Finance and the Real Finance and the Real Economy:Economy: Session TwoSession Two

Terry McKinleyTerry McKinleyDirector, Centre for Development Policy & Director, Centre for Development Policy &

ResearchResearchMuttukadu Conference on Muttukadu Conference on

‘‘Reforming the Financial System’Reforming the Financial System’26 January 201026 January 2010

The Globalisation of The Globalisation of InflationInflation

Inflation targeting by central banks has usually Inflation targeting by central banks has usually assumed that inflation is caused by monetary assumed that inflation is caused by monetary excess, driven by fiscal deficitsexcess, driven by fiscal deficitsYet just prior to the financial crash, the rise in Yet just prior to the financial crash, the rise in inflation was driven by international factors inflation was driven by international factors (rising food & fuel prices), not domestic factors (rising food & fuel prices), not domestic factors under the control of national policymakersunder the control of national policymakersAs global trade and capital flows have become As global trade and capital flows have become more integrated (especially because of more integrated (especially because of ‘financial globalisation’), inflation itself has ‘financial globalisation’), inflation itself has become increasingly ‘globalised’become increasingly ‘globalised’

CDPR Development Viewpoint #14, Sept. 2008: ‘The CDPR Development Viewpoint #14, Sept. 2008: ‘The Globalisation of Inflation and Misguided Monetary Globalisation of Inflation and Misguided Monetary Policies’Policies’

The Globalisation of The Globalisation of InflationInflation

Two Resultant Problems:Two Resultant Problems:1.1. The increased volatility of food and oil pricesThe increased volatility of food and oil prices2.2. Their persistently high levels, even after Their persistently high levels, even after

their peakstheir peaksThe first problem is easier to explain than the The first problem is easier to explain than the second: why do higher price levels persist?second: why do higher price levels persist?

What is the role of financial factors in causing What is the role of financial factors in causing such inflation?such inflation?

What kind of policy response is necessary to What kind of policy response is necessary to deal with such factors?deal with such factors?

‘‘Asset Inflation’ Vs. Asset Inflation’ Vs. ‘Goods Inflation’‘Goods Inflation’

What is the difference between ‘asset What is the difference between ‘asset inflation’ and ‘goods inflation’?inflation’ and ‘goods inflation’?

Commodities such as food and oil have become Commodities such as food and oil have become depositories of short-term speculative depositories of short-term speculative investment investment

Where does ‘goods inflation’ end and ‘asset inflation’ Where does ‘goods inflation’ end and ‘asset inflation’ begin?begin?

Will such speculation lead to only temporary price Will such speculation lead to only temporary price volatility, systematic volatility or persistently high levels volatility, systematic volatility or persistently high levels of inflation?of inflation?

The world’s financial assets have grown faster The world’s financial assets have grown faster than GDP since 1990 than GDP since 1990 capital has been capital has been increasingly channelled into financial assets increasingly channelled into financial assets rather than productive investment rather than productive investment what is what is the likely effect on inflation?the likely effect on inflation?

Speculative Flows of Speculative Flows of CapitalCapital

Speculative flows of capitalSpeculative flows of capital (especially (especially in the last 20 years) have become a in the last 20 years) have become a persistent source of persistent source of price instabilityprice instability

Asset bubbles in equities and real estate Asset bubbles in equities and real estate have become well recognized—even now have become well recognized—even now among mainstream economistsamong mainstream economists

Now asset bubbles in commodities have Now asset bubbles in commodities have become a prominent problembecome a prominent problem

Such bubbles are a potential problem for Such bubbles are a potential problem for both emerging economies (Brazil) and both emerging economies (Brazil) and resource-rich economies (Zambia)resource-rich economies (Zambia)

Speculative Flows of Speculative Flows of CapitalCapital

‘‘Hot Money’ financial inflows can have an Hot Money’ financial inflows can have an inflationary impact (on the ‘real’ exchange inflationary impact (on the ‘real’ exchange rate through influencing domestic prices)rate through influencing domestic prices)Or an impact on appreciating the nominal Or an impact on appreciating the nominal exchange rateexchange rateRapid overvaluation can eventually lead to a Rapid overvaluation can eventually lead to a sharp depreciation—with an inflationary sharp depreciation—with an inflationary impact transmitted through importsimpact transmitted through importsThe 2008 crisis experience of Brazil (and its The 2008 crisis experience of Brazil (and its current dilemma) is illustrative of this problemcurrent dilemma) is illustrative of this problemRecently, Brazil tried implementing a Recently, Brazil tried implementing a ‘transaction tax’ in order to slow speculative ‘transaction tax’ in order to slow speculative capital inflowscapital inflows

