metadata: authors: 0: author: Amra,Rashaad
1: author: Hanusch,Marek
2: author: Jooste,Charl
count: World
docna: 0: docna: When the Cycle Becomes the Trend : The
            Emerging Market Experience with Fiscal Policy during the
            Last Commodity Super Cycle
docty: Policy Research Working Paper
subtopic: Macro-Fiscal Policy,Economic Adjustment and Lending,Public Finance Decentralization and
            Poverty Reduction,Public Sector Economics,Commodity Risk Management,Public Financial Management,Administrative & Civil Service Reform,Public Sector Administrative and Civil
            Service Reform,De Facto Governments,Democratic Government,Public Sector Administrative & Civil
            Service Reform,Economic Growth,Economic Theory & Research,Industrial Economics
teratopic: Agriculture,Public Sector Development,Social Protections and Labor,Governance,Macroeconomics and Economic Growth,Industry
abstracts: cdata!: Fiscal buffers have shrunk across the
            world. This paper argues that limited fiscal room in
            emerging market economies today is partly due to the
            commodity super cycle of 2000-15. The super cycle created
            the mirage that economic performance had structurally
            improved, mistaking a long, commodity-fueled uptick in the
            business cycle for higher trend growth. This thinking
            supported fiscal expansions. When the commodity boom ended,
            it became apparent that countries had saved less than they
            should have, and that fiscal policy had, perhaps
            inadvertently, been pro-cyclical. It left countries with
            depleted fiscal buffers and large budgets when the cycle
            came to an end, limiting room for fiscal stimulus when
            needed. The paper illustrates the argument with reference to
            the South African experience.
repnme: repnme: When the Cycle Becomes the Trend : The
            Emerging Market Experience with Fiscal Policy during the
            Last Commodity Super Cycle
display_title: When the Cycle Becomes the Trend :
            The Emerging Market Experience with Fiscal Policy during the
            Last Commodity Super Cycle
listing_relative_url: /research/2019/01/30770297/cycle-trend-emerging-market-experience-fiscal-policy-during-last-commodity-super-cycle
topicv3: Economic Growth m1326241 471,Public Finance Management m1326316 716,Employment and Wage Data m1327013 2055,Fiscal Policy m1327144 445,Commodity and Resource Prices m1503849 3034
publishtoextweb_dt: 2019-01-18T00:00:00Z
historic_topic: Agriculture,Public Sector Development,Social Protections and Labor,Governance,Macroeconomics and Economic Growth,Industry
no_of_pages: 30
author_keys: 0: author_key: 1045860
1: author_key: 1368476
model_extractions: WPS8712 Policy Research Working Paper 8712 When the Cycle Becomes the Trend The Emerging Market Experience with Fiscal Policy during the Last Commodity Super Cycle _Rashaad Amra Marek Hanusch Charl Jooste_ Macroeconomics, Trade and Investment Global Practice January 2019
Policy Research Working Paper 8712

# **Abstract**

Fiscal buffers have shrunk across the world. This paper argues that limited fiscal room in emerging market economies today is partly due to the commodity super cycle of 2000–15. The super cycle created the mirage that economic performance had structurally improved, mistaking a long, commodity-fueled uptick in the business cycle for higher trend growth. This thinking supported fiscal expansions.

When the commodity boom ended, it became apparent that countries had saved less than they should have, and that fiscal policy had, perhaps inadvertently, been pro-cyclical. It left countries with depleted fiscal buffers and large budgets when the cycle came to an end, limiting room for fiscal stimulus when needed. The paper illustrates the argument with reference to the South African experience.

This paper is a product of the Macroeconomics, Trade and Investment Global Practice. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http://www.worldbank.org/research. The authors may be contacted at mhanusch@worldbank.org.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
# When the Cycle Becomes the Trend: The Emerging Market Experience with Fiscal Policy during the Last Commodity Super Cycle

Rashaad Amra<sup>*</sup> , Marek Hanusch<sup>+</sup> and Charl Jooste<sup>+</sup> JEL Classifications: C54, E02, E62, F41 Keywords: Fiscal policy, commodity super cycle, business cycles

> * Parliamentary Budget Office, South Africa

> + Global Practice for Macroeconomics, Trade and Investment, The World Bank

> _____________________________ The views expressed do not necessarily reflect the views of the Parliamentary Budget Office or The World Bank. The authors would like to express their thanks for various contributions and comments to Asli Senkal, Dinar Prihardini, Ha Nguyen, Sudarshan Gooptu, Vincent Dadam, and Sebastien Dessus. The paper draws on quantitative text analysis conducted by Slava Mikhaylov.
# 1. Introduction

Fiscal stabilization works to effectively maximize the effects of fiscal policy on output while avoiding a sustainability trap (both from a liquidity and solvency perspective). If governments run large deficits and accumulate debt it detracts from future spending as financing deficits requires revenues to service debts and/ or spending cuts. Consequently, the “when and how” to spend are critical for fiscal policy plans. During economic downturns, fiscal policy can be used to cushion some of the adverse economic shocks and help stabilize the business cycle. However, the scope of economic downturn intervention is partly determined by how much fiscal space government created during economic booms. A large saving during booms implies that governments have more room to intervene during recessions. However, fiscal policy can destabilize the business cycle by being procyclical – that is, expenditures increase when there are booms and decreases when there are recessions. This type of policy may prolong business cycles and may create fiscal sustainability concerns, limiting the generation of fiscal buffers.

In this paper we analyze the fiscal stance of selected emerging markets and developing economies (EMDEs), and how the commodity super cycle affected it. South Africa will serve as an illustration of our argument. In a nutshell, we argue in this paper that the long commodity super cycle created the mirage among policy makers that the cycle had become the trend, in other words, that growth had structurally—rather than temporarily—increased. This allowed for higher expenditures, commensurate with higher economic potential. This miscalculation inadvertently supported pro-cyclical policy, as expenditures rose with the (long) cycle rather than with potential. When the cycle ended, it became clear that governments had saved less than they should have to create the fiscal buffers needed to stimulate their economies.

Commodity super cycles are not infrequent. According to World Bank (2015), four commodity super cycles can be distinguished since the 19<sup>th</sup> century: from 1894 to 1932, from 1932 to 1971, from 1971 to 1999, and, most recently, from 2000 to 2015. We focus on this most recent commodity super cycle. Figure 1 illustrates the magnitude of the cycle for key commodities.

