Heightened Foreign Economic Policy Uncertainty Shocks on the South African Economy: The Role of Credit Conditions and the Capital Flows Channels

Abstract

This chapter determines the transmission of economic policy uncertainty shocks via selected financial channels and how these impact the credit conditions index (CCI). In addition, the chapter examines whether economic policy uncertainties and credit conditions channels impact the monetary policy responses to positive inflation shocks. Evidence shows that positive foreign economic policy uncertainty shocks lead to a significant reduction in equity and debt inflows. Furthermore, the size of the foreign policy uncertainty shocks matters. Evidence shows that large positive foreign policy uncertainty shocks depress equity inflows more than smaller uncertainty shocks. Credit conditions exhibit prolonged periods of tightening due to positive European, US and China policy uncertainty shocks. The type capital of inflows matters because a reduction in equity inflows amplifies the tightening of credit conditions compared to debt inflows. The repo rate tightens so as to curb positive inflationary pressures irrespective of whether foreign policy uncertainty shocks are endogenous or exogenous in the model. However, a counterfactual analysis shows that the decline in equity inflows which leads to tightening credit conditions exacerbates the adverse impact of monetary policy tightening on GDP growth.