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The South African Index Investor
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Newsletter: June 2006
The World According to SARB
By Daniel R Wessels
The South African Reserve Bank (SARB) is the primary custodian of the South African monetary and
financial system and defines its primary objective as the achievement and maintenance of price stability.
Therefore the Reserve Bank identifies and analyses potential risks to financial stability on a continuous
basis and its assessment is published in the semi-annual Financial Stability Review. In this month’s
newsletter I comment on the March 2006 publication with specific focus on the major risks to global
economic and financial stability.
The Bank perceives among the key risks to global economic and financial stability the phenomena of
global imbalances, inflated asset prices (especially real estate prices in certain areas), the abundance of
global savings with the associated search-for-yield, and the possible mispricing of risk with the extended
period of favourable economic conditions and low levels of volatility in financial markets.
The ever-growing imbalance between countries with a current account deficit and those with a current
account surplus is probably the biggest risk facing the global economy (see also my March 2006
newsletter). In fact, we are getting so used to it by now that some economists are referring to this
imbalance as the “stable disequilibrium”. In essence it boils down to two macro-players, the USA and
Asia, whose relationship could be described as symbiotic in so far as Asia needs the US consumer to
buy its goods and the US needs Asia to finance its consumption. The net result is that the USA accounts
for 70% of the world’s current account deficits, while Japan and China (both with currency reserves in
excess of $850bn) together hold about 45% of the total issued US treasury securities!
China’s economy as a proxy for the Asian economies is predominantly export-led with domestic
spending modest by comparison and high saving ratios. The spectacular rise of China’s economy is
certainly nothing short of amazing. Merely two years ago its currency reserves were only (?) $450bn
while Japan’s reserves stood at $800bn; today China has pushed Japan out of the top spot with
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reserves in excess of $875bn. But this was done by pegging its currency (yuan) to the dollar in order to
sustain China’s competitiveness in the global arena. Other Asian countries have followed more or less
similar strategies by quasi-pegging their currencies to the US dollar. Typically, these countries hold most
of their reserves in US dollar, a decision which is probably more driven by their need to support US
dollar strength than pure economic sense.
On the other side of the scale the US economy is typified by very low savings and huge current account
deficits (7% of the US GDP), a trend that accelerated over the past few years aided by the effects from a
boom in the US housing market.
Typically, one would expect the currency of a nation experiencing such current account deficits to
depreciate sharply with a resultant slowdown in economic growth. Given the dominance of the US
economy in the global arena, world economic growth and financial stability will take a serious
hammering if such a scenario should unfold. Furthermore, sharp dollar depreciation would be even
worse for the foreign holders of US dollar securities, such as the Asian countries, simply because the
value of their holdings, which is primarily invested in US dollar, will be quickly diluted. Therefore, until
today no sharp dollar depreciation has occurred because there are sufficient financiers, and probably for
more self-centred reasons than simply diversification or ultimate faith in the US economy, to make up
the US current account deficits.
Indeed, a stable disequilibrium is in place and this can continue for some time still, but in the end no
country, not even the US, can indefinitely increase debt without foregoing some of its attractiveness to
investors. If such an adjustment in capital flows to the US should take place in a disorderly manner, it
could be very costly and disruptive to the global financial system.
The major global players are fully aware of this conundrum. Hence, it is worth noting that both Japan
and China are shifting their economic policies, which include “looser” exchange rates, to promote
domestic demand in their own economies. Thus, their economic policies will be more inwardly focused
as opposed to export promotion at all costs. Furthermore, China has recently tightened its monetary
policy, while Japan is considering doing away with its zero interest rate policy (ZIRP). In effect it means
that global liquidity will be more contained than we have seen in the recent past. Whatever transpires,
one can only hope that this position of extreme imbalances will slowly unwind without disastrous effects
on global economic growth.
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A direct consequence of a global economy fuelled by cheap finance has been the steep increase in real
estate prices over the past few years across most Anglo-Saxon markets. Whether one perceives the
real estate market as a bubble or not, a few facts cannot be overlooked. First, the ratio of house prices
relative to average household income is at record highs; and second, economic growth has been
boosted substantially by the housing boom. For example, it is estimated that the housing boom in the
US has contributed one-third of economic growth over the past two years. But bear in mind that the
benefits of the rise in housing prices are relatively short-lived, especially if not accompanied by fixed
investment in productive capital as opposed to consumer spending only.
