“Economic Affairs”

or
“ Understanding the Business Pages”

Handout

Facilitator: Bilal Ilahi.

b_ilahi@yahoo.com
19.02.10 MBA, LUMS.

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A word from the facilitator.
This handout is being provided to supplement this learning activity. Please read it.Also it
should be understood that, you need to constantly update your knowledge of the business
pages. This can only be done by doing your reading every day.The tools required to
understand the contents will be provided to you during the course of this workshop. If
you require a copy of my power point presentation, it will be provided to you also.
If you have any questions or problems in understanding the business pages feel free to
contact me on b_ilahi@yahoo.com GOOD LUCK…..

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FISCAL & MONETARY POLICY

Business Cycles. The term business cycle refers to fluctuations in economic activity
(business fluctuations) around a long-term growth trend. It typically involves shifts over
time between periods of relatively rapid growth of economic output / GDP growth
(expansion or boom), and periods of relative stagnation or decline (contraction or
recession). These fluctuations are often measured using the growth rate of real GDP.

GDP represents the total aggregate output of the economy. Too much GDP growth
is also dangerous, as it will most likely come with an increase in inflation. Once inflation
is in place, it can quickly become self-reinforcing. This is because in a country where
inflation is increasing, people will spend more money because they know that it will be
less valuable in the future.

So wanting GDP growth and fighting inflation are competing objectives. A crucial
question for economic policy makers is, what maximum inflation rate and what minimum
GDP growth rate (& unemployment rate) is acceptable for an economy.

Macro-economic policy consists of Fiscal Policy (made by the Finance Ministry) and
Monetary Policy (made by the Central Bank). The objectives of fiscal and monetary
policy are the same i.e. the maximum and sustainable GDP growth rate along with an
acceptable rate of inflation.

Fiscal policy refers to government attempts to influence the direction of the economy
through changes in government taxes, or through government spending. It is the use of
revenue collection and government spending to influence the economy and is reflected in
the budget document.

Pakistan’s Fiscal Policy 09-10.

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Pakistan's Budget, 09-10 (in million):
Some salient features of the budget are:
Total Expenditure = Rs.2,482,300. (Rs. 2.48 tr)

Defence = Rs. 342,900. (2 % of GDP. 15% of the budget)

PSDP =Rs. 646,000. (4 % of GDP. Includes ERRA)
Tax Revenue (FBR) = Rs.1,378,000. (Tax to GDP ratio 08-09= 9.50%. In 98-99= 11%.)
Privatization proceeds = Rs.19,400.
Bank borrowing = Rs. 144,600

Monetary policy attempts to stabilize the economy by controlling interest rates and the
supply of money. The main monetary policy instruments available to central banks are:
1.Open market operation. To release or mop up excess liquidity in the economy.
2.Reserve requirement. Increasing this for the commercial banks will reduce their lending
capacity.
3.Interest rate policy. In a contractionary policy, interest rates will go up. Inflation will
come down.This will put upward pressure on currency value.

These two policies are used in various combinations in an effort to direct a country's
economic goals. It is critical for macroeconomic stability that the objectives of both fiscal
and monetary policy should be identical. For example a tight monetary policy to control
inflation also needs a tight fiscal policy where the budget deficit is controlled. A lack of
coordination, can lead to slow growth without bringing inflation fully under control.
Fiscal and monetary coordination is critical for macro-economic stability.

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CURRENCIES MARKETS.

Increased demand for a currency is due to “transaction demand” for money OR

“speculative demand” for money.
FOREIGN EXCHANGE MARKET. One of the largest in the world---- $3.5 trillion of
currency changes hands every day. Doubled in last 4 years.
SPOT EXCHANGE RATE - Current Exchange Rate.
FORWARD EXCHANGE RATE - Quoted and traded today but for delivery and
payment on a specific future date.

