Hollywood and War Movies - Fuller, Kubrick, Altman, Malick and Coppola (forthcoming)

 

South Africa Post-Election Economic (Policy) Outlook (2024)

South Africa is stuck in a low growth trap. South Africa’s economic performance has deteriorated significantly in recent years. Not only has economic growth decelerated tangibly. But economic growth compares very poorly to South Africa’s regional peers. As a consequence, socio-economic indicators have deteriorated sharply, particularly since the pandemic, even though per capita income began to stagnate before. Low economic growth has sharply curtailed the government’s ability to support economic growth through fiscal means, not least because government debt has continued to increase and put downward pressure on sovereign credit quality. A lack of investment and deteriorating infrastructure have added to economic woes, including power shortages, which have added to socio-economic dissatisfaction and weighed on the economic growth outlook. Unemployment, historically very high, has increased further. Income inequality is (among) the highest in the world.

> Per capita income began to stagnate and decline even before the COVID-19 pandemic due to slowing economic growth.

> Unemployment rates has increased form 25% in the 2010s to 34% today. Youth unemployment currently exceeds 50%.

> South Africa continues to suffer high crime rates. It has the third-highest murder rate in the world with 42 intentional homicides per 100,000 people.

> Corruption is high and has increased. Transparency International ranks South Africa 83rd out of a 180-off countries in terms of corruption (higher the rank, the worse the corruption).

> South Africa is one of the world’s most unequal countries with a Gini coefficient of 0.63. (A Gini index of 1 expresses maximum inequality.) Income inequality is significantly higher than the emerging economy average.

> All three major international rating agencies, S&P, Moody’s and Fitch, assign a long-term foreign-currency rating of BB- (or its equivalent) to the South African sovereign.

South Africa’s economic challenges are not going to go away. With an economic growth rate of 1-2% and effectively stagnating per incomes, growth-enhancing economic reform is more important than ever. However, in the short, there are simply no funds available to meaningfully tackle South Africa’s economic and socio-economic challenges. In the medium term, this will increase the risk of broader economic and financial instability. Economically, fiscal space is restricted due to already high government debt and a large underlying fiscal deficit. The government also faces significant contingent liabilities in the form of bailouts of companies operating in the critical infrastructure sector, which will further add to the government debt burden. Meanwhile, relatively high inflation will continue to erode real incomes, particularly of poorer socio-economic groups due to their inability to hedge against. This will further erode the political willingness to pursue a forceful fiscal adjustment or costly reform. South Africa is stuck in a low-level economic equilibrium. 

> The IMF projects medium-term real GDP growth of 1.4%, a very low level by emerging standards and insufficient to address socio-economic problems. By comparison, real GDP growth in sub-Saharan Africa is projected to average 4-5% in the next few years. Economic growth barely keeps up with population growth, which will translate into stagnating per capita incomes.

> Low growth will also put significant pressure on fiscal account, constraining the government’s ability to support investment or significantly increase social expenditure to address failing infrastructure and socio-economic grievances. Government debt has increased from around 50% of GDP in 2018 to more than 70% last year and reach 85% of GDP by 2028. This projection does not take into account additional contingent liabilities, such as the government’s bailout of Eskom, which cost the government 3% of GDP.

> Energy production and weakening infrastructure will remain a challenge, fuel public discontent and weigh on economic growth. Rolling blackouts have become more likely and fixing the problem will take time.

Despite a downbeat economic outlook and deteriorating fundamentals, South Africa’s economy does benefit from important risk mitigating features, which a broader economic or financial instability unlikely, at least in the near to medium term. First, even though government debt is high and increasing, external debt and foreign-currency-denominated debt as share of total debt is low. This limits South Africa’s vulnerability to exchange rate shocks or a foreign investor strike. Second, government debt is high, but its maturity structure limits liquidity risks, not least because much of the debt is held by domestic banks and investment companies. Third, a floating exchange rate and limited foreign-currency mismatches allow the economy to absorb a precipitous decline in capital inflows without sustaining broader financial damage, as a weaker exchange rate then boosts export and foreign-currency revenues. Fourth, a relatively independent central helps maintain investor confidence, fiscal challenges notwithstanding. Fifth, thanks to a floating exchange rate, current account deficits are generally manageable, limiting the build-up of foreign debt. 

> The structure of government remains solid due to local currency denomination and ability to issue long-term debt. However, with government debt projected to increase in the medium term, credit quality will deteriorate and the risk of financial distress will increase, if only gradually.

> South Africa has had a floating exchange rate regime for many decades, affording it to absorb balance-of-payments shocks through currency depreciation rather than the sale of foreign-exchange reserves.

> The bank system remains well-capitalized, well-managed and solid liquidity. Larger, systemically important banks are financially stronger than smaller banks. However, banks’ holdings of government has increased, which in turn has increased the banking sector’s vulnerability in case of severe sovereign distress.

> An independent central bank committed to an inflation target of has translated into relative policy credibility. Thanks to an independent central bank, inflation should remain under control and fall toward the target of 3-6%, barring a major exchange rate shock. 

The next ANC(-led) government will find it politically difficult to implement the reforms necessary to revive economic growth in the face of a weakened political position and continued high levels of socio-economic dissatisfaction, which complicate structural reform and macroeconomic adjustment. According to opinion poll, the ANC will fail to win a majority of seats in the lower house. This will make it politically harder to push though politically costly, forward-looking economic reforms. To the extent that the ANC requires support from other parties, necessary compromises will dilute policy measures and reforms. Moreover, unless the government commits to reforms right after the elections, the likelihood of forward-looking reform will diminish. A more fragmented parliamentary base would make painful economic reform more difficult to implement. Absent a major financial crisis, which remains unlikely in the near term, a major reform push is unlikely. However, should financial conditions deteriorate significantly, which is not likely in the next 2-3 years, the government would likely do what it takes to restore stability, even though it would be unlikely to address the structural factors that hold back economic growth and increase government debt, such as a failing infrastructure, insufficient investment and increasing corruption. This, after all, would require an even greater macroeconomic adjustment and will encounter strong socio-economic opposition, including unions.

