Category: Economics for Business: Ch 27

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Worries about the Chinese economy

According to the IMF, Chinese GDP grew by 5.2% in 2023 and is predicted to grow by 4.6% this year. Such growth rates would be extremely welcome to most developed countries. UK growth in 2023 was a mere 0.5% and is forecast to be only 0.6% in 2024. Advanced economies as a whole only grew by 1.6% in 2023 and are forecast to grow by only 1.5% this year. Also, with the exception of India, the Philippines and Indonesia, which grew by 6.7%, 5.3% and 5.0% respectively in 2023 and are forecast to grow by 6.5%, 6.0% and 5.0% this year, Chinese growth also compares very favourably with other developing countries, which as a weighted average grew by 4.1% last year and are forecast to grow at the same rate this year.

But in the past, Chinese growth was much higher and was a major driver of global growth. Over the period 1980 to 2018, Chinese economic growth averaged 9.5% – more than twice the average rate of developing countries (4.5%) and nearly four times the average rate of advanced countries (2.4%) (see chart – click here for a PowerPoint of the chart).

Not only is Chinese growth now much lower, but it is set to decline further. The IMF forecasts that in 2025, Chinese growth will have fallen to 4.1% – below the forecast developing-country average of 4.2% and well below that of India (6.5%).

Causes of slowing Chinese growth

There are a number of factors that have come together to contribute to falling economic growth rates – growth rates that otherwise would have been expected to be considerably higher as the Chinese economy reopened after severe Covid lockdowns.

Property market
China has experienced a property boom over the past 20 years years as the government has encouraged construction in residential blocks and in factories and offices. The sector has accounted for some 20% of economic activity. But for many years, demand outstripped supply as consumers chose to invest in property, partly because of a lack of attractive alternatives for their considerable savings and partly because property prices were expected to go on rising. This lead to speculation on the part of both buyers and property developers. Consumers rushed to buy property before prices rose further and property developers borrowed considerably to buy land, which local authorities encouraged, as it provided a valuable source of revenue.

But now there is considerable overcapacity in the sector and new building has declined over the past three years. According to the IMF:

Housing starts have fallen by more than 60 per cent relative to pre-pandemic levels, a historically rapid pace only seen in the largest housing busts in cross-country experience in the last three decades. Sales have fallen amid homebuyer concerns that developers lack sufficient financing to complete projects and that prices will decline in the future.

As a result, many property developers have become unviable. At the end of January, the Chinese property giant, Evergrande, was ordered to liquidate by a Hong Kong court, after the judge ruled that the company did not have a workable plan to restructure around $300bn of debt. Over 50 Chinese property developers have defaulted or missed payments since 2020. The liquidation of Evergrande and worries about the viability of other Chinese property developers is likely to send shockwaves around the Chinese property market and more widely around Chinese investment markets.

Overcapacity
Rapid investment over many years has led to a large rise in industrial capacity. This has outstripped demand. The problem could get worse as investment, including state investment, is diverted from the property sector to manufacturing, especially electric vehicles. But with domestic demand dampened, this could lead to increased dumping on international markets – something that could spark trade wars with the USA and other trading partners (see below). Worries about this in China are increasing as the possibility of a second Trump presidency looks more possible. The Chinese authorities are keen to expand aggregate demand to tackle this overcapacity.

Uncertainty
Consumer and investor confidence are low. This is leading to severe deflationary pressures. If consumers face a decline in the value of their property, this wealth effect could further constrain their spending. This will, in turn, dampen industrial investment.

Uncertainty is beginning to affect foreign companies based in China. Many foreign companies are now making a loss in China or are at best breaking even. This could lead to disinvestment and add to deflationary pressures.

The Chinese stock market and policy responses
Lack of confidence in the Chinese economy is reflected in falling share prices. The Shanghai SSE Composite Index (an index of all stocks traded on the Shanghai Stock Exchange) has fallen dramatically in recent months. From a high of 3703 in September 2021, it had fallen to 2702 on 5 Feb 2024 – a fall of 27%. It is now below the level at the beginning of 2010 (see chart: click here for a PowerPoint). On 5 February alone, some 1800 stocks fell by over 10% in Shanghai and Shenzhen. People were sensing a rout and investors expressed their frustration and anger on social media, including the social media account of the US Embassy. The next day, the authorities intervened and bought large quantities of key stocks. China’s sovereign wealth fund announced that it would increase its purchase of shares to support the country’s stock markets. The SSE Composite rose 4.1% on 6 February and the Shenzhen Component Index rose 6.2%.

