Transcript Global Crisis and South Africa (2011)x

Lessons from the current
macroeconomic environment –
globally and locally
Kenneth Creamer
Overview of lecture
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1. Introduction
2. Crisis in US
3. Crisis in Europe
4. Impact of global recession on South
Africa
• 5. Economic policy lessons for South
Africa
• 6. Conclusion
1.Introduction
• What is an economic crisis?
– It is a period of economic stress and failure in which confidence
evaporates, growth rates fall, investment declines, government’s
get into debt, banks fail and unemployment rises?
• The lecture will provide explanations of the causes and
dimensions of the current global financial crisis which has
been underway since 2009
• Even though it is rooted in the developed world there is
much we can learn about how economies work by
analysing the crisis – we can draw lessons applicable to our
own experience
• Also the ongoing global economic crisis has direct
implications for the South African economy it is important
to try and understand how the crisis impact on our
economy and discuss the policy implications
Tale of Two Crises – US and EU
• US crisis
– Private sector financial crisis leading to public sector
problems
– Failure of regulation of financial system
– Fiscal and monetary policy have been used to try and
resolve the crisis but there is a strong critique that
attempts to re-regulate the financial sector to avoid
such crises in future have been inadequate
– US has pursued aggressive fiscal and monetary
stimulus, but:
• space for fiscal stimulus is reduced due to huge US govt debt
and political discord about raising taxes or cutting spending
in future
• There is not much scope for monetary stimulus as interest
rates are close to 0, yet Quantitative Easing is being used to
try and reflate the economy
EU Crisis
• European crisis
– Government Debt (Public Sector) crisis putting pressure on private
banking system
– The creation of the common Euro currency has removed the ability of
government’s to use monetary policy or exchange rate policy to
stimulate the economy and ease fiscal imbalance
– Policy makers have not developed consensus on the extent to which
European monetary policy can be used to alleviate the crisis, fiscal
policy (particularly cutting spending is proving difficult to implement)
and efforts to re-regulate the financial system (Basle 3) run the risk of
being pro-cyclical i.e. deepening the crisis
– Future of EU and Euro at risk as Germany and the ECB are against
using monetary stimulus like the US is doing and prefer a route
whereby countries undertake fiscal austerity (even giving up
sovereignty over fiscal policy)
2. US Crisis – regulatory failure
• A major regulatory change lies at the heart of the current US financial crisis
• In 1999 the Glass-Steagall Act of 1933 was repealed (New Deal programme
after banking crises of the Great Depression late 1920’s early 1930’s)
• The Glass-Steagall Act had provided for a strict separation of investment
banking and commercial banking
• Under the Glass-Steagall Act depositors money could not be used by
commercial banks to invest in high risk securities (this would have been the
preserve of investment bank who were taking risk-taking investors money
and chasing high return)
• In a sense it the repeal of the Glass-Steagall Act took away on important
regulatory pillar of the process of financial intermediation which matched
that risk-averse depositors (with govt-backed deposit insurance) with low
risk (lower return) types of investment and disallowed depositors fund to be
used in the high risk-high reward “casino” of Wall Street
• What is financial intermediation?
– banks take depositors money and then lend it to investors (i.e. savings are
transformed into investments and the banks make a profit as they pay
depositors a lower interest rate than the return they make an the investments
that they fund i.e. borrowers pay a higher interest rate than depositors receive)
US Sub-prime crisis
• In 1999 the year before the repeal of the Glass-Steagall Act
sub-prime loans were around 5% of all mortgage lending, in
2008 sub-prime loans were around 30% of all mortgage
lending
• In chasing high returns the less regulated banks started
using depositors money to chase the high returns
associated with lending people money to buy houses that
they probably not be able to afford
• Sub-prime loan is a housing loan to a person who is due to
their poor financial position is going to pay a higher interest
rate for the house that they purchase – often with “teaser
rates” or with “repayment holiday” clauses
• Speculators would also buy houses assuming that they
could resell these at a higher price in the future (fueled by
the “Greenspan put” of very low interest rates “too low for
too long” pushing up housing and financial asset prices)
The securitisation of sub-prime loans
• Sub-prime loans were securitised i.e. financial companies take 10 000
bonds and rolled them up into a product called “Property Bond Product A”
• A bank no longer regulated under Glass-Steagall takes depositors money
and buys this product “Property Bond Product A” as it offers good returns
i.e. the bond repayments of 10 000 families each month as well as the
underlying value of the property (which was assumed always to be rising)
• Furthermore, the rating agencies (S&P, Moodey’s, Fitch, etc) have rated
products such as “Property Bond Product A” as a completely safe and
secure investment i.e. AAA rated based on the assumption that while one
or 10 families may defaults on a bond it is not possible for 10 000 families
to default and on the assumption that property prices will always rise
• Financial companies such as insurance company AIG sold credit default
swaps (CSS) which essentially allowed those who wished to bet against the
sub-prime billions of $ of insurance if the sub-prim market failed
• All in the name of “financial innovation”
Then the wheels feel off….
