Acknowledgements This edition of the South Sudan Economic Update is a joint Macroeconomics and Fiscal Management - Poverty product. The report was prepared by Nora Dihel (Senior Economist) and Utz Pape (Economist) with input from Facundo Abraham (Consultant), Arti Grover (Senior Economist), Luca Parisotto (Consultant) and Sergio Schmukler (Lead Economist). Zerihun Getachew Kelbore (Research Assistant) provided statistical assistance. Karima Laouali Ladjo (Program Assistant) provided assistance with formatting. Abebe Adugna (Practice Manager, Macroeconomics and Fiscal Management), Pierella Paci (Practice Manager, Poverty), Sahr Kpundeh (Country Manager, South Sudan) and Carolyn Turk (Country Director, South Sudan) provided overall guidance. The team wishes to thank Michael Geiger (Senior Economist), Kevin Carey (Lead Economist) and Jean-Pierre Chauffour (Lead Economist) as well as peer reviewers Fiona Davies (Advisor, Ministry of Finance and Planning), Praveen Kumar (Lead Economist, World Bank), Elliot Mghenyi (Senior Agriculture Economist, World Bank), Richard Newfarmer (Country Director, Rwanda, South Sudan, and Uganda, International Growth Centre) and Malcolm Smart (Senior Economic Adviser, DFID South Sudan) for their constructive input. The World Bank team welcomes feedback on the South Sudan Economic Update. Please send comments to Nora Dihel (ndihel@worldbank.org) and Utz Pape (upape@ worldbank.org). Acknowledgements i CONTENTS Acknowledgements i Contents ii Executive Summary iv 1 2 Economic developments – Special Focus - Taming the Soaring inflation, poverty and tides of high inflation: policy food insecurity options for South Sudan page 1 page 26 1.1 Background 1 2.1 Introduction 26 1.2 Recent economic developments 3 2.2 Exchange-Rate-Based Stabilization 1.3 Poverty and livelihoods in a high (ERBS) plans 30 inflation environment 11 2.3 Money-Based Stabilization (MBS) 1.4 Food insecurity due to conflict and plans 35 high inflation 16 2.4 Country experiences 39 1.5 Perceptions of welfare and performance 2.5 Lessons for South Sudan 43 of public institutions 21 1.6 Outlook and risks 24 References 44 Annex 1: Countries with a history of hyperinflation 52 Annex 2: Countries following inflation targeting 53 Annex 3: Dynamics of ERBS in Latin America 53 Annex 4: MBS versus ERBS in Latin America 56 Annex 5: Deflation in countries post stabilization programs 59 ii Contents Table 1 Macroeconomic outlook - South Sudan 4 Table 2 Annual inflation rates before and after ERBS 54 Table 3 Annual GDP growth rates before and after ERBS 55 Table 4 Annual inflation rates before and after MBS 57 Table 5 Annual GDP growth rates before and after MBS 57 Figure 1 Projections of oil revenues 6 Figure 2 Exchange rate SSP to USD 7 Figure 3 CPI inflation, year-on-year 8 Figure 4 Sectoral expenditure, percentage 9 Figure 5 Urban poverty headcount 12 Figure 6 Urban poverty gap 12 Figure 7 Source of livelihood by poverty status, urban 14 Figure 8 Poverty headcount by source of livelihood, urban 14 Figure 9 Employment by type, urban 15 Figure 10 School attendance children aged 6-13, urban 16 Figure 11 School attendance children aged 14-18, urban 16 Figure 12 Food security outcomes, April 2017 17 Figure 13 Estimated cereal deficit/surplus 2014-2017 18 Figure 14 Changes in cultivated area from 2012/2013 to 2016 18 Figure 15 Consumer Price Index (CPI) of select commodity groups in Juba, South Sudan 19 Figure 16 Hunger incidence over the past 4 weeks, urban 19 Figure 17 Feeling in control over own life, urban 21 Figure 18 Life satisfaction score, urban 21 Figure 19 Perception of economic conditions, urban 22 Figure 20 Perceptions of effectiveness of public institutions, urban 23 Figure 21 Top 5 hyperinflation situations in history 27 Figure 22 Exchange-Rate Stabilization (ERBS) vs Monetary-Based Stabilization (MBS) 29 Box 1 Inflation stabilization plans ix Box 2 Monetary policy and exchange rate regimes in post-conflict countries x Box 3 Oil revenue forecast and governance 5 Box 4 The High Frequency Survey collects key data in South Sudan 12 Box 5 Hyperinflation experiences 27 Box 6 Advantages and disadvantages of dollarization 31 Box 7 Monetary policy and exchange rate regimes in post-conflict countries 45 Contents iii EXECUTIVE SUMMARY 1 Economic developments – Soaring inflation, poverty, and food insecurity 1. The Republic of South Sudan emerged in with output contracting, and inflation and 2011 from decades of conflict as the world’s parallel exchange market premium spiraling. newest independent country, with huge state While the lack of reliable information makes and peace building challenges, and extreme it difficult to assess the current state of the institutional and socio-economic deficits. Six economy, GDP is estimated to have contracted years after independence, South Sudan remains by about 11 percent in FY2016/17 due to conflict, one of the world’s most conflict-affected and oil production disruptions and below-average fragile countries, unable to emerge from cycles agriculture production. On the demand side, of violence. The escalation of the war generated exports and household consumption declined, large displacements of population – most notably while government consumption increased due since November 2016. The famine declared in to spending on defense and security operations. February 2017 underscores the severity of the humanitarian crisis. By July 2017 about 6 million 3. The fiscal deficit remained high, although its (about 50 percent of the population) had been exact magnitude is difficult to estimate given food insecure, 1.9 million had been internally the lack of real time data. Based on the 2016/17 displaced, and 2 million had fled the country. budget, the fiscal deficit is estimated at about 14 percent of GDP. The 2016/17 budget allocated 2. By August 2016, South Sudan displayed about 42 percent of the total domestically all the signs of macroeconomic collapse, financed budget to salaries, 19.5 percent to iv Executive Summary operating and capital expenditure, 19 percent prices and lower oil production. Oil production is to transfers to states and counties, and about 14 estimated to have decreased to about 120,000 percent to peace and security. barrels per day in 2016 down from 165,000 barrels per day in 2014, itself less than half of the 4. The financing situation is dire. Not only is the peak production before independence in 2011. government financing itself through accumulated However, imports also decreased by more than arrears to civil servants - many of whom have exports, narrowing the current account deficit. not been paid for months and are probably no longer working; moreover, the government has 7. The South Sudanese Pound (SSP) continued accumulated large contingent liabilities on its to depreciate. Following the move to a more balance sheet. Sources of deficit financing have flexible exchange rate arrangement in 2015, the dried up. Deficits associated with the war and South Sudanese Pound (SSP) depreciated on security spending are requiring the government both the official and the parallel market. On the to cover its costs by printing money, driving parallel market, it depreciated from SSP 18.5 per inflation. dollar in December 2015 to SSP 70 per dollar by August, 2016 and SSP 172 per dollar by August 5. Monetization of the fiscal deficit explains to 2017. Political events drove the volatility of the SSP: a large extent the high inflation, although there the pound initially appreciated on the parallel are some indications that borrowing from the market when the Government of National Unity Bank of South Sudan had been limited in recent came into place, but it later depreciated steadily, months. The annual Consumer Price Index (CPI) in particular after the new fighting erupted in July increased by 480 percent in 2016 and by 155 2016. It has continued to depreciate steady since percent during July 2016-June 2017, according as instability across the country continues. to the latest official statistics. Notwithstanding the recent downward trend, the very high inflation 8. Restoring peace, including reform of the security continues to put many households in both urban sector, followed by efforts to rein in public sector and rural areas in a very difficult position, as they borrowing to levels that avoid printing money are unable to afford the minimum food basket. are necessary preconditions for any stabilization program. The only way to halt the economic 6. The current account deficit is estimated to devastation is to put in place a consistent have narrowed to about 1.6 percent in FY2016/17 and credible macroeconomic program, with from about 6.1 percent of GDP in FY2015/16. transparent administration and external support Export revenues decreased due to declining oil both for financing and credibility purposes. The 2016/17 budget allocated about... 42% 19.5% 19% 14% salaries operating & capital states & counties peace & security expenditure Executive Summary v 9. The FY17/18 National Budget aims to restore macroeconomic stability, but lacks credibility. It puts special emphasis on controlling public Poverty in urban areas expenditure, increasing non-oil revenues, INCREASED FROM encouraging investment and economic 49% 70% diversification and removing subsidies to the national oil company (Nilepet). The Budget also aims at refraining from borrowing from the Bank in 2015 in 2016 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 work or on their own business enterprise will be available to execute all budgeted items. into poverty. Although households supported While it is difficult to predict the prioritization of primarily by wage earners remain amongst the expenditures, it is likely that the government will richest groups in South Sudan’s population, the continue to protect security spending and core decline in purchasing power caused many of these executive functions. Thus, the population will households to fall into poverty. Poverty amongst become even more dependent on humanitarian wage earning households more than doubled relief and donor funded development projects for from 28 percent in 2015 to 62 percent in 2016, a access to services. Even if the economy showed stark increase relative to most other households. some recovery starting in 2018, projections suggest that poverty will continue to rise through 12. Economic instability led many of the working 2019 as economic growth is likely to be surpassed age to drop out of the labor force. The urban labor by population growth. force participation rate in urban South Sudan dropped from one half to one third between 2015 Poverty, food insecurity, and perceptions in a and 2016 (50 percent to 33 percent respectively). high inflation environment The particularly volatile economic, political and security conditions may be responsible for this 10. Poverty in urban areas of South Sudan low active labor force participation. increased from 49 percent in 2015 to 70 percent in 2016. The macroeconomic collapse, high 13. South Sudan’s unprecedented level of food inflation and increasing food prices have led to insecurity is the most alarming signal of the a sharp increase in urban poverty between 2015 country’s larger economic collapse. Despite the and 2016. The urban poverty gap increased from agricultural potential, the rural population has 22 to 36 percent between 2015 to 2016, meaning been continuously affected by food insecurity in that the average poor urban household went from the last few years. As of February 2015, 2.5 million consuming 22 percent less than the international people, or about one fifth of the population, poverty line to 36 percent less in 2016. Inequality were in either “Crisis” or “Emergency” levels of amongst the poor also worsened, and the poverty food insecurity, more than double the number severity index doubled from 0.10 in 2015 to 0.20 recorded in December 2013, when the fighting in 2016. broke out. A further 3.9 million people are in a state of food security stress, and likely to slip further 11. The large loss of wages’ purchasing power down the rankings should livelihood support, drove many households relying on salaried security, and markets fail. Predicted changes in vi Executive Summary climate, both in terms of more intense rainy 15. Many households perceived that economic seasons as well as hotter and dryer dry seasons, conditions would continue to deteriorate. In could heighten future food insecurity nationally. 2015, about two thirds of the South Sudanese Heightened tensions and renewed clashes across residing in urban areas felt that economic the country following the July 2016 conflict have conditions in their country were bad or very bad; further aggravated already overwhelming needs. in 2016 this figure increased to almost 9 in 10. Nearly 3.6 million people were estimated to be The people of South Sudan are not optimistic severely food insecure between October and about the future. In 2016 more than 3 in 4 stated December 2016, the highest levels experienced that in 3 months’ time the economic situation in South Sudan at harvest time. In both rural and will be worse or much worse, with a notable 47 urban areas, the food insecure population has percent of households believing the latter. This at least doubled compared to the same time pessimism with regards to the future of economic last year. conditions in South Sudan increased between 2015 and 2016, and the share of households 14. Hunger for the poorest households increased believing that conditions in three months will be sharply between 2015 and 2016. The likelihood worse increased from 38 in 2015 to 65 percent of experiencing hunger ‘often’ (more than 10 in 2016. times per month) increased from 2 percent to 13 percent for the poorest quintile of households, 16. Economic and political volatility negatively while the incidence of experiencing hunger ‘often’ affected households’ perceptions of the or ‘sometimes’ (3 to 10 times per month) increased Government’s and other public institutions’ from 26 to 44 percent for the second poorest performance. Households in urban areas do expenditure quintile. While richer households not think that the Central Government and may be able to respond to a rise in food prices other domestic public institutions are effective by adjusting their diets towards more staple and in improving the living conditions and life of the less expensive foods, the poorest households’ diet people of South Sudan. The Central Government may already be consisting primarily of such foods, of South Sudan in particular is consistently and as prices increase they are unable to afford perceived amongst the least effective of these even basic sustenance. In 2016, households in the institutions. Households’ perception was already poorest quintile were more than ten times more in low in 2015, with half of all households believing likely than households in the top four quintiles that the Central Government is ineffective or to have experienced hunger ‘often’ in the past very ineffective in improving the daily life of its month (15 vs. about 1 percent respectively). constituency. In 2016 almost 3 in 4 households 47% of households believe that in 3 months the economic situation will be much worse Executive Summary vii held a negative view of the Central Governments’ coping with high inflation in South Sudan. Rather, effectiveness situation up from 50 percent in 2015. it is expected that the number of refugees will increase, putting additional pressure on receiving 17. While awaiting the government’s commitment neighboring countries. to a political settlement and macroeconomic reforms, the population will likely be forced to 18. Top priorities for the Government are to engage in creative survival and coping strategies. restore peace and security, and implement There is a risk that South Sudanese citizens are urgent macroeconomic measures to reduce already engaged or will be forced to participate high inflation. If the macro-economic imbalances in informal and often illegal activities. However, are not managed in an effective and timely the majority of the population in rural areas manner, poverty could rise even further. In the will continue to rely on subsistence agriculture, absence of reforms South Sudan will spiral further facing dire conditions. There is little evidence that towards being a failed state. remittances from diaspora have a significant role in 2 Taming the tides of high inflation: policy options for South Sudan 19. A key policy priority for South Sudan is to 20. Political will is critical to pursue any stabilization curb inflation. What can the country do in this plan. Peace and security remain a crucial regard? Countries have historically tamed extreme precondition for any macro stabilization. Moreover, inflationary situations using Exchange-Rate any reform plan requires credible commitment -Based Stabilization (ERBS) plans or Money-Based to take concrete steps to address the economic Stabilization (MBS) plans (see Box 1). Monetary or issues. Effective programs have sequenced the inflation targeting has been popularly adopted by initial stabilization programs with structural and many central banks around the world as a strategy institutional reforms. The latest economic and for monetary policy with the expectation that security developments in South Sudan seem to the adoption of such a monetary regime would indicate that despite the urgent need for fiscal help control money supply and reduce inflation consolidation and exchange rate adjustment, and inflation volatility. Alternatively, an exchange the Government continues to focus on conflict- rate anchor, in combination with a broader set of related policy choices that delay any meaningful stabilization programs that combine fiscal prudence reforms. Without clear political commitment, any with a tighter monetary regime of varying forms stabilization plan will be meaningless. may be another option to control inflation. The Government continues to focus on conflict-related policy choices that delay any meaningful reforms viii Executive Summary Box 1 Inflation stabilization plans All stabilization plans need a nominal anchor to lower inflation and they differ among each other depending on which nominal anchor is used. Nominal anchors play a fundamental role in successful stabilization plans. First, setting a predetermined path for the exchange rate or the amount of money helps pin down prices and controls inflation expectations. Second, a nominal anchor limits political pressures to pursue expansionary monetary policies that could fuel inflation. Third, nominal anchors send a strong signal to the market that the policy regime has shifted and the government is credibly committed to fighting inflation. Experiences with stabilization plans suggest that they vary in their speed at which inflation is reduced, the business cycle they create, and their sustainability over time. When choosing a stabilization plan, policymakers are confronted with trade-offs regarding “speed vs. sustainability” and likely “recession now vs. recession later.” On the one hand, ERBS is very successful at reducing inflation quickly, even in countries where inflation is exceptionally high. In addition, immediately after its implementation it creates an economic boom. However, over time the economic expansion is followed by a recession. The economic downturn, which might include a financial crisis, can trigger the collapse of the stabilization plan and the reemergence of inflation. As a result, ERBS is relatively short-lived, sometimes only being in place for four or five years before it is abandoned. On the other hand, MBS decreases inflation but only gradually while initially creating a contraction of economic activity. However, once this downturn is passed, economic growth returns and inflation continues to slow down. As a result, MBSs are more sustainable over time. A common feature of ERBS and MBS is that both require a strong institutional framework to be implemented successfully. Whether the central bank is targeting the exchange rate, the growth rate of money, or the inflation rate, the monetary authority needs to send clear signals to the public that its main goal is to comply with the target. This includes, among others, that the central bank is independent, has a legal mandate to control inflation, is free from political pressures, and has adequate disclosure standards. If the public does not believe that the central bank is committed to fighting inflation, the stabilization plan will unlikely succeed. Another important precondition for the successful adoption of ERBS and MBS is fiscal discipline. A country that implements a stabilization plan but fails to control fiscal deficits is more prone to pursuing an expansionary monetary policy. For countries under an ERBS, expansionary monetary policies would sooner or later lead to a fall in reserves that could force the central bank to abandon the peg. Likewise, in countries under an MSB, an increase in the money supply beyond the target would undermine the credibility of the central bank. In both cases, this will weaken the main pillar of the stabilization plan: the nominal anchor supposed to endure in the long term. Executive Summary ix 21. Which stabilization path for South Sudan? from conflict, is to establish credibility of the Although there is a clear agreement that South chosen monetary regime through a nominal Sudan needs to reform, vested interests and rent anchor. The empirical evidence is not conclusive seeking behavior from the politically connected on whether this can be done more successfully who have access to foreign currency at the official through inflation targeting or a hard currency peg or rate are preventing or delaying the reform process. a crawling peg with a narrow band. Monetary policy There is also a lack of agreement on the specifics of becomes more effective when the central banks are the reform to support lower inflation. For example, successful in leading inflation expectations and can it is not clear whether the country would be most credibly alleviate the traditional short-term trade-off suited to adopt a currency board approach or a full between inflation and unemployment. The success dollarization or continue with a floating regime. of any monetary regime is directly associated with Finally, reforming the monetary regime involves a forward-looking behavior, which, in turn, highlights major change in the economic environment, and the relevance of credibility. This aspect is particularly a major shock for the economy. The uncertainty relevant for developing and post-conflict economies surrounding the impact may add to the reluctance (see Box 2). A strong and credible commitment to of the reform process. maintaining low inflation through any monetary regime credibility thus fosters an environment that 22. The main challenge for developing stimulates output growth. economies, particularly for countries emerging Box 2 Monetary policy and exchange rate regimes in post-conflict countries Does the choice of exchange rate regime matter for aid effectiveness in restoring macroeconomic stability? Based on the experience of 38 countries emerging from war and conflict, Elbadawi and Soto (2013) suggest that post-conflict performances of the fixed and managed regimes were very similar, and were superior to that of a floating regime. While inflation was in single digits under the fixed and the managed floating regimes, it was more than 16 percent under the floating regime. More in-depth empirical analysis confirms that in post-conflict economies, both the fixed and managed regimes have direct stabilizing effects on inflation. Aid does not seem to have a direct effect on post-conflict inflation under the fixed and managed regimes, while it was found to have a stabilizing impact under the floating regime. Therefore, it seems that the free-floating exchange regime may not be appropriate for countries emerging from wars and conflict situations. The managed floating regime seems to have an edge on two critical areas of economic performance: (i) aid promotes post-conflict demand for money balances and (ii) the monetary reconstruction role of aid is likely to be more effective under this exchange rate regime. Source: Elbadawi and Soto (2013) x Executive Summary 23. Under South Sudan’s current managed market. While an auction mechanism is already floating exchange rate regime, a monetary in place, challenges to determine the exchange policy regime (without an exchange rate anchor) rate remain. would require an explicit and clearly understood alternative nominal anchor. Theoretically, the 2 country could initially implement a plan based on targeting the growth rate of money and then, over time, transition to inflation targeting. The second challenge would be to build an Compared to inflation targeting, using the growth adequate system to monitor public and private rate of money as the nominal anchor can be sector exchange rate risk. Since July 2015, the implemented by a central bank with relatively commercial banks’ balance sheets are showing less independence. Targeting the growth rate of negative net foreign assets. With the 500 percent money imposes some limits to the discretionary depreciation of the SSP in December 2015, the actions of the central bank because it requires this net foreign liabilities (negative net foreign assets) institution to follow a specific rule. The public can of the commercial banks has increased to more easily observe the compliance of this rule so any than four times their capital, representing a deviation would result in an increase in inflation rather high exchange rate risk exposure. The BSS expectations and the collapse of the plan. This would need to enforce prudential requirements suggested path was followed by some countries to safeguard the integrity of the banking system. 