Wednesday, September 23, 2020

IS the Botswana economy not affected by the meltdown in Europe and America?

It often amuses me how and why the so-called celebrated economists sometime enjoy the limelight so much so that they sometime make hasty pronouncements without having thoroughly considered their accuracy and/or ramifications.
Recently, it was reported in the local press that one well-known economist had made a statement to the effect that the credit crunch in America and Europe would not affect Botswana economy. Initially, I was reluctant to respond but perhaps it is now opportune to respond and try to demonstrate why the eminent economist should rethink his statement.

First of all, let us try to track the events that led to the melt down. It was first the reports that came out of America in August 2007 where it was reported that many banks were in the midst of a crisis relating to failures of the so-called sub-prime mortgage lending which itself was blamed on predatory lending by mortgage banks.
In mature markets of North America and Europe, it is very common for investment banks and hedge funds to acquire and pool these mortgage loans into special purpose vehicles (spvs) usually private corporations registered in some offshore tax haven) and issue securities on the back of these mortgage loans through a process we normally refer to as securitisation.

When packaged like this and, perhaps insured by the so-called bond insurers or the Freddie Macs of this world, the securities, or bonds to be precise, become very attractive to institutional investors such as investment banks and other fund managers looking for higher returns and perhaps increased property exposure. After all, some of these securities are supported by some of the well-respected bond insurers and government sponsored guarantors and, therefore, even if the underlying mortgage loans may be sub-prime. The fact that the investors have invested in what is more liquid (until the credit crunch sets in, of course) as well as the fact that the packaged mortgage book tends to be well diversified should reduce credit risk to some extent; or should it? Not when the guarantors (the likes of Freddie Mac and Fannie Mae) and the bond insurers come under financial distress themselves.

The structure I have described above is obviously the most basic in terms of complexity; in reality these spvs tend to take very complex structures with differing segmented risk and return profiles.
The problem starts when the underlying mortgage loans start failing in mass; we tend to rash to blame predatory lenders and those who got themselves into mortgage loans that they could ill-afford but during a cyclical downturn, what might have started off as good lending could very easily and quickly become sub prime as mortgage borrowers quickly discover that they can no longer service their loans.
The casualties of the sub-prime mortgage lending are well known and they come in all sort of names ranging from well respected sport personalities to some of the hitherto well respected banks and hedge funds. The likes of Northern Rock in England could not stand the heat because as soon as word got around, their depositors started developing cold feet and wanted to withdraw their money, a process that ultimately led to the Bank of England intervening to save the bank. But the damage had been done; the first run on a British bank in 44 years had gone into the history books and my sense is that when it is finally rehabilitated, it will need to quickly change its name and/or be acquired by some other bank.

As you might have guessed, this irrational exuberance and shenanigans tend to gain popularity at the height of strong financial markets. But why it is always that it is the mortgage/property sector that seems to precipitate or be the main victim of an economic downturn.
During times of economic stability or boom, every one wants to build up his portfolios as quickly as possible; you cannot blame the predatory lenders, after all, their bonuses depend on them. Secondly, mortgage lending tends to be long term because of amounts involved. On an aggregate basis, property or mortgage loans represent a significant stock of every country’s stock of debt; therefore any shock felt by the sector tends to have far reaching and snow bowling effect on the rest of the economy and beyond.

Most economic observers will tell you that the property sector has always been at the centre of every economic meltdown whether you talk about the economic recessions of 1979/80 caused by oil shock, the 1990/91 meltdown precipitated by the collapse of the property market itself, the 1999/2002 slowdown traceable to the so-called the Asian contagion or the current slowdown blamed on the property market.
The first to be hit were the mortgage lenders themselves, then came the hedge funds and the bond insurers and lastly those institutional investors who held the asset backed securities in their portfolios. This sent shivers in the international financial markets which caused widespread fear and panic resulting in a credit crunch a situation that is usually characterized by illiquidity and high cost of borrowing.

Inter bank lending disappeared over night and where it existed, it was at exorbitant cost.
On the other hand, fearing for the negative impact on domestic economic activity, which was already shaky, the Fed decided to cut its key short term interest rates. That could have only provided short term respite because the problem was fundamentally due to illiquidity problem which, despite the huge interventions across America, Europe and England, persisted and many say it is still going to get worse before it gets better.
Now how could a well drilled economist have made a statement that these events and phenomenon would not affect Botswana economy! Frankly, I do not know; I am just as baffled.

There are essentially two possible ways that the local economy and in particular those entities that might have directly invested in investment banks and/or those that invested in mutual funds directly holdings stocks of sub-prime mortgage lenders.
In Botswana, pension funds and other endowment funds can only invest a maximum of 30 per cent of the value of the funds. This money would normally be handed over to off-shore fund managers to invest on behalf of the local fund managers.
Now, as it is normally the case, these off-shore fund managers are given full discretionary powers in how to manage the funds; meaning that if they chose to invest in mutual funds that have exposure to sub-prime mortgage in their portfolios or in the securities issued by the mortgage lenders themselves, they can do so. Now if a fund is exposed to the sub-prime mortgage lending in this way, it would be affected, albeit indirectly. To what extent? It would depend on the extent of exposure and is difficult to speculate without a survey on the way the local institutional investors have their funds invested.

The other transmission mechanism would have been through the foreign exchange market.
Now we know what happened to the US dollar following the sub-prime mortgage crisis and ultimately the credit crunch. The US dollar is not only a hard currency but it also tends to be currency of choice to most investors outside America.

The problem is that if a fund finds itself over exposed to dollarized assets either because the investment advisor does not believe in the US dollar depreciating against third world currencies, when the dollar depreciates, as it did following the credit crunch, the funds that are exposed to the US dollar would be affected. It is through this transmission mechanism that, in my view, Botswana funds invested in dollarized assets could not have escaped the impact of the economic meltdown in America, itself precipitated by the initial sub-prime mortgage crisis and ultimately the credit crunch that resulted both leading the Fed, the ECB and the BoE to adopt a more accommodatory monetary policy stance, specifically by reducing their key short term interest rates in the quest to provide liquidity to their financial markets.

The other not so well understood transmission mechanism comes in through credit policy guidelines from panicky risk management officials in the headquarters of the foreign controlled banks who typically do not distinguish from one jurisdiction to the other when they pronounce their credit appetite.

Even here in Botswana there is evidence, albeit at micro level, of tightening of credit guidelines and heightened cost of borrowing both of which can be ascribed to the credit crunch prevailing in North America and Europe.
A credit crunch means that the banking system can no longer sustain the level of credit extension and the cost thereon at the levels that they have hitherto sustained. This generally leads to a deferment of investment and consumption by the private sector, which in turn dampens aggregate demand in the economy and ultimately leads to an economic slowdown.
Now how could our economist have said that the sub-prime mortgage lending crisis in America would not affect Botswana. I honestly do not know, but my guess is that we all have been affected, albeit indirectly; the pension funds, the foreign exchange reserves of the country and others.
I hope this article has helped remove some of the misconceptions and ill-conceived conclusions about whether Botswana economy has been affected by the financial meltdown in mature markets or not. The important thing is for the reader to recognise that the credit market, the foreign exchange market, the equity market and other sub-market for financial instruments are all connected and it is usually impossible to fully insulate against the risks associated with these markets.

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The Telegraph September 23

Digital edition of The Telegraph, September 23, 2020.