations using Exchange-Rate -Based Stabilization (ERBS) plans or Money-Based Stabilization (MBS) plans. Monetary or inflation targeting has been popularly adopted by many central banks around the world as a strategy for monetary policy with the expectation that the adoption of such a monetary regime would help control money supply and reduce inflation and inflation volatility. Alternatively, an exchange rate anchor, in combination with a broader set of stabilization programs that combine fiscal prudence with a tighter monetary regime of varying forms may be another option to control inflation.
Political will is critical to pursue any stabilization plan. Peace and security remain a crucial precondition for any macro stabilization. Moreover, any reform plan requires credible commitment to take concrete steps to address the economic issues. Effective programs have sequenced the initial stabilization programs with structural and institutional reforms. The latest economic and security developments in South Sudan seem to indicate that despite the urgent need for fiscal consolidation and exchange rate adjustment, the Government continues to focus on conflict related policy choices that delay any meaningful reforms. Without clear political commitment, any stabilization plan will be meaningless.
Which stabilization path for South Sudan? Although there is a clear agreement that South Sudan needs to reform, vested interests and rent seeking behavior from the politically connected who have access to foreign currency at the official rate are preventing or delaying the reform process. There is also a lack of agreement on the specifics of the reform to support lower inflation. For example, it is not clear whether the country would be most suited to adopt a currency board approach or a full dollarization or continue with a floating regime. Finally, reforming the monetary regime involves a major change in the economic environment, and a major shock for the economy. The uncertainty surrounding the impact may add to the reluctance of the reform process.
The main challenge for developing economies, particularly for countries emerging from conflict, is to establish credibility of the chosen monetary regime through a nominal anchor. The empirical evidence is not conclusive on whether this can be done more successfully through inflation targeting or a hard currency peg or a crawling peg with a narrow band. Monetary policy becomes more effective when the central banks are successful in leading inflation expectations and can credibly alleviate the traditional short-term trade-off between inflation and unemployment. The success of any monetary regime is directly associated with forward-looking behavior, which, in turn, highlights the relevance of credibility. This aspect is particularly relevant for developing and post-conflict economies. A strong and credible commitment to maintaining low inflation through any monetary regime credibility thus fosters an environment that stimulates output growth.
Under South Sudan’s current managed floating exchange rate regime, a monetary policy regime (without an exchange rate anchor) would require an explicit and clearly understood alternative nominal anchor. Theoretically, the country could initially implement a plan based on targeting the growth rate of money and then, over time, transition to inflation targeting. Compared to inflation targeting, using the growth rate of money as the nominal anchor can be implemented by a central bank with relatively less independence. Targeting the growth rate of money imposes some limits to the discretionary actions of the central bank because it requires this institution to follow a specific rule. The public can easily observe the compliance of this rule so any deviation would result in an increase in inflation expectations and the collapse of the plan. This suggested path was followed by some countries in Latin America, such as Mexico or Peru, which started targeting the rate of money growth and after a few years moved to inflation targeting.
If South Sudan decided to adopt MBS, it would need to ensure that the exchange rate regime is compatible with macroeconomic fundamentals and closes the gap between the official and the parallel rate.