THE current global economic landscape is not very encouraging and the world economy remains highly fragile.
While the shortoutlook is for contraction in several advanced economies (AEs) in Europe, growth in others, including the US, is weak and erratic. And more importantly, the medium-term prospects are bleak almost everywhere.
Global financial markets suffer from considerable uncertainty. Asset and commodity prices, risk spreads, capital flows and exchange rates are highly susceptible to sudden swings with devastating consequences for growth and employment.
While growing public deficits and debt are an ongoing source of economic stress in several major AEs, the Achilles Heel of the international economy is the eurozone (EZ).
At a first glance, recent record looks very promising for developing countries(DEs). The new millennium has witnessed a staggering rise of the South. During 200308, the average growth of DEs exceeded that of advanced economies (AEs) by some five percentage points, compared to around one point in the 1980s and 1990s. The difference widened during 200811 as most DEs proved resilient to the crisis while AEs collapsed.
A closer look suggests that the growth surge in DEs owes more to exceptionally favourable international economic conditions than improvements in their underlying fundamentals.
Before the financial crisis, the credit, consumption and property bubbles in AEs generated a highly favourable global economic environment for DEs in trade and investment, capital flows and commodity prices.
From the early years of the 2000s, low interest rates and rapid expansion of liquidity in the US, Europe and Japan triggered a boom in capital flows to DEs. This was supplemented by a surge in workers’ remittances, which exceeded three per cent of GDP in India and reached doublefigures in some smaller DEs. Commodity prices rose strongly, largely thanks to rapid growth in China.
With the financial crisis, global economic environment deteriorated in all areas that had previously supported expansion in DEs. AEs contracted, capital flows were reversed and commodity prices declined sharply.
However, DEs showed resilience and were able to rebound quickly, particularly where a strong countercyclical response was made possible by favourable payments, reserves and fiscal positions built up during the preceding expansion. As a result, the growth impulse in some leading Southern economies has shifted to domestic demand.
At the same time, shortspeculative capital inflows surged with sharp cuts in interest rates and quantitative easing in AEs in response to the crisis. These have been more than sufficient to meet growing deficits in several major DEs including India, Brazil, Turkey and South Africa. But they have also widened deficits by leading to currency appreciations.
This rapid domestic demandgrowth has now come to an end. China cannot maintain investmentgrowth indefinitely. But it also faces hurdles in shifting rapidly to consumptionled growth. Even a moderate slowdown in China, towards seven per cent, could bring an end to the boom in a broad range of commodities. This can be aggravated by a rapid exit of investors and traders in commodity derivatives as happened in 2008 after the collapse of the Lehman Brothers.
Developing economies also face significant downside risks from AEs, including dampened export prospects and unstable capital flows. As noted by the IMF “even absent another European crisis, most advanced economies still face major breaks on growth.
And the risk of another crisis is still verypresent and could well affect both advanced and emerging economies.”
There can be little doubt that the crisis has posed difficult policy challenges for AEs. But there have also been shortcomings in the policy response. First, there is a failure to maintain adequate demand by reconciling the need for shortfiscal stimulus with a credible programme for longconsolidation.
Second, public interventions have failed to alleviate the debt overhang and deleveraging and retrenchment at the expense of employment and growth.
Banks remain highly fragile. They are shrinking their balance sheets by selling assets and cutting credit, impairing access of DEs to trade financing.
Third, deep cuts in interest rates and quantitative easing have not been very effective in addressing overindebtedness and reversing spending cuts, but have led to “currency tsunami” and problems for DEs in macroeconomic and exchange rate management.
The surge in shortcapital flows have shifted exchange rates and trade not only between the North and the South but also among DEs, creating tensions in the trading system.
The IMF lacks effective surveillance to bring discipline and elicit responsible behaviour on the part of reservecountries. With the surge in destabilising capital flows, it has abandoned willyits orthodoxy and has offered a framework to DEs for managing inflows, including capital controls as a last resort and temporary measure. This is rightly rejected by DEs, in an effort to retain their policy autonomy in managing capital flows and avoid new obligations.
Finally, despite recurrent sovereign debt difficulties, the international community has not been able to introduce orderly debt workout mechanisms. The attempt made at the IMF in the early years of the 2000s to establish a Sovereign Debt Restructuring Mechanism was blocked by some major AEs. But no progress has been made so far. —Courtesy: South Centre, Geneva