Four Musketeers facing off three jokers…..

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-?-?-?-?-?-?-?-?-?-?-?-?-?-?-? Four Musketeers facing off three jokers

By Cees Bruggemans, Chief Economist FNB
28 October 2008

You may recall the tales of the four swashbuckling musketeers, defending the interests of their French king?

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Today we also have four musketeers, namely oil, Rand, budget and interest rates. And daily between them they face three jokers, namely global financial cleansing, global economic recession, and local politics.

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The challenge is to navigate these crises without losing our economic footing, or at least minimize the cost of any adjustments and transition to the next long-wave expansion.

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It isn’t quite obvious which one of these identified jokers is the biggest one, but each in its own right is potentially massive and capable of sinking our world. Having to face them off in union is therefore quite a challenge, but all just in a day’s work, however hard this must sound.

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The global financial cleansing, starting with US subprime losses, and ultimately extending to just about the entire global banking balance sheet, pulling insurers, mortgage originators, hedge funds, private equity, pension funds, some corporates and many individuals in their wake, has created panic sell-offs in equities, commodities and even countries.

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The key is deleveraging as failed assets are written off, good assets are sold to raise cash to redeem debt or pay out departing investors.

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It is a monumental exercise, marked by deepening fear, as panic about wealth losses spreads contagiously.

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That was bad. What’s worse is the subsequent marking down of economic expectations. Instead of global high growth with a high profit share continuing indefinitely, and over-exuberantly discounted into present values, we encounter across the board capitulation.

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Global growth should underperform for at least two years (2008-2009). Company earnings should take a similar hit. Such diminishing expectations further need to absorb the hard-hitting pessimism now infiltrating every niche.

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Thus the world’s paper wealth is shrinking by a third, with global housing wealth taking a 20% hit (from the peak), equity wealth a 50%-80% hit (half of it already in the bag), and good-as-gold fixed-income Treasury bonds gaining about a quarter as safe haven yields are suppressed. That leaves exotic open speculative positions (commodities, currencies, derivatives).

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Do appreciate all of this is approximate, and reckoned on the back of a cigarette box, across time zones, where huge variations and currency fluctuations can play havoc with one’s senses.

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Anyway, so the world first doubled its paper wealth this decade, and now gives back a third, after which it may try its luck in the next decade. Admittedly a little extreme, but hardly the hard-luck story of the 1930s needing a world war to get back on its feet (parts of it, that is, as other parts were pulverized).

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So why not a drowning swimmer’s deadly embrace and race for the ultimate bottom, as we liquidate, liquidate, and liquidate some more, until there are no more Kulaks to liquidate (borrowing a bit from Stalin here, according to whom one death was a tragedy, but millions of deaths was a mere statistic)?

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Well, there is a learning curve operating.

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This didn’t prevent creative financial engineering, a generous Greenspan put, confidence tricks, poor regulating and consenting adults enjoying themselves. And none of this recent failure will prevent it happening again, the human condition being the one constant in which we can trust.

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But there was some method in why Alan believed in encouraging folly and only cleaning up afterwards. No use in getting in front of an exuberant bus, which won’t be held back by a mere tightening of interest rates, while vested interests can be trusted to take care of any other obstacles, such as unwanted regulatory inhibitions, politicians, and wavering investors.

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No, it was ultimately much easier to clean up afterwards once the party had ended, even if in an implosion. For at least on that score the learning curve has been massively successful. This is so very unlike the early 1930s, when the Fed didn’t respond early and the US government didn’t want to intervene.

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Not that this doesn’t come without a few ideological hiccups. Will governments start believing in their own powers, to the point of wanting to recast economic life? Will too much monetary accommodation be provided, and not taken away timely? Will failed entities be saved in order to repeat their failures? Will there be no examples held up to the survivors, reinforcing all the wrong instincts?

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But it boils down to government not allowing uncontrolled implosions until all is destroyed.

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The central banks have ultimately unlimited capacity to expand their balance sheets and provide their economies with liquidity (cash) in times of need, if need be displacing banks as deposit-taking and lending entities until the crisis is over.

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Similarly, governments really do have unlimited balance sheets in the short term to provide the sense of safety needed to restore confidence. Once asset values stop plunging and revive, government guarantees can be suspended, and any assets acquired at fire sale values sold for full value.

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There will be real asset losses, but they will be highly personal and distributed. In other words, householders, shareholders and pension-holders will all be worth less than before. But allow that the preceding boom probably overstated peak asset values, and that future booms will allow paper losses to be recouped (but not real losses incurred when assets were sold or nationalized).

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And, yes, the global growth underperformance, say two years of at least 2%, could be $2 trillion of goods and services that will never be produced and consumed, and the only real loss that matters.

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Will government balance sheets be permanently burdened? In the case of the US, recognizing Fanny and Freddie as publicly owned merely confirms a reality, though the US balance sheet also gets expanded by the housing value underlying such mortgage debt longer term.

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As to the remaining $2-$4 trillion of global debt issuance and government guarantees to address this financial crisis, it will probably all be off public balance sheets once again within five years or even less.

