In recent months the Chinese central bank (the People’s Bank of China) has taken a number of measures to boost aggregate demand and arrest the slowing economic growth rate. Such measures have included quantitative easing, cuts in interest rates, a devaluation of the yuan and daily injections of liquidity through open-market operations. It has now announced that from 1 March it will reduce the reserve requirement ratio (RRR) for banks by a half percentage point.
The RRR is the percentage of liabilities that banks are required to hold in the form of cash reserves – money that could otherwise have been used for lending. This latest move will bring the compulsory ratio for the larger banks down from 17.5% to 17%. This may sound like only a small reduction, but it will release some ¥650bn to ¥690bn (around $100bn) of reserves that can be used for lending.
The cut from 17.5% to 17% is the fourth this year. Throughout 2014 and 2015 it was stable at 20%.
The hope is that this lending will not only help to boost economic growth but also stimulate demand for the consumption of services. The measure can thus be seen as part of a broader strategy as the authorities seek to re-balance the economy away from its reliance on basic manufacturing towards a more diversified economy. It is also hoped that the extra demand will help to boost jobs and thus provide more opportunities for people laid off from traditional manufacturing industries.
It is expected that further reductions in the RRR will be announced later in the year – perhaps a further 1.5 to 2 percentage points.
But what will be the effect of the releasing of reserves? Will the boost be confined to $100bn or will there be a money multiplier effect? It is certainly hoped by the authorities that this will stimulate the process of credit creation. But how much credit is created depends not just on banks’ willingness to lend, but also on the demand for credit. And that depends very much on expectations about future rates of economic growth.
One issue that concerns both the Chinese and overseas competitors is the effect of the measure on the exchange rate. By increasing the money supply, the measure will put downward pressure on the exchange rate as it will boost the demand for imports.
The Chinese authorities have been intervening in the foreign exchange market to arrest a fall in the yuan (¥) because of worries about capital outflows from China. The yuan was devalued by 2.9% in August 2015 from approximately ¥1 = ¢16.11 to approximately ¥1 = ¢15.64 (see chart) and after a modest rally in November 2015 it began falling again, with the Chinese authorities being unwilling to support it at the November rate. By January 2016, it had fallen a further 2.8% to approximately ¢15.20 (click here for a PowerPoint file of the chart).
But despite the possible downward pressure on the yuan from the cut in the reserve requirement, it will probably put less downward pressure than a cut in interest rates. This is because an interest rate cut has a bigger effect on capital outflows as it directly reduces the return on deposits in China. The central bank had already cut its benchmark 1-year lending rate from 6% to 4.35% between November 2014 and October 2015 and seems reluctant at the current time to cut it further.
China central bank resumes easing cycle to cushion reform pain Reuters, Pete Sweeney (29/2/16)
China cuts reserve requirements for banks to boost economy PressTV (29/2/16)
China Moves to Bolster Lending by Easing Banks’ Reserve Ratio New York Times, Neil Gough (29/2/16)
Economists React: China’s ‘Surprise’ Bank Reserve Cut Wall Street Journal (29/2/16)
China Cuts Banks’ Reserve Requirement Ratio Bloomberg, Enda Curran (29/2/16)
China Reserve-Ratio Cut Signals Growth Is Priority Over Yuan Bloomberg, Andrew Lynch (29/2/16)
China reserve ratio cut not a signal of impending large-scale stimulus: Xinhua Reuters, Samuel Shen and John Ruwitch (2/3/16)
China injects cash to boost growth and counter capital outflows Financial Times, Gabriel Wildau (29/2/16)
China’s Economic Policy Akin To Pushing On A String Seeking Alpha, Bruce Wilds (2/3/16)
China cuts banks’ reserve ratio for fifth time in a year: Why and what’s next Channel NewsAsia, Tang See Kit, (1/3/16)
Questions
- Explain what is mean by the required reserve ratio (RRR).
- Explain how credit creation takes place.
- What will determine the amount of credit creation that will take place as a result of the $100bn of reserves in Chinese banks released for lending by the cut in the RRR from 17.5% to 17%.
- What prompted the recent cuts in the RRR?
- Why may China’s recent monetary policy measures be like pushing on a string?
- Is the reduction in the RRR a purely demand-side measure, or will it have supply-side consequences?
- Explain how different types of monetary policy affect the exchange rate.
- Should other countries welcome the cut in China’s RRR? Explain.
There is a lot of pessimism around about the state of the global economy and the prospects for more sustained growth. Stock markets have been turbulent; oil and other commodity prices have fallen; inflation has been below central bank targets in most countries; and growth has declined in many countries, most worryingly in China.