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. 3 24. If South Sudan decided to adopt MBS, it would need to ensure that the exchange rate The third challenge for the government would be regime is compatible with macroeconomic to identify appropriate intervention measures in fundamentals and closes the gap between the the foreign exchange market to ensure stability. official and the parallel rate. International experience shows that central banks could intervene in the exchange market when they detect exchange rate misalignment or 1 judge volatility destabilizing. These interventions could be on a discretionary basis or regular, preannounced, and rule-based to support the The first challenge would be to deepen the information flow to the market and reduce noise. foreign exchange market to make it more liquid In the case of South Sudan, it seems that BSS for an adequate determination of the exchange will continue to supply the forex market with rate. The challenge for the Bank of South Sudan foreign currency because of its role as banker (BSS) will be to supply the market without to a government that receives revenues from signaling an intention to defend a particular oil, borrows from abroad and receives grants in exchange rate level to maintain commitment foreign currency. The government has issued to floating exchange rate. By limiting its new guidelines for the implementation of the participation to frequent or periodic interventions regulation on floating exchange rate regime (daily or weekly) using transparent and market instituting an auction mechanism that is in line allocation mechanism such as auctions, the BSS with international standards. However, given the could promote the development of the forex low level of foreign reserves, the government Executive Summary xi should be very selective in its interventions to build Exchange-Rate-Based Stabilization (ERBS) plans its credibility and promote market confidence. 26. Another option would be to follow an ERBS. Given the high inflation in South Sudan and the 4 lack of credibility of monetary policy, inflation could be tamed through a hard peg of South The fourth challenge would be to find an Sudanese dollar. The disadvantage of hard pegs alternative nominal anchor for its monetary is the loss of an autonomous monetary policy, but policy. Despite the weak relationship between at the current state of institutional development monetary aggregates and inflation, money in South Sudan such autonomy might not be targeting can serve as an alternative nominal beneficial. The key decision to make in this case is anchor for monetary policy. Many countries shifting to identify the anchor currency. IMF (2010) suggests from a fixed to flexible exchange rate regimes that this choice should be contingent on whether have favored an inflation targeting framework over the anchor-currency country meets the criteria money targeting. Many of them adopted inflation for an optimal currency area: (i) higher trade; (ii) targeting over long time horizons, taking the time symmetric shocks; (iii) higher labor mobility; and required to fulfill the institutional requirements (iv) higher fiscal transfers within the region. and macroeconomic conditions. It is too early for South Sudan to adopt inflation targeting, 27. If South Sudan decided to pursue the given the weakness of the financial sector and ERBS path, full dollarization may be an the low government capacity. Monetary targeting option. Dollarization may indeed be a stronger combined with tight coordination with fiscal arrangement than a currency board, as it policy would be a more appropriated framework. eliminates the risk of future currency crises and Reducing the central bank financing of the fiscal reduces the costs of international transactions. deficit should be an intermediary target of the Credibility of dollarization can be boosted monetary policy, and more appropriated than by political backing of the country whose direct price administration. currency is adopted and with an agreement on seigniorage sharing. A currency board could, in 25. Considering the limited institutional capacity, principle, impose a much stricter discipline on the lack of independence of its central bank the monetary authority than dollarization, but and significant credibility problems in recent given the history of governance problems with history, it is highly unlikely that South Sudan has the Bank of South Sudan and the failure of an the capacity to follow an MBS. Credibility issues earlier fixed exchange rate regime, establishing associated high inflation, governance problems the credibility of a currency board arrangement at the central bank, and fiscal dominance, as without externally imposed safeguards could be well as a low level of financial development and difficult. Further, more time might be needed significant weaknesses in statistical databases to garner political support for adopting a (both precluding reliable monitoring and central bank and fiscal responsibility legislation forecasting of macroeconomic indicators) make consistent with international best practice. MBS an unlikely choice at this stage. Also, ERBSs are typically short-lived because they are prone to runs on the currency and to real xii Executive Summary exchange rate appreciations that are corrected 29. Upon stabilization, South Sudan would need by devaluations. By eliminating the domestic to implement structural and fiscal reforms to currency, dollarization eliminates currency crises enhance efficiency and to prevent recurrence. and increases exit costs. As a result, dollarization Once the high inflation situation stabilizes, South can be sustained over a longer period of time. Sudan should prepare to implement a broader set of structural and fiscal reforms along with 28. Dollarization might help improve some of price and exchange rate liberalization to prevent the macroeconomic weaknesses present in recurrence.1 To unlock affordable credit lines South Sudan. Dollarization could eliminate the from international capital markets, South Sudan possibility to finance the fiscal deficits by printing needs to manage its public debt, improve export money and, thus, could promote fiscal discipline. competitiveness and also offset the negative Moreover, the halt to discretionary monetary repercussions of the appreciation of the currency policy could help lower inflation expectations. of the country from where it sources its imports In addition, the elimination of exchange rate against the US dollar. Attracting both debt and risk might increase capital inflows, which could non-debt creating capital flows, notably foreign improve the external balance. An additional and direct investment, would require supportive important consideration is that dollarization is not measures such as the alignment of the country’s irreversible and the government of South Sudan investment laws and procedures to international could decide to introduce a domestic currency best practices, investor-friendly policies, better and move toward an MBS if it desired. In practice, enforcement of rule of law and the respect of hard pegs, including dollarization, have proven property rights. The government should also strive to be easier to abandon than originally believed to improve its relations with the international by, for example, issuing quasi-monies or official community to deal with negative perceptions money accepted for tax collection (de la Torre that have tended to increase the country’s risk, et al., 2003). The experience of dollarization in making borrowing from offshore sources very Ecuador described in the previous section could expensive, even for private sector entities. be relevant for South Sudan. Which stabilization path for South Sudan? Exchange- Rate-Based Stabilization or Money-Based Stabilization? ¹ The importance of structural reforms cannot be overemphasized even countries that do not have their own currency. For example, in crisis in Greece was fueled by the lack of supportive policies to keep the budget deficit under control, which undermined confidence in the country’s ability to remain within the European Monetary Union. Executive Summary xiii 1 Economic developments – Soaring inflation, poverty and food insecurity 1.1 Background 1.1 Background 1. The Republic of South Sudan emerged in affected and fragile countries, unable to 2011 from decades of conflict as the world’s emerge from cycles of violence. The narrow newest independent country, with huge state elite capture of the state created by the 2011 and peace building challenges, and extreme political settlement, the legacy of several decades institutional and socio-economic deficits. South of conflict that help legitimize violence, the Sudan became independent on July 9, 2011 intercommunal violence, rebel movements and after a six-year transitional period that followed local militia represent significant threats to peace the signing of the 2005 Comprehensive Peace and stability in South Sudan. Its conflict with Agreement (CPA). The CPA ended decades of Sudan over border issues and the outbreaks of war between the Government of Sudan and internal violence in December 2013 and July 2016 the Sudan People’s Liberation Movement/Army that morphed into interethnic conflict suggest (SPLM/A). The SPLM/A formed the Government of that South Sudan is trapped in a cycle of violence. the new country, based on the results of elections Since 2013, combatants officially committed to held in 2010. South Sudan joined the World Bank peace on at least 11 occasions, only to violate Group in April 2012 (World Bank, 2015). their commitments almost immediately. Despite the signing of the peace agreement in 2. Six years after independence, South Sudan August 2015, SPLM/A in Government, SPLM/A in remains one of the world’s most conflict- Opposition and other armed groups undertook 1 1. Economic developments - Soaring inflation, poverty and food insecurity military operations, including targeting of civil war. As a response, the Government tried civilians, throughout 2016 and 2017 with dire to cut spending but with its limited room to consequences for the population. The escalation maneuver, the fiscal deficit more than tripled to of the war generated large displacements of reach 12 percent of GDP in FY14/15, up from 3.7 population – most notably since November 2016. percent in FY13/14, financed mainly by the Bank The famine declared in February 2017 underscores of South Sudan (BSS). the severity of the humanitarian crisis. 5. A dual exchange rate has fueled rent-seeking 3. At independence, the new government inherited behavior and introduced economic distortions. a country with favorable macroeconomic South Sudan has maintained an exchange rate conditions. Almost three quarters of the oil peg to the dollar since the early months after production of pre-independence Sudan, 55 independence. However, stabilizing the foreign percent of its fiscal revenues, and about two- exchange market at the peg has been very thirds of its foreign exchange earnings, belonged difficult as this requires a large level of foreign to South Sudan. In 2011, both fiscal and current reserves but reserves have dramatically declined account balances displayed surpluses of due to disruptions in oil production and low respectively 3.7 percent and 9.5 percent of Gross prices exacerbated by a disadvantageous transit Domestic Product (GDP). The stock of outstanding arrangement with Sudan. The financing of the external debt was below 7 percent of GDP since widening current account deficit has been no apportionment of Sudan’s unsustainable difficult and the pressure on international reserves burden took place, and all the major donors increased significantly pushing the Government were ready to support the country’s development to implement currency restrictions. As a result, agenda. While poverty was high with 47 percent economic agents shifted demand to the parallel at independence, it was on a downward trajectory exchange market, driving the unofficial rate to from 51 percent in 2009. more than 18 South Sudanese Pound (SSP) per dollar by end November 2015, against an official 4. The cumulative effects of repeated policy rate at 2.95 SSP per dollar, yielding a market mistakes, the escalation of violence since premium of more than 500 percent that favored a December 2013, and inadequate response to hidden transfer of resources from the government external shocks, including the declining oil prices, to vested interests who received dollar allocations have jeopardized the country’s macroeconomic at the overvalued official rate. framework. The heavy dependence on oil led to a growth collapse (over 45 percent GDP contraction) 6. The Government of South Sudan abandoned in 2012 following the dispute between South Sudan the fixed exchange rate arrangement and and Sudan and the subsequent oil shutdown, adopted a floating exchange rate regime in with exports, imports, investment and household December 2015. The decision was expected to consumption decreasing sharply. Macroeconomic help reduce the country’s huge macroeconomic stability has been compromised following each imbalances and create the conditions to build episode of conflict escalation. Lower oil production, a stable macroeconomic framework. Although loss of assets and livelihood opportunities, the fiscal situation improved after the floating and destruction of market infrastructure have of the exchange rate, the positive effects of the contributed to further GDP contractions starting devaluation were eaten up by further declining 2014. Declining oil production and prices have international oil prices. Non-oil revenues were put additional pressure on the economy already absorbed by government agencies overspending weakened by the oil shutdown and the ongoing on operating budget lines, while the transfers 1. Economic developments - Soaring inflation, poverty and food insecurity 2 to Sudan were paid in dollars. Fiscal space was price in food and non-alcoholic beverages. further reduced by security spending and a massive civil servant pay increase. The currency 8. The renewed threat of violence and instability reflected expectations of continued monetary are likely to aggravate the situation. In a financing of the deficit. The SSP continued to context of violence and widespread conflict, it depreciate on the parallel market from SSP 18.5 is unlikely that the macroeconomic woes of the per dollar to SSP 70 by dollar by end August 2016 South Sudanese will be remedied anytime soon. and SSP 172 by August 2017. Instability is contributing to the limited supply of foreign exchange by deterring foreign investors 7. Increasing inflation. Consistent with exchange and traders from contributing to the South rate changes, we observe an increase in annual Sudanese economy. The conflict has also impacted Consumer Price Index (CPI) from 1.7 percent in aid work, and is likely to reduce the livelihoods of 2014 to about 30 percent in 2015 and 480 percent the poorest and of those displaced by the conflict, in 2016. The increases were mainly driven by high who may need to rely on humanitarian relief. 1.2 Recent economic developments Growth 9. By August 2016 South Sudan displayed all the 10. Declining oil production and prices have put signs of macroeconomic collapse, with output additional pressure on the economy already contracting, completely depleted fiscal and weakened by the 2012 oil export shutdown external buffets inherited at independence, risk (linked to a dispute with Sudan about transit of hyperinflation and parallel exchange market fees) and the civil war. Oil production decreased premium spiraling. The economy is estimated to to about 120,000 barrels per day in FY16/17 down have contracted by 11 percent in FY2016/17 due to from around 140,000 barrels per day in FY2015/16, conflict, oil production and agriculture disruptions, 165,000 barrels per day in 2014 and a peak of reversing the trend of poverty reduction reaching a 350,000 barrels per day before independence in poverty headcount rate of 66 percent.² The economy 2011, while oil prices declined from US$96 in 2014 to is expected to contract further by about 11.2 percent US$ 43 in 2016 and US$ 55 in 2017. Despite a slight in FY2016/17 with both the oil and the non-oil increase in 2017, oil prices continue to mute the sectors expected to decrease.³ On the demand side, exchange rate reform initiated in December 2015 exports and household consumption are expected as the increase in the SSP value of oil revenues is to decline, while government consumption is eaten up by the drastic decrease in the USD value projected to increase due to spending on defense of oil revenues. and security (Table 1). ² South Sudan High Frequency Survey Wave 1 restricted to 6 states (Greater Equatoria and Greater Bahr El Ghazal). ³ The magnitude of the contraction needs to be considered with care given lack of reliable information on the current state of economy. 3 1. Economic developments - Soaring inflation, poverty and food insecurity Table 1 Macroeconomic outlook - South Sudan 2012 2013 2014 2015e 2016e 2017f 2018f 2019f GDP, at constant market prices -46.1 13.1 3.4 -10.8 -11.2 -6.6 0.4 2.1 Private Consumption 4.5 4.2 -6.5 -25.3 -15.8 -14.4 -2.0 0.7 Government Consumption -6.8 10.9 13.0 0.4 3.0 3.0 4.0 4.0 Gross Fixed Capital Investment -53.2 17.6 -2.5 0.0 0.0 3.0 4.0 5.0 Change in Inventories, % contrib 0.1 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Exports, Goods and Services -91.9 99.5 52.8 -40.0 -44.0 -20.0 0.0 5.0 Imports, Goods and Services -35.3 10.7 5.1 -41.0 -17.0 -10.0 3.2 5.1 GDP, at constant factor prices -46.1 13.1 3.4 -10.8 -11.2 -6.6 0.4 2.1 Agriculture 8.4 15.5 5.0 2.5 -15.0 -10.0 -5.0 0.0 Manufacturing -81.2 45.7 26.9 -23.3 -20.5 -5.9 1.1 3.0 Services 4.8 18.2 -6.2 -6.1 -6.1 -6.1 0.0 2.0 Inflation (Consumer Price Index) 45.1 0.0 1.7 153.0 410.0 na na na Current Account Balance,% of GDP -20.6 8.7 -4.8 -6.1 -5.0 3.1 -11.5 0.0 Fiscal Balance, % of GDP -16.3 -3.3 -12.0 -12.9 -14.2 -13.8 -10.7 -12.5 Poverty rate ($1.90 a day, PPP terms) 50.1 .. 55.1 65.6 Poverty rate ($3.10 a day, PPP terms) 71.0 .. 74.6 85.8 Notes: e = estimate, f = forecast. Source: World Bank Macro Poverty Projections 2017 11. Sizeable payments from South Sudan to could potentially increase its current receipts from Sudan as part of the Transitional Financial oil production, but the range depends much on Arrangement (TFA) are further diminishing oil the magnitude of the actual renegotiation. Even if revenues. The TFA is based on South Sudanese South Sudan manages to negotiate better terms oil volumes flowing through Sudan for export for the TFA payments, there remain concerns through Port Sudan, and covers a transit fee of about security and the durability of the peace US$9.5 that is added to a rate of US$ 15 per barrel. agreement. Furthermore, additional measures As a result, oil revenues had fallen from 23 % of to address production recovery, transport GDP in FY13/14 to 14.6 % of GDP in FY14/15 and and infrastructure barriers and the poor local are estimated to have dropped to 11.4% of GDP in management are required for the revitalization FY15/16. With lower TFA payments South Sudan of the oil sector (Box 2). Policy mistakes and violence jeopardize the macroeconomic framework 1. Economic developments - Soaring inflation, poverty and food insecurity 4 Box 3 Oil revenue forecast and governance4 South Sudan’s legal frameworks for oil and gas management are either poorly implemented or partially absent. The absence of a permanent constitution leads to uncertainty with respect to the legal framework related to the oil and gas sector. Currently, the management of petroleum and gas is based on two legal frameworks. The National Petroleum Act (PA) of the Republic of South Sudan (RSS) governs the management of petroleum resources while the Petroleum Revenue Management Act (PRMA) governs the allocation and accounting for the proceeds of the government’s share of production. Although the frameworks exist, their implementation is very limited. Furthermore, the downstream sector (refining, exporting and product pricing) is currently not regulated. Petroleum revenue management is insufficiently monitored. The last national and publicly released audit was conducted for 2008 raising major concerns for accounting and documentation of transactions. The National Audit Chamber would benefit from appropriate funding and staffing so that audits of the national accounts can be brought up to date and extended to the state and local levels. Additional gaps could be reduced by establishing regulatory certainty by regulations, formal processes for budget interactions with the operators, a recoverable cost audit, improved and better resourced internal and external audit function as well as establishing the Public Accounts Committee. The RSS can induce oil operators to continue production at low oil prices by allowing larger recovery of costs. Once oil production becomes unprofitable in the medium-term, operators are likely to terminate their contracts. An oil price of at least US$83/bbl is required to keep production in all blocks going. The minimum oil price required drops by 20 percent if the operators are allowed to recover 100 percent of costs. Oil production becomes unprofitable for all blocks at an oil price below US$38.2/ bbl even if Government allows 100 percent cost recovery and relinquishes its share in revenues. Thus, an oil price permanently below this will likely lead to a stop of production. Large-scale investment in investment in Enhanced Oil Recovery (EOR) can substantially increase oil revenues for the Government. A resumption of production in all blocks would generate 18 percent higher Government oil revenues over the remaining lifetime of the oil fields compared to current production (Scenario “Peace” in Figure 1). Additional investment into EOR and the construction of a 350 km pipeline to remove restrictions on current production due to export limitations would provide 142 percent additional revenues (Scenario “Investment’ in Figure 1). Thus, an investment into EOR and the pipeline – if enabled by security as well as regulatory and contractual certainty – can substantially increase oil revenues for the next decades. At this stage, however, such a scenario remains highly unlikely. ⁴ South Sudan Inclusive Growth Economic Memorandum Background Paper: South Sudan Petroleum Sector – Revenue Forecast and Governance, World Bank (2017). 