Issue: July/Sept 2010
Back to basics 1

A-Z guide through the financial crisis

Jac Laubscher

Laubscher...structural changes ahead

What you might have wanted to know but were too shy to ask. In this Q&A with TT, Sanlam group economist Jac Laubscher offers the answers.

Question: Enormous amounts of money have been pumped by the US Federal Reserve and Bank of England (to bail out American and British banks respectively), and by the European Central Bank/International Monetary fund (to relieve the sovereign debt of Greece). Who ultimately funds these institutions and must bear the cost of the bailouts?

Answer: The cost is ultimately borne by taxpayers, but it will be for a lot less than the gross amounts involved. For example, a large part of the support is in the form of guarantees that will not necessarily become effective, and the shares that governments acquired in banks through capital injections will be sold at a profit. In the US the latest estimate shows the likely cost of the bailouts to be less than 1% of gross domestic product (gdp).

Is there a responsibility to repay this money? If so, by whom?

The banks which have received government support are responsible for its repayment. In the US, most of it has already been returned. The government also has the option to recover any loss from the financial industry as a whole, e.g. through a special tax or levy.

Might there be a possibility that moneys cannot be fully repaid, to any of the lending institutions, and what are the consequences if they aren’t repaid?

If an institution becomes insolvent it will of course not be able to meet its obligations. The purpose of government support is to prevent exactly this. If need be, governments will probably accept a conversion of repayment obligations into equity.

Can a country go insolvent? What then happens in such a country?

Countries cannot go bankrupt in the same way as an individual or business. There is no sovereign bankruptcy law or procedure in terms of which creditors can lay claim to a country’s assets.

However, countries can default on their debt. This will result in them being shut out of international capital markets until they have been rehabilitated in the eyes of investors (as has happened with Argentina). They will then be forced to limit their budget deficits to what can funded locally.

What is meant by “contagion”? Has the risk of it been eliminated?

Contagion is the process by which a problem with a specific asset spreads to other assets with similar characteristics. Take the Greek government-debt crisis. As it evolved, markets started demanding higher interest rates of other peripheral European countries with high levels of government debt or budget deficits. Contagion risks will always be with us.

What is “public debt”? At what point does it become dangerous?

Public debt is the cumulative net total of borrowings by the public sector, of which the general government is the largest component. The level at which a specific country’s debt will become dangerous will differ from country to country. For example, the more dependent it is on international markets to fund its borrowing requirements, the lower the threshold will be.

As a rule of thumb, the public debt of developed countries should not exceed 60% of gdp and that of emerging market countries 40%. But many countries have sustained much higher levels for prolonged periods.

By approximately how much has the public debt of the US, UK and Eurozone been increased by these bank and country bailouts? Put differently, what would be their public debt as a proportion of gdp today compared with say three years ago?

The public debt of the developed countries as a group is expected to increase from 72% of gdp in 2009 to 107% in 2014. Only 10% of the increase in government debt is directly due to the bailing out of financial institutions. The negative impact of the recession on government revenue, and the counter-cyclical fiscal policies that have been adopted, will contribute the remaining 90%. To reduce their budget deficits and debt, most of these countries have already announced plans to cut expenditure and increase taxes.

What is the relevance of looking at public debt as a proportion of gdp? Why do these proportions matter?

The size of the public debt that a country can bear depends on the size of its economy. The latter determines the size of the tax base from which the servicing and repayment of public debt must be funded. Gdp is the standard measure of an economy’s size.

Is the increase in public debt more likely to stimulate or inhibit worldwide economic recovery?

The increase in public debt, as a result of expansionary fiscal policies, will initially stimulate economic activity. These policies result in higher budget deficits and debt levels. When they’re brought down, the opposite effect applies. Persistently high government borrowing and debt also mean that there will be less capital available for the private sector. So long-term interest rates will rise, which is bad for growth.

How are taxpayers affected?

They ultimately bear the burden of the interest on, and repayment of, the public debt. Also at stake is the important issue of “inter-generational equity”. Often the current generation will enjoy the benefit of higher borrowing, but future generations will have to repay the resulting debt.

What is meant by “printing” money? Is this what’s happened here?

When central banks buy government bonds, financed through an increase in the size of their balance sheets, they are said to “print” money. They can neutralise the effect of buying government bonds by selling other assets.

Central banks in the US, UK and Europe have indulged in this “printing” practice as a temporary measure to assist markets . They all intend to reverse these positions at some point after “normality” has returned.

Could a significant increase in inflation now be expected? If so, can it assist in reduction of public debt? In other words, would governments and central banks have a reduced incentive to control inflation?

A long period of persistently higher inflation will reduce the real value of the existing debt, although it will make new debt more expensive. At the moment in the world there is so much excess capacity, including unemployment, that there is no inflation threat to speak of in the medium term.

For governments and central banks to be more lenient on inflation will be risky. How does one get the genie back into the bottle once it has been let out? Amongst other things, this route would require inflation targets and central bank independence being abandoned. There is currently no meaningful support for the idea.

To what extent is SA immune from the public-debt crisis abroad?

We’re affected negatively by increased risk aversion which discourages the flow of capital, and lower economic growth globally will reduce demand for our exports. SA’s own public debt is expected to peak at approximately 45% of gdp. Plans set out in the

Medium Term Budget Framework, gradually to reduce the budget deficit, has found favour with the markets. So we don’t face any near-term public debt crisis of our own.

What about people’s savings, particularly in pension funds? Can these savings be eroded by, say, spiralling inflation and/or governments using them (perhaps by direct taxation or forcing them to invest in low-yielding government bonds) to help reduce public debt? Or is it reasonable to assume that savings will largely be cushioned by investment in equities keeping pace with inflation?

Investors are faced with a riskier investment environment and with the prospect that future returns will on average be much lower than during the 2004-07 boom years. Yet a well-balanced investment portfolio, with an emphasis on growth assets such as equities, should continue to outperform inflation in the medium to long term. Meantime, investors will have to deal with increased levels of volatility. A higher savings rate may be required to meet asset-accumulation goals.

How probable would you rate a medium-term scenario where public debt constrains economic recovery -- hence also company earnings, wage/salary increases and employment growth – in an environment of higher inflation?

Such a scenario carries a low probability in emerging-market countries as a group, including SA. In the developed countries, economic recovery will indeed be held back by fiscal-consolidation programmes. This will also act as a constraint on inflation. And bear in mind that many multinationals, based in developed countries, derive an increasing part of their earnings from the emerging world which will continue to enjoy healthy growth.

What, on a five-year view, would be your best-case yet most realistic scenario for worldwide economic recovery inclusive of SA?

The recovery is likely to continue, but it will be gradual. More important is that the world, including SA, is faced with a structurally different future. The global financial crisis will have long-lasting effects and will require major adjustments. A new balance between the respective roles of the private sector and government will have to be found.

Average growth rates in the next five years are likely to be lower than in the five years before the crisis.