US $.
The pre-eminent global currency. Also known as the global reserve currency. The IMF
counts 13 countries using $ as their currency eg. Ecuador. Half of all notes in circulation,
$ 350 bn., are held outside of USA.
THE FED, “The Federal Reserve”, is the central bank of the USA.

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FOMC. The Federal Open Market Committee of the FED sets interest rates (“The
discount rate” and “The Federal Funds rate”). Every 1 ½ months, worldwide currency
markets are focused on the meeting of FOMC (Is the interest rate on the US $ going up or
not? This can affect US$ value. What does the “beige book” say? The beige book is the
FED’s report giving its assessment about the US and the global economy and is eagerly
awaited by currency dealers and other stake holders all over the world)
O.M.O. (open market operations) carried out by the FED to control liquidity and
inflation.

$ OUTLOOK; Between 2002 - 2008, the dollar lost 40% of its value. As the dollar lost
value, other currencies gained. In 2002 a Euro was worth 87 cents but by April 2008 it
was worth $1.60. But the $ and gold have safe haven status and after April ‘08, the
dollar grew stronger as businesses started hoarding them in a ‘flight to safety’. However
in the summer of 2009 it traded at $1.45 range as investors ‘risk appetite’ increased and
they took “flight from safety’ increasing Euro’s appeal.
Until the recession ends, the dollar may remain strong, since it is a safe haven or it may
weaken because US interest rates are low and investors become ‘risk averse’ and take
‘flight from safety’! As the global economy recovers, the demand for the dollar may fall
again for the same reasons it declined in recent times:

1. The U.S. debt will probably continue to rise. Foreign investors are
concerned that the U.S. may let the dollar decline so the relative value of its
debt is less.
2. The large debt could force the U.S. to raise taxes to pay it off,
which would slow economic growth, weakening the $ further.
3. As more countries join or trade with the EU, demand for the euro
will increase.
4. Foreign investors may want to diversify their portfolios with more
non-dollar denominated assets.
5. As the dollar begins to decline again, investors will be less likely
to hold assets in US$.
6. China and Russia are both keen that gradually US $’s role be
reduced which will lessen its appeal.
7. “Carry-trade” takes place when large investors borrow in low
interest rate currencies like the $ and invest in assets in high yielding
currencies. As the $ is sold off to buy the other currency the value of the $
falls. This is called the $ Carry Trade. Asset bubbles can be created as a
consequence of this trade.

Euro.
Euro is the currency of the EURO ZONE (15 countries) and not the entireEU (28
Countries).
E.C.B. is the central Bank of the E.U. and the guardian of the Euro.
Interest rates are set by the ECB’s Governing Council.

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ECB’s medium-term inflation target is 2% (“Growth and stability pact” of EU for the
Eurozone).
In 2007, Euro was appreciating as the economy of EUROZONE was performing well.
GDP growth brings with it inflation or risk of inflation & therefore higher interest rates
from ECB. Higher interest rates curb both inflation and economic growth but also cause
the currency (Euro) to rise further!! This makes the Euro more attractive than the $.
Demand for Euro went up hence its appreciation! Euro gained 12% against US $ in ‘07.
A higher Euro put Euro zone exporters at a disadvantage. Eg. Airbus Industries which ran
into problems.

Pound Sterling.
Bank of England or BOE is the central bank of the UK. Responsible for “monetary
policy” & the “exchange rate system”.
Monetary Policy Committee or MPC is responsible for formulating monetary policy.
FSA i.e. the Financial Services Agency which monitors the commercial banks.

Yen.
Central bank of Japan is THE BANK OF JAPAN or BOJ.
Criticized for lack of autonomy despite’97 law.
1998-2005. Deflation along with slump in demand and excess capacity. BOJ drops
interest rate to 0.10%. Gives rise to “Yen Carry Trade” with a size of $ 1 trillion. Cutting
the interest rate close to zero did not work. No impact, people had become ‘risk averse’.

