Three balancing acts

Indian Express, 17 October 2011

The world economy went through a surprisingly easy recovery in 2010. However, the deeper economic problems did not get solved that easily. The outlook for the world economy is now once again gloomy. Indian policy makers need to understand where the risks to the Indian economy lie and have action plans ready in case a crisis recurs.

When the global crisis erupted in late 2008, policy makers worldwide were very conscious that this was the biggest economic crisis since the Great Depression of the 1930s. The collapse in financial firms and markets served as an early warning system; the policy responses came early. Governments used monetary policy and fiscal policy to the utmost extent possible. The short-term response was surprisingly good. World GDP growth bounced back from -0.7% in 2009 to +5.1% in 2010.

At a deeper level, though, the fundamental macroeconomic problems did not get resolved. Frail financial firms were rescued by governments, but many governments then became frail. These problems particularly erupted in the countries in Europe with big welfare programs, high indebtedness, and the political inability to close down welfare programs.

The short-term fiscal stimulus had to fade away, and get replaced by higher private demand. But the citizenry understood that higher taxes were coming, and that the world was a difficult place, and responded by saving more. The handover from public to private demand has thus stalled.

One fundamental element of the required adjustment -- reduction in the US current account deficit and in the Chinese current account surplus -- has not begun. The US Senate has now passed legislation that could punish China for its alleged currency manipulation. The Bill still has to go to Congress and is creating concerns about trade wars if the US decides that China is manipulating its currency and imposes tariffs on Chinese products.

High growth is the goal of policy makers from the viewpoint of the welfare of the citizens. But in a peculiar way, slow growth is an important problem in itself. The world economy is suffering from two vicious cycles right now, each of which is critically driven by slow growth.

The first vicious cycle is about the fiscal situation. When GDP grows well, the debt/GDP ratio becomes modest. Conversely, when GDP growth slows, the debt/GDP ratio ratchets up harshly. Slow growth is inducing fiscal distress. Governments have to pull back, with fiscal tightening, but if they do this too harshly, then this will damage growth.

The second vicious cycle has to do with bank fragility. Slow growth is hurting bank balance sheets. But if banks pull back on lending too much this will damage growth.

The IMF's World Economic Outlook has projected 4% growth in 2011 and 2012. This would be a small reduction compared with the 5.1% growth of 2010. There are two problems with this benign picture. The first is the high uncertainty: growth in 2012 will range from 1.5% to 6.2% with a 90% confidence. The second problem is that this projection is rooted on things going well. It assumes that the Euro crisis will subside, that the US makes progress on fiscal consolidation and that no new hiccups will surface in finance. If even one of these three elements falters, global growth in 2012 will work out significantly worse than 4%.

Of particular importance to India is trade growth. Indian exports growth has only a weak link with the INR/USD exchange rate; it has a strong link with world trade growth. In 2009, world trade dropped by 10.7%. It bounced back to +12.8% growth in 2010. The IMF WEO projects growth of 5.8% in 2012. This suggests that Indian exports growth will slow down in 2012.

The IMF estimates the probability of a financial crisis on each of the G-20 countries. The top six countries and their crisis probabilities are: Turkey (7.6%), Indonesia (4.8%), South Africa (3.5%), Brazil (3.3%), Italy (2.8%) and then India (2.4%). While we are immersed in our domestic crisis of governance of the UPA-II administration, we should also take heed of this. We are only a bit safer than Italy.

The global recovery hinges on three delicate balancing acts. First, OECD countries need to find the middle ground between gaining fiscal credibility while avoiding drastic actions which choke the recovery. The most important element of this is the scaling back of welfare programs. This bolsters long-term fiscal credibility by boosting long-term growth, while inducing only small shocks to the economy in the short term.

The second balancing act is that of financial firms putting more equity capital on their balance sheets. More equity capital is undoubtedly required, but this process cannot be rushed: pulling back on credit would choke the recovery.

The third balancing act is that of the Chinese current account surplus. China needs to appreciate the currency, and undertake many other policy moves that reduce the investment binge. At the same time, drastic actions need to be avoided, which would plunge the Chinese economy into a recession. There is no sign so far of progress on this. If anything, there is some evidence that the gradual appreciation of the Chinese yuan stalled in mid August.

While global policy makers should worry about delicately solving these three balancing acts, we in India should worry that conditions in the world economy are not promising, and focus on our own economic problems. There could not be a worse time for domestic policy making to be in disarray. Decaying growth momentum will exacerbate fiscal distress. The absence of economic reform is damaging optimism and investment.

At the same time higher inflationary expectations are feeding back into inflation. With a central bank that lacks commitment and credibility for inflation control, India coud well be headed towards not just slower growth, but many months of stagflation. We are ill-prepared for a crisis in global financial markets, that could make this worse.

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