**Figure 1: The 2000-2015 commodity super cycle**

_(index, 1990=100, real 2010 US dollars)_ <!-- Start of picture text --> 400<br>350<br>300<br>250<br>200<br>150<br>100<br>50<br>0<br>Energy Agriculture Metals & Minerals Precious Metals<br>1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017<br><!-- End of picture text --> Source: World Bank Pink Sheets, 2018. Note: Agriculture includes beverages, food, and raw materials (timber and other).

EMDEs managed to significantly reduce public debt levels during the early 2000s, partly with the additional resources associated with the commodities boom. Public debt fell from 52.1% of GDP in 2002 to 33.9% by 2008 (Figure 2). Then the global financial crisis struck, followed by a global economic downturn. Commodity prices dipped briefly in 2009, but returned to elevated levels until 2
about 2015 (led by a plummeting oil price). In response to slow growth, debt levels started rising again, reaching 49.0% by 2017. A large number of EMDEs saw their sovereign credit ratings downgraded since about 2016. South Africa lost its investment grade credit rating in early 2017. Fiscal buffers are depleted in many EMDEs, making them vulnerable to an economic downturn. Rebuilding those buffers is critical (World Bank, 2018), as is ensuring that the mirage of _the cycle is the trend_ does not undermine fiscal policy in the future. Great care is needed in producing economic forecasts, especially during commodity super cycles, paying close attention to distinguishing structural from cyclical factors.

**Figure 2: Public debt in advanced and emerging economies**

_(gross public debt in percent of GDP)_ <!-- Start of picture text --> 120<br>100<br>80<br>60<br>40<br>20<br>0<br>Advanced economies Emerging market and developing economies<br>2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017<br><!-- End of picture text --> Source: IMF World Economic Outlook, April 2018.

This work builds previous research that looks at long cycles and fiscal policy (Strawczynski and Zeira, 2013) as well as commodity prices and fiscal policy (Cespedes and Velasco, 2013). The innovation of this paper is to understand the stance of EMDE countries using the combined _the cycle is the trend_ methodology while controlling for commodity price cycles. In addition, we argue that a fiscal stance need not be fixed over time (something that is commonly assumed). We extract time varying parameters that measure the fiscal stance over different periods.

In the next section we use the simple theoretical framework of Strawczynski and Zeira (2013) to illustrate how a structural shift in gross domestic product (GDP) translates into higher expenditures. If a cyclical uptick in growth is mistaken for an increase in trend growth, this increase in expenditure will, unintentionally, constitute pro-cyclical fiscal policy. We then turn to an empirical investigation of fiscal policy in EMDEs during the last 20 years, demonstrating that the latest commodity boom has indeed lengthened business cycles, posing one possible explanation for the pro-cyclical policy stance in our sample of EMDEs.

We then zoom into the South African experience, as the commodity boom had a particularly strong impact on lengthening the South African business cycle. We show how this supported overly optimistic growth forecasts, being one of the likely factors explaining an increase in expenditures and a reduction in fiscal buffers that limit South African policy space today.

# 2. A Simple Framework of the Government’s Fiscal Policy Stance

The model of Aguiar and Gopinath (2007) explicitly decomposes shocks into trends and transitory shocks and illustrates that it is optimal for governments to stimulate the economy and smooth out consumption if there is a negative transitory shock. Similarly, it is optimal for government to reduce 3
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> n= ~~[2Sp71~~ |+y(a-olA :1-6 f=)B ~~—=~~ OH ~~ae~~ =U'U'C)e pt— y y=-. ~~S=~~ OH -ya-pa-o|a, -*_ F|
yeu'e"a—pya-oa ¢* F] <!-- Start of picture text --> U"(C)e~P* — puU'(C)ePh’ =<br>"( C)— Pt pu'(c)et = U'(C)e PABA, ¢? F|<br>—pt U'(C)<br>T oeMa o[K*<br>- o() -—o-1 dC. = p-a-pa-ofa re_ f<br>._ dcr<br>© at<br>— [a-pa-nla -* Flo]<br>eek Peeey<br>t<br>((1-£)G -7) [|B- —p<br><!-- End of picture text -->

t= TY o=1 t=tY t = BY:
<!-- Start of picture text --> “The cycle is the<br>” Business<br>trend .<br>cycley<br>6 ore<br>oO -<br>2a Actual trend<br>a ne r oe<br>a =e" -~<br>|<br>Qa ao" Mirage of a aa tonne”<br>negative Actual<br>output gap negative<br>output gap<br>i<br>Time<br><!-- End of picture text -->

t = SBB, + ABB, t t Vt) ay t t Vt
price effects we construct a real commodity export price index as in Keyfitz (2004) that is weighted by trade shares using the World Bank WITS data set and deflating it by the GDP deflator for each country. We take a simple HP-filter on this series to get the commodity price cycle (CMD� � �CMD� �CMD���) (see Alberola et al. (2016) for an alternative measure).

� where the weights w� are calculated using the share of each commodity (Pcomm�) in total country exports in the base period (the average observed between 2009-2011) deflated using GDP deflator (P��).

The output gap minus the fitted line on the real commodity price gap yields an estimate of the noncommodity output gap :

# **_Cyclicality of Fiscal Policy: The Role of Cyclical Lengths_**

To investigate the possibility that policy makers incorrectly identified long-term growth, and adjusted their fiscal policy accordingly, we follow Strawczynski and Zeira (2013). They show that the extent to which expenditures respond to output depends on the length of the cycle. This is related to the simple illustration in the theory section above. Fiscal policy is prone to become procyclical in cases where shocks lengthen the duration of the cycle. We follow Strawczynski and Zeira (2013) and Aguiar and Gopinath (2007) to create a variable that measures how the cycle becomes the trend: Where y� is the log of per-capita real GDP and K is the number of lagged differences. We normalize � � the above to one using σ∆��� �σ∆� and express the time sequence as: This ratio provides a measure of long-run variability to short-run variability, or the degree to which the cycle is the trend. If the standard deviation of per capita real GDP for any period lagged is the same as the difference of one period lagged, then there is no cyclical trend. However, we interpret a persistent cycle as one where the lagged variance to that of one period ago is larger than one. Note that equation (10) essentially boils down to a variance ratio test (see Cochrane, 1988). In essence, it is testing for a random walk in GDP vs. temporal shifts in GDP. If GDP is trend stationary, then GDP will fluctuate around that trend over time – implying that shocks to GDP are only temporary. If GDP is a random walk with drift, then shocks may push GDP on different paths (i.e. there is no reason to assume trend correction). One way to interpret (10) is that a value of C� �1 implies a random walk, C� �1, implies mean reversion and C� �1 implies some very persistent movements in output. Table A1 in the annex summarizes the statistical significance for each country for various horizons.

