GEOPOLITICS, INTEREST RATES AND THE GLOBAL ECONOMY
By: Roy Tanga.
Policy actors and mechanisms have to adopt to the changing policy landscapes of the new century. Beyond the orthodox beliefs, domestic policies are increasingly having an influence over the borders of their respective jurisdictions, as economic policies and politics of the day, in a way shape the global economy. This paper tries to project the thoughts of the author, while welcoming other contributions on the correlation between geopolitics, interest rates and the global economy.
By 2020, half of the world’s savings and investment will be in emerging markets and Africa, last year investors poured USD 50 billion for mutual funds that invest in developing countries, according to EPFR Global. Zambia, Angola, and Nigeria, one of the biggest commodity-dependent economies in the continent have also received their fair share from the China slowdown and a lack of a diversified economy leading to devaluations in their respective currencies and a significant impact o the Zambian Kwacha. The S&P 500 index of the biggest publicly traded companies hit a record of 2135 on the 21st of May, before sliding by 12.4 per cent three months later as oil prices weakened and on the China slowdown, leading to increased unemployment in oil related sectors, especially in Dakota, U.S. The effects of falling oil prices on Russia and Venezuela sent the economy into a recession, and for the case of Russia, capital flight, weakening currency; the Rubble, geopolitical instability and sanctions, from the EU and the U.S had a devastating impact on the economy.
Inevitably geopolitical chaos has a significant impact on the market, seen in the Russia- Ukraine crisis of Crimea and its annexation, giving a blow to Russia’s biggest energy player, Gazprom and sending the Ukrainian Hryvnia into a tailspin.
The Trans pacific partnership trade pact majorly involving Japan, the U.S and the countries of the Pacific Rim has had major economic and geopolitical strategic importance to Japan and the United States and the basis of which will have a big impact on the trade between Europe and North America.
Interestingly, the European Central Bank (ECB) is set to extend their quantitative easing policies, likely by the end of the year; this will definitely be beneficial to the emerging markets and Africa, as there will be increased capital in flows to their bond markets and in the form of foreign direct investment which Africa needs to best the levels of employment, with Kenya having more than 40 per cent of the population unemployed. The U.S, The E.U, The U.K and Japan’s respective currencies are reserve currencies and as such, the resulting inflation is simply exported abroad. Quantitative easing and ultra low interest rates affect the cost of housing, as money is more readily available for housing due to low interest rates, leading to high housing prices and the effect on the real estate sector. With the rapid real estate development in Africa and the effect on infrastructure financiers, such a policy makes financing cheaply available, while eroding the profitability of the banking and the financial markets.
Quantitative easing became popular in the period of the financial crisis of 2008, when Ben Bernanke was chair of the U.S Federal Reserve (2006-2014) to inject liquidity into the markets and prevent a catastrophic failure of the financial system and to revive the flow of credit within the global economy, which he shares in his book, “The Courage to Act: A Memoir of a Crisis and its Aftermath”, in which he also shares his perspective about the economic future.
Jeremy Corbyn of The Labour Party, in his paper, “The Economy in 2020” shares an interesting version of Quantitative easing for the people (People QE) and not for banks, where the Bank of England will be given a mandate to upgrade the British economy to invest in new large scale housing, energy, transport and digital projects and to strip out some of the huge tax reliefs and subsidies on offer to the corporate sector, which amounts to £93 billion a year to be used in direct public investment, which would in turn give stimulus to the private sector supply chains and use this fund to establish a national investment bank to invest in new infrastructure. It has been at the core of the UK’s Labour Party in their policy blueprint to establish a British Investment Bank and to keep Britain in the EU; this obviously has strong economic and geopolitical implications.
As of 21st September of this year, the Federal Reserve had maintained the interest rates at ultra-low rates (0 percent). Low interest rates pump liquidity into the market to spur economic growth. High interest rates encourage a saving behaviour and as well ensure profitability for financial services sector. The increase in the interest rates is done when the economy begins to recover and if done too early, it can slow the momentum of economic growth.
When interest rates rise, the public sector debt service costs rise as well. Rising interest cost on debt would put government’s budgets under additional stress, forcing the government either to raise taxes or cut spending on key projects and sectors.
