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SOUTH AFRICA IN A CHANGING WORLD:

CURRENT WORLD ECONOMIC TRENDS AND CRISES

2012/16/27

Dr. Mark EllyneUCT Summer School 2012

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Lecture Outline

• Some general world trends of the last 30 years• Economic transmission of crises• International imbalances• The Sub-Prime financial crisis• The Euro crisis and Greece• Implications for South Africa2012/16/27

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I. The World Is Growing Rapidly19

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8000Population (millions)European UnionSouth AsiaLatin America & Carib-bean (all income levels)Sub-Saharan Africa (all income levels)World

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Re-gions

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Living Standards Are Rising1969

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World (left)

Latin America (left)

USA (right)

East Asia (incl China) (left)

South Asia (incl india) (left)

Sub-Saharah Africa (left)

$ per annum USA, $

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II. Economic Geography of the World Economy is Shifting

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, bn

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$ billions% of World

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Geography of World Economy is Shifting

1980 % Share

2010 % Share

USA 2,888 26.0 14,527 23.1European Union

3,652 34.1 16,242 25.8

South American

845 7.9 4,834 7.7

Asia 667 6.2 9,536 15.2 China 203 1.9 5,878 9.3Africa 277 2.6 1,049 1.7 South Africa

81 0.8 364 0.62012/16/27

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III. The World Economy is More Integrated

•World trade is growing 50% faster than nominal GDP• International capital flows are

growing faster than trade• Telecommunications/internet

makes international investment opportunities more easily available

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IV. Is the Economy is More Volatile?

Reinhart and Rogoff, This Time Is Different“... financial crises are nothing new.”“There have been at least 250 sovereign

default episodes during 1800-2009”“ Today’s emerging market countries did

not invent ... repeated sovereign defaults. Rather, a number of today’s now-wealthy countries had similar problems when they were emerging markets.” 2012/16/27

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Volatility Remains in Commodities19

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Food Price In-dex

Oil Price/barrel (left)

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US$/barrrel Index

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V. More Economic Convergence?1980

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Lowest re-gional growth

Highest regional growth

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Inflation Has Been Variable but Converging

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Observations

1. World growing strongly2. Economic geography changing3. World is more integrated4. Volatility remains5. More convergence?

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VI. Economic Transmission Mechanisms

How are shocks transmitted internationally? Trade-related (traditional) linkages

Financial and Contagion linkages

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Traditional Shock Transmission to Africa – Foreign Demand

• Lower demand from Rest of World —especially advanced economies — reduces demand for African exports (and vice versa)• IMF estimates that a 1% slowdown

in GDP in the rest of the world leads to a 0.5% slowdown in SSA

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Traditional Shock Transmission to Africa - Other

• International prices affect African import and export prices• Economic conditions in advanced

economies affect foreign aid levels• Economic conditions in advanced

countries affect worker remittances to Africa

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Financial Transmission

Interest rate is key mechanism for international economic

transmission•With capital mobility, interest rates of small

countries tend to move toward the interest rate of large open economies.• Raising the interest rate in a small country

tends to strengthen the exchange rate, and/or increase capital inflows.

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Balance Sheet EffectsCommercial Risk

Assets LiabilitiesCommercial Loans DepositsGovernment Bonds

= Net Worth (>0) (Shareholder capital) (Reserves/past profits)

Bad loans → Net Worth ↓Reduce Capital2012/16/27

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Balance Sheet Effects:Foreign Borrowing & Exchange Risk

Assets (Rand) Liabilities (Rand)Commercial Loans DepositsGovernment Bonds

Shareholders Capital

Domestic Loans Borrow $ FundsValuation Effect (-)

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Balance Sheet EffectsForeign Investment & Exchange Risk

Assets LiabilitiesCommercial Loans DepositsGovernment Bonds

Invest in Foreign AssetsBad Loans (-)Valuation Effect (-) Net Worth ↓

Shareholders Capital ↓2012/16/27

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Contagion

• A liquidity crunch in an advanced economy can spread to smaller markets as economic agents (individuals + companies) look for cash.• A contagion effect may result when

economic agents believe that a crisis in one country will occur in other similar countries.

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VII. Global Imbalances Problem

• The exchange rate should adjust to ensure the tendency toward current account balance, so country’s current account balance cycles around 0 for stability.• Sustained deficits (or surpluses) for long

periods indicate some other serious structural problem.

