Global Economy in Crisis: Minister of Finance briefing

Meeting report

Address by the Minister of Finance: Global Economic Crisis
Hon Trevor Manuel, Minister of Finance, commented that he, together with exchange rate and other officials of the National Treasury, had just returned from a harrowing schedule of international meetings that centred around trying to understand the current global economic environment, discussing remedies to the problems and examining how to proceed in future. These meetings had included a meeting with the Commonwealth Ministers of Finance, the World Bank and International Monetary Fund (IMF) International Monetary Fund International Monetary and Financial Committee, the Meeting of African Ministers of Finance Ministers and Planning and Governors of Central Banks and the Meeting of the G-20 countries’ Ministers and Governors. The message that arose from these meetings was that work would continue at an intense pace until April in order to deal with the ramifications of the financial crisis.

He noted that the communiqués tabled were very important as they spoke to observations, changes and the internalised impact of the global economy on countries. This was not the time to crow about issues, but was a time for leadership that would include leadership from the legislators. The National Treasury had always had a good relationship with the Portfolio Committee on Finance, and indeed with Parliament, and hoped to continue in that spirit.

The Minister quoted George Soros and Warren Buffet and their comments on "over the counter" derivatives. He also specifically noted what happened with AIG and their contracts being recalled and labelled "toxic debt". The real problem with AIG’s default was that the insurance they had provided to ordinary people was lost. Such losses would dominate; they would have a once-in-a-lifetime impact on people and this was the biggest kind of loss since the deposit crisis of the Great Depression in 1929.  There was a need to apply minds to what was needed in South Africa..

Mr Lesetja Kganyago, Director-General: National Treasury, reviewed the origins of the crisis and the manifestations emanating from the financial sector. The global economic outlook and a study by the International Monetary Fund (IMF) emphasised that the most pronounced economic recession impact was preceded by a banking crisis. These recessions tended to be more serious and more protracted. The scenario for South Africa in a global context could be examined from the point of view that the IMF kept revising figures downward. The current environment was a forecaster's nightmare and had its roots in an era of very cheap credit. The global abundance of liquidity had encourage return / yield seeking which meant that investors constantly assumed more risk as yields fell, in order to maintain the returns margins.

He provided the Committee with a brief explanation of sub-prime. A sub-prime borrower was not the same as a prime borrower.; the distinction was that the former was not regarded as credit worthy. Such borrowers were colloquially referred to in the USA as ninjas - no income, no jobs and no assets. This made these borrowers a greater risk on loans, as they posed the real risk that when prices (specifically house prices) fell and debt servicing costs increased due to higher interest rates, these borrowers would default on their loans.

He traced the roots of the crisis back from the early signs in August 2007 to the present pivotal events. He said that in the period between August 2007 and November 2007 there were notable losses of BNP Paribas, the run on Northern rock, the fall of share prices, Global Central Banks and coordinated liquidity injections. Further impacts were the predictions of Mark-to-market losses of $200 billion on the US mortgage related securities, the Merrill Lynch loss, the write-downs of UBS, Deutsche Bank, Merrill Lynch, Nomura and Citigroup.  In December, the central banks had to inject liquidity into the grid locked credit market. The crisis steadily deepened through 2008. In January 2008, the USA Federal Reserve (the Fed), in an unprecedented move, had  cut rates by 125 basis points in two steps over nine days. By March 2008, there were more co-ordinated interventions by the central banks, crossing over into exchange transactions. Bear Stearns was acquired by JP Morgan Chase for $2 a share. In September Fannie Mae and Freddie Mac, the USA mortgage federally-sponsored corporations, were taken into ‘conservatorship’ by the USA government. Lehman Brothers filed for bankruptcy, the remaining investment banks apply to become deposit taking banks and the Fed loaned $85 billion to AIG, showing that the problem was more widespread than previously thought.