However, the rally eased as investors waited to see what more fundamental measures the authorities would take to support the stock markets and the economy more generally. Policies are needed to boost the wider economy and encourage a growth in consumer and business confidence.

Interest rates have been cut four times since the beginning of 2022, when the prime loan rate was cut from 3.85% to 3.7%. The last cut was from 3.55% to 3.45% in August 2023. But this has been insufficient to provide the necessary boost to aggregate demand. Further cuts in interest rates are possible and the government has said that it will use proactive fiscal and effective monetary policy in response to the languishing economy. However, government debt is already high, which limits the room for expansionary fiscal policy, and consumers are highly risk averse and have a high propensity to save.

Graduate unemployment
China has seen investment in education as an important means of increasing human capital and growth. But with a slowing economy, there are are more young people graduating each year than there are graduate jobs available. Official data show that for the group aged 16–24, the unemployment rate was 14.9% in December. This compares with an overall urban unemployment rate of 5.1%. Many graduates are forced to take non-graduate jobs and graduate jobs are being offered at reduced salaries. This will have a further dampening effect on aggregate demand.

Demographics
China’s one-child policy, which it pursued from 1980 to 2016, plus improved health and social care leading to greater longevity, has led to an ageing population and a shrinking workforce. This is despite recent increases in unemployment in the 16–24 age group. The greater the ratio of dependants to workers, the greater the brake on growth as taxes and savings are increasingly used to provide various forms of support.

Effects on the rest of the world

China has been a major driver of world economic growth. With a slowing Chinese economy, this will provide less stimulus to growth in other countries. Many multinational companies, including chip makers, cosmetics companies and chemical companies, earn considerable revenue from China. For example, the USA exports over $190 billion of goods and services to China and these support over 1 million jobs in the USA. A slowdown in China will have repercussions for many companies around the world.

There is also the concern that Chinese manufacturers may dump products on world markets at less than average (total) cost to shift stock and keep production up. This could undermine industry in many countries and could initiate a protectionist response. Already Donald Trump is talking about imposing a 10% tariff on most imported goods if he is elected again in November. Such tariffs could be considerably higher on imports from China. If Joe Biden is re-elected, he too may impose tariffs on Chinese goods if they are thought to be unfairly subsidised. US (and possibly EU) tariffs on Chinese goods could lead to a similar response from China, resulting in a trade war – a negative sum game.

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Questions

  1. Why is China experiencing slowing growth and is growth likely to pick up over the next five years?
  2. How does the situation in China today compare with that in Japan 30 years ago?
  3. What policies could the Chinese government pursue to stimulate economic growth?
  4. What policies were enacted towards China during the Trump presidency from 2017 to 2020?
  5. Would you advise the Chinese central bank to cut interest rates further? Explain.
  6. Should China introduce generous child support for families, no matter the number of children?
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What does 2023 have in store for the UK economy?

Last year was far from the picture of economic stability that all governments would hope for. Instead, the overarching theme of 2022 was uncertainty, which overshadowed many economic predictions throughout the year. The Collins English Dictionary announced that their word of the year for 2022 is ‘permacrisis’, which is defined as ‘an extended period of instability and insecurity’.

For the UK, 2022 was an eventful year, seeing two changes in prime minister, economic stagnation, financial turmoil, rampant inflation and a cost of living crisis. However, the UK was not alone in its economic struggles. Many believe that it is a minor miracle that the world did not experience a systemic financial crisis in 2022.

Russia’s invasion of Ukraine has led to the biggest land war in Europe since 1945, the most serious risk of nuclear escalation since the Cuban missile crisis and the most far-reaching sanctions regime since the 1930s. Soaring food and energy costs have fuelled the highest rates of inflation since the 1980s and the biggest macroeconomic challenge in the modern era of central banking (with the possible exception of the financial crisis of 2007–8 and its aftermath). For decades we have lived with the assumptions that nuclear war was never going to happen, inflation will be kept low and rich countries will not experience an energy crisis. In 2022 all of these assumptions and more have been shaken.

With the combination of rising interest rates and a massive increase in geopolitical risk, the world economy did well to survive as robustly as it did. However, with public and private debt having risen to record levels during the now-bygone era of ultra-low interest rates and with recession risks high, the global financial system faces a huge stress test.

