Download Macroeconomic Crises and the Open Economy

Macroeconomic Crises and the
Open Economy
Lecture from Course on Trade and Finance in
Economic Development – Wits University
9 October 2013
Presented by Kenneth Creamer
Overview
1. Understanding the historical evolution of the
macroeconomic environment
1.
2.
3.
4.
Inflation (1970’s)
Public debt (1980’s)
Financial deregulation (1990’s)
Socialising losses via public debt (2000’s)
2. Open economy policy challenges
1. Data for South Africa
2. International Macroeconomic Theory
3. Policy implications – a strategic perspective
Topic 1
Introduction – historical evolution of the
macroeconomic environment
• “Democratic capitalism is a political economy
ruled by two conflicting principles… of resource
allocation: one operating according to… what is
revealed as merit by a ‘free play of market
forces’, and the other based on social need or
entitlement, as certified by the collective choices
of democratic politics.”
• “one side emphasizing the entitlements of
citizenship and the other those of property and
market power”
Wolfgang Streeck, New Left Review Sept/Oct 2011
Phases of the global economy
• After WW2 (1945 to late 1960’s) democratic capitalism
was based on the following settlement of these two
conflicting principles by putting in place:
– An expanding welfare state
– The right of workers to collective bargaining
– A political guarantee of full employment
• From late 1960’s / early 1970’s growth started to falter
due to factors such as:
– (1) falling productivity, (2) an oil price shock, (3) Demand
management resulting in inflation rather than to output
and employment gains
– leading to a series of crises for democratic capitalism
– By Okun’s law if growth falls then unemployment rises
Series of crises
• The crises in the democratic capitalist system
were managed as follows as mechanisms were
sought to appease the contradictory forces of
the market and democratic politics:
• 1970’s rising inflation
• 1980’s growing public debt
• 1990’s financial deregulation
• 2000’s socialising the losses of the financial sector
and related public debt
• Above Mechanisms used to introduce resources
into distributional conflicts
1970’s inflation
• When growth slowed in 1970’s (due to oil price shock
and productivity slow down, etc.) policy makers had
two options:
– Use tri-partite social compacts with the aim of achieving
wage restraint and promoting growth and development
(where class conflict is mediated by widening and
lengthening of interest away from narrow, short-run
interests e.g. labour prioritise wages, growth and
employment; capital prioritise investment, long-run profit,
efficiency wage, etc.) (Lesson for SA?)
– In most cases, tripartite structures were not strong enough
so accommodating monetary policy was pursued as in the
short-run this allowed relatively full employment and
collective bargaining to continue, but lead to rising
inflation and falling real wages (as workers could not de
facto index their wages to inflation)
1970’s inflation
• Forms become fetters as ultimately “inflation will
produce unemployment, punishing the very
workers whose interests it may initially have
served” (inflation results in rising interest rates
and falling investor confidence resulting in
increased unemployment)
• Under democratic capitalism, governments will
then come under pressure to restore monetary
discipline, and this is what happened….
1980’s Public Debt
• Inflation was brought under control after the Volcker shock of 1979 and
in the 1980’s
• It was accompanied by determined attacks on trade unions by
governments and employers, this has been characterised as the
beginning of the neo-liberal era
• But, as inflation receded, public debt begun to increase, because:
– Taxes revenues received by govt’s fell (as growth fell) and
– expenditure by govt’s rose due to social assistance needed to compensate
the rising numbers of unemployed
– Therefore govt’ begun to borrow heavily as “Public debt turned out to be
a convenient functional equivalent of inflation, as public debt made it
possible to introduce resources into distributional conflicts”
• “as the struggle between market and social distribution moved from
the labour market to the political arena, electoral pressure replaced
trade union demands” (see falling strike activities)
1980’s Public Debt
• Forms become fetters – the accumulation of
public debt cannot go on forever as it will drive
up interest rates, and limit growth, and a growing
share of public spending will have to be devoted
to debt servicing,
• Therefore a new mechanism had to be found to
manage social conflict which included “fiscal
discipline” but provided the resources needed for
growth – this is the political economy origin of
the financial deregulation of the 1990’s
1990’s financial deregulation
• The 1990’s saw an attempt to control public debt
leading to rapidly rising inequality, as a result of
weakened trade-unionism, cuts in social spending (as
Clinton heralded the end to ‘welfare as we know it”
and reduced growth due to austere fiscal policy
• Private debt replaced public debt as the financial
markets were deregulated and were expanded
• “Instead of govt borrowing money to fund equal access
to decent housing, or the formation of skills. It was
now individual citizens who, under a debt regime of
extreme generosity, were allowed.. to take out loans at
their own risk to pay for their education or to move to
a less destitute urban neighbourhood.” (See Fig.