• Families began defaulting on sub-prime bonds and the
property bubble burst – property prices began to fall
• AAA-rated products like “Property Bond Product A”
which had been worth hundreds of millions of dollars
one day (and had been bought with depositors money
were worth almost nothing as the products become
illiquid and cannot be sold “toxic”)
• The US government had to bail out banks that had lost
depositors money (or more banks would close like
Lehman Brothers)
• The US government had to bail out the insurance
companies (like AIG) that had miscalculated risk and
had to pay out billions of $ on credit default swaps
(CDS)
Recession stalks the US
• Dangers in US - Unemployment is high, confidence is
low and government debt is high
• There is a danger that the US government does not
have the instruments to turn the economy around as
both fiscal and monetary instruments are appearing
impotent
– Fiscal policy – govt is heavily indebted and is running a
large budget deficit with no political consensus on whether
to raise taxes or cut spending (hence the downgrading of
US bonds by S&P earlier in the year)
– Monetary policy – interest rates are very low and cannot
go much lower, resulting in the risk of deflation deflation 0
bound) therefore the Fed is using non-interest rate
instruments such as Quantitative Easing (QE) i.e. huge
increases in the money supply to try and inject some
inflation and liquidity into the system
Dangers of Deflation
• There is the danger of a deflation trap e.g. where nominal interest
rates are zero and there is deflation then the real interest rate is
positive,
– r = i – π (real interest rate) and i ≥ 0
– If i = 0 then r = – π
– If π < 0 (deflation) then minimum real rate is positive and r rises as
prices fall further (further deflation)
• Demand channel: If there is continued weak demand and deflation
is fueled further this will lead to a rise in the real interest rate (the
wrong impulse as it results in further suppression of demand)
• Financial channel: Deflation means that bond payments go up in
real terms (as in nominal terms they are fixed but price and wages
are falling) e.g. if you owe R1-million but your wages are falling this
leads to increased likelihood of default and banking crisis
• Consumption channel: Deflation slows consumptions as delayed
consumption will be rewarded with lower prices
3.European Crisis
• At the root of the crisis – government borrowing by
countries such as Greece and Italy
• Expenditure = Tax revenue + Borrowings
• Borrowing = Expenditure – Tax Revenue
• In order to borrow govt’s sell bonds e.g. govt sells a
bond for Euro 1 bn
• “follow the money” – this means govt is given Euro 1
bn and makes a commitment to pay this bond back
with interest
• NB – the amount of interest you must pay depends on
how risky you are perceived to be by lenders (what is
important here is often subjective and based on herd
mentality – behavioural vs rational economics)
European bond market
• Greece and Italy and increasingly France are beginning
to be perceived as more risky so there cost of
borrowing is rising
• Language of the bond market – “the yield spreads are
rising” i.e. the amount of interest that they will have to
pay on the Euro 1 bn that Greece is borrowing will be
much more than the interest rate that Germany has to
pay (as Germany is perceived to be less risky)
• The result for Greece is that its fiscal position appears
to be shifting from precarious to unsustainable i.e.
