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Chapter II: Swaziland’s Interconnection with the Global Economy

Author(s):
Olivier Basdevant, and Borislava Mircheva
Published Date:
February 2013
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Information about Sub-Saharan Africa África subsahariana
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Swaziland is highly interconnected with South Africa and with the global economy. As the global economy faces higher risks of adverse shocks, Swaziland may be affected by spillover effects. These shocks would mainly arise from lower demand and increased risk aversion in financial markets, either directly or indirectly through South Africa (IMF 2012a). The spillover effects would come from two core elements: (i) intrinsic vulnerabilities, specific to Swaziland, which are then (ii) aggravated by specific external shocks. This Chapter discusses these two points, while policy issues are discussed in a broader context, in the next section.

A. Understanding Spillovers from the World Economy to South Africa and Swaziland

Swaziland is an economy integrated with the global economy through two main channels: directly, largely with sugar exports to the European Union, and indirectly, through its close economic and financial integration with South Africa.

This section investigates how the interconnections among the global economy, South Africa, and Swaziland play out in defining possible risks to Swaziland’s economic outlook. The main possible risks are threefold: (i) a projected downturn in the global economy, if materialized, would negatively affect Swaziland, (ii) financial deleveraging in the South African economy may spread to Swaziland, because its banking sector is dominated by South African banks, and (iii) Swaziland’s fiscal position is unsustainable over the medium term, and threatens external sustainability. These latter risks may also have outward spillover effects for Lesotho, Namibia, and South Africa, because these countries have pegged their currency to the South African rand in the CMA (Box 1).

Swaziland faces a variety of risks over the medium term (Table 2):

  • The growth outlook for the global economy has significant downside risks, primarily because of uncertainty in advanced economies (IMF, 2012b). These uncertainties could spread to other economies, primarily through a contraction of global demand, which would reduce growth prospects. Another possible risk is a hard landing for fast growing emerging markets. However, this is generally considered as a tail risk for the time being as its impact on South Africa and Swaziland would be different (it would negatively affect commodity prices of many goods produced and exported by sub-Saharan African countries).
  • A tail risk of a hike in oil prices, largely as a result of perceived geopolitical risks (IMF, 2012b) could negatively affect the terms of trade in Swaziland, further weakening domestic demand.
  • A hypothetical financial deleveraging risk for South Africa is viewed as a tail risk (IMF, 2012c), with a low impact on South African banks. However, a deleveraging, small by South African standards, if materialized, could have serious implications on credit to the private sector in Swaziland. The risk of deleveraging for Swaziland is assessed to be higher, because the perceived higher country risk makes South African banks more likely to deleverage their operations in Swaziland than in other countries.
  • Finally, several possible risks are specific to Swaziland and SACU. These risks are broadly classified in two categories. The first category relates to the impact of the global economy on SACU imports that may imply a large decline in SACU transfers over the medium term, which would subsequently require an equally large fiscal adjustment (see Mongardini and others, 2011, and Basdevant and others, 2011). Trade liberalization, expected to happen in the coming years, could reduce the SACU pool as well. Finally, the SACU transfer for 2012/13 is largely due to one-off factors and could revert to lower levels in the coming years. The second category relates to the unsustainable current fiscal policy. Absent a credible fiscal adjustment plan, Swaziland remains exposed to external and fiscal sustainability risks, which could trigger, among other things, portfolio outflows and an unsustainable external position.
Table 2.Cross-Country Risk Assessment Matrix
RisksImpact if Realized1
SourcesDownside (⇩) or Upside (⇧)Likelihood1
Growth slowdown in the US2LowHigh

Lower exports to the US, spillovers from lower activity in South Africa. Possibly lower SACU transfers over the medium term.
Growth slowdown in the euro area2MediumHigh

Lower exports to the euro area, spillovers from lower activity in South Africa. Possibly lower SACU transfers over the medium term.
Growth slowdown in emerging economies3LowHigh

Lower exports to the emerging markets, spillovers from lower activity in South Africa. Possibly lower SACU transfers over the medium term.
Hike in oil prices4LowMedium

Risk of a growth slowdown
Financial deleveraging by South African banksLowHigh

South African banks could reduce their exposure to Swaziland further. Risk of a credit crunch and growth slowdown.
Portfolio outflows5MediumHigh

With large portfolio outflows, external sustainability could rapidly be jeopardized, because deposits would most likely be transferred to South Africa.
Unaddressed fiscal imbalances6High7High

Without a credible fiscal adjustment plan, Swaziland’s fiscal and external positions are unsustainable over the medium term.

With a fiscal adjustment plan, Swaziland could restore both fiscal and external sustainability.

Classified as high, medium, or low.

Advanced countries face two main risks: a potential deepening of the crisis in the euro area, and a fiscal cliff in the United States.

Emerging economies continue to face risks of overheating, as well as perceptions of higher uncertainty.