The Instability of Capital The Instability of Capital Flows: Brazil’s ExperienceFlows: Brazil’s Experience

Brazil’s adoption of a ‘transaction tax’ has Brazil’s adoption of a ‘transaction tax’ has highlighted the growing role of the global highlighted the growing role of the global integration of financial markets in integration of financial markets in intensifying the instability of capital flowsintensifying the instability of capital flows

CDPR Development Viewpoint #42, December: ‘Brazil CDPR Development Viewpoint #42, December: ‘Brazil in the Global Financial Crisis’in the Global Financial Crisis’

Late in 2008 Brazil experienced one of the Late in 2008 Brazil experienced one of the largest exchange-rate depreciations in the largest exchange-rate depreciations in the world (more than 60%) even though its world (more than 60%) even though its ‘economic fundamentals’ (current account, ‘economic fundamentals’ (current account, fiscal balance, public-sector debt) looked fiscal balance, public-sector debt) looked satisfactorysatisfactory

Previously, foreign capital had poured into the Previously, foreign capital had poured into the economy seeking out high returns on short-term, economy seeking out high returns on short-term, highly liquid financial assetshighly liquid financial assets

The Instability of Capital The Instability of Capital Flows: Brazil’s ExperienceFlows: Brazil’s Experience

Portfolio investors required that they could quickly Portfolio investors required that they could quickly convert their newly acquired Brazilian wealth into convert their newly acquired Brazilian wealth into dollar-denominated assets if neededdollar-denominated assets if needed

Meanwhile, they could benefit from Brazil’s high real Meanwhile, they could benefit from Brazil’s high real rate of interest and a likely further appreciation of rate of interest and a likely further appreciation of the the RealReal (which they were helping cause) (which they were helping cause)

In late 2008 they spirited their money out of In late 2008 they spirited their money out of the economy BECAUSE OF rising losses in the economy BECAUSE OF rising losses in global financial markets—not because of global financial markets—not because of deteriorating conditions in Brazil!deteriorating conditions in Brazil!

In other words, they not only precipitated In other words, they not only precipitated the Brazilian financial and exchange-rate the Brazilian financial and exchange-rate crisis but also helped create its foundations crisis but also helped create its foundations

Some Policy ImplicationsSome Policy Implications

Brazil was particularly vulnerable to such Brazil was particularly vulnerable to such financial speculation because of its high-interest financial speculation because of its high-interest monetary policies (based on inflation targeting)monetary policies (based on inflation targeting)

It was also vulnerable because it did not manage It was also vulnerable because it did not manage its exchange rate (as many other countries do)its exchange rate (as many other countries do)

Additionally, it did not manage its capital Additionally, it did not manage its capital account (as few countries do)account (as few countries do)

Ironically, the central bank worsened conditions Ironically, the central bank worsened conditions through the sterilisation measures that it through the sterilisation measures that it implemented to mop up liquidity, e.g., selling implemented to mop up liquidity, e.g., selling securities with securities with increasingly shortenedincreasingly shortened maturities maturities and and increasingly higherincreasingly higher interest rates interest rates

Some Policy ImplicationsSome Policy Implications

One of the major lessons of such crises is that One of the major lessons of such crises is that macroeconomic policies need to be macroeconomic policies need to be coordinatedcoordinated

But coordinating fiscal and monetary policies But coordinating fiscal and monetary policies is clearly not sufficientis clearly not sufficient

These policies also need to be coordinated These policies also need to be coordinated with management of the exchange rate and with management of the exchange rate and capital flowscapital flows

But even such coordinated alternative But even such coordinated alternative macroeconomic policies cannot avert, by macroeconomic policies cannot avert, by themselves, financial contagion and instability: themselves, financial contagion and instability: there is an urgent need for financial regulationthere is an urgent need for financial regulation

Medium-Term Prospects of Medium-Term Prospects of Continuing ‘Global Continuing ‘Global Financialisation’Financialisation’

A Protracted Period of Deleveraging looks A Protracted Period of Deleveraging looks likely in developed countries (US, UK, Spain): likely in developed countries (US, UK, Spain): Such periods are common after financial crises, Such periods are common after financial crises, especially if there is a resort to public ‘belt-especially if there is a resort to public ‘belt-tightening’tightening’

