Inflation Dynamics In Post-Secession Sudan Suwareh Darbo and Amandine Nakumuryango aper Series n°305 orking P January 2019 W African Development Bank Group Working Paper No 305 Abstract parallel rate, credit to the private sector as a The objective of this working paper is to investigate percentage of GDP, and crude oil prices. The results the factors contributing to inflation in Sudan in the indicate that, in the long run, oil prices have a wake of South Sudan’s secession, which resulted in negative effect on inflation while money supply, the loss of 75% of the country’s oil exports. The credit to private sector, and nominal effective paper uses a single equation model in a Vector Error exchange rate have positive effects. This Correction Model (VECM) to investigate the underscores the need to manage money supply, the determinants of inflation. The independent variables exchange rate, and credit to the private sector, all of included in the model are money supply, the which can be influenced by the monetary nominal effective exchange rate based on the authorities—that is, the Central Bank of Sudan. This paper is the product of the Vice-Presidency for Economic Governance and Knowledge Management. It is part of a larger effort by the African Development Bank to promote knowledge and learning, share ideas, provide open access to its research, and make a contribution to development policy. The papers featured in the Working Paper Series (WPS) are those considered to have a bearing on the mission of AfDB, its strategic objectives of Inclusive and Green Growth, and its High-5 priority areas—to Power Africa, Feed Africa, Industrialize Africa, Integrate Africa and Improve Living Conditions of Africans. The authors may be contacted at [email protected]. Rights and Permissions All rights reserved. The text and data in this publication may be reproduced as long as the source is cited. Reproduction for commercial purposes is forbidden. The WPS disseminates the findings of work in progress, preliminary research results, and development experience and lessons, to encourage the exchange of ideas and innovative thinking among researchers, development practitioners, policy makers, and donors. The findings, interpretations, and conclusions expressed in the Bank’s WPS are entirely those of the author(s) and do not necessarily represent the view of the African Development Bank Group, its Board of Directors, or the countries they represent. Working Papers are available online at https://www.afdb.org/en/documents/publications/working-paper-series/ Produced by Macroeconomics Policy, Forecasting, and Research Department Coordinator Adeleke O. Salami Correct citation: Darbo S. and A. Nakumuryango, A (2019), Inflation Dynamics in Post-Secession Sudan, Working Paper Series N° 305, African Development Bank, Abidjan, Côte d’Ivoire. Inflation Dynamics in Post-Secession Sudan Suwareh Darbo1 and Amandine Nakumuryango 2 JEL classification: E310, E520, E580 Keywords: Inflation, money supply, exchange rate, credit, oil prices Sudan. 1 Principal Country Economist, African Development Bank (AfDB) 2 Consultant, African Development Bank (AfDB). 1 1. Introduction Sudan faced daunting challenges in the conduct of monetary policy following the secession of South Sudan in 2011. Its economic conditions deteriorated rapidly, with GDP growth rates plummeting from an average of 7.5% in the five years preceding secession3 to 0.9% in 2011, with a slight improvement to 1.4% in 2012. Though GDP growth rates started to slowly pick up and reached 4.9% in 2015, the basic fundamentals of the economy remain very weak, with only modest growth of about 3% and 3.5% projected in 2016 and 2017, respectively (Figure 1), driven by the non-oil sectors, notably agriculture, gold, and services. Figure 1: GDP growth and inflation 60 50 40 30 20 10 0 2010 2011 2012 2013 2014 2015 *2016 *2017 GDP Growth Rate Inflation Source: AfDB Statistics database Note: *=Projections The economy also slipped into fiscal and current account deficits in 2011 and 2012, from which it has not fully recovered. The current account deficit almost hit double digits (- 10.3% of GDP) in 2012 and -8.1% in 2013, up from -1.9% in 2011 due to the loss of oil revenue, while the fiscal deficit deteriorated from a surplus of 0.1% in 2011 to -3.1% and -2.2% of GDP in 2012 and 2013 respectively. The current account has not fully recovered either and remains stubbornly high at -5.3% of GDP in 2016 and projected at -4.9% in 2017 (Figure 2). 3 The year 2007 recorded a GDP growth rate of 10.5%, which made Sudan one of the fastest growing economies in Africa. 