The latest worry, expressed by finance ministers at the G20 conference in Shanghai, is that UK exit from the EU could have a negative impact on economic growth, not just for the UK, but for the global economy generally.
But is this pessimism justified? In an interesting article in the Independent, Hamish McRae argues that there are five signs that the world economy is not doomed yet! These are:
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There are more monetary and fiscal measures that can still be taken to boost aggregate demand. |
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Despite some slowing of economic growth, there is no sign of a global recession in the offing. |
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US and UK growth are relatively buoyant, with consumer demand ‘driving the economy forward’. |
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Deflation worries are too great, especially when lower prices are caused by lower commodity prices. These lower costs should act to stimulate demand as consumers have more real purchasing power. |
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Inflation may start to edge upwards over the coming months and this will help to increase confidence as it will be taken as a sign that demand is recovering. |
So, according to McRae, there are five things we should look for to check on whether the global economy is recovering. He itemises these at the end of the article. But are these the only things we should look for?
Five signs that the world economy is not doomed yet Independent, Hamish McRae (27/2/15)
Questions
- What reasons are there to think that the world will grow more strongly in 2016 than in 2015?
- What reasons are there to think that the world will grow less strongly in 2016 than in 2015?
- Distinguish between leading and lagging indicators of economic growth.
- Do you agree with McRae’s choice of five indicators of whether the world economy is likely to grow more strongly?
- What indicators would you add to his list?
- Give some examples of ‘economic shocks’ that could upset predictions of economic growth rates. Explain their effect.
In an attempt to prevent recession following the financial crisis of 2007–8, many countries adopted both expansionary monetary policy and expansionary fiscal policy – and with some success. It is likely that the recession would have been much deeper without such policies
But with growing public-sector deficits caused by the higher government expenditure and sluggish growth in tax receipts, many governments soon abandoned expansionary fiscal policy and relied on a mix of loose monetary policy (with ultra low interest rates and quantitative easing) but tight fiscal policy in an attempt to claw down the deficits.
But such ‘austerity’ policies made it much harder for loose monetary policy to boost aggregate demand. The problem was made worse by the attempt of both banks and individuals to ‘repair’ their balance sheets. In other words banks became more cautious about lending, seeking to build up reserves; and many individuals sought to reduce their debts by cutting down on spending. Both consumer spending and investment were slow to grow.
And yet government and central banks, despite the arguments of Keynesians, were reluctant to abandon their reliance solely on monetary policy as a means of boosting aggregate demand. But gradually, influential international institutions, such as the IMF (see also) and World Bank, have been arguing for an easing of austerity fiscal policies.
The latest international institution to take a distinctly more Keynesian stance has been the Organisation for Economic Co-operation and Development (OECD). In its November 2015 Economic Outlook it had advocated some use of public-sector investment (see What to do about slowing global growth?. But in its Interim Economic Outlook of February 2016, it goes much further. It argues that urgent action is needed to boost economic growth and that this should include co-ordinated fiscal policy. In introducing the report, Catherine L Mann, the OECD’s Chief Economist stated that:
“Across the board there are lower interest rates, except for the United States. It allows the authorities to undertake a fiscal action at very very low cost. So we did an exercise of what this fiscal action might look like and how it can contribute to global growth, but also maintain fiscal sustainability, because this is an essential ingredient in the longer term as well.
So we did an experiment of a two-year increase in public investment of half a percentage point of GDP per annum undertaken by all OECD countries. This is an important feature: it’s everybody doing it together – it’s a collective action, because it’s global growth that is at risk here – our downgrades [in growth forecasts] were across the board – they were not just centred on a couple of countries.
So what is the effect on GDP of a collective fiscal action of a half a percentage point of GDP [increase] in public investment in [high] quality projects. In the United States, the euro area, Canada and the UK, who are all contributors to this exercise, the increase in GDP is greater than the half percentage point [increase] in public expenditure that was undertaken. Even if other countries don’t undertake any fiscal expansion, they still get substantial increases in their growth rates…
Debt to GDP in fact falls. This is because the GDP effect of quality fiscal stimulus is significant enough to raise GDP (the denominator in the debt to GDP ratio), so that the overall fiscal sustainability [debt to GDP] improves.”
What is being argued is that co-ordinated fiscal policy targeted on high quality infrastructure spending will have a multiplier effect on GDP. What is more, the faster growth in GDP should outstrip the growth in government expenditure, thereby allowing debt/GDP ratios to fall, not rise.
This is a traditional Keynesian approach to tackling sluggish growth, but accompanied by a call for structural reforms to reduce inefficiency and waste and improve the supply-side of the economy.
