The 21^st Meeting of the COMESA Committee of Governors of Central Banks was held from 18-19 November 2015 in Lusaka, Zambia. Governors reviewed the activities that were undertaken by COMESA Monetary Institute (CMI) and the COMESA Clearing House for enhancing monetary cooperation in the region and endorsed a 2016 Work Plan for the two COMESA institutions.

The Secretary General of COMESA, in his statement, emphasized that monetary cooperation programmes at the regional level are building blocks for achievement of continental integration. He, therefore, proposed to make monetary cooperation as a Tripartite (COMESA, EAC and SADC) agenda for speeding up continental integration which is currently being pursued by the Association of African Central Banks (AACB). This he said will avoid duplication of efforts due to overlapping membership. He also emphasized the importance of the region’s involvement in supranational and global value chains as well as international production aimed at high value products that can access global markets.

He pointed out that industrialization can diversify the region’s dependence on commodity trade and emphasized the importance of collective thoughts to come up with a good industrialization policy for the region. He underscored the importance of prudent fiscal policies and financial intermediation for making the region a zone of macroeconomic stability and enhancing integration. He stated that the speedy implementation of the Regional Payment and Settlement System (REPSS) will significantly contribute to the expansion of intra-COMESA trade. He, therefore, urged all member Central Banks to expeditiously use REPSS for payment for their intra-COMESA transactions.

Report of the 13th Meeting of the Monetary and Exchange Rates Policies Sub-Committee

The Effects of Fiscal Policy on the Conduct and Transmission Mechanism of Monetary Policy

Governors were informed that research papers were prepared by experts from Central Banks of Burundi, Egypt, Kenya, Malawi, Mauritius, Rwanda, Swaziland, Sudan, Uganda, Zambia and Zimbabwe. The papers focused on the following:

1. Key features of the operational framework for fiscal and monetary policy and interaction between fiscal and monetary policies;

2. Theoretical and empirical literature on the different channels through which fiscal policy can affect monetary policy;

3. Trends in fiscal performance including trends on dependence on foreign borrowing and grants;

4. Review of existing legal and institutional development which are necessary in order to avoid fiscal dominance and to ensure effective coordination of monetary and fiscal policies;

5. Challenges facing the existing fiscal policy regime;

6. Empirical analysis of the channels in which fiscal policy affects monetary policy; and

7. Recommendations.

Governors noted the following salient features of the research papers:

Key features of Fiscal and Monetary Policies in COMESA member countries in recent years

Governors were informed that the following are key features of fiscal policy in selected countries:

• Many countries introduced Public Finance Management System (PFM). PFMs require that the budget is comprehensive by including all financial operations of the Government. Thus both the current and capital budget should be included under one budget and aid and debt, as well as other off-budget items (including contingent) must be captured in the budget. Such a comprehensive sweep of the budget would facilitate coordinating fiscal policies within a macroeconomic policy framework and enable assessment of the sustainability of fiscal policies over the short and medium term. Having a robust PFM by member countries is one of the requirements of the COMESA Multilateral Fiscal Surveillance Framework.

• Many Member countries are making significant progress in preparing their budgetary policies within a comprehensive medium term financial management framework, comprising a set of four separate frameworks: A Medium Term Fiscal Framework (MTFF), a Medium Term Budget Framework (MTBF) and Medium Term Expenditure Framework (MTEF). The COMESA Multilateral Fiscal Surveillance Framework is based on the availability of all the four components of the Medium Term Financial Management Framework. However, their development in member countries is constrained due to insufficient availability of data, and capacity for data analysis which could only be built from the medium to long run.

• The institutions and laws governing fiscal policy are enshrined in legislation and often derived from constitution.

• All countries have legal systems that define functions and responsibilities of the Ministry of Finance in the country’s debt management process. This also specifies the limit of indebtedness and guarantees that the country can undertake. This strengthens fiscal discipline in the country and ensures that the country remain on a prudent fiscal path.

• Many member countries undertook the following tax reforms:

  • Significant attempt has been made by most member countries to reduce reliance on the taxation of international trade and to shift the tax system toward domestic transactions and sources of income.

  • VAT was introduced in almost all member countries. Tax reforms have also been instrumental in shifting excises from a specific to an advalorem valuation basis.