Market conditions could be affected by perceived geopolitical risks, but prospects remain otherwise favorable.

The financial sector stability is vulnerable to portfolio outflows, as commercial banks’ deposit base has been eroded by preferences for investments with asset management companies.

Swaziland’s fiscal and external positions are vulnerable because of (i) a high dependence on SACU transfers; (ii) uncontrolled public spending; and (iii) an unfavorable business climate.

The risk could materialize as early as 2012/13. Pressures have already emerged for higher spending, with demands for wage increases and renewed efforts in areas with no impact on poverty alleviation (construction of a new airport).

Classified as high, medium, or low.

Advanced countries face two main risks: a potential deepening of the crisis in the euro area, and a fiscal cliff in the United States.

Emerging economies continue to face risks of overheating, as well as perceptions of higher uncertainty.

Market conditions could be affected by perceived geopolitical risks, but prospects remain otherwise favorable.

The financial sector stability is vulnerable to portfolio outflows, as commercial banks’ deposit base has been eroded by preferences for investments with asset management companies.

Swaziland’s fiscal and external positions are vulnerable because of (i) a high dependence on SACU transfers; (ii) uncontrolled public spending; and (iii) an unfavorable business climate.

The risk could materialize as early as 2012/13. Pressures have already emerged for higher spending, with demands for wage increases and renewed efforts in areas with no impact on poverty alleviation (construction of a new airport).

The risks to Swaziland’s economic situation are also expected to have implications for other CMA members. Although direct impacts are minor, spillover effects are not. An unsustainable external position in Swaziland could have strong spillover effects to other CMA members (Lesotho, Namibia, and South Africa).

B. Modeling Potential Spillovers of External Shocks to the Swaziland Economy

This section focuses on analyzing the two main potential spillover risks that could be faced by Swaziland (a growth slowdown in the global economy and deleveraging in South Africa), to understand (i) the potential magnitude of these shocks and (ii) their transmission mechanisms. These are critical to understanding how Swaziland could strengthen its resilience to external shocks. This quantitative analysis is done using the Global Integrated Monetary and Fiscal (GIMF) model (see Kumhof and others, 2010, for a general presentation).

GIMF is suitable to analyze spillover effects because it is a multi-country model, with a dynamic stochastic general equilibrium structure. The structure used here is a three-country model, with Swaziland, South Africa, and the rest of the world. The three components of the model are linked through bilateral trade and relative prices, including interest rates and exchange rates, which are explicitly modeled. Apart from general features of the model (Box 2), the following features have strong implications on simulation results.

  • The share of households without access to credit is estimated at 70 percent in Swaziland and South Africa (Canales-Kriljenko, 2011), and 50 percent in the rest of the world.
  • Trade data2 indicate several stylized facts. Swaziland’s trade is largely dependent on South Africa, which provides almost all of Swaziland imports and absorbs about two-thirds of its exports. Overall, Swaziland is a net importer of South African goods. However, the weight of Swaziland in South African trade is limited, with the rest of the world making up about 98 percent of South African imports and exports.
  • South Africa is a major source of financing for Swaziland, through investment (direct and portfolio), remittances, and domestic financing, as three out of four Swaziland banks are South African.
  • Finally, the calibration of the model is based, for South Africa, on a previous study done by Canales-Kriljenko (2011), and the rest of the world from Kumhof and others (2010), while other parameters on Swaziland are derived from Basdevant and others (2011).

Fiscal policy responses are based on maintaining a structural surplus consistent with stable ratios of government debt to GDP over the medium term. This assumption is important, because some results are partly mitigated by countercyclical policies. Other elements could prevent such policies, notably in Swaziland where fiscal space is limited. This assumption is discussed further when analyzing simulation results.

Impact of a Fiscal Contraction in the Global Economy

The first simulation exercise consists of a fiscal adjustment in the global economy of 1 percent of GDP for two years, which is consistent with the fiscal risks in advanced economies. As shown in Figure 2, the spillover risks for Swaziland are quite significant. A one-half percent GDP decline in the global economy could translate into a slowdown of at least one-eighth of GDP in Swaziland. The main transmission channels are (i) the contraction of demand for Swaziland’s goods, which affects part of its exports, and (ii) the indirect impact on South Africa, not only through a demand effect (by lowering South Africa’s growth, the demand for Swaziland’s goods would be affected), but also through the policy response impact.

Figure 1.Impact of a Fiscal Contraction in the Rest of the World1

Source: IMF staff estimates.

1 Responses are shown on an annual basis, with the shock happening in t=1.

Figure 2.Impact of Deleveraging in South Africa1

Source: IMF staff estimates.

