The end of recovery and start of a new global downturn

Yilmaz Akyüz

03/10/2011

Opinión

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I will discuss the issues we are facing in the global economy today and short and medium term prospects. In a sense, I would like to give you a cocktail of a series of papers on the global economic crisis produced by the South Centre with some rethinking and reflections. I will first look at the current economic conditions and problems in the major economies, the US, Europe and China; then discuss the vulnerability of developing and emerging economies to financial risks posed by advanced economies, notably the US and Europe; and finally, global economic prospects with respect to stability and growth.

Life after crisis

We are facing renewed risks of instability and slowdown before fully recovering from the so-called Great Recession and the chances of averting such an outcome are becoming quite slim. This is largely because the imbalances and fragilities built-up over several years in the past as a result of misguided policies in the US and Europe cannot be easily undone, regardless of the policy pursued today. These have resulted in distortions and imbalances in economic structures and private balance sheets and they cannot be corrected overnight. This is a main reason why recovery in advanced economies is sluggish, erratic and jobless.

The strong growth in developing and emerging economies we have been witnessing since mid-2009 is not sustainable because of the following reasons. First, it is the outcome of a strong policy response to the crisis whose effects are wearing out in several developing economies particularly in China which has been a major locomotive to commodity-rich developing countries as the number one global commodity importer. Secondly, the response to the crisis in advanced economies through excessive liquidity generation and sharp cuts in interest rates is actually creating bubbles, not in Europe and US, but in commodity markets and the developing world. This cheap money in search for yield is a major factor behind the rapid growth in several emerging economies.

That we now have a two-track world economy is a fallacy – very much like the belief initially held during the sub-prime crisis that the developing economies would be decoupled. These economies are still highly susceptible to destabilising and deflationary impulses from advanced economies even though there is considerable diversity among them regarding the channels of transmission of such impulses, the degree of vulnerability and their ability to respond.

The US: Maybe no double dip, but many problems

A double dip recession in the US is now believed to have been averted, but there is little doubt that it is experiencing the weakest recovery in its post-war history – jobless and without much investment. This is often the case in recoveries from financial crises because incomes need to be used to address excessive debt and balance sheet distortions before being spent on investment and hiring new people.

Growth forecasts in the US have been cut down by the Fed and growth is not seen as self-sustaining through expansion of private spending and/or exports. The policy of easy money pursued to sustain recovery has led to the weakest dollar in effective terms since 1973, and is creating bubbles in the developing world and commodity markets. With weak and erratic recovery, the US is facing a growing public deficit, presently at some 10 per cent of GDP. The IMF expects US public debt to rise to 110 per cent of GDP in 2016, up from 70 per cent in 2008. Under the current growth path, there is no way for the US to halve its public deficit by half by 2013, as it promised to the G20.

The US fiscal response to the crisis focussed on raising private consumption though perhaps it should have emphasised investment, which is needed to accelerate export growth. Despite that, US consumers have been retrenching. Any fiscal adjustment coming on top of consumer retrenchment would bring down growth considerably unless exports closed the gap. President Obama’s National Export Initiative launched in 2009 targeted to double US exports in five years, but this is unlikely to be attained – it would require 15 per cent growth annually but so far exports have grown by an average 10 per cent per annum, despite the bounce back from a depressed level. It is unlikely that the US can shift to an export-led growth in the near future unless Europe deals quickly with its sovereign debt problems and restores strong and broad-based growth and developing countries, notably those in Asia, reduce their dependence on exports and maintain strong growth based on domestic demand.

There is a risk that US interest rates may rise before full recovery is achieved. First, the bubble in the commodity market could be translated into inflation particularly if oil prices continue to go up, and the Fed may have to respond in the same way as it did in the late 1970s to the second oil hike and rising inflation. Second, growing concern over public debt and deficits could lead to a surge in long-term interest rates – that current yields are very low is no guarantee that they will remain so in the foreseeable future.

Europe: unstable and uneven:

Europe has been grappling with sovereign debt in the periphery and is engaged in fiscal consolidation and monetary tightening in its search for stability. Eurozone growth is anaemic - one and a half per cent in 2010 – and is highly uneven - Germany is growing much faster, relying on exports. For the rest of the Eurozone Germany is not a locomotive but deadweight – it pursues a policy of competitive disinflation. Its unit labour costs are lower than many other Eurozone countries not because of its exceptional productivity growth but because of wage suppression. This creates considerable difficulties in maintaining growth and external balance for countries incapable of cutting wages to the same extent. However, German exports and growth may not be sustained if the rest of the Europe doesn’t do well.