there is a risk that it will not be able to re-pay its debt
and this results in a vicious circle where the risk of
default pushes up interest rates and makes it even
harder for Greece to pay its debts
The Market for Greek Debt
• If supply rises of something prices come down (Greeks need to borrow)
• If demand falls for something then prices come down (perceptions of
Greek risk rising)
• As Greek position worsens they may wish to sell a bond for Euro 1bn
• Originally the could have sold this bond (a commitment to repay Euro 1bn
in 10 years) for Euro 950 million [case 1]
• During the crisis as Supply is up and Demand is down they may only be
able to sell the bond for Euro 700 million) [case 2]
• The bond yield, interest rate or cost of borrowing is calculated as follows:
– Case 1 (1 + Interest Rate)10 = 1000/950
=> Interest Rate = (1000/950)1/10 – 1 = 0.51% per year
– Case 2 (1 + Interest Rate)10 = 1000/700
=> Interest Rate = (1000/700)1/10 – 1 = 3.63% per year
• So the bonds spread between Case 1 and Case 2 is 3.12% or 312 basis
points
• The Greek cost of borrowing has risen – what are the implications?
Budget or fiscal implications
• Rising interest rates crowds out other spending
• As interest rates rises a higher an higher portion of tax revenues
have to paid in interest payments
• Year 1
• Tax (950) + Borrowing (50) = Spending (1000) (comprising salaries
and consumption 750 + investment 240 + interest repayments 10)
• Year 2 (after interest rates borrowing costs rise)
• Tax (950) + Borrowing (50) = Spending (1000) (comprising salaries
and consumption 750 + investment 210 + interest repayments 40)
• Notes:
– In year 2 interest payments have risen sharply “crowding-out”
investments (as salaries and consumption are typically more difficult
to reduce)
– If interest rates and interest rates continue to rise then country may
enter a debt trap where money is borrowed just to pay short-term
debts (and is not invested in growth generating projects which would
push up revenue and make it possible to repay debts)
Europe’s perfect storm
• Greek’s have a low income tax compliance
putting further pressure on fiscus
• The move to the Euro has resulted in:
– A move from high inflation to low inflation which
created the climate for a property bubble
– Euro has meant that Greece and other countries
have lost access to their monetary and currency
instruments
Housing Bubble
• Moving from high inflation to low inflation e.g.
countries like Greece, Italy and Spain - money illusion
in buying houses
• Housing bubble occurs as property prices are perceived
to be lower (due to lower nominal payments, but over
time the real payments are higher due to lower
inflation) (see next slide)
• As a result there is an investment boom in housing
stock and then when it is revealed that people cannot
afford housing then housing price fall and housing
developments are left unfinished
• This puts further pressure on economy and banks as
defaults rise
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1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21
Money illusion – moving from high to low inflation
High Inflation Case: Initial bond payment is Euro 10000 but with inflation at 25% p.a. the
real bond payments rapidly decrease over 20 years
Low Inflation Case: Initial bond payment is Euro 1000 but but with inflation at 5% p.a.
the real bond payments are comparatively higher over the 20 year life of the bond
Due to misperception that the low inflation case is cheaper (Euro 1000) than the high
inflation case (Euro 10 000) a housing bubble develops
Current debate in policy about the role of monetary policy or macro prudential policy in
avoiding the development of asset bubbles e.g. push up taxes / transfer duties on
houses when you move from high inflation to low inflation (e.g. Singapore)
Loss of monetary and exchange rate
instruments
• Could get out of debt by cutting interest rates or
devaluing the currency – cannot be done in Euro
area as ECB controls interest rate and there is a
single currency
• Real exchange rate is given by RE = P*e/P, can’t
influence P* (foreign inflation) or the nominal
exchange rate (e)(the Euro) therefore the must
try to reduce P (domestic prices) to devalue the
real exchange rate to increase “competitiveness”
– but this is politically very difficult e.g. reducing
public servants salaries
Likely results of European Crisis
• Euro introduced to avoid currency volatility and
currency speculators
• Now bond markets are exerting discipline and
causing imbalances
• Euro will collapse (countries will leave) or
• Countries will lose fiscal policy independence as
well (e.g. budgets will have to be passed by panEuropean govt in Brussels with the aim of
preventing too much borrowing or allowing
unsustainable spending)
4. Impact of recession on South Africa
• South Africa is a relatively open economy so when there is an
economic crisis in the US and EU this has negative economic
consequences for SA
• Growth is effected, exports are effected, capital flows are effected
• See diagram showing long run trends from 1950 to 2010 – 1994