Articles
Osborne urged to spend more on infrastructure by OECD Independent, Ben Chu (18/2/16)
OECD blasts reform fatigue, downgrades growth and calls for more rate cuts Financial Review (Australia), Jacob Greber (18/2/16)
OECD calls for less austerity and more public investment The Guardian, Larry Elliott (18/2/15)
What’s holding back the world economy? The Guardian, Joseph Stiglitz and Hamid Rashid (8/2/16)
OECD calls for urgent action to combat flagging growth Financial Times, Emily Cadman (18/2/16)
Central bankers on the defensive as weird policy becomes even weirder The Guardian, Larry Elliott (21/2/16)
Keynes helped us through the crisis – but he’s still out of favour The Guardian, Larry Elliott (7/2/16)
G20 communique says monetary policy alone cannot bring balanced growth
Reuters (27/2/15)
OECD publications
Global Economic Outlook and Interim Economic Outlook OECD, Catherine L Mann (18/2/16)
Interim Economic Outlook OECD (18/2/16)
Questions
- Draw an AD/AS diagram to illustrate the effect of a successful programme of public-sector infrastructure projects on GDP and prices.
- Draw a Keynesian 45° line diagram to illustrate the effect of a successful programme of public-sector infrastructure projects on actual and potential GDP.
- Why might an individual country benefit more from a co-ordinated expansionary fiscal policy of all OECD countries rather than being the only country to pursue such a policy?
- What determines the size of the multiplier effect of such policies?
- How might a new classical/neoliberal economist respond to the OECD’s recommendation?
- Why may monetary policy have ‘run out of steam’? Are there further monetary policy measures that could be adopted?
- Compare the relative effectiveness of increased government investment in infrastructure and tax cuts as alterative forms of expansionary fiscal policy.
- Should quantitative easing be directed at financing public-sector infrastructure projects? What are the benefits and problems of such a policy? (See the blog post People’s quantitative easing.)
On 20 February, the UK Prime Minister, David Cameron, announced the date for the referendum on whether the UK should remain in or leave the EU. It will be on 23 June. The announcement followed a deal with EU leaders over terms of UK membership of the EU. He will argue strongly in favour of staying in the EU, supported by many in his cabinet – but not all.
Two days later, Boris Johnson, the Mayor of London, said that he would be campaigning for the UK to leave the EU.
In the meantime, Mr Johnson’s announcement, the stance of various politicians and predictions of the outcome of the referendum are having effects on markets.
One such effect is on the foreign exchange market. As the Telegraph article below states:
The pound suffered its biggest drop against the dollar in seven years after London Mayor Boris Johnson said he will campaign for Britain to leave the European Union [‘Brexit’].
Sterling fell by as much as 2.12pc to $1.4101 against the dollar on Monday afternoon, putting it on course for the biggest one day drop since February 2009. Experts said the influential Mayor’s decision made a British exit from the bloc more likely.
The pound also fell by as much as 1.2pc to €1.2786 against the euro and hit a two-year low against Japan’s yen.
This follows depreciation that has already taken place this year as predictions of possible Brexit have grown. The chart shows that from the start of the year to 23 February the sterling trade weighted index fell by 5.3% (click here for a PowerPoint).
But why has sterling depreciated so rapidly? How does this reflect people’s concerns about the effect of Brexit on the balance of payments and business more generally? Read the articles and try answering the questions below.
Articles
Pound in Worst Day Since Banking Crisis as `Brexit’ Fears Bite Bloomberg, Eshe Nelson (21/2/16)
Pound hits 7-year low on Brexit fears Finiancial Times, Michael Hunter and Peter Wells (22/2/16)
Pound in freefall as Boris Johnson sparks Brexit fears The Telegraph, Szu Ping Chan (22/2/16)
Pound falls below $1.39 as economists warn Brexit could hammer households The Telegraph, Peter Spence (24/2/16)
Why is the pound falling and what does it mean for households and businesses? The Telegraph, Szu Ping Chan (23/2/16)
Pound heading for biggest one-day fall since 2009 on Brexit fears BBC News (22/2/16)
Cameron tries to sell EU deal after London mayor backs Brexit Euronews, Guy Faulconbridge and Michael Holden (22/2/16)
EU referendum: Sterling suffers biggest fall since 2010 after Boris Johnson backs Brexit International Business Times, Dan Cancian (22/2/16)
Exchange rate data
Spot exchange rates against £ sterling Bank of England
Questions
- What are the details of the deal negotiated by David Cameron over the UK’s membership of the EU?
- Why did sterling depreciate in (a) the run-up to the deal on UK EU membership and (b) after the announcement of the date of the referendum?
- Why did the FTSE100 rise on the first trading day after the Prime Minister’s announcement?
- What is the relationship between the balance of trade and the exchange rate?