In our sample, South Africa has the largest persistence (Figure 4): the long-run variability of output to short-run variability is more pronounced compared to its peers, reaching a maximum of about 12 years (this compares well with the average duration of business cycles as estimated by the South African Reserve Bank (according to the 2018 Quarterly Bulletin). The _trend is the cycle_ indicator is above 1 for most countries, indicating that cycles are persistent. The persistent cycle could create the illusion that GDP is on a long-term higher trajectory and could lead to fiscal policy becoming procyclical.

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**Figure 4: Variability in output cycles in selected EMDEs**

_(Long-to-short term variability of GDP per capita at various lags)_ <!-- Start of picture text --> 4.0 ZAF BRA<br>IND BWA<br>3.5 RUS MEX<br>PER IDN<br>3.0<br>TUR<br>2.5<br>2.0<br>1.5<br>1.0<br>0.5<br>0.0<br>1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27<br>K<br>Relative Variances at K<br><!-- End of picture text -->

# Source: Authors’ calculations.

Note: ZAF: South Africa; IND: India; RUS: Russia; PER: Peru; TUR: Turkey; BRA: Brazil; BWA: Botswana; MEX: Mexico; IDN: Indonesia.

Finally, a measure that captures _the cycle is the trend_ is calculated by taking the above indicator (equation 10) and multiplying it by the smoothed (three-year moving average) growth in per-capita GDP: As with the non-commodity output gap, we also compute the non-commodity CITT variable as: Figure 5 provides a sense of how much the commodity cycles in each country contributed to larger growth rate than what would have been observed without movements in real commodity prices. The left panel highlights CITT before the crisis in 2007, the center panel compares CITT and CITT excluding commodity price movements during 2009, and the right panel provides an estimate of the two CITTs in 2016. A 45-degree line divides the charts in two.

Note that the majority of the countries are to the right of the line in 2007 – non-commodity CITT was much lower relative to actual CITT, which supports the hypothesis that commodity prices cycles prolonged the economic cycle. During the financial crisis, countries moved closer to the 45-deggree line, implying that the effects of commodities contributed little to the economic cycle.

8
<!-- Start of picture text --> Cycle is the trend before crisis = 2003 Cycle is the trend before crisis = 2007<br>88<br>&05- =e os-<br>3 3 ZAF «<br>8 AUS 8 ga, ° (RUS<br>2 ZAF 2 5<br>= ° ND, =<br>5 e 5<br>0.5- 0.5-<br>0.5 0.0 0.5 0.5 0.0 0.5<br>cnt cnr<br>Cycle is the trend during crisis = 2009 Cycle is the trend after crisis = 2016<br>& 05- a 05-<br>8 oN 8 .<br>33 00- Z8° ° ZAFeB ND -* 3o 00- st bee. 90 9 bad<br>&&B°.<br>rs)E. rs)5 ° . (ZAF<br>RUS<br>0.5- 0.5-<br>0.5 0.0 0.5 0.5 0.0 0.5<br>cit cnr<br><!-- End of picture text --> A(—SBB;r) _= Ooi + OtVieNC + it Alog(G;,) =_ Ooi + Ait itNC t+ €it oi = Yoo + Uj 00 i at =Yor +t Yor t+Ut t t it~N(O,<sup>o</sup> 2<sup>)</sup> . 0 2 ( i 00 t)=n( **0** 1) 1t > 9 1,t > 0
<!-- Start of picture text --> Alog(Git) = fC CITTAS) Alog(Git) = fC CITTA') A(-SBBit) = fGND A(-SBBit) = f ON)<br>0,1<br>1,t<br>2<br>00<br>2<br>01<br>2<br><!-- End of picture text --> <!-- Start of picture text --> S<br>3<br>28<br>A o<br>iy<br>w8<br>E® Oo<br>58<br>Bogo 2<br>zo<br>=<br>3<br>:-| SERRE<br>2003 2005 2007 2009 2011 2013 2015<br><!-- End of picture text -->

<!-- Start of picture text --> ©<br>2<br>os<br>2&3 oY<br>:<br>=<br>8<br>=2<br>7<br>| onl olli ieole<br>rr ss ss Os cs Os a<br>2003 2005 2007 2009 2011 2013 2015<br><!-- End of picture text -->
# 4. Fiscal policy and _the cycle is the trend_ in South Africa

Since democracy in South Africa in 1994, three distinct phases characterized fiscal policy. The end of Apartheid heralded a period of debt repayments. South Africa repaid legacy debt to external creditors and pursued consolidated fiscal accounts. In its annual budgets following the transition to democracy in 1994, it identified fiscal consolidation as the country’s main fiscal policy objective – a continuation of the fiscal policy objective from 1992 (National Treasury, Budget Reviews 1994 - 1997). In a context of inherited national debt amounting to 48.7% of GDP, together with weak revenue collection, the government identified the need to reduce the budget deficit and government dissaving (borrowing), moderate government consumption expenditure as a share of GDP, and avoid a permanent increase in the tax burden as its main fiscal policy goals (Budget Reviews 1994 – 1998). The government affirmed this policy stance over the subsequent years until 2001 (Budget Reviews 1999 – 2000). From 1998 onwards a more pronounced emphasis on fiscal sustainability, and an attempt to link expenditure growth to economic growth can be observed. By the 1999 Budget, following poor economic growth in the previous year, the government deferred its fiscal deficit target – an early case of fiscal responsiveness to economic performance.

From 2001, the government stated its intention to shift towards an expansionary fiscal policy stance to support the economy, investment and social spending. It noted that the fiscal consolidation of the previous years (1994 – 2000) provided the basis upon which to embrace its expansionary fiscal policy stance. South Africa reduced gross debt from 41% of GDP in 2001 to 26% of GDP in 2009 by running primary surpluses and acquired favorable credit ratings (Figure 7). This period also coincided with real commodity price increases, which benefited commodity trade. GDP growth was on an upward path, which together with an improvement in tax collection methods led to increase in revenues. Sustained strong growth over this period seemed like a permanent shift in GDP. This period also saw a permanent shift in revenues, which allowed for sustained real growth in expenditure. Public expenditure<sup>2</sup> increased from 24.4% of GDP in 2001/2002 to 24.9% of GDP in 2007/2008, while revenues<sup>3</sup> increased from 23% of GDP in 2001/2002 to 25.9% in 2007/2008 (Budget Reviews). Both revenues and expenditures outpaced nominal GDP growth, reflecting a wider tax base, profitable institutions, higher returns to factor inputs, and most likely spill-overs from commodity prices.

