The pros and cons of using SARB gold and foreign exchange contingency reserves to avoid fiscal measures

Daniel Makina, University of South Africa

In October this year, a group of one hundred economists and nongovernmental organisations led by the Institute for Economic Justice (IEJ) wrote a letter to the President urging him to consider using gold and foreign exchange contingency reserves to avoid fiscal austerity measures. The idea is reminiscent of the concluding pages of the seminal book – General Theory of Employment, Interest and Money – in which John Maynard Keynes wrote that ideas “are more powerful than is commonly understood. Indeed, the world is ruled by little else. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. … But, soon or late, it is ideas, not vested interests, which are dangerous for good or evil.” Recently, the Financial Times reported that Amia Capital, a London-based hedge fund has joined the fray in calling for President Cyril Ramaphosa to consider using the reserves to ease fiscal pressure. Indeed, the idea of using gold and foreign exchange contingency reserves is gaining currency as National Treasury and the SARB are in discussion to explore the possibility in the face of the fiscal crisis. As at the end of March 2023 these contingency reserves held by the SARB amounted to R459 billion, about the size of Eskom total debt.

Gold and foreign exchange contingency reserves are assets held by the South African Reserve Bank (SARB) to ensure stability in financial markets and meet any unexpected economic challenges. They consist of gold reserves (a form of insurance against currency fluctuations and economic uncertainties) and foreign exchange reserves which can be used to intervene in currency markets to influence the exchange rate or to pay off international debts. In essence, these reserves act as a buffer so that the state can respond to economic challenges such as currency crises, and sudden capital outflows.

On the positives, the SARB gold and foreign exchange contingency reserves can be used to alleviate fiscal imbalances in various ways. First, if a country experiences persistent trade deficits, the reserves can be used to address the imbalance either to stabilize the currency or to directly fund imports. South Africa does not face this problem although there is some noticeable worsening of the balance of payments, albeit not outside acceptable limits. Second, when country experiences problems in honouring its external debts, it can use its foreign exchange reserves to prevent default on foreign loans. Again, South Africa is not in a situation where it is about to default on its foreign debt. Its problem is significant share of domestic debt denominated in rand, which theoretically it can solve by printing money. Third, when a country is experiencing volatile currency fluctuations, the central bank can intervene using reserves to stabilize the currency. This usually happens when a country has a managed exchange rate regime. However, South Africa operates a flexible exchange rate regime which self-corrects. Fourth, the reserves could be utilized for short-term fiscal relief, that is providing a quick injection of funds to cover budget shortfalls, and thus assisting the government meet its immediate financial obligations. To a large extent South Africa has been having budget deficits since 2013 which are getting worse. In the current fiscal year the budget deficit is expected to be 4.9% of GDP which is well above the allowable 3%. The question is whether using foreign exchange reserves can provide short-term relief to a problem that has become structural. That brings us to cons of using foreign exchange reserves.

The first negative is that using foreign exchange reserves to inject funds in the economy can cause inflationary pressures. This arises because foreign currency needs to be sold for domestic currency which acts to increase money supply which in turn causes a rise in inflation. This is why the SARB is concerned with the liquidity management cost if reserves are utilized in this manner.

The second negative is that holding foreign exchange reserves involves an opportunity cost since the funds could be invested for potential good returns. This opportunity cost needs to be calculated and weighed by National Treasury and SARB before using reserves to fund government expenditure. If the reserves are invested in interest-bearing assets, using them means foregoing potential earnings. This could result in additional costs for the government if it needs to borrow more or if it loses out on income from the investment of those reserves.

The third negative is that depleting reserves means reduced cushion for future shocks because they act as a safety net and using them to plug fiscal gaps leaves the country more vulnerable to future economic challenges. In this case, it is better to address underlying fiscal issues.

The fourth negative is use of foreign exchange reserves can affect market and investor confidence. Investors often view robust reserves as a sign of a country’s economic strength and ability to weather uncertainties. Prudent management is crucial to maintain trust in the stability of a country’s financial system. A significant reduction of reserves may raise concerns about the country’s macroeconomic stability.

The fifth negative is that using reserves to address fiscal imbalances might postpone the need for necessary long overdue structural reforms in public finances. This will in turn exacerbate long-term fiscal sustainability challenges which South Africa is facing.

In conclusion, fiscal and monetary authorities should be aware that whilst using reserves can provide short-term fiscal relief, it is imperative to carefully weigh the short-term benefits against the potential long-term fiscal risks that could erode investors’ confidence, and ultimately lead to significant increases in borrowing costs and potentially to debt distress. To ensure sustained macroeconomic health of the country it is advisable to take a balanced approach, considering alternative fiscal measures and reforms.