showing the rise in private debt)
1990’s financial deregulation
• The rich benefited – as they were spared
increased taxes (as spending was contained) and
they invested in financial services bubble (See
diagrams showing increasing income inequality of
the 1990’s and early 2000’s)
• The poor seemed to benefit (but did not) – as
access to cheap money and sub-prime mortgages
become a substitute for reduced social protection
and labour protection as the labour market
become ‘more flexible’
US income inequality
16
Income inequality increased across a
range of countries - not just the US
17
A longer view of inequality
18
1990’s financial deregulation
• Forms become fetters – as the financial
system was not well regulated it became a
dangerous bubble that burst with devastating
consequences
• This was exacerbated by the very low interest
rate policies by the US Fed after 2001, know as
the Greenspan put – where the Fed would cut
interest rates to provide stimulus to the
financial sector
2000’s – Socialising the losses of the
financial sector via public debt
• In response to the collapse of the financial system
in 2008:
– govt’s bailed out the financial sector, essentially
socialising the bad loans that had been made by the
financial sector which was deemed “too big to fail”
– Introduced fiscal stimulus to try and boost economic
growth
– To save democratic capitalism “political power was
deployed to make future resources available for
securing present social peace” and financial stability
– In addition to this (points Streeck does not mention):
• A process of financial re-regulation i.e. Dodds-Frank and
Basel 3
• New macroeconomic policy frameworks developed in the
field of macroprudential regulation
2000’s – Socialising the losses of the
financial sector
• Forms become fetters – the increased budget
deficits and increased public debt needed to
save the financial system has been met by calls
for fiscal austerity (e.g. for Greece and Spain
and Ireland)
• But in the current period there is a contestation
between those who wish to prioritise growth
(e.g. in the US) and those who wish to prioritise
austerity and primary budget balance (such as
in the EU) so as to avoid further indebtedness
US Response
•
•
•
•
•
2008 – 2012 sought to stimulate the US econ, through ‘unconventional’ QE i.e.
increased money supply/liquidity, low interest rates (so low that no longer an
instrument of monetary policy), weaken dollar (see off potential political disaster
of the fiscal cliff – contractionary)
2013 - now with some economic growth talk of end of QE so called ‘tapering’ of
future bond buying, interest rates begin to rise
Effect on SA:
QE phase: much money from US QE flowed into emerging markets like SA
strengthen rand – bad for exports, pushed up imports and increased deficit on the
BoP current account
Good for infrastructure expansion as capital inflows
– Not all capital inflows go to real investment (much is speculative)
– But in SA national investment > national savings (so there is some real benefit of inflow of
foreign savings)
– possible channels: 1. keep interest rates lower than they would be without such inflows and
make infrastructure investments cheaper) (although sometimes consumption has grown more
than investment) 2. increased share price – effectively lowers the cost of investment by firms
at ipo
•
Tapering phase: money flows out of emerging markets back into US, weakening
the rand and other currencies – after some time lag this may improve exports and
lead to improvements in the current account of BoP, but will also lead to inflation
and rising interest rates (pushing up cost of investment)
EU Response
• 2008 - 2013 EU has followed a programme of austerity, as much of
the financial crisis left EU member states with very bad fiscal
positions – high debt and rising bond spreads
• EU countries like Greece, Portugal and Ireland did not control
monetary policy and did not have a currency to devalue, so
austerity (reduced govt spending, attempts to control wages and
prices) was imposed on them
• As a result of EU austerity the bloc moved a current account deficit
