Terry mc kinley

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Terry mc kinley

  1. 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. 2. The Globalisation of Inflation <ul><li>Inflation targeting by central banks has usually assumed that inflation is caused by monetary excess, driven by fiscal deficits </li></ul><ul><li>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 </li></ul><ul><li>As global trade and capital flows have become more integrated (especially because of ‘financial globalisation’), inflation itself has become increasingly ‘globalised’ </li></ul><ul><li>CDPR Development Viewpoint #14, Sept. 2008: ‘The Globalisation of Inflation and Misguided Monetary Policies’ </li></ul>
  3. 3. The Globalisation of Inflation <ul><li>Two Resultant Problems: </li></ul><ul><li>The increased volatility of food and oil prices </li></ul><ul><li>Their persistently high levels, even after their peaks </li></ul><ul><li>The first problem is easier to explain than the second: why do higher price levels persist? </li></ul><ul><li>What is the role of financial factors in causing such inflation? </li></ul><ul><li>What kind of policy response is necessary to deal with such factors? </li></ul>
  4. 4. ‘ Asset Inflation’ Vs. ‘Goods Inflation’ <ul><li>What is the difference between ‘asset inflation’ and ‘goods inflation’? </li></ul><ul><li>Commodities such as food and oil have become depositories of short-term speculative investment </li></ul><ul><li>Where does ‘goods inflation’ end and ‘asset inflation’ begin? </li></ul><ul><li>Will such speculation lead to only temporary price volatility, systematic volatility or persistently high levels of inflation? </li></ul><ul><li>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? </li></ul>
  5. 5. Speculative Flows of Capital <ul><li>Speculative flows of capital (especially in the last 20 years) have become a persistent source of price instability </li></ul><ul><li>Asset bubbles in equities and real estate have become well recognized—even now among mainstream economists </li></ul><ul><li>Now asset bubbles in commodities have become a prominent problem </li></ul><ul><li>Such bubbles are a potential problem for both emerging economies (Brazil) and resource-rich economies (Zambia) </li></ul>
  6. 6. Speculative Flows of Capital <ul><li>‘ Hot Money’ financial inflows can have an inflationary impact (on the ‘real’ exchange rate through influencing domestic prices) </li></ul><ul><li>Or an impact on appreciating the nominal exchange rate </li></ul><ul><li>Rapid overvaluation can eventually lead to a sharp depreciation—with an inflationary impact transmitted through imports </li></ul><ul><li>The 2008 crisis experience of Brazil (and its current dilemma) is illustrative of this problem </li></ul><ul><li>Recently, Brazil tried implementing a ‘transaction tax’ in order to slow speculative capital inflows </li></ul>
  7. 7. The Instability of Capital Flows: Brazil’s Experience <ul><li>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 </li></ul><ul><li>CDPR Development Viewpoint #42, December: ‘Brazil in the Global Financial Crisis’ </li></ul><ul><li>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 </li></ul><ul><li>Previously, foreign capital had poured into the economy seeking out high returns on short-term, highly liquid financial assets </li></ul>
  8. 8. The Instability of Capital Flows: Brazil’s Experience <ul><li>Portfolio investors required that they could quickly convert their newly acquired Brazilian wealth into dollar-denominated assets if needed </li></ul><ul><li>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) </li></ul><ul><li>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! </li></ul><ul><li>In other words, they not only precipitated the Brazilian financial and exchange-rate crisis but also helped create its foundations </li></ul>
  9. 9. Some Policy Implications <ul><li>Brazil was particularly vulnerable to such financial speculation because of its high-interest monetary policies (based on inflation targeting) </li></ul><ul><li>It was also vulnerable because it did not manage its exchange rate (as many other countries do) </li></ul><ul><li>Additionally, it did not manage its capital account (as few countries do) </li></ul><ul><li>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 </li></ul>
  10. 10. Some Policy Implications <ul><li>One of the major lessons of such crises is that macroeconomic policies need to be coordinated </li></ul><ul><li>But coordinating fiscal and monetary policies is clearly not sufficient </li></ul><ul><li>These policies also need to be coordinated with management of the exchange rate and capital flows </li></ul><ul><li>But even such coordinated alternative macroeconomic policies cannot avert, by themselves, financial contagion and instability: there is an urgent need for financial regulation </li></ul>
  11. 11. Medium-Term Prospects of Continuing ‘Global Financialisation’ <ul><li>A Protracted Period of Deleveraging looks likely in developed countries (US, UK, Spain): </li></ul><ul><li>Such periods are common after financial crises, especially if there is a resort to public ‘belt-tightening’ </li></ul><ul><li>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 </li></ul><ul><li>Total debt levels remain high (because of the addition of government debt) and are likely to exert a significant drag on growth </li></ul><ul><li>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 </li></ul>
  12. 12. Medium-Term Prospects of Continuing ‘Global Financialisation’ <ul><li>Investment banking (speculation) appears to have recovered and is enjoying hefty profits but not commercial lending for productive purposes </li></ul><ul><li>There appears to be a limited prospect of sustained acceleration of inflation—even though public-sector deficits have replaced private-sector borrowing </li></ul><ul><li>Increased inflation in the medium term is not likely to be due to excessive global demand pressures </li></ul><ul><li>The wild card appears to be international commodity speculation, such as on oil and food </li></ul>
  13. 13. The Pattern of Growth of World Financial Assets <ul><li>Between 1980 and 2007, the value of the world’s financial assets nearly quadrupled relative to global income </li></ul><ul><li>Reaching $194 trillion by 2007, or 343% of global income </li></ul><ul><li>Most of this rapid growth was driven by increases in equities and private debt in developed countries </li></ul><ul><li>These asset classes are now likely to grow more slowly, in line with slower GDP growth—though government debt will be on the rise </li></ul><ul><li>Equities took the biggest hit during 2008, dropping from $62 to $34 trillion globally </li></ul><ul><li>The total value of financial assets fell by 15% in emerging economies and capital inflows dropped by 39% </li></ul>
  14. 14. Medium-Term Prospects of Continuing ‘Global Financialisation’ <ul><li>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 </li></ul><ul><li>Growing economies, such as Brazil, India, Russia and China, appear to be emerging as more likely sites of financial speculation and asset bubbles </li></ul><ul><li>Net new flows into emerging-economy mutual funds rose in 2009 (though cross-border bank lending had not recovered) </li></ul><ul><li>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 </li></ul>
  15. 15. Medium-Term Prospects of Continuing ‘Global Financialisation’ <ul><li>Those with high savings rates, current-account surpluses and pro-active economic management (China) are in the strongest position </li></ul><ul><li>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 </li></ul><ul><li>There is a clearer need than ever for reforms in macroeconomic management, especially for exchange-rate and capital-account management </li></ul>

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