5 1. Economic developments - Soaring inflation, poverty and food insecurity Figure 1 Projections of oil revenues 4,500 4,000 3,500 3,000 Millions US$ 2,500 2,000 1,500 1,000 500 0 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 2032 2033 2034 2035 2036 2037 2038 2039 2040 2041 2042 2043 2044 (1) Status Quo (2) Peace (3) Investment Source: Republic of South Sudan Inclusive Growth Country Economic Memorandum, World Bank (2017). The RSS can help attract needed investment by providing security, regulatory certainty and overcoming the monopolistic export infrastructure. Investors need to be confident that the state can provide the necessary security for the private sector to work in the contract area without disruption. Furthermore, investors still face risks arising from changes in regulatory and legal framework. The risk could be reduced by implementing a permanent constitution and the ratification of existing laws governing the sector. Another disincentive to investment is that the only export infrastructure available is under a monopolist control. In addition to moderately high oil prices, discoveries must be large enough to justify construction of alternative export routes. The international community could support the necessary studies to establish the costs of an alternate pipeline route. This would likely establish some negotiating boundaries for the parties and potentially lead to a long-term agreement to provide the certainty for investment in the petroleum sector in the RSS. A reform in the oil sector should be accompanied by a transparent use of funds to benefit the people of South Sudan. Even if the contracts are extended and investments are made, it will be difficult to ensure that oil revenues are consistently used for the “benefit of the people of South Sudan” as the Transitional Constitution requires. The RSS could create a social protection program using oil funds to make periodic payments to specific categories of vulnerable citizens. However, for the public to able to participate in the discussion related to the use of resource revenues, they would also need to have access to information regarding the amount of revenues received and their current distribution. A transparent, fair and public use of funds would add to the credibility of the Government and, thus, could contribute to stability and peace in South Sudan. Source: Republic of South Sudan Inclusive Growth Country Economic Memorandum, World Bank (2017). 1. Economic developments - Soaring inflation, poverty and food insecurity 6 Exchange rate and inflation 12. Devaluation and the move toward managed exchange rate arrangement) to SSP 70 per dollar float of its currency in December 2015 only by end August, 2016 and SSP 150 by mid-May 2017 partially remedied South Sudan’s economic (Figure 2). Political events drove the volatility of the problems. In the short-run, the decision was SSP: the pound initially appreciated on the parallel expected to improve the country’s fiscal and market and converged with the commercial rate external positions, by increasing oil revenues and when the Government of National Unity came aid inflows in local currency and reducing imports. into place, but it later depreciated steadily, in However, devaluation alone has not resolved the particular after the new fighting erupted in July fiscal situation as some of the positive effects of 2016. It has continued to depreciate steadily devaluation were diminished by further declining since as instability across the country continues. international oil prices that are putting significant Following a temporary convergence of the two pressure on the exchange rate (which is feeding rates in March 2017, the spread between the official into domestic prices) and contributing to widening and the parallel market rates has widened again by the fiscal deficit. May 2017 with an increasing gap. The divergence between the two rates reflects that demand for 13. The South Sudanese Pound (SSP) is continuing hard currency continues to outweigh the limited it depreciation. The SSP depreciated from SSP 18.5 supply of foreign exchange given unresolved fiscal per dollar in December 2015 (following the move and monetary issues as well as challenges in the to a managed floating exchange rate from a fixed interbank market for foreign exchange. Figure 2 Exchange rate SSP to USD Gap between the parallel and commercial rates 180 160 140 120 100 80 60 40 20 0 12/10/2015 12/11/2015 12/12/2015 12/01/2016 12/02/2016 12/03/2016 12/04/2016 12/05/2016 12/06/2016 12/07/2016 12/08/2016 12/09/2016 12/10/2016 12/11/2016 12/12/2016 12/01/2017 12/02/2017 12/03/2017 12/04/2017 12/05/2017 12/06/2017 Parallel Commercial Source: World Bank High Frequency Survey⁵ ⁵ http://www.thepulseofsouthsudan.com/data/ 7 1. Economic developments - Soaring inflation, poverty and food insecurity 14. Evidence from other African countries Zambia). Fiscal factors account for a substantial suggests that a unification of the official and rise in the inflation rate following the unification parallel markets by exchange rate policy cannot attempt. Given that the parallel market rate is succeed without fiscal discipline. A review of an implicit tax, there is a trade-off between the African countries’ experience with market-based premium (tax on exports) and inflation (tax on exchange rate arrangements, specifically with domestic currency holdings) in financing the foreign exchange auctions and floating rates, budget deficit. The loss of revenue from exports shows that success of such auctions to absorb through unification is replaced by an increase in the parallel market and reduce or eliminate the monetary financing of the budget deficit and a premium (for example, in Gambia) is associated higher tax on domestic cash balances. with stabilization or reduction of liquidity growth. By contrast, the failures of auctions and floats (for 15. The rapid depreciation of the SSP has example, in Ghana and Zambia) are associated coincided with a period of high inflation. The with a loss of control over monetary policy annual Consumer Price Index (CPI) increased by (Agenor, 1992). The evidence also suggests that the 480 percent in 2016 and by 155 percent during premium fell sharply in all countries following the July 2016-July 2017 according to the latest official exchange rate reform, but a significant premium statistics (Figure 3). Notwithstanding the recent reemerged subsequently in those countries downward trend, the very high inflation continues where money growth was not kept under control to put many households in both urban and rural (for instance, in Ghana, Somalia, Sierra Leone and areas unable to afford the minimum food basket. Figure 3 CPI inflation, year-on-year 600 500 400 300 200 100 0 May 2015 Jun 2015 Jul 2015 Aug 2015 Sep 2015 Oct 2015 Nov 2015 Dec 2015 Jan 2016 Feb 2016 Mar 2016 Apr 2016 May 2016 Jun 2016 Jul 2016 Aug 2016 Sep 2016 Oct 2016 Nov 2016 Dec 2016 Jan 2017 Feb 2017 Mar 2017 Apr 2017 May 2017 Jun 2017 Jul 2017 Source: South Sudan National Bureau of Statistics⁶ CPI increased by 155% during July 2016 - July 2017 ⁶ http://www.ssnbs.org/cpi/ 1. Economic developments - Soaring inflation, poverty and food insecurity 8 Fiscal policy 15. The fiscal deficit remains wide, but real the Bank of South Sudan to bring down inflation magnitudes are difficult to estimate given the and prevent further depreciation of the currency. In high inflation and lack of real time data. Based terms of resource allocations for 2016/17, about 42 on the FY 2016/17 budget, the fiscal deficit is percent of the total domestically financed budget estimated at about 14 percent of GDP. of about 33.3 billion SSP would be allocated to salaries dominated by the security sector, 19.5 16. The 2016/17 budget was expected to restore percent to operating and capital expenditure, 19 macroeconomic stability. The 2016/17 budget percent to transfers to states and counties, and proposal was presented to the Transitional National about 14 percent to peace and security. In terms Legislature in October 2016. The Economic and of sectoral expenditure, combined expenditure Fiscal Stabilization Measures and Action Plan on health and education is expected to make up presented as part of the budget put special around 6 percent of total government spending, emphasis on increasing non-oil revenues, reducing with expenditure on security, public administration expenditure and improving cash management. The and rule of law projected to get the largest share plan also recommended to stop borrowing from continuing the trend of the last two years (Figure 4). Figure 4 Sectoral expenditure, percentage 2.2 Natural resources 3.5 3.2 1.4 Infrastructure 1.8 1.7 1.8 3.1 Health 3.5 4.2 Education 6.6 5.6 33.1 Security 44.3 36.6 Accountability, Public Admin 26.7 30.7 & Rule of Law 24.7 0 5 10 15 20 25 30 35 40 45 50 2016/17 2015/16 2014/15 Sources: 2016/17 Budget Proposal and 2015/16 and 2014/15 Macro Fiscal Reports⁷ 17. The Government of South Sudan’s expenditure conflict “remission” episodes (Carey and Harake, on defense is high relative to other countries 2017) shows that post-conflict spending on military emerging from violent conflict. While the current declines sharply to between 2 to 3 percent of GDP crisis in South Sudan has unique characteristics, in remission countries with a rearrangement of it may be useful to look at other cases of conflict spending priorities toward social objectives. By resolution to provide guidance on policy options contrast, spending on military in South Sudan and implementation. A recent review of violent amounted to more than 33 percent during the ⁷ http://grss-mof.org/ 9 1. Economic developments - Soaring inflation, poverty and food insecurity last three fiscal years. There is need to reprioritize 2013, the civil conflict that erupted in December allocation of public expenditure away from defense 2013, and the sharp drop in international oil prices with increased focus on capital expenditure and since mid-2014. Moreover, a highly overvalued poverty-targeted expenditure such as education, exchange rate in the period up to the liberalization health, agriculture, natural resources, and roads. of the foreign exchange market in December 2015 contributed to the rapid depletion of foreign 18. The current account deficit is expected to exchange reserves. As a result, by June 2016, the narrow to 1.6 percent in FY16/17 from about stock of domestic and external debt owed or 6.1 percent of GDP in FY15/16. Export revenues guaranteed by the central government amounted decreased due to declining oil prices and lower oil to about US$1.4 billion (38 percent of GDP), while production. Oil production is expected to decrease foreign exchange reserves had dwindled to about to about 120,000 barrels per day this fiscal year US$70 million (about 2 weeks of prospective down from 165,000 barrels per day in 2014. imports). This crisis has caused payment delays on This is less than half of peak production before international obligations, on civil servant salaries, independence in 2011. However, imports are also and other government obligations. However, expected to decrease significantly, narrowing the international lines of credit have been restructured current account deficit. on longer maturities, international reserves have declined to near exhaustion, and the country is Debt currently constrained from accessing long term external financing. 19. South Sudan is in debt distress. Despite moderate levels of external debt, the combined 20. Assuming implementation of economic impact of a civil conflict, a large fall in oil prices, adjustment policies and a successful peace and high levels of fiscal spending has left South process, the debt outlook would improve Sudan in debt distress. At independence in July considerably.⁸ With peace, good policies, a 2011, the country had neither domestic nor foreign cautious borrowing strategy, and a relatively stable debt. However, since then the fiscal position external environment, South Sudan could attain deteriorated markedly because of a shutdown of external viability over a relatively short period and oil production between January 2012 and April achieve an improvement in its risk of debt distress Debt owed or guaranteed by the central government amounted to about US$1.4 billion by June 2016 ⁸ IMF (2017) “Republic of South Sudan Staff Report for 2016 Article IV Consultation—Debt Sustainability Analysis”. 1. Economic developments - Soaring inflation, poverty and food insecurity 10 rating. This scenario assumes scaling up of external these risks include lack of political commitment borrowing for infrastructure investments in the to implement strong macroeconomic adjustment medium term and cautious domestic borrowing. measures, deadlock in implementing sustainable peace, under-investment for enhanced oil recovery, 21. However, vulnerabilities remain high unresolved territorial issues with Sudan, and and a prolonged period of lower oil prices or protracted rent seeking behavior and corruption. failure to address the country’ s economic and These risks of prolonged fragility underscore the security problems could cause continued debt importance of a commitment to internal peace, sustainability problems. There are substantial economic reforms, and close cooperation with the downside risks to the scenario that assumes international community. adjustment. In addition to subdued oil prices, 1.3 Poverty and livelihoods in a high inflation environment 22. The macroeconomic collapse, particularly Poverty through high inflation and increasing food prices, has led to a sharp increase in 23. Poverty in urban areas of South Sudan consumption based measures of poverty in increased from 49 percent in 2015 to 70 percent urban areas between 2015 and 2016. Urban in 2016.¹¹ In 2016, almost 7 in 10 South Sudanese households are more reliant on markets and in urban areas were living below the international have less recourse to their own production of poverty line¹² (Figure 5). Female headed households food when faced with shortages and rising prices. were poorer than male headed households, with They are also more likely to earn their livelihood more than 3 in 4 female headed households through wages and salaries or through their living in poverty.¹³ These and the following poverty own business enterprise compared to rural estimates exclude 4 out of the 10 former states that households.⁹ Hence, stagnant wage levels and are most insecure (Greater Upper Nile and Warrap) a general slowdown of economic activity will and should be considered lower bounds for poverty. have led to these households experiencing a real Furthermore, data collection in 2016 was limited to decline in purchasing power and heightened urban areas due to growing security and budget food insecurity as food prices rise relative to constraints, and poverty in rural areas South Sudan income levels.¹⁰ tends to be more prevalent than in urban centers.¹⁴ ⁹ Based on the full HFS Wave 1 data (2015), 39 percent of urban households earn their livelihood primarily through wages and salaries and 15 percent from their own non-farm businesses. In contrast, only 6 percent of rural households sustain themselves earning wages and salaries and 4 percent from non-farm businesses. ¹⁰ A more comprehensive presentation of livelihoods and perception can be found in the background paper ‘Poverty, Livelihoods and Perception in a High Inflation Environment’. ¹¹ Poverty is measured by the poverty headcount index, defined as the percentage of the population living below the poverty line. The analysis is based on the international US$1.90 PPP (2011) poverty line, which translates into 8.71 SSP in July 2015. The South Sudanese PPP equivalent of the 2011 USD 1.90 international poverty line is USD 1.23 PPP. This is converted into South Sudanese Pound (SSP) at the USD-SSP exchange rate in 2011 of 2.95 and then adjusted for inflation using the CPI calculated by the NBS. All monetary values in this survey are converted into July 2015 SSP PPP. . ¹² With a point-estimate of 70 percent and a 95 percent confidence interval from 63 to 75 percent. ¹³ 66 and 76 percent respectively, p<0.01 ¹⁴ In the first wave of the HFS the poverty headcount was about 50 percent in urban areas, and 68 percent in rural areas. 11 1. Economic developments - Soaring inflation, poverty and food insecurity Figure 5 Urban poverty headcount Figure 6 Urban poverty gap 100% 10 9 (Mean consumption shortfall 80% 8 22% 19% 26% relative to PPP line) Poverty Gap in SSP 7 36% 33% 42% Percentage 60% 6 5 40% 4 3 20% 2 1 0% 0 2009 2015 2016 2015 2016 2015 2016 2015 2016 2015 2016 2015 2016 Total Male Female Total Male Female Head Head Head Head Poverty gap Poverty line Source: Authors’ own calculations based on NBHS 2009, and HFS 2015 and 2016 data. Box 4 The High Frequency Survey collects key data in South Sudan. The High Frequency Survey collected panel data for a representative sample of urban households to relate inflation to changes in livelihoods between 2015 and 2016. The survey conducted repeated interviews for a sample of 643 households in urban centers across 6 of the 10 former states of South Sudan, drawn randomly based on a stratified two stage clustered design.¹⁵ The fieldwork for Wave 1 was undertaken between the months of February to November 2015, and Wave 2 from January to May 2016. Although inflation had not reached its current levels, price increases remained high over the sample period, with prices in May 2016 reaching almost five times their February 2015 levels.¹⁶ The conflict did not escalate until after July 2016, thus, the changes in livelihoods observed between the two waves were not primarily driven by insecurity. The HFS questionnaire covers a large range of topics, and paints a well-rounded picture of the material and psychological well-being of people in urban areas of South Sudan. The HFS questionnaire ¹⁵ The surveys were conducted over two waves of data collection. Wave 1 was carried out from February to November 2015, and Wave 2 from January to May 2016. A more detailed breakdown of the interviews by month can be found in the technical appendix accompanying the data. The data and the appendix are freely available on the World Bank’s Microdata Library catalog (http://microdata.worldbank.org). ¹⁶ Based on the High Frequency Price Index calculated using HFS market prices data. 1. Economic developments - Soaring inflation, poverty and food insecurity 12 covers topics including demographics, employment, education, consumption, as well as perceptions of well-being and of the effectiveness of public institutions. Consumption is measured using the newly developed rapid consumption methodology. In the rapid consumption methodology food and non-food consumption items are partitioned into core and non-core modules, and households are asked only about items in the core and in an assigned module. This reduces the number of items asked to households from 270 to about 120, household consumption is then estimated based on within survey multiple imputations.¹⁷ The data is complemented by video testimonials providing a glimpse of the lives of the people of South Sudan. At the end of the interviews, respondents are offered to provide a short video testimonial where they can share their views and anything they would like to communicate. This creates a more rounded perception of the situation on the ground in South Sudan. The translated testimonials are available at http://www.thepulseofsouthsudan.com. 24. Poor urban households were worse off in richer groups in the population of South Sudan 2016 than they were in 2015, as indicated by an (Figure 7), wage earning households experienced increase in the poverty gap. The urban poverty the largest decline in consumption compared gap increased from 21 to 36 percent between 2015 to households relying on other sources of to 2016, meaning that the average poor urban livelihood. Between 2015 and 2016, consumption household went from consuming 21 percent less for salaried households fell by more than a third than the international poverty line of US$ 2011 PPP (p<0.001). This caused many of these households 1.90 in 2015 to 36 percent less in 2016.¹⁸ Female to fall into poverty, and the poverty headcount headed households tended to be further away amongst wage earning households more than from the poverty line, with an average poverty gap doubled between 2015 and 2016 (28 and 62 of 41 percent compared to 25 percent for their percent respectively, Figure 8, p<0.001). Indeed, male counterparts (Figure 6, p<0.05). Inequality the households still relying on wages and salaries amongst the poor also worsened, and the poverty in 2016 were disproportionately represented in severity index doubled from 0.10 in 2015 to 0.20 the population that fell into poverty between in 2016 (p<0.001).¹⁹ 2015 and 2016 (45 and 33 percent respectively, p<0.05). Similarly, poverty amongst households 25. The rapid loss of wages’ purchasing power drawing on their own business enterprise for their accounted in large part for the increase in livelihood saw a marked increase, from 43 to 61 poverty. Although households supported percent between 2015 and 2016 (Figure 8, p<0.05). primarily by wage earners remained amongst the ¹⁷ More details on the rapid consumption methodology can be found in Pape and Mistiaen (2015). ¹⁸ The poverty gap is the average gap in consumption of poor households relative to the poverty line. ¹⁹ Poverty severity is the average of the squared poverty gap, the poverty severity index therefore places more weight on poorer households and can capture inequality among the poor. 13 1. Economic developments - Soaring inflation, poverty and food insecurity Figure 7 Source of livelihood by poverty Figure 8 Poverty headcount by source of status, urban livelihood, urban 100% 100% 80% 80% 60% 60% Percentage Percentage 40% 40% 20% 20% 0% 0% 2015 2016 2015 2016 2015 2016 2015 2016 2015 2016 2015 2016 2015 2016 Non-Poor Poor Agricultural Production Wages & salaries Own business enterprise Property income Remittances/ Aid/Others Remittances/Aid/Others Property income Own business Wages & salaries Agriculture Source: Authors’ own calculations based on HFS 2015 and 2016 data. Labor and employment 26. Economic instability led many of the and across expenditure quintiles, but in 2016, working age to drop out of the labor force. this difference became much more marked, The urban labor force participation rate in especially amongst people in the poorest urban South Sudan dropped from one half to quintile for whom the labor force participation one third between 2015 and 2016 (50 percent rate dropped from one half in 2015 to below one to 33 percent respectively, p<0.001).²⁰ The fifth in 2016 (51 and 17 percent respectively). particularly volatile economic, political and security conditions may be responsible for this 27. The unemployment rate remained stable surprisingly low active labor force participation.²¹ between 2015 and 2016, and about one in Poorer households experienced a larger decline ten South Sudanese were unemployed. The in labor force participation. In 2015, the labor unemployment rate in South Sudan was 9 force participation rate remained relatively percent in 2015 and 11 percent in 2016. Relatively similar between poor and non-poor households high levels of employment are common in ²⁰ The labor force participation rate is the ratio of the active in the labor force to the total working age population. A person is defined as active if of working age and currently in employment or unemployment. More details on the construction of these variables can be found in the technical appendix. ²¹ The labor statistics of the HFS are drawn from an interview of a knowledgeable person (often the household head) in the household asked about the other members in the household. This often results in less accurate reporting than individual interviews with all household members. The labor force participation over a longer reference period, 12 months instead of 7 days, is considerably higher and more consistent with levels typical of a developing country higher (75 percent in 2015 and 54 percent in 2016, p<0.001). 