It was only in 2007 that the government identified the relationship between its fiscal policy stance and the economic cycle through the introduction of the concept of a cyclically-adjusted budget balance in its 2007 medium-term budget (MTBPS 2007, Budget Review 2007). In 2009, as the country experienced the effects of the global financial crisis, the government retrospectively referred to its fiscal policy stance over the previous period (since 2001) as countercyclical, and explicitly committed itself to a countercyclical fiscal policy. In subsequent budgets, the government affirmed its counter-cyclical fiscal policy stance, and stated its objective of counteracting variations in the business cycle and supporting growth through public spending. It identified countercyclicality as one of the principles underlying fiscal policy in South Africa (Budget Reviews 2008 – 2014). The fiscal policy response during this period seemed standard and appropriately countercyclical with a combination of automatic stabilizers acting together with discretionary fiscal measures to stabilize, or spur on demand during what was likely to be its longest downward phase of the economic cycle. The economic response was muted and consequently left the government with a sizable debt burden with high interest repayments, and possibly lower long-run growth.

2 Main budget expenditure.

3 Main budget revenue.

11
<!-- Start of picture text --> 6% 55%<br>5%<br>4% 50% q<br>a<br>3% 9<br>2% 45% :<br>1% et<br>0% 40% pi<br>-1% %<br>-2% 35% 732<br>“vv<br>-3% fe)<br>30% =<br>-4% 7<br>5% 25%<br>-6%<br>-7% 20%<br>OC A & OD OD db db _@® MO O Aw OD AD wy AD 0D a 0 WO A<br>ONSWP SfSPRRSyNS eoSP WeRPFPSWPASss\WP SsEeAP PPP SsAS SsOeAP sREAP PP SoAP SPPWP SsEEWP SPPWP SsPPOP KS)GS” OPSY3PPP Ke KS oh cSOeSY AGM EenS” WPK'snO” LW cSnO” nO”<br>mm Main budget balance as a share of GDP (%) - left axis<br>== Real GDP growth (%) - left axis Lar ieee" saa<br>to downward-phase<br>«== Gross debt as a share of GDP (%) - right axis of the business cycle<br><!-- End of picture text -->
progressively narrower budget deficits, eventually realizing two years of budget surpluses. This allowed the government to reduce its debt stock (as a share of GDP) – a stated fiscal objective. Between 2009/10 – 2015/16 expenditure growth exceeded economic growth and revenue growth, resulting in sustained large budget deficits and an increased in its debt stock (as a share of GDP).

It is possible that the commodity boom period of 2001 to 2007 in South Africa would have seemed like a permanent shift in output. Government spending and revenues during this period increased rapidly. It is difficult to pinpoint whether this increase was due to an upward forecast bias in potential GDP, or whether it was intentional. There is some support that South Africa erred in terms of estimating potential GDP (Anvari et al. (2014)) after the financial crisis. Figure 8 illustrates this point, comparing the threeyear (and a few months) forecasts from the Budget Reviews and Medium Term Policy Statements (MTBPS) with actual growth outturn, i.e. it looks at the first outer year estimate/print published by the National Treasury. Figure 8a compares projections and outturn and Figure 8b looks at the cumulative forecast-outturn difference. Figure 8a demonstrates the over-optimism about future growth, following the global financial crisis and 2009 recession.

In Figure 8b, a flat line would suggest that there is no discrepancy between forecasts and outturns, a downward trend would suggest that projected growth was lower than observed and an upward trend would suggest that growth projections were larger than observed growth. The lines clearly point upwards both for Budget Reviews and MTBPSs after 2009, indicating an upward growth bias.<sup>4</sup> The optimistic bias from 2007/08 until 2016/17 in the graphs provides some evidence that potential GDP growth was perceived as much larger than it actually was.

# **Figure 8: Growth projections vs. growth realization**

_(forecasts vs. actual and cumulated projection growth differentials with actual growth)_ a) Outer-year forecast vs actual GDP growth <!-- Start of picture text --> 7%<br>Real GDP 3.25yr forecast Real GDP 3.5yr forecast<br>6% Real GDP growth Actual<br>5%<br>4%<br>3%<br>2%<br>1%<br>0%<br>‐1%<br>‐2%<br><!-- End of picture text -->

> 4 Investigating the potential biasness of the National Treasury’s GDP growth forecasts, the Parliamentary Budget Office found some statistical evidence of biasness for several forecast horizons, including the three-and-a-half and three-and-a-quarter year forecasts, with a tendency to overestimate GDP growth (Parliamentary Budget Office, 2016).

13
b) Cumulative projected growth differentials with actual growth <!-- Start of picture text --> 10.0%<br>8.0% MTBPS<br>BR<br>6.0%<br>4.0%<br>2.0%<br>0.0%<br>‐2.0%<br>‐4.0%<br>% pts<br><!-- End of picture text --> Source: Budget Reviews (BRs), Medium Term Budget Policy Statements (MTBPSs) and authors’ calculations.

Note: First print of outer-year forecast.

# **_An empirical investigation of the_ cycle is the trend** **_in South Africa_**

We now empirically look at whether the cycle is the trend mattered in South Africa. For the case study of South Africa, we develop a more sophisticated measure of the structural budget balance than in the panel analysis of EMDEs above, which is easier in a simple time-series setting. Details about deriving the structural balance can be found in Annex 2. Figure 9 plots our estimate of South Africa’s structural budget balance. It suggests that although South Africa saved between 2006 and 2008 (a positive _overall_ budget balance), the _structural_ balance was already in deficit by 2005, and deteriorated significantly between 2007 and 2009. Since 2008, both South African _overall_ and _structural_ balances were in deficit and have not recovered since. The sustained _structural_ deficits since 2005, together with corresponding _overall_ budget deficits since 2009, was chiefly responsible for South Africa’s large and sustained increase in debt since 2009, significantly reducing fiscal space.

**Figure 9: Estimates of South Africa’s budget balances**

(budget balances in percent of potential GDP) <!-- Start of picture text --> 2.0%<br>0.0%<br>‐2.0%<br>‐4.0%<br>‐6.0%<br>‐8.0%<br>‐10.0%<br>2002 2004 2006 2008 2010 2012 2014 2016<br>Recessions Budet Balance<br>Structural Budget Balance Structural Budget Balance (SS)<br>% of potential<br><!-- End of picture text --> Source: World Development Indicators and authors’ calculations 14
We augment equations (13) and (14) for South Africa and control for the effects of large policy changes to isolate the cyclical stance of the government – such as national plans that explicitly state what fiscal policy ought to do. These represent outlier cases of fiscal policy and would have an impact if any of the β� measures are significant: ������ We construct DUM� using the various policy documents from 1991 onwards. We assign a value of 1 when the document outlines a path of government that supports higher spending. This helps us to approach the narrative of policy and its relation to government outcomes and disentangle policies that were expansionary vs. contractionary (the assumption that contractionary policies do not alter the results). Annex 3 provides further information on the construction of the dummies.