to a current account surplus (also within the EU Germany had
current account surplus in its trade with other EU members)
• Effect on SA–
– austerity and slow growth in EU meant less exports to EU which is an
important trading partner
Topic 2
Open economy policy challenges
• Data Analysis
• South Africa is a relatively open economy as compared to other
countries
• While SA has its own internal economic dynamics (due to
consumption, investment, government taxation and spending)
South Africa experiences positive growth and negative shocks linked
to developments in the rest of the world
• The recent Great Recession (2008-2009) had roots in the developed
world, but transmitted globally, including to South Africa
• In the past 10 years Africa is a region experiencing relatively high
economic growth (second only to Asia), but there are concerns
about the quality of Africa’s growth as it is not based on industrial
development i.e. there is mining, agriculture and tourism, but not
enough secondary industry to support these sectors
DEGREE OF OPENNESS
(imports + exports as % of GDP)
120
100
South Africa
80
Brazil
60
Russia
India
40
China
World
20
2008
2005
2002
1999
1996
1993
1990
1987
1984
1981
1978
1975
1972
1969
1966
1963
1960
0
DEGREE OF OPENNESS
• South Africa has been a relatively open economy
over the past 50 years, sanctions against
apartheid decreased that openness in the 1980’s
and 1990’s, but our openness has increased since
democracy in 1994
• India, China and Russia have rapidly opened up to
international trade in the past 20 years
• Brazil is noticeably less open than the rest of the
BRICS (but it is likely to become more open in the
year’s ahead)
GREAT RECESSION (2008-2009) AND BEYOND
(GDP growth rate (%))
14
12
10
8
6
4
2
0
-2
-4
-6
World
Developed
Asia
SubSaharaAfrica
GREAT RECESSION (2008-2009) AND BEYOND
• The world economy operates as a relatively integrated
system – when the developed world entered the 2008-2009
recession due to a financial crisis all regions of the world
were effected
• In the next five years, it is projected that Asian growth will
be around 7-8%, Africa around 6% and the developed world
around 2%.
• There is no certainty on this and there are risks (e.g. Euro
Area implosion, China’s growth, US fiscal cliff), but if these
projections are correct then in the next few years we can
expect that international growth will contribute positively
to South Africa’s growth and development.
SA AND WORLD GROWTH
(GDP Growth rate (%))
8
6
4
World
2
SubSaharaAfrica
South Africa
0
-2
-4
SA AND WORLD GROWTH
• South Africa’s growth since 1994 has suffered from 2 significant
negative international shocks
– 1998’s Asian crisis
– 2008-2009’s Great Recession
• South Africa experienced high growth (up to 5%) in the period 2003
to 2008 this was closely linked to high global growth (and a boom in
commodity prices)
• Not all negative shocks are due to external factors. For example,
South Africa in the late apartheid period had much lower growth
rates than the rest of the world)
• Internal events like the recent strike wave in mining and other
sectors also have the potential to result in negative growth shocks –
resulting in falling investment, loss of confidence and lower growth
rates.
SA GDP AND INVESTMENT GROWTH
(growth rate (%))
15
10
5
GDP Growth
Investment
0
-5
-10
SA GDP AND INVESTMENT GROWTH
• South African investment (private sector, SOE’s,
government and foreign investment) is linked to growth
• Strong investment growth took place from 1994 to 1996
(RDP period) and from 2003 to 2008 (Asgisa period)
(period’s of growth in the world economy)
• Investment has fallen sharply during periods of
international crisis
• This illustrates the need for counter-cyclical fiscal and
monetary policy to try and stimulate growth and
investment during down-turns
• As we can see from the next slide: the public sector and
SOE’s are leading the growth in investment a la some form
of state capitalism (unlike the GEAR period in which private
sector investment was meant to take the lead, but did not).