1. Economic developments - Soaring inflation, poverty and food insecurity 14 developing countries, largely because the many unemployed become inactive because lack of a social safety net eventually forces the they give up looking for a job after losing hope unemployed into subsistence farming and other to find one of the few opportunities. such forms of basic self-sustenance. In addition, Figure 9 Employment by type, urban 2015 2016 Poor Poor Non-Poor Non-Poor Richest Quintile Richest Quintile Q4 Q4 Q3 Q3 Q2 Q2 Poorest Quintile Poorest Quintile Women Women Men Men Total Total 0% 20% 40% 60% 80% 100% 0% 20% 40% 60% 80% 100% Percentage Percentage Salaried labour or labour paid in kind Run a non-farm business Help in any kind of non-farm business Apprenticeship Farming/hunting/fishing at own account Source: Authors’ own calculations based on HFS 2015 and 2016 28. Farming, hunting, and fishing at own account were undertaking agricultural production in 2015. became a more common type of employment, In 2016, this number doubled to about 4 in 10 in particular amongst the richest households (from 18 to 36 percent for the top quintile, p<0.01, (Figure 9). In 2015, the non-poor were much and from 19 to 42 percent for the fourth quintile, more likely to be employed as salaried workers p<0.05). This shift in employment patterns is (29 and 28 percent for the top and fourth consistent with business income or wages and quintile respectively), or to help in or run a non- salaries becoming less reliable sources of income, farm business (46 and 52 percent for the top forcing people to enter agricultural production and fourth quintile respectively). Meanwhile, at their own account. workers in the second and third quintiles of income were more likely to farm, hunt, or fish at 29. Despite lower economic outcomes school their own account compared to workers in the attendance remained stable, about 3 in 4 of top two quintiles and the bottom quintile (20 vs. the South Sudanese children were attending 38 percent respectively, p<0.05). The economic school in early 2016. The school attendance rate turmoil changed this, and many households in was 76 percent in both 2015 and 2016. This is a those quintiles turned to agricultural production. relatively high rate of attendance, and may have Only about 2 in 10 people in the top two quintiles deteriorated since, given the political instability 15 1. Economic developments - Soaring inflation, poverty and food insecurity and escalation of insecurity that took place since sustain its livelihood. However, there were no this data was collected. Nevertheless, educational indications that this was happening at a large outcomes amongst the poor slightly improved scale in the states covered by the survey in 2016. from 2015 to early 2016. In particular, school The school attendance rate of boys aged 14 to attendance of children in the poorest quintile 18 was slightly lower in 2016, having declined increased from 61 percent in 2015 to 72 percent from 88 percent in 2015 down to 79 percent in in 2016 (p<0.05). 2016 (Figure 11). However, this difference is not statistically significant. Again, it should be noted 30. In early 2016, there were no indications that that this data dates from early 2016, before the older children were dropping out of school to conflict escalated. It is difficult to predict how join the labor force. It would be expected that these trends may have evolved since, but these during times of economic hardship children of figures do indicate that inflation at the levels working age would drop out of school and join which it stood in the period under study did not the workforce in order to help the household cause a large decline in school attendance. Figure 10 School attendance Figure 11 School attendance children aged 6-13, urban children aged 14-18, urban 2015 2015 2016 2016 2015 2015 2016 2016 2015 2015 Total Total 2016 2016 0% 20% 40% 60% 80% 100% 0% 20% 40% 60% 80% 100% Attending Not attending Attending Not attending Source: Authors’ own calculations based on HFS 2015 and 2016 1.4 Food insecurity due to conflict and high inflation 31. South Sudan’s unprecedented level of have further aggravated already overwhelming hunger is the most alarming signal of the needs. Nearly 3.6 million people were estimated country’s larger economic collapse. Despite the to be severely food insecure between October and agricultural potential, the rural population has December 2016, the highest levels experienced been continuously affected by food insecurity in in South Sudan at harvest time. In both rural and the last few years. Food security in South Sudan urban areas, the food insecure population has is increasingly deteriorating since the conflict in at least doubled compared to the same time 2013. Heightened tensions and renewed clashes last year. As of February 2017, famine has been across the country following the July 2016 conflict declared in parts of South Sudan, with about 1. Economic developments - Soaring inflation, poverty and food insecurity 16 4.9 million people (and projected to increase to (Figure 12). The total number of refugees from 5.5 million in July 2017) in need of urgent food, South Sudan has increased to 1.3 million, while agriculture and nutrition assistance (FAO, 2017). two million people are counted to be internally This condition (IPC Phase 5) is marked by high displaced. Predicted changes in climate, both levels of excess mortality. Unity State, where in terms of more intense rainy seasons as well displaced households already face an extreme as hotter and dryer dry seasons, could heighten lack of food, is the area of greatest concern future food insecurity nationally. Figure 12 Food security outcomes, April 2017 Source: FEWSNET (2017a)²² 32. A confluence of reasons has led to the 33. Food production shortfalls are substantive. observed food insecurity. These include: (i) Preliminary results of the FAO/WFP Crop and reductions in domestic production due to Food Security Assessment Mission ( CFSAM) conflict and drought; (ii) regional drought in the state that overall food production for 2016 (the Horn of Africa (especially Uganda and Sudan, the last harvests of which came in January, 2017) major sources of South Sudan’s food imports) is estimated at about 10 percent below the which has reduced output in these countries already low and insufficient long-term average thus constricting the amount of imports that of 826,000 tons. In addition, FAO and WFP South Sudan can viably access; (iii) high food (2017) estimate a cereal deficit of about 498,800 prices mainly driven by the high inflation rate tons in 2017 up from 381,000 tons in 2016 and and the depreciation of the local currency; and 248,666 in 2015 (Figure 13). With the exception (iv) destabilization of markets due to restrictions of Warrap, all states in South Sudan face deficits on movements in commodity supply corridors. of cereals in 2017. The conflict-troubled state of ²² http://www.fews.net/east-africa/south-sudan/food-security-outlook/february-2017 17 1. Economic developments - Soaring inflation, poverty and food insecurity Jonglei is projected to face the highest deficit over 300,000. In certain states such as Lakes, of over 150,000 tons of cereals. The largest 2017 Northern Bahr el Ghazal and Western Bahr el deficits are forecasted in the three most conflict- Ghazal states, FAO and WFP (2017) forecasts a stricken states of Jonglei, Unity and Upper Nile moderate deficit of less than 40,000 tons. states, with an aggregate shortfall in cereal of Figure 13 Estimated cereal deficit/surplus 2014-2017 100,000 50,000 0 -50,000 -100,000 -150,000 -200,000 Central Eastern Western Jonglei Upper Nile Unity Lakes Warrap Western Northern Equatoria Equatoria Equatoria Bahr el Bahr el Ghazal Ghazal 2014 2015 2016 2016 Source: FAO and WFP (2017) 34. The decline in production could be also key cultivation months. Production is expected to attributed to a significant decline in the area be significantly below average. In Unity State and under cultivation. Specifically, Aweil North and Central Equatoria State, the results of area planted Aweil West of Northern Bahr el Ghazal State are mixed. Decreased cultivation is also observed both witnessed a significant decline in area in Mayom, which is a part of the state of Unity. In cultivated in 2016 vis-à-vis that in 2012 (Figure Panyijiar, however, above-average cultivation was 14). The reduction in area cultivated is attributed, observed, which was partly driven by substantial in part, to displacement out of the state during IDP inflows. Figure 14 Changes in cultivated area from 2012/2013 to 2016 80% 58% 60% 40% 20% 14% 10% 7% 0% -20% -6% -6% -40% -24% -31% -36% -60% Nyagon, Nyiguol, Angyul, Akwongrail, Mondikolok, Igata, Ikotos, Naperetom, Ador, Tonj Rimenze, Mayom, Panyjiar, Aweil NOrth, Aweil West, Kajo-Keji Eastern Budi, Eastern East, Yambio, Unity Unity Northern Northern Central Equatoria Equatoria Warrap Western Bahr El- Bahr El- Equatoria Equatoria Ghazal Ghazal Source: FEWSNET (2016) 1. Economic developments - Soaring inflation, poverty and food insecurity 18 35. The collapse of the macro-economy, 334 percent between May 2016 and May 2017. especially high inflation has led to large increases The highest increases are registered for bread, especially in food prices. On average, the prices cereals, and fruits with prices increasing by more of most food crops in major markets now hover than 500 percent between February 2016 and around 345 percent to 1100 percent above their February 2017 (Figure 15). Such extreme increases long-term average (2007-2015). According to the in prices have had a serious adverse impact on National Bureau for Statistics, the Consumer Price the purchasing power and the food security of Index for food products increased by 513 percent poor households, the majority of whom depend between December 2015 to December 2016 and on the market for their food supplies. Figure 15 Consumer Price Index (CPI) of select commodity groups in Juba, South Sudan 3,500 Consumer Price Index 3,000 2,500 2,000 1,500 1,000 500 0 Jan 2015 Feb 2015 Mar 2015 Apr 2015 May 2015 Jun 2015 Jul 2015 Aug 2015 Sep 2015 Oct 2015 Nov 2015 Dec 2015 Jan 2016 Feb 2016 Mar 2016 Apr 2016 May 2016 Jun 2016 Jul 2016 Aug 2016 Sep 2016 Oct 2016 Nov 2016 Dec 2016 Jan 2017 Feb 2017 Bread & Cereals Meat Oil & Fats Vegetables Source: SSNBS CPI²³ 36. Hunger for the poorest households increased Figure 16 Hunger incidence over the past 4 sharply between 2015 and 2016. The likelihood weeks, urban of experiencing hunger ‘often’ (more than 10 times per month) increasing from 2 percent to 100% 13 percent for the poorest quintile of households, 80% Percentage while the incidence of experiencing hunger 60% ‘often’ or ‘sometimes’ (3 to 10 times per month) 40% increased from 26 to 44 percent for the second 20% poorest expenditure quintile (Figure 16). While 0% richer households may be able to respond to a rise in food prices by adjusting their diets towards 2015 2016 more staple and less expensive foods, the poorest Poorest Quintile Poorest Quintile households’ diet may already be consisting primarily of such foods, and as prices increase Never Rarely (1-2 times) they are unable to afford even basic sustenance. Sometimes (3-10 times) In 2016, households in the poorest quintile were Often (more than 10 times) more than ten times more likely than households Source: Authors’ own calculations based on HFS 2015 in the top four quintiles to have experienced and 2016. ²³ Available at: http://www.ssnbs.org/cpi/ 19 1. Economic developments - Soaring inflation, poverty and food insecurity hunger ‘often’ in the past month (15 vs. about 1 fuel and mineral dealers profited most from percent respectively, p<0.05). the country’s economic chaos. 37. Survival and coping strategies for the • Those with relatives in the diaspora and population. While awaiting the government’s those engaged in the cross-border trade also commitment to a political settlement and managed to cope with the crisis.²⁴ macroeconomic reforms, the population will likely be forced to engage in creative survival and • Businesses would be advised to never allow coping strategies, often in the informal sector as cash to remain idle, be prepared to convert seen elsewhere. Examples from Zimbabwe, a dollars into a stable foreign currency, whenever country whose annual inflation rate skyrocketed possible, deal in cash payments, develop above 100-thousand percent, highlight innovative practices that enable to internally finance coping mechanisms to allow consumers to afford working capital, and consider the possibility a few basic food items. of acting as an acceptance company to facilitate your customers’ purchases. • Very often homeowners or business owners in Zimbabwe demanded rents and payments 38. Displacement and despair. There is a risk that in US dollars or South African rand. Many South Sudanese citizens are already engaged or residents of high-density areas became will be forced to participate in similar informal vendors, selling a variety of commodities. and often illegal activities. However, the majority Once they got their money at the end of of the population in rural areas will continue the day, they immediately bought foreign to rely on subsistence agriculture, facing dire currency which was resold at a profit. conditions. As opposed to Zimbabwe, there is little evidence that remittances from diaspora • Government employees were still able to go have a significant role in coping with high inflation to work daily and leave for home with some in South Sudan. Anecdotal evidence from South money in their pockets. Some government Sudanese refugees in Australia suggests that most workers reported to have converted their remittances destined to South Sudan (Nimule, Yei, offices into mini-supermarkets to sell scarce Juba) are spent in Uganda and Kenya (Kampala commodities. They were well-positioned and Nairobi). Due to lack of infrastructure (financial because they had phones at their institutions), South Sudanese have to travel to disposal. Their superiors received generous neighboring countries (Kenya, Uganda) to receive allocations to allow them continue such remittances and purchase goods and services informal activities. there. However, with the deteriorating security situation, it is unlikely that such travel remains • A big part of the parallel market revolved possible. Rather, it is expected that the number of around fuel procured by agents of senior refugees will increase, putting additional pressure government officials at subsidized government on receiving neighboring countries.²⁵ rates and resold at high profit margins. Illegal ²⁴ http://www.voanews.com/a/a-13-2008-03-20-voa39/339761.html ²⁵ UNHCR reports that 60,000 people have fled the country since violence broke out in Juba in July, bringing the overall number of South Sudanese refugees in neighboring countries since December 2013 to nearly 900,000. Uganda is currently seeing the heaviest refugee influx, receiving more than 52,000 South Sudanese refugees since the beginning of July 2016. Kenya has reported the arrival of 1,000 refugees in the same period, while 7,000 have fled to Sudan. 1. Economic developments - Soaring inflation, poverty and food insecurity 20 1.5 Perceptions of welfare and performance of public institutions 39. Many household reported lower life for poor and non-poor households overall. This satisfaction and felt less in control of their general decline in life satisfaction was mirrored by daily lives. Respondents were asked to score a growing feeling amongst the South Sudanese their life satisfaction from 0 to 10, where 10 was that they are powerless in the face of deteriorating characterized as the best possible life and 0 as economic and political conditions. The share of the worst possible life for them. The average life respondents who felt that they had no control satisfaction score fell between 2015 and 2016, over their daily lives increased from about one from about 3.5 to about 2.4 out of 10 (Figure quarter to more than one third between 2015 18, p<0.001). A similar decline is observed for and 2016 (25 and 38 percent respectively, Figure respondents across expenditure quintiles, and 17, p<0.01). Figure 17 Feeling in control over own life, urban Figure 18 Life satisfaction score, urban 100% 5 4.5 Mean life satisfaction 80% 4 3.5 (score 0-10) 60% 3 2.5 40% 2 1.5 20% 1 0.5 0% 0 2015 2016 2015 2016 2015 2016 Total Poorest Quintile Q2 Q3 Q4 Richest Quintile Non-Poor Poor Total Poor Non-Poor Complete control A great deal of control Some control No control 2015 2016 Source: Authors’ own calculations based on HFS 2015 and 2016. 40. The majority of respondents were in 2016 (Figure 19, p<0.001). Furthermore, when pessimistic about the future of South Sudan asked about their greatest fear for the future of and believed that economic conditions would South Sudan, respondents in 2016 were much continue to deteriorate. The South Sudanese more likely to cite concerns such as the lack of were increasingly worried about the future of opportunities for youth, a lack of jobs, poverty, their nation’s economy, and pessimism with and an overall bad economy than they were in respect to future economic conditions became previous years. About 3 in 10 respondents cited more prevalent. The share of households believing economic concerns as their main fear for the that conditions in three months will be worse future in 2015, compared to one half in 2016 (29 increased from 38 percent in 2015 to 65 percent and 50 percent respectively, p<0.001). 21 1. Economic developments - Soaring inflation, poverty and food insecurity Figure 19 Perception of economic conditions, urban 2014 Future economic Present economic conditions 2015 2016 2015 (3 months) conditions 2016 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Very bad/Much worse Fairly bad/Worse Neither good nor bad/The same Fairly good/Better Very good/Much better Source: Authors’ own calculations based on HFS 2015 and 2016. 41. Economic and political volatility negatively respondents held a negative view of the Central affected respondents’ perceptions of the Governments’ effectiveness situation (50 and Government’s and other public institutions’ 72 percent respectively, Figure 20, p<0.001). performance. Respondents in urban areas did Respondents were especially dissatisfied with not think that the Central Government and the Government’s performance in dealing other domestic public institutions were very with matters of economic policy. About 9 out effective in improving the living conditions and of 10 respondents rated the government’s life of the people of South Sudan. Respondents’ performance in keeping prices down badly perceptions were already in low in 2015, with in both years. Similar levels of dissatisfaction half of all households believing that the Central were felt with respect to the Government’s Government was ineffective or very ineffective performance in creating jobs and ensuring in improving the daily life of its constituency. everyone had enough to eat, where about 8 out These numbers increased sharply between 10 and 9 out of 10 households respectively rated 2015 and 2016, and in 2016 almost 3 in 4 it as bad or very bad. About 9 out of 10 respondents rated the Government’s performance in keeping prices down badly 1. Economic developments - Soaring inflation, poverty and food insecurity 22 Figure 20 Perceptions of effectiveness of public institutions, urban 2015 Central Government of South Sudan SPLA and SPLM Business Leaders State Government SSPS Local Government Community Leaders UNMISS Local and International NGOs International community Other UN Agencies (i.e. UNHCR, UNICEF, UNDP) Churches and mosques 0% 20% 40% 60% 80% 100% Percentages 2016 Business Leaders Central Government of South Sudan SPLA and SPLM SSPS UNMISS State Government Local Government Community Leaders Local and International NGOs International community Churches and mosques Other UN Agencies (i.e. UNHCR, UNICEF, UNDP) 0% 20% 40% 60% 80% 100% Percentages Very ineffective Fairly ineffective Fairly effective Very effective Source: Authors’ own calculations based on HFS 2015 and 2016 data. 23 1. Economic developments - Soaring inflation, poverty and food insecurity 1.6 Outlook and risks 42. The growth outlook for FY17/18 remains dire. displaced by the conflict, who may need to rely Real GDP is projected to further contract by 6.6 on humanitarian relief. percent. The fiscal deficit is projected to increase. Continued exchange rate depreciation and 45. Prior to adopting an adequate anchor to volatility will likely be associated with increasing address high inflation, the government needs dollarization (Table 1). to pursue fiscal consolidation by limiting expenditure and raising revenues. The government 43. A key priority for the government is to address can limit an imminent economic crisis scenario the underlying causes of the country’s current and start stabilizing the economy by committing to macroeconomic collapse and food insecurity. improve the fiscal situation as a key priority. Falling It urgently needs to restore peace and security revenue coupled with rising spending, in extremely and implement comprehensive macroeconomic high magnitudes, constitutes a major problem in reforms. The latter include measures to unify South Sudan. Therefore, strong commitment to the official and parallel exchange markets and fiscal discipline is key for recovery. First, any fiscal reduce inflation, as well as longer term action deficit should be limited in size to the amount to boost employment, build infrastructure and the government can borrow externally to avoid diversify the economy, with special emphasis recourse to the inflation tax. Second, monetary on agriculture development. Trade and deeper expansion needs to be limited to increases in NFA regional integration with the EAC neighbors can of the Bank of South Sudan. become an effective instrument for ensuring food security and facilitating longer term market 46. A credible fiscal consolidation requires the development. It is likely that immediate measures implementation of reforms on the revenue will focus on working with humanitarian actors and the spending side. Reforms on the revenue on delivering emergency food to communities side include: (i) increasing non-oil revenues by in need, although ongoing conflict could derail reviewing the tax base, including customs duties this effort. Without the government’s real and introducing incentives to increase compliance; commitment and proactive action to end the and (ii) increasing transparency of oil revenues conflict and stabilize the economy, it is premature through full and transparent enactment of the to envisage a post-conflict path for the economy. Petroleum Revenue Management Act and effective implementation of a single USD account system 44. The renewed threat of violence and to better account for USD spending at Ministry of instability are likely to aggravate the situation. Finance and Economic Planning and Bank of South In a context of violence and widespread conflict, Sudan. Reforms on the spending side include: it is unlikely that the macroeconomic woes of (i) reviewing the civil servant salary pay system the South Sudanese will be remedied anytime and cleaning up the payroll; (ii) implementing soon. Instability is contributing to the limited states transfers’ reductions, reductions of current supply of foreign exchange by deterring foreign operational spending and restructuring of Nilpet investors and traders from contributing to the operations; (iii) rationalizing the usage of explicit South Sudanese economy. The conflict has and implicit subsides currently at use; and (iv) also impacted aid work, and is likely to reduce passing into law the Public Procurement and the livelihoods of the poorest and of those Disposal of Assets Bill. 1. Economic developments - Soaring inflation, poverty and food insecurity 24 47. The FY17/18 National Budget Plan aims to 49. Complementary Public Financial management restore macroeconomic stability, but lacks (PFM) reforms related to transparency around credibility. It puts special emphasis on controlling budget execution and oil revenues remain critical, public expenditure, increasing non-oil revenues, especially as regards the activities of Nilepet encouraging investment and economic (the national oil company) and the Ministry of diversification and removing subsidies to the Finance and Economic Planning, and the link of national oil company (Nilepet). The plan also oil revenues to foreign exchange management recommends to refrain borrowing from the Bank of and on-budget revenues. The Government would South Sudan to bring down inflation and prevent need to improve the PFM framework, particularly further depreciation of the currency. Although the establishment of a Cash Management the FY17/18 draft Budget foresees a two-fifth cut Committee and require the immediate transfer in expenditure in dollar terms compared to the of revenues from government accounts in the 2016/17 budget, it is unlikely that enough cash commercial banks to the treasury accounts. will be available to execute all budgeted items. While it is difficult to predict the prioritization of 50. Longer term measures should include expenditures, it is likely that the government will social protection programs to create resilience continue to protect security spending and core against future shocks and create jobs for more executive functions. Thus, the population will sustainable livelihoods as well as measures become even more dependent on humanitarian to build infrastructure and diversify the relief and donor funded development projects for economy, with special emphasis on agriculture access to services. Even if the economy showed development. Trade and deeper regional some recovery starting 2018, poverty projection integration with the EAC neighbors can become suggests poverty will continue to rise through an effective instrument for ensuring food security 2019 as economic growth is likely to be surpassed and facilitating longer term market development. by population growth. It is likely that immediate measures will focus on working with humanitarian actors on delivering 48. In addition to credible fiscal consolidation, emergency food to communities in need, reform would require an “anchor” for the value of although ongoing conflict could derail this effort. the currency to bring expectations under control. In any event, without the government’s real Part 2 provides more details and guidance to commitment and proactive action to end the policy makers in South Sudan on options to conflict and stabilize the economy, it is difficult to choose an anchor to control inflation based on engage in realistic discussions about a sustainable the experience of other developing countries, post-conflict stabilizing and – prospectively – including post-conflict countries. development trajectory. 