South African Reserve Bank governor Lesetja Kganyago. Photo: Waldo Swiegers/Bloomberg/Getty Images
Fiscal decisions are often a source of risk in emerging and developing economies and climate change will amplify the risks, according to South African Reserve Bank governor Lesetja Kganyago.
He was delivering a public lecture at Nelson Mandela University on Climate Change and Policy Co-ordination: What Can Central Banks Do?
Kganyago explained that major economic disruptions caused by floods and droughts can increase spending pressures as governments need to rebuild destroyed infrastructure or compensate farmers for lost income. “At the same time, tax revenue will decline as economic activity slows,” he said.
The impact of fiscal decisions on monetary policy and financial stability are well illustrated in South Africa’s case, he said, describing how fiscal balances had deteriorated significantly after the 2008 global financial crisis.
Strong real growth in government wages was funded by higher taxes, contraction in public investment and rapid debt accumulation.
“The outcome was high inflation and weaker growth. At the same time, financial stability risks increased as banks increased their holdings of government debt that has a higher probability of credit default.”
Monetary policy in South Africa faced strong fiscal dominance effects, in particular in the post-global financial crisis period as well as through the Covid-19 pandemic.
“When fiscal imbalances are large and fiscal credibility wanes, it may become increasingly harder for the monetary authority to stabilise inflation around its desired target. If the monetary authority increases rates in response to high inflation, the economy enters a recession, which increases the debt-to-GDP ratio,” he said.
Large fiscal buffers
If the monetary tightening is not supported by the expectation of appropriate fiscal adjustments, the deterioration of fiscal imbalances leads to even higher inflationary pressure, he explained. As a result, a “vicious circle” of rising nominal interest rates, rising inflation, economic stagnation and increasing debt would arise.
By contrast, monetary and fiscal responses to the South African economy’s green transition would be more effective if large fiscal buffers are built and spending is prioritised for investment in infrastructure and to develop new skills to drive economic growth.
Equally important, the tax system needs to tackle the historically low costs of generating greenhouse gas emissions, for example, through carbon taxation and providing tax incentives for firms and consumers to invest in cleaner technologies.
These actions provide clear relative price signals to decarbonise the economy. “This type of fiscal policy allows central banks to support the transition by maintaining price and financial stability.”
Kganyago emphasised that if government actions do not create the appropriate relative price signals, “then our investment and consumption decisions will continue to support brown sectors; our exports will face carbon-border tax adjustments and foreign funding will decline as investors become more considerate of climate-related issues”.
“Under these conditions, there is limited potential for expansionary monetary policy to support economic activity.”
Tipping points
The 2022 floods in KwaZulu-Natal, in which nearly 500 people died and more than 4 000 homes were destroyed, “reminded us yet again that climate change is real and can devastate households, businesses and property”, Kganyago said. At the same time, “we saw dams running dry in the Nelson Mandela Bay area, limiting water supply to firms and households”.
The frequency and severity of extreme events is increasing across the world, he said. “Just last month, powerful winds and severe rainfall damaged houses and roads in the Western Cape. Most recently, elsewhere, Storm Daniel caused extreme flooding across countries in the Balkans and Mediterranean with more than 10 000 people reported missing in Libya and the city of Derna completely destroyed when the walls of its dams burst.”
The world is rapidly approaching global climate tipping points which, “once crossed, lead to greater disruptive effects of climate change on our livelihoods”, Kganyago said, adding decisive action is needed to slow rising temperatures.
According to the Intergovernmental Panel on Climate Change, achieving the goal of limiting temperature increases to 1.5°C requires global greenhouse gas emissions to peak before 2025 and then decline 43% by 2030, a goal that “appears increasingly difficult to achieve”, he said.
“While the combination of urgency and complexity is daunting, it is important that we think carefully about policy co-ordination. We should think about the roles and responsibilities of the public regulatory system and how their actions impact the behaviour of economic agents, firms and households.”
Central banks globally have been drawn into these policy debates and “while we certainly have a role to play”, when it comes to broader society and economy-wide systems, it’s best to think of central banks as “just one important node in a neural network”.
Core mandate
Climate change affects economies through multiple supply and demand channels. And, unlike other supply-side shocks, those from climate change are expected to be persistent, with frequently irreversible effects, Kganyago said, noting how climate change will affect labour supply, capital accumulation and productivity.