  • Almost all countries have simplified and improved the equity and efficiency of their personal income taxes by scaling down the highest marginal rates, reducing the number of rates, and reducing exemptions and deductions.

  • Tax administration in almost all countries has improved through better training and salaries and conditions of service for revenue collection personnel. Special emphasis was placed on providing adequate trained manpower and other infrastructural facilities to enable the attainment of revenue potential.

• Some countries use countercyclical interventions when the economy is below or above potential growth path. Countercyclical expenditures involves increasing public spending when the economy is growing below its long run potential, and decreasing it when output rises close to potential and is threatening to cause resource scarcities that provoke inflationary pressures.

Governors observed that the following are key features of monetary policy in selected member countries:

• The overriding objective of monetary policy for most central banks is price stability. Other objectives pursued by many central banks in the region in recent years include financial stability and economic growth.

• Most COMESA member countries removed exchange controls and adopted a more flexible exchange regime.

• Most countries moved from direct to indirect monetary management. This includes establishment of open market operations for monetary policy purposes and to improve liquidity management. Some countries introduced framework for repurchase and reverse repurchase transactions. In some countries for example Mauritius, Key Repo Rate (KPR) acts as a policy rate to signal its monetary policy stance.

• Many countries still use base money or reserve money as operational target in the conduct of monetary policy while broad money has been used as the intermediate target with inflation being the ultimate target.

• Many countries are embarking on modernizing their monetary policy framework with the ultimate objective of adopting an inflation targeting monetary policy framework. Some countries have introduced policy rates. The motivations for modernizing the monetary policy regime are to enhance market participants understanding of the monetary policy stance and to strengthen the monetary policy transmission channel, particularly the interest rate channel.

• Some countries like Mauritius, Kenya and Swaziland are making remarkable attempts on inflation targeting approach in the conduct of monetary policy.

• Most central banks have Monetary Policy Committees with diverse membership.

Governors also noted that the following are direct and indirect channels through which fiscal policy affects monetary policy in selected countries:

• Fiscal policy influences demand pressures and thus impacts inflation, via both direct spending by government and changes to private disposable income (through taxation and the benefit system). In particular, through the monetization of the fiscal deficits, fiscal policy undermines monetary policy as it fuels inflationary pressures. Even in the absence of monetization by the central bank, higher deficits may cause inflation, as the government’s borrowing requirements will increase the net credit demands, drive up interest rates and crowds out private investment. The resulting reduction in economic growth would lead to a decrease in the amount of goods available for a given level of cash balances, causing higher price levels;

• Fiscal policy affects monetary policy directly through indirect taxes. If governments resort to substantial increases in indirect taxes-sales taxes, value added tax – this would have a direct impact on prices through the wage-price spiral;

• Perceptions and expectations of huge budget deficits, and resulting large borrowing requirements are likely to trigger a lack of confidence in the economic prospects, posing risks to financial system stability;

• On the external side, there are risks of too much dependence on foreign funding of domestic debt, arising from unsustainable fiscal deficit. This may result in exchange rate and/or balance of payment crisis which are worrisome to central banks;

• Fiscal policy affects monetary policy through both domestic and public debt depending on its sustainability. If market participants perceive the growth in domestic/public debt as unsustainable, the credibility of the overall policy mix is reduced and interest rates will rise. Also, adverse shocks to external indebtedness tend to shift the long run interest rate spreads. Wider interest rates spreads lead to higher yields on government bonds and to higher commercial interest rates.

Challenges for Implementation of Fiscal and Monetary Policies

Governors observed that the following are some of the challenges for fiscal policy implementation in selected COMESA member countries:

• Low level of private savings partly because of low income levels due to high levels of poverty.

• A sizeable portion of most developing economies is non-monetized, rendering fiscal measures of the government ineffective and self-defeating.

• External shocks on commodity prices such as oil, copper price shocks and external debt in most member countries affect the stance of fiscal policy.

• In a number of countries, fiscal policy effectiveness is hindered by the difficulty to generate direct tax revenues; the inefficient collecting schemes of taxes; low rates of taxes on property; and a decline in taxes on international trade due to tariff reductions, trade agreements, and discretionary exemptions.