25 1. Economic developments - Soaring inflation, poverty and food insecurity 2 Special Focus - Taming the tides of high inflation: policy options for South Sudan 2.1 Introduction 51. What can South Sudan do to curb spiraling programs that combine fiscal prudence with a inflation? As described in Part 1, on an annual tighter monetary regime of varying forms may basis inflation was just slightly under the be another option especially in countries with hyperinflation mark of 500 percent in 2016. As limited institutional capacity. described in Part 1, on an annual basis, inflation was just slightly under the hyperinflation 52. All stabilization plans need a nominal anchor mark of 500 percent (see Box 4 for more on to lower inflation and they differ among each hyperinflation, including the top hyperinflation other depending on which nominal anchor is episodes in history). Countries have historically used. Nominal anchors play a fundamental role tamed extreme inflationary situations using in successful stabilization plans. First, setting a Exchange-Rate -Based Stabilization (ERBS) predetermined path for the exchange rate or plans and Money-Based Stabilization (MBS) the amount of money helps pin down prices and plans. Monetary or inflation targeting has been controls inflation expectations. Second, a nominal popularly adopted by many central banks anchor limits political pressures to pursue around the world as a strategy for monetary expansionary monetary policies that could fuel policy with the expectation that the adoption inflation (Mishkin, 1999). Third, nominal anchors of such a monetary regime would reduce send a strong signal to the market that the policy inflation and inflation volatility. Under a spiraling regime has shifted and the government is credibly inflationary situation, an exchange rate anchor, in committed to fighting inflation (Bruno, 1991). combination with a broader set of stabilization 2. Special Focus - Taming the tides of high inflation: policy options for South Sudan 26 Box 5 Hyperinflation experiences Many countries ranging from France in 1795 to Zimbabwe in the recent years have witnessed periods of hyperinflation. More developed countries such as Germany, USSR, Austria, Poland, Bulgaria and Hungary have gone through hyperinflation, albeit way back in time after the First World War. After the Second World War, Hungary, Greece, China, Taiwan and the Philippines went through exceptionally high inflation. During the 1990s, many Europe and Central Asian (ECA) economies such as Armenia, Ukraine, Bulgaria, Estonia, Azerbaijan, Russia, Kyrgyzstan, Tajikistan, and Kazakhstan went through hyperinflation. Latin American countries such as Peru, Argentina and Brazil, as well as African countries such as Congo (and the DRC in the late 1990s), Angola and Zimbabwe also went through hyperinflationary situations.²⁶ The reality of hyperinflation is that prices change so rapidly that everyday items rise exponentially and money becomes worthless, virtually overnight or even in the course of a working day (see Figure 21). Figure 21 Top 5 hyperinflation situations in history Zimbabwe Hungary Greece Germany Yugoslavia 1946 1999 2008 1944 1923 Highest monthly Highest monthly Highest monthly Highest monthly Highest monthly inflation inflation inflation inflation inflation 13,800% 29,500% 313,000,000% 79,600,000,000% 13,600,000,000, 000,000% Prices doubled Prices doubled Prices doubled Prices doubled every every every every Prices doubled every 4.3 days 3.7 days 1.4 days 24.7 hours 15.6 hours ²⁶ This is based on Hanke and Krus (2013) compilation. This is different from previous studies using Cagan (1956) definition that documented fewer records of hyperinflation. For example, Fisher, Sahay, and Végh (2002) report that between 1920 and 1946 there were eight hyperinflations, while there were no cases between 1947 and 1984. Since 1984 to 2007, there have been fifteen hyperinflation cases. Using a 12-month inflation rate of 1,000 percent as the threshold for defining a period of high inflation, Coorey et al. (2007) identify 30 episodes of inflation in 24 countries between 1980 and 2005, including countries from Latin American (5), Europe and Central Asia (17), and Africa (2). Six of these countries (Argentina; Brazil; Democratic Republic of Congo; Macedonia, FYR/SFRY; Nicaragua; and Tajikistan) out of the 24 countries experienced two periods of high inflation. 27 2. Special Focus - Taming the tides of high inflation: policy options for South Sudan In general, hyperinflation coincides with wars and a series of ill-advised fiscal policy decisions that result in a rapid increase in the money supply without economic growth support. Hanke and Kruse (2013) point out that hyperinflation occurred when the supply of money had no natural constraints and was governed by a discretionary paper money standard.” This shows that any fiat currency is susceptible to rampant inflation, although to take hold, hyperinflation requires a series of extreme political and social circumstances. The length and the severity of hyperinflation have varied across countries. For example, Hanke and Krus (2013) report that during the inflationary period in Hungary (1945-46), an increase in consumer prices as high as 4.19 × 1016% was recorded in July 1946 (see Annex 2 for more details). Coorey et al. (2007) find that the length of the crisis in ECA countries is close to one year, while in Latin American economies the median was twice as long. Until the early 2000s, high inflation was prevalent in Latin American economies. In fact, the region suffered from chronic inflation and registered the highest inflation rate in the world. Inflation reached a peak between the 1980s and 1990s when many Latin American countries suffered from exceptionally high inflation and, even, hyperinflation. In the period 1981-90 the average annual inflation rate among Latin American countries reached 145 percent whereas in the period 1991-98 this value was 97 percent (Elberg et al., 1999). In some years, annual inflation even surpassed 1,000 percent in some countries (Burki and Perry, 1997). However, by the end of the 1990s, inflation started to relent in Latin America and in 1998 average annual inflation in the region reached 11 percent (Elberg et al., 1999). Since then, Latin American countries have been successful in maintaining inflation in check and, with some exceptions, countries have been able to keep annul inflation below a two-digit value. In the context of unbridled inflation during the 1980s and the 1990s, Latin America became a laboratory in which policymakers experimented with a wide range of stabilization plans in an attempt to put a halt to inflation. Source: Hanke and Kruse (2013) 53. What matters for South Sudan is to learn how and preconditions for their successful adoption these countries, including conflict countries, following the plan below (Figure 22). Then, we have managed to stabilize the inflationary present some stylized facts on the conditions crisis and what lessons can be drawn from in which they were adopted, their effects on their experience. To provide such guidance, this inflation and other macroeconomic variables, section summarizes the main characteristics of and their duration. We conclude the section with ERBS and MBS, and compares their effects on some key lessons that can be drawn from other the economy using the experiences of countries countries’ experience, including conflict states, in Africa, Latin America, Europe and Asia as a and how these lessons could be useful when guide. For each of the two groups of stabilization designing a stabilization plan for South Sudan. plans, we discuss its main features, benefits, costs, 2. Special Focus - Taming the tides of high inflation: policy options for South Sudan 28 Figure 22 Exchange-Rate Stabilization (ERBS) vs Monetary-Based Stabilization (MBS) Exchange-Rate-Based Stabilization (ERBS) vs Money-Based-Stabilization (MBS) Choice of Nominal Anchor to Stabilize the Economy From soft pegs to hard pegs and dollarization Monetary or inflation targeting Main Features Main Features • Inflation falls gradually and converges to the • Inflation falls gradually and converges to the rate of devaluation rate of growth of the money supply • Initial expansion of real economy followed by a • Initial contraction in economic activity later contraction • Real appreciation of the domestic currency • Real appreciation of the domestic currency • No definite impact on the trade balance and • Deterioration of the trade balance and current current account account deficit • Initial increase in real interest rates • Ambiguous impact on real interest rates Benefits Benefits • Good alternative for countries that lack • Allows for independent inflation goals based on credibility in their monetary policy own monetary policy path • Expected to induce monetary and fiscal discipline • Foreign shocks not transmitted to domestic • Reduces exchange rate risks economy through inflation • Flexibility to respond to domestic shocks using monetary policy Challenges Challenges • Loss of monetary policy independence Stringent preconditions : • Speculative attacks risk • Independence of Central Bank • Fragility risk especially in developing countries • Ability of Central Bank to effectively control monetary aggregates • Sustainable fiscal discipline 29 2. Special Focus - Taming the tides of high inflation: policy options for South Sudan 2.2 Exchange-Rate-Based Stabilization (ERBS) plans 54. An ERBS takes place when the central 56. Hard pegs. On the other hand, a country can banks commit to a predetermined path for opt for a “hard peg”. In this case, the central bank the exchange rate in the future. In the extreme is given a legal mandate to sustain the peg. case, the path could entail that the exchange rate remains fixed at a specific value over time. • A hard peg can take the form of a currency The exchange rate acts as a nominal anchor by board in which a country passes legislation pinning down the price of internationally traded that fixes the exchange rate at a determined goods. In a small open economy, the price of parity. A currency board consists of three tradable goods is equal to the international price features: (i) an exchange rate that is fixed to of these goods multiplied by the exchange rate. a foreign currency²⁷ (typically a hard currency, Thus, by controlling the exchange rate, the price of such as the U.S. dollar), (ii) a promise by the tradable goods becomes an anchor that can help central bank to exchange domestic currency keep inflation in check (Dornbusch and Fischer, for foreign currency, and vice versa, at the 1986; Mishkin, 1999; Corbo, 2002). Moreover, predetermined exchange rate whenever in very high inflation scenarios, exchange rate desired, and (iii) a guarantee that the system tends to be used as an indexation mechanism will be maintained in the long term (for to set prices and wages. Thus, anchoring this example, by including a legal mandate in variable is a reasonable mechanism to stop the central bank law). For a currency board inflation (Dornbusch, 1986). But it is important to to be sustainable and credible, the central determine an adequate exchange rate for fixing bank must hold foreign exchange reserves the currency. (measured in domestic currency at the fixed exchange rate) for at least 100 percent of the 55. Soft pegs. ERBSs differ depending on how money base in order to assure the public that committed is the central bank to maintaining every bill in circulation is backed by foreign the peg (Frenkel and Rapetti, 2010). On the one currency (Enoch and Gulde, 1998). hand, a country can adopt a “soft peg” in which the central bank publicly announces a future path • In the extreme, a country could directly for the exchange rate but has no legal mandate opt for a full-fledged dollarization of the that binds it to follow the path. A soft peg can economy, in which the domestic currency is include, for example, an announcement by the abandoned and is entirely replaced by a hard central bank to intervene in the exchange market currency (see Box 5 for more on dollarization). to maintain the exchange rate at a certain level There are certain advantages of choosing a or within a specific band, or a crawling peg in hard peg, or an exchange rate anchor: (i) easy which the central bank pre-announces the rate implementation: as it provides a simple and of devaluation of the exchange rate over time. transparent target for policymakers; (ii) greater ²⁷ A credible and clear policy that pins down the currency exchange, be it gold standard or another stable currency, has helped. In the case of Germany, for instance, it was the adoption of the gold standard system that brought down inflationary pressures. Following Germany, many other European countries accepted to peg their currency against gold as a strategy for curbing inflation. These countries include Austria (1923), Poland (1924), and Hungary (1925). Since the abandonment of the gold standard at the outbreak of WWI and the Bretton Woods Conference following WWII, several countries have managed to stabilize their currency by pegging their local currency to a major convertible currency. 2. Special Focus - Taming the tides of high inflation: policy options for South Sudan 30 exchange rate stability, which encourages expectations to the desired long-run level trade and foreign investment; and (iii) greater targeted by policymakers. For these reasons, verifiability by market participants as it allows adoption of hard pegs has in many instances for easier judgement on whether the target been successful in stabilizing inflation from is being achieved ex post and thus may historically high levels. permit a more rapid convergence of agents’ Box 6 Advantages and disadvantages of dollarization Advantages associated with dollarization.²⁸ Dollarization (i) resolves the problem of credibility and hence promotes macroeconomic stability, with declining inflation and interest rates; (ii) eliminates the risk of depreciation of the domestic currency, a factor that contributes to accelerated inflation; (iii) lowers the currency risk premia associated with depreciation and hence improves access to international capital markets (Berg and Borensztein, 2000) and lower information costs (Calvo 2002); (iv) eliminates transaction costs of currency exchange to the anchor currency (Fischer 1982; De Grauwe 2000) and reduces financial fragility (Hausmann et al., 1999); and (v) enhances fiscal discipline by eliminating the possibility of monetization of fiscal deficits (Fischer 1982; Eichengreen 2001) and by motivating the government to either look for alternative sources of revenue or reduce expenditures. Disadvantages to dollarization. These include: (i) loss of the option to print money, influence the economy, including the right to administer monetary policy and any form of exchange rate regime; (ii) loss of the central bank’s ability to collect seigniorage revenue, which is instead collected by the U.S. This could be as high as 7% of GDP (Bogetic, 2000); (iii) loss of the central bank’s role as the lender of last resort for its banking system; and (iv) need to buy back securities in U.S. dollars, implying that the country would have to collect enough reserves or run a current account deficit. Early empirical work on fully or partially dollarized economies suggests that for a given fiscal deficit, dollarization exacerbates the resulting inflation rate, and increases the volatility of inflation and exchange rates (Rojas-Suarez, 1992; McNelis and Asilis, 1992; Akçay, Alper and Karasulu, 1997). Several studies confirm that the exchange rate pass through on inflation is higher for dollarized economies (e.g. Reinhart, Rogoff and Savastano, 2003). For instance, Kavila and Roux (2016) find that a post- dollarization in Zimbabwe one percent increase in South African inflation resulted in a 0.3 percent increase in inflation in Zimbabwe. Similarly, a one per cent appreciation in the South African rand against the US dollar induced a 0.1 per cent increase in inflation in Zimbabwe. ²⁸ Bogetic´ (2000); Chang (2000); LeBaron and McCulloch (2000), offer different perspectives on the costs and benefits of official dollarization. 31 2. Special Focus - Taming the tides of high inflation: policy options for South Sudan 57. ERBS seem to have a high record of success initial expansion of the economy is followed by a in hyperinflationary situations. Successful recession. This pattern contrasts with MBS, which stabilization programs in high inflation countries first generates a recession and then a boom of have involved a paradigm shift in policy. These the economy (Kiguel and Liviatan, 1992; Calvo and covered fairly broad-based reform agendas, Vegh, 1994, 1999; Reinhart and Vegh, 1994). The including not just fiscal and monetary tightening initial expansion in GDP growth could have several but also institutional changes that sought to potential explanations. restore confidence and establish credibility of these reforms. Such programs can potentially snaffle inflation and also help in a rapid recovery of output.²⁹ Empirical evidence across 30 inflationary episodes in 24 countries over the Inflation stickiness can explain the initial expansion period 1980 - 2005, studied by Coorey et al. in GDP growth. A decrease in the devaluation (2007) suggest that stabilization programs have rate is expected to lower nominal interest rate successfully helped in reducing median annual through the interest rate parity condition. If inflation from a peak of about 1,600 percent to inflation expectations were sticky, then a lower 180 percent within 12 months after the peak nominal interest rate but unchanged inflation and simultaneously supported output recovery expectations would lower the real interest rate, within the first or second year of stabilization. The stimulating aggregate demand (Rodriguez, 1982). median output decline slowed significantly, from some -7 percent to about -0.5 percent, in the first year of stabilization and positive output growth in the second year of stabilization.³⁰ Lack of credibility could have also explained this 58. Countries generally opted for ERBS when behavior (Calvo and Vegh, 1993). If households suffering relatively high inflation rates. A expected the stabilization plan to be abandoned possible explanation why countries with relatively and, thus, the exchange rate to depreciate, they high inflation chose ERBS could be that the would have preferred to consume in the early higher inflation is, the lower is the confidence stages of the plan (when the peg kept nominal that the central bank can pursue an independent interest rates low) rather than later (when the monetary policy. Thus, an ERBS may be a more exchange rate would be devalued and nominal appealing option than an MBS, as the probability interest rates would be high). The drop in inflation that the latter would succeed was lower (Stein et al., is smaller the lower the credibility of the program. 2000). Furthermore, in Latin America ERBSs used In fact, under lack of credibility, inflation inertia to be more credible than MBSs and, as a result, may easily occur. (Shahnawaz, 2006). after they were announced they tended to lead to a larger drop in inflation inertia (Prazmowski and Sanchez-Fung, 2014). (See Annex 3 for Latin America’s experience with ERBS). Wealth effects associated with the reduction 59. Conventional wisdom sustains that ERBS of the inflation tax and an expected decrease is followed by “boom-bust” cycles, in which an in government expenditure related to higher ²⁹ See, for instance, Bruno et al. (1991) for a review of several inflation stabilization reforms. ³⁰ Sargent, (1982); Fischer, Sahay, and Végh, (2002); Easterly, (1996). In Sub-Saharan Africa, countries with hard pegs have lower inflation and a more favorable fiscal position - see Bleaney and Francisco (2016). 2. Special Focus - Taming the tides of high inflation: policy options for South Sudan 32 fiscal discipline could have also boosted rate at the announced level. On the fiscal side, a consumption and growth in the early stages of collateral effect of ERBS is that it is expected to these plans (Helpman and Razin, 1987; Drazen promote fiscal discipline because fiscal deficits and Helpman, 1988). could threat the long-term sustainability of the peg. A lax fiscal policy would eventually lead to 60. Benefits of ERBS. There are several benefits the increase in money supply. This excess in the that a country could attain from implementing a money supply would have to be withdrawn from stabilization plan that relies on the exchange rate. the economy by the central bank selling foreign currency, which would decrease the foreign exchange reserves and reduce the ability of the 1 government to sustain the peg. First, ERBS can be a good alternative for countries that lack credibility in their monetary policy. For 3 countries without an independent monetary policy, implementing a stabilization plan that relies on controlling the amount of money can Third, this type of stabilization plan reduces be problematic because political pressures might exchange rate risk because the future changes sooner or later induce monetary policy to deviate in the exchange rate are known beforehand. from its target and over-expand, compromising Through the interest rate parity condition, this the sustainability of the plan. Moreover, even if reduces interest rates. Likewise, lower exchange authorities comply with the announced path of rate risk increases incentives of foreign investors monetary policy, lack of credibility might induce to lend in foreign currency. Fourth, compared economic agents to believe that the monetary to the money supply, using the exchange rate policy will deviate in the future and, thus, fail to as a nominal anchor is simpler and clearer. The lower their inflation expectations. In this context, exchange rate is a variable that the public can ERBS can help countries “import” credibility easily understand and monitor daily to check from abroad. When the exchange rate is fixed, whether the government is complying with the the inflation rate of tradable goods will be equal target. (Mishkin, 1999; Velasco, 2000; Mishkin and to the inflation rate of these goods in the foreign Savastano, 2001). country to whose currency it is pegged. Thus, domestic inflation will be linked to the path of 61. Challenges of ERBS. Despite its benefits, some inflation in the foreign country. of the strengths of ERBS are also its weaknesses. • Loss of independent monetary policy also 2 means that a country cannot use a monetary expansion to respond to negative shocks and boost economic activity. In a context of Second, ERBS is expected to induce monetary nominal wage rigidity, negative shocks could and fiscal discipline. On the monetary side, ERBS generate unemployment because the fixed can eliminate incentives to pursue an expansionary exchange rate prevents depreciation of real monetary policy that fuels inflation. Under wages (Schmitt-Grohe and Uribe, 2011). exchange rate targeting, the monetary policy of the central bank becomes endogenous: it has to • Likewise, inability to conduct an independent buy and sell currency to maintain the exchange monetary policy could restrict the ability 33 2. Special Focus - Taming the tides of high inflation: policy options for South Sudan of the central bank to act as a lender of 62. It is often argued that currency boards and last resort (Mishkin and Savastano, 2001). dollarization could help reduce some of the costs However, some countries have overcome this of ERBS. For example, by eliminating domestic limitation by establishing emergency liquidity currency, dollarization prevents speculative funds to assist banks with liquidity problems attacks. A similar argument has been made about (for example, this is the case of Ecuador). currency boards: if the central bank has enough foreign reserves to cover the stock of currency • An additional problem is that countries with a in circulation, there would be no incentive for fixed exchange rate are prone to speculative speculators to attack the peg because the central attacks. Speculative attacks can arise when bank would have enough resources to defend it. the government combines a fixed exchange Another alleged advantage of dollarization and rate with monetization of fiscal deficits. The currency boards is that, compared to soft pegs, increase in money supply would return back they could induce more fiscal discipline. These to the central bank through the purchase of programs legally bind the central bank from foreign currency by the public. As a result, printing money to finance fiscal deficits. Thus, they foreign reserves would diminish. When the need strict fiscal discipline to be sustainable over level of foreign reserves is low enough that time. Furthermore, the stronger commitment the peg cannot be sustained, agents could implied in dollarization and currency boards conduct a speculative attack that would increase exit costs, which raises credibility. force the central bank to abandon the peg (Krugman, 1979; Obstfeld and Rogoff, 1995). 