Sud­denly the wor­ries shift

Finweek English Edition - - News -

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.

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