The approach to sovereign debt problems in Europe invokes memories of the 1980s. It cost a decade of development to learn that debt overhang could not be removed by getting countries into more debt and cutting growth. Insisting that the debt should be fully paid can make it even less payable. The European periphery, unlike the Latin Americans in the 1980s, do not have the option of devaluing their currencies except through deflation by creating larger and larger unemployment – a cure worse than the disease, as Argentina knows very well. If the current strategy continues and the EC and ECB pretend that this is a liquidity crisis, the European periphery will remain susceptible to speculative attacks and messy defaults.

A growth-oriented adjustment in Europe calls for Germany to start acting as a locomotive. There is a need for a real appreciation of the Euro for Germany, but not for the others; that is through higher German wages. This could generate faster growth in domestic demand needed to maintain growth while reducing dependence on exports and allowing other Europeans to grow faster.

Growth and adjustment in China

China introduced a massive stimulus programme in response to the crisis, reaching 15 per cent of GDP, three times the US. But it focused on investments pushing it to over 50 per cent of GDP. Support to household incomes has remained moderate even though the country faces a problem of underconsumption, with private consumption hovering around 36 per cent of GDP, half the level of the US.

Chinese growth has also been pushed up because of large amounts of private foreign capital inflows. Before the crisis, private capital went almost everywhere in the developing world in search for yield. Subsequently, it was withdrawn from most countries in Central and Eastern Europe, and China has become the largest recipient. According to Chinese official estimations, one third of net capital inflows from non-residents are now in “hot money”, meaning not linked to investment and productions. A quarter of FDI inflows are in commercial real estate, adding to the property bubble fuelled by rapid credit expansion as part of the crisis response. The economy has been overheating and the government is now applying monetary breaks to slow it down.

China needs to reduce its dependence on exports and rely on domestic markets for growth. Its current account surplus fell from a peak of 11 per cent of GDP in 2006 to around 5 per cent in 2010; now lower than the German surplus. Chinese adjustment needs to be based on significantly faster growing household income – that is, rapid expansion of wages without a pass-through to prices, and employment. This would appreciate the currency while simultaneously creating domestic demand to offset the slowdown in exports. By contrast, a nominal appreciation of the RMB would not necessarily translate into faster domestic demand. In fact, it could result in a slowdown in domestic demand if the burden is passed on to wages.

China now recognises the needs to shift to consumption-led growth. It has recently taken several measures in terms of minimum wages, higher wage growth, faster job creation, emphasising the services sector, better social safety nets etc. The 12th 5-year plan envisages several measures on these fronts, but a shift from export-led to consumption-led growth is a slow process particularly since it requires a significant redistribution of income from corporations to households, increased government transfers and faster job creation.

Before the crisis Chinese exports were growing at 25 per cent per annum in real terms. According to my calculations, around 50 per cent of Chinese growth was due to exports, including spillovers to domestic consumption and investment. But this figure was around 90 per cent for Germany and between the two for Japan even though all the attention has been on China. Now China’s 5-year plan projects a 7 per cent growth, in recognition that China cannot keep on raising its real exports 25 per cent per annum as it did for 7 or 8 years before the crisis. If Chinese export growth fell to some 10 per cent, its GDP growth rate could indeed come down to 7 or 7 1/2 per cent without a massive shift to consumption. Attempts to fill the gap with a new surge in investment could simply amount to postponing the underconsumption crisis, to come back even with a greater force.

Impact of Chinese slowdown on other developing countries

What will happen if China slows down? Its strong growth has been a major factor in the recent commodity surge. Commodity stockpiling was a reason for the emergence of a trade deficit in the first quarter of this year for the first time for many years. A slowdown from double-digit rates to 7 per cent could have a serious adverse impact on commodity exporters. On the other hand, over the longer term, a successful shift to consumption-led growth could also shift the Chinese demand from hard to soft commodities, particularly grains and meat, aggravating the global food shortage. It has indeed already turned from a grain exporter to an importer.

A slowdown in Chinese exports to the US would hurt other countries linked to the Sinocentric production network even if this is fully compensated by increased Chinese domestic consumption. This is because Chinese consumption has little foreign content, directly or indirectly. Some countries in the region are already facing the so-called middle-income trap with low investment and sluggish consumption but large current account surpluses, like Malaysia at 16 per cent of GDP. An interregional redistribution of investment from China to the other countries in the region is needed. Countries in South East Asia also need to expand domestic consumption, and again the problem here is worsened income distribution. But a shift of China from exports to domestic demand would be good for some newcomers in labour-intensive industries such as Vietnam, which could actually make more headway into US markets.