Investment growth over past 5 years
has been driven by the Public Sector
-5
-10
-15
-20
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
SA EXPORT AND IMPORT GROWTH
(growth rate (%))
20
15
10
5
0
Exports
Imports
SA EXPORT AND IMPORT GROWTH
• Import growth is linked closely with economic growth
in SA
• Export growth is linked closely with economic growth
in the the rest of the world (trading partners)
• In the longer-run, these dynamics can be structurally
altered by:
– trade policies that create access for our exports to new
markets (linked to our trade and industrial policy), but this
will usually require a reciprocal opening of our markets to
certain imports)
– Local content, import substitution policies aimed at
promoting our own industry e.g. local content
requirements around our electricity or rail infrastructure
expansions
SA EMPLOYMENT (% CHANGE)
6
4
2
"Public sector"
0
"Private sector"
19901992 19941996199820002002200420062008 2010
-2
Total employment
-4
-6
Note: 13.5 million employed and 4.2 million unemployed (23.9%), with a labour
force of 17.7 million (QLFS Q42011). 13.2 million employed and 5.6 million
unemployed (29.8%), with a labour force of 18.8 million (Census 2011)
TOTAL EMPLOYMENT (000’s)
14200
14000
13800
13600
13400
13200
13000
12800
12600
12400
EMPLOYMENT TRENDS BY AGE GROUP
SA EMPLOYMENT
• The South African economy creates employment
during periods of economic growth e.g. 2003 to
2008
• Jobs are lost during periods of low growth
(usually linked to international crises such as the
Great Recession)
• Public sector employment seems to be relatively,
but not completely, de-linked from developments
in the international economy
• The employment of young people has declined
more sharply than of older people in the
Recession period.
SA CURRENT ACCOUNT FINANCIAL
ACCOUNT AND RESERVES (R millions)
200000
150000
100000
50000
Current Account
0
-50000
-100000
-150000
-200000
Reserves
2003 2004 2005 2006 2007 2008 2009 2010 2011
Financial Account
SA CURRENT ACCOUNT FINANCIAL
ACCOUNT AND RESERVES
• South Africa imports more than it exports (leading to a
current account deficit)
• More foreign savings (foreign capital) flows into South
Africa than flows out of South Africa (leading to a financial
account surplus)
• Inflow of foreign savings is useful as it tends to finance
investment (e.g. higher shares prices and lower interest
rates), but it poses some dangers if it funds a consumption
bubble and it is reversible as it is sentiment driven
• South Africa is tending to grow it holdings of foreign
reserves as a matter of policy –
– at times to slow upward/strengthening pressure on the rand
and
– to hold reserves representing a higher number of weeks of
imports
REAL EXCHANGE RATE (2000=100)
155
145
135
125
115
Rand Exchange Rate
105
95
85
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
75
REAL EXCHANGE RATE
• The real exchange rate has been volatile preand post the 1994 democratic period
• The Rand weakened sharply form 1996 to
2002
• The Rand strengthened during the growth
period form 2003 to 2006
• And then weakened during the Great
Recession period, strengthened and then
weakened again….
2. International macroeconomic theory
• A. Consider first the theory of the “Open Economy
Trilemma” originally muted in:
– Obstfeld, Maurice and Alan Taylor (1997) “The Great
Depression as a watershed: International Capital Mobility
over the long run”, NBER Working Paper 5960, and
– Obstfeld, Maurice and Alan Taylor (2004) “Global capital
markets: integration, crisis and growth”, Cambridge
University Press.