Turning to the estimates of equations (15) and (16), we show that:

- Each of the policy measures (∑���� β�DUM�������) are positive and consequently lead to higher expenditures or a larger structural deficit.

- The coefficients on the trend is the cycle variable, however, is positive in all controls, indicating fiscal policy in South Africa has not really been countercyclical. This can be attributed by several factors such as correct intentions by the fiscal authorities, but missing either important turning points of the business cycle, perceiving long-cycles as the trend, poor choices on spending which are difficult to reverse such as wages or weak policy coordination where funds are disbursed and allocated but not spent on time. We discuss some of these factors in the next section.

It should be noted that our results are in line with Cespedes and Velasco (2013) who analyze the fiscal stance for commodity exporters. They study whether policy has been less procyclical or countercyclical in the recent commodity boom episode compared to previous episodes. While they find that for most countries the elasticity of overall balance to the cyclical component of commodity prices has increased, for South Africa it has become negative, implying procyclical fiscal policy during the 2006-2009 period as opposed to the 1973-1990 commodity price boom.

**Table 3: The fiscal stance of the South African government**

|||Model 1<br>∆ln�G�)|Model 2<br>∆ln�G�)|Model 3<br>∆ln�G�)|Model 4<br>∆ln�G�)|Model<br>5<br>∆��SBB�)|Model<br>6<br>∆��SBB�)|Model<br>7<br>∆��SBB�)|Model<br>8<br>∆��SBB�)|
|---|---|---|---|---|---|---|---|---|---|
||CITT|0.27**<br>(0.11)||0.24**<br>(0.10)||0.01<br>(0.02)||0.03<br>(0.02)||
||YGAP||0.85<br>(0.81)||0.69<br>(0.73)||0.94<br>(13.09)||1.18<br>(13.81)|
|�<br>�<br>���|β�DUM�<br>������<br>|||0.13|0.10|||1.45|0.13|
||adj R<sup>�</sup>|0.28|0.01|0.44|0.22|-0.03|-0.07|-0.02|-0.16|
|F-Stat|(P-value)|0.02|0.31|0.03|0.16|0.57|0.94|0.48|0.48|

Source: Authors’ calculations. Notes: Standard errors in parentheses.

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# **_Fiscal policy intentions: Accidental or intentional?_**

Did the South African government pursue procyclical policy accidentally or on purpose? Assuming two objective functions, we construct measures of intentions that we call consistency: meaning the government achieves its intended outcomes. We define these objectives as (i) the government attempting to stabilize the economy and (ii) the government attempting to run sustainable fiscal policy. We collect a data set using various Budget Reviews (starting in 1998) and analyze text related to a set of words that are related to these objectives. We build indices of these words (normalized by the total number of words in each document), which we then evaluate with outcomes (correlations to the budget deficit and to the output gap). Our correlations are referred to as consistency measures, i.e. capturing whether a government achieves its stated policy objectives.

The words are related to statements regarding _stabilizing the economy, smoothing out business cycles_ , and _countercyclical fiscal policy_ .

We create two measures of consistency.

1. One where the government announces that it will aim to smooth the business cycles compared to movements in the actual business cycles. The word frequencies related to business cycle stabilization are correlated with the inverse of the output gap �Consistency�

- ����������,�<sup>�∗</sup> � �� �<sup>~~∗~~</sup> . A positive correlation implies that the government follows through on its

- �<sup>�����</sup> � � �

statements, i.e. that statements of stabilizing the economy are followed through by a stabilizing event. To this end we have an illustration of consistent demand management policies.

2. The second measure correlates the word frequencies related to the stance of the government to actual changes in the budget balance. This measure is perhaps more important than the first measure given the direct control that the fiscal authorities have on setting budget targets. As an example, words related to stimulus and the deficit are measured as: Consistency�,� � ����������,∆����� ~~,~~ or consolidation: Consistency� ����������,∆����� ~~.~~ If the government �<sup>�����</sup> �<sup>∆����</sup> �<sup>�����</sup> �<sup>∆����</sup> announces a period of expansion or consolidation and the actual budget balance follows those announcements, then policy is consistent.

Consistency� will naturally fluctuate between -1 and 1. If Consistency� �0 during a consolidation effort, then the government does what it says – where once again, consistency is the intent of government measured against outcomes.

If the government is countercyclical, then it is possible that both objectives can be met and hence they should consequently co-move. **A procyclical stance would imply competing objectives where one would for example emphasize output maximization policies over a stable budget** . Note here that maximization of output is not stabilization of output – here again one could see how a government can prolong a business cycle.

Figure 10 plots the frequency of words related to consistency of the _budget_ and _output stabilization_ . It is interesting to note that _budget_ and _output stabilization_ are almost inversely related to each other during 2011-2015: During the financial crisis (2008/2009) there was an emphasis on using countercyclical fiscal policy to stimulate the economy, however in the years since 2013 the Budget has focused its efforts on terms related to _output_ consistency but at the expense of foregoing countercyclical policy. An obvious caveat is the limited number of words in each Budget Review related to these objectives. It is striking that little space is devoted to discussing budget stabilization policies.

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**Figure 10: Counts of words regarding various consistency measures**

_(word frequencies in Budget Reviews)_ <!-- Start of picture text --> Word Frequencies<br>30<br>25 Consistency: Output Stabilization<br>Consistency: Budget Stabilization<br>20<br>15<br>10<br>5<br>0<br>1998 2000 2002 2004 2006 2008 2010 2012 2014 2016<br><!-- End of picture text --> Source: Budget Reviews and authors’ calculations.

In Figure 11 we plot the rolling correlations of these two measures with (i) the output gap and (ii) the realized budgets. Again, these two terms do not always move in a similar manner.

- The authorities’ announced budget intentions (“consolidate the deficit”) and realized budget outcomes demonstrate limited consistency. The sudden change in signs from a consistent positive correlation to consistent negative correlation in 2011 is suggestive of either intentional procyclical policy or calculation errors in terms of potential GDP.

