The “Fragile Five” is the popular term first coined by an analyst at Morgan Stanley and refers to the 5 emerging economies that have persistent current account deficits. These “Fragile Five” economies include: Brazil, India, Indonesia, South Africa and Turkey (Morgan Stanley, 2013). The “Fragile Five” are of interest because they consistently rely on significant capital inflows to finance their existential growth ambitions. Given their reliance on financial inflows, any volatility in international capital markets, will inevitably cause erratic changes in their exchange rate. This causes obfuscation within the various local economies. Given this, it would be worthwhile to focus exclusively on one of these countries, South Africa, and the policy instruments that can be applied to decrease the current account deficit. The Mundell- Fleming framework will be used as a means of explaining the efficacy of the various instruments available to policy makers in South Africa. This analysis will further discuss the effects of monetary policy on an economy on the brink of a recession. Finally, this post will propose alternative strategies that can be adopted to correct the current account deficit.
Since the reintegration of South Africa into the international monetary system in 1994, the country has improved its reputation as an African powerhouse. This has resulted in an increase in foreign capital inflows into the country that has financed a persistent current account deficit of 4.4% per year. These foreign capital inflows consist of both portfolio and foreign direct investment (The World Bank, 2016). This development has taken place in a relatively stable macroeconomic environment. That said policy makers, labor unions and economists remain skeptical regarding the sustainability of such a deficit. Given this, the Mundell-Fleming model is a powerful pedagogical tool that can be applied to South Africa’s current account challenge. Moreover, the model provides a framework that acts as the starting point to suggest effective use of expenditure switching, changing and direct control policies available to South African policy makers (Salvatore, 2001).
In order to understand which policies are effective under this framework, it is important to highlight the degree of openness and capital mobility within South Africa. That is, South Africa’s economy is characterized by a high level of openness. A historical measure of the country’s export and imports as a percentage of GDP is significantly higher than the world average (Bhorat, Hirsch, Kanbur, & Mthuli, 2013). Moreover, the country has a highly sophisticated and robust financial system that ranks 12th in the world (Schwab, 2015). This has provided the country with a significant amount of capital mobility that is both a blessing and a curse. That is, the South African economy’s flexible exchange rate is currently ranked amongst the most volatile in the world (Bond, 2016).
The Mundell-Fleming proposes that, given South Africa’s flexible exchange rates, high level of capital mobility and openness, the country’s policy makers should adopt expansionary monetary policy. That is, the central bank should increase the money supply which will induce a decrease in interest rates. This will lead to capital outflows that would depreciate the currency. The short term consequences of the central bank’s expansionary monetary policy would actually be an initial widening of the current account balance. That is, until the J-curve effect sets in exports start to increase over time. In the long run however, this depreciation stimulates output and employment through an increase in exports and the production of import substitutes (Salvatore, 2001). Put another way, exports and output will increase and imports will decrease. The criticism with this approach is that even though the country will be able to generate a trade surplus, it will be at the expense of a decrease of society’s welfare due to the high cost of inflation.
Expansionary monetary policy in an international system dominated by investors seeking attractive yields may cause serious portfolio investment outflows. That is, the United States, with its integral role in the international monetary system, is likely to increase interest rates as the country experiences robust economic growth and labor market gains. This could lead to billions of dollars whipped out of the local economy (Winsor, 2015). Notwithstanding, it is not in the interest of the central bank’s to pursue expansionary monetary policy at the expense of an increase in inflation.
Researchers at the African Development bank and other research agencies have argued that there are other ways to improve the trade balance. The starting point of the argument is that South Africa’s persistent current account deficit does not pose an existential threat to the economy. That is, a deep dive into the composition of South Africa’s trade suggests that the country is largely importing capital goods such as machinery and electronic equipment (Workman, 2016). Various researchers such as Hausman (2008) and Draper and Freytag (2008) suggest that instead of increasing exports through expansionary monetary policy, the country should direct trade policy towards improving competition and efficiency within the economy. That is, the country should recognize the importance of the aforementioned composition of imports as a means for the economy to both grow and diversify is export basket.
This policy should be complemented with the government ensuring a more stable inflow of capital inflows. That is, the government should ensure that it minimizes public sector debt that crowds out investment. This in turn will promote Foreign Direct Investment (FDI) rather than portfolio inflows. These FDI flows are longer term in nature and will provide a safety net against the volatile and fickle nature of portfolio investments (Khan, 2016). This policy should be coupled with improved oversight and regulation of illicit financial outflows from the South African Reserve Bank and Revenue Service respectively (Bond, 2016).
In addition to improving the level of efficiency within the South African economy, policy makers should also ensure that reevaluate the direct controls and tariffs imposed. More specifically, policy makers should reevaluate the existence of tariffs on intermediate goods that act as a tax on companies that use these goods as inputs for exports as a means of improving the competitiveness of South African goods on the international market (Draper & Freytag, 2008).
In concluding, this post presented a potential solution to South Africa’s persistent current account deficit. That is, economic theory proposes that expansionary monetary policy would allow the country to increase exports, economic growth and decrease imports. That said, the Reserve Bank, faces the challenge of increasing interest rates in the United States and capital outflows. Therefore, expansionary monetary policy would have severe ripple on effects on the exchange rate and inflation within the country. Alternatively, this post suggests that policy makers should direct trade policy towards improving the competiveness of the country’s exports, minimizing government debt, severing illicit capital outflows and direct efforts to create a macroeconomic environment that promotes FDI flows rather than portfolio flows. The Reserve Bank is in a precarious position in terms of its ability to directly influence the current account deficit. That said, policy makers across various functions will need to work together in order to ensure that the economy is robust enough to improve its trade balance over time. The solution is not an easy one, but necessary nonetheless.