In October, the Dow Jones Industrial Average (DJIA) lost 22.1% in one week.  The world Central Banks made more co-ordinated interest rate cuts. This was accompanied by transfers of capital from emerging markets to the advanced markets – or the so called "flight to quality". The G7 countries agreed on a five point plan of action and the G20 Finance Ministers and Central Bank governors called an extra-ordinary meeting, addressed by President Bush. The G7 interventions precipitated a stronger flight of capital away from emerging markets. By this point the financial market crisis was filtering into the real economy, resulting in rapidly falling commodity prices.

Mr Kganyago reported that the deteriorating economic growth prospect was well illustrated by Japan's confirmation of a recession that morning. The bulk of the growth would come from the emerging markets. The major capital outflows in the near term would hit share prices, resulting in large exchange rate movements worldwide. Generally a reduced risk appetite was creating flight to the dollar and the yen. China’s contribution to world growth was still high, but slowing. The rapid fall in commodities prices was a double edged sword for South Africa. This concerned the major South African exports of gold, coal and platinum and its major import of oil. Lower commodity prices meant a lower petrol price, and lower earnings on exports. Inflation was likely to fall, resulting in lower interest rates over time.

He said that the income earned by South African exporters remained relatively high for now. Household debt levels continued to moderate. The resultant slower growth would lower the current account deficit.  South African policy was aimed at maintaining investment in future and sustaining the financing of the current account deficit.

Mr Kganyago noted the Japanese yen and stated that in the flight to quality there had been reinvestment in the Japanese equity markets, away from riskier regions. The Japan Nikkei had depreciated significantly.  The Johannesburg Stock Exchange (JSE) had not taken as big a knock as it was better diversified. In South Africa the currency also acted as a shock absorber. The producer price index (PPI) was showing a decline of a full 3%. This would inevitably filter into the consumer price index (CPI). He noted that South Africa had not yet seen the second-round effects of the increases in electricity tariffs and the oil and food price decline. Even as these effects filtered through, South Africa was still above the target inflation band. As household debt levels moderated, there had been a stabilisation of figures and these should begin to come down. At the current rate of 12,5%, South Africa had a real negative interest rate.

Mr Kganyago stated that the critical question for South Africa was where it should be placed when the global cycle turned. He said that for some countries, lending and borrowing were seizing-up. The effects on South Africa would be that as commodity prices increased and foreign demand for exports decreased, this  would lead to lower growth in GDP, or lower economic growth. As food and oil prices decreased, inflation would also decrease. As the rand depreciated that would have a counter-effect of increasing inflation. The short term adjustments envisaged on the demand side were that the fiscal deficit would support consumption and investment. In the long-term the domestic side needed to be more productive, more export-oriented, have a higher saving and investment rate, and produce more rapid growth.

Mr Manuel then tabled slide 16 of the presentation, on household debt levels. This formed the key area of debate on policy. It was indisputable that the problems in the USA were caused by copious amounts of cheap credit being available and the disconnect between savings and leveraging. He stated that there had too frequently been arguments against inflation targeting. They had advocated a move toward a low interest rate and cheap credit. Many measures in the future would pivot on credit, savings and dependence on foreign savings.
The current account deficit was a manifestation of the savings and investment imbalance in South Africa. It was too soon to tell if South Africa was reaching the turning point. The gap still had to be financed offshore in the form of portfolio investment. South Africa had to take steps to mitigate the losses due to the sudden slowdown in such investment.

He referred to the G20 Action Plan. The critical question for South Africa was where it should be after the storm had passed. The opposing forces of earnings on gold and losses on oil were the subject of vigorous debate at the National Treasury. Day traders often responded quickly to isolated indicators, but there was a much bigger picture to consider. To this end the National Treasury had had a counter-cyclical fiscal policy with the maintenance of the fiscal surplus over recent years. The previously projected GDP growth of 6% would have been ideal, but the projection for this year was 3,7%. In view of this, it would be important to stay the course. Real growth would come from micro interventions to boost exports to sustain economic growth.

