Rule out use of the Reserve Bank’s balance sheet to finance state debt

But the central bank should keep stepping in to maintain financial and price stability during Covid-19

The gravity of the Covid-19 crisis has encouraged long lists of policy interventions, and shorter lists of how these should be prioritised or financed. Given SA’s serious fiscal constraints, the belief that the Reserve Bank’s balance sheet offers a costfree alternative to funding these priorities is not only deeply misguided — it is dangerously widespread.

As policymakers prepare to deploy the full arsenal of policy tools in the fight against the economic devastation of the coronavirus pandemic and lockdowns, discussions around the role of so-called “balance-sheet policies”, including quantitative easing (QE), by the Reserve Bank are intensifying.

Of course, calls for the Bank to make wider use of its balance sheet predate the current crisis. In June 2019, ANC secretary-general Ace Magashule suggested an exploration of QE “to address intergovernmental debts and make funds available for developmental purposes”. It was a preposterous suggestion then. And it still is, if the suggestion was that the Bank bail out any of the ailing state-owned entreprises.

This weekend, deputy finance minister David Masondo encouraged the Reserve Bank to use its balance sheet, one-off, to finance health-related interventions and economic recovery measures. Given the severity of the economic disruption that has only just started, a legitimate debate over the appropriate scale and scope of balance sheet policies by the Bank should be welcomed.

Let us consider first the least controversial of contexts in which the central bank’s balance sheet can — and we would argue should — be used. Central banks have a mandate to promote (and in cases ensure) financial, and price, stability. Indeed, a renewed focus on the financial stability function after the 2008 global financial crisis has returned central banking to what monetary economist Charles Goodhart calls its “essence”: its power to create liquidity in times of crisis.

Under normal circumstances, central banks undertake open market operations in short-term money markets, so as to keep market interest rates in line with the official policy rate. However, in times of financial distress, things become more complicated. A disturbance to the ordinary functioning of financial markets can hinder the transmission of the central bank’s policy rate to the real economy and prices. In Goodhart’s words, “liquidity management takes on a life of its own, potentially independent of official interest rates”.

The expanded use of the central bank’s balance sheet to manage liquidity has become commonplace in recent years. After the global financial crisis in 2008, the world’s leading central banks established new liquidity facilities to complement their ordinary open market operations, and stepped in to promote liquidity and ordinary borrowing and lending among banks by buying their mortgage-backed securities, asset-backed commercial paper and other collateralised debt obligations.

Interestingly, the SA Reserve Bank has already used its balance sheet to great effect during this crisis to promote financial stability. In mid-March, extreme risk aversion in global financial markets temporarily undermined the proper functioning of the SA bond markets. The Bank stepped in to buy bonds in the secondary market, providing liquidity to a market that has since functioned smoothly. This is an entirely appropriate policy objective.

The second, and more controversial, use of balance sheet policies has emerged in response to the reality of deflation, or the risk of its imminent emergence, when policy interest rates are already at or near the zero lower bound. In these cases, the policy objective is to inflate the economy and return to low and stable inflation rates. Since the zero lower bound constrains the central bank’s ability to inflate the economy, its balance sheet offers an alternative, complementary, policy tool.

It is possible for the central bank to use its balance sheet — that is, create local currency liabilities — to buy longer-dated government bonds. This lowers the cost of borrowing, both for the government and other borrowers whose interest rates are affected by yields in the bond markets. But it bears repeating that the objective of this policy is to create inflation in circumstances of deflation. A similar intervention while the economy has an inflation rate of 4.1% — last month’s rate in SA — is sure to create inflation too.

However, forecasts of SA inflation are much lower, with the Bureau for Economic Research at Stellenbosch University predicting headline inflation to average only 2.8% in 2020, that is, at the lower bound of the 3%-6% target range. Given the adverse supply and demand shocks to the economy, and dire international prospects, the Bank has already cut the repo rate to 4.25%, while the monetary policy committee’s April statement provided the market with forward guidance of a further 25 basis points cut between April and the first quarter of 2021. If the zero lower bound became relevant, these options will be available to the Bank, and the objective will be inflation.

It is not necessary to dwell here on the problematic track record of these balance sheet interventions when used as an antideflation policy, as the SA debate has taken a different turn. In recent weeks we have been assured the Bank can create rand liabilities and use these to provide "outright monetary finance" for the government. What is more, such finance will come at no cost.

It is incoherent to argue that the use of the Bank’s balance sheet with the explicit purpose to finance government expenditure will not come with the cost of inflation. The implications of outright monetising debt will run along the same channels as the balance sheet interventions at the zero lower bound. Increased rand liabilities will lead to rand depreciation — as the dollar did following QE by the US Federal Reserve — which will raise local inflation and bond yields, with spillover to all other local capital markets.

The reason this can happen, even in an economy with apparently low inflationary pressure, is that the Bank’s creation of rand liabilities in an open economy offers a direct mechanism to inflate local prices. This is why the monetary economist Lars Svensson called such balance sheet policies a “foolproof” exit from deflation. It is no less foolproof as the route to inflation. In addition, such policies risk the hardwon independence of the Bank, especially when it is expected to buy bonds in the primary market, thus financing the government directly.

In summary, the Bank should continue to step in to maintain financial stability. Beyond this, the use of QE to stimulate demand would have to be meticulously calibrated and communicated. It would need to present evidence of deflationary risk, despite near-zero nominal policy rates.

A communication strategy highlighting an exit plan from the treacherous path of subsidising the government’s cost of borrowing would be essential. The suggestion that the Bank can systematically monetise the state’s debts should be ruled out in no uncertain terms. Above all, we need to preserve and treasure the independence of our central bank. Economics teaches us that choices have consequences. In the case of outright monetary finance, the cost would be measured in inflation and the loss of the Bank’s independence.