Following the global financial crisis of 2008, the term ‘overheating’ has gained prominence. In the East, China has been the clear frontrunner as an overheated economy, but recently Africa has been showing similar signs. Renowned publications like The Economist have developed indices such as the emerging market overheating index. However, most have neglected the African continent in their investigations.

Is this just another phase in the African growth story? Should the 'O' word be a part of the current discourse, or is it too alarmist to consider such a perspective this early? It is imperative to establish this fact now, because all eyes, be they investors or other developing nations, are on the ‘continent of hope’. Africa is seen as a growth pole that will be a driving force in the growth of the world economy.

This CAI paper proposes, through various examples, that the African economy is at risk of overheating. It defines ‘overheating’, how it comes into play, and sheds some light on the skepticism the term has received over time. It discusses the symptoms of an overheated economy, including those shown by Nigeria and Ethiopia through various indices and parameters. The paper examines measures that can be taken by nations to prevent or minimise the impact such a condition has on nations.

What rising temperatures mean and how they work

Overheating is a situation that arises when aggregate demand for goods and services is increasing so fast and recklessly that it cannot be met by the economy's productive capacity, leading to inflation. It can be loosely termed as a condition in which too much money is chasing too few goods.

Figure 1: Overheated economic growth⁽²⁾

As shown in the graphic above, overheating occurs over a period of time. The early indicators of an economy overheating are high gross domestic product (GDP), high inflation and increasing money supply over a sustained period. These indicators tend to be overlooked as signs of distress, because they are simultaneously indicators of a healthily, growing economy.

But over time, these indicators can lead to exogenous shocks, followed by a drastic decline in GDP, but with continued increases in inflation. Eventually, the economy runs into stagflation, a state of persistent high inflation combined with high unemployment and stagnant demand in a country's economy. Countries are then left with few options, usually involving inflationary and deflationary stances to bring interest rates in line with GDP growth rates. An increase in repo or bank rates, loan interest rates and savings rates would decrease growth in money supply within an economy, leading to reduced demand, which can help curb inflation. A decrease in these rates, a stance taken to cater for deflation, has the opposite effect on money supply.

The volley between these monetary policy stances is a dicey issue and there is a chance of policy stances overshooting requirements. In January 2013, China issued US$ 400 billion in bank lending credit and non-bank financial institutions’ credit. But the following month, it had to withdraw US$ 145 billion from the economy via open-market operations, its biggest weekly cash drain ever.⁽³⁾ The ability to ascertain a perfect balance between the two policy stances makes for quite a challenge.

Even if economic balance can be restored, the path to recovery is much slower than required for economic growth, harming various sectors and facets of the economy in the process.

Overheating - a taboo word?

Most governments whose economies have been subject to overheating refrain from acknowledging the term. To them overheating is no less than a double-edged sword. On the one hand it suggests that the economy has crossed the ceiling of sustainable growth, news that is warmly accepted by most at a macro-economic level. However, the consequences that follow this stage of sustained growth are not seen as favourable. Any attempt to continue to grow at the same rate or at a higher rate would lead to bloated prices as an economy’s accelerated growth would lead to further increases in demand, fuelling further inflation.

On the other hand, if an economy concedes it has overheated, it would acknowledge that price changes would stabilise only if the growth rate was reduced. Few governments, especially those that wish to sustain their time in power, would like their claims of accelerated double-digit growth to be negated.

The first school of thought fails to realise the downside of prolonged accelerated growth, and the latter chooses not to acknowledge such an economic state owing to vote banks (groups of electors who vote en masse for a particular party or candidate, in lieu of incentives and promises made, in case the party leader wins), and other myopic interests.

Impact of over-heated economies

At the outset, the impact of over-heated economies seems only beneficial for a nation. At a macro-economic level, growth rises but at a micro-economic level, ordinary people suffer with prices of goods and services becoming unaffordable. Moreover, another constant among overheating economies is high unemployment rates.

Other parties drastically affected by overheating include a nation’s trading partners, investors and investees. Since there is excess money in the economy, a nation can choose to invest with other nations and make overseas investments in any form it deems fit. On the other hand, overheating economies seem lucrative to foreign investors who will try and pool in more capital, increasing the money supply that a country is trying to dry up in the first place.

