Absorbing bad news in waves

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By Cees Bruggemans

This is turning out to be a trying month for most emerging markets.

With relative low per capita incomes, their inflation baskets are heavily weighted with food and oil costs.

This has made emerging-market inflation rise much faster than developed-country inflation in response to rapidly increasing commodity prices, moving in most instances well outside their inflation targets. Especially so in countries where basic consumer products are not subsidized (explaining why South Africa’s inflation virulence of late is even greater than in some other countries, such as India).

This inflation breakout is creating a dilemma for macro-policymakers. Protect growth and accept higher inflation? Or protect the hard-won long-term gains on the inflation front by temporarily accepting slower growth?

The answer seems to be pretty uniform. Last week oil reached $115, agricultural commodity prices continued to escalate, and Brazil and India increased interest rates.

South Africa and Iceland weren’t after all alone or in a unique situation when they raised rates the week before. A large number of countries have now tightened.

In the case of South Africa there is an additional factor to take into account, namely our exposed external situation and what this means for the rand and its knock-on implications for inflation.

Back in 2003, our households started to whoop it up early, having successfully absorbed our political adjustment a decade earlier. Even so, our industrial policymakers were still tangling with the mining industry about tax regimes and mining rights. Between these responses, we basically committed ourselves to a growing savings shortfall and current account deficit, as consumption outranked savings, imports outshone exports.

In contrast, Brazil at the time (early 2000s) was still digesting Lula da Silva as President, something that induced much uncertainty, low business confidence and even less investment commitment.

Thus Brazil was growing its domestic demand very slowly for some years even as global conditions started hugely favouring its commodity exports and their prices. This combination of events forcefully boosted its trade account deep into surplus, in turn inviting even larger capital inflows, firming their currency and suppressing inflation.

The same more or less happened to us, except that with us the domestic boom started much earlier and much more vigorously, while our domestic preoccupations prevented us from reaping the export gains they did.

This led the world to mark us down early as a bad risk in terms of deteriorating trade accounts despite record capital inflows. From 2005 our currency started to weaken, since then assisting inflation higher.

In the case of Brazil, it took much longer to take their economy into booming territory. They took their time in the 2000s getting used to Lula, not unlike us politically in the mid-1990s. Brazil thus only fairly recently became enticed by all the liquidity and falling interest rates.

But now their economy is also finally pumping at full capacity, the current account surplus is eroding, but more importantly the relentless rise in global commodity prices has also started to boost their inflation levels.

Same story in India, where the global commodity prices could ultimately not be fully contained, of late pushing their CPI inflation easily through 7% (in China’s case already through 8%).

With low to middle single-digit inflation targets in all these countries, the consequences are straightforward. Domestic players are going to put up their wage demands and prices, unless the economic environment induces them not to do so. The only real inducement not to do so is more competition and fear, in other words economic slack, a heavy price to pay for continuing inflation stability.

It is much easier to convince a population of being the beneficiary of a windfall than having to accept impoverishing news.

Windfalls are joyfully received, and in a democracy not easily denied by policymakers. Incoming capital windfalls tend to be absorbed into higher consumption, boosting the growth performance, making business more confident and willing to incur risk, making the growth acceleration more permanent. Also, not so incidentally, in the process it fills the government’s pockets with tax bonanzas, allowing it politically to play kindly uncle to the poor and others not equally benefiting from the incoming global windfalls.

It would perhaps have been wise to prevent the generosity from becoming too big and preventing interest rates from falling as far and the currency from firming as much, by earlier starting to deflect the windfalls into a sovereign wealth fund, aiming for global investment.

But South Africa, Brazil and India didn’t think in those terms, being far too growth preoccupied and much more inclined to absorb the incoming windfall immediately rather than over time (as a sovereign wealth fund would allow them to do).

Events that impoverish the nation tend to be received quite differently. Whether it is a bunch of Viking raiders coming ashore, an earthquake devastating a region or drought punishing farmers, a modern market system and democracy tend to be entitlement driven. So protect me from all devastations, oh Lord, and compensate me in case of losses.

When global financial raiders devastate the currency, pushing up imported prices and global commodity producers gain advantage from rising prices by levying effectively a commodity tax on all global consumers, a modern market system and democracy tend to unite in their responses.

Claim the natural right to defend thyself by insisting on compensation, by demanding higher wages as labour and passing on any cost increases as businesses, defending the profit margin. For this to work, it needs of course, to be accommodated by the nice man at the central bank who has to usefully oblige by printing more money, making it all possible.

That’s the problem with a fiat (paper) currency where money can be created out of thin air, unlike an old metal standard (gold, silver) where one had to physically obtain such resources first. A paper currency does give one flexibility to print as much of the stuff as participants may decide on.

So the ultimate defence barrier for a fiat currency dispensation against printing too much money is to have an independently-run central bank. In other words, a bunch of appointed technocrats with no links to any vested interests, be it government, labour, business, or whoever. A professional money manager willing and able to protect the common good against narrow vested interests, whoever they may be (the thing Keynes apparently really feared most).