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So the world is having a detour. It will come back to even keel because the financial system is getting overdue maintenance, a new coat of paint, and economic policies will be focused on limiting the growth loss and restarting growth revival back towards global potential.

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And here the biggest driver will be the global catch-up story (involving about six billion people), while the world’s rich one billion will want to resume its steady 2.5% growth performance linked to long-term technical innovation and the productivity and income gains this makes possible in the long term.

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So where do our Musketeers fit in?

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See the world’s oil producers as a giant tax authority ripping global consumers for own account. By mid-July 2008, their annualized income stream was topping $4.7 trillion. That was up by $3 trillion in a matter of two years, a huge drain on world consumption and fixed investment of $50 trillion.

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But in a matter of just a few months, this $3 trillion of annualized oil income will have been restored to global consumers and businesses if oil reaches $50 shortly as expected. After playing a major role in suppressing global growth over the past year, oil is a massive shock-absorber over the coming year, giving the world the equivalence of an enormous tax break.

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But it will go beyond that. Oil producers hadn’t yet figured how to spend $150-driven revenue streams, building up huge wealth surpluses. But these producers were already consuming oil revenues near the $100 level, with what implications?

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Some of these oil producing countries will succeed in cutting back on some of their more extravagant spending. But mostly they will be liquidating some of their Treasury bond holdings, in this way funding their newly created income shortfalls. On balance, that’s another global stimulus. Possibly worth of the order of an extra $1 trillion (annualized).

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None of these numbers will survive for long, for the world will be moving too fast. But any US fiscal package of say $200bn shortly should be outshone by the oil supernova effectively being 20-fold bigger in impact.

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In our case, the oil bonanza unfortunately gets cancelled out by massive drops in platinum and other commodity export prices, so the country’s national income doesn’t gain too much, but at least we don’t get devastated overall by the export Dollar price collapse this year.

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There are still winners and losers, except that the Rand is taking the sting out of the worst adjustments.

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The bad losers are the exporters as Dollar prices collapse and export volumes suffer, but helpfully a 50% Rand depreciation is limiting the pain.

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Similarly, households should have been the great gainers of the oil price decline, except it is largely neutralized by the 50% Rand decline. There will still be some net benefit, but not hugely so.

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So the Rand assists in limiting the sectoral disturbance and real damage that could have been incurred if a more abrupt change of fortune had been visited upon us.

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That leaves Mr Manuel and Mr Mboweni.

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Mr Manuel last year ran up a budget surplus estimated at 1.3% of GDP. Next year he expects a deficit of 1.6% of GDP. If he has been somewhat overoptimistic about growth, corporate tax returns, consumer spending and indirect tax collections, and employment levels and income tax, though allowing for the inflationary tax boost, the deficit could easily come in nearer 2.6% of GDP next year.

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That would be a 4% of GDP shift in the fiscal stance over two years, and a very important safety net for the economy, in the spending it still disburses and the borrowing it is prepared to increase to fund its spending even as private tax collections fall away.

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That leaves the SARB and what it will do about the interest burden on the economy, still providing serious incentive to delay consumer replacement decisions, reduce inventory, postpone private fixed investment and possibly cut working hours and even employment.

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With the world heavily selling off emerging markets, also depressing the Rand exchange rate, it may be the wrong moment to incur the wrath of global financial markets by cutting our interest rates. Besides, our inflation trajectory will be somewhat uncertain in the short-term, even if next year it should be down.

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But once global markets have climaxed (having found their bottom on completing their deleveraging), with those so far holding their powder dry starting to re-enter the ring (Buffett apparently as usual being a tad too eager), our asset markets and the Rand can also be expected to come back from their overshoot.

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This makes the overshooting bottom less interesting than the eventual return journey. Long-term Rand value with the world reviving towards potential growth and commodity prices commencing another slow boom would be in 8-10:$ territory (allowing that we will likely be penalized for our lingering savings and current account shortfalls).

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Even with oil eventually also rebounding, the inflation outlook doesn’t look hopeless. There is a lot of netting out in all these numbers, but with food price inflation probably also subsiding, and the rebasing and re-weighting bonuses still to be allowed. As two second-round effects, semi-indexed wages will move up and down with the overall inflation rate, while the economy’s underperformance these next 18 months should exert some downward pressure on inflation.

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If we can therefore look through the volatile market uncertainty of the next few days, weeks and months, out there somewhere looms a point where the SARB can be expected to start easing rates, lagging rich world policy actions but not necessarily by much.

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A year from now, looking back, we will have absorbed the full extent of our growth slowdown-cum-recession, but our shock-absorbers (oil, Rand, budget) will have functioned supportively at maximum ability, while the SARB should by then have shown the full extent of the hand it was eventually willing to play.

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By then the new government will have much to think about as to the kind of economic policies it will want to follow. Go radical, or be sobered by the recent global adventures of a lifetime, easily providing food for thought for another lifetime. It also may encourage continuity in office of experienced policymakers, at least of those wanting to stay on.-? -?-?-?-?-?-?-?-?-?-?-?

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Cees Bruggemans is Chief Economist of First National Bank. Register for his free e-mail articles on www.fnb.co.za/economics

FERRIER International thanks Cess Bruggemans the Chief Economist of First National Bank for this article.

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