63. In some cases, the potential ERBS benefits Even when the economy has no fundamental might not materialize, particularly when the problems, speculative attacks can still occur economy is subject to extreme shocks (see Annex because expectations that the peg can be 3 for details). Currency boards can be subject to abandoned in the future could trigger a run speculative attacks because, even if the central on the currency that could drain foreign has enough reserves to sustain the peg, in the exchange reserves and force the government event of an actual attack it might not be willing to abandon the peg (Obstfeld, 1986). to exhaust its foreign reserves to sustain it (Kasa, 1999). Moreover, in some cases dollarization and • Furthermore, pegging the exchange rate currency boards have not induced higher fiscal can produce financial fragility in developing discipline because the government could obtain countries. Lower interest rates and increase funding from domestic and international debt in foreign financing produced by a reduction markets. In addition, currency boards might be in exchange rate risk could result in an abandoned easier than expected by, for instance, increase in foreign debt by governments, issuing quasi-monies (Goldfajn and Olivares, 2001; firms, and, even, banks. In this scenario, an de la Torre et al., 2003). abandonment of the peg and a depreciation of the currency would deteriorate the balance 64. Preconditions for successful ERBS plans. sheet of the banking sector: foreign-currency In order to mitigate its potential costs, countries liabilities increase in value (measured in might want to satisfy certain requirements before domestic currency) while assets and revenues putting in place an ERBS. Countries could benefit remain flat. As the debt burden increases, from pegging their currency to a country that is government and firms have difficulty meeting subject to similar real shocks and has a similar their obligations and might even default on preference for inflation. Financial discipline their debt (Mishkin, 1998). is another important precondition because 2. Special Focus - Taming the tides of high inflation: policy options for South Sudan 34 fiscal deficits can undermine the success of the under a peg central banks cannot conduct an program over time and trigger speculative attacks. independent monetary policy and, thus, the Moreover, countries seeking to adopt these types ability to act as a lender of last resort is limited, of plans are advised to first consider implementing countries adopting exchange rate targeting labor reforms that increase flexibility of the labor would benefit from a sound and well-regulated market and allow nominal wages to adjust rapidly financial sector (Velasco, 2000). when negative shocks occur. In addition, because 2.3 Money-Based Stabilization (MBS) plans 65. Money targeting and inflation targeting. 67. In a developing country context, monetary MBS traditionally consisted in the government targeting comes with multiple responsibilities. setting a predetermined path for the growth rate In a strict monetary targeting, the main objective of money supply in the future. By controlling the of the central bank is to maintain price stability. money supply in the economy, the government However, given the multiplicity of problems in can indirectly control the eventual equilibrium developing economies, monetary targeting is price level and, thus, inflation. More recently, loaded with responsibilities. For instance, with the directly targeting the inflation rate rather than aim of making monetary policy more effective, indirectly fixing prices through the quantity of Bangladesh instituted this policy framework money has also become an extended practice after moving to a managed float regime in 2003. in MBS.³¹ The monetary authorities were responsible for establishing not only price stability and economic 66. To curb inflation, central banks can limit the growth but also nominal exchange-rate stability money supply. A central bank can maintain low (Hossain, 2010). Overall, it remains unclear how and steady inflation by keeping the money supply the already capacity constrained central banks growth rate low and steady. A key assumption in developing countries can maintain exchange- underlying this approach to monetary policy is rate stability while maintaining the required that the money demand function is stable and control over the money supply. The thrust of the country under consideration operates under a monetary targeting is to maintain the broad flexible exchange-rate system so that the central monetary aggregate at a pre-determined level, bank can acquire the maximum possible control which is estimated on the basis of an expected over the money supply. The greater the central increase in real output and a “tolerable rate of bank’s control over the money supply, the more inflation”. The multiple set of objectives and accurately it can calculate and target the rate of the lack of direction on how to achieve these monetary growth necessary for price stability. objectives through monetary policy may make it ³¹ In this note we consider inflation targeting as a specific case of money targeting stabilization plans. The theoretical literature typically analyzes them as different types of stabilization plans (see, for example, Mishkin 1999 or Corbo, 2002). However, in empirical papers, this distinction is not made (see, for example, Kiguel and Liviatan, 1992, Reinhart and Vegh, 1994, and Calvo and Vegh, 1999). We opt for the latter option because looking at their characteristics inflation targeting is essentially a monetary targeting plan with additional features. In fact, many countries that have started with monetary targeting, over time refined their plans and transitioned toward inflation targeting. 35 2. Special Focus - Taming the tides of high inflation: policy options for South Sudan All stabilization plans need a nominal anchor to lower inflation difficult for monetary authorities to maintain price rate channel). It also requires a certain level of stability. This has been the case with Bangladesh exchange-rate stability such that monetary policy where monetary targeting has been met with intervention in the foreign exchange market moderately high and volatile rates of inflation over can be used as a channel for targeting inflation the past four decades (Hossain, 2009, 2010). rates. Furthermore, developing economies that lack institutional maturity (such as central 68. Inflation targeting does not require the bank independence, fiscal discipline and central bank to follow a mechanic rule but, financial sector development) and consistency instead, to use all the available information of macroeconomic variables (e.g. exchange rate and instruments to achieve the inflation target gap, output gap and trade openness) may end (Mishkin, 1999). Typically, inflation targeting is up with poor performance on inflation targets achieved through the use of different monetary when using inflation targeting (Bernanke and policy rules, which guide de conduct of monetary Woodford, 2005; and Mishkin, 2000, 2004; Hove policy (Svensson and Woodford, 2004). In their et al., 2017). Finally, economic growth should not most simple form, these rules consist in the be a concern for the country targeting inflation central bank mechanically setting a value for an because sometimes it is not feasible to couple instrument variable (for example, the interest rate) the two objectives. based on the information available. The most popular rule of this kind is the Taylor rule, in which 70. MBS are predicted to generate a “boost – the central bank sets the interest rate depending boom” cycle. A noticeable difference between on the deviation of the inflation rate and the MBS and ERBS is that the former seemed to output level from their desired level (Taylor, 1993). have reduced inflation more gradually. Whereas More complex rules are the “targeting rules.” ERBS generates a boom-bust cycle, MBS are These rules imply designing loss functions that predicted to cause instead a “bust-boom” cycle. increase their value when the deviations of the The implementation of these programs is typically target variables from their desired target levels are followed by an initial contraction of economic larger. The role of the central bank is to minimize activity. The tightening of monetary policy this loss function (Svensson, 2002). increases interest rates and reduces aggregate demand, reducing output as well. After the initial 69. Tough preconditions for MBS through contraction, the economy rebounds and growth inflation targeting. Inflation targeting requires resumes (Kiguel and Liviatan, 1992; Calvo and a certain level of preparedness with respect to Vegh, 1994, 1999; Reinhart and Vegh, 1994) (see the depth of the financial systems so as to have Annex 4 for details on Latin America’s experience a well-developed monetary policy transmission with MBS). mechanism (for example, through the interest 2. Special Focus - Taming the tides of high inflation: policy options for South Sudan 36 71. The presence of oil revenues as major (CPI). The argument is that by excluding energy source of foreign reserves adds another and food products, which are subject to temporary layer of complication. There are examples of price shocks, core CPI provided a better measure countries dependent on oil exports that have of inflation. However, for commodity exporters successfully maintained over time their MBS. targeting the core CPI might not be the best In Latin America, examples are Colombia and alternative. These countries export energy and food Mexico, which depend heavily on oil exports products so the core CPI mainly reflects the price and have MBSs in place since 1999 and 1995, of imported goods whereas it excludes exported respectively. However, implementing MBS goods. As a result, in the event of negative terms poses some additional challenges to different of trade shocks, the central bank would react by countries. For example, oil-producing countries tightening monetary policy to curtail the rise in react differently to shocks to the price of oil. the CPI, which would appreciate the exchange Whereas in non-exporters an increase in oil rate. In other words, commodity exporters would prices boosts production costs and decreases be appreciating its currency when the terms of output, in exporters these negative effects might trade are worsening. Thus, these countries could be compensated by a positive wealth effect due benefit from targeting an output-based price to higher revenues from oil exports. Thus, it has index, such as an export prices index or an index been proposed that oil-producing countries of domestically produced goods (Frankel, 2011). could benefit from following different monetary Among the alternative monetary policy rules rules than the rest of the countries. For example, analyzed for the case of Algeria,³² Allegret and a Taylor rule that reacts to consumption rather Benkhodja (2015) find that in the presence of real than output gaps might be welfare increasing external shocks, headline inflation targeting³³ may for these countries (Romero, 2008). lead to excessive volatility of real macroeconomic variables, core inflation monetary rule allows the 72. An additional concern for oil-exporters is best combination in terms of price stability and the choice of the price index that needs to be low volatility of production. targeted. Traditionally, the literature has argued that central banks are advised to target the core 73. Benefits of MBS. MBS can fix some of the rather than the headline consumer price index problems associated with ERBS. MBS allows Oil revenues as a major source of foreign reserves adds another layer of complication ³² These are a fixed exchange rate rule, a headline inflation targeting rule, and a core inflation targeting rule. ³³ In this case the central bank targets only the deviation of the CPI inflation rate relative to its steady state equilibrium 37 2. Special Focus - Taming the tides of high inflation: policy options for South Sudan countries to pursue independent inflation goals. complying with the money growth rate targets. Unlike ERBS in which countries import inflation In addition, compared to targeting the exchange from abroad, countries under an MBS can design rate, the public might not easily understand what the path of monetary policy in order to achieve money targeting means. Not only the data on their desired inflation rates. This also implies that monetary aggregates is less direct and clear to foreign shocks would not be transmitted to the interpret than the exchange rate but also the domestic economy through inflation. Moreover, public has to comprehend the relation between MBS gives governments certain flexibility to monetary supply and prices. respond to domestic shocks using monetary policy. Under an MBS, a country suffering a 75. Compared to targeting the amount of money, negative shock can use monetary policy to targeting inflation has additional advantages depreciate the value of the currency, lower real but also higher challenges. The main advantage wages, and stimulate output. However, the use of inflation targeting is that it does not require the of this instrument is somewhat limited because demand for money to be stable. The central bank too much monetary expansion might lead to is not committed to follow any rule regarding deviations from the target. the growth of the money supply and, thus, has the flexibility to adjust this variable in the face of 74. Nevertheless, MBS also poses some shifts in the money demand without generating challenges to policymakers. For a successful any suspicion in the public that the target has adoption of an MBS, the central bank has to be been abandoned. Moreover, using inflation as independent from any political influence and the target helps overcome the problem that have the capacity to implement a monetary policy targeting the amount of money might be less consistent with controlling inflation. In addition, transparent and confusing. the central bank should effectively be able to control the targeted monetary aggregates. 76. Even if desirable, inflation targeting is While the central bank can easily control the not feasible everywhere. Inflation targeting monetary base, this does not necessarily imply is much easier to implement in countries it can control larger aggregates such as M2 or with high credibility and a strong institutional M3. Another important precondition for MBS is framework. Under inflation targeting, the central that the relation between the money base and bank does not follow a predetermined rule as inflation needs to be somewhat stable. If the in the traditional MBS or ERBS. Instead, it has money demand is often subject to unpredictable the autonomy to use all the monetary policy and large shocks, then targeting the money instruments at its disposal to achieve the inflation supply might not generate the expected inflation target. In this sense, inflation targeting grants more objectives. This can be particularly problematic discretion to the central bank. The counterpart in countries that are shifting from high to low of giving more freedom to the central bank is inflation regimes. When inflation is reduced, the that the public needs signals that the policies relation between money supply and inflation that of the central bank are driven toward complying was valid during the high inflation environment with the inflation target. Thus, the central bank might no longer hold. As a result, predicting the needs to have a strong legal mandate that sets money demand can be difficult (Mishkin, 1999; price stability as its primary goal. Also, it requires Corbo, 2002). Furthermore, as with ERBS, MBS having adequate resources and instruments at needs fiscal discipline to be sustainable over its disposal to fulfill this goal. In addition, the time. A country that runs fiscal deficits financed central bank needs to have a strong informational by monetary expansion would have difficulty in framework. This framework could include frequent 2. Special Focus - Taming the tides of high inflation: policy options for South Sudan 38 communication with the public to disclose not the interest-rate channel and the demand for only the inflation targets but also how they will be money may not work in an African context achieved, as well as the medium-term views on due to underdeveloped financial systems and monetary policy and inflation. Furthermore, the weak interest-rate responsiveness of aggregate central bank could be held accountable when the spending (Khan, 2011). Several studies have shown targets are not met (Mishkin, 1999). that instability of money demand is particularly common to developing countries undergoing 77. The monetary transmission process required processes of financial liberalization, like those for money targeting to work may not be fulfilled in Sub-Saharan Africa, yet even industrialized in Sub-Saharan Africa. The traditional monetary countries are not immune (e.g. the case of Germany transmission mechanism working through studied in Mishkin and Savastano, 2000). 2.4 Country experiences 78. Examples of ESRB soft pegs in Latin America sacrifices the ability to use the exchange rate as include, among others, the tablitas³⁴ adopted an adjustment tool and constrains the authorities’ by Argentina, Uruguay, and Chile in the late ability to alter monetary policy, with the potential 1970s; the Pacto in Mexico between 1988 and of creating inconsistencies between monetary 1994 which alternated between a fixed exchange and fiscal policies and/or pro-cyclical monetary rate, a crawling peg, and an exchange rate band; conditions. Moreover, the currency board the exchange rate band regime in Uruguay that arrangement is likely to remain viable as long was in place from 1990 to 2001; and the fixed as there is sufficient political will to subordinate exchange rate regime known as the Real Plan in fiscal policy to maintaining the peg—in the sense Brazil between 1994 and 1998 (see Annex 3 for of having a “money dominant” regime. This is more details). a hard position to maintain. The high level of public indebtedness in post stabilization years 79. A currency board has helped tackling the in Argentina suggests that it slipped back into a inflationary situation in several countries, such as “fiscal dominant” regime, thereby dooming the Bosnia and Herzegovina, Argentina, Estonia, and currency board arrangement. Thus, although Lithuania. In the case of Argentina, for instance, a currency board can have specific temporary the currency board was widely viewed as providing advantages, irrespective of a country’s economic the needed monetary stability after a long history structures—such as achieving disinflation—it of monetized fiscal deficits, high inflation, and low is important to allow for flexibility to exit the and volatile growth. Nonetheless, the long term arrangement in time before market pressures value of a currency board is questionable as it make it untenable.³⁵ ³⁴ The tablitas were popular stabilization plans in the late 1970s in the Southern Cone. Their name comes from the charts (“tablas” in Spanish) that the government made public and that contained the projected evolution of the daily official exchange rate over time. ³⁵ For example, a hard peg in Argentina did secure credibility through 2000 as it enabled it to borrow from the capital markets at spreads that did not fully reflect the risks. Although this insulated the country temporarily from adverse market reactions to unsustainable policies, nonetheless it ultimately led way to a much bigger disaster. 39 2. Special Focus - Taming the tides of high inflation: policy options for South Sudan 80. Dollarization has helped several countries at an average of 4 percent in the subsequent years. emerge from monetary crisis. The Zimbabwean On the fiscal side, Ecuador started to run fiscal hyperinflation crisis of 2007, ended abruptly surpluses, which helped reduce the debt burden. when the country gave up the local currency However, fiscal improvement did not seem to and adopted a multicurrency system in 2009. derive from greater fiscal discipline. Spending Dollarization weakened parallel market activities increased rather than decreased and the strong and arbitrage opportunities, and dissipated fiscal position was achieved mainly by an increase inflationary pressures.³⁶ Real GDP rose from 5.4 per in oil revenues due to higher oil prices. Similar cent in 2009 to 9.6 percent in 2010, 10.3 percent is the case of the external balance. The current in 2011 and 4.4 per cent in 2012 (Kavila and Roux, account deficit was reduced but primarily due to 2016). Overall, dollarization played a dominant role higher oil exports and lower interest rates across in contributing to macroeconomic stability in the the world. In other words, the good economic country (Sikwila, 2013). In Ecuador, full dollarization performance of Ecuador after dollarization occurred in the midst of an economic and banking seemed to be less related to this stabilization plan crisis (Quispe-Agnoli and Whisler, 2006) and and more to external factors, namely the high helped the country get back on track. (see Box 4 price of oil (IMF, 2006; de la Torre and Mascaro, for more on dollarization including pros and cons 2011). As external conditions recently worsened of such a stabilization plan). since 2014, the macroeconomic weaknesses of Ecuador were unveiled. The fall in oil prices 81. Ecuador’s experience with dollarization can contracted economic activity and output growth provide useful guidance to South Sudan. When became negative. What made the adjustment Ecuador implemented dollarization in 2000, the harsher was that dollarization had limited the country was in a similar condition than South ability of the government to address the economic Sudan today. In 1999, inflation in Ecuador was downturn. One alternative for the government above 60 percent whereas the domestic currency could be to pursue a fiscal expansion that could had lost more than 60 percent of its value. expand aggregate demand and stimulate the Moreover, the fiscal deficit surpassed 5 percent of economy. However, this would run contrary to GDP and debt exceeded 100 percent of total GDP. the goal of sustaining dollarization and it would Furthermore, banking sector deposits were frozen, need to be financed somehow. The decrease and 16 financial institutions had failed (IMF, 2006; in oil prices reduced government’s revenues de la Torre and Mascaro, 2011). Another common and, thus, made fiscal deficits higher, crippling feature between Ecuador and South Sudan is that its expansionary capacity. Another option for both countries are major oil exporters. the government could be to stimulate exports by depreciating the RER. Ecuador has an 82. Shortly after dollarization the main appreciated RER due to the strengthening of macroeconomic variables of Ecuador started the U.S. dollar, the increase in the price of non- to improve. By the end of 2000, inflation started tradable goods during the period of economic to fall and converged to international levels. In expansion, and Ecuador’s trading partners addition, the volatility of interest rates and the depreciating their currencies. However, again RER had been reduced. As a result of higher dollarization limits the ability of the government macroeconomic stability, annual GDP had grown to implement this alternative (IMF, 2015; de la 8 percent in the first quarter of 2001 and remained Torre and Hidalgo Pallares, forthcoming). ³⁶ During 2009 to 2012, annual inflation averaged below 5 percent, and monthly inflation was, on average, less than 0.5 percent. Zimbabwe began to perform better than its counterparts in SADC, particularly in respect of inflation. 