- Looking at the policy intention to ‘smooth the business cycle’ (i.e. countercyclical fiscal policy), actual policy reflected intentions up to 2006. In 2007, when the overall budget balance was still in surplus but the structural balance deteriorated markedly (as shown in Figure 8), intentions decoupled from the actual stance, suggesting that the authorities had underappreciated that strong commodity prices were still positively underpinning South Africa’s business cycle. The cycle had become the trend. Intentions remains decoupled from the actual dynamics of the economy until 2014/15, the actual end of the commodity super cycle.

By 2016, South Africa’s fiscal buffers were depleted and creditworthiness had declined. South Africa lost its investment grade credit rating in early 2017, being downgraded to BB+ by both Fitch and Standard and Poors, although Moody’s maintained an investment grade credit rating. When South Africa slipped into recession in the first half of 2018, room for fiscal stimulus was severely limited.

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**Figure 11: Rolling correlations of various consistency measures**

_(rolling correlation)_ <!-- Start of picture text --> Rolling Correlations<br>1.2<br>0.8<br>0.4<br>0.0<br>-0.4<br>-0.8 Consistency: Output Stabilization<br>Consistency: Budget Stabilization<br>-1.2<br>03 04 05 06 07 08 09 10 11 12 13 14 15 16<br><!-- End of picture text --> Source: Various Budget Reviews and authors’ calculations

# **_Policy Discussion_**

As many other EMDEs, South Africa seems to have been surprised by the length of the commodity super cycle, and its impact on extending domestic business cycles. Procyclical fiscal policy in South Africa was thus partly unintentional. However, _the cycle is the trend_ is not necessarily the only reason for this procyclicality. This section reviews potential other reasons:

1. Limited access to international credit markets and limited depth of domestic financial markets

2. Political economy and institutional factors 3. Design of countercyclical expenditure response and expenditure composition 4. Underestimated structural dynamics _1. Access to international credit markets and limited depth of domestic financial markets_ Countries experiencing adverse economic conditions find it difficult to access credit, and if available it is generally very expensive. The absence of affordable credit limits the degree to which countries can employ countercyclical fiscal policy. Adverse economic conditions may force countries to increase taxes and/or reduce government spending, which further entrenches a procyclical fiscal stance (Calderón, Chuhan-Pole, & López-Monti, 2017, Frankel, et al., 2013, and Gavin et al., 1996).

Limited access to international and domestic credit markets is highly implausible as a reason for South Africa’s observed procyclical fiscal policy stance. South Africa, after transition to democracy in 1994, was able to access domestic and international credit, despite its relatively high levels of inherited public debt. Its debt issuance increased gradually from 1994, and quite rapidly after 2006. The country’s borrowing costs declined consistently from 1994, and by 2001 credit ratings agencies Standard and Poor’s, Moody’s, and Fitch all rated the country’s foreign and local currency debt at investment grade. By 2012 the country was included in the Citibank World Government Bond Index, allowing it improved access to foreign lenders and lower rates. While the country has experienced downward revisions to its local and foreign currency credit ratings since 2014—and lost its investment grade credit rating on 18
foreign-denominated debt—it still enjoys access to domestic and foreign credit markets, with its bond auctions remaining well subscribed. Limited liquidity for the government is an unlikely contributor to South Africa’s observed procyclical fiscal stance.

# _2. Political economy and institutional factors_

In periods of strong economic growth, with high revenue growth and easy access to cheaper finance, ministers of finance find it difficult to resist additional demands for further appropriations, referred to as _voracity effects_ . These voracity effects are stronger when there are genuine and critical social needs (e.g. welfare spending, education, health care, housing, and other unfunded or underfunded mandates), and when there exist significant differences between the demands of different groups exerting demands over public resources (Abbott & Jones, 2013). Under such conditions, ministers of finance are often forced to make additional appropriations, which prove difficult to reverse (Perry, 2003). It is easy to see how _voracity effects_ can interact with overoptimistic growth assumptions when _the cycle is the trend_ : Given higher expectations on growth, more ambitious future spending allocations are budgeted for in medium term fiscal frameworks.

The degree to which a minister of finance and treasury can mediate and manage the competition for public spending and pursue countercyclical fiscal policy is also a function of domestic institutional strength. A country with weak institutions—including weak rule of law, lack of enforcement of property rights for investors, and widespread corruption—is less likely to be able to enforce countercyclical fiscal policy. The competition over fiscal allocation, combined with weak political institutions, may result in additional appropriation of public resources during periods of high growth, thereby locking-in a procyclical bias (Abbott & Jones, 2013).

World Bank Group (2018) argues that pressures to raise appropriations are high in South Africa, as the country aims to tackle the high levels of inequality it inherited of a history of separation and apartheid. Pressures for redistribution are thus high and can support _voracity effects_ . In addition, post-apartheid South Africa saw an erosion in the quality of institutions since about 2007, including institutionalized corruption (“State Capture”) that not only undermined state-owned enterprises and law enforcement agencies, but also reduced administrative efficiency in the South African Revenue Service and aimed to undermine the National Treasury. These factors may have contributed to undermining countercyclical policy making in South Africa, despite official intentions. Given a propensity to overestimate future growth in South African Budget Reviews, _voracity effects_ may well have interacted with _the cycle is the trend_ dynamics in South Africa.

# 3. _Design of countercyclical expenditure response and expenditure composition_

The ability of a government to successfully pursue countercyclical fiscal spending is dependent on the responsiveness of public spending to changes in the business cycle. This, in turn, is a function of a) _institutional arrangements and design of countercyclical expenditure response_ , and b) _the composition of public spending_ .

In the pursuit of countercyclical fiscal policy, _institutional arrangements and design of countercyclical expenditure response_ must allow for a deliberate, timely, targeted and temporary increase in public spending in response to a downward-phase in the economy, and a winding-down during an upwardphase. Public spending directed towards countering the effects of the business cycle may be automatic (non-discretionary) or discretionary. Given the lags associated with identifying changes in the business cycle, as well as developing, appropriating and implementing spending programs, automatic expenditure stabilizers allow for more agile fiscal responsiveness compared to discretionary interventions (Baunsgaard and Symansky, 2009, Elmendorf and Furman, 2008 and Taylor, 2000). In addition, effective discretionary fiscal spending, effected through legislative appropriation, is contingent on political support for both implementation and winding-down when the business cycle changes.

