Financial markets the world over are once again in turmoil.
The successive international financial crises of the 1990s, and of 2001, demonstrated that we live in an age of volatility. These events prompted emerging market economies to work hard to improve their national balance sheets by adjusting their fiscal, monetary and exchange rate policies, and to promote economic diversification.
The events of the past week demonstrated that economic distortions in the world’s largest economies should concern all of us. Emerging market economies have not escaped contagion.
On August 9 and 10, stressed financial institutions in Europe and North America were allowed to source liquidity from the European Central Bank and the US Federal Reserve, and central banks in a range of other countries also provided emergency liquidity. Well over US$200-billion was provided to the markets.
The source of the problem was that some banks and other financial institutions had invested in assets formed with mortgage loan repayments, but suddenly found themselves unable to sell these assets at any price. The value of the assets had declined, and the solvency of some institutions was at risk. Since they could not find buyers, the banks were unable to raise cash and a liquidity crisis developed. The magnitude of the crisis was increased by the extent of borrowing by hedge funds to buy riskier assets in recent years and rising interest rates in major economies.
The abrupt unwinding of the positions taken in mortgage-backed securities has affected investments in emerging markets, including South Africa, despite our limited exposure to the US home loans market.
When risk rises in global financial markets, investors often sell riskier assets, which include anything denominated in emerging market currencies. Hence the decline last Friday in the quoted prices of many South African firms on the Johannesburg stock exchange and the movements in the value of the rand.
In sum, however, these movements have been relatively small and prices have rebounded quickly. The bounce in the value of the rand was relatively small, about 2,5% by the end of the day on August 10.
Market volatility is likely to continue over the next week or two as investors take time to assess the full extent of the credit risks faced by banking systems in the US, Europe and elsewhere. It is likely that more banks will be found to be overexposed to mortgage securities.
Since 1994, South Africa’s economic policy has been characterised by opening up to the global economy, both through higher levels of trade and by being able to attract foreign capital to supplement our low level of savings. We have also gradually built up our safeguards and shock absorbers to be able to withstand global financial turmoil.
In recent years, South Africa has experienced a widening of the current account deficit, implying that we have become increasingly reliant on foreign capital to finance our investment needs. We have benefited from relatively low interest rates globally and high levels of liquidity. For this reason, we need to be vigilant and conscious of the fact that changes in the global markets can have negative consequences for our economy.
Nevertheless, there are a number of reasons why we should not be too worried about further volatility. First, the US Federal Reserve, European Central Bank, and other central banks are alive to the liquidity crunch and understand how to address it.
Second, our economy remains sound, with strong growth across most sectors. Commodity exports are doing well. Asset prices are based on sound fundamentals. Credit extension has been strong, reflecting rapid economic growth and positive structural changes, such as higher employment and a growing middle class.
Third, South African banks say that they have little or no exposure to the cause of the trouble — subprime lending or hedge funds with subprime assets.
Finally, the Reserve Bank and national treasury are in daily contact about robust policy frameworks for dealing with volatility. Fiscal and monetary policies are flexible enough to address negative economic shocks. Prudent budgeting has created fiscal space and resources for countering such shocks should they occur. The floating exchange rate creates a cushion for the real economy when rand assets are sold by non-residents.
While global financial crises, such as the one we are presently experiencing, are not of our making, they have the potential to derail our own development efforts. The lesson to draw is that we must continue to strengthen our shock absorbers. Sound fiscal and monetary policy, a floating exchange rate, well-regulated financial markets, prudent credit policies by South African banks and high levels of transparency in financial reporting are the policy instruments that will ensure that our economy continues to grow, and that we continue to benefit from the global economy.
Lesetja Kganyago is Director General at the National Treasury