Government pledges

Rishi Sunak, the UK Prime Minister, started 2023 by setting out five pledges: to halve inflation, boost economic growth, cut national debt as a percentage of GDP, and to address NHS waiting lists and the issue of immigrants arriving in small boats. Whilst most would agree that meeting these pledges is desirable, a reduction in inflation is forecast to happen anyway, given the monetary policy being pursued by the Bank of England and an easing of commodity prices; and public-sector debt as a percentage of GDP is forecast to fall from 2024/25.

Success in meeting the first four pledges will partly depend on the effects of the current industrial action by workers across the UK. How soon will the various disputes be settled and on what terms? What will be the implications for service levels and for inflation?

A weak global economy

Success will also depend on the state of the global economy, which is currently very fragile. In fact, it is predicted that a third of the global economy will be hit by recession this year. The head of the IMF has warned that the world faces a ‘tougher’ year in 2023 than in the previous 12 months. Such comments suggest the IMF is likely soon to cut its economic forecasts for 2023 again. The IMF already cut its 2023 outlook for global economic growth in October, citing the continuing drag from the war in Ukraine, as well as inflationary pressures and interest rate rises by major central banks.

The World Bank has also described the global economy as being ‘on a razor’s edge’ and warns that it risks falling into recession this year. The organisation expects the world economy to grow by just 1.7% this year, which is a sharp fall from an estimated 2.9% in 2022 according to the Global Economic Prospects report (see link below). It has warned that if financial conditions tighten, then the world’s economy could easily fall into a recession. If this becomes a reality, then the current decade would become the first since the 1930s to include two global recessions. Growth forecasts have been lowered for 95% of advanced economies and for more than 70% of emerging market and developing economies compared with six months ago. Given the global outlook, it is no surprise that the UK economy is expected to face a prolonged recession with declining growth and increased unemployment.

The current state of the UK economy

Despite all the concerns, official figures show that, even though households have been squeezed by rising prices, UK real GDP unexpectedly grew in November, by 0.1%. This has been explained by a boost to bars and restaurants from the World Cup as people went out to watch the football and also by demand for services in the tech sector.

At first sight, the UK’s cost of living crisis might look fairly mild compared to other countries. Its inflation rate was 10.7% in November 2022, compared to 12.6% in Italy, 16% in Poland and over 20% in Hungary and Estonia. But UK inflation is still way above the Bank of England’s 2% target. The Bank went on to tighten monetary policy further, by increasing interest rates to 3.5% in December. Further rate rises are expected in 2023. In fact, the markets and the Bank both expect the main rate to reach 5.2% by the end of this year. With the consequent squeeze on real incomes, the Bank of England expects a recession in the UK this year – possibly lasting until mid-2024.

The UK is also affected by global interest rates, which affect global growth. Global interest rates average 5%. A 1 percentage point increase would reduce global growth this year from 1.7% to 0.6%, with per capita output contracting by 0.3%, once changes in population are taken into account. This would then meet the technical definition of a global recession. This means that the Bank’s November economic forecast, which was based on a Bank Rate of 3%, may worsen due to an even larger contraction than previously expected. The resulting drop in spending and investment by people and businesses could then cause inflation to come down faster than the Bank had predicted when rates were at 3%.

There could be some positive news however, that may help bring down inflation in addition to rate rises. There has been some appreciation in the pound since the huge drop caused by the September mini-budget that had brought its value to a nearly 40-year low. This will help to reduce inflation by reducing the price of imports.

As far as workers are concerned, pay increases have been broadly contained, with 2022 being one of the worst years in decades for UK real wage growth. Limiting pay rises can have a deflationary effect because people have less to spend, but it also weighs on economic growth and productivity. Despite the impact on inflation, there is a lot of unrest across the UK, with strike action continuing to be at the forefront of the news. Strikes over pay and conditions continue in various sectors in 2023, including transport, health, education and the postal service. Strikes and industrial action have a negative effect on the wider economy. If wages are stagnating and the economy is not performing well, productivity will suffer as workers are less motivated and less investment in new equipment takes place.

Financial stresses

The UK economy is also under threat of a prolonged recession due to the proportion of households that lack insulation against financial setbacks. This proportion is unusually large for a wealthy economy. A survey conducted prior to the pandemic, found that 3 million people in the UK would fall into poverty if they missed one pay cheque, with the country’s high housing costs being a key source of vulnerability. Another survey recently suggested that one-third of UK adults would struggle if their costs rose by just £20 a month.