2. Special Focus - Taming the tides of high inflation: policy options for South Sudan 40 A common feature of ERBS and MBS is that both require a strong institutional framework to be successful 83. The situation in Ecuador shows that, whereas targeting. Mexico did so in 2001 and Peru in 1994. dollarization might not be the cause of economic Other countries directly implemented an MBS problems, it restricts the options available to the that relied on inflation targeting, such as Chile government to deal with crises. Thus, complying since 1991, and Colombia and Brazil since 1999. All with the preconditions for a successful adoption of these plans are still in place today (see Annex 4 of ERBS is highly recommended. Among these for more details). Relative to ERBS, countries with preconditions, fiscal discipline is of particular lower inflation have opted for MBS. importance to countries whose fiscal policy depends on revenues from exports of natural 85. Countries’ decision to adopt inflation resources, such as Ecuador or South Sudan. targeting depends on several factors including Negative shocks that reduce the price of exports their development stage. In a high-income could significantly lower revenues and produce country, inflation targeting is motivated by the fiscal deficits, which might compromise the desire to maintain credibility on low inflation rates, sustainability of an ERBS. Countries could mitigate especially under flexible exchange rate regime. this weakness by establishing ex ant a stabilization In any case, the implementation of the inflation fund, in which extraordinary revenues during targeting rule requires certain preconditions, good times are saved for bad times when prices including the central bank’s independence, drop. As a result, stabilization funds can, in the especially relating to monetary policy, financial long run, allow countries to smooth government depth, the fiscal policy and position, and flexibility spending and avoid cutting expenditures during in interest rates and exchange rates (Amato and economic downturns (Sugawara, 2014). Gerlach, 2002; Eijffinger and de Haan, 1996; Hu, 2006). In the case of OECD countries, for instance, 84. Since the first attempt on inflation targeting the low level of debts, high inflation rates, and in New Zealand in 1990, many countries have flexible exchange rate have likely inspired the adopted the MBS approach to curb inflation. choice of inflation targeting (Goncalves and Several Asian developing counterparts, such as, Carvalho, 2008, 2009). Unlike their developed Indonesia, the Philippines and Thailand have country counterparts, the effect of high inflation adopted inflation targeting after the Asian financial rates on the choice of inflation targeting is crisis of the late 1990s. In Latin America, there are insignificant in developing countries. Furthermore, several examples of MBS. For example, Mexico, low-income or developing countries with a large between 1995 and 2000, and Peru, between 1990 size of public debts are not likely to choose and 1993, implemented MBSs that relied on the inflation targeting as fiscal fragility discourage growth rate of money as the nominal anchor. Later monetary authority to adopt restrictive monetary on, both countries transitioned toward inflation policy under inflation targeting (Ismailov et al., 41 2. Special Focus - Taming the tides of high inflation: policy options for South Sudan 2016).³⁷ This monetary regime works as a guide health infrastructure, and social safety for inflation expectations and is associated net protecting vulnerable groups, need with an increase in central bank transparency, to be prioritized, while some other heads which, in turn, increases accountability in the such as the government wage bill, capital implementation of monetary policy and thus expenditures and subsidies to public sector improves the central banks’ credibility.³⁸ enterprises can be reduced (e.g. Coorey et al., 2007). In the case of Poland, the 86. Irrespective of the selected stabilization plan, success in taming hyperinflation in 1989 was country experiences highlight the following key achieved through a substantial reduction requirements to successfully curb high inflation: in the noninterest fiscal deficit, mainly achieved through tax reform, reduction of • Large fiscal adjustments have been subsidies and renegotiation of external debt a critical component of stabilization (Wijnbergen and Budina, 2001). programs. A cross country study by Tsibouris et al. (2006) covering 165 countries from 1971 • F i s ca l co n s o l i d a t i o n needs to be to 2001 confirms that countries embarking accompanied by an elimination of quasi- on large upfront fiscal adjustments were fiscal activities. Reduction of quasi-fiscal the most successful in coping with inflation. activities (QFA) of the central bank and other The study finds a median reduction in public entities played a key role in fighting the primary fiscal balance of about 12.5 inflation in more than half of the countries percentage points of GDP (ranging from in their sample (see Coorey et al. 2007). For 6.3- 29.9 percentage points of GDP) in one instance, prior to stabilization, central banks year. To give specific examples, in Nicaragua in Bolivia, Croatia, and Macedonia provided and Armenia primary fiscal deficit was financial support to loss-making state- adjusted by 23 and 9 percent points of owned enterprises. In Angola and Bulgaria, GDP respectively within one year. In 1989, central banks were responsible for bailing Poland was under severe risk of sliding out other banks in distress. In Zimbabwe, into hyperinflation but the hyperinflation while the government reported a small process stopped abruptly during the first primary surplus of around 2 percent in 2006, quarter of 1990 and inflation rate fell from accounting for quasi-fiscal activities of the over 600% in 1989 to below 20% in 1996 central bank shifted the adjusted primary due to debt-management policies in the balance to a deficit of almost 25 percent macroeconomic stabilization package of GDP. To reduce the public financing (Wijnbergen and Budina, 2001). requirements, any stabilization program must also involve a strict enforcement • Which co m p o n e n t of g ove r n m e n t of discipline on state-owned enterprises expenditure should be curtailed? Fiscal through hard budget constraints. spending that ensure food security, ³⁷ Theoretically speaking, political institutions and stability should matter for adopting a particular monetary regime (perhaps by affecting the autonomy of central banks), there is absence of hard evidence on such factors being consequential for OECD countries (Goncalves and Carvalho, 2008) as well as in low-income countries (Ismailov et al., 2016). ³⁸ See, Svensson (1997), Mishkin (1999), Bernanke et al. (1999), Landarretche et al. (2001), de Mendonça and Simão Filho (2007), and Blinder et al. (2008). 2. Special Focus - Taming the tides of high inflation: policy options for South Sudan 42 • Price and exchange rate regime liberalization reforms such as improvements in the rule of was often a priority to succeed with fiscal law, reforms of the public sector, the central and monetary stabilization (e.g. in Azerbaijan bank and the labor market were started and Bolivia). Although liberalization may immediately for instance in Nicaragua and have contributed to a one-time increase in Peru to make the stabilization package the price level, it helped allocate resource credible and increase the confidence of more efficiently and eliminated subsidies domestic and external investors. (Coorey et that fueled inflation. Finally, institutional al. 2007). 2.5 Lessons for South Sudan 87. Which stabilization path for South Sudan? commitment to take concrete steps to address Although there is a clear agreement that South the economic issues. Effective programs have Sudan needs to reform, vested interests and sequenced the initial stabilization programs rent seeking behavior from political clout with with structural and institutional reforms. The access to foreign currency at the official rate are latest economic and security developments in preventing or delaying the reform process. There South Sudan seem to indicate that despite the is also a lack of agreement on the specifics of the urgent need for fiscal consolidation and exchange reform to support lower inflation. For example, it rate adjustment, the Government continues to is not clear whether the country would be most focus on conflict-related policy choices that suited to adopt a currency board approach or delay any meaningful reforms. Without clear a full dollarization or continue with a floating political commitment any stabilization plan will regime. Finally, reforming the monetary regime be meaningless. involves a major change in the economic environment, and a major shock for the economy. 89. Experiences with stabilization plans suggest The uncertainty surrounding the impact may add that they vary in their speed at which inflation is to the reluctance of the reform process. reduced, the business cycle they create, and their sustainability over time. Namely, when choosing 88. Political will is critical to pursue any a stabilization plan, policymakers are confronted stabilization plan. Peace and security remain a with trade-offs regarding “speed vs. sustainability” crucial precondition for any macro stabilization. and likely “recession now vs. recession later.” On Moreover, any reform plan requires credible the one hand, ERBS is very successful at reducing 43 2. Special Focus - Taming the tides of high inflation: policy options for South Sudan inflation quickly, even in countries where inflation control fiscal deficits is more prone to pursuing is exceptionally high. In addition, immediately after an expansionary monetary policy. For countries its implementation it creates an economic boom. under an ERBS, expansionary monetary policies However, over time the economic expansion is would sooner or later lead to a fall in reserves that followed by a recession. The economic downturn, could force the central bank to abandon the peg. which might include a financial crisis, can trigger Likewise, in countries under an MSB, an increase the collapse of the stabilization plan and the in the money supply beyond the target would reemergence of inflation. As a result, ERBS is undermine the credibility of the central bank. In relatively short-lived, sometimes only being in both cases, this will weaken the main pillar of the place for four or five years before it is abandoned. stabilization plan: the nominal anchor supposed On the other hand, MBS decreases inflation but to endure in the long term. only gradually while initially creating a contraction of economic activity. However, once this downturn 91. The main challenge for developing economies, is passed, economic growth returns and inflation particularly for countries emerging from conflict, continues to slow down. As a result, MBSs are more is to establish credibility of the chosen monetary sustainable over time. regime through a nominal anchor. The empirical evidence is not conclusive on whether this can 90. A common feature of ERBS and MBS is that be done more successfully through inflation both require a strong institutional framework targeting or a hard currency peg or a crawling peg to be implemented successfully. Whether the with a narrow band. Monetary policy becomes central bank is targeting the exchange rate, the more effective when the central banks are growth rate of money, or the inflation rate, the successful in leading inflation expectations and monetary authority needs to send clear signals can credibly alleviate the traditional short-term to the public that its main goal is to comply with trade-off between inflation and unemployment. the target. This includes, among others, that the The success of any monetary regime is directly central bank is independent, has a legal mandate associated with forward-looking behavior, which, to control inflation, is free from political pressures, in turn, highlights the relevance of credibility. This and has adequate disclosure standards. If the aspect is particularly relevant for developing and public does not believe that the central bank is post-conflict economies (see Box 6). A strong committed to fighting inflation, the stabilization and credible commitment to maintaining low plan will unlikely succeed. Another important inflation through any monetary regime credibility precondition for the successful adoption of thus fosters an environment that stimulates ERBS and MBS is fiscal discipline. A country output growth. that implements a stabilization plan but fails to 2. Special Focus - Taming the tides of high inflation: policy options for South Sudan 44 Box 7 Monetary policy and exchange rate regimes in post-conflict countries Does the choice of exchange rate regime matter for aid effectiveness in restoring macroeconomic stability? Based on the experience of 38 countries emerging from war and conflict, Elbadawi and Soto (2013) suggest that post-conflict performances of the fixed and managed regimes were very similar, and were superior to that of a floating regime. While inflation was in single digits under the fixed and the managed floating regimes, it was more than 16 percent under the floating regime. More in-depth empirical analysis confirms that in post-conflict economies, both the fixed and managed regimes have direct stabilizing effects on inflation. Aid does not seem to have a direct effect on post-conflict inflation under the fixed and managed regimes, while it was found to have a stabilizing impact under the floating regime. Therefore, it seems that the free-floating exchange regime may not be appropriate for countries emerging from wars and conflict situations. The managed floating regime seems to have an edge on two critical areas of economic performance: (i) aid promotes post-conflict demand for money balances and (ii) the monetary reconstruction role of aid is likely to be more effective under this exchange rate regime. Source: Elbadawi and Soto (2013) 92. Under South Sudan’s current managed in Latin America, such as Mexico or Peru, which floating exchange rate regime, a monetary started targeting the rate of money growth and policy regime (without an exchange rate anchor) after a few years moved to inflation targeting. would require an explicit and clearly understood alternative nominal anchor. Theoretically, the 93. If South Sudan decided to adopt MBS, it country could initially implement a plan based would need to ensure that the exchange rate on targeting the growth rate of money and regime is compatible with macroeconomic then, over time, transition to inflation targeting. fundamentals and closes the gap between the Compared to inflation targeting, using the growth official and the parallel rate. rate of money as the nominal anchor can be implemented by a central bank with relatively less independence. Targeting the growth rate of 1 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 The first challenge would be to deepen the easily observe the compliance of this rule so any foreign exchange market to make it more liquid deviation would result in an increase in inflation for an adequate determination of the exchange expectations and the collapse of the plan. This rate. The challenge for the Bank of South Sudan suggested path was followed by some countries (BSS) will be to supply the market without 45 2. Special Focus - Taming the tides of high inflation: policy options for South Sudan signaling an intention to defend a particular oil, borrows from abroad and receives grants in exchange rate level to maintain commitment to foreign currency. The government has issued floating exchange rate. By limiting its participation new guidelines for the implementation of the to frequent or periodic interventions (daily or regulation on floating exchange rate regime weekly) using transparent and market allocation instituting an auction mechanism that is in line mechanism such as auctions, the BSS could with international standards. However, given the promote the development of the forex market. low level of foreign reserves, the government While an auction mechanism is already in place, should be very selective in its interventions to build challenges to determine the exchange rate remain. its credibility and promote market confidence. 2 4 The second challenge would be to build an The fourth challenge would be to find an adequate system to monitor public and private alternative nominal anchor for its monetary sector exchange rate risk. Since July 2015, the policy. Despite the weak relationship between commercial banks’ balance sheets are showing monetary aggregates and inflation, money negative net foreign assets. With the 500 percent targeting can serve as an alternative nominal depreciation of the SSP in December 2015, the anchor for monetary policy. Many countries shifting net foreign liabilities (negative net foreign assets) from a fixed to flexible exchange rate regimes of the commercial banks has increased to more have favored an inflation targeting framework over than four times their capital, representing a money targeting. Many of them adopted inflation rather high exchange rate risk exposure. The BSS targeting over long time horizons, taking the time would need to enforce prudential requirements required to fulfill the institutional requirements to safeguard the integrity of the banking system. and macroeconomic conditions. It is too early for South Sudan to adopt inflation targeting, given the weakness of the financial sector and 3 the low government capacity. Monetary targeting combined with tight coordination with fiscal policy would be a more appropriated framework. The third challenge for the government would be Reducing the central bank financing of the fiscal to identify appropriate intervention measures in deficit should be an intermediary target of the the foreign exchange market to ensure stability. monetary policy, and more appropriated than International experience shows that central banks direct price administration. could intervene in the exchange market when they detect exchange rate misalignment or 94. Considering the limited institutional capacity, judge volatility destabilizing. These interventions the lack of independence of its central bank could be on a discretionary basis or regular, and significant credibility problems in recent preannounced, and rule-based to support the history, it is highly unlikely that South Sudan has information flow to the market and reduce noise. the capacity to follow an MBS. Credibility issues In the case of South Sudan, it seems that BSS associated high inflation, governance problems at will continue to supply the forex market with the central bank, and fiscal dominance, as well as a foreign currency because of its role as banker low level of financial development and significant to a government that receives revenues from weaknesses in statistical databases (both 2. Special Focus - Taming the tides of high inflation: policy options for South Sudan 46 precluding reliable monitoring and forecasting of bank and fiscal responsibility legislation consistent macroeconomic indicators) make MBS an unlikely with international best practice. Also, ERBSs are choice at this stage. typically short-lived because they are prone to runs on the currency and to RER appreciations 95. Another option would be to follow ERBS that are corrected by devaluations. By eliminating to curb inflation. Given the high inflation in the domestic currency, dollarization eliminates South Sudan and the lack of credibility of currency crises and increases exit costs. As a monetary policy, inflation is more likely tamed result, dollarization can be sustained over a longer through a hard peg of South Sudanese dollar. period of time. The disadvantage of hard pegs is the loss of an autonomous monetary policy, but at the current 97. Dollarization might help improve some of state of institutional development in South Sudan the macroeconomic weaknesses present in such autonomy might not be beneficial. The key South Sudan. Dollarization could eliminate the decision to make now is to identify the anchor possibility to finance the fiscal deficits by printing currency. IMF (2010) suggests that this choice money and, thus, could promote fiscal discipline. should be contingent on whether the anchor- Moreover, the halt to discretionary monetary currency country meets the criteria for an optimal policy could help lower inflation expectations. currency area: (i) higher trade; (ii) symmetric In addition, the elimination of exchange rate shocks; (iii) higher labor mobility; and (iv) higher risk might increase capital inflows, which could fiscal transfers within the region. improve the external balance. An additional and important consideration is that dollarization is not 96. If South Sudan decided to pursue the ERBS irreversible and the government of South Sudan path, full dollarization may be the easiest to could decide to introduce a domestic currency implement in the near term, both operationally and move toward an MBS if it desired. In practice, and institutionally. Dollarization may indeed hard pegs, including dollarization, have proven be a stronger arrangement than a currency to be easier to abandon than originally believed board, as it eliminates the risk of future currency by, for example, issuing quasi-monies or official crises and reduces the costs of international money accepted for tax collection (de la Torre transactions. Credibility of dollarization can be et al., 2003). The experience of dollarization in boosted by political backing of the country whose Ecuador described in the previous section could currency is adopted and with an agreement on be relevant for South Sudan. seigniorage sharing. A currency board could, in principle, impose a much stricter discipline on 98. Upon stabilization, South Sudan would need the monetary authority than dollarization, but to implement structural and fiscal reforms to given the history of governance problems with enhance efficiency and to prevent recurrence. the Bank of South Sudan and the failure of an Once the high inflation situation stabilizes, South earlier fixed exchange rate regime, establishing Sudan should prepare to implement a broader the credibility of a currency board arrangement set of structural and fiscal reforms along with without externally imposed safeguards could be price and exchange rate liberalization to prevent difficult. Further, more time might be needed recurrence.³⁹ To unlock affordable credit lines to garner political support for adopting a central from international capital markets, South Sudan ³⁹ The importance of structural reforms cannot be overemphasized even countries that do not have their own currency. For example, in crisis in Greece was fueled by the lack of supportive policies to keep the budget deficit under control, which undermined confidence in the country’s ability to remain within the European Monetary Union. 