> Polls suggest that the ANC will lose seats and may lose its parliamentary majority altogether. The ANC has continuously controlled both house of parliament since the end of apartheid. The ANC failed to receive a majority of votes in 2021 local elections. Polls point to the ANC’s waning popularity with support dropping from 55-60% in 2019 to less than 40% most recently. In the last general elections, the ruling ANC won 230 out of 400 seats.

> A hung parliament, minority government or coalition government are not conducive to a strategic policy of economic reform that South Africa requires to escape from the low-growth trap. While a new ANC-led government is unlikely to adopt outright populist, destabilizing policies, a likely failure to address structural and macroeconomic challenges points toward continued erosion of economic fundamentals and worsening of socio-economic conditions in the next few years, even if the risk of severe financial distress will remain manageable.

On Trade, a Return of Trump Would Spell Trouble for EU (2024)

If Donald Trump wins the US presidential election in November, Europeans should once again brace for major transatlantic tensions on trade. An EU policy of strength would be the right response.

Under former President Donald Trump, the United States pursued an aggressive, unilateral trade policy between 2017 and 2021 that was characterized by protectionist threats and measures, was based on the exploitation of bilateral economic and security dependencies and was mostly aimed at gaining trade concessions. At the global level, it terminated negotiations to establish a Trans-Pacific Partnership and effectively suspended the dispute settlement procedure of the World Trade Organization (WTO). These measures were intended not only to reduce curbs on America's trade policy power but also to protect US industry. The Trump administration introduced punitive tariffs on imports of goods including washing machines, solar panels, steel, and aluminum.

Threats led to the partial reform of the US free trade agreements with Korea (KORUS), Canada and Mexico (NAFTA, later USMCA) as well as the conclusion of a “mini-trade agreement” with Japan (USJTA). The Trump administration also sparked a trade conflict with China, forcing Beijing to make economic and trade policy concessions. Similarly, the threat of US punitive tariffs on European car imports prompted the EU to agree to negotiations on a possible bilateral trade agreement. In addition, the Trump administration tightened its export control policy, especially towards China. However, that was mainly linked to national security interests.

Political incentives to pursue a protectionist trade policy and adhere to a protectionist narrative remain significant. A free trade policy lacks sufficient domestic political support. Although opinion polls suggest that a majority of Americans regards free trade as economically beneficial, it also support protectionist measures as long as they are seen as safeguarding American jobs – however intellectually contradictory such a view may be (Chicago Council on Global Affairs). Of greater importance is the fact that the outcome of the presidential election will strongly depend on whether the candidates can prevail in swing states. As many of them have experienced significant economic dislocation in recent decades, including de-industrialization, protectionist narratives and policies enjoy broad support in swing states.

Not surprisingly, consensus for free trade policies has long since evaporated in the United States, which gives both the incumbent, President Joe Biden, and his likely challenger incentives to advocate protectionist measures. In this sense, there are parallels between Trump’s “America First” policy and Biden's premise of a “Foreign Policy for the Middle Class.”

Of course, one shouldn’t attach too much weight to statements made by presidential candidates given that they are often aimed at mobilizing their party base. The trade policy a US president eventually pursues is also influenced by advisors and the so-called “adults in the room,” technocrats who tend to be more moderate. That said, Trump’s trade policy 1.0 has proven that the executive branch has far-reaching leeway when it comes to protectionist policies. It would therefore be a mistake to dismiss Trump's trade policy statements as mere campaign rhetoric.

Outlines of a Trump Trade Policy

The conceptual outlines of a “Trump 2” trade policy are gradually becoming discernible. A second Trump administration would introduce a “universal baseline tariff” of 10 percent on all imports and a tariff of 60 percent on imports from China. This is reminiscent of former President Richard Nixon’s decision in 1971 to impose an additional 10 percent tariff on America's trading partners to force them to renegotiate international exchange rates.

The details are still unclear, but the basic idea of leveraging America’s trade power to win concessions is largely in line with Trump's previous trade policy. Under a second Trump administration, existing transatlantic trade conflicts (Airbus-Boeing subsidy dispute, steel and aluminum tariffs, and European digital taxes) would also likely intensify.

In addition, Trump’s team appears to be considering an even tougher policy toward China. The planned suspension of the “most favored nation” status for China would allow the US to impose far-reaching protectionist measures on Beijing. In this context, a complete ban on certain Chinese imports such as steel and pharmaceutical products is also being contemplated, to be implemented over a period of four years.

Meanwhile, Trump has been voicing strong criticism of the Biden administration’s Inflation Reduction Act (IRA). The extent to which a second Trump administration would be willing and able to partially or completely repeal the law is uncertain. But it would probably attempt to de facto repeal parts of the IRA through administrative and regulatory measures. Scrapping the law could help to reduce transatlantic tensions and the subsidy dispute linked to it. However, that would be little consolation at best if European goods become subject to a 10 percent tariff.

Trade policy under the first Trump administration showed a tendency to exploit economic and security dependencies to strengthen America’s bargaining position. However, it also showed a certain willingness to withdraw protectionist threats, albeit not in all cases (China), if a trading partner was prepared to make more or less major concessions (KORUS, NAFTA, EU). In some cases, the Trump administration even accepted exceptions without any quid pro quo on trade (for example on the issue of tariffs on Australian steel imports).

The European Union’s export dependency on the US is greater than vice versa. In 2022, EU exports to the US amounted to 2.8 percent of European GDP, while US exports to Europe amounted to only 1.4 percent of US GDP. In theory, this creates an asymmetric interdependence in favor of the US. But in practice, the average tariffs of around 3 percent in bilateral trade are among the lowest in the world, making the potentially high costs of a trade conflict difficult to justify.

