Finance and the Real Economy: Session Two

1. 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

2. 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’

3. The Globalisation of Inflation • Two Resultant Problems: • The increased volatility of food and oil prices • 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?

4. ‘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?

5. 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)

6. 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

7. 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

8. The Instability of Capital Flows: Brazil’s Experience • Portfolio investors required that they could quickly convert their newly acquired Brazilian wealth into dollar-denominated 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

9. 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

10. 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

11. 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 ‘belt-tightening’ • 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

12. 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

13. 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%

14. 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

15. 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