He referred back to his Medium Term Budget Policy Statement (MTBPS) speech, stating that policy decisions were sometimes controversial. These decisions were based on a long term view. Policy makers and day traders could not be equated. Members of Parliament should focus on policy issues, not the noise on any given day. The financial sector inevitably spilled over into the real sector as the prices of inputs that were determined affected every successive level of the value chain. The linkages had to be understood.

Mr Manuel referred Members to several paragraphs of the International Monetary and Financial Committee communiqué, specifically paragraphs 2, 4 and 5. He then highlighted also paragraphs 3, 6, 7 and 10 of the Communiqué of the G-20 Meeting of Ministers and Governors for attention

The Minister referred broadly to the G20 action plan, with reference to the outcomes of the communiqués. The main issues that had arisen included the spending to maintain progress on the Millennium Development Goals (MDG). Wealthy countries would also still be required to maintain their aid flows as the implication of a lapse in this area would be a set-back for international development.

He reported that the National Treasury was in the final stages of the budget and would take account of all of the issues. Policy would have to be flexible, but the National Treasury would not lose its foresight. It would continue to look into the issues as a member of the G20. He stressed that unrealistic expectations for the future must be avoided.

Discussion
Mr B Mnguni (ANC) commented that the bail outs were viewed by certain economists as a bad practice, and that banks were reckless to resort to such bailouts, using the central banks as lenders of last resort. He asked the National Treasury to explain the rationale as to why there should be a bail out.

The Minister responded that the much vexed question in the story of the bail out was when support to bad management would stop.  The big problem was that if borrowers could not secure future revenue streams, then household consumption would die and as a result, economies would die. There was a need to keep the financial sector going to that end. The ideal was that matters should be kept as generic as possible, but a balance would be found between ensuring accountability, transparency and objectives. Objectives, in particular, should be made clearer. The financial institutions could not keep coming back for bail outs, as this begged the question of where this would end. It was not possible simply to respond to those whose voices were the loudest. There was indeed a challenge in making the policy decision.

Mr Mnguni referred to the comments made on the importance of co-ordinated effort by the central banks and noted that the South African Reserve Bank (SARB) was in transition. He asked what the SARB's role would be here.

The Minister responded that the transmission mechanism, which was a process by which a change in the repo rate caused a change in spending and inflation over time,  in monetary policy was actually very slow. He referred the Committee to the slide on household debt (Slide 16) and again noted its importance. The interest rate was high in 1998. The interest rate decrease was probably led by the downturn in household debt. In 2004, the levels at which people were taking credit compelled the SARB to take action. With the resultant increase in interest rate, household debt rose, in accordance with the higher cost of servicing debt. In Germany the savings rate was much higher. In the USA, with the current lack of savings, the line would soar off the graph. The challenge for the SARB was now how to  finance that debt.

Mr Mnguni commented on the use of futures, forwards, interest rate swaps and other "over the counter" derivatives, and the implied intention by investors to subvert regulations and escape supervision. He asked if financial stability could be expected in South Africa under the current regulatory regime.

Mr Kganyago responded that there was nothing wrong with derivatives if used correctly. They were, in fact, an essential component of the international financial system. Hedging risk was a very old concept and it used derivatives in the forward and futures. Many derivatives were publicly traded. The Brent Crude price was used as an example. This trade was usually conducted based on the future price, not on the spot price. Producers in an economy used that future price to forecast production costs. The experience with the “over the counter” derivatives was different. They were regulated but the problem was that many other financing instruments were written on the back of these derivatives. The investors struggled to keep up with the pace of the additional derivatives, and this led to a failure in accounting. When accounting failed, problems were introduced. In the quest to sort out the accounting, they had introduced procyclicality. When financing instruments were marked “to market”, meaning at fair market value, the balance sheets of companies would grow when the market rallied. By the same token, the balance sheet would decline when the market declines. An unintended consequence was thus this procyclicality.

Although any regulation could be contravened or abused by some people, regulations were very important. The market had over time formed some contrary perceptions. He never thought the Iceland bankruptcy could cause markets to gyrate like that.