• B. Consider the recent literature that the policy choice
really a “Open Economy Dilemma”:
– Rey, Helene (2013) “Dilemma not Trilemma: The Global
Financial Cycle and Monetary Policy Independence”
(presented at Kansas Federal Reserve Bank Policy
Symposium at Jackson Hole, USA)
A. Theory of an “open economy trilemma”
• International economic theory poses what is
called the “open economy trilemma” to
explain policy options and limitations
• This theory states that due to limitations only
two of three beneficial policies can be
maintained simultaneously:
– Open capital market
– Fixed exchange rate
– Monetary policy independence
Fixed Exchange
Rate
China
Monetary
Independence
Hong
Kong
South
Africa
Free Movement of
Capital
The tri-lemma in South Africa
• In South Africa, as we have chosen to have free capital flows and
independent monetary policy then the theory tells us that we cannot fix our
exchange rate.
• If we try to fix our exchange rate and then the exchange rate comes under
pressure then we will have to increase our interest rate (give up monetary
policy independence) or limit capital outflows (with dire consequences for
future inflows). (Only 2 out of 3 possible)
• During the 1998 Asian crisis Chris Stals’s SARB tried a version of this where,
in an attempt to strengthen the Rand, they raised interest rates to over 20%
and intervened in the capital market (borrowing USD30-billion to buy Rands
and strengthen it). But Rand still depreciated.
• Stals could not beat the tri-lemma so after this, under Mboweni, SA made it
clear that it would let the rand float freely in future, and monetary policy
would be set based on domestic inflation conditions and would not be used
to try to fix the exchange rate. Resulting in a period of relatively low interest
rates in South Africa (see next diagram). (partly due to global Great
Moderation)
Interest rates
The tri-lemma in Hong Kong
• Hong Kong – has chosen a fixed exchange rate
and free movement of capital, therefore its
interest rate is determined by factors outside of
their economy (no independent monetary policy)
• If Hong Kong tries to increase interest rates (due
to low US-linked interest rates promoting a
property bubble) then capital will flow into the
economy (and capital will have to be blocked) or
the exchange rate will strengthen (and will not
longer be fixed)
• (Only 2 out of 3 possible)
The tri-lemma in China
• China – has chosen a fixed exchange rate and
independent monetary policy, therefore it cannot allow
free movement of capital
• If China tries to allow free movement of capital (as it
may want to in order to extend the power of its
financial system) then capital might flow into the
economy and the exchange rate would strengthen
(and will no longer be fixed) or if it wishes to keep a
fixed exchange rate it might need to lower its interest
rate to avoid a currency appreciation (and thus lose its
ability to have an independent monetary policy)
• (Only 2 out of 3 possible)
B. Theory of the “Open Economy Dilemma”
• There is considerable opinion that some
controls on capital inflows may be necessary,
as these flows have the potential to be highly
disruptive to emerging market economies.
• For example, Rey (2013) has shown the
existence of a global financial cycle, where
asset prices in emerging markets and
developed economies move up and down
together, regardless of whether the exchange
rate is fixed or floating.
Dilemma vs trilemma
• The “dilemma” theory – which is based on an empirical
insight called the global financial cycle - posits a
breakdown in the “trilemma” theory as follows:
• even if an economy chooses a floating exchange rate,
monetary independence and free capital flows, then
the global financial cycle will mean that monetary
policy independence is not in fact possible
• The key empirical question in choosing between these
theories is whether in countries like SA:
– Is monetary policy (interest rate setting) determined by
the international cycle (‘dilemma theory’ or by domestic
conditions (‘trilemma theory’), in other words the
‘dilemma theory’ suggests that where the capital account
is open the international cycle overwhelms monetary
policy
What happens if when there is an uptick in
global financial cycle
• According to the “trilemma” theory if SA chooses a floating exchange rate and
free capital flows it will be able to retain monetary policy independence
– i.e. lower risk aversion and rising asset prices in the US would result in falling US
interest rates and the free-floating SA Rand would strengthen (as capital inflows are
attracted by the rising interest rate differential between the US and SA), as the
rand strengthens inflationary pressures are reduced in the SA economy
– i.e. the SA interest rate is set based on SA inflationary conditions - of which
international cycle is a component- rather than primarily following the
international cycle
• According to the “trilemma” theory if SA chooses a fixed exchange rate and
free capital flows then SA will not have an independent monetary policy
– i.e. if US asset prices rise and US interest rates go down then SA will also have to
reduce its interest rates in order to avoid a strengthening of the SA Rand
• According to the “dilemma” theory theory whether SA chooses either a floating
exchange rate of a fixed exchange rates make no difference
– i.e. when US interest rates go down then the SA interest rate goes down (and vice
versa)
– Conclusion is that monetary independence is lost, unless SA is prepared to
implement controls over capital inflows.