Capital flows and bubbles

Following a short-lived interruption after the Lehman collapse in September 2009, private capital flows to developing countries recovered rapidly, particularly to those with higher interest rates and better growth prospects. While almost all emerging economies have seen their currencies appreciate, appreciations have been faster in deficit countries such as Brazil, India, Turkey, and South Africa than Asian surplus countries. Like China, most deficit countries are also facing credit and asset bubbles, with, credit growth in the range of 25- 35 per cent per annum, risking a hard landing

There is a remarkable correlation between recent movements in capital flows to developing countries, commodity prices and the dollar. After the outbreak of the subprime crisis until the Lehman collapse, capital flows to developing countries held up. Similarly, commodity prices which had started rising in 2003 and accelerated in 2006, reached the peak in the middle of the crisis in summer 2008 when oil hit $150 per barrel. Why? The factors which kept up capital flows to developing countries also kept the flows into commodity markets. The downturn was seen as a hiccup and the growth was expected to pick up quickly – in fact, the IMF was upgrading its global growth projections in the middle of 2008. But when Lehman collapsed, commodity prices and capital flows plummeted and the dollar shot up as a result of flight to safety. But, from the first quarter of 2009 onwards, all these were reversed; dollar started weakening, capital flows began picking up and commodity prices started rising again. Strong Chinese growth was an important factor in the commodity surge. But commodity speculation has also played an important role,

How might the capital and commodity bubbles be ended?

How will all these end up? I can see four possible scenarios. First, these bubbles could end with an abrupt monetary tightening in the US. It can happen even before full recovery for the reasons I have already discussed – that is, as a result of rising inflation and/or bond market pressures. No matter what, near-zero interest rates are not there to stay forever, but the question is whether they return to “normalcy” gradually (soft landing) or abruptly.

Second, a significant slow-down of growth in China, possibly aggravated by the bursting of the credit and property bubble, could bring an end to the boom in commodity markets and capital flows. It could not only depress Chinese demand for commodities but also trigger a massive exit of speculative capital flow from commodity markets.

Third, a balance-of-payments crisis in a major developing economy can bring an end to the boom in capital flows by leading to a contagion across emerging markets. For example, Turkey now has a current account deficit close to 10 per cent of GDP and deficits are also high and growing in some other emerging economies. A sudden change of moods in markets, as in East Asia during 1997, could trigger a currency and payments crisis in such countries.

Finally turmoil in the Eurozone resulting from sovereign debt difficulties in the periphery could cause a flight to safety in much the same way as the Lehman collapse resulted in the reversal of capital flows even in emerging economies with sound fiscal and payments positions and banking sectors.

In any of the four of these scenarios, it is highly likely that the downturn in capital flows will be associated with a reversal of commodity prices. As a result, the most vulnerable countries are those which have been enjoying the twin benefits of global liquidity expansion, that is, the surge in capital inflows and the commodity boom. This is more or less what happened in the 1980s. Mexico which had enjoyed the twin booms in the 1970s in international lending and oil prices was the first country to get into trouble in Latin America in the early 1980s. Commodity importers such as Turkey and India may benefit from a downturn in commodity prices even though they may get hurt by capital reversal.

In this regard, Asia is less vulnerable to balance of payments and currency crises, because of sound balance of payments positions and strong reserves. However, outflows could explode bubbles, notably in the property markets, as happened during the Lehman collapse. Still, Asia can be expected to achieve an orderly moderation of growth. But adjustment in commodity-dependent and deficit economies may not be so orderly. Unlike Asia where reserves are earned from current account surpluses in deficit countries they are borrowed, coming from capital inflows. Hence, with a reversal of capital flows they can disappear as fast as they were accumulated.

The global economy is in a very fragile situation – with mounting budget deficits and sovereign debt in advanced economies, asset and credit bubbles and growing current account deficits in several major emerging economies. It is increasingly recognized that the world economy is unlikely to make a smooth transition to a stable, sustained and broad-based growth – hence the repeated talk of the “next crisis”.

Many of the current problems originate from systemic shortcomings in global economic governance. Despite growing interdependence, in particular in finance, there is lack of multilateral disciplines over macroeconomic, exchange rate and financial policies of countries that have a disproportionately large impact on global economic and financial conditions. Similarly, the rhetoric on financial regulations has not yielded any meaningful discipline over financial markets and institutions. Despite a promising start in the counter-cyclical policy response to the crisis, the G20 has unfortunately been highly ineffective in addressing these two major sources of instability.

- Dr Yılmaz Akyüz, South Centre's Chief Economist

Source: South Bulletin, 3 October 2011 (South Centre)

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