Yuan ( Chinese)
The central bank of China is called The Peoples Bank of China or POBC. Record-
breaking “trade surpluses” with the U.S. which should have caused the Yuan to
appreciate. But From 1994 to 2005 there was a “Fixed peg” @ 8.28 Yuan / $ allowing
the currency to fluctuate only in a narrow band. A landmark date is 21 July, 05 when the
end of the Yuan-$ peg was announced by the Chinese Government. PBOC said it would
adjust the YUAN value based on a basket of currencies. This led to a modest revaluation
of the Currency by 2.1 %. First step towards a free float.

Currencies are increasingly demonstrating a strong correlation with other markets

particularly stock markets. E.g. Shanghai dropped 9% in Feb.2007 because of Yen Carry
Trade.

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 COMMODITIES MARKETS.

The 3 commodity types Grain ,Coal and Metals. Historically move according to separate
business cycles. The recent boom in all 3 was unusual.

COMMODITY PRICING. Contango is when commodity prices are lower in “spot

market” & higher in the “futures market”. Normally interest costs means that “futures
prices” are higher. Backwardation is when commodity prices are higher in the “spot
market” and lower in the “futures market”. Maybe because there is currently a supply
bottleneck.

Crude Oil.
The most important commodity in the world today. There are 161 different
internationally traded crude oils. They have different characteristics quality and market
penetration. The benchmark oils are West Texas Intermediate (the underlying commodity
of New York Light Sweet Crude) & Brent North Sea.
The most important futures oil market is NYMEX (New York Mercantile
Exchange).Internationally the price of oil is set in US dollars per barrel, by the forces of
demand and supply. Some of the important volatile supply factors are:

• Iraq
• Nigeria
• Venezuela
• Choke points
• Hurricane season
• Tanker capacity
• Refinery capacity
• Capital Investment. Low as oil prices fall.
• Strategic reserves of USA. Also Japan and India

Some of the important volatile demand factors are:

 USA a.) Summer driving season. b.) N.E. winter season.

 China
 India.

 Value of the US $.

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CRUDE OIL OUTLOOK; In 2007 & 2008 oil prices determined as much by supply-
demand mismatch as by speculation by hedge funds and pension funds.
Consumption fell in 2009. Expected to rise in 2010 depending on global economic
growth and the value of the $.

Cotton.
Total international trade in cotton is $12 bn. whereas international trade in textiles is
close to $ 400 bn. Pakistan produced 11.5 mn. bales in 07-08. Global consumption 98
million bales. Cotton is a thirsty crop. Pakistan’s “water resources’?
Rate 1 maund = (37/ 32 Kg) = RS.5,000. (Pakistan -KCE). $0.70 / lb. New York.
1 bale of Cotton = 4.05 maunds. 1 Lot = 100 bales.
Demand factors are:
1. Purchasing power for textile products in EU &USA
2.)Pakistan’s local demand 16 million bales based on 10 million spindles.
3.) “Substitute effect” of polyester, nylon, acrylic, etc.
Supply factors are:
1.) USA, Pakistan, India, China etc crop. Acreage and Yield is a big factor.
2.) Supply of man-made fibers e.g. polyester and acrylic.

Copper.
One of the most important Base Metals.
Demand Factors are:
1.) China
2.) India.
3.) Global construction industry, for use in electric wires.
Supply factors are:
1.) Chile etc.
2.) Investment in mines and equipment.

Palm Oil.
Some of the Demand Factors:
1.) Global demand for food. Used for edible oil.
2.) Bio-diesel etc.
3.) Palm oil falls as Ringgit gains. Just as Crude oil falls with $ gaining.
Supply Factors:
1.) Indonesia & Malaysia are major producers. Requires lots of land.
2.) Soya oil is a close substitute (Brazil).

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Gold.
Rate 1 0z. =$ 1,200 ( Nov‘09. World market.).
Market: London Bullion Market.