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To the extent that South Africa pursued countercyclical fiscal spending, it was predominantly discretionary. Its primary automatic stabilizer on the expenditure side is payments from its Unemployment Insurance Fund (UIF), which comprised a particularly small share of the country’s overall budget, limiting its effect on aggregate demand.<sup>5</sup> In its pursuit of discretionary fiscal policy as a stabilization tool, the South African government made only limited explicit reference to which expenditures have been increased specifically in response to the business cycle. The absence of clear identification of discretionary spending, including amounts and time-frames, may have led to fungibility between funding unfunded or insufficiently-funded mandates (baseline expenditure) and discretionary fiscal spending, making the discretionary fiscal policy responses more difficult to reverse upon changes in the business cycle. Interestingly, in the 2015 MTBPS the government proposed a “fiscal guideline” linking expenditure in the outer-year of its three-year budget-planning-framework to potential GDP. While it is not clear if the proposed “fiscal guideline” was adopted and implemented, even if adopted earlier its potential efficacy would have been limited by the accuracy of potential GDP estimates.

Moreover, A country is more likely to have a procyclical fiscal policy bias to the extent that its _expenditure composition_ is distributed in favor of expenditure items that display procyclical behavior. Of particular relevance to South Africa is wage spending, given its rapid growth since 2008, contributing 38% to the overall increase in expenditure between 2008 and 2016 (see Table 4). Several studies find the public sector wage bill to behave in a strong procyclical manner across the economic cycle (in booms and busts) (Eckardt and Mills, 2014, Lamo et al. 2013, and Lane, 2003). In addition to the overall wage bill being procyclical, Lamo et al (2013) also find that public employment levels, and remuneration per public sector employee also move in the same direction as the business cycle.

With rapid growth in the public wage bill since 2008, due to headcount growth and above-inflation remuneration increases, South Africa’s public wage bill is likely to have contributed to a procyclical fiscal policy bias. As upward-adjustments to the public wage bill are politically difficult to reverse, de facto, wages in South Africa are nondiscretionary. This is likely to have limited the extent to which the government was able to respond to a downward phase in the economic cycle, resulting in entrenched medium-term compositions relative to other expenditure items.

**Table 4: Consolidated public spending by main category** _(share of total central government expenditure)_

|_(share of total)_|1997/98|2001/02|2008/09|2014/15|2016/17|Contribution to<br>overall increase in<br>expenditure (%)<br>2008/09-2016/17|
|---|---|---|---|---|---|---|
|Compensation of employees|39%|37%|33%|34%|35%|38%|
|Transfers|20%|29%|34%|40%|33%|32%|
|Goods and services|13%|13%|17%|12%|14%|12%|
|Interest payments|20%|18%|8%|10%|11%|13%|
|Capital|8%|4%|7%|4%|6%|6%|
|_Total_|_100%_|_100%_|_100%_|_100%_|100%|-|

Source: Budget Reviews and authors’ calculations.

> 5 The degree to which Unemployment Insurance Fund disbursements serve as an automatic stabilizer is limited by the portion of the population eligible for UIF unemployment benefits, slow employment growth, and modest rand value of unemployment benefits disbursed. To be eligible for UIF unemployment benefits, a person had to previously contribute to the UIF, generally necessitating formalized employment. On average, about 40% of the employed have historically not been eligible for UIF.

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The pursuit of countercyclical fiscal policy through discretionary increases to public spending, with the wage bill comprising the largest share of overall expenditure increases, resulted in South Africa’s budget structurally increasing to a higher level of expenditure to GDP. To the extent that the expansion of expenditure was based on a mirage of higher potential GDP, it is difficult to reverse past decisions and return to a budget size more in line with actual potential GDP. In South Africa, in light of high public debt, high expenditures but slowing revenue dynamics, this has only left the option to cut discretionary spending, notably on infrastructure. Yet, cutting investment eventually comes at the expense of raising future potential, to the levels where it was perhaps expected when the cycle became the trend.

## _4. Underestimated structural dynamics_

The commodity super cycle is one possible reason why potential GDP growth was overestimated. Another potential reason is that South Africa’s structural constraints—and the ability to resolve them— have been underestimated, resulting in an unanticipated slowdown in potential GDP growth. World Bank Group (2018) shows that total factor productivity growth has been decelerating significantly in South Africa, and declining in recent years. This can be due to multiple factors, including rigid factor markets that keep factors from being allocated more efficiently. It can also be due to South Africa losing global competitiveness due to labor ad factor market rigidities and the weakening of the performance of important state-owned enterprises, in electricity or transport. South Africa has also been attracting relatively limited investment (both physical and in innovation). The World Bank Group partly attributed this to policy uncertainty that is keeping investors wary. An underappreciation of the magnitude of South Africa’s challenges may also have resulted in overestimates of potential growth, in addition and beyond _the cycle is the trend_ .

# 5. Conclusion

Fiscal policy is an important stabilization tool. Adequate countercyclical fiscal policy may stabilize the economic cycle. Unfortunately, policy mis-steps such as the mistiming of fiscal policy can destabilize the cycle, or prolong recessions. This paper estimates the cyclical stance of EMDEs with a focus on South Africa by decomposing the budget into transitory and permanent components. To control for the variability in output, a _cycle is the trend_ variable is constructed, but cleaned of commodity price effects. This accounts for the possibility that the authorities might perceive long cycles as the trend – in which case they run the risk of enacting procyclical fiscal policy.

The results show that fiscal policy in EMDEs has been mostly procyclical. This result is robust regardless of different lengths of _the cycle is the trend_ or alternative measures of the cycle such as the output gap. This can be attributed to good intentions by the fiscal authorities, but missing either important turning points of the business cycle, perceiving long-cycles as the trend due to commodity price cycles, poor choices on spending which are difficult to reverse such as wages or weak policy coordination where funds are disbursed and allocated but not spent on time.

We study South Africa to understand the extent to which this may have played out in a case study. An interesting outcome of the analysis for South Africa is the relationship between the fiscal stance and a derived _intention_ measure which is calculated using texts from various Budget Reviews. The difference between outcomes and intentions yields a set of consistency measures. They show that meeting budget announcements and stabilizing the business cycle have been at odds at times and the outcomes related to intentions sometimes went in opposite directions. There exists thus a mismatch between what the government aimed to achieve (e.g. countercyclical fiscal policy) and the outcome. Imperfect knowledge regarding the length of the economic cycle (e.g. the commodity boom in the 2000s), and external shocks and other exogenous shocks may have contributed to this mismatch.

These results imply that forecasts of GDP and specifically the output gap have a large weight in policy errors. A clearer understanding of the duration of cycles, the impact of expenditure and revenue policies on the cycle and credibility of fiscal policy will go a long way in aligning fiscal policy with macroeconomic objectives of sustainable countercyclical fiscal policy.