More importantly, given that most economies are interdependent on each other through trade, the size or base of an overheating economy is irrelevant. Though Africa’s economies are not the world’s largest, they fuel the growth of most large economies like China and the United States (US).

Gauging the heat: Symptoms of an overheated economy

The biggest, but most neglected, factor that points to an economy overheating is its GDP growth rate. GDP growth at a blistering pace should be seen as an anomaly and should catch anyone’s eye, even if off a low base. However, stellar performance by a country is rarely seen as a red flag, rather it is seen as an achievement, and one that must be prolonged for as long as possible.

Loose monetary policy, a policy stance that allows for the unrestrained flow of money into an economy, is yet another factor that contributes heavily to overheating. This is due to continuously low interest rates that stimulate credit and growth.⁽⁴⁾

A case in point is Ethiopia, whose real growth rates increased alongside inflation over a prolonged period of time. Economic growth and inflation have remained consistently high in Ethiopia over the past few years, with the exception of 2009/10, when demand worldwide fell drastically owing to recession, causing a decrease in inflation. More importantly, money supply increased 156% between 2007 and 2011. Narrow money refers to physical money like coins and currency along with demand deposits and other liquid assets held by the central bank. Quasi money refers to non-cash assets that are highly liquid, such as bank deposits, certificates of deposit and Treasury Bills.

Figure 2: Money supply trends in Ethiopia (Birr in million)⁽⁵⁾

Other symptoms of an overheated economy include output growing beyond potential; large current account deficits (CADs), caused by a country's total imports of goods, services and transfers exceeding exports; an appreciating real exchange rate; and high unemployment.

When taken as a whole, on the CAD front, Africa has managed to stay afloat. Though, it was in negative territory in 2009 and 2010, it resurfaced to a current account surplus thereafter.⁽⁶⁾ However, the caveat is that these numbers represent the entire continent, and hence at a micro level there could be countries facing large CADs.

The Africa region exhibits some strong signals for real exchange rate overvaluation over the past three years. In Nigeria there are strong and persistent signs of overvaluation. Latest data show Nigeria’s current real effective exchange rate (REER), or the weighted average of a currency relative to an index or basket of other major currencies adjusted for the effects of inflation, yields a 30% gap with respect to the long-term trend, indicating the currency is overvalued.

Similarly, the equity market gap, or the gap between prices that occurs when the price of a stock moves sharply up or down with no trading in between, is very wide at 21%. Credit growth, on the other hand, remains subdued, possibly related to Nigeria’s past banking problems. This may mitigate overheating pressures emanating from the REER and equity market gap, at least for now.⁽⁷⁾ Similar situations have been noticed across nations affected by overheating, especially Thailand over the past three years and presently. The current stock market gap against the long-term trend is no less than 66%, whilst the REER is almost 10% above trend, and the credit-to-GDP ratio about 8%.⁽⁸⁾

High unemployment, especially amongst youth, has remained a key characteristic of African labour markets in recent years. According to the International Labour Organisation (ILO), the unemployment rate in Central and North Africa has constantly remained between 10% and 11%, while the world average stood between 5.6% and 6.6% during the period 2007 to 2011.⁽⁹⁾

Cooling down: Measures to control the effects of overheating

As previously mentioned in this paper, overheating is not an overnight process. It takes prolonged fast-tracked growth for an economy to gain that title. Why is it that economies neglect symptoms when they initially surface? Though the symptoms may be misunderstood initially, there is ample time for governments to gauge the root cause and bounce back before it is too late. Constant forecasting, measurement and analysis are required to determine the cause of macroeconomic instability.⁽¹⁰⁾

Constant appraisal of policies and frameworks is yet another less applied requirement among various nations. The goal of a nation is not to suit its policy to situations, but to moderate them in such a manner that economic distress is less likely to arise. Maintaining equilibrium in the economy will inevitably prevent excess growth or stagnation in an economy.