Why the ‘trilemma’ is questioned?
• The “trilemma” states that free capital mobility
and independent monetary policies are only
feasible if exchange rates are floating.
• But the evidence shows that whenever capital is
freely mobile, cross‐border flows transmit
monetary conditions globally, even under floating
exchange‐rate regimes.
• The global financial cycle transforms the
trilemma into a “dilemma” i.e. independent
monetary policies are possible if and only if the
capital account is managed, directly or indirectly.
Evidence of Global financial cycle
• Evidence:
– Strong commonality in gross capital inflows and
outflows around the world
– Negative co‐movements of these gross flows with
the VIX, index of market risk aversion and
uncertainty i.e. empirical insight if uncertainty
falls (VIX falls) then capital flows rise
– Credit flows are especially pro‐cyclical.
What drives the financial cycle?
• Rey’s analysis suggests monetary policy in the
centre country (US) is an important determinant
of the global financial cycle
• When the Federal Funds rate goes down, the VIX
falls, banks’ leverage rises, as do gross credit
flows. (The VIX is the Chicago Board Options
Exchange Market Volatility Index, a popular
measure of market volatility)
• A fall in the VIX leads to an increase in global
domestic credit.
Policy implications of “Dilemma” theory
• impose targeted capital controls (or accept a loss of monetary
policy independence):
– If this is not done then when the central bank’s of large economies,
such as the US and EU, lower interest rates then capital washes into
emerging market economies, potentially fuelling asset price bubbles.
– When interest rates are raised in the US and EU then capital flows are
reversed leading to sharp currency devaluations and other forms of
disruption.
• act on one of the sources of the financial cycle itself: the monetary
policy of the Fed and other main central banks EME OMO);
• act on the transmission channel cyclically by limiting credit growth
and leverage during the upturn of the cycle using macro‐prudential
policies;
• act on the transmission channel structurally by imposing stricter
limits on leverage for all financial intermediaries (e.g. Basel 3 and
Dodds-Frank).
Potential problems with implementing the
policy implications of the “dilemma”
•
•
•
In terms of Rey’s dilemma a country must choose either free capital flows or an
independent monetary policy. This insight may have serious implications for South
Africa, as it suggest that may only be through the limitation of capital inflows that
South Africa will be able to maintain an independent monetary policy, but it does
not consider the considerable adjustment costs of limiting capital inflows for a
relatively low savings economy like South Africa.
Logically, another way of interpreting the policy implication of Rey’s arguments for
a country like South Africa, is that if the adjustment costs for SA giving up capital
flows is too high (and as a result SA cannot give them up), SA may need to come to
terms with the fact that it should not aspire to full monetary policy independence.
In fact, resolving Rey’s dilemma by choosing capital flows rather than capital
controls, would for SA not constitute a complete change from the country’s
historical monetary policy situation. As it can be shown that movements in
international interest rates have historically acted as an important prompt in SA’s
interest rate setting process, indicating that SA’s monetary policy should not be
regarded as having been historically fully independent.
Furthermore, it implies that if South Africa followed the international interest rate
cycle i.e. gave up its monetary policy independence, then the imbalances
associated with capital flows might be diminished. At first blush, this appears to
be ‘overly optimistic’ and a very unlikely conclusion.
Emerging Market open mouth operations
• Another approach is to highlight the need for
developed-world economic policy maker’s to
take greater cognizance of the effects of their
policies on developing countries.
