Transcript Finance and the Real Economy: Session Two

Finance and the Real Economy:
Session Two
Terry McKinley
Director, Centre for Development Policy & Research
Muttukadu Conference on
‘Reforming the Financial System’
26 January 2010
The Globalisation of Inflation
Inflation targeting by central banks has usually
assumed that inflation is caused by monetary
excess, driven by fiscal deficits
Yet just prior to the financial crash, the rise in
inflation was driven by international factors
(rising food & fuel prices), not domestic factors
under the control of national policymakers
As global trade and capital flows have become
more integrated (especially because of ‘financial
globalisation’), inflation itself has become
increasingly ‘globalised’
 CDPR Development Viewpoint #14, Sept. 2008: ‘The
Globalisation of Inflation and Misguided Monetary Policies’
The Globalisation of Inflation
Two Resultant Problems:
1. The increased volatility of food and oil prices
2. Their persistently high levels, even after their


peaks
The first problem is easier to explain than the
second: why do higher price levels persist?
What is the role of financial factors in causing
such inflation?
What kind of policy response is necessary to
deal with such factors?
‘Asset Inflation’ Vs.
‘Goods Inflation’
What is the difference between ‘asset
inflation’ and ‘goods inflation’?
 Commodities such as food and oil have become
depositories of short-term speculative investment
 Where does ‘goods inflation’ end and ‘asset inflation’ begin?
 Will such speculation lead to only temporary price volatility,
systematic volatility or persistently high levels of inflation?
 The world’s financial assets have grown faster
than GDP since 1990  capital has been
increasingly channelled into financial assets
rather than productive investment  what is the
likely effect on inflation?
Speculative Flows of Capital
Speculative flows of capital (especially in the
last 20 years) have become a persistent source of
price instability
 Asset bubbles in equities and real estate have
become well recognized—even now among
mainstream economists
 Now asset bubbles in commodities have become a
prominent problem
 Such bubbles are a potential problem for both
emerging economies (Brazil) and resource-rich
economies (Zambia)
Speculative Flows of Capital
‘Hot Money’ financial inflows can have an
inflationary impact (on the ‘real’ exchange rate
through influencing domestic prices)
Or an impact on appreciating the nominal
exchange rate
Rapid overvaluation can eventually lead to a
sharp depreciation—with an inflationary impact
transmitted through imports
The 2008 crisis experience of Brazil (and its
current dilemma) is illustrative of this problem
Recently, Brazil tried implementing a ‘transaction
tax’ in order to slow speculative capital inflows
The Instability of Capital
Flows: Brazil’s Experience
 Brazil’s adoption of a ‘transaction tax’ has
highlighted the growing role of the global
integration of financial markets in intensifying
the instability of capital flows
 CDPR Development Viewpoint #42, December: ‘Brazil in the
Global Financial Crisis’
 Late in 2008 Brazil experienced one of the largest
exchange-rate depreciations in the world (more
than 60%) even though its ‘economic
fundamentals’ (current account, fiscal balance,
public-sector debt) looked satisfactory
 Previously, foreign capital had poured into the economy
seeking out high returns on short-term, highly liquid
financial assets
The Instability of Capital
Flows: Brazil’s Experience
 Portfolio investors required that they could quickly convert
their newly acquired Brazilian wealth into dollardenominated assets if needed
 Meanwhile, they could benefit from Brazil’s high real rate of
interest and a likely further appreciation of the Real (which
they were helping cause)
 In late 2008 they spirited their money out of the
economy BECAUSE OF rising losses in global
financial markets—not because of deteriorating
conditions in Brazil!
 In other words, they not only precipitated the
Brazilian financial and exchange-rate crisis but
also helped create its foundations
Some Policy Implications
Brazil was particularly vulnerable to such
financial speculation because of its high-interest
monetary policies (based on inflation targeting)
It was also vulnerable because it did not manage
its exchange rate (as many other countries do)
Additionally, it did not manage its capital account
(as few countries do)
Ironically, the central bank worsened conditions
through the sterilisation measures that it
implemented to mop up liquidity, e.g., selling
securities with increasingly shortened maturities
and increasingly higher interest rates
Some Policy Implications
 One of the major lessons of such crises is that
macroeconomic policies need to be coordinated
 But coordinating fiscal and monetary policies is
clearly not sufficient
 These policies also need to be coordinated with
management of the exchange rate and capital
flows
 But even such coordinated alternative
macroeconomic policies cannot avert, by
themselves, financial contagion and instability:
there is an urgent need for financial regulation
Medium-Term Prospects of
Continuing ‘Global Financialisation’
A Protracted Period of Deleveraging looks likely in
developed countries (US, UK, Spain):
Such periods are common after financial crises,
especially if there is a resort to public ‘belttightening’
 During 2000-2008 domestic private and public debt grew by
157% in the UK, 150% in Spain, 80% in France and 70% in
the US
Total debt levels remain high (because of the
addition of government debt) and are likely to
exert a significant drag on growth
 Moreover, the global economy remains vulnerable to further
shocks: the global debt-to-equity ratio jumped, for instance,
from about 124% in 2007 to about 244% by end 2008
Medium-Term Prospects of
Continuing ‘Global Financialisation’
Investment banking (speculation) appears to
have recovered and is enjoying hefty profits but
not commercial lending for productive purposes
There appears to be a limited prospect of
sustained acceleration of inflation—even though
public-sector deficits have replaced private-sector
borrowing
Increased inflation in the medium term is not
likely to be due to excessive global demand
pressures
The wild card appears to be international
commodity speculation, such as on oil and food
The Pattern of Growth
of World Financial Assets
Between 1980 and 2007, the value of the world’s financial
assets nearly quadrupled relative to global income
 Reaching $194 trillion by 2007, or 343% of global income
Most of this rapid growth was driven by increases in
equities and private debt in developed countries
These asset classes are now likely to grow more slowly, in
line with slower GDP growth—though government debt will
be on the rise
 Equities took the biggest hit during 2008, dropping from
$62 to $34 trillion globally
The total value of financial assets fell by 15% in emerging
economies and capital inflows dropped by 39%
Medium-Term Prospects of
Continuing ‘Global Financialisation’
An increasing share of global asset growth in the
future is likely to occur in emerging economies,
which will enjoy faster growth and have more
room for expansion of financial assets
Growing economies, such as Brazil, India, Russia
and China, appear to be emerging as more likely
sites of financial speculation and asset bubbles
Net new flows into emerging-economy mutual
funds rose in 2009 (though cross-border bank
lending had not recovered)
Inflationary pressures are more likely to build up
in emerging economies where, for example, high
real estate prices in certain areas have not
undergone any correction
Medium-Term Prospects of
Continuing ‘Global Financialisation’
Those with high savings rates, current-account
surpluses and pro-active economic management
(China) are in the strongest position
In emerging economies without such strong
fundamentals, there is a continuing threat of
financial instability, due to rising speculative
investment, followed eventually by rapid capital
outflows, depreciation and likely inflation
There is a clearer need than ever for reforms in
macroeconomic management, especially for
exchange-rate and capital-account management