Demand Factors:
1. Safe haven…US.$ or Gold
2. Lower interest rates in the US, lead to lower $ against other hard currencies, gold up.
3. Hedge against oil-led inflation.
4. Indian wedding season.
5. Alternative form of money.
Supply Factors:
The most important is South Africa, which had production problems in its mines last year
because of electricity problems.

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CAPITAL MARKETS

CAPITAL MARKET includes institutions that channelize supply & demand for long
term capital e.g. Stock Exchange, Banks, and Insurance cos.
STOCK EXCHANGE. A market in which shares are bought and sold. They facilitate
saving and investment in the economy.

 “Trust is the cornerstone of the markets” E.g. in USA, DJIA fell twice as much
at the time of financial scandals of 2003, than it did on 9 / 11.
 Joseph Stiglitz, Nobel Prize winner:
1. “The stock market does not always reflect the broader economic reality”
2.“Economic science has shown that it is virtually impossible systematically to
make money by beating the market”
 “The efficient markets hypothesis”. All available information is rapidly taken into
account in share prices. E.g. “factored in” or “priced in” OR is it?
 “The myth of return on shares”. If you take any 20 years period, Wall Street has
delivered positive real returns…higher than government bonds. Correct but only 3
other countries match this.
 Nikkei 225:
Dec 1980 38,915. .
Oct 2007 17,000 .
Oct 2008 7,162

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COMMODITIES MARKETS, CURRENCY MARKETS and CAPITAL MARKETS &
other markets are constantly reacting within themselves AND with each other e.g. :

1.) Palm oil and Soya oil ,as substitutes ( within commodities markets )
2.) Crude oil and palm oil .When crude goes above $70, bio-diesel story begins.
(within commodities markets)
3.) “Yen-carry trade” .Yen, NZ$, NZ stock market, Shanghai stock mkt. (currencies
markets and capital markets)
4.) Crude Oil and US$. (commodities markets & currency markets)
5.) US $ and Gold. Inverse relationship. Both safe havens. (currency markets and
commodity markets.)
6.) “Sub-prime mortgage” crisis in the USA will cause repossession of estimated
1 million homes and a slump in the real estate market .This could put a brake on US
GDP growth. Downward pressure on the US $. (Real estate market and currencies).
7.) Because of investments in bonds called “mortgage backed securities” Merrill
Lynch forced to write off $7.9 billion in losses. Merrill Lynch stock dropped. Dow
Jones fell. (Bonds market and stock market.)

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INTERNATIONAL TRADE & W.T.O.

INTERNATIONAL TRADE. Measured by the volume of imports & exports which

has grown 17 times between 1950 & 2000 when output (GDP) increased only 6
times.
GDP = C + I+ G + ( X – M ). This is the output method of GDP calculation.
EXPORTS. Sales abroad.
IMPORTS. Purchase of foreign goods and services.
There are a few cases of rapid development in modern history that has not relied on
exports as an engine of GDP growth.
In 2008 world trade to grow at 8% while global GDP at4.5%.
PROTECTIONISM. To protect a countries economy from foreign competition.
FREE TRADE is the opposite of Protectionism.
TARIFF. Tax on goods produced abroad. E.g. Custom duty by CBR.
SUBSIDY. Money paid by government to keep prices below what they would be in a
free market. A form of protectionism.
QUOTA. A limit on the number of goods that can be imported. Also protectionism.
W.T.O. Promotes trade by lowering of tariffs, subsidies and quotas. Sets and enforces
the rules of international trade. Formed 1995. H.Q. Geneva. Membership of 153
countries.

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DUMPING. Selling goods in export market for less then the cost of producing it.
Opposed by WTO.
ANTI-DUMPING DUTY. As per WTO. Imposed by NTC in Pakistan.
DOHA ROUND is the current round of WTO talks.
Pakistan is a member of the WTO. (automatically because of GATT).

Current issues facing WTO:

1.Trading in farm products which is the agenda of the under-developed countries.
2. Trading in services & industrial products is the agenda of the developed
countries.

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