Economics: A Bipolar Recovery
As signs of a global economic recovery mount, the key question facing financial markets at the start of 2010 is the nature of the expansion and the likely reaction of policy-makers.
As signs of a global economic recovery mount, the key question facing financial markets at the start of 2010 is the nature of the expansion and the likely reaction of policy-makers. While the recovery seems well established in a number of emerging countries – including key players such as China, India and Brazil – and in some developed ones closely linked, via exports, to them – Australia, Canada – doubts remain about the solidity of the recovery in most of the developed world.
Those doubts appear well placed. The extraordinary measures introduced by governments in late 2008 and early 2009 have prevented the collapse of the financial system and have limited the associated recession in the real economy. But many of the underlying imbalances – high indebtedness ratios of households and, in some countries, the corporate sector – remain unresolved, and its digestion will take quite some time. Moreover, the Great Recession has left a legacy of unsustainable public sector deficits and going forward governments will have to tighten their belts.
This divergence between emerging and developed economies reasserts the phenomenon observed since the start of this century; namely, the increasing role of emerging countries as the main drivers of global economic growth. Moreover, unlike on previous occasions, emerging countries entered the 2008-09 global cyclical downturn in a relatively comfortable position – with low inflation and large external surpluses – and were able to react forcefully with stimulative measures. This prudence (in contrast with the large debt build-up in developed economies) is now a major relative advantage.
THE END OF STIMULUS
In developed countries, the key near-term uncertainty is the sustainability of the recent upturn as the effect of the stimulus measures fades and the inventory cycle runs its course. Given the usual lags, the maximum impact from monetary easing will happen early this year, after which the beneficial effect will start to diminish. In addition, the fiscal expansion may have already reached its peak in most countries; in fact, financial markets are forcing an increasing number of governments, especially in Europe, to start fiscal consolidation in 2010. Finally, the expansionary effect on real incomes of last year´s commodity price decline is gone by now.
The banking sector is another potential drag on the recovery. The major central banks have started to exit from some of the unconventional measures introduced after the Lehman collapse (quantitative and credit easing, extra liquidity for the banking system) and governments also will, at some point, unwind the banking support measures (recapitalisations, debt guarantees, purchases of toxic assets). Regardless of how fast all that takes place, banks will probably remain focused on rebuilding their solvency ratios and reducing their funding gaps. The implication is that the supply of bank credit to households and firms will remain scarce. This is not a problem for large companies (with access to capital markets) but is a major constraint for households and small firms.
With the prospect of a gradual economic upturn plus all those uncertainties in mind, central banks should maintain a very accommodative monetary stance. Core inflation is low and falling, and even if a vigorous economic recovery in emerging countries boosts commodity prices, inflation expectations in developed countries are very well anchored. Against this backdrop, only massive growth surprises would convince central banks to start the tightening cycle before end-2010 – at the earliest.
WHERE IS POTENTIAL?
Looking beyond the near term, one of the legacies of the debt-induced expansion of 2003-07 and the ensuing financial crisis may be a lower potential growth in the affected economies. As the theory goes (and evidence of past financial crises tends to confirm), the inevitable restructuring of the banking sector eliminates one of the major sources of growth during the expansion (i.e., debt-financed consumption and real estate investment) and may even reduce the availability of credit to firms and households for other spending (business investment) well beyond 2010.
In the present circumstances characterised by a hostile atmosphere against banks, such a prospect looks realistic. Having peered over the edge of the precipice, policy-makers and regulators are determined to curb future excesses in the banking sector. Details of the new regulations will emerge in coming months but the general thrust is clear: Higher Basel II capital requirements (including a higher proportion of common equity), lower overall leverage ratios, stronger liquidity positions and more stringent provisioning. In summary, regulators want banking to become a “dull” business again, with more stability and probably, lower profitability. Disintermediation will be back in vogue.
If confirmed, a lower potential growth rate has important implications for financial markets. Domestic income growth (including corporate earnings) will be on average slower than in pre-crisis times but, short of an unlikely inflationary spiral, interest rates will tend to be historically low on average over the business cycle as well. Hopes for dynamic earnings growth are, once again, placed on emerging markets, where potential growth is high and has not been compromised by the financial crisis in the developed world. The good news is that an increasing share of corporate profits of listed companies in the U.S. and Europe derive, directly or indirectly, from emerging markets.
The growth divergence between emerging and developed countries suggests that emerging market currencies will continue to strengthen. But the voyage may be rough in the near term. Some hints of trouble are already visible. To rebalance the composition of demand in favour of exports, the U.S. needs an orderly depreciation of the dollar, ideally against fast-growing Asia. However, China (the key player in the region) is reluctant to allow its exchange rate to rise until its own expansion is well secured on domestic grounds and less dependent on exports. (Even as this shift happens, China will probably allow just a gradual appreciation of the yuan). Meanwhile, European policy-makers are fretting about the possibility that the euro bears the brunt of a possible run on the dollar.
There is no obvious solution for these policy discrepancies. The G-20 is not yet a well established forum for macro-economic policy coordination (it is mainly dealing for now with financial regulation). Without a coordinated approach to currency management, the risk of overheating in Asia (where interest rates are too low) and a stalling recovery in the U.S. and Europe (where exchange rates should weaken) may well fuel nervousness in currency markets, with potentially very wide exchange rate fluctuations that could mask temporarily the long-term trend towards a weaker dollar and stronger Asian currencies. International policy conflicts typically are a recipe for exchange rate tensions that can easily dominate asset returns in global portfolios.
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