represents a clear opening up of the SA economy
• See recent trends effected by the global recession
– Exports decline 2008-2009 as growth in our export markets slows
down
– Imports decline as growth in SA slows down and imports move with
growth
– Capital inflows drop sharply – as there is a flight from risk (SA has used
this inflows of foreign savings to fund growth enhancing capital
projects (investment) beyond our domestic savings pool, but there is
an argument that the capital flows can be destabilising
– When growth slows this impact on employment in the SA economy
with the global recession costing us around 1 million jobs between
2008Q4 and 2010Q4
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Axis Title
South Africa Exports and Imports as % of GDP
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30
25
20
South Africa Exports as % of GDP
15
South Africa Imports as % of GDP
10
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0
South African Current Account and Financial Account 1956 2010 (as % of GDP)
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Current Account
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Financial Account
Employment since 2008
5.Economic policy lessons for SA
• From the US crisis – keep appropriate regulation
of the financial sector
– In SA we have had exchange controls on SA citizens
and companies and prudential regulations on the
banks (versus ideological position of maximum
freedom minimum regulation a la Greenspan)
• From EU crisis – avoid getting into fiscal distress
– In SA we have avoided debt trap (see diagram that we
are relatively strong in this regard)
– Recently increased budget deficits have meant that
govt debt has been on the rise (mostly Rand
denominated)
Gross government debt as a % of GDP
17.1
China
25.4
Indonesia
Turkey
39.4
SA
39.6
2007
2011
63.9
Spain
65.7
Brazil
80.1
Germany
83.0
UK
Euro area
87.3
France
87.6
90.6
Portugal
99.5
US
102.9
Advanced
114.1
Ireland
120.3
Italy
152.3
Greece
229.1
Japan
0
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Gross government debt: % of gdp
Developmental state and open
economy
• Benefits of an open economy include foreign funding of job creating
infrastructure and private investment, exports provide larger markets and
huge growth potential, imports bring in technology and oil, etc.
• But an open economy is subject to shocks caused elsewhere
• The developmental state will experience these shocks and cannot make
our economy recession proof, but it can look to ways of generating
domestic investment in growth and employment generating projects:
– creating greater investor certainty,
– guiding investment into new sectors (e.g. renewable energy, road, rail and
water infrastructure) lengthen the planning horizon in the domestic economy
• Capital expansion must be done at a sustainable pace so as not to create a
fiscal crisis (often private sector finance can be used instead of govt
finances and risk e.g. in mining private finance should be used to expand
our mining output and create employment albeit in an efficiently
regulated manner)
• If we over extend the fiscus this will requires sharp cut-backs in spending
which will have negative social consequences for education and health,
teachers and nurses salaries will have to be cut, etc. and a legacy of
unfinished projects and unfulfilled promises
Prioritise employment creating growth
• Go for growth difference between 3% growth and 7%
growth over 20 years is that the GDP will be more than 2
times larger after 20 years i.e. 1.8 times larger at 3% growth
vs 3.9 times larger at 7% growth
• It is only growth that can generate employment – but
growth is necessary but not sufficient
• But govt policy can assist in shaping the growth to be more
employment creating and sustainable growth:
– Industrial policy encourages employment generating sectors
– Planning encourages changes in infrastructure provision, moves
toward new form of energy, etc.
– Local content in procurement has vast potential to increase the
number of people employed as a result of infrastructure
expansion
• Trade policy to open up exports markets to strong emerging
economies and Africa (see slides of potential here)
Emerging economies to be
key drivers of world growth…
Annual gdp growth: %
10
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0
-2
Advanced Economies
Emerging Economies
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Africa’s economic growth accelerated after
2000, making it the world’s third-fastest growing region
6. Conclusion
• In a sense this is an introductory lecture
• Firstly, a detailed discussion on the current global
economic crisis
• Secondly, in looking at how we should respond in this
climate this lecture has offered a foretaste, or a
bringing together, of many of the issues that will be
dealt with in greater detail during the days ahead in
this Political School, such as:
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–
–
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Fiscal and monetary policy
Industrial and minerals policy
Trade policy
Growth and employment policies