Of course, this doesn’t mean that a second Trump administration wouldn’t try to push the EU to make trade policy concessions by threatening higher tariffs, as the first Trump administration did in 2018 when the threat of higher tariffs on European car imports was initially intended to force the EU to open its agricultural market to American exports.

An EU Trade Policy of Strength

The European Union should therefore pursue a trade-focused deterrence policy aimed at preventing a second Trump administration from adopting protectionist measures directed against Europe. In anticipation of possible US measures, the EU should signal unequivocally, even before potential Trump’s potential inauguration, that it is prepared to take prompt countermeasures and accept the costs of a trade conflict with the US. Brussels should also make it clear to American policymakers that the EU has newly created trade policy instruments at its disposal, such as the Anti-Coercion Instrument which provides a more effective and credible trade deterrence and defense.

At the same time, such a geo-economic deterrence policy should be accompanied by a willingness to negotiate, not least to give a second Trump administration the opportunity for a face-saving compromise that can be sold domestically as a success. As was the case during the first Trump administration, the EU should focus on offering a further liberalization of transatlantic trade relations in its negotiations with the US. A combination of toughness and flexibility might help to avoid a trade conflict that would be economically costly for both sides.

Could a second Trump administration exploit security dependencies? Donald Trump’s pre-election campaign threat not to defend NATO members that do not meet the 2 percent defense spending target seems to make the exploitation of security dependencies a real possibility. Seoul was threatened with the withdrawal of American troops during the renegotiation of the Korea-US free trade agreement. (Game theorists call this “cheap talk,” as opposed to “costly signaling”). Nevertheless, there are good reasons to doubt whether such a threat to the EU would be truly credible.

Of course, a Trump administration could initially implement smaller steps without immediately withdrawing from the NATO alliance. The provision of further aid to Ukraine could be made conditional on trade concessions, and this could weaken the EU's bargaining position. But trade negotiations last many months and even years so a reduction in security assistance, which could lead to the destabilization of Eastern Europe, would not be particularly well suited to gaining concessions on beef imports, for example.

Such threats would also be widely seen as disproportionate and would lack credibility. And even a President Donald Trump would hesitate to risk the destabilization of Eastern Europe’s security for the sake of lower EU agricultural tariffs. If, on the other hand, a second Trump administration were to categorically rule out further aid for Ukraine and other security support, the associated bargaining potential and negotiating advantage for the US would also disappear.

But even if a second Trump administration were to explicitly link security policy support to trade concessions, an EU trade policy that is both strong and conciliatory would still be the best strategy to counter a more aggressive and unilateral US trade policy. This also applies if the EU were ultimately forced to make greater trade policy concessions than in a scenario in which the United States did not play on Europe’s security policy dependency.

See also: https://ip-quarterly.com/en/user/26900/markus-jaeger

Are Chinese Economic Policymakers Playing Whack-a-Mole? (2024)

Worried about macro-financial risks, Chinese economic policymakers have been seeking to rein in unsustainable investment in infrastructure and the real estate sector, but such an approach tackles primarily the symptoms rather than the underlying cause, as a sustainable solution to the so-called excess savings problem requires broad reform aimed at reducing savings or creating more profitable investment opportunities. The underlying cause of increased financial risks appears to be a very high savings rate in the context of a declining profitability of investment. At the very least, it is the structure of Chinese investment, concentrated in infrastructure and housing, that is generating declining and increasingly negative financial returns. A declining profitability of investment is to be expected as China approaches the technological frontier and the marginal productivity of capital declines and highly profitable investment projects become scarcer. The recurring misallocation of capital or overinvestment forces policymakers to rein in investment, most notably investment by local governments in infrastructure and, more recently, by real estate developers in housing. These policies aim to limit economically unproductive and financially loss-making investments that do support sustainable growth and increase financial instability risks. This is very challenging given the financial interrelationship between housing, banks, local governments and the central government and given the high levels of debt that have hitherto accumulated.

> Real estate sector related activities account are estimated to account for 30% of GDP. This much higher than in advanced economies, where the equivalent ratio is 10-20% of GDP. Shifting around 10% of GDP from one sector to another or others necessarily creates a significant economic drag if it is done precipitously and not strongly supported by massive, flanking macroeconomic measures.

> Total social financing, or total debt outstanding, particularly for an emerging economy, if less so for an economy with a high savings rate. Debt has doubled in the past 15 years, increasing from 150% of GDP in 2009 to 300% of GDP today. This extraordinarily rapid increase and high levels of debt raises concerns about creditworthiness and financial stability risk. Declining economic growth and low inflation, alone deflation risk being exacerbating credit and financial risks because they make it harder to service the debt.

> China’s economic growth has decelerated from more than 10% in 2009 to around 5% in 2023. The IMF projects a further deceleration to less than 4% in the next few years. The incremental capital-output ratio, which measures the amount of capital required to generate one unit of economic output, has halved. This suggests that the efficiency of investment has declined dramatically. Investment is too high, or investment opportunities are too limited.

To avoid the so-called middle income trap, Chinese policymakers have been facing a difficult balancing act in terms of shifting investment and the economy away from unsustainable infrastructure and real estate sector investment while limiting macro-financial risks and sustaining robust economic growth. China appears to be facing the so-called middle income trap where the old high-growth model becomes unviable as a country approaches middle-income levels and a sudden, substantial downward shift in economic growth takes places, often in the context of a broader economic or financial crisis. The middle income trap is a frequently observer empirical reality, but not a theoretical inevitability, provided policymakers pursue a forward-looking policy aimed at reforming the economic growth model and managing macro-economic and macro-financial risks properly. A policy aimed at structural, productivity-growth-enhancing reform allows for more profitable investment opportunities and a more economically productive allocation of China’s large savings. If flanked by prudent financial policies aimed at maintaining financial stability, such as ensuring adequate bank capitalization and other prudential policies as well as by supportive macroeconomic policies to limit the negative economic effects of macro rebalancing, macro-financial and macro-economic risks will be manageable. 