The overlying movements were difficult to explain, especially those of the rand. The life of a foreign exchange dealer was a 5-minute one. There were reasons behind market fluctuations, from current account deficit to the situation in Zimbabwe, oil prices and political changes. Actions were often informed by sentiment. People believed certain things, behaved accordingly and exacerbated market fluctuations

Dr D George (DA) thanked the presenters for their thorough presentation. He commented that the National Treasury had provided comfort that the domestic banking sector had avoided much of the internal economic fallout. He referred to the non-banking section of the financial sector, specifically the insurance companies and pension funds and asked what the effect was on them

The Minister responded that in the main, the major banks were happily quite stable. In regard to the non-bank financial institutions, he said that their regulation married prudential limits and exchange controls. The additional requirement of a good match between assets and liabilities for the Life Offices compelled higher investment in this sector. This meant that the so-called “yield hounds” could not take pension funds to remote countries like Iceland in search of higher yields. As the country of Iceland had recently declared bankruptcy, this policy has stood South Africa in good stead.

Dr George asked why the rand was performing comparatively worse, as measured against other comparative emerging market economies.

Dr George asked if the recent downgrade in credit rating by Fitch and Standard & Poor was an indication of a deteriorating view on South Africa.

Mr Kganyago responded that there needed to be global regulation of ratings agencies. Shortly before they crashed, Fitch had rated sub-prime mortgages at AAA (Fitch top rating) rating, and these agencies would be the first to backtrack when decline set in.

Mr Manuel also picked up the issue of the ratings agencies.  He referred to page 26 of the MGM communiqué. The question was: who would rate the raters? 

Mr S Marais (DA) asked if any South African companies had applied for help from the SARB. He wondered if the SARB would respond if such a request were made.

The Minister referred to the response to Mr Mnguni’s first question. It was very difficult to take these decisions. There was a need to have decided policy in place in order to avoid favouritism.

Mr Marais referred to the comments relating to decreased vulnerability. He noted South Africa's practice of using mainly portfolio investment to finance the current account deficit. There was relatively low foreign direct investment (FDI) and exports. He asked if there was any intervention to drive foreign direct investment and exports from the National Treasury's side, as these were factors that could reduce the vulnerability.

The Minister responded that the National Treasury had financed the current account deficit (gap between savings and investment graph), being 8% of GDP or R 3, 5 billion. Treasury would manage this in line with objectives. He added that international analysts had commended National Treasury on the management of the current account deficit.

Mr N Singh (IFP) referred to the banks with foreign relations, and asked if any effect was envisaged on the banking sector in view of these links.

The Minister replied that the China ICBC deal with Standard Bank had successfully launched the Independent Public Offering (IPO) two years ago and this was currently very solid , with only the usual marginal issues to contend with. Barclays was one of the only British banks that had chosen not to seek support from the Bank of England (BoE) and for this reason their deal with ABSA looked solid.

Mr Singh asked what South Africans could expect in regard to oil prices.

The Minister responded that South Africa had lived through oil price spikes and that they were, by and large, not simple supply and demand issues. There was a series of other factor determining oil price behaviour. As these factors were mostly based on expectations, speculation and exogenous factors, the price was very difficult to predict.

Mr Singh referred to the fact that there were very sharp fluctuations in the financial markets, minute-to-minute or overnight, and asked what caused this.

Mr Singh asked if there were any alarm bells ringing in the domestic economy at this time.

The Minister responded that the South Africa economy was not in a recession. The best of their analysts did not indicate the require two quarters of negative growth that would determine a recession.

A Member asked if the Financial Services Board (FSB) would be still attending the meeting.

The Chairperson responded that the FSB would no longer be attending as the National Treasury could talk to the policy issues. The Committee could conduct an oversight visit of the FSB in order to deal with prudential issues.

Mr J Bici (UDM) asked if there could be a rapid change in exchange regulations, as a result of the recession.

Mr Bici asked if the economic crisis posed any threat to the Medium Term Expenditure Framework (MTEF) outlook.