The pandemic itself meant that over 4 million households have taken on additional debt, with many now falling behind on repaying it. This, combined with recent jumps in energy and food bills, could push many over the edge, especially if heating costs remain high when the present government cap on energy prices ends in April.

However, there could be some better news for households with the easing of COVID restrictions in China. This could have a positive impact on the UK economy if it helps ease supply-chain disruptions occurring since the height of the global pandemic. It could reduce inflationary pressure in the UK and other countries that trade with China by making it easier – and therefore less costly – for people to get hold of goods.

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Questions

  1. Define the term ‘deflation’.
  2. Explain how an appreciation of the pound is good for inflation.
  3. Discuss the wider economic impacts of industrial strike action.
  4. Why is it important for the government to keep wages contained?
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The Pound Sterling – A week of Turmoil

On 23 September, the new Chancellor of the Exchequer, Kwasi Kwarteng, announced his mini-Budget. It revealed big tax-cutting plans with the aim of stimulating economic growth. See the blog From Reaganomics to Trussonomics for details. However, the announcement triggered a crisis of confidence in the markets. The government says the measures will kickstart economic growth, but with the tax cuts funded through extra government borrowing, markets have raised alarm over the plans, sending the pound plunging.

On Monday 26 September, traders in the UK awoke to see that the pound had fallen to the new lowest level on record against the dollar of $1.03. Although it came at a time when the markets expected the pound to weaken, the announcement pushed a fall in the pound beyond previous expectations. Concerns about where the extra money would come from to pay for the tax cuts were reflected in market movements. A weaker currency suggests investors’ faith in a country’s economic prospects is wavering.

What does a falling pound mean?

The pound’s value affects everyone – from shoppers to business owners and investors. The main impacts of the falling pound include:

  • Higher prices. A fall in the value of the pound will increase the price of goods and services imported into the UK from overseas. When the pound is weak against the dollar, it costs more for companies in the UK to buy things such as food, raw materials or parts from abroad. Firms are likely then to pass on some or all those higher costs to their customers.
  • Higher mortgage repayments. By increasing inflation, a falling pound is likely to push the Bank of England to raise interest rates to counter this. With two million people in the UK on a tracker or variable rate mortgage, monthly costs could increase substantially. Lenders are also likely to increase the rates charged on credit cards, bank loans or car loans.
  • Further pressure on energy costs. The price of all of the gas that the UK uses is based on the dollar – even if the gas is produced in the UK. As oil prices are based on the dollar, petrol and diesel could also be more expensive for UK drivers as it costs more to be imported by fuel companies. Although the dollar price of oil has been falling in recent weeks, consumers are not likely to see the benefit at the pump due to the slide in the value of the pound.
  • Stronger sales for UK firms who sell goods abroad. Some businesses in the UK could get a boost from a fall in the value of the pound. A cheaper pound makes it less expensive for people from around the globe to buy goods and services from British firms, making them more competitive.
  • More expensive trips abroad. The plunge in the pound means that people’s holiday money won’t stretch as far, particularly for anyone planning a trip to the USA. The depreciation of the pound could also see airlines face sharply increased costs, with fuel and aircraft leases often denominated in dollars.

Threat to confidence

The Bank of England said a weaker outlook for the UK economy as well as a stronger dollar were putting pressure on sterling. However, market responses were clear that Kwarteng’s mini-Budget was threatening to undermine confidence in the UK. The pound plunged to its lowest since Britain went decimal in 1971, as belief in the UK’s economic management and assets evaporated.

By Tuesday 27 September, there were expectations that the Bank of England would have to raise interest rates to counter the extra spending in the mini-Budget. Economists from the City suggested the slump in the pound would not just force the Bank of England into raising rates at the next MPC announcement in November, but to intervene now by announcing an emergency interest rate rise to support the currency. This sent mortgage activity into a frenzy as brokers worked around the clock to help clients secure deals before lenders pulled their products or replaced them with more expensive ones. By the end of the week there were 40% fewer products available than before the mini-Budget.

The Bank of England

In August, the Bank predicted that the UK would go into recession, lasting some 15 months. It did so as it raised interest rates by the highest margin in 27 years (0.5 percentage points) in a bid to keep soaring prices under control. Higher interest rates can make borrowing more expensive, meaning people have less money to spend and prices will stop rising as quickly. The Bank of England is expected to raise interest rates by an even larger amount to combat the inflationary impact of the mini-Budget, as a weakening pound drives up costs of imports. The money markets are pricing a doubling of UK interest rates to more than 5% by next summer.