Despite significant policy efforts, China has made little progress in reducing excess savings and rebalancing the economy towards more sustainable medium-term growth. As far back as 2008, then-President Hu Jintao called for economic rebalancing. The initial impetus for rebalancing and reform was China’s dependence on exports and export-sector focused investment against the backdrop of the global financial crisis in 2008, which showed how vulnerable China’s export-oriented growth models was in the face of large external shocks. At its height, China’s current account surplus exceeded 10% of GDP, which also lead to trade tensions, particularly with the United States. After implementing a massive infrastructure investment program as a response to the global financial crisis, policymakers’ efforts were forced to focus on controlling the build-up of macro-financial risks related to massive infrastructure investment. The sharp investment-related increase in debt, particularly among local government, led policymakers rein in local and provincial level infrastructure investment through a stricter enforcement of local borrowing, including off-balance sheet structures like local government financing vehicles (LGFV). In 2020, efforts have focused on tackling over-investment in the real estate sectors. Thanks to policies aimed at reining in excessive investment, China has managed to avoid broader financial instability but it has thus far failed to bring about macroeconomic rebalancing. Savings are lower than 15 years ago, but investment has remained virtually unchanged. 

>  In August 2020, China introduced the so-called “three red lines” policy, which imposed ceilings on debt-to-cash, debt-to-assets and debt-to-equity ratio for real estate developers. The policy was meant to reduce excessive debt of real estate developers and, indirectly, rein in excessive investment in the sector by forcing financially to exit. This has led to significant financial distress among developers and a sharp real estate downturn.

> China’s national savings rate fell from more than 50% of GDP in 2009 to 45% of GDP in 2023. But the savings ratio is same as in 2016. At 42% of GDP, the savings rate is virtually unchanged compared to 2009. The difference is accounted for by far smaller current and trade surpluses.

While economic rebalancing has led to a cyclical deceleration of economic growth, policymakers have thus far taken only modest countercyclical macroeconomic measures. The rationale appears to be that the housing market will not shrink forever and significant macroeconomic measures might undermine rebalancing. Policymakers have several options to provide short-term countercyclical support to limit the economic downturn (and the risk of deflation) They can pursue a more expansionary fiscal policy aimed at spurring consumption, a more expansionary monetary policy aimed (primarily) at increasing investment or measures aimed at allowing for a weaker exchange rate to boost exports. Such policies would help counter the cyclical drag from the real estate sector adjustment and, at the margin, reduce savings by increasing consumption and especially household consumptions. China has refrained from resorting to quasi-fiscal and investment-fueled spending comparable to the post-global financial crisis, as this would exacerbate imbalances due to infrastructure-focused growth and as they seem to expect the economy to recover on its own. But the option remains on the table. However, structurally, underlying housing demand will decline sharply 35-50% due to demographic change. This raises the question where savings will go if they are not converted into housing. A possible solution consists of lowering the savings rate by increasing domestic and especially household consumption through broader fiscal reform aimed at raising household incomes, such as providing social security or health care benefits. Another solution consists of implementing productivity-enhancing economic reform that allows for a financially productive conversion of savings into investment, such as pro-market reform.

> Underlying housing demand will decline sharply 35-50% due to demographic change, slowing urbanization and changes in household formation, according to the IMF.

> The PBoC has been cautious with respect to loosening monetary and financial conditions over the past couple of years. The government has refrained from administering a large-scale fiscal stimulus. Instead, the central government has provided limited fiscal support to cash-strapped local governments to counteract the fiscal drag from lower spending. Local government’s reliance on land sales and other real estate sector related activities reduced the amount of money available to support local government spending. The central government is in a position to provide greater support, should it choose to do so, despite relatively high public sector debt.

Despite the growth slowdown and financial stress, macro-financial risks will remain manageable due to the government’s ample ability to intervene in case financial distress threatens to turn systemic. Systemically important national banks’ loans to both real estate developers and mortgages appear manageable. Smaller, regional banks as well as non-bank financial institutions are at greater risk. The slowdown in real estate sector activity is also affecting local government finances, spending and economic growth. Should financial losses accumulate, the central government has a strong enough financial balance and sufficient scope for intervention to preempt local financial distress from turning into a systemic financial crisis. It can also exercise regulatory forbearance. In case of a run on a bank, it can simple take over the bank, write down equity holders and junior creditors, while guaranteeing deposits. Not only are the central government and the central bank able to absorb the losses, if necessary, but they have also wide-ranging discretion about how to distribute financial losses across different creditor classes. The same rationale applies to a large, systemically important banks that already benefit from implicit government backing. 

The government can and will backstop  systemically important financial institutions should they run into financial trouble. If these smaller banks get into trouble, the authorities will step in if they pose broader risks to financial sector stability through recapitalization, forced mergers or an orderly resolution. In case of systemic crisis risk, the authorities can simply bailout the banks creditor, bail out part of the banks’ creditors (like retail depositors). The government or government-owned Chinese banks can help backstop through liquidity guarantees, takeover or financial support and recap and more sustainable model by not reward moral hazard to force private sector to internalize economic and financial risks (losses borne by risk-takers), improving the efficiency of capital allocation and reducing financial and macro-financial risks. Similarly, the bailout and restructuring of local government debt simply leads to a reshuffling of national balance sheet/ assets and liabilities between central government, local, banks, investors households. Ultimately, it is the authorities’ ability to provide financial support and largely determine to what extent to bail out or bail in creditors that allow the government to intervene should destabilizing financial distress emerge. Capital controls and a net international creditor position make it impossible and unnecessary for depositors to move money out of China, further enhancing the government’s ability to deal with macro-financial risks. 

