Suddenly the worries shift
THE FEAR OF DEFLATION is back on the global agenda. Just six months ago central banks were grappling with concerns about runaway inflation driven by oil prices north of US$150/barrel and food prices looking to spiral out of control. Now the spectre of a prolonged recession as well as the potential of a contraction of the global economy is looming. Six of the world’s biggest central banks last week cut interest rates by 50 basis points in their first co-ordinated effort since the post 9/11 fallout: they’re under pressure to deal with the world’s most serious financial crisis since the Thirties.
However, the remedy did little to convince markets the action would provide any longterm solution to the current malaise. “The banking sector has three inter-linked problems: a huge pool of toxic assets, in the form of mortgage-backed securities; inadequate levels of capital, given that values of assets have had to be written down dramatically; and a lack of funding liquidity,” says Kevin Lings, chief economist at Stanlib. “No asset class or investment market has been immune from the impact of slowing global growth and the increased risk aversion that’s resulted from the global financial system crisis.”
In just a few unprecedented short months, the dynamics of the global economy have changed. Inflation is still at historically high levels in South Africa, as it is in most Western economies. In the United States inflation still has a way to fall after it came in at 4,5% in July – its highest level since 1991. In Britain it’s above 5% – more than twice the level of its inflation target.
Markets are suffering a severe bout of indigestion.
“When asset bubbles burst the highest risk one faces is deflation and the biggest problem comes in geared assets, where values drop below what’s owed on them,” cautions Chris Hart, chief economist at Investment Solutions, who also warns there are no quick fixes to the crisis.
Credit has dried up as banks that have cash hoard it, fearful of the liabilities that lurk in the financial system. Though frenetic efforts to restore liquidity and confidence to the financial system have at times appeared to stem some of the initial panic, investors remain dubious about the ability of authorities worldwide to restore stability.
“Credit is the oxygen of business,” says David Beim, professor of finance at New York’s Columbia University. “Without it companies and economies suffocate.”
SA is still seeing positive growth. However, recent currency weakness and falling precious metals prices threaten that position. “SA’s economy is already in a consumer-led downturn that’s yet to bottom,” says Sanlam group economist Jac Laubscher, warning that this country’s economic growth may already have slowed to around 2%. He’s concerned export volumes and values could be driven lower, which would negatively affect the current account and says capital flows are likely to come under pressure.
The threat of deflation – an environment where a general decline in prices persists – is often caused by a reduction in the supply of credit. The global credit crunch, which has seen liquidity dry up and interbank lending slow to a trickle, provides an ideal breeding ground for that to happen.
The consequences of deflation can be far more destructive and long lasting than inflation. It becomes increasingly harder for economies to extricate themselves from an environment where increased unemployment drives a lower level of demand in the economy, which can ultimately lead to an economic depression.
The rate cuts by central banks in the US, Britain, EU, Switzerland, Sweden and Canada were just one of the measures implemented by foreign governments last week. The US Federal Reserve also unveiled plans to buy up short-term corporate debt. Interest in short-term corporate debt had all but dried up in recent weeks, making it hard for companies to access operating capital.
The British government last Wednesday announced a £50bn rescue package aimed at making extra capital available to its biggest banks and building societies in return for preference shares. Effectively, it’s a partial nationalisation of the banking system. Absa’s controlling shareholder Barclays plc was one of the banks that announced it would be taking part in the scheme.
Former Fed chairman Alan Greenspan managed to stave off the threat of deflation five years ago as inflation sank to around 1%. He cut interest rates aggressively and the threat receded. But many now argue the current financial crisis was sparked by unsustainably low rates that were kept too low for too long.
The International Monetary Fund last week warned the economic crisis worldwide was deepening and increased its estimate of financial sector losses due to the sub-prime crisis and subsequent financial meltdown to US$1,4 trillion. In its quarterly assessment of global capital markets, the IMF said world economic activity is slowing as growth in advanced economies decelerates and – possibly more concerning – that emerging economies have started to lose momentum.
South African investors have seen the consequences of that through plummeting resources shares, which have been affected by sharply lower commodity prices.