The scary part is that if analysts are correct in arguing that residential values are much higher than
market fundamentals would suggest, a fall in national house prices, for example of 10% in the US, could
reduce economic growth by between one and two percent! No reason exists to doubt that the same
effect will not be seen in those economies that experienced similar real estate price increases.
A further consequence of the extended favourable economic conditions around the globe has been
surging stock markets with relatively low volatility over the past two years. In fact, in many cases stock
market volatility is only half the usual measure. However, such conditions invariably lead to the
mispricing of risk, in other words investors on the aggregate are prepared to pay too much for risky
assets, which more than likely will unwind with disappointing returns.
High energy prices and spiking commodity prices have been characteristic of global markets over the
past few years. The oil price is unlikely to fall materially in the near future, especially with the growing
demand from China and oil supply problems stemming from political tensions in Nigeria, the Middle East
and South America. The spectacular rise in the gold price is certainly driven by speculative demand, but
nonetheless perhaps a good indicator of a global economy not at ease with possible dollar depreciation,
inflationary concerns and geopolitical tensions around the globe. Commodity prices in general should
moderate with a slowdown in global economic growth and tightening of monetary policies in the US,
Europe and Asia.
The emerging-market economies have been a major beneficiary of the current economic cycle with
record foreign investment and equity portfolio inflows. In general these countries were able to build
considerable reserves and balance-of-payments positions, because they have benefited largely from
high oil and commodity prices, low interest rates and continued investor appetite for risk. The position of
increased reserves means that these countries should be more resilient to future shocks. For example,
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when one measures the ratio of reserves relative to foreign short-term debt (the so-called Guidotti ratio)
South Africa’s ratio increased from a modest 0.2 in 1996 to a sound level of 1.5 in 2005. [Countries like
Thailand, Korea and Indonesia have ratios of 5.4, 3.1 and 2.1 respectively.]
Notwithstanding the above favourable trends, emerging-market economies face some specific risks.
While the credit spread among emerging-market countries narrowed to extremely low levels – around
200 basis points versus 900 basis points only three years ago – further interest rate hikes in the US or
other developed economies may cause a change in investors’ sentiment, which will lead to a reversal of
capital flows and correction in asset prices. But given the much better currency reserves position
described above, a similar occurrence of the meltdown of emerging markets, which happened in 1997
and 1998, is highly unlikely.
The outlook for South Africa’s economy on face value has not looked better in decades than right now.
Business confidence and consumer confidence metrics are indicating fantastic numbers. However,
some dark clouds are appearing which could easily turn into a formidable storm. Strong consumer
spending, fuelled by aggressive credit growth, has led the SA economy into a current account deficit
situation, roughly 4.5% of GDP. At the moment that is not particularly worrying since portfolio flows
make up more than the deficit, but nonetheless the exchange rate of the rand is susceptible to changes
in investors’ sentiment.
Credit growth has accelerated since 2003 to such an extent that household debt as a percentage of
disposable income has reached a record level of 66%, but the financing cost (interest) of household
debt makes up only 7% of disposable income. This number is not really problematic assuming interest
rates remain more or less stable.
Yet, whether interest rate stability and for that matter the high economic growth scenario will remain
intact is to be seen. First of all, the developed economies are concerned about inflation and will continue
on their path to squeeze out excess liquidity. This may cause global investors to repatriate their
investments from emerging markets to relatively high yielding instruments in developed markets (exactly
what started to happen during the middle of May). Due to South Africa’s substantial current account
deficit, the rand is exposed and may depreciate fairly rapidly. Eventually a weaker rand will have an
adverse effect on inflation numbers which will leave the Reserve Bank with little option but to increase
interest rates. This in itself will have a slowdown effect on economic growth, if it has not already been
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brought about by a global slowdown in economic growth. In short, I expect a challenging economic
period, despite all the current positive indications of a strong growing economy.
How will the above scenario affect stock market returns? Knowing that economic growth and stock
market returns are not necessarily highly correlated, I still have little reason to believe that stock market
returns in the next three to five years will closely resemble the kind of returns we have seen in the past
three years. I do not expect disastrous returns, but rather subdued or below-average returns.
One final thought: how the economic future will pan out is always uncertain as many variables, some of
which have been sketched above or others not discussed at all, might have the dominant say.
Nonetheless, one should perhaps prepare for a period of lower global economic growth as the world
comes to grips with getting rid of excesses that might have been caused by the current period of
buoyant growth with cheap and easy credit. I do not expect disasters, but I am certainly not
extrapolating the immediate past as the basis for my future expectations.
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