Extreme heat is expected to increase mortality and morbidity, reducing the skills base. Human capital is likely to be affected by mass migration, crime and social unrest. Some estimates, Kganyago noted, suggest a 7% decline in GDP per capita by 2100 for every 0.04°C rise in temperatures globally.
Unintended consequences
Countries are moving to reduce greenhouse gas emissions while trying to increase the resilience of their economies to the effects of climate change. But these efforts could generate “unintended negative consequences”.
South Africa’s high carbon intensity of production has already exposed the country to the EU’s Carbon Border Adjustment Mechanism, which “will see an increase in the cost of our exports”.
The mechanism is a carbon tariff on carbon-intensive products imported by the EU, such as cement; iron and steel; aluminium; fertilisers; electricity and hydrogen.
Kganyago said the combination of rising temperatures, more frequent and extreme events and policy actions to mitigate and adapt “may increase macroeconomic volatility and put pressure on the balance sheets of some households and firms”.
Prices of products and services from weather-dependent sectors, such as agriculture, and carbon-intensive sectors will increase more rapidly, he said. Banks might be faced with stranded assets as global demand for carbon-intensive goods declines. Price and financial stability will be affected simultaneously with impacts characterised by these tipping points.
In the face of all this, central banks have started to consider the effect of climate change on the economy and the financial sector.
“Many are conducting financial sector climate stress tests, greening their portfolios, assessing the impact of extreme weather events and mitigation policies on inflation and incorporating climate-related considerations in financial sector supervision.”
Avoiding over-reach
On the role of central banks in the green transition, Kganyago said its main drivers are relative price changes that provide a strong signal for households and firms to consume and invest in greener goods and services; new technologies that reduce the cost of adaptation and mitigation and infrastructure that is more resilient to extreme weather events and supports the economic transition.
“The tools that we have as central bankers cannot impact these elements directly.”
Carbon pricing is considered the most effective and efficient instrument in changing the relative price of carbon-intensive goods and services. “Yet, carbon prices remain low and governments try to achieve these relative price shifts using second-best options.”
From 2010 to 2020, the cost of solar and wind generation has fallen by 85% and 56%, respectively, and adoption rates have grown exponentially. On what role central banks have played in the development of renewable energy technology, the “answer is, not much”, Kganyago said.
“We have neither the skills nor the tools to assist. The major driving forces of green innovation are factors such as carbon taxation, research and development investment and equity funding, often in the form of venture capital.”
These fall entirely within the mandate of governments.
“The best way for a central bank to support technology development and adoption is not by funding it but by being better at reducing the costs associated with inflation, hedging and financial instability. Lower and stable inflation reduces risk premiums and also translates into less-volatile exchange rates.”
Infrastructure
Climate change will require significant investment in adaptation and mitigation infrastructure.
“We must make our roads and buildings climate resilient. We need to cope with increased flooding, droughts and fires. And we need charging stations for our new electric vehicles.”
The Blended Finance Taskforce, which was set up to mobilise private capital for the sustainable development goals, estimates $250 billion is needed for investment over the next 30 years.
“We are not infrastructure financiers and we have seen that infrastructure budgets are often not spent,” Kganyago said. “There is little we can do to improve the different phases of developing and executing a project, which are often listed as the main obstacles to infrastructure development in South Africa.”
Microeconomic policies
Central banks have an important role to play in the climate transition. “It is to maintain financial and price stability, produce analytical work to support policy-making and address financial market data gaps,” Kganyago said.
“These will enable an environment for financial institutions to provide green funding; for companies to invest in new technologies and productive capacity as well as for households to shift their consumption patterns. Our actions will be effective only if they fall within our mandate and as part of a bigger government response.”
The contribution of central banks to climate change-related objectives and their contribution to the transition is conditional on government policy actions.
“The biggest levers of the transition sit with microeconomic policies. Well-designed and co-ordinated actions generate an orderly green transition while minimising any unintended consequences,” Kganyago said, citing how policy actions to help workers reskill and relocate to greener firms will maximise employment gains.
Reducing the cost of new technologies through an appropriate mix of incentives and the removal of trade tariffs will lower transition costs.
“This will also support the development of new industries. Transitioning the electricity sector more rapidly to green generation can be a major catalyst for investment in sectors across the economy,” he said.