Changes to Algeria's macroeconomic strategy

Faced with slowing economic growth and an increasingly constrained banking sector, Algeria decided to change its macroeconomic strategy in October 2017. As part of the new plan, monetary and fiscal policies would be eased simultaneously, an approach which has come to be known in Algeria as “quantitative easing”. Instead of continuing to narrow the budget deficit every year until coming to balance by 2020, the target for a balanced budget was pushed back to 2022, with the budget for 2018 to be expansionary instead of contractionary as was previously planned. Additionally, the Bank of Algeria is permitted to purchase debt directly from the government, public enterprises and the National Investment Fund for a period of five years. In terms of sovereign debt, ad hoc government issuances of bonds with long maturities and an interest rate of 0.5% are purchased by the Bank of Algeria.

Unconventional Approach

In response to the global financial crisis of 2007-08, many leading global central banks, including the US Federal Reserve, the European Central Bank, the Bank of Japan and the Bank of England, pursued unconventional monetary policies, in addition to reducing their interest rates to zero. These alternative monetary policies are sometimes referred to as quantitative easing.

Indeed, there are similarities between the quantitative easing policies undertaken by the world’s leading banks and the monetary policy adopted by the Bank of Algeria since late 2017. Both involve expanding a central bank’s balance sheet to purchase sovereign bonds, which should drive down long-term interest rates and increase liquidity in the banking sector. Some economists have argued that quantitative easing was simply a form of monetary financing, whereby central bank purchases of sovereign debt were essentially used to finance government debt, a policy mix that has been known to lead to a surge in inflation, even hyperinflation. There are important distinctions, however, between the quantitative easing strategy pursued by leading global central banks and Algeria’s quantitative easing policy. First, interest rates were not already at zero in Algeria, so it is difficult to view this approach as a purely monetary policy measure. Second, the purchase of sovereign bonds by global central banks was done on the secondary rather than the primary market, meaning those central banks were not directly financing the government or quasi-governmental agencies. Third, rather than pursuing fiscal consolidation alongside monetary expansion, as was the case with quantitative easing, the Algerian authorities pursued a policy of simultaneous monetary and fiscal expansion, with a commitment to fiscal consolidation only over the longer term.

By the Numbers

According to the IMF’s 2018 Article IV Consultation for Algeria, between November 2017 and June 2018 the Bank of Algeria purchased sovereign debt equivalent to 3% of GDP from 2017. A further 8.6% of GDP was made up of debt held by state-owned enterprises and the National Investment Fund, with the latter having used the loans to finance capital and infrastructure investment projects in the country. By the end of May 2018 the total amount of non-conventional financing reached AD3.6trn (€26.1bn), according to the Bank of Algeria, while the IMF estimated that by the end of that year monetary financing will amount to 23% of GDP in 2018. To the extent that government deficit targets for 2019 or subsequent years are not met, there is a risk that the shortfall will be made up with further monetary easing measures. These operations contributed to 8.3% growth in the broad money supply and were one of the factors behind the 12.8% growth in credit to the economy, according to the IMF.

Impact

Algeria’s quantitative easing policy has thus far had the desired effect of supporting economic growth, with the IMF forecasting GDP growth to increase from 1.4% in 2017 to 2.5% in 2018. As a result of the new strategy, the government reversed course on its fiscal consolidation path, expanding the budget deficit in 2018 after having narrowed it in 2017.

Liquidity was also reported to have returned to the banking sector, supporting credit growth and in turn economic growth. In essence, the new macroeconomic strategy allowed the government to postpone tough choices, such as reducing the budget deficit, increasing foreign financing or resorting to a loan from the IMF. At the same time, it increases the longer-term risks facing the economy, namely rising inflation.

Inflationary Pressure

Any rapid expansion in the money supply, beyond that justified by underlying economic growth, can lead to higher inflation, even runaway inflation. There were fears that quantitative easing would lead to increased inflation, but this has not come to pass. Similar fears have been expressed in the instance of Algeria, but as of December 2018 there was no sign of a significant pickup in consumer prices. Average prices for the first seven months of 2018 were 4.5% higher than prices during the corresponding period in 2017. As of mid-2018, however, consumer price inflation had trended downwards.

The central bank is aware of these inflation risks and has taken steps to contain them. In January 2018 the reserve ratio for banks was doubled from 4% to 8%. A further hike to 10% in March 2018 meant that banks in Algeria would have to hold 2.5 times as much capital to support the same amount of lending. To some extent, this has sterilised the significant increase in the money supply, warding off excessive credit growth or a surge in inflation. In its 2018 IV Consultation for Algeria, the IMF suggested that the central bank should ready itself to tighten monetary policy, if inflation pressures arise, by introducing safeguards such as strict quantitative limits to financing, for example.

External Factors

Rising oil prices in 2018 will likely have had a positive impact on Algeria’s year-end public finances. The IMF forecast hydrocarbons revenue would increase from AD2.4trn (€17.4bn) in 2017 to AD2.6trn (€18.9bn), which would serve to reduce the budget deficit and thereby lower the need to resort to quantitative easing to finance public expenditure. While higher energy prices can be expected to feed through to higher consumer prices, any reduction in the government’s reliance on monetary financing should have the opposite effect, by slowing the expansion in the money supply and thereby reducing inflationary pressures. If higher oil prices were to be sustained over the medium to long term, this should lead to a reduction in budget deficits, lower government debt and increased economic growth – the latter due to greater investment and activity in the hydrocarbons sector rather than a further pickup in fiscal stimulus. Sustained higher oil prices are also expected to lead to a reduction in external balances, notably the current account, and therefore ease pressure on central bank reserves. However, the break-even oil price, which would bring the government budget in balance, remained at over $90 per barrel in 2018 and significantly higher than the spot price on the market, despite the break-even price having fallen from a high of almost $140 per barrel in 2014 and the spot price having strengthened throughout 2018.

Emerging markets, and particularly those with large fiscal and current account deficits, have come under pressure on financial markets in 2018. Algeria has been largely insulated from such pressures due to its relatively low level of external debt, which amounted to only 2.4% of GDP in 2017, equal to $4.1bn, and is projected to decline gradually over the coming years.

Long-term Risks

Any sharp reduction in oil prices, whether due to a reduction in global demand or an increase in global supply, raises the risk that the economy and government finances underperform, putting greater pressure on the fiscal and external balances as well as on central bank reserves. In turn, this could increase pressure on the government to rely more heavily than anticipated on non-conventional monetary financing, which could raise inflation. Alternatively, if the authorities were to opt to rely on foreign financing, this could raise the risk of a sudden stop in such financing and a balance of payments crisis.

Looking Ahead

The real test of the quantitative easing strategy will come in 2019 after the presidential election. The government has committed to achieving a balanced budget by 2022, with the path of fiscal consolidation to begin in 2019. The 2019 draft budget law suggests the budget deficit will not narrow substantially before 2020, and that the burden of fiscal consolidation, and the likely negative impact on economic growth as a result, will be postponed until later. That would mean that Algeria would either have to resort to foreign financing, which they have been highly reluctant to do for many years, or to monetary financing to a greater extent than had been previously envisaged. If inflationary pressures do materialise, and the government responds by ramping up spending so as to maintain the real value of public sector wages and other spending, the IMF noted that this risks “plunging the economy into an inflationary spiral”.