• Lack of statistical information as regards the income, expenditure, savings, investment, employment etc. This makes it difficult for the public authorities to formulate a rational and effective fiscal policy.

• Fiscal policy requires efficient administrative machinery to be successful. Most developing economies have corrupt and inefficient administrations that fail to implement the requisite measures vis-à-vis the implementation of fiscal policy.

• Gaps in the legal and institutional framework governing fiscal policy in some countries.

• Significant powers and responsibilities given to the Minister of Finance which could create fiscal dominance and thereby render monetary policy ineffective.

• Huge external debt which result in serious repayment difficulties.

• Huge increase in recurrent expenditure such as wages and salaries, interest payment on domestic debt, subsidies, grants and social benefits expenditure.

• In some countries, the government crowds-out the private sector and distorts any investment and development prospects because of the limited financial resources.

Governors also noted that the following are some of the challenges of implementation of Monetary Policy in selected COMESA member countries:

• For some countries, there is no central bank independence and there is lack of transparency in monetary policy conduct and implementation:

  • No publication of the discussion of the MPC and MPAC.

  • No provision for external membership in the MPC, and no provision for the publications of inflation forecasts to guide expectations.

  • The tenure of the governor and board members are not protected in constitution thereby creating vulnerability of the Banks’ independence.

• In some countries, increased domestic borrowing has led to higher market lending rates and the crowding out of the private investment.

• In some countries, currency outside banks or chronic excess liquidity posed serious challenges to the effectiveness of monetary policy.

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Study on the Challenges of Dollarization to COMESA Member Countries

Governors noted the following definition and various facets of dollarization:

• Dollarization occurs when a country adopts the currency of another as a legal tender (not necessarily restricted to the US Dollar). The domestic money is either replaced or used in parallel with the foreign currency.

• There are various forms in which dollarization can happen, which include asset, liability, partial and full dollarization.

• Official full dollarization occurs where a Government endorses, through political consensus, a foreign currency as having the exclusive status of legal tender in a country and abandons the use of its national currency.

• With full dollarization, a country completely gives up control of monetary and exchange rate policy; and

• Semi-official dollarization refers to a situation where both the local and the foreign currencies are used as legal tender.

Causes of Dollarization in COMESA region

• Large macroeconomic imbalances and hyperinflation;

• Financial repression and capital controls;

• Underdeveloped financial markets – domestic borrowers contract debt in foreign currencies in response to the lack of domestic currency alternatives in incomplete financial markets.

Costs of dollarization

• Immediate loss of monetary policy autonomy and the benefits of seigniorage (the profits accruing to the monetary authority from its right to issue currency – buy back “stock” of domestic currency or giving up future seigniorage earnings gained by issuer country unless there is agreements to share the same).

• Country also lose the “exit option” to devalue in face of major exogenous shocks (Berg and Eduardo, 2000).

• Dollarization also increases the susceptibility of the host country’s economy to shocks in the anchor country.

• The Central Bank loses the lender of last resort function – Central banks lacks instruments to influence monetary aggregates and anchor private sector expectations of inflation.

• Dollarization may lead to loss of political sovereignty.

• For a country with a small export base, dollarization also leads to liquidity problems and hence lowers economic growth (Nota and Sakupwanya, 2013).

• Liquidity risk – Sudden changes in investor and depositor perceptions about the health of the banking system may result in a deposit run and compromise international reserves holding.

• Balance sheet risks – tend to arise in cases of partial dollarization. Banking sector vulnerabilities may be heightened because of direct exchange rate risks that result from currency mismatches in banks’ balance sheets.

• The absence of monetary and exchange policy – may induce more volatility of GDP, and exposes the economy to shocks and other vulnerabilities that the Central Bank and Government are not able to offset.

• Dollarization may disable the Central Bank and Government to issue domestic financial instruments, resulting in limited money market and inter-bank trading activities.

• Under dollarization, the flexibility to use exchange and monetary policy is limited, and with it also, the inability of authorities to implement counter-cyclical measures.

Benefits of Dollarization

• Dollarization being an irreversible institutional change leads to lower inflation, fiscal responsibility and transparency.

• Reduces country risk premium on foreign borrowing, obtaining lower interest rates and leads to higher investment.

