Tuesday, March 17, 2009

The integrated global economy and the crisis

The last two decades have seen the build-up of global macro-economic and structural imbalances on a massive scale. The technology shares and then the real estate bubbles in the US generated a wave of "irrational exuberance" and a widely shared "wealth effect" that triggered off a massive consumption binge among American consumers. The former was fuelled by what Ben Bernanke called the "global savings glut" which had its origins in the emerging economies and was sustained by the loose monetary policy followed by Alan Greenspan.

Chastened by the bitter experience of the their crisis of 1997, the Central Banks of East Asia ran up massive foreign exchange surpluses, which, in the absence of sufficiently mature domestic financial markets, they invested in the safety and liquidity of the US Treasury Securities, despite their low yields. At its peak, these inflows were financing the US deficits at the stunning rate of $ 2 bn per day, and blowing up one bubble after another! The cheap capital in turn spawned a massive spurt in financial engineering and innovation, resulting in the proliferation of large number of complex financial instruments and products.

All this in turn generated a wealth effect that was encashed by the American consumers through a massive consumption binge, that was sustained to a large extent by borrowings. The cheap imports from the export hungry economies of East Asia in turn fed this consumption boom in the US besides keeping a tight lid on inflationary pressures.

In other words, there were a series of striking complementarities. One part of the world economy had huge capital surplus, which was readily absorbed by another part. One part provided cheap exports which were lapped up by consumers in another part. Cross-border capital flows found favorable investment climate among the emerging economies. Massive surpluses in one part sustained equally massive deficits in another part. Thrift and savings in one part of the world financed borrowings and consumption in another.

Many leading economists like Ken Rogoff had cautioned about the over heating global economic growth. The steep rise in foodgrain, energy and commodity prices in 2007-08 and the attendant global inflation scare was the first sign of an over heating global economy.

The sub-prime mortgage bubble is only a sub-set of this spectacular house of cards built up by these imbalances. In many ways, the much bigger bubble that has been pricked is the spectacular trilogy of unprecedented global economic growth, international trade in goods and services, and cross-border flows of capital. The financial market bubble was only the first to blow out, triggering off a cascading effect on the other two dimensions.

That the ongoing economic crisis had its origins largely in the sub-prime mortgage section of the American financial markets is now widely acknowledged. It is therefore surprising that it has had equally devastating effect on financial markets and economies elsewhere, both developed and emerging. There have been five major transmission mechanisms

1. De-leveraging from emerging economies
As the sub-prime mortgage bubble burst and the writedowns started mounting, the Wall Street firms started unwinding their positions in emerging economies to shore upt he balance sheets of their beleaguered parent firms in the US. There was a stampede towards the exit doors from emerging markets, sharply pulling down their equity markets.

The cascading effect of the de-leveraging and the wobbling global economy only added to the pressure on these foreign investors to repatriate their capital to the relative safety of US Treasuries. In fact, the first signs of appreciating dollar may itself have been a contributing factor towards investors exiting these economies.

The first half of the decade was the high noon of capital flows into the equity markets of the emerging economies. Private money invested in so-called emerging countries plunged from $928 billion in 2007 to $466 billion last year and is likely to fall to $165 billion this year, according to the Institute of International Finance.

2. Rising dollar
The de-leveraging saw American investors unwinding their foreign investment positions and bringing back the dollars home, thereby resulting in the appreciation of dollar. Apart from boosting the embattled balance sheets of their parent firms, these dollars have found a safe haven in the liquidity of American Government bonds. The emerging economy Central Banks too continue their investments in US Treasuries.

In 2008, the dollar rose 13% against major foreign currencies after adjusting for inflation, according to Federal Reserve data and foreign holdings of Treasury bills rose by $456 billion. Though this has been described as being similar to jumping into a house on fire, investors appear to believe that US Government will not default on its debt, re-affirming dollar's supremacy as the global reserve currency of choice.