2 Figure 2: Current account and fiscal balance as a% of GDP 5 0 2010 2011 2012 2013 2014 2015 2016 *2017 -5 -10 -15 Current account as a % of GDP Fiscal Defiict as a % of GDP Source: AfDB Statistics database Note: *=Projections With very limited concessional resources due to the country’s staggering debt— estimated at USD 53.6 million as at December 2016—coupled with limited fiscal scape, the government of Sudan resorted to monetizing the fiscal deficit, fuelling high inflation—36.9% in 2014. Monetization of the fiscal deficit continues to increase, reflecting limited access to foreign borrowing and non-inflationary financing. Figure 3 compares Sudan’s average inflation rates during the period 2010-2016 with those of some of its regional neighbours, including Kenya, Ethiopia, Uganda, and Tanzania. Kenya, Uganda, and Tanzania have registered the lowest average rates (5.8%, 7.1%, and 8.6% respectively) while Ethiopia and Sudan (14% and 24.3%, respectively) registered the highest average rates. However, fiscal consolidation policy4 implemented since 2012 curbed the fiscal deficit to about -1.6% of GDP in 2015, and estimated at -1.8% of GDP in 2016 (Figure 2), thus 4 Fiscal reform measures in 2012/2013 on the expenditure side included: (i) reducing the size of the government by about 50%; (ii) removing 50% subsidies on oil products; (iii) reducing government-procured goods and services; and (iv) eliminating 3 reducing inflation from 36.9% in 2014 to 13.5% in 2016. However, higher central bank purchases of gold, which accounted for 39% of exports in 2017, coupled with lending to agriculture caused reserve money to grow from 27.5% of GDP at end-2016 to 52% in June 2017. Consequently, inflation soared to 35.1% in September 2017 and reached 52% in January 2018. Hence the need the need to investigate the root causes of inflation. Macroeconomic stability in Sudan is undermined by several other factors, including a narrow export base, quasi fiscal operations of the government5, an unconducive investment climate, failure to deepen reforms by agreeing with the IMF on the 14th Staff Monitored Program6 (SMP) in 2015, a multiple exchange rate system7, sanctions, and ill-targeted subsidies. While the IMF advised the Central Bank of Sudan to tighten its control of credit to the government so as to reduce inflation and also avoid crowding out private investment, it also advised it to use other monetary instruments to mop up the bank’s reserves. However, because the central bank is operating under the Sharia law, it cannot use interest-bearing debt instruments or discount these instruments in the secondary markets. The central bank is thus left with three alternative instruments: equity-based instruments, quantitative ceilings on credit, or a reserve ratio. Each of these has shortcomings. The equity-based instrument cannot be priced efficiently. And quantitative ceilings and reserve ratios cannot guarantee full control of the supply of money. The central bank, therefore, has less effective monetary control instruments than other countries operating under the traditional non-Sharia system and must resort to monetization of the deficit (accommodative monetary policy). This is how it lost control over credit to government and public enterprises. So far, the country has implemented 13 SMPs. The fourteenth one was not implemented due to policy slippages (disagreement on the macroeconomic framework), and the fact that it exchange rate distortions. Revenue side measures included tax reform, tightening loopholes for corruption, and increasing oil and gold production. For details, please refer to the three-year Salvation Program, 2011-2013. 5 The central bank’s policy of purchasing gold at the parallel market exchange rate to finance strategic imports (fuel, wheat, and pharmaceuticals) at the official rate, which translates into money supply growth. 4 The Government of Sudan implemented 13 Staff Monitored Programs since 1997. The 14th one was not fully implemented due policy differences in the macroeconomic framework. 7 There are four exchange rates in Sudan: official rate, incentive rate, rate for public transactions and parallel market exchange rate. 4 has not resulted in highly indebted poor country (HIPC) debt relief. The authorities have realized that HIPC debt relief hinges more on political considerations. The multiple exchange rate system subdues exports and therefore erodes the competitiveness of the external sector. This, coupled with U.S. sanctions8, has resulted in the rapid depreciation of the exchange rate and increased inflationary pressures. In addition, the ill-targeted wheat subsidies9 and quasi-fiscal operations of the Central Bank of Sudan—including in particular buying gold at the incentive exchange rate and selling it overseas at the official exchange rate—have contributed to distortions in the foreign exchange market, thus adding to inflationary pressures. The objective of this paper is to investigate the factors contributing to the country’s inflation in the wake of the secession of South Sudan, which resulted in the loss of 75% of the country’s oil exports. The introduction is followed by Section 2, the literature review. Section 3 explains the model used in the study, while Section 4 presents the empirical results.