• Inability of the Central Bank to embark on expansionary monetary policies also bestows a measure of confidence in the economy, thereby helping to lock away damaging and often self-fulfilling inflation expectations.

• The absence of currency risk helps to eliminate externally induced banking and financial crises.

• The absence of seignorage induces more fiscal discipline, while the absence of a lender of last resort induces banks to seek for alternative contingent funds. This gives a competitive edge to international banks over domestic banks inducing a more stable international banking system.

• Dollarization makes economic integration easier, establishes a firm basis for a sound financial sector and thus promote strong and steady economic growth.

• Dollarization also bring about a closer integration in financial markets

• Dollarization avoids currency and balance of payments crises. Without a domestic currency there is no possibility of a sharp depreciation, or of sudden capital outflows motivated by fears of devaluation.

• By definitively rejecting the possibility of inflationary finance through dollarization, countries strengthen their financial institutions and create positive sentiment toward investment, both domestic and international.

Governors noted the following recommendations from the study:

i) There is need for countries to avoid policies that may lead to stagflation and severe macroeconomic disruptions which precipitates the need for dollarization.

ii) Successful de-dollarization requires implementation of an appropriate mix of sound macroeconomic policies, market-based incentives, and microprudential measures including:

1. Active bank supervision to ensure that banks fully cover their foreign currency loans positions

2. Having a higher reserve requirement on foreign currency liabilities helps make such liabilities more costly

3. Maintaining a sufficient level of international reserves

4. Regulations to encourage use of local currency (e.g. prices to be denominated in local currency)

5. Policies that promote use of the local currency for payments through convenient and lower-cost services than for foreign currency

6. Moving toward risk-based supervision could help better monitor risks taken by banks in extending credit.

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Enhancing the effectiveness of fiscal policy for domestic resource mobilization in the COMESA region

Introduction

One of the key lessons from the Euro debt crisis of 2011 has been the importance of long-term fiscal sustainability in economic development. The crisis in Greece and Spain was largely attributed to fiscal indiscipline over a long period of time. Recent trends in fiscal performance of most countries in the COMESA region demonstrate shrinking fiscal space as revenue mobilization has been slow compared with the fast increasing spending growth. For most COMESA member countries there is a wide gap between total investment needs and domestic resource mobilization. In order to achieve sustained growth, COMESA member countries are therefore, expected to pursue prudent fiscal policies supported by increased domestic resource mobilisation in order to ensure faster pace of monetary integration which will culminate in monetary union.

The justification for prescribing prudent fiscal policy to enhance regional integration is that they ensure the viability and sustainability of the monetary integration programme, by ensuring that a member state does not out pace other members in terms of larger budget deficit and inflation rates.  Prudent fiscal policies also protect member countries from being exposed to contagion effects of macroeconomic instability in one or more member countries. It also contributes for effective domestic resource mobilization for increased investment.

In order to achieve fiscal prudence in member countries, the COMESA Summit adopted in 2012 the COMESA Multilateral Fiscal Surveillance Framework. The Surveillance process is based on countries developing national convergence programmes that will be the subject of the Multilateral Fiscal Surveillance Mechanism.

The purpose of this paper is to consider the relationship between fiscal policy and domestic resource mobilization in the COMESA region. The overall goal of the paper is to present alternatives for increasing the mobilization of resources to accelerate growth and facilitate poverty reduction.

The role of fiscal policy in economic development

The role of fiscal policy in developed economies is to maintain full employment and stabilize growth. In contrast, in developing countries, fiscal policy is used to create an environment for rapid economic growth. The various roles fiscal policy plays in this regard are the following:

• Mobilisation of domestic resources: Developing economies are characterized by low levels of income and investment, which are linked in a vicious circle. This can be successfully broken by mobilizing domestic resources for investment energetically. Fiscal policy can play an important role in enhancing domestic resource mobilisation

• Resource allocation to achieve accelerated growth: Fiscal policy entails use of government expenditure and tax policies to boost efficiency and improve long term economic performance by dealing with critical market failures. For instance, government provisions of infrastructure, research and development, or education among other public goods which the private sector itself is unable to provide in optimal quantity or quality because of market failures, are good examples. However, benefits of a change in public expenditure need to be weighed against how the expenditure is financed. Most taxes generate distortions and efficiency costs while public borrowing and growing debt affect growth. The government has not only to mobilize more resources for investment, but also to direct the resources to those channels where the yield is higher and the goods produced are socially acceptable.

