Global Economy

Global economy’s greatest test since 1930s depression?


Diverging monetary strategies by major economies and trade blocks are likely to not only trigger serious currency turbulence but to confront the present global financial/monetary system with its sternest test yet.

A complicated set of interacting factors impacting on the system of global capital flows, from Switzerland’s recent ‘competitive devaluation’-manipulated oil markets to Europe’s version of quantitative easing, could soon test capital flows across the global economy, including emerging markets like South Africa.

As talk about ‘currency wars’ becomes increasingly frequent, the governor of the Bank of England at the just concluded meeting of the World Economic Forum (WEF) in Davos, Switzerland warned about a “liquidity storm as (the) global currency system turns upside down”.

Regulators have cleaned up the banks and tried to prepare for the tectonic shift taking place in the international currency structure, but major risks remain. “This will test the resilience of that new financial system. It has a potential feedback and we have to be aware of that,” he said.

Currency war already on

At the WEF, Goldman Sachs President Gary Cohn said the world has been in a currency war since Japanese Prime Minister Shinzo Abe's policies started pushing down the yen's rate two years ago. 

The authoritative website Bloomberg last week, in response to Europe’s quantitative easing move, reported that other central banks, in India and Canada among others, have been cutting rates and weakening their currencies too.

US hedge fund manager Ray Dalio predicted the moves could lead to a “short squeeze” on the US dollar, like the one seen in the 1980s, which required concerted action from central banks to curb the dollar's rise and prevent the US economy from tanking. This time, however, such action is far less likely because countries such as Italy see QE as their big chance to restore growth. It's certainly easier to print money than to raise productivity closer to the US level.

But it might not be all that simple and could rather demonstrate the limited ability of authorities to manipulate market forces indefinitely. A dissenting voice on the ‘currency war’ theme came last week from the magazine The National Interest.

It described the move by the Swiss National Bank (SNB) to give up its peg of the Swiss franc to the euro as part of recent and likely currency moves as “much less a matter of targeted, warlike policies than they are a reflection of economic and financial fundamentals that have continued, and for the time being at least will continue, to favour the swissie and the dollar over the euro and most other currencies. The only targeted currency policy was Switzerland’s efforts to keep its franc cheap, and the central bank’s action signals defeat, not the start of a war.”

The Swiss story started in 2011 when in response to the ongoing eurozone fiscal/financial crisis money flooded into Swiss franc, pushing its value up by 25% against the euro between late 2009 and August 2011. The SNB intervened by selling francs and buying euros to keep it at 1.20 to the euro.

The theory was that since Switzerland can create as many francs as it wishes; this policy could be maintained indefinitely. The assumption turned out to be false and the un-pegging was in response to the then eminent introduction of QE by the European Central Bank (ECB) in the face of fears of Japanese-like deflation.

At the same time it has taken interest-carrying deposits in francs further into negative territory at -1.25%.

Another source of the disruption of markets is what has been happening to the US dollar, having gained about 15% against a composite of world currencies, including 18% against the euro over the past six months. The National Interest argues that this is a reflection of true market and economic conditions, which will be strengthened if the US follows through with plans for an increase in interest rates, pulling capital towards the US economy.

This trend has serious implications, especially for developing nations where companies have borrowed up to nine trillion US dollars, the cost of repayment of which keeps climbing.

The United Kingdom’s Carney said last week he is “particularly concerned about an illusion of liquidity” that has existed in a number of financial markets. “I would say that illusion of liquidity is gradually being disabused,” he said, adding that the so-called ‘flash crash’ in the US Treasury market last October was a wake-up call even if the bouts of losses have been small so far.

Mr Carney said the global authorities have clamped down on excess leverage and the sort of behaviour by banks that caused the financial crisis seven years ago, but new worries have emerged. 

The scale of dollars held by mutual funds is so large – as much as $35 trillion – that should they in a crisis all head for the exit door, it might become a disaster, hence the ECB’s response with their own version of QE.

South Africa

In Davos, South African governor of the Reserve Bank, Lesetja Kganyago, reacted cautiously to the ECB’s stimulus package, including the €1.1 trillion QE and said it would be “positive” for the country if it worked to stimulate the European economy. However, he felt it was two years too late.

He also said that the Reserve Bank would wait for the “second-round effects” of the sharp drop in oil prices before making a policy response. 

While about 25% of South African exports go to the EU the advantage on that side might be largely negated by a depreciation of the euro. It is also unlikely to stimulate capital flow to the country.

Last week Kganyago’s approach proved to be prudent when the Cold War type sanctions and the plunging oil price saw Standard & Poor’s downgrade Russia’s credit rating with a broader negative sentiment towards emerging markets, including South Africa. For South Africa, combined with the long shadow of the electricity supply crisis, the net result was a further weakening of the rand against the dollar.

Bottom line

ECB governor, Mario Draghi, was at pains to explain that the bank’s target is not the exchange rate but to avoid stagnation, stimulate growth and get the inflation rate up to around 2%. Devaluation has, however, already proven to be an unavoidable side effect, taking the euro to its lowest level against the dollar in eleven years and taking Europe, and the globe’s financial system, into uncharted territory.

The bottom line is that no one really knows how the witches’ brew of the present round of effective devaluation, manipulated oil prices and an emerging Cold War II will eventually play out. In the words of a trader on the New York Stock Exchange, as far as it shapes up “the book has not yet been written”.

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by Piet Coetzer

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