An economy functions on demand, supply, market forces and performance of individual economic sectors. Sectors that grow faster due to market conditions are one of the primary causes of an economy overheating. Restricting the volume of credit and the cash flow that goes to certain overheated sectors can help curb overheating to a large extent.⁽¹¹⁾

Sectors, especially banking, must be deregulated and privatised. Foreign investors are willing to pay a premium for access to African markets, and many other investors are willing to put money into the financial future of the African economy. Partially or fully privatised institutions, with foreign participation, will bring new skills and resources to support Africa’s financial turmoil and will help create powerful constituencies for further reform.⁽¹²⁾ With banking in the hands of private players, constant checks on an economy’s money supply can at least be expected. It would also give the government more time and resources to focus on other sectors of the economy that have not been performing too well. Investment in such sectors will balance circulation of money between various sectors, leading to a decline in overheating, whilst other sectors will become more profitable and start to flourish.

Since much of the overheating is assumed to be due to a loose policy framework, the most obvious cooling measure is that of raising interest rates and increasing the number of regulations on lending.⁽¹³⁾ Doing so would decrease money supply and consequently decrease domestic demand in the market. Since overheating is essentially a demand-pull situation, this should eventually bring down prices as well. However, this would inevitably lower the growth rate of an economy.

Apart from regulation of interest rates, another way to manage the extent of money flow within the economy would be through currency revaluation. A stronger currency would reduce inflationary pressures by making imported raw materials and foods cheaper. It would cool fevered investment in some dubious projects and sectors, as the reality of international competition becomes more apparent.⁽¹⁴⁾ This measure may cause harm to certain domestic industries, hence it is important to analyse the impact of such a measure before any action is taken.

Conclusion

Overheating of economies has been a hot topic amongst economists and policymakers since the beginning of the decade. Clearly, the first step is for nations to scrutinise their current growth patterns and acknowledge overheating in situations where it is required. Then they will be in a position to tackle overheating, either by their own means or through collective help from other nations.

On the whole, Africa does show signs of overheating, but the evidence presented in this paper is only suggestive and not conclusive. Also, it would be best for Africa to learn from its counterparts while it has the time, to avoid all that can be avoided, for it is Africa’s growth story that gives it hope at this point – hope to be a ‘global growth pole’ in the decades to come.

Written by Mridulya Narasimhan ⁽¹⁾

NOTES:

(1) Contact Mridulya Narasimhan through Consultancy Africa Intelligence's Finance & Economy Unit ( finance.economy@consultancyafrica.com). This CAI discussion paper was developed with the assistance of Ingi Salgado and was edited by Nicky Berg.
(2) Abouchakra, R., et al., ‘Cooling down overheated economies’, Booz & Company, 2008, http://www.booz.com.
(3) Stephen, C., ‘China’s premature overheating’, Market Watch, 24 February 2013, http://www.marketwatch.com.
(4) Zharina, G., ‘Beyond overheated economy: Comparative analysis of Ethiopian fastest growing economy recent figures’, Aiga Forum, February 2013, http://aigaforum.com.
(5) Ibid.
(6) ‘Economic report on Africa 2012’, United Nations (UN) Economic Commission for Africa, March 2012, http://regionalcommissions.org.
(7) Lanzeni, M. and Weistroffer, C., ‘Emerging markets - who is vulnerable to overheating?’, Deutsche Bank,March 2013, http://www.dbresearch.com.
(8) Ibid.
(9) ‘Economic report on Africa 2012’, United Nations (UN) Economic Commission for Africa, March 2012, http://regionalcommissions.org.
(10) Abouchakra, R., et al., ‘Cooling down overheated economies’, Booz & Company, 2008,  http://www.booz.com.
(11) Naughton, B., ‘How to handle an overheated economy’, Foreign Policy, 1 November 2004, http://www.foreignpolicy.com.
(12) Ibid.
(13) Zharina, G., ‘Beyond overheated economy: Comparative analysis of Ethiopian fastest growing economy recent figures’, Aiga Forum, February 2013, http://aigaforum.com.
(14) Naughton, B., ‘How to handle an overheated economy’, Foreign Policy, 1 November 2004, http://www.foreignpolicy.com.