The Minister responded that the National Treasury was looking at the MTEF matter all the time. The facts had been stated as they stood at the Medium Term Budget Policy Statement (MTBPS) speech. As the facts changed, there would be changing assumptions and numbers. However it was not negotiable that the Budget would be ready on 11 February 2009. All the documents would be there, but what they would contain could not at this stage be cast in stone.

Ms J Fubbs (ANC) stated that in South Africa the impact of the global economic crisis had been that people could not service their debt. Looking at vehicle sales, that were usually a good indicator of economic trends, she noted that dealers had been offering people break from payments and a lower interest rate simply to maintain their margins. This was in response to the high rate of repossessions, and this was getting close to the cavalier attitude on vehicle sales.
 
The Minister responded that the National Treasury had, in many areas, taken decisions early, and that approach had been their mainstay. An examination of the fiscal stance since 2000, showed an expansionist approach that was very conscious of the underlying issues. After the implementation of the National Credit Act and National Credit Regulator, the National Treasury had been inundated with queries from other countries on how the NCR worked. Many people were of the view that the NCR had shielded South Africa considerably from the fallout of the global economic crisis. The impact had been comparatively low, in comparison with the effect on the USA. Part of the problem with the levels of indebtedness was that South African’s consumption spending was driven by status seeking, so that goods like expensive cars were bought as status symbols.  South Africa did not have a savings culture. The NCR looked at the issue of access versus pure prudential requirements. Overall, things were not so bad in South Africa as the NCR was a bulwark against the global economic crisis.

Ms Fubbs asked, in view of the Japan developments in declaring a recession in 2008, and the samurai market,  what the substance of South Africa's security was.

Mr Kganyago replied that the Japanese samurai market was mostly in yen dollar denominated loans and had not been very active over the past three years. The Japanese had an historically low interest rate and saved for the sake of saving. The samurai market was a tool to look for yields elsewhere. They had become risk averse in terms of foreign exchange trade and would like foreign bonds, but required the bonds to be yen denominated.

Ms Fubbs asked if the recession would affect the samurai market.

The Minister responded that there was very extensive currency carry  trade, which was fairly disruptive and New Zealand, Australia, Singapore and Indonesia markets were also affected by this carry trade, but this had changed as the risk appetite had changed.

The Chairperson queried the “issuer pays” principle of credit ratings agencies, and asked if this was not a conflict of interest and if it did not impact on the ability of the agencies to have an objective view.

The Chairperson asked, with reference to the sub-prime crisis, if there was any discussion toward compelling proper due diligence on the granting of loans. Related to this was the fact that origination fees were not reflected on the balance sheet if they were channelled into Special Purpose Vehicles (SPVs). This practice meant that there was no incentive to manage risk.
Mr Kganyago responded that bond originators often had an originate and distribute model. The problem was that once distributed, these assets and transactions were no longer carried on the balance sheet, therefore it was impossible to carry out a proper credit review. What happened in South Africa was that the banks had to assume the risk, therefore keeping the transactions on their balance sheets, allowing them to do the credit review. One thing that had become clear was that there was a need for a regulatory framework for bond origination.

The Chairperson referred to the issue of commercial paper by corporates. The Federal Reserve (the Fed) had, in the past bought the commercial paper, but had now added the condition that they would only buy if it was secured. He asked how this would affect the credit crisis.

Mr Kganyago responded that commercial paper was predominantly how corporates funded themselves, and was part of the connection between the financial market and the real economy. Previous economic crises had lead to a corporate slowdown and increased borrowing on the part of corporates. This was a situation where the financial sector was in trouble and, because it was in trouble, it was no longer availing credit to the real sector. He referred to research conducted by the IMF that showed that if a economic contraction was preceded by a banking crisis, the resulting recession would be more pronounced than in the usual economic cycle. This prompted the Fed to step in to unlock the credit markets, buying commercial paper to fund corporates.
He reminded members that when the Financial Services Charter was negotiated, a conscious decision was taken against securitisation and government guarantees of that. If that had gone ahead, South Africa might be experiencing its own sub-prime crisis now.

The meeting was adjourned.