• In this regard, South Africa’s authorities have
used international platforms, such as the G20,
to begin to challenge the disruptive effects of
the global financial cycle. (See quote on next
slide)
SA Statement to G20 (September 2013)
• President Jacob Zuma, in his statement to the G20 Summit in St
Petersburg in 2013, reminded those present that:
• “The summit will take place at a time of increased turbulence in
global financial markets, which has been brought about by
speculation that the US Federal Reserve will soon cut back on the
$85 billion it has been pumping into the financial markets every
month. Emerging economies like South Africa have benefitted
from the actions of the Federal Reserve, as foreign investors have
bought huge amounts of South African government bonds at fairly
low yields and equities. Therefore, the prospect that the Federal
Reserve will cut-off these flows of funds has resulted in emerging
market currency volatility, which has been yet another reminder of
the risks and the potentially destabilising and negative effects that
policies and shocks in major economies can have on other countries
and regions.”
3. Policy implications – a strategic perspective
• Strategic question – how can SA take advantage of the trade and
capital linkages with the global economy?
• Interaction with the international economy gives us positives:
– Markets to sell goods (growth and expansion)
– Access to savings (capital)
– Access to technology
– Access to skills and labour
• And Negatives
– Exposure to shocks
– Exposure to unfair trade
• What is needed is a long-run strategic perspective which we
should expect may suffer short-run reversals as a result of
negative shocks, but which will seek to maximise the positives
and minimise the negatives of our interaction with the global
economy.
Strategic perspective (trade)
• Trade linkages –
– increased exports can assist in expanding access to larger
African and global markets and create space to develop
domestic industry and employment
– Technology transfer can be used to seed the development
of domestic industry and stimulate jobs e.g. through local
content requirements around our infrastructure expansion
– Aggressive positioning is required to make most beneficial
use of trade and to engage assertively in trade conflicts
e.g. British attempt to steal our wine bottling industry
– Geo-political alliances such as those offered through BRICS
and the AU provide an important foundation for this
strategic approach
Strategic perspective (capital)
• Capital linkages –
– The inflow of foreign capital can assist in lowering interest rates
and lowering the cost of investment which will stimulate growth
and investment
– But, short-run capital flows can misalign the currency are
sentiment driven, and can be highly volatile and disruptive
– Should we attempt to mitigate this:
• Through active foreign exchange market intervention using SA’s
holdings of foreign reserves and even build a greater reserve pool
including the reserve of the BRICs countries, or
• by implementing controls over capital flows – there has been some
success in this regard e.g. in Brazil, but the introduction of controls
might trigger the very thing that we are trying to avoid (i.e. volatility
and adjustment costs),
– or should we ‘ride the tiger’ of international capital flows
knowing that they are volatile and sentiment-driven, but that
the benefits (access to capital and lower interest rates) are
greater than the costs (of greater volatility)?
Policy options within this strategic
perspective
Option 1
Option 2
• Floating exchange
rate
• Free capital flows
• Independent
monetary policy
• Weakened / pegged
exchange rate
• Free capital flows OR
• Independent
monetary policy
Pros and Cons of Option 1
• Pros:
– Gives SA access to foreign savings, for as long as there are net inflows this will
finance investment, growth and jobs beyond our own savings base, keep downward
pressure on interest rates
– Caveat – to be effective these capital flows must be channeled into productive
longer run infrastructure investment with positive returns on investment this will
promote growth and employment and boost the level of exports (this important as
foreign ownership of assets lead to the outflow of future dividend payments that
must be countered by export earnings and in-flowing dividends), such a programme
requires a committed long-run policy and a high degree of policy consensus
• Cons:
– The exchange rate is volatile, periods of exchange rate strength driven by capital
inflows lead to falling exports and rising imports (limiting growth and job creation)
– Capital flows are sentiment driven and highly reversible
– Capital inflows can be used to finance consumption and imports rather than
infrastructure investment, industry and employment creation (as such some have
suggested increased consumption taxes or even a higher VAT rate for luxury goods)
– Capital flows are often short-term in nature and can lead to bubbles and to
financialisation of the economy rather than real economic activity
– Capital flows confined to the financial sector can led to increased income inequality
Pros and Cons of Option 2
• Pros
– A weakened Rand will make our exports more
competitive, stimulating investment and jobs
• Cons
– we would have to then give up monetary policy
independence (like Hong Kong our interest rates would
follow those of the country to which we pegged our
currency)
– or we would have to give up on free capital flows likely
resulting in high interest rates and increasing cost of
capital/investment (with significant domestic adjustment
costs if currency inflows dried-up)
– Exchange rate weakening is likely to only provide a
temporary boost as the real exchange rate RE = P*e/P and
if the nominal exchange rate e rises (depreciates) then
domestic prices (P) will rise wiping out the deprecation of
RE
Weighing-up the options
• On the balance of evidence, it would appear that
Option 1 is preferable as it provides access to
foreign financial flows that are essential to the
growth and infrastructure investment phase that we
are undertaking, but this brings with it the risks
associated with exchange rate volatility and with
volatile capital flows.