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Persistent Current Account Surpluses And Deficits are a Problem

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Implications of Current Account Balance

• Current account Deficit → capital account borrower, or debtor

(and vice versa: Surplus → Creditor)•Deficit → Currency depreciates [Surplus → Currency appreciates]

• But what about China and USA?2012/16/27

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China - USA Symbiosis

• China has large surpluses so its currency should appreciate• China loans USA large amounts of

money (by buying US government treasury bills) to continue trade imbalance without adjusting• And, China’s exchange rate is fixed

to US$2012/16/27

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Is China Adjusting

1980 Q1 1983 Q1 1986 Q1 1989 Q1 1992 Q1 1995 Q1 1998 Q1 2001 Q1 2004 Q1 2007 Q1 2010 Q10

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Reserves/GDP (left)

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Is China Adjusting?

1980 Q1 1983 Q1 1986 Q1 1989 Q1 1992 Q1 1995 Q1 1998 Q1 2001 Q1 2004 Q1 2007 Q1 2010 Q10.00

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Same China Story with South Africa?

2012/16/27

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Is China Helping or Hurting Us?

• Persistent large surplus → exports are too cheap?

•Who receives the benefits?

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VIII. 2008-09 Financial Crisis

What happened?•US and international banks invested in

US subprime mortgage bonds because they provide good return•Quality of those bonds deteriorated•Banks have balance sheet imbalance —

fewer assets than liabilities (deposits)Liquidity Crunch

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2008-09 Sub-Prime Financial Crisis

What to do?• Raise more capital from shareholders

o Takes money out of system• Stop lending and call in loans

o Fewer loans mean less economic growth• Issue: Is this systemic risk that

requires official intervention?

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“Moral Hazard” Question

• Let them go bankrupt• Bailouts

encourage bad behaviour of banks• Must be

consequences for risky behaviour

• Bailout needed• To protect others

and prevent panic widespread financial meltdown• Must restore

profitability of banking system

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Official Response to Financial Crisis

• Central bank buys bad assets at full value; i.e. swaps bad bonds for good government treasury bills, thereby improving solvency of banks• Fed reduces interest rates to stimulate

lending• Government provides fiscal stimulus to

offset reduction in private sector activitySide effects: rising government debt

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Consequences

• Banks stop lending to reduce risk, become profitable, and rebuild their balance sheets: reduce bad debts, increase capital and cash, raise profits. Result is recession.• Government stimulus creates rising

government debt and fear of debt crisis.Should we be fighting recession or

debt crisis?2012/16/27

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IX. Greece & the 2011 Euro Crisis

What Happened• Rising Greek government debt service created

an expanding budget deficit•Market perceived government inability to pay

debt service•Government can no longer sell treasury bonds

at same low interest rate thus making deficit worse•Debt trap: need to run fiscal surplus just to

get out of debt; Can’t grow out of your debt/GDP ratio

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2011 Euro Crisis

What to do• Cut government deficit → raise taxes and cut

spending (ouch!)•Have European Central Bank buy Greek

treasury bonds at low interest rate = “Bailout”•Make all holders of Greek debt take a “Haircut”

(i.e. forgive debt)•Greek must leave Euro and devalue currency

to reduce domestic demand and stimulate exports

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Why Leave the Euro?Flexible Exchange Rate Adjusment

• If country has high inflation or its production costs become uncompetitive at the existing exchange rate, it should depreciate to make exports cheaper and imports more expensive

Depreciation→ M↓ and X↑2012/16/27

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Adjusting With a Fixed Exchange Rate

• To stimulate private sector activity while contracting public sector, must reduce unit labour costs to make Greek economy more internationally competitive• If you can’t devalue currency,

must cut wages2012/16/27

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But…Is This Just a Greek Problem?

•Who is holding Greek debt? EU commercial banks are threatened• Is this a European sub-prime crisis?• If the EU is current account is in

balance, should surplus countries in EU also be adjusting?• How to ensure that Greek

government behaves in the future?2012/16/27

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Meaning for South Africa

• SA is an open economy that has a current account deficit and financial account surplus, owing to its large financial sector and stock exchange.• It is subject to international trade

shocks and financial contagion.• Thus, good economic policy is

necessary to avoid contagion effect.

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Characteristics of South Africa Economy

• South Africa’s fiscal deficits are 3-5% of GDP, which are moderate.• Government debt is about 48% of

GDP, which is a safe level.• Inflation is moderate (4-7%) and

the real interest rate (interest rate-inflation) is low.• The exchange rate is volatile.2012/16/27

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Questions and Discussion

•World trends – is anything new?•Global imbalances – who’s fault is it?• The subprime crisis and financial

asset shocks – can we prevent another one?• The Euro Crisis – who will save the

euro?

2012/16/27