On Thursday 29 September the cost of government borrowing was rising to levels many economists thought were concerning. After the mini-Budget, the UK Debt Management Office, which borrows on behalf of the government by issuing new government bonds (‘gilts’), plans to raise an additional £72bn before next April, raising the financing remit in 2022/23 to £234bn. The investors in bonds are mainly large institutions, such as pension funds.

New bonds are issued at a fixed payment per annum based on the face value. If interest rates rise, then new bonds must pay a higher amount per annum to attract purchasers. Old bonds with a relatively low payment per year will fall in value. For example, if a £100 bond issued a while back paid £2 per annum (a nominal 2%) and interest rates on equivalent assets rose to 4%, the market price of the bond would fall to £50, as £2 per annum is 4% of £50. This percentage of the market price (as opposed to the face value) is known as the ‘yield’. With worries about the rise in government borrowing, bond prices fell and yields correspondingly rose. Investors were demanding much higher interest rates to lend to the UK government.

The Investment Director at JM Finn compared investing in government bonds to sloths, they’re low risk and typically don’t move. This is because lending to the UK is usually considered as an ultra-safe bet. However, some bonds fell in price by 20% in two days (26–28 September).

There was concern that the mini-Budget threatened the financial health of Britain’s biggest pensions and insurance companies, which together manage trillions of pounds of people’s cash. These companies hold large amounts of UK government bonds and the fall in their price was significantly reducing the value of their assets.

The Bank of England thus announced that it would step in to calm markets, warning that continued volatility would be a ‘material risk to UK financial stability’. The Bank would start buying government bonds at an ‘urgent pace’ to help push their price back up and restore orderly market conditions. It would set aside £65bn to buy bonds over 13 working days. It is hoped that the Bank’s action will now ease the pressure on pension funds and insurance companies.

But the purchase of bonds increases money supply. This was the process by which money supply was increased during periods of quantitative easing (QE). Increasing money supply, while helping to dampen the rise in interest rates and stabilise the financial markets, is likely to lead to higher inflation. The Bank of England had previously planned to do the opposite: to engage in quantitative tightening (QT), which involves selling some of the stock of (old) bonds which the Bank had accumulated during the various rounds of QE.

Despite the Bank of England’s action which helped to curb the fall in the sterling exchange rate, some analysts warned it could fall further and could even reach parity with the dollar. There are concerns that the Bank is simply firefighting, rather than being able to solve the wider problems. There is now growing pressure on the government to make clear the financial cost of its tax cuts and spending plans.

Criticism from the IMF

There has been widespread criticism of the government’s plan, with the International Monetary Fund warning on Tuesday 27 September that the measures were likely to fuel the cost-of-living crisis and increase inequality. The stinging rebuke from the IMF arrived at the worst moment for the UK government. The IMF works to stabilise the global economy and one of its key roles is to act as an early economic warning system. It said it understood the package aimed to boost growth, but it warned that the cuts could speed up the pace of price rises, which the UK’s central bank is trying to bring down. In an unusually outspoken statement, the IMF said the proposal was likely to increase inequality and add to pressures pushing up prices.

Mark Carney, the former Governor of the Bank of England also criticised the government, accusing them of ‘undercutting’ the UK’s key economic institutions. Mr Carney said that while the government was right to want to boost economic growth, ‘There is a lag between today and when that growth might come.’ He also criticised the government for undercutting various institutions that underpin the overall approach, including not having an OBR forecast.

What is next for the economy?

Before the announcement, the Bank had expected the economy to shrink in the last three months of 2022 and keep shrinking until the end of 2023. However, some economists believe the UK could already be in recession. The impacts of the mini-Budget have so far not alleviated fears of the UK diving into recession. However, the Governor of the Bank of England, Andrew Bailey, also warned that little could be done to stop the UK falling into a recession this year as the war in Ukraine continued. He added that it would ‘overwhelmingly be caused by the actions of Russia and the impact on energy prices’.

Despite the external pressures on the economy, it is clear that recent market activity has damaged confidence. The Bank has already said it will ‘not hesitate’ to hike interest rates to try to protect the pound and stem surging prices. Some economists have predicted the Bank of England will raise the interest rate from the current 2.25% to 5.75% by next spring.