• Option 1 would also allow SA to position itself as a
capital center for African development – potentially
transforming s-r flows into l-r flows for investment in
Africa
• SA could also try to replace s-r flows with l-r flows
be creating greater long-run policy certainty (such as
debates around the NDP)
Problems with Option 2
• To choose Option 2 and to attempt to fix the exchange
rate at more competitive levels will mean that we
must begin to regulate capital flows at this stage or to
give up our monetary policy autonomy and there is a
real probability that the boost will only be temporary
• This could serve to introduce new kinds of shocks and
volatility to the economy, and would certainly include
serious adjustment costs.
• It would be particularly problematic to adopt any
policy that might cause a sharp drop in investment
flows during the current period of infrastructure
expansion, as this would serve to retard and push up
the costs of such investments.
Two target two instrument policy
• Perhaps, within the ambit of Option 1 we could explore
what has been termed by IMF researchers a “Two
target two instrument policy” (IMF discussion note
SDN/12/01 by Ostry, Ghosh and Chamon (2012))
1. Use the interest rate instrument to maintain low
inflation (primary target)
2. Use sterilised foreign exchange market interventions
(instrument) to ameliorate volatile currency movements
(secondary target)
Note in SA, SARB should be given unlimited swap options
which will enable it to sterilise more cheaply than the
current practice of selling bonds to sterilise and then
servicing those bonds.
How would it work if the rand
strengthens?
• If the Rand appreciates (strengthens)
• Intervene in the foreign exchange market by buying
FOREIGN RESERVES (SELLING RANDS) => weakening
the Rand
• But the money supply will grow, unleashing inflation =>
the to achieve the INFLATION TARGET the intervention
must be sterilised by selling bonds (and there is a cost
in servicing these bonds)
• The limitation is that if inflation persists (and it is the
primary target) then interest rates will have to rise
which may cause the rand to appreciate/strengthen
again
How would it work if the rand
weakens?
• If the Rand depreciates (weakens)
• Intervene in the foreign exchange market by
selling FOREIGN RESERVES (BUYING RANDS) =>
strengthening the Rand
• But the money supply will fall, inflation will fall =>
under INFLATION TARGETING then interest rates
may fall and this may further weaken the rand
• The limitation is that you can only use this
strategy while you are holding sufficient foreign
exchange reserves (and you risk running down
the reserves at times of currency weakness)
Resourcing the Developmental state
• In order to change lives the structure of opportunity SA
must change to provide inter alia for:
– More equitable, quality education
– A National Health Insurance system
– Active Industrial policy to create employment
– Effective trade policy
– Land reform and rural development
– Expanded infrastructure
– Expanded Public Works Programmes
• The state needs the resources to fund such
transformative interventions.
Resourcing the Developmental state
• SA’s macroeconomic policies must be
designed to ensure that sufficient resources
are made available for such development
– These resources come from internal sources –
taxation, borrowing
– And from external sources – trade and investment
flows