1 Responses are shown on an annual basis, with the shock happening in t=1.

Two caveats must be emphasized though:

  • First, the impact of the fiscal contraction in the global economy is projected to be relatively limited, largely owing to an accommodative monetary policy. Multipliers may actually be stronger than expected before the crisis (IMF, 2012d). For example, with multipliers closer to 1, the pass-through of a fiscal contraction by 1 percent of GDP in an advanced economy could well translate into a similar decline of 1 percent in GDP for global economic growth.
  • Second, accommodative policies in South Africa and Swaziland would help reduce the impact of the growth slowdown in the global economy. While Swaziland would automatically benefit from an accommodative monetary policy in South Africa, owing to the parity with the rand, the capacity of these countries to implement a countercyclical fiscal policy would remain subject to the available fiscal space. While South Africa still has significant fiscal space, if market pressures were the main trigger for the fiscal adjustment in advanced economies, these pressures could also spillover to South Africa. Swaziland’s fiscal policy is more constrained, as the fiscal space is at present inexistent. However, with a fiscal adjustment in place and renewed access to external financing, Swaziland could still let automatic stabilizers play out in the event of an external shock.

Additional Risks: SACU Transfers Volatility in the Global Slowdown

Finally, in both of these experiments, SACU transfers are not explicitly modeled. There is, however, a significant fiscal risk pertaining to any adverse global shock. As discussed in Mongardini and others (2012), small shocks on South African GDP have very significant impact on SACU transfers received by smaller members of the union, such as Swaziland. South Africa generates about 90 percent of the revenue of the SACU pool,3 and the existing rules make BLNS4 receipts heavily dependent on South Africa GDP projections. Thus, as described in Cuevas and others (2011), revenue received in a given year t is based on GDP projections for that year; and an adjustment is made in year t+2, to correct for discrepancies between the transfers received (i.e., based on the projections) and the level corresponding to the actual collection (i.e., based on actual numbers). Empirically, this two-year lag has led to severe procyclical transfers because downward adjustments have usually been concomitant with lower activity in the cycle. This procyclicality has proven, in the context of the 2008 crisis, very damaging because the sharp contraction of SACU transfers contributed to risk of debt distress. In the event of an adverse shock to the global economy and/or South Africa, an additional fiscal adjustment could then be needed, in particular when a shortfall of SACU transfers is too large to be absorbed otherwise. The fiscal implications are discussed further in Basdevant and others (2011).

Box 2.Outline of the Main Components of the GIMF Model1

Real Sector

There are two types of households: those with access to financial markets, represented by overlapping generations (OLG), who have a life-cycle behavior over a finite horizon; and those who are liquidity constrained and consume their income out-of-pocket. Both types of households supply labor, with wages set by unions, and pay direct taxes on income, indirect taxes on consumption spending, and a lump-sum tax. All households can benefit from government transfers. Firms are owned by households, use capital and labor to produce two types of goods (tradable and non-tradable). They also have a finite planning horizon that gives rise to a substantial equity premium. Firms pay capital income taxes to the government and wages and dividends to households. Monopolistic competition allows for a markup over marginal costs. Firms use public investment as input, in combination with tradable and non-tradable intermediate goods.

Financial Sector

The financial sector contains a limited set of financial assets. OLG households can acquire domestic government bonds, international bonds, and fixed term deposits. Debt is denominated in domestic currency and financial assets, as well as ownership of firms. It is not tradable across borders. The corporate balance sheet channel (endogenous borrowing premium) and the bank balance sheet channel (endogenous lending spread) provide the basis for macrolinkages (Bernanke, Gertler and Gilchrist, 1999).

Monetary Policy

Because the lilangeni is pegged to the South African rand, the monetary rule follows the maintenance of the peg. Monetary policy in South Africa and the rest of the world follows an inflation targeting regime, approximated by a Taylor rule.

Fiscal Policy

Fiscal policy is based on several instruments (government consumption and investment, lump sum transfers, taxes on labor, corporate profits and consumption, and tariffs). Non-Ricardian features allow for a sizable impact of spending- and revenue-based fiscal measures. Thus, a fiscal impulse typically leads to stimulating economic activity in the short run and crowding-out private investment and net foreign assets in the long run. The larger the proportion of liquidity-constrained households, the larger the fiscal multiplier from temporary changes to taxes and transfers.

1 See Kumhof and others (2010) for a general presentation of GIMF.

Implications of Financial Deleveraging in South Africa

Financial deleveraging in South Africa could be triggered by the need for commercial banks to replace their domestic wholesale funding with more expensive funding. To model this deleveraging we simulate a shock increasing the risk premium for financing firms. The results present a persistent shock to the risk premium, peaking at 1 percentage point higher than in the steady state (Figure 2. Impact of Deleveraging in South Africa).

Deleveraging in South Africa would have significant implications for Swaziland, because of the strong presence of South African banks in its banking sector. The transmission channel would be twofold, with a direct contagion impact of the deleveraging process and another indirect impact of lower financing on demand for Swaziland’s exports.

Similar to the previous simulation, fiscal policy and monetary policy are assumed accommodative in both countries. The assumed fiscal space for Swaziland remains subjected to the limited fiscal space.

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