As is the case currently with the Fed, those that take up loans as the rates are this low, could be greatly affected when interest rates rise, as servicing this loan will be more expensive.
The current ultra-low interest rates in the United States, have forced capital outflows from the United States to Africa and the emerging markets, especially to their bond markets. Ultralow interest rates have an effect have an effect on capital flows to emerging markets, especially foreign investor purchases of emerging market bonds, issued by governments and corporates, due to low yields in advanced economies as investors search for a higher return elsewhere.
Capital flows can be divided into two categories;
a) Foreign Direct Investment, where foreign entities make a direct involvement by putting up factories and companies, to the benefit of the employability of the locals
b) Foreign investors make portfolio investment into the bond and stock markets, which don’t have as many benefits as foreign direct investment, which Kenya can do a great deal to improve.
The Renminbi Effect
Commodity producing economies such as Zambia have been greatly affected by the China slowdown that resulted to a double devaluation of the Yuan, because of this devaluation, commodity based economies that sell their raw materials to China, which is the biggest market for commodities felt the pressure.
Shortly after the devaluation, Bank of America indicated that a 1 per cent devaluation of the Yuan resulted into a 0.5-0.6 per cent fall in U.S dollar commodity prices. With a lot of involvement of Brazil, Chile, Zambia and Venezuela these economies are most vulnerable. The China effect followed downturns in U.S stocks, with the S&P 500 and global stock markets being hit.
The Chinese government control, through the People’s Bank of China (PBOC) of the onshore Yuan as the offshore Yuan is determined by the market. On the 2 per cent devaluation of the onshore Yuan or the “Government’s Yuan”, the offshore Yuan or “Market Yuan” fell 2.5 per cent and this has a negative effect on commodity prices.
Inevitably, devaluations, lead to capital flight, as investors move their money somewhere else in expectation of a further fall. This may be great news for holders of U.S dollar denominated assets and not great news for the holders of the assets in the devalued currencies, with China’s corporate debt environment having the biggest debt, according to Standard and Poor (S&P), China’s companies holding euro or dollar denominated debt have higher interest payments, according to Bloomberg, this adds 100 billion U.S dollars to their 529 billion U.S dollar in debt. Here in Kenya, according to the Auditor General’s report, the country’s stock of debt stands at 2.5 trillion shillings, with Treasury insisting that this debt is manageable. For the dollar-denominated debt, increase to the interest rates will increase the debt and the same could apply to euro-denominated debt.
With the current Federal Reserve rate at 0 per cent and the weakening of African currencies against the U.S dollar, how further will the local currencies weaken against the dollar when rates rise? And what will happen to the African economies’ dollar-denominated debt? My guess is that this will put a lot of pressure on governments’ budgets and consequently the government will be caught between raising taxes and cutting spending, there should be a balance between fiscal and monetary policies. Fiscal deficits and debt are the source of economic instability, which is currently the case in Kenya, especially with the ballooning wage bill of 52 per cent of all revenue collected.
Economies engage in competitive devaluation or “Currency Wars” to encourage the export sector’s growth and for the case of China, her exports fell by 8.9 per cent between July 2014 and July 2015. The other thing is that the policy makers in Beijing are trying to move the economy from “export-based” to a domestic consumption-based and this can be done by making the currency cheap to encourage local uptake of liquidity, unlike doing the opposite (increasing the value of the currency) through higher interest rates to promote the dollar-denominated export sector and make it more attractive and promote a “more domestic” based economy rather than a foreign-investor based.