> At more than 100% of GDP, government debt, and especially so-called augmented government, which includes local government’s off-balance sheet liabilities is high. But gross debt does not account for the extensive assets, the public sector holds. The IMF estimates the public sector’s net financial worth may not be negative. Virtually all debt is owed to residents. Capital control prevent destabilizing capital flights.

> China’s international balance sheet is solid. Large foreign-exchange reserves, exceeding $3 trillion, and capital controls and net foreign creditor position make a balance-of-payments or external debt crisis impossible. China's banking sector’s net external assets amounted to $169.6 billion, including net RMB liabilities of $287.3 billion and net foreign currency assets of $456.8 billion. This suggests that the banking sector would benefit from a weaker currency, all other things equal.

> A further deterioration of local government’s financial position and financial viability of LGFVs will sooner or later require a central government bailout or a debt restructuring, including write-downs and assets sales. This will help limit creditor losses, including banks. Government guarantees and regulatory forbearance as well as an ability to provide a government guarantee if necessary sharply curtail the risk of a systemic financial crisis due to local government debt problems. About two thirds of the total LGFV debt is in the form of bank loans. The IMF estimates that 1/3 LGFVs are financially nonviable.

> The bank sector as a whole is characterized by low levels of non-performing loans and overall fair capital adequacy ratios. More importantly, property sector and mortgage loans represent a much smaller share of assets among large banks than smaller banks as well as various non-bank financial institutions.

While the risk of destabilizing, systemic financial crisis is low, the risk of a further economic slowdown in the context of insufficient demand and continued, relatively unproductive over-investment will be substantial, unless policymakers implement productivity-enhancing, market-oriented economic reform. However, it is highly uncertain that policymakers will implement necessary productivity-enhancing reform. In 2013, the government committed to let the market play a “decisive” role more than a decade ago. But the government has made little progress towards greater market-oriented liberalization. The government and SOEs are playing a greater role in capital allocation and government officials play a more important on corporate boards. Private-sector investment remains low, while public-sector investment has increases in the past few years. Greater government intervention is taking placing against the backdrop of intensifying geopolitical competition, international economic fragmentation, technological decoupling as well as adverse demographics. Nevertheless, China has opted for less risky and more sustainable growth, even if it means lower growth. Economic growth is unlikely to exceed 5% unless the government shifts towards a greater market-based allocation of savings flanked by growth-enhancing structural reform and a fiscal policy geared towards reducing the national savings by increasing household incomes and private consumption.

Macroeconomic Adjustment and Economic Outlook in Nigeria (2024)

Despite the new government’s commitment to macroeconomic adjustment, the economic outlook for the Nigerian economy will remain challenging in 2024 and 2025 amidst modest economic growth, elevated inflation and fiscal discipline; this will keep the risk of both socio-economic unrest and policy slippage high. The Nigerian economy will grow at around 3% a year in 2024 and 2025, which is only a tad higher than the population growth rate. This translates into only a very modest improvement of per capita income, on average. Given the substantial devaluation of the naira over the past year, per capita income in nominal dollar has actually fallen substantially, further adding to the economic pain. Meanwhile, continued high inflation will keep food insecurity high and will likely increase the poverty rate, as the government will be to fiscally constrained to maintain real income levels for the economically more vulnerable parts of the population. This, in turn, will lead to increasing political demands for the government to address socio-economic demand, which will increase the risk of policy slippage over time. Due to the continued downward adjustment of the naira, domestic per capita income measured in current dollars has declined from $2,000 in 2021 to $1,300 (in current dollars). In 2023, 25% of the population was at risk of food insecurity and the poverty rate was 37% in 2022.

Since coming to office in May 2023, President Tinubu has pursued fundamental macroeconomic policy reform with the aim of putting the economy on a sounder financial footing. In terms of fiscal policy, the government has pursued a tighter fiscal policy to reduce the deficit. It did so (initially) by removing fuel subsidies, even though it backtracked somewhat later on. The fiscal adjustment is essential if the government is to reduce its reliance on the central bank financing, which contributes to endemic inflation. As regards monetary policy, the central bank has begun to prioritize price stability and disengaged from some quasi-fiscal activities, such as the provision of loans and guarantees to domestic financial institutions. It has increased its policy rate several times. However, a combination of insufficient monetary tightening and significant nominal exchange rate depreciation has thus far failed to bring down inflation. Ex-post real interest rates remain deeply negative, thus contributing to high inflation. As regards exchange rate policy, the Central Bank of Nigeria (CBN) has moved towards a greater liberalization of the foreign-exchange regime and a unified, more market-determined exchange rate. In this context, the CBN has also been seeking to clear its overdue dollar obligations vis-a-vis domestic banks to ease the pressure on the naira and re-establish stability in the foreign-exchange market. At the same time, it seeking to address the backlog of dollar demand from foreign companies eager to repatriate their funds in the face of dollar scarcity and tight foreign-exchange controls.

Modest economic growth in the context of tight fiscal and monetary policies but high inflation will fuel demand for increased subsidies social spending. With the presidential elections more than three years away, the government faces solid incentives to stick with politically painful macroeconomic adjustment over the next 1-2 years in the hope of stabilizing the economy and creating sufficient space to accelerate economic growth in 2027. A lack of fiscal capacity and flexibility will make it difficult to generate the resources to support growth-enhancing investment or social spending to help offset the welfare losses suffered by high inflation and modest growth, unless it is willing to jeopardize economic and financial consolidation. The limited availability of international private and official financing further constrains the government. On the flipside, a roughly balanced current account will help limit the drain on Nigeria’s foreign-exchange rate reserves, and the IMF projects a gradual recovery of FX reserves in the context of limited dollar inflows. This will limit the risk of sovereign default in the next 12-24, not least because Nigeria retains the option of requesting a Fund program to avoid a broader balance-of-payments crisis.