- What are meant by the ‘six-month implied volatility in sterling/dollar’ and the ‘six-month risk reversals’?
- Why is it difficult to estimate the effect of leaving the EU on the UK’s balance of trade?
Some of the largest companies around the world operate in multiple locations. This allows them to take advantage of wider markets, cheaper transport and of course, lower taxes. In many cases, we see companies selling in one country, but locating their Headquarters in another, where tax rates are cheaper and hence their tax bills are lower. Much criticism has been levelled at such companies, who are accused of not paying their fair share in tax. There has been a crackdown on these companies and the UK is playing a leading role in this tightening of tax laws. Google is the latest company to face a large payment in backdated taxes.
This is a company with a complex structure, which has involved Bermuda as a key location, with its zero rate of corporation tax and a Irish European base. Though locating its business in different countries is legal, it has now agreed to pay HMRC £130 million in back taxes from 2005, following a 6 year investigation. Google will also change its accounting system such that it pays more tax in Britain for sales in this country.
Google may be the first in a line of companies making such changes to its accounting practices following a global drive to tackle the low levels of taxes paid by these large companies. This change in tax rules may bring welcome relief to government coffers, though criticisms remain about the ‘real’ figure that Google owes. As an example of this: in 2013, Google’s UK revenues were $5.6bn. Yet it only paid £20.5m in tax on its UK profits. The Head of Google Europe, Matt Brittin said:
“The rules are changing internationally and the UK government is taking the lead in applying those rules so we’ll be changing what we are doing here. We want to ensure that we pay the right amount of tax.”
Mr Brittin was clear in saying that these back dated taxes are not evidence that they had been paying too little tax in previous years. He confirmed that they were abiding by tax laws at the time and that tax laws are now changing and hence so will the amount of tax they pay. He continued:
“I think there was concern that international companies were paying only in respect of profits that they make and those were the rules and the pressure was to see us pay in respect of the sales we make to UK customers – and the same for other companies…So, we are making a change because we want to continue to comply with the rules and the rules are changing.”
As the push to tighten tax laws changes, with firms paying more tax on sales as well as profits, we may observe more companies changing their accounting structures. The OECD has taken a big step in simplifying international tax laws and the coming years will tell us just how big an impact this will have and whether companies such as Google will face tax bills in other European countries as well. The following articles consider this taxing matter.
Google agrees £130m UK tax deal with HMRC BBC News, Kamal Ahmed (23/01/16)
Google strikes £130m back tax deal Financial Times, John Gapper (22/01/16)
Google strikes deal with UK tax authority Wall Street Journal, Sam Schechner and Stephen Fidler (23/01/16)
Google agrees to pay HMRC £130m in back taxes The Guardian, Kevin Rawlinson (23/01/16)
Google tax labelled ‘derisory’ by Labour’s John McDonnell BBC News (23/01/16)
Google to pay £130 million UK back taxes, critics want more Reuters, Tom Bergin (23/01/16)
Google to pay UK £130m in back taxes The Telegraph (22/01/16)
Google says it will pay £130m in back taxes Independent, Adam Barnett (23/01/16)
Google ‘agrees’ to pay £130m in extra UK tax after outrage when it coughed up just £20m on UK sales of nearly £4bn Mail Online, Imogen Calderwood (22/01/16)
Google agrees to pay $185 million in UK tax settlement Bloomberg, Brian Womack (23/01/16)
Questions
- What is the difference between a tax on sales and a tax on profits?
- How can companies legally avoid tax? Do you think they have a moral duty to pay tax?
- If firms face higher rates of taxation, how will this affect their costs and profits?
- Why are the larger multinationals, such as Google more able to engage in tax avoidance schemes?
- Do you think the problem of tax avoidance is one of the negative consequences of globalisation?
- Is the criticism about the ‘low’ amount of taxes paid to HMRC justified?
- The OECD has taken a leading role in tightening international tax policy. Do you think this will negatively impact the competitiveness of the global market place?
- What are the costs and benefits to a country of having a low rate of corporation tax?
In recent months the Chinese central bank (the People’s Bank of China) has taken a number of measures to boost aggregate demand and arrest the slowing economic growth rate. Such measures have included quantitative easing, cuts in interest rates, a devaluation of the yuan and daily injections of liquidity through open-market operations. It has now announced that from 1 March it will reduce the reserve requirement ratio (RRR) for banks by a half percentage point.
But what will be the effect of the releasing of reserves? Will the boost be confined to $100bn or will there be a money multiplier effect? It is certainly hoped by the authorities that this will stimulate the process of credit creation. But how much credit is created depends not just on banks’ willingness to lend, but also on the demand for credit. And that depends very much on expectations about future rates of economic growth.