The Bank’s action of emergency bond purchases helped provide Kwarteng with some respite from the financial markets after three days of turmoil, which included strong criticism of the mini-Budget from the International Monetary Fund, about 1000 mortgage products pulled and interest rates on UK government bonds hitting their highest level since 2008.

On 3 October, at the start of the Conservative Party annual conference, Kwarteng announced that the planned cut in the top rate of income tax from 45% to 40% would not go ahead. This showed that the government would change course if pressure was strong enough. That day, the sterling exchange rate against the dollar appreciated by around 0.5% to around $1.12.

But this was not enough. The pressure was still on the government. There were urgent calls from the House of Commons Treasury Select Committee to bring forward the government’s financial statement, which was not due until 23 November, by at least a month. The government was urged to publish growth forecasts as soon as possible to help calm the markets. In response, on 4 October the government agreed to bring the financial statement forward to late October along with the forecasts of its impacts from the OBR.

However, Truss and Kwarteng have so far resisted this pressure to bring analysis of their tax plans forward. They have refused independent analysis of their plans until more than six weeks after receiving them, despite more calls from Tory MPs for Downing Street to reassure the markets. The Prime Minister and Chancellor said they would only publish the independent forecasts on 23 November alongside a fiscal statement, despite them being ready on 7 October.

Longer term impacts

Amongst all the activity in the week following the mini-Budget, there are real concerns of the longer-term impacts the budget will have on the economy. Some experts predict that the lasting effects of the ‘mini’ Budget will be felt far beyond the trading floors. Large tax cuts the government claimed would boost growth have instead convinced markets the UK’s entire macroeconomic framework is under threat. Although this turmoil has been the short-term result, it’s important to step back and think about how the effects of this abrupt shift in economic policy will be felt far beyond the trading floors.

Sterling’s partial recovery a few days after the mini-Budget reflects an increased confidence that there will be a large interest rate rise coming on November 3. However, the bleak economic outlook has removed any fiscal headroom the government may have had. The largest tax cuts in five decades need funding, while spooking the markets means another £12.5bn a year added to the debt interest bill. However, Kwarteng remains committed to debt falling eventually.

It is estimated that there needs to be a fiscal tightening of around £37–£47bn by 2026/27. Even more could be required to ensure that tax revenues cover day-to-day spending or for even a small margin for error. Many have therefore called for a U-turn on the measures announced in the mini-Budget beyond abolishing the cut to the top rate of income tax. Performing a U-turn on some of the tax cuts would make the fiscal tightening much more achievable. However, it could be politically detrimental. Much lower taxes will mean less public spending. Some suggest that this trade-off was ignored when those tax cuts were announced, but market pressure has now put it centre stage.

The Prime Minister has since admitted that mistakes were made in the controversial ‘mini’ Budget that sparked market turmoil in the last week of September. However, a day before reversing the cut in the top rate of income tax, she said she would not retreat on her plan to deliver £45bn of unfunded tax cuts, insisting it would help deliver growth, but admitted: ‘We should have laid the ground better and I have learned from that.’

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Questions

  1. Explain how the announced tax cut will stimulate economic growth.
  2. What is the impact of the weakened pound on UK households and businesses?
  3. Draw a diagram illustrating the way in which the $/£ exchange rate is determined.
  4. How is UK inflation likely to be affected by a depreciation of sterling?
  5. Are there any advantages of having a lower pound?
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Inflation in Turkey: a self-inflicted problem?

Inflation has been rising around the world as a combination of a recovery in demand and supply-chain issues have resulted in aggregate demand exceeding aggregate supply. Annual consumer price inflation at the beginning of 2022 is around 2.5% in China, 3.5% in Sweden, 5% in the eurozone, Canada and India, 6% in the UK and South Africa, 7% in the USA and 7.5% in Mexico. In each case it is forecast to go a little higher before falling back again.

Inflation in Turkey

In Turkey inflation is much higher. The official annual rate of consumer price inflation in December 2021 was 36.1%, sharply up from 21.3% in November. But according to Turkey’s influential ENAGrup the December rate was much higher still at 82.8%. Official producer price inflation was 79.9% and this will feed through into official consumer price inflation in the coming weeks.

The rise in inflation has hit the poor particularly badly. According to the official statistics, in the year to December 2021, domestic energy prices increased by 34.2%, food by 44.7% and transport by 53.7%. In response, the government has raised the minimum wage by nearly 50% for 2022.