Economics and Politics of Defense Spending (2024)

Absent entitlement reform, U.S. government debt will continue to increase in the context of large fiscal deficits, which will limit policy flexibility in terms of medium- and long-term defense spending. The Congressional Budget Office (CBO) projects large fiscal deficits and a continued increase of the debt-to-GDP ratio, driven by increasing (mandatory) entitlement and net interest expenditure. It is highly unlikely that the projected increase in government over the next two decades will cause any financing difficulties, let alone a financial crisis, not least due to the pivotal role of the dollar, the relative attractiveness of U.S. assets and a more favorable growth outlook than in most other advanced economies. However, a combination of more modest economic growth and large fiscal deficits will translate into greater defense spending constraints.

> U.S. federal government is $35 trillion, which translates into more than $100,000 per citizen. U.S. federal government debt has more than tripled since the beginning of the century, increasing from 32% of GDP in 2001 to 96% of GDP in 2023. The CBO currently projects the debt-to-GDP ratio to reach 116% of GDP by 2034 and 166% of GDP in 2054. Federal budget deficits will average around 6% of GDP.

> Mandatory spending will increase from 13.9% of GDP to 15.1% of GDP over the next ten years, while discretionary spending will decrease from 6.4% of GDP to 5.1% of GDP. If the decline in discretionary defense and non-defense spending were to be evenly split, U.S. defense spending would be less than 3% of GDP by the middle of the next decade and close to an all-time post-World War II low.

A significant fiscal adjustment involving a reform of social security is necessary would help create more space for significant defense expenditure increase, but such a reform is highly unlikely to take place in the short or even medium term. Mandatory spending covers spending for entitlement and other programs, such as Social Security, Medicare, Medicaid, and several other health and old-age programs. Discretionary spending is controlled by annual budget process and pays for the operations of most federal agencies and national defense programs. Discretionary spending as a share of GDP has declined gradually over time, mandatory has continued to increase. Reducing, less so limiting the growth of government spending invites a political backlash from those groups that will be negatively affected. Demographic change and the emergence of a “grey majority” is making it even more difficult to substantially reduce entitlement spending, as the affected groups is gaining electoral weight by the year. Psychological biases, such as the endowment effect, further strengthens opposition to reforms. At a minimum, this will require any entitlement reform to phase in a reduction of expenditure (relative to baseline) in a very gradual fashion. But even then, it will be difficult. It is no coincidence that neither party supports a reform of social security and other programs. The last significant entitlement reform that sought to balance the books took place in 1983.

> In FY 2023, the U.S. federal government spent $6.1 trillion dollar. The U.S. federal government spends more than what the Japanese economy, the world’s third-largest, produces.

> Mandatory spending accounts for 60% of federal spending, discretionary spending for 30% and interest on debt 10%. Discretionary spending includes defense and non-defense spending with defense spending account for 13-15% of federal spending (or roughly half of discretionary spending.

 

The constraints on U.S. defense spending are political, financial and economic, and these constraints and trade-offs will increase over time. Economically, high levels of defense spending are detrimental to long-term growth if spending limits the availability of national savings and investment. In the short run, however, a sharp increase in defense expenditure can help boost economic growth, particularly in the context of an economy with ample spare capacity. Financially, increased defense expenditure needs be financed through higher debt, increased revenues or reduced expenditure. With more resources allocated to consumptive defense spending and no offsets elsewhere, savings and investment will fall or private consumption will fall, or both. If the former, economic growth will suffer over the medium- to long-term. If the latter, political opposition to higher defense spending will increase. The end of the Cold War led most Western countries to reap the so-called peace dividend, meaning reduced military expenditure led to increased savings, investment, lower interest rate and higher economic growth. Faced with increased geopolitical competition, the need for increased defense spending will make for painful economic, financial and political choices, while increased defense spending (as a share of GDP) will weigh on the longer-term growth outlook. While none of this means that the U.S. will not be able to increase defense expenditure, it does mean that the economic, financial and political trade-offs and constraints will become more important.

> In the short run, government can almost always mobilize massive resources to support defense spending, if flanked by appropriate economic and financial measures, such as capital controls or central bank buying of additional debt issuance. U.S. defense spending (including Department of Energy spending on nuclear weapons) was 3.5% of GDP. In 1953 (Korean war), U.S. defense spending reached 11.3% of GDP. In 1968 (Vietnam war), 8.6% of GDP, In 1999, it fell to a post-1940 low of 2.7% of GDP before it increased again to reach 4.5% of GDP in 2010 (Afghanistan and Iraq wars). Defense spending exceeded 40% of GDP during World War II. 

> In the long-term, there are economic limits to excessive defense spending. The reduction of defense spending following the end of the Cold War led to the so-called “peace dividend,” allowing for more productive government spending, higher national savings and lower interest rates. Unsustainable defense spending drove the USSR into economic stagnation, financial failure and ultimately political collapse. The USSR spend a disproportionate amount of its GDP on defense as opposed to private consumption or investment, which led to both economic stagnation and contributed to growing political discontent. 

The United States remains the world’s top military spender by a wide margin, but Chinese defense spending has been increasingly rapidly on the back of rapid economic growth, which, in turn, is putting increased pressure on U.S. military spending. The U.S. remains the world’s largest defense spender. If a decade or so ago, it spent more on defense than the rest of the world combined, U.S. expenditure today continues to account for nearly 40% of global spent, while China accounts for less than half of U.S. spending. The size of defense spending matters, but it is not everything. Several caveats apply. First, comparing military spending, even if adjusted for PPP to take capture the effective spending power, is difficult, as different countries include and exclude different defense-related spending categories and items, and some countries’ defense expenditure figures lack transparency altogether. Second, even with a PPP adjustment, it is not obvious one dollar of defense spending buys an equivalent amount of security. Leaving aside that security is a relative concept, using PPP to compare spending is unsatisfactory due to differences in terms of what the money is spent on as well as what adjusted dollars can buy, given that advanced military technology is not traded on international markets and local production costs differ, and sometimes certain defense-related technologies are not available at all to allow for comparisons. Third, it matters not only what the money is spent on but how it is spent, and ultimately what “strategic bang for one’s financial buck” one get. For example, directing funds to procurement and development rather than outdated platforms or personnel, including veterans’ pensions may not translate into increased military effectiveness. Lastly, when comparing U.S. and Chinese defense expenditure, it is important to take into consideration differences in terms of force structure and military posture. The U.S. has world-wide commitments and a costly and extensive global footprint. China does not and its military forces are geographically much more concentrated. Military spending should therefore at best seen as a proxy for defense capabilities. In this sense, the constraints the U.S. the relatively greater and faster increasing constraints the U.S. is facing in terms of increasing defense expenditure is a constraint, but it is a constraint that can be also be alleviated, at least partly, by ways other than spending increases. Over the long term, however, significant differences in spending will matter from a security point of view.