This flight to dollar has had many effects. Primarily it has ensured that President Obama has enough funds (atleast until now) to finance the massive deficits to bailout the financial markets and stimulate the economy. It has hurt the US exports by reducing their competitiveness. However, it has contributed to keeping the price of oil down (oil prices are benchmarked to the dollar). Most importantly, it has had the effect of reversing the recently established pattern of capital flows from developed economies to emerging economies.

But unfortunatley, this default flight to dollar has the potential to build up another set of distortions and imbalances. It is seriously eroding the competitiveness of American exports, a major handicap at a time when America strices to lower its massive current account deficit. Further, as the Times writes, "A dollar invested by foreign central banks and investors in American government bonds is a dollar that is not available to Eastern European countries desperately seeking to refinance debt. It is a dollar that cannot reach Africa, where many countries are struggling with the loss of aid and foreign investment." Finally, the fact that American can still borrow at lower costs to finance its massive deficits is a strong dis-incentive for the US from making further structural adjustments on both spending and savings side.

3. The crisis in Eastern Europe - The last few years have also witnessed massive foreign currency borrowings, especially in Euros, by East European corporates (NYT has this story on the Russian oligarchs) to finance grandiose projects. As East European stock markets soared along with that of the remaining emerging economies and oil and commodity prices soared creating new billionaires in these parts, European banks cometed against each other in lending to these borrowers. There was a widespread belief that these borrowers, especially those from Russia, had implicit government backing and therefore the risk of default was minimal.

Now, with the global economy tethering on the precipice, these loans are already turning sour, as the borrowers struggle in the face of increased real debt burden and deteriorating balance sheets. The former is a consequence of the declining domestic currencies and the latter an inevitable accompaniment to the global economic slowdown. These defaults have the potential to trigger off major turmoil in Western European financial markets, and those loans could end up being Europe's equivalent of sub-prime bubble. In many respects, the sitaution in Eastern Europe looks similar to East Asia in the late nineties.

4. Falling exports
The heavy reliance of the East Asian economies on exports to drive economic growth has been exposed by the global economic slowdown. For far too long, the insatiable appetite of the American consumers for cheap imports of all kinds of goods had provided the perfect market for East Asian exporters. Now, as the American consumers have shut their doors tight, the exports have dried up dramatically. The knock-on effect of this external shock has been devastating on the economic growth of these economies, most of whom contracted in the last quarter of 2008.

5. Global deflation
The other major worry for the world economy is the strong possibility of a deflationary spiral gripping it, with clear trends of rapidly falling inflation in both developed and developing economies. If this trend continues, the world economy would be staring at what Nouriel Roubini has already predicted as the "stag-deflation", a devastating cocktail of growth recession and deflation. And the low interest rates across the world, kissing the zero-bound in most of the developed economies and close to the same elsewhere, makes the situation even more depressing as it forecloses the many of the conventional monetary policy responses to stimulating growth.

The major exporting economies of Europe, mainly Germany and France, too have been badly hit by the steep decline in global demand. It is one of the great ironies of the times and a testimony to how intimately linked are the fortunes of the economies of the world, that even those relatively healthy and fundamentally strong economies of the world like Germany and many of the East Asian economies, have been devastated by a crisis that had its origins in a sliver of the American financial markets.

The biggest cause for concern is that unlike in the previous crises, this time every major economy - developed and developing - and every sector - services and manufacturing - is badly affected, thereby leaving the global economy with no anchor to pull itself out. Previous crises were confined to a few economies or sectors, who could then rely on the others to bail them out and export their way out of the crises. The East Asian economies and Japan could rely on the massive demand from American consumers to export their way out of trouble. Similarly, the American financial markets found willing collaborators in the Asian and East European Central Banks and Sovereign Wealth Funds (SWFs) to keep up a strong flow of credit and calm the markets after the collpase of the equity markets in the aftermath of the bursting of the bubble in technology stocks.

We have the first truly global economic crisis. It cannot be denied that the chickens of globalization have now come home to roost. The two critical touchstones of globalization - trade in goods and services, and cross-border capital flows - are in retreat, and with some vengeance. A new World Bank report has predicted that the global economy would shrink in 2009 for the first time in more than half a century and forecast that global trade would decline for the first time since the early 1980s.

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