• Reduce inequality by investing in human capital: This will be done by increased spending on education and health. Spending that improves the quality of health and education services at all levels will endow the population with the necessary tools to take advantage of opportunities and thus reduce inequality. It is therefore, imperative that budgets provide adequate resources to build the human resources for the future, including improving school infrastructure, educational materials and equipment, clinics, and hospitals. Inequality can also be reduced by explicit policies to enhance social protection, food security and nutrition; as well as development of low income housing.

• Increasing employment opportunities: Fiscal incentives, in the form of tax-rebates and concessions, can be used to promote the growth of those industries that have high employment generation potential. Moreover public investment (including PPPs) on infrastructure such as transport, logistics, energy, water resource development, schools, hospitals will help create employment directly in the formulation and construction of projects, the production of inputs for the projects, and the operation and maintenance of new facilities. Public investment also crowds in private investment and so would create employment indirectly by improving the efficiency of the economy and laying the basis for faster growth.

• Macroeconomic stabilization: This entails using countercyclical fiscal policy in the short run to offset the impact of macroeconomic shocks that create large or persistent gaps between aggregate demand and potential output, thereby helping to avert both excessive cyclical unemployment and inflationary pressure. In the long run, macroeconomic stabilization entails keeping fiscal deficits and public debt on a sustainable path, so that public finances do not themselves become source of macroeconomic instability.

The ability to perform the above mentioned role of fiscal policy depends particularly on domestic capacity to mobilise resource especially public revenue. Effective mobilization of domestic resources can generate the following benefits among others:

1. Taxation, which is the major component of domestic resources for most countries in the region, is generally associated with more efficient resource use, accountability and greater public participation required for the success of development process.

2. Relying on domestic resources negates the effects of Dutch disease commonly associated with external inflows, and reduces the vulnerability to speculative attacks on currencies or even financial crisis.

3. Domestic resources brings about a sense of patriotism and ownership of development policies and outcomes unlike foreign aid that comes with conditionalities, constraining a country’s ability to maneuver and adopt policies that are consistent with its national development goals. That is, domestic resources give governments’ the latitude required to use fiscal policy to achieve their development objectives.

4. Domestic resources are predictable, less volatile and stable than external finance. Reliance particularly on foreign aid is facing serious head winds including donor fatigue, many unmet conditionalities, mismatch between pledges and actual disbursements, and changing motives by donors which make access to aid more difficulty. Falling foreign aid resources and volatility of commodity prices have only made the situation worse, calling for renewed efforts to accelerate mobilization of domestic resources as well as for reforms to increase spending efficiency.

However, the benefits of domestic resource mobilisation only accrue to countries that make deliberate efforts to exploit the existing opportunities especially since resource mobilization is not a costless activity and its effectiveness depends on whether governments have the political will and capacity to create a conducive environment as well as put in place the appropriate policy measures. The important role of fiscal policy in domestic resource mobilization emanates from its effect on the capacity of government to increase domestic revenue through various taxes and expenditure policy measures and how such measures in turn affects households and firms incentive to save and work. Mobilizing domestic resources is therefore, an expensive affair and requires concerted efforts from individuals, firms and governments.

Challenges to Fiscal Policy Implementation

The following are some of the challenges for fiscal policy implementation in COMESA member countries:

1. Low level of private savings. This is partly because of a large informal sector, where transactions do not pass through the formal banking system; low incomes due to the high level of poverty; and inadequate incentives for people earning low incomes to use formal banking services.

2. A sizeable portion of most economies in COMESA is non-monetized, rendering fiscal measures of the government ineffective and self-defeating.

3. Lack of statistical information as regards the income, expenditure, savings, investment, employment etc. This makes it difficult for the public authorities to formulate a rational and effective fiscal policy.

4. Fiscal policy cannot succeed unless people understand its implications and cooperate with the government in its implication. This is due to the fact that, in developing countries, a majority of the people are illiterate.

5. Large-scale tax evasion, by people who are not conscious of their roles in development, has an impact on fiscal policy.