Causes of high and rising inflation

Why is Turkey’s inflation so much higher than in most developed and emerging economies and why has it risen so rapidly? The answer is that aggregate demand has been excessively boosted – well ahead of the ability of supply to respond. This has driven inflation expectations.

Turkey’s leader, President Erdoğan, in recent years has been seeking to stimulate economic growth through a mixture of supply-side, fiscal and monetary policies. He has hoped that the prospect of high growth would encourage both domestic and inward investment and that this would indeed drive the high growth he seeks. To encourage investment he has sought to reduce the reliance on imports through various measures, such as public procurement favouring domestic firms, tax reliefs for business and keeping interest rates down. He has claimed that the policy is focused on investment, production, employment and exports, instead of the ‘vicious circle of high interest rates and low exchange rates’.

With the pandemic, fiscal policy was largely focused on health, social security and employment measures. Such support was aided by a relatively healthy public finances. General government debt was 32% of GDP in 2020. This compares with 74% for the EU and 102% for the G7. Nevertheless, the worsening budget deficit has made future large-scale expenditure on public infrastructure, tax cuts for private business and other supply-side measures more difficult. Support for growth has thus fallen increasingly to monetary policy.

The Turkish central bank is not independent, with the President firing senior officials with whom he disagrees over monetary policy. The same applies to the Finance Ministry, with independently-minded ministers losing their jobs. Monetary and exchange rate policy have thus become the policy of the President. And it is here that a major part of the current problem of rising inflation lies.

Monetary and exchange rate policy

Despite rising inflation, the central bank has reduced interest rates. At its monthly meeting in September 2021, the Turkish central bank reduced its key rate from 19% to 18% and then to 16% in October, to 15% in November and 14% in December. These unprecedented rate cuts saw a large increase in the money supply. M1 rose by 11.7% in November alone; the annual growth rate was 59.5%. Broad money (M2 and M3) similarly rose. M3 grew by an annual rate of 51% in November 2021. The cut in interest rates and rise in money supply led to a rise in nominal expenditure which, in turn, led to higher prices.


The cut in interest rates and rise in nominal aggregate demand led to a large depreciation in the exchange rate. On 1 September 2021, 100 Turkish lira exchanged for $12.05. By 11 January 2022 the rate had fallen to $7.22 – a 40.1% depreciation. This depreciation, in turn, further stoked inflation as the lower exchange rate pushed up the price of imported goods. (Click here for a PowerPoint of the chart.)

Attempts were made to stem this fall in the lira on 20 December, by which point 100 lira were trading for just $5.50 (see chart) and speculation against the lira was gathering momentum. President Erdoğan announced a scheme to protect lira deposits against currency volatility, guaranteeing lira deposits in hard currency terms. The mechanism adopted was a rise in the interest rate on lira deposits with a maturity of 3 to 12 months, thereby encouraging people to lock in deposits for the medium term and not, therefore, to use them to speculate against the lira by buying other currencies. Other interest rates would be unaffected. At the same time the central bank used foreign currency reserves to engage in large-scale purchases of the lira on the foreign exchange market.

The lira rallied. By 23 December, 100 lira were trading for $8.79. But then selling of the lira began again and, as stated above, by early January 100 lira had fallen to $7.22. The underlying problem of excess demand and high inflationary expectations had not been solved.

It remains to be seen whether the President will change his mind and decide that the central bank needs to raise interest rates to reduce inflation and restore confidence.

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Questions

  1. Until the pandemic, the Turkish economy could be seen as a success story. Why?
  2. What supply-side policies did Turkey pursue?
  3. Use either an aggregate demand and supply diagram or a dynamic aggregate demand and supply (DAD/DAS) diagram to explain what has happened to inflation in Turkey in the past few months.
  4. Explain the thinking behind the successive cuts in interest rates since September 2021.
  5. Why did the measures introduced on 20 December 2021 only temporarily halt the depreciation of the lira?
  6. Choose a country with a higher rate of inflation than Turkey (see second data link above). Find out the causes of its high rate. Are they similar to those in Turkey?
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Getting real with pay

One of the most enduring characteristics of the macroeconomic environment since the financial crisis of the late 2000s has been its impact on people’s pay. We apply the distinction between nominal and real values to evidence the adverse impact on the typical purchasing power of workers. While we do not consider here the distributional impact on pay, the aggregate picture nonetheless paints a very stark picture of recent patterns in pay and, in turn, the consequences for living standards and wellbeing.

