The global economy, films and natural disasters
Last year at the IMF, I spoke about the global outlook in the context of three films. The first was ‘No Country for Old Men’, as the catchphrase of that film – “You can’t stop what’s coming” – described the imminent global recession. The second was ‘Apollo 13’, in which the head of mission control, Gene Krantz, is told, “This is NASA’s worst moment”. He replies that if the three astronauts are brought back to earth safely, it will be NASA’s best moment – and is proven right. Likewise, if the problems facing the financial sector were addressed properly and it emerged from the crisis in good shape, this would be an Apollo 13 moment for the financial industry.
The third film was ‘Singing in the Rain’, which aptly described the optimistic outlook for emerging markets at the time. But as I pointed out, while Gene Kelly did sing in the rain, he was completely soaked. And so it proved for emerging economies in the wake of last year’s crisis. While the outlook for many emerging regions looks good, they are not immune to setbacks in the West.
This year – given the general consensus, the risk of further shocks, and the fact that many countries have already used their policy tools to the full – I used three analogies related to natural events, things beyond our control: a flash of lightning, a tidal wave, and a volcanic eruption.
The U.S. recovery may be a flash of lightning
We are past the worst, and a recovery is here, but it is vital to focus on absolute levels. The world economy is just under $61 trillion in size; the U.S. economy is $14.3 trillion. If the West is not booming, emerging economies cannot boom. They can grow, but this requires self-sustained, domestically-driven demand. Although the next six months could be strong for the world economy as policy easing and inventory rebuilding feed through, beyond that, there are challenges.
Deleveraging still needs to feed through. Will this be a U-, a V-, or a W-shaped recovery? For the U.S., the recovery will more likely be a brief flash of lightning before the economy slips again. After strong near-term growth, the recovery may fade just as quickly. Firms in the West are more likely to seek out investment opportunities in the East. Thus, the West may experience a jobless recovery, prolonging the adjustment phase. International firms are more likely to invest in fast-growing markets in the East, probably adding to protectionist pressures in the West – and improving the chances of a U-shaped recovery in the East.
A tidal wave of controls
Regulatory overkill threatens the structure of the economic and financial system. This crisis was triggered by a systemic failure in the financial system, a failure to heed early warning signs, and an imbalanced global economy. Correcting global imbalances is key. The solution is easy to say, but hard to achieve: the West must spend less, the East must spend more. It will take considerable time, and there are many obstacles in the way – particularly the risk of a tidal wave of controls and regulations as political agendas drive the process. Excessive regulation and the unintended consequences of such regulation are a key concern.
Emerging economies need deeper and broader capital markets, as well as social safety nets, to allow firms and people to reduce savings and spend more, aiding economic rebalancing. Yet in many countries, the desire to open the financial sector is not there. If this does not occur, inflows are likely to find homes in equities and real estate, fueling fears of asset bubbles and increasing pressure to erect capital controls to stem hot money inflows.
A volcanic eruption underneath the dollar
Fault lines beneath monetary policies have been there for some time, and this crisis has exposed them. In the West, the issue is pursuing appropriate exit strategies from loose monetary and fiscal policy and government involvement in the financial sector. Yet exit strategies are every bit as much a concern across emerging economies.
Can export-oriented economies afford to tighten policy before the U.S. does? If they do hike rates, they risk attracting hot money. If they don’t, they risk fueling domestic asset prices, keeping policy rates lower than they should be. The choice is tough. The likes of South Korea, Indonesia, and India may hike rates early in 2010, but in China – where policy stimulus has played a key role – leaders’ worries over exports and jobs may take precedence over central bank concerns about asset-price inflation.
Economies in many regions, particularly Asia, face such policy challenges. Many, fearful of a future crisis, are keen to build currency reserves. That in itself is a concern. There is a potential volcanic eruption threatening to take place underneath the dollar. Even though reserves may rise, there is a desire to diversify away from the dollar. Yet, what are the alternatives? China is undermining the dollar through the back door, questioning it as a store of value or as a medium of exchange. It is engaging in currency swap arrangements and trying to boost trading of the CNY offshore. The general feeling in Istanbul is that there are no alternatives to the dollar. That may be right, but if there is one thing this crisis has taught us, it is not to ignore the fundamentals.