> In current dollars, the United States accounts for almost 40% of global military. China and Russia account for a combined 17%. The big-4 European countries account for 9.5%, compared to Russia’s 3.9%.

> In 2023, U.S. defense expenditure accounted for 3.5% of GDP, China’s official defense expenditure for less than half at 1.6% of GDP. Due to much more rapid underlying economic growth, Chinese defense expenditure as a share of GDP has been growing much more rapidly without translating into higher expenditure. 

> In nominal dollar terms, the US spent about $900 billion and China $300 billion on defense. Adjusted for PPP, the difference would be far smaller, but Chinese spending would be only about half of U.S. spent. In 2010, the U.S. spent $740 billion, compared to Chinese spending of $100 billion. In PPP terms, China has been catching up even faster.

> In addition to faster economic growth, China has also greater scope to increase defense spending as a share of GDP without jeopardizing long-term economic outlook, because it has excess savings and limited profitable investment opportunities. This should allow it convert its excess savings into military consumption without unduly undermining the long-term growth outlook. The U.S. is far more constrained in this respect.

> U.S. defense spending currently breaks down into the following spending categories: $182 billion for personnel (25%), $338 billion for operations and maintenance (40%), $168 billion for procurements of weapons and equipment (20%), $143 billion for R&D (15%).

Governability and Dollarization - The Case of Ecuador (2024)

A challenging financial outlook and significant governability challenges make for a difficult economic and political outlook in Ecuador, leaving the government with little choice to agree to a another IMF program if it wants to avoid a destabilizing economic and financial crisis by 2026. Ecuador has a history of governability challenges and financial stability. The presidency of Rafael Correa (2007-2017) proved an exception, which can be largely attributed to a favorable international economic environment. A significant increase in oil revenues allowed for a significant expansion of social spending, which supported political stability. More typically, however, a combination of economic challenges, socio-economic discontent and, at the institutional level, legislative-executive deadlock circumscribe the ability of Ecuadorian governments to pursue a forward-looking economic policies and contributes to recurring financial problems. Most recently, President Guillermo Lasso was effectively forced out of office in the context of a stand-off between the executive and the legislature. Ecuador is also a serial defaulter and mostly recently restructured its international bonds as well as its debt owed to China in 2020-22. 

> In the past 30 years, many Ecuadorian presidents were ousted, deposed or impeached (e.g. Bucaram in 1997, Arteaga in 1997, Mahuad in 2000, Gutiérrez in 2005, Lasso in 2023). 

> Ecuador has defaulted almost a dozen times since its independence. Most recently, the government was in default on its international bonds in 1997-2000 and in 2008-09, and it restructured its international bonds in 2020, which economically translated into a default due to a reduction in the net present value of the bonds.

> In 2020-22, Ecuador also restructured its debt with Chinese banks, while an oil-based credit agreement with PetroChina was modified to allow for debt relief. In May 2023, Ecuador’s creditors also agreed to a debt-for-nature debt swap.

Governability challenges are compounded by a dollarized economy and commodity dependence, which makes the Ecuadorian economy more susceptible to exogenous shocks, while it limits its to pursue forward-looking economic policies consistent with the macroeconomic constraints imposed by dollarization. Full dollarization is constraining in macroeconomic terms because it effectively removes monetary and exchange rate policy from the government’s toolkit to stabilize the economy in the face of shocks, including commodity-related terms-of-trade or interest rates shocks. Dollarization also eliminates seigniorage. This forces policymakers to rely even more on fiscal policy to stabilize the economy and the financial situation. By severely curtailing the central bank’s lender-of-last-resort function and removing the ability to stimulate the economy through currency depreciation or lower interest rates, fully dollarized economies are more susceptible to greater economic and financial volatility as well as fiscal and debt crises. A fully dollarized economy that is subject to large terms-of-trade or inflation shocks will experience greater interest rate, price and inflation volatility, which can undermine the government’s financial position. Governments need to save oil-related windfalls so as not to be forced into pro-cyclical austerity during the next downturn. This requires a government that is able to pursue prudent, forward-looking fiscal policies. Failing to build up fiscal buffers when economic growth is high or keeping inflation under control when experiencing favorable commodity price shocks, governments in dollarized monetary regimes are then often forced into protracted low economic growth and fiscal restraint, which raises the risk of socio-economic and political instability. In face of increasing financial instability, governability challenges, such as the executive’s limited control of the legislature, tends to undermine market confidence further, as policymakers prove unstable to implement the measures necessary to counteract instability. This captures Ecuador’s experience under dollarization fairly well. Political stability and economic progress was relatively high when Ecuador benefitted from oil-related revenue windfalls under Correa, but instability increased after oil prices declined and the government had overspent and over-borrowed. 

> Ecuador’s export revenues are highly dependent on volatile commodity prices. According to the World Trade Organization, fuels and mining products account for almost 40% and agricultural products for more than 50% of total exports. Meanwhile, dollarized export markets, the United States and Panama, account for 40% of all Ecuadorian exports.