While the distinction between nominal and real values is perhaps best know in relation to GDP and economic growth (see the need to get real with GDP), the distinction is also applied frequently to analyse the movement of one price relative to prices in general. One example is that of movements in pay (earnings) relative to consumer prices.

Pay reflects the price of labour. The value of our actual pay is our nominal pay. If our pay rises more quickly than consumer prices, then our real pay increases. This means that our purchasing power rises and so the volume of goods and services we can afford increases. On the other hand, if our actual pay rises less quickly than consumer prices then our real pay falls. When real pay falls, purchasing power falls and the volume of goods and services we can afford falls.

Figures from the Office for National Statistics show that in January 2000 regular weekly pay (excluding bonuses and before taxes and other deductions from pay) was £293. By December 2018 this had risen to £495. This is an increase of 69 per cent. Over the same period the consumer prices index known as the CPIH, which, unlike the better-known CPI, includes owner-occupied housing costs and Council Tax, rose by 49 per cent. Therefore, the figures are consistent with a rise both in nominal and real pay between January 2000 to December 2018. However, this masks the fact that in recent times real earnings have fallen.

Chart 1 shows the annual percentage changes in actual (nominal) regular weekly pay and the CPIH since January 2001. Each value is simply the percentage change from 12 months earlier. The period up to June 2008 saw the annual growth of weekly pay outstrip the growth of consumer prices – the blue line in the chart is above the red line. Therefore, the real value of pay rose. However, from June 2008 to August 2014 pay growth consistently fell short of the rate of consumer price inflation – the blue line is below the red line. The result was that average real weekly pay fell. (Click here to download a PowerPoint copy of the chart.)

Chart 2 show the average levels of nominal and real weekly pay. The real series is adjusted for inflation. It is calculated by deflating the nominal pay values by the CPIH. Since the CPIH is a price index whose value averages 100 across 2015, the real pay values are at constant 2015 prices. From the chart, we can see that the real value of weekly pay peaked in March 2008 at £482.01 at 2015 prices. The subsequent period saw rates of pay inflation that were lower than rates of consumer price inflation. This meant that by March 2014 the real value of weekly pay had fallen by 8.8 per cent to £439.56 at 2015 prices. (Click here to download a PowerPoint copy of the chart.)

Although real (inflation-adjusted) pay recovered a little during 2015 and 2016, 2017 again saw consumer price inflation rates greater than those of pay inflation (see Chart 1). Consequently, the average level of real weekly pay fell by 1 per cent between January and November 2017. Since then, real regular pay has again increased. In December 2018, average real pay weekly pay was £462.18 at 2015 prices: an increase of 1.1 per cent from November 2017. Nonetheless, inflation-adjusted average weekly pay in December 2018 remained 4.1 per cent below its March 2008 level.

Chart 3 shows very clearly the importance of the distinction between real and nominal when analysing the growth of earnings. The sustained period of real pay deflation (negative rates of pay inflation) that followed the financial crisis can be seen much more clearly by plotting growth rates rather than their levels. Since June 2008 the average annual growth of real regular weekly pay has been −0.2 per cent, despite nominal pay increasing at an annual rate of 2 per cent. In the period from January 2001 to May 2008 real regular weekly pay had grown at an annual rate of 2.1 per cent with nominal pay growing at an annual rate of 4.0 per cent. (Click here to download a PowerPoint copy of the chart.)

The distinction between nominal and real helps us to understand better why some argue that patterns in pay, living standards and well-being have been fundamental in characterising the macroeconomic environment since the financial crisis. Indeed, it is not unreasonable to suggest that these patterns have helped to shape macroeconomic debates and broader conversations around the role of government and of public policy and its priorities.

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Questions

  1. Using the example of GDP and earnings, explain how the distinction between nominal and real relates to the distinction between values and volumes.
  2. In what circumstances would an increase in actual pay translate into a reduction in real pay?
  3. In what circumstances would a decrease in actual pay translate into an increase in real pay?
  4. What factors might explain the reduction in real rates of pay seen in the UK following the financial crisis?
  5. Of what importance might the growth in real rates of pay be for consumption and aggregate demand?
  6. Why is the growth of real pay an indicator of financial well-being? What other indicators might be included in measuring financial well-being?
  7. Assume that you have been asked to undertake a distributional analysis of real earnings since the financial crisis. What might be the focus of your analysis? What information would you therefore need to collect?