According to Bloomberg economist, Tom Orlik, “The risk is that depreciation triggers capital flight, dealing a blow to the stability of China’s financial system” and by extension the financial markets, with a big blow to the Shanghai Composites, Orlik goes ahead to state “our calculations is that 1 per cent Yuan depreciation against the dollar triggers about 40 billion dollars in capital flight”
In such a situation, a central bank should be more cautious about global stability than domestic aspirations as to avoid huge capital flights, while promoting the “people’s economy”. In my opinion, this devaluation and the aspirations by Beijing for a more domestic economy makes the housing prices in China more expensive and the general real estate sector and definitely having well defined consequences for the Africa China controlled real estate sector for example as Christopher Lee of the S&P Hong Kong says “Chinese property developers have lots of offshore debt outstanding, more than 20 per cent f their total debt for some”
It is quite tricky, devaluation for China can cost billions of dollars in capital flight and debt servicing, which could have been used in infrastructure projects, which China has a high reputation in, with the Asian Infrastructure Investment Bank (AIIB) for infrastructure development in the BRISC economies and gauging by how the these countries’ financial markets and their economies responded to that, especially Brazil.
Due to China’s corporate debt and as history has generously shared with us; China’s has been forced to bail out a number of local corporations to save thousands of jobs and in the event of any further depreciation of the Yuan against the dollar and other major foreign currencies, there could be more bail outs and more defaults, and this is a terribly delicate ground to be played on by a central bank.
Two way trade between China and the U.S has grown from 33 billion dollars in 1992 to 590 billion dollars in 2014, especially in machinery (U.S is China’s largest export market) as well China is a popular destination for U.S foreign direct investment, with more than 60 billion dollars in the manufacturing sector.
Japan and China are largest holders of U.S treasury bonds worth trillions of dollars. It has been argued that the massive involvement of Japan and China in U.S treasury bonds and the substantial amounts of forex reserves as a safe and stable way to maintain an export-led economy. Imagine if Japan and China, the greatest holders of treasury debt dumped their bonds, how will this affect the U.S dollar?
China’s been selling their U.S treasuries to prevent the Renminbi from weakening as a monetary policy tool, as abrupt selling would prove not feasible due to a lack of an alternative. Since 2005, the Yuan has appreciated by 25 per cent against the dollar, giving room for devaluation. As according to The Wisdom Tree Dreyfus Chinese Yuan Fund, for measuring changes of the U.S dollar relative to the Yuan. China’s new focus of growing the domestic consumption will see a loose approach on her sovereign wealth fund and the internationalization of her currency could see a strengthening of the Yuan (due to demand factors as the Yuan Renminbi seeks to become a reserve currency beyond the borders of China) and there will be a continued dilution of U.S treasury bonds held by The People’s Bank of China. Japan overtaking China as the largest holder of treasury bonds signals China’s new change of course.
The future of the East African monetary union could borrow a leaf from the Maastricht Treaty and what’s been happening with The Greece Debt Crisis, forcing the Greek banking sector to desperate measures such as capital flight and stricter rules on the use and move to crypto currencies such as bitcoin.
The Greece debt crisis provide a good case study for a future monetary union aspiration by any group of countries, as this automatically mean a loss of monetary policy sovereignty. According to a documentary by Al Jazeera, the crisis in Athens was as a result of a dark connection between Wall Street derivatives market and the debt in 2001. At the time, the rules governing the euro common currency were not friendly to Greece, having a debt of €600 million or about $660 million. Through a currency swap, where Greek debt issued in dollars and yen was exchanged for euros at very low rates and the investment house, Goldman Sachs set up an off-market interest rate swap to lower their debt through a currency deal. This swap made 2 per cent of Greek debt to disappear and in return the Greek government was charged a premium and revenue from the Greek tax payers.
There should be a balance in fiscal and monetary policy and a reduction in the debt to Gross Domestic Product ratio for an assured economic future for the general population.
• International Journal of Central Banking
• U.S foreign trade balance http://www.census.gov/foreign-trade/balance/c5700.html
• QE and Ultra-low interest rates: Distributional effects and risks by Richard Dobb, Susan Lund, Tim Koller and Ari Shwayder
• Global Impact and Challenges of unconventional monetary policy, IMF policy paper, October 7th 2013
• John C. Williams, “Lessons from the Financial Crisis for unconventional monetary policy” presented in Boston Massachusetts October 18th 2013
• The U.S Department of State http://www.state.gov/documents/organization/229096.pdf
GEOPOLITICS, INTEREST RATES AND THE GLOBAL ECONOMY
A discussion paper
Submitted to: The Central Bank of Kenya
Author: Roy TANGA
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