> Social spending doubled between 2007 and 2016 from 4.3% to 8.6% of GDP, the Gini coefficient declined, and both inequality and poverty fell. A fair share of the improvement has reversed in the past few years, while homicides increased sharply, as Ecuador was forced into fiscal adjustment in the face of external shocks (oil after 2015, COVID-19 in 2020).

> Government debt did initially decline when oil prices increased, but the government failed to save enough revenues when the times were good and failed to resist increasing difficult-to-reverse social spending. After the end of the oil price related boom in 2015, successive governments have failed to stabilize the economy.

 

Despite the recent debt restructuring in during 2020-22, Ecuador continues to face significant external financing challenges, which will give it little choice but to sign up for another IMF program if it wants to avoid broader economic instability, even if it will not necessarily help it avoid another restructuring of international bonds. Ecuador faces high interest rates due to high U.S. interest rates and weak economic growth. Although the fiscal deficit has declined following the COVID-19 pandemic and IMF-supervised macroeconomic adjustment, increasing oil prices explain a fair share of improved budgetary outcomes. Unable to implement a structural fiscal adjustment, the government often resorts to one-off measures. This casts doubt on the long-term sustainability of the fiscal adjustment. The government remains in domestic arrears and its remains locked out of international capital markets, forcing to rely on multilateral borrowing, despite the 2020-22 debt restructuring. External debt service is set to increase significantly in 2025 and 2026, including IMF loans. (e.g. drawing down deposits, tapping the central bank. 

> As Ecuador was already granted exceptional access under its previous program, net new financing will be limited, but it will be helpful to effectively roll over IMF loans. Ecuador owes IMF almost $ 8 billion, which will be coming due in the next few years. IMF roll-over. But effectively rolling IMF loans and unlocking additional multilateral borrowing will help support Ecuador’s external financing outlook. But this does not mean that Ecuador will avoid another debt restructuring. But another debt restructuring in the context of an IMF program would prove less disruptive than “hard” default.

> The IMF understands that macroeconomic adjustment in a fully dollarized economy is financially and politically difficult. The older staff members will remember how quickly the Argentina program went off trach in the late 1990s and 2000s and how the Fund’s reputation was tainted, suggesting the risk of supporting adjustment programs in macroeconomically constrained, dollarized, commodity exporters. While the Fund will therefore demand significant assurances from the government, it will also be keen to agree to a new program in order to reduce the possibility of Ecuador defaulting on its IMF obligations.

A new IMF program would ensure that the government continues to implement macroeconomic adjustment, help unlock additional, multilateral and possibly bilateral funding with the aim of avoiding broader medium-term economic and financial destabilization. If it is to avoid a default on its IMF and private external debt, it will need to reach an agreement with the IMF. Negotiations with the IMF will prove challenging, and it remains to be seen whether the IMF’s insistence on financing assurances will lead to yet another restructuring of Ecuador’s international market debt. The IMF has already granted Ecuador exceptional access under its EFF, meaning the Fund will not be willing to run financial risks in the context of uncertain ability of the current government to stick with implementation and commitment of next president. At the same time, the IMF will have an interest in a new agreement if only to avoid broader destabilization, including potential default of Ecuador on its IMF debt.

> After an initial IMF program was terminated prematurely (March 2019 – May 2020), Ecuador signed up to a new Extended Fund Facility (EFF) arrangement in December 2020, after also receiving COVID-19-related IMF financial support in the guise of the Rapid Financing Instrument (RFI). The IMF completed the final review of an 27-month EFF program in December 2022. Although the program helped improve Ecuadorian fiscal and debt dynamics and help put shore up the dollarization regime by reversing much of the institutional erosion in terms of the government weakening the central bank, Ecuador remains shut out of international bond markets in view of the increasing external debt service in 2025-27. All major international credit rating agencies rate Ecuador close to default (CCC+/ Fitch, Caa3/ Moody’s, CCC+/ S&P). 

> The 2019 and 2020 IMF program helped strengthen the central bank after years of weakening of central bank and foundation of dollarization (e.g. central bank lending to state-owned banks, direct government financing), which had led to weakening of central bank balance sheet (e.g. reserve coverage of banks’ deposit) and help put the dollarized regime on a sounder footing. While fiscal targets were met, this was primarily due to increased oil-related revenues and higher growth. Some of the structural fiscal measures fell short, largely due to domestic political opposition and the president’s inability to get the relevant measures approved by congress.

President Daniel Noboa will not be able to reestablish access to international markets before his term expires in May 2025, unless his government agrees to a new IMF program, and even then regaining access to international markets will remain highly uncertain in the near term (> 12-15 months). Since taking office in November 2023, President Noboa has sought multilateral loans and in March official requested a new IMF program. But Noboa’s National Democratic Action alliance holds only 10% of all seats, which will make it difficult to push through necessary reform and especially fiscal austerity. The upcoming 2025 presidential elections will also make it politically costly (CAN RUN AGAIN?). Continued socio-economic pressures combined with congressional fragmentation will make it difficult to implement the necessary reform, not least because the next presidential elections will take place in 2025. Rather than adopt structural measures that promise putting Ecuador on a sustainable economic and financial path, the Noboa government will be more inclined to implement one-off measures to address the financial challenges. Significant fiscal retrenchment would weigh on economic growth and employment outlook and will fund at best limited political support from the executive and the legislature. Negotiating an IMF program in view of Ecuador’s economic challenges and political situation will prove challenging, and if a program is agreed, it remains to see to what extent Ecuador will live up to its reform commitment. 

> Government debt peaked at more than 60% of GDP in 2021, but medium-term debt dynamics remain vulnerable, not least due to a strong dollar and high U.S. interest rates. The Noboa government has relied on one-off measures rather than structural adjustment (e.g. reprofiling public debt held at the central bank), while deposits continue to fall and domestic arrears continue to increase, pointing to very considerable domestic and external financing challenges.