During 2000-2008 domestic private and public debt grew During 2000-2008 domestic private and public debt grew by 157% in the UK, 150% in Spain, 80% in France and by 157% in the UK, 150% in Spain, 80% in France and 70% in the US 70% in the US

Total debt levels remain high (because of the Total debt levels remain high (because of the addition of government debt) and are likely to addition of government debt) and are likely to exert a significant drag on growthexert a significant drag on growth

Moreover, the global economy remains vulnerable to Moreover, the global economy remains vulnerable to further shocks: the global debt-to-equity ratio jumped, further shocks: the global debt-to-equity ratio jumped, for instance, from about 124% in 2007 to about 244% by for instance, from about 124% in 2007 to about 244% by end 2008end 2008

Medium-Term Prospects of Medium-Term Prospects of Continuing ‘Global Continuing ‘Global Financialisation’Financialisation’

Investment banking (speculation) appears to Investment banking (speculation) appears to have recovered and is enjoying hefty profits have recovered and is enjoying hefty profits but not commercial lending for productive but not commercial lending for productive purposes purposes There appears to be a limited prospect of There appears to be a limited prospect of sustained acceleration of inflation—even sustained acceleration of inflation—even though public-sector deficits have replaced though public-sector deficits have replaced private-sector borrowingprivate-sector borrowingIncreased inflation in the medium term is not Increased inflation in the medium term is not likely to be due to excessive global demand likely to be due to excessive global demand pressurespressuresThe wild card appears to be international The wild card appears to be international commodity speculation, such as on oil and commodity speculation, such as on oil and foodfood

The Pattern of Growth The Pattern of Growth of World Financial Assetsof World Financial Assets

Between 1980 and 2007, the value of the world’s financial Between 1980 and 2007, the value of the world’s financial assets nearly quadrupled relative to global incomeassets nearly quadrupled relative to global income

Reaching $194 trillion by 2007, or 343% of global incomeReaching $194 trillion by 2007, or 343% of global income

Most of this rapid growth was driven by increases in Most of this rapid growth was driven by increases in equities and private debt in equities and private debt in developed developed countriescountries

These asset classes are now likely to grow more slowly, in These asset classes are now likely to grow more slowly, in line with slower GDP growth—though government debt will line with slower GDP growth—though government debt will be on the risebe on the rise

Equities took the biggest hit during 2008, dropping from Equities took the biggest hit during 2008, dropping from $62 to $34 trillion globally$62 to $34 trillion globally

The total value of financial assets fell by 15% in emerging The total value of financial assets fell by 15% in emerging economies and capital inflows dropped by 39% economies and capital inflows dropped by 39%

Medium-Term Prospects of Medium-Term Prospects of Continuing ‘Global Continuing ‘Global Financialisation’Financialisation’

An increasing share of global asset growth in the An increasing share of global asset growth in the future is likely to occur in emerging economies, future is likely to occur in emerging economies, which will enjoy faster growth and have more which will enjoy faster growth and have more room for expansion of financial assetsroom for expansion of financial assetsGrowing economies, such as Brazil, India, Russia Growing economies, such as Brazil, India, Russia and China, appear to be emerging as more likely and China, appear to be emerging as more likely sites of financial speculation and asset bubblessites of financial speculation and asset bubblesNet new flows into emerging-economy mutual Net new flows into emerging-economy mutual funds rose in 2009 (though cross-border bank funds rose in 2009 (though cross-border bank lending had not recovered)lending had not recovered)Inflationary pressures are more likely to build up Inflationary pressures are more likely to build up in emerging economies where, for example, high in emerging economies where, for example, high real estate prices in certain areas have not real estate prices in certain areas have not undergone any correctionundergone any correction

Medium-Term Prospects of Medium-Term Prospects of Continuing ‘Global Continuing ‘Global Financialisation’Financialisation’

Those with high savings rates, current-account Those with high savings rates, current-account surpluses and pro-active economic management surpluses and pro-active economic management (China) are in the strongest position (China) are in the strongest position In emerging economies without such strong In emerging economies without such strong fundamentals, there is a continuing threat of fundamentals, there is a continuing threat of financial instability, due to rising speculative financial instability, due to rising speculative investment, followed eventually by rapid capital investment, followed eventually by rapid capital outflows, depreciation and likely inflationoutflows, depreciation and likely inflationThere is a clearer need than ever for reforms in There is a clearer need than ever for reforms in macroeconomic management, especially for macroeconomic management, especially for exchange-rate and capital-account managementexchange-rate and capital-account management