This sounds a bit idealistic, of course, as are all human constructs, but nonetheless doable.

And so, like the good sports that they really are, though generally low on humour, bar one or two exceptions (being ‘real’ characters), central bankers today are stepping into the breach that has suddenly opened up. Not only as bailers of last resort (as in the US and Europe), but also as anti-inflation defenders of last resort (in Europe, but also in most of the rest of the world).

After a period of good growth, adversity has hit in the US as its housing and banking sectors have to be reconfigured after exceptional speculations. This is coming at the cost of growth, which is also eroding growth elsewhere (though not nearly devastating to the same degree).

But simultaneously, the exceptional Asian growth, along with a myriad of insidious global supply constraints, has pushed commodity prices of all stripes to record highs.

Good for producers who benefit from the higher incomes. But universally bad for all consumers, on whom it is acting like an impoverishing tax.

The first human impulse to such a tax is defensive. Attack is accepted as a superior defence. This was again on display in recent weeks as there were organized marches on selected retailers, as if these poor middlemen were to blame for what is happening higher up the global distribution chain. Or the criticism on our farmers who happen to be enjoying record harvests due to good rains and good product prices, but whose costs (nearly all energy-based) have gone through the roof as well.

No, the problem resides globally, is intractable, and will likely get worse before it gets better, going by the apparent intractable nature of the supply problems.

Consumers have a choice between accepting this commodity tax for what it is (a relative change in prices which reduces their real income, just like the Minister of Finance does when he increases our tax rates); or seeking wage compensation by forcing their central banks to be more forthcoming by allowing more money printing. The latter option would vest a higher inflation rate, which will have long-term costs of its own, far worse than the temporary commodity price setback.

And the answer?

You guessed it. Take a hike. Possibly more than one. But the bottom line is ‘grin and bear it’. Inflation is a scourge on society, influencing economic decisions for the worse by favouring inefficient hedging rather than real investing. It devastates the poor, who have no negotiating power, except politically. A can of worms if ever one was invented.

So, yes, instead of accepting higher inflation expectations, rather adapt your real income and spending expectations. Use fewer commodities, go for less expensive substitutes, make savings elsewhere in the spending basket. How about less yakkidiya? Saving more on electricity and gaining a double bonus? Delay replacement of just about anything, for it will hugely benefit the household cash flow and reduce the pain of having less income, yet not unduly reducing the living standard for the time being, as your existing goodies probably have a lot of useful life left. Also, repair rather than replace, except when it is no longer sensible to delay.

Meanwhile, collectively behave yourself, prune those tail feathers a bit, make lots of eyes, for the global commodity producers now have growing sovereign wealth funds, who like tax farmers of old, after squeezing you half to death, are now also increasingly coming to look over your remaining assets (daughters?) and whether there is something nice to buy.

Yes, sir, we have an entire stock exchange for sale, about R6 trillion worth of assets of which so far barely R1 trillion currently in foreign hands. Mind you, we only need R150 billion annually, and a fair portion of that is already supplied (we don’t quite understand how but don’t let that bother you). So, yeah, do board us with your hard-earned dollars and buy some more of our equities. Hopefully, in the process you will assist in causing the entire stock of equities to go up in value, and if per chance they could start growing again at 16% per annum, your annual take will in any case be chicken feed in the greater context of things.

Always a silver lining, not so?

Not only are the newly rich global parvenus looking for investment diversification but the US banking crisis also seems to be stabilizing following the Bear Stearns decision (the Fed effectively guaranteeing the continuation of any large institution capable of devastating the system). The Fed may start slowing down its rate cutting (next cut possibly only 0.25%, down to 2%), and this may also mildly assist the dollar, in turn creating less global stress.

And less global strain is now also at a premium for us. For a beggar like us with 7%-of-GDP shortfalls can’t afford periods of global stress and deepening risk aversion, as we seem to get it in the neck first nearly every time, weakening the rand and thereby increasing our domestic woes (higher inflation and interest rates and yet weaker growth).

So, yes, please let up globally, will you.

This may also mean that the rand after all has less downside than upside, remaining below 8:$. This could assist the virtuous process of reducing inflation, especially once Eskom tariff increases have been digested this coming July.

Besides, these oil and food price escalations have to slow down sometime. Only in fairytales do beanstalks grow to heaven. In real life all escalations end eventually under their own weight, even if sometimes things really can get ridiculous before the tide finally turns. It could well be that the Fed slowing down its rate cutting, and ultimately bottoming out later this year, is the real key to slowing down the commodity speculation as well.

So if for now the situation is grim, hang in there. It will eventually end. Consumers and central banks should therefore be united in seeing this through, focusing on what’s important longer term and not allowing themselves to be hijacked by short-term events, however painful.

It looks like another rate hike in June, and thereafter August looms, unless someone changes the rules of the game before then. And little can be certain at present as we collectively wing it through these trying times.

Source: Cees Bruggemans, Chief Economist, FNB, April 22, 2008.

 

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