Monday, 6 July 2009

What could go wrong

Manila Bulletin

As usual, I would like to see the glass as being half-filled. There are signs that the ongoing global economic crises is coming to an end and that we can see the light at the end of the tunnel. As I discussed in last week’s column, there are evidences of “green shoots” all over the global economy, particularly in the U.S.

I would like, however, to alert the readers about the so-called downside risks. There is always Parkinson’s law: What could go wrong will go wrong. As a part-time gardener, I find the reference to "green shoots" suggestive of what could go wrong with the recovery, even if indeed it starts by September of 2009. Anyone with a minimum acquaintance with nurturing green shoots to healthy and mature plants know that green shoots can still die because of too much water, too much chemicals either in the form of insecticides or fertilizers, the appearance of worms and insects that eat the green shoots or over-exposure to the sun. Let me draw the parallel between botany and economic recovery.

Too much water obviously suggests the excessive liquidity that has resulted from the trillions of dollars from the aggressive pump priming of the Obama government and the constant decrease in interest rate engineered by the Federal Reserve System of the U.S. to stimulate economic activity. This interest cutting is not limited only to the U.S. As reported by the Economist Intelligence Unit last May 17, interest rates have been cut dramatically in all major countries and unorthodox measures such as quantitative easing (increased central bank purchases of various types of assets to increase the money supply) are now a cornerstone of policy in the U.S., and other developed economies are following suit. The major economies will all implement significant fiscal stimulus packages. The developed world's budget deficits will, on average, reach almost 9% of GDP in 2010, six times higher than before the crisis. In February 2009, the U.S. government approved a stimulus package of US$787 billion, or 5.5% of GDP (to be disbursed mainly over the next two years). In December 2008 the EU reached an agreement to provide a fiscal stimulus package worth around US $266 billion, or around 1.5% of the region's GDP. In early April this year, the Japanese government announced new stimulus measures worth some 2% of GDP, in addition to already approved measures of 2.4% of GDP. A number of emerging markets, most notably China, have also taken aggressive fiscal policy action.

There is a risk that the recovery may be nipped in the bud by runaway inflation if the U.S. and other governments are unable to siphon off effectively the excess liquidity. Last June 8, in a forum in Montreal, IMF chief Dominique Strauss-Kahn and World Bank President Robert Zoellick talked about the major risks to the recovery. Strauss-Kahn reminded policy makers that the same policies that helped them through the crisis will cost them dearly in years to come as fiscal and monetary stimulus is withdrawn. The threat of spiraling inflation tops the list of concerns: "The risk of very rapid inflation at the end of the crisis is a real risk. How are we going to dry up all the markets?" he asked. "The world after the crisis is not that simple."

In fact, Marc Faber, the famous investor, believes that the United States is going to enter a period of hyperinflation because the Federal Reserve will be reluctant to raise interest rates: "I am 100% sure that the United States will go into hyperinflation," Faber told Bloomberg News on May 27. "The problem with government debt growing so much is that when the time will come and the Fed should increase interest rates, they will be very reluctant to do so and so inflation will start to accelerate."

A related problem is the rising price of oil. Already in early June 2009, West Texas crude rose above $65. This means that its price has risen by more than 40% this year. Since oil closed at its lowest price of US$33.98 last February 12, it has risen by more than 80%. Something similar is happening to Brent, which is followed in Europe. Since January, its price has risen by more than 35%, and it has risen about 55% since its low for the year. According to Professor Rafael Pampillon of the IE Business School in Madrid, Spain, three factors explain the rise in the price of crude. "Demand for petroleum in China, the second-largest consumer in the world; consistent speculation about buying now, given the prospects for future increases; and the depreciation of the dollar." The devaluation of the dollar, which will be an inevitable result of the excessive supply of dollars in the global market (already a source of serious concern among the Chinese leaders), will lead to speculative purchases of oil and other commodities, exacerbating the hyperinflational pressures which could threaten the economic recovery.

The damage done to green shoots by chemicals can be compared to the uncontrolled rise of toxic assets in the financial system. IMF Chief Strauss-Kahn warned that the biggest risk to the economic recovery is countries taking too long to cleanse toxic assets from their banking systems: "You never recover until the cleansing of the balance sheet of the financial sector has been completed." He said that banks should disclose not only losses related to U.S. subprime mortgages but other losses linked to the economic slowdown. "What we are noticing is that there still is a system of credits, or of losses that are not made public. These are not things that are linked today to the original subprime crisis, but to the fact that the economic slowdown has rendered a certain number of assets of poor quality and that new losses were registered. The loss of confidence comes from the fact that we do not know exactly where the losses are and what they are."

This lack of transparency may also be included in the overall problem of dishonesty, corruption, and bad governance that may persist in both developed and emerging markets. These moral evils can derail the economic recovery. They can be compared to the worms and insects that destroy the green shoots, preventing them from growing into healthy and mature plants. There can still be unscrupulous bankers, corporate executives and regulators who may lower the confidence of investors and of the consuming public at large in the economic system and can lead to another downturn after a short recovery. We can call this as the moral threat to the recovery.

Finally, the reference to too much sun--which can also cause green shoots to wither--brings to mind the possible scorching heat of over-regulation. There is a possibility that Governments may swing to the other side and suffocate the private sector with too many restrictions and regulations. There are already signs in some Latin American countries of the return to the so-called commanding heights of socialism or mercantilism that caused the downfall of India, China, Russia and a host of Latin American countries in the last century. A related threat is the return to protectionist measures, which explained the backwardness of most of today's emerging markets during the 1950s all the way to the 1970s. The Economist Intelligence Unit, reporting on the global business environment in its Executive Summary of May 19, 2009, zeroed in on this real danger that can derail the global recovery in 2010.

The EIU reports: "The weakening of the global economy has led to a rise in protectionist sentiment and some protectionist policies are being implemented. A number of factors are expected to mute protectionist pressures. Countries today are far more interdependent than in the past, export lobbies now wield more power, and successive GATT/WTO agreements provide greater legal stability for trading relations. The business environment rankings embody the baseline assumption that globalisation will stall over the next five years. However, there is also a significant risk of even worse outcomes--that globalisation could suffer more severe setbacks. Even before the current crisis, globalisation was under threat from a variety of sources. The danger to globalisation has now increased many times over. In particular, the potential damage to the global business environment and to longer-term economic growth prospects cannot be underestimated, were there to be a descent into significant and sustained protectionism around the world."

Considering all these threats to the recovery, it is essential that our policy makers and business executives continue to explore the many opportunities within our own domestic market as well as intensifying our trade and investment relations with such emerging markets as China, India, Indonesia, Vietnam, South Korea and other countries that are still growing positively during the ongoing crisis. If the U.S. economy relapses into another recession after a brief recovery, we must be ready with our contingency plans.

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