47 2. Special Focus - Taming the tides of high inflation: policy options for South Sudan needs to manage its public debt, improve export making borrowing from offshore sources very competitiveness and also offset the negative expensive, even for private sector entities. repercussions of the appreciation of the currency of the country from where it sources its imports 99. A key economic priority for the Government against the US dollar. Attracting both debt and is to restore peace and security, implement non-debt creating capital flows, notably foreign urgent macroeconomic measures to reduce direct investment, would require supportive high inflation. Dollarization may be the easiest to measures such as the alignment of the country’s implement in the near term, both operationally and investment laws and procedures to international institutionally. Observed inflation over the last three best practices, investor-friendly policies, better months has considerably deteriorated purchasing enforcement of rule of law and the respect of power of households. If the macro-economic property rights. The government should also strive imbalances are not managed in an effective and to improve its relations with the international timely manner, poverty could rise even further. In community to deal with negative perceptions the absence of reforms South Sudan will spiral that have tended to increase the country’s risk, further towards being a failed state.   2. 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What Do We Still Not Know?” G-24 Discussion Papers number 5, United Nations Conference on Trade and Development. World Bank, 2017. “Poverty, Livelihoods and Perception in a High Inflation Environment”, Poverty & Equity Global Practice. World Bank, 2015. “Republic of South Sudan – Systematic Country Diagnostic”, October 2015. 51 References Annex 1 Countries with a history of hyperinflation Annexes 52 Notes: - When a country experiences periods of hyperinflation that are broken up by 12 or more consecutive months with a monthly inflation rate below 50%, the periods are defined as separate episodes of hyperinflation. - The currency listed in the chart is the one that, in a particular location, is associated with the highest monthly rate of inflation. The currency may not have been the only one that was in circulation, in that location, during the episode. - We are aware of one other case of hyperinflation: North Korea. We reached this conclusion after calculating inflation rates using data from the foreign exchange black market, and also by observing changes in the price of rice. Based on our estimates, this episode of hyperinflation most likely occurred from December 2009 to mid- January 2011. Using black-market exchange-rate data, and calculations based on purchasing power parity, we determined that the North Korean hyperinflation peaked in early March 2010, with a monthly rate of 496% (implying a 6.13% daily inflation rate and a price-doubling time of 11.8 days). When we used rice price data, we calculated the peak month to be mid-January 2010, with a monthly rate of 348% (implying a 5.12% daily inflation rate and a price-doubling time of 14.1 days). All of these data were obtained August 13, 2012 from Daily NK, an online newspaper that focuses on issues relating to North Korea (http://www.dailynk.com/english/market.php). We also acknowledge that our investigation was aided by reports from Good Friends USA, a Korean-American advocacy and research organization, as well as from Marcus Noland at the Peterson Institute for International Economics. (*) The authors calculated Zimbabwe’s inflation rate, from August to November 2008, using changes in the price of the stock, Old Mutual, which was traded both on the Harare and London stock exchanges. The stock prices yielded an implied exchange rate for Zimbabwe dollars, under purchasing power parity. (†) The Republika Srpska is a Serb-majority, semi-autonomous entity within Bosnia and Herzegovina. From 1992 until early 1994, the National Bank of Republika Srpska issued its own unique currency, the Republika Srpska dinar. (‡) Greece’s inflation rate was estimated by calculating the drachma / gold sovereign exchange rate. (§) The peak monthly inflation rate listed for China in the table differs from that presented in one of the authors’ previous pieces on hyperinflation (Hanke and Kwok, 2009). This revision is based on new data from a number of sources, which were recently obtained from the Library of Congress in Washington, D.C. (**) We calculated the Free City of Danzig’s inflation rate using German inflation data, since the German papiermark was in circulation in Danzig during this time. It is worth noting that Germany and Danzig experienced different peak months of hyperinflation. This is case because the last full month in which the German papiermark circulated in the Free City of Danzig was September 1923. Germany continued to circulate the papiermark beyond this point, and subsequently experienced its peak month of hyperinflation (October 1923). (††) The data for many of the post-Soviet countries were only available in the World Bank’s Statistical Handbook: States of the Former USSR. In this publication, the authors stated that the data should be viewed with an extra degree of caution because the statistics were taken from the corresponding official internal government source and not independently reviewed by the World Bank. However, these statistics are official and are the only source of data available for the corresponding time periods for each country. (***) We calculated PPP implied inflation for Venezuela using black market exchange rate data from dolartoday. com. 68 Annexes Annex 2 Countries following inflation targeting Country Adoption Year Real GDP per capita Exchange Rate Regime de facto de jure 1 Albania 2009 2620.82 float float 2 Armenia 2006 1625.40 peg float 3 Australia 1993 33,947.56 float float 4 Canada 1991 35,087.89 peg float 5 Colombia 1999 3392.92 float float 6 Czech Republic 1997 12,705.61 peg float 7 Ghana 2007 501.86 peg float 8 Guatemala 2005 2146.18 peg float 9 Hungary 2001 10,936.95 peg float 10 Iceland 2001 54,885.26 float float 11 Indonesia 2005 1273.47 float float 12 Korea Rep. 2001 17,550.85 float float 13 Mexico 2001 7,666.70 float float 14 New Zealand 1990 27,357.86 float float 15 Norway 2001 65,767.02 float float 16 Peru 2002 2863.48 peg float 17 Philippines 2002 1200.94 peg float 18 Poland 1998 7963.02 float float 19 Romania 2005 4572.05 float peg 20 Switzerland 2000 51,734.30 float float 21 Thailand 2000 2689.95 float float 22 Turkey 2006 7129.58 float float 23 United Kingdom 1992 38,121.56 peg float Source: Ismailov et al. (2016) Annex 3 Dynamics of ERBS in Latin America In Latin America, countries generally opted for percent, with inflation ranging from 61 to 2,477 ERBS when suffering relatively high inflation percent. A possible explanation why countries with rates. In Latin America an example of a currency relatively high inflation chose ERBS could be that board is the Convertibility Plan in Argentina the higher inflation is, the lower is the confidence that lasted from 1991 to 2001. An example of that the central bank can pursue an independent dollarization is Ecuador, which since 2000 monetary policy. Thus, an ERBS became a more eliminated its domestic currency and adopted the appealing option than an MBS, as the probability U.S. dollar as legal tender. Among the surveyed that the latter would succeed was lower (Stein et al., countries, the median value of annual inflation in 2000). Furthermore, in Latin America ERBSs used the year before implementing an ERBS was 126 to be more credible than MBSs and, as a result, Annexes 69 after they were announced they tended to lead to example, only two years after the implementation a larger drop in inflation inertia (Prazmowski and of ERBS, inflation in Argentina and Brazil was Sanchez-Fung, 2014). In fact, as shown in ERBSs reduced from 1,344 to 13 percent and from 2,477 were very successful at quickly reducing inflation, to 9.6 percent, respectively. even when inflation was exceptionally high. For Table 2 Annual inflation rates before and after ERBS Country Period Annual inflation rate One year Two years Year of One year before after termination after implementation implementation termination Argentina tablita 1978-1981 176 87.6 131.3 209.7 Chile tablita 1978-1982 91.9 31.2 20.7 23.4 Uruguay tablita 1978-1982 61.1 42.8 20.5 51.5 Mexico Pacto 1988-1994 159.2 29.9 7.1 52.0 Uruguay exchange rate bands 1990-2001 89.2 58.9 3.6 26.0 Argentina Convertibility Plan 1991-2001 1,343.9 12.6 -1.5 41.0 Brazil Real Plan 1994-1998 2,477.1 9.6 1.7 8.9 Ecuador dollarization 2000- 60.7 9.4 - - Source: Data on annual inflation rates is from the IMF World Economic Outlook. Implementation and end dates of the stabilization plans are from Calvo and Vegh (1999) and Frenkel and Rapetti (2010). Conventional wisdom sustains that ERBS is was implemented, growth jumped to 11 percent. followed by “boom-bust” cycles, in which an Similar is the case of Chile. In 1978 when the initial expansion of the economy is followed by a tablita was announced, annual GDP growth was recession. This pattern contrasts with MBS, which 8.3 percent compared to an average growth of only first generates a recession and then a boom of 0.2 percent in the previous three years. The case the economy (Kiguel and Liviatan, 1992; Calvo and of Argentina under the tablita and of Uruguay Vegh, 1994, 1999; Reinhart and Vegh, 1994). The under the exchange rate band seemed to go Latin American experience with ERBS seemed to against this pattern because economic activity fell conform to this trend of initial boom followed by a during the year these plans were implemented. crisis. As shown in Table 3, countries experienced a However, these might be associated with the fact substantial jump in annual GDP growth the same that both plans were implemented in December year the ERBS was implemented. For instance, the and, hence, their effects would not be noticeable case of Argentina was remarkable. In the three until the following year (where in fact a significant year prior to the Convertibility Plan, Argentina increase in annual GDP growth can be observed). experienced on average a negative annual GDP Although we do not show data, a consumption growth of -3.4 percent. The same year this plan boom accompanied GDP growth in all countries. 53 Annexes Table 3 Annual GDP growth rates before and after ERBS Country Period Annual inflation rate Average three Year One year Last year years before program was after of program program implemented program Argentina tablita 1978-1981 0.1 -3.4 7.1 -5.7 Chile tablita 1978-1982 0.2 8.2 8.3 -13.6 Uruguay tablita 1978-1982 3.7 5.3 6.2 -9.3 Mexico Pacto 1988-1994 0.3 1.3 4.1 4.8 Uruguay exchange rate bands 1990-2001 3.5 0.3 3.5 -3.5 Argentina Convertibility Plan 1991-2001 -3.4 10.5 10.3 -4.4 Brazil Real Plan 1994-1998 1.7 5.3 4.4 0.3 Ecuador dollarization 2000- 1.0 1.1 4.0 - Source: Data on annual GDP growth rates is from the IMF World Economic Outlook. Implementation and end dates of the stabilization plans are from Calvo and Vegh (1999) and Frenkel and Rapetti (2010). The initial expansion in GDP growth could have Even when initially beneficial, the early expansion several potential explanations. For example, it has been typically followed by a decline in could have been due to inflation stickiness. A economic activity leading to the abandonment decrease in the devaluation rate is expected to of the stabilization plans. As Table 3 shows, except lower nominal interest rate through the interest in the case of the Mexican Pacto, ERBSs were rate parity condition. If inflation expectations abandoned after the country suffered a stop or a were sticky, then a lower nominal interest rate but contraction in economic activity. For instance, Chile unchanged inflation expectations would lower the and Uruguay experienced on average annual GDP real interest rate, stimulating aggregate demand growth of 7.7 and 4.8 percent, respectively, during (Rodriguez, 1982). Lack of credibility could have the first four years after the implementation of the also explained this behavior (Calvo and Vegh, 1993). tablitas. However, they had to abandon the plans If households expected the stabilization plan to after output fell by 14 and 9.6 percent, respectively, be abandoned and, thus, the exchange rate to in the fifth year. Likewise, under the Convertibility depreciate, they would have preferred to consume Plan, Argentina experienced on average annual in the early stages of the plan (when the peg kept GDP growth of 5.9 percent between 1991 and nominal interest rates low) rather than later (when 1998. Since 1999, Argentina started to experience the exchange rate would be devalued and nominal negative annual growth rates. Eventually, the interest rates would be high). Wealth effects Convertibility Plan collapsed in 2001 after GDP associated with the reduction of the inflation growth dropped by 4.4 percent. In all countries, tax and an expected decrease in government after the stabilization plan was abandoned, expenditure related to higher fiscal discipline could inflation resumed. have also boosted consumption and growth in the early stages of these plans (Helpman and Razin, The own dynamics of ERBSs might have planted 1987; Drazen and Helpman, 1988). the seeds of their destruction. On the one hand, Annexes 54 ERBSs were associated with an appreciation of As a result of these dynamics, ERBS in Latin the real exchange rate (RER), which reduced America were in general short lived. The competitiveness. RER appreciation was caused by dollarization in Ecuador, which has been in place inflation converging slowly to the devaluation rate. for 17 years so far, is the longest ERBS among the On the other hand, as explained above, ERBSs led surveyed countries. The relatively long duration to consumption booms. Lower competitiveness of this plan might be associated to the above- in the context of a consumption boom, increased mentioned facts that dollarization shields imports, generating large trade deficits (Calvo and countries from speculative attacks and to the high Vegh, 1994, 1999). Sooner or later these trade deficits costs of abandoning these types of programs. became unsustainable and the misalignment in the Among the rest of the surveyed programs (in all of RER needed to be corrected. RER appreciations which countries continued to use their domestic could be corrected either by price adjustments or currency), none of them lasted longer than ten devaluations. In general, policymakers chose the years. The convertibility in Argentina and the latter option because it was faster and less costly exchange rate bands regime in Uruguay were the (Goldfajn and Valdes, 1999). But this route ended ones that lasted the most, being place for ten up undermining the initial idea of having a credible years. At the other extreme, the Argentina tablita anchor that would persist over time. only lived for four years.   Annex 4 MBS versus ERBS in Latin America In Latin America, there are several examples Another noticeable difference between MBS of MBS. For example, Mexico, between 1995 and ERBS is that the former seemed to have and 2000, and Peru, between 1990 and 1993, reduced inflation more gradually. To illustrate implemented MBSs that relied on the growth rate this point, one can compare the developments in of money as the nominal anchor. Later on, both Brazil under the ERBS discussed in the previous countries transitioned toward inflation targeting. section and Peru under a MBS. Both countries Mexico did so in 2001 and Peru in 1994. Other implemented stabilization plans after undergoing countries directly implemented an MBS that similar inflation rates. Brazil adopted ERBS after relied on inflation targeting, such as Chile since annual inflation reaching 2,477 percent whereas 1991, and Colombia and Brazil since 1999.⁴⁰ All of Peru implemented its money-targeting plan these plans are still in place today. with an annual inflation of 2,775. Two years after the implementation of ERBS, Brazil had annual Relatively to ERBS, countries that had lower inflation inflation of 9.6 percent whereas in Peru annual have been the ones that ended up implementing inflation was 57 percent. In fact, Peru needed MBS Table 4). Among the surveyed countries, the seven years to reach one-digit inflation. This median value of annual inflation in the year before pattern helps further explain why MBS was not implementing an MBS was 17 percent, compared the preferred choice of countries with relative to 126 in countries adopting ERBS. In some cases, higher inflation. In these countries, governments such as Brazil and Mexico, countries adopted MBS might not have had the time or the political after experiencing one-digit inflation. But, MBS has support to implement a stabilization plan that also been adopted in the case of exceptionally high would lower inflation gradually. inflation too, as was the case in Peru. ⁴⁰ Dating the start of MBSs in Latin America is not an easy task and different studies consider different starting dates. We set the start dates of these plans based on the studies by Jimenez (2004) and Broto (2011). 55 Annexes Table 4 Annual inflation rates before and after MBS Country Period Annual inflation rate One year Two years Five years Average ten before after after years after implementation implementation implementation implementation Chile 1990- 21.2 12.9 8.3 8.6 Peru* 1990- 2,775.3 56.8 10.2 29.3 Mexico* 1995- 7.1 15.7 9.0 10.6 Brazil 1999- 1.7 7.7 7.6 6.7 Colombia 1999- 16.7 7.6 5.5 6.0 *: Mexico and Peru started with monetary targeting and then transitioned toward inflation targeting in 2001 and 1994, respectively. Both separate approaches are considered as a single stabilization plan in the analysis. Source: Data on annual inflation rates is from the IMF World Economic Outlook. Implementation dates of the stabilization plans are from Jimenez (2004) and Broto (2011). Whereas ERBS generates a boom-bust cycle, MBS expansion was generally followed by an economic are predicted to cause instead a “bust-boom” downturn. Colombia and Mexico suffered negative cycle. The implementation of these programs economic growth after their MBSs were put in is typically followed by an initial contraction of place. Peru also exhibited negative growth the economic activity. The tightening of monetary year it implemented its MBS. However, the causal policy increases interest rates and reduces relation is less clear because the economy was aggregate demand, reducing output as well. After already under negative growth. Brazil and Chile the initial contraction, the economy rebounds and experienced a deceleration of economic growth growth resumes (Kiguel and Liviatan, 1992; Calvo but output growth was still positive. However, in all and Vegh, 1994, 1999; Reinhart and Vegh, 1994). As of these countries growth resumed one year after Table 5 shows, in Latin America the implementation the implementation of the plan and remained of MBS conformed to this pattern and an initial strong during the subsequent years. Table 5 Annual GDP growth rates before and after MBS Country Period Annual inflation rate Average three Year One year Average ten years before program was after years after implementation implemented implementation implementation Chile 1990- 8.2 3.7 7.9 6.4 Peru 1990- -5.0 -5.1 2.2 4.0 Mexico 1995- 3.5 -5.8 5.9 3.4 Brazil 1999- 2.0 0.5 4.4 3.4 Colombia 1999- 2.0 -4.2 2.9 4.0 *: Mexico and Peru started with monetary targeting and then transitioned toward inflation targeting in 2001 and 1994, respectively. Both separate approaches are considered as a single one in the analysis. Source: Data on annual GDP growth rates is from the IMF World Economic Outlook. Implementation dates of the stabilization plans are from Jimenez (2004) and Broto (2011). Annexes 56 The evidence on MBSs in the selected Latin economy quickly entered into a path of economic American countries suggests that these growth and inflation gradually slowed down. As programs were relatively more sustainable over a result, good economic performance increased time compared to ERBSs. In all of these countries support for the program and the belief that it could MBS is still in force and have been in place for over be sustained, which in turn reinforced its stability. 18 years. One could think of two possible reasons behind the higher stability of MBS. First, the After the experiences in the 1980s and 1990s, destabilization factor of ERBSs was not present Latin American countries have predominantly in MBSs. In other words, MBSs did not lead to tilted toward MBS to deal with inflation. One the large trade deficits that could be sustained and one hand, ERBS only managed to control inflation forced a depreciation of the currency. In MBSs, for a short period of time and also frequently led inflation converged slowly to the money supply, to recessions and eventual crises that precipitated which appreciated the RER. However, in contrast the exit. As a result, Latin American countries to what happened under ERBSs, the contraction that during the 1980s and 1990s experimented in consumption caused by the fall in economic with ERBS, such as Argentina, Brazil, and Mexico, activity more than compensated the effect of lower have decided to move on to MBS. On the other competitiveness so, as a result, countries tend to hand, countries that have put in place MBS have experience trade surpluses (Calvo and Vegh, 1994, continued with their plan and, even, moved from 1999). Second, after the initial contraction, the a money growth target toward an inflation target. 57 Annexes Annex 5 Deflation in countries post stabilization programs Country Disinflation Period Main Official Fund Fund Disinflation Development Arrangement in Arrangement in Years Assistance & Aid the 12 Months the 12 Months (% of GDP)2 After the Peak 3 After the Peak? Peak 12 Months After Peak Angola Dec 1996 - Jan 1998 1997 2,660.8 131.5 4.6 No Argentina Jul 1985 - Jun 1986 1985 - 1986 1,128.9 50.1 0.0/0.08 Yes Argentina Apr 1990 - Jun 1994 1990 - 1991 20,266.0 287.3 0.1/0.1 Yes Amenia Jun 1994 - Feb 1997 1994 - 1995 27,019.7 196.7 14.5/14.8 No3 Azerbajan, Rep. of Dec 1994 - Feb 1997 1995 1,898.4 173.6 3.9 No3 Bolivia Oct 1985 - Sep 1987 1985 - 1986 23,447.0 94.1 6.3/8.4 Yes Brazil May 1990 - Jul 1991 1990 - 1991 6,821.3 375.2 0.0/0.0 No Brazil Jul 1994 - Feb 1997 1991 - 1995 4,922.6 33.0 0.0/0.0 No Bulgaria Apr 1997 - Nov 1998 1997 - 1998 2,019.5 22.1 2.1/1.9 Yes Congo, Dem. Rep. of Oct 1992 - Oct 1993 1992 - 1993 7,689.2 486.2 1.7 No Congo, Dem. Rep. of Oct 1994 - Sep 1995 1994 - 1995 91,253.1 330.2 4.2/3.5 No4 Croatia Jul 1993 - Nov 1994 1993 - 1994 19,449.5 209.7 0.8 No3 Estonia 1993 1993 1,069.0 89.0 1.1 Yes3 Georgia Feb 1995 - Sep 1995 1995 2,667.8 42.9 7.8 Yes3 Kazakhstan Aug 1994 - Mar 1999 1994 - 1995 3,121.4 156.1 0.3/0.3 Yes Kyrgyz Republic Sep 1993 - Feb 1996 1993 - 1994 1,311.8 169.6 5.5/10.3 Yes3 Macedonia, FYR/SFRY1 1990 1990 1,239.9 608.4 n.a. Yes Macedonia, FYR Nov 1992 - Dec 1996 1993 2,100.5 241.7 0.1 No Moldova 1994 1994 2,705.7 104.6 3.2 Yes3 Nicaragua Feb 1989 - Mar 1990 1989 43,033.7 1,074.4 24.1 No Nicaragua Apr 1991 - Apr 1992 1991 63,775.7 24.2 56.3 Yes Peru Sep 1990 - Sep 1995 1990 - 1991 12,377.8 230.4 1.5/1.8 No Poland Mar 1990 - Mar 1992 1990 - 1991 1,173.3 90.9 2.2/3.3 Yes Russia Oct 1993 - Nov 1994 1993 - 1994 1,066.7 221.1 0.6/0.5 No3 Slovenia/SFRY1 Feb 1990 - Mar 1991 1990 3,450.0 51.2 n.a. Yes Tajikstan Jan 1994 - Dec 1994 1994 7,344.0 1.1 50 No Tajikstan Mar 1996 - Mar 1997 1996 - 1997 2,266.8 13.4 9.8/9.3 Yes Turkmenistan Jul 1996 - Feb 1998 1996 - 1997 1,633.6 98.4 1.0/0.5 No Ukraine Jan 1994 - Nov 1997 1994 - 1995 10.155.0 401.1 0.6/0.7 No3 Uzbekistan Nov 1994 - Oct 1996 1995 1,844.2 189.4 0.6 No3 Source: Coorey et al. (2007) 1 Slovenia, before June 1991, and Macedonia, before September 1991, were part of the Socialist Federal Republic of Yugoslavia (SFRY). 2 The official development assistance and official aid data refers to the main disinflation years. 3 These countries made drawings under the Systemic Transformation Facility (STF). 4 Democratic Republic of Congo had a staff-monitored program (SMP) from January 1994 to December 1996 that did not involve financing. Annexes 58 59 Annexes