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# Annex 1: Variance-Ratio tests

## **<u>Table A1: Variance-Ratio tests</u>**

||**K = 2**|**K = 4**|**K = 8**|**K = 16**|**K =**<br>**32**|
|---|---|---|---|---|---|
|**ZAF**|1.5*|2.2*|3.7*|5.7*|0.8|
|**IND**|1.3|0.8|1.0|NA|NA|
|**BRA**|1.3*|1.4|1.6|2.5*|NA|
|**BWA**|0.8|0.5|0.2|0.3|NA|
|**RUS**|1.5*|2.0*|3.0*|NA|NA|
|**CRI**|1.1|0.8|0.6|0.6|NA|
|**ARG**|1.3|1.4|1.2|0.4|NA|
|**COL**|1.4*|2.0*|2.2*|1.3|2.2|
|**PER**|1.4|1.9*|2.4*|2.9*|2.1|
|**MEX**|0.9|0.7|0.4|0.5|NA|
|**NGA**|1.6*|2.7*|4.6*|6.9*|NA|
|**EGY**|1.9*|3.6*|3.3*|NA|NA|
|**MAR**|0.7*|1.3|1.6|NA|NA|
|**MUS**|0.7|0.7|0.4|0.2|NA|
|**MYS**|0.8|0.6|0.0*|NA|NA|
|**IDN**|1.4*|1.6*|1.6|1.2|NA|
|**POL**|1.0|1.1|0.9|2.4*|NA|
|**PHL**|1.3|1.9*|1.7|2.7*|NA|
|**VNM**|1.6*|2.1*|1.6|2.7*|NA|
|**BGR**|1.3|2.1*|3.3*|1.8|NA|
|**TUR**|1.3*|1.6|0.4|0.4|NA|
|**JAM**|1.6*|2.3*|2.8*|0.1|NA|
|**LBN**|1.2|1.4|1.1|2.0*|NA|
|**PAK**|1.4*|1.7*|1.5|0.3|NA|
|**LKA**|1.4*|2.0*|2.8*|2.3*|0.2|
|**NAM**|1.5*|2.3*|3.7*|5.8*|2.3|

Notes: *,**,*** indicate significance at 10%,5% and 1% level.

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<!-- Start of picture text --> t<br>t= Rt _ Ge<br>-, . _<br>p=ctat+A(L)y_,+uy<br>t A(L)<br>t E(u,z) = 0 Eur =u<br>t={GDP, ¢ ¢ t}<br>t=Aot t<br>t0<br>t<br>12 21<br>—b,3 g 12 g<br>—bo3 T _|oon T<br>—b3, —b32 y v<br>—b4, —baz —ba3 D D<br><!-- End of picture text -->
Our interest lies with an estimate for b��, which is the automatic response of revenues to the business cycle. Interestingly there are a quite a few studies in South Africa that estimate b�� using a variety of methodologies (c.f. Du Plessis and Boshoff (2007) and Swanepoel and Schoeman (2003)). In general, it can be shown that this estimate corresponds to the product elasticity of the tax base to revenues and � �,�� ��,�<sup>�</sup> <u>�</u> output to the tax base (b� �∑��� ε� ε� � ). We calibrate this value to be 1 using an average of the literature in a meta-analysis setting.

Table 1: Output elasticities

||b�|
|---|---|
|Du Plessis et al. (2007)|1.06|
|Swanepoel et al. (2003)|0.91|

Equation (16) can be used to analyze the historical shock contributions of each variable on revenues (Figure 2). These are labeled baseline (refers to structural revenues), changes in expenditures, real GDP growth, changes in debt, and other factors (noise). Real revenues fell markedly during the recession in 2009. Two major factors contributed to the sharp decline: revenue responses to GDP shocks and noise shocks (which is the residual and accounts for other factors). The feedback effects of expenditure decisions are also clearly seen on revenue responses – especially in 2015 as revenues adjust in a rulelike manner. Growth in structural revenues has been moderating over time and decreasing since 2012 implying a slowdown in trend GDP.

# **Figure A1: Decomposing real revenue growth**

_(annual percentage change)_ <!-- Start of picture text --> 20.0<br>15.0<br>10.0<br>5.0<br>0.0<br>‐5.0<br>‐10.0<br>‐15.0<br>2002 2004 2006 2008 2010 2012 2014 2016<br>Baseline Expenditures GDP Noise Debt Actual<br>% change<br><!-- End of picture text --> Source: Authors’ estimations.

The estimates of equations (5) and (11) allow us to create our fiscal stance measures – which here refers to the discretionary decisions of the government regarding the business cycle. It should be noted that these measures do not apply a statistical filter to obtain structural shares of the budget to output policy as is done typically when smoothing GDP. We argue this is a useful approach – we explicitly model the unobserved potential GDP by identification using a structural model (the SVAR), and by assuming that the long-run part of the government moves slowly in line with the long-run part of the economy around a stationary point. These estimates of the structural budget balance can then be compared to each other.

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# Annex 3: Empirically controlling South African policy shifts

## **Table A2: Dummy variable definition for national policies**

|Year|Shifts in plans<br>R|elatio|n to fiscal policy|
|---|---|---|---|
||||Gt|
|1994 -DUM����<br>�������1|Reconstruction<br>and<br>Development Program||overnmen<br>establishes<br>extensive<br>welfare system|
||||Without adequate tax<br>reform,<br>expenditure<br>policies<br>aimed<br>at<br>creating growth were<br>constrained|
|1995 -DUM����<br>�������1|Abolish dual exchange rate||Effects debt payments<br>to rest of the world|
|No dummy|Growth<br>Employment<br>and<br>Redistribution policy||Reduce fiscal deficits|
|No dummy|SARS autonomy granted||Increase in efficiency<br>in collecting taxes|
||||Increased<br>planning|
|No dummy|Medium<br>Term<br>Expenditure<br>Framework (MTEF) adopted||<br> <br>over budget cycles|
||||Departments<br>plan|
|No dummy|Public Finance Management<br>Act||<br> <br>better<br>over<br>budget<br>cycle|
|2005 -DUM����<br>�������1|Accelerated and Shared Growth<br>Initiative for South Africa||Targeted spending to<br>help reduce poverty<br>and<br>halve|
||||unemployment<br>by<br>predefined dates|
|2010 -DUM����<br>�������1|National<br>Industrial<br>Policy<br>Framework<br>and<br>subsequent<br>Industrial Policy Action Plans||Spending allocated to<br>identified<br>economic<br>sectors|
||||Eliminate poverty and|
|2013 -DUM����<br>�������1|National Development Plan||<br>reduce inequality by<br>2030|

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