6. Fiscal policy requires efficient administrative machinery to be successful. Most developing economies have corrupt and inefficient administrations that fail to implement the requisite measures vis-à-vis the implementation of fiscal policy.

7. Private capital flows especially in form of foreign direct investments have not had a noticeable impact in filling the resource gap since many countries in the region have not been very attractive to such flows although the trend is now changing. Political instability, security, infrastructure deficit and low incomes are some of the main hindrance to foreign direct investments.

Summary and Conclusions

In COMESA region as elsewhere, fiscal policy can and should be used effectively to foster growth, reduce short term fluctuations of economic activity and maintaining economies close to their potential growth paths. The necessity to carry out these tasks is emphasized by the following conclusions:

1. Domestic revenue to GDP ratios remain low for most member countries (figure 2) attributed to among others low per capita income and growth, institutional problems and weak governance. Addressing these challenges provides a case for fiscal policy in domestic resource mobilization.

2. Improved fiscal policies are needed to increase revenue mobilization. These policies include, reducing tax exemptions and incentives, increasing VAT rates on luxury consumption goods, increasing the outreach of property taxes and excise duties, reducing dependence on trade taxes through diversification of the tax structure, among other policies.

3. Addressing inefficiencies and improving tax and custom administration through computerization of tasks, improved tax audits and reporting, and training of tax officials among others, increases tax revenue without the need to raise rates of existing taxes.

4. Good governance is required in order to deal with corruption, tax evasion and avoidance and to link tax collection to service delivery. Improving efficiency, better public finance management, accountability and transparency in the use of public funds are important in enhancing domestic resource mobilization.

5. The need to contain external debt to sustainable levels is necessary for enhancing domestic resource mobilization. High external debt results in future capital outflows and often creates debt–servicing difficulties in the short-run. High debt increases vulnerability to shocks thereby contributing to macroeconomic instability which constrains growth. Alternatively, domestic borrowing is equally problematic since it exacts pressure on domestic real interest to rise, reducing private sector credit, private investment and growth, which in turn adversely affects domestic resource mobilization.

6. The public sector can contribute to domestic resource mobilization by indirectly boosting private savings through a number of ways including creating a good physical and social environment as well as adopting appropriate economic policies. Policies to address the high cost of doing business, raise incomes, address weak domestic financial infrastructure and systems, promote capital market development and financial inclusion, reduce dependency ratio, ensure macroeconomic stability, reduce capital flight, ensure good governance and political stability will significantly boost private savings which in turn will enhance domestic resource mobilization.

7. Public investment is essential for fostering growth in the region, which implies a pragmatic approach to fiscal deficits. If a country’s long-term average growth rate is low, as is the case for most member countries, it is appropriate to increase public investment in order for the country to reach its long term potential. Similarly, governments can use current expenditure as the counter-cyclical mechanism to generate the additional demand necessary to reach the greater potential created by the public investment. Using current expenditure to compensate when private demand is insufficient to keep growth near its potential implies increasing fiscal deficits or reducing surpluses.

8. The use of fiscal deficits for counter-cyclical management and to fund public investment need not be inflationary. Inflation in most member countries has a strong structural component which can be addressed through growth and development of economic and financial infrastructure rather than through deficit reduction.

9. Increasing public revenue requires rational approach to foreign investment based on explicit assessment of costs and benefits. It is rational policy to maximize the benefits of foreign investment, including the revenue benefits.

10. In COMESA region, private saving is constrained by poverty of households and the underdevelopment of the so called formal sector. Raising savings rate will be a long term task, achieved through the development of medium and large scale private enterprises and rising income of the workers. Governments should also pursue aggressive policies of financial system development.

11. Research indicated that for more than forty years, 1965-2006, 40% of development assistance went to domestic consumption, more than one third to capital outflows and only one quarter to domestic investment. This distribution, contrary to all principles of fostering growth and development, could be changed with donor flexibility.

12. Remittances from both workers who are temporarily abroad and long-term diaspora households represent a potential albeit small source of domestic investment. Governments design schemes to bring some remittances into formal financial channels, while accepting that the high consumption rate of remittances limits the potential to do so.

13. Reversal of capital outflows, “capital flight” could have a dramatic impact on resource mobilization. Independent research suggests these outflows were enormous. Capturing even a small part of capital outflows could dramatically increase public revenue.