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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