Roger Donnelly, Chief Economist
rdonnelly@efic.gov.au
The views expressed in World Risk Developments are EFIC's. They do not represent the views of the Australian Government.
Though the world economy is now recovering from the financial and economic upheavals of 2008-09, threats to the outlook remain. This month we look at three: incomplete global rebalancing, a return to excessive risk-taking, and incomplete deleveraging. Together, they are part of a ‘great unwinding’ story that still has some surprises in store.
Incomplete global rebalancing. An underlying cause of the global financial crisis was the unbalanced nature of growth beforehand. Broadly speaking, East Asia and the Gulf oil-exporting economies became overly-dependent upon saving, exports and accumulating foreign reserves, while another group of countries, roughly the US, UK, Spain and ‘peripheral Europe', became overly-fond of consuming, importing and overseas borrowing. To boost their exports, the 'shipping nations' held their exchange rates down and accumulated foreign currency reserves, which they lent to the 'shopping nations', predominantly the US, to fund their buoyant imports and consumption.
Thus a co-dependence developed, but it was a dangerous one, because it contributed to excessive credit growth in both sets of countries. This is easy to understand for the shipping nations: there, central bank purchases of foreign exchange boosted domestic ‘monetary bases’, which were difficult to ‘sterilise’. For the shopping nations it is less straightforward: because their net exports were shrinking under competitive pressure from the shipping nations, central banks in the shopping nations were in turn under pressure to loosen monetary policy to prevent unemployment from rising. (There were clearly other reasons to loosen policy as well, such as the bursting of the tech share bubble in 2000-01.)
Because of loose monetary policy in both sets of countries credit booms got underway, which in turn encouraged reckless lending and speculation and the emergence of asset bubbles. The subsequent puncturing of those bubbles brought on the financial crisis.
To achieve sustainable global growth, it seems pretty clear that the shipping nations will need to ship less and shop more, and the shopping nations ship more and shop less. More prosaically, three big adjustments need to take place: an increase in US private saving, an eventual, if not immediate, decline in the US fiscal deficit, and a decline in the current account surpluses of China and other emerging economies.
Are these adjustments happening? One is, according to a recent IMF study, Global Imbalances: In Midstream?: the increase in US private saving (see chart). But the other two remain. ‘If these do not take place, there is a high risk that the recovery will be weak and unbalanced. Staying in midstream is dangerous’, the study concludes.
Return to excessive risk-taking? A similar warning not to slip back into old habits came last week from the international association of central banks, the Bank for International Settlements. According to the Financial Times of 7 January, the BIS fears that ‘the prolonged assurance of very cheap and ample funding may encourage excessive risk-taking’. It warns banks in particular about borrowing cheap short-term funds to invest in higher-yielding government securities. Come the time when official interest rates go up again, banks could find themselves in a precarious position, as happened during the 1994 bond market turbulence.
The warning applies not just to banks, but to investors more generally. There is mounting evidence that the sharp rally since March 2009 in high-yielding assets – shares, commodities and floating currencies, including the A$ – and concurrent fall of the US dollar is driven partly by a US$-funded 'carry trade' in which investors borrow cheap US funds to invest in higher-yielding assets, picking up in the process not just a 'positive carry’ or interest rate spread, but also in many cases a currency gain – so long as non-US currencies are appreciating. The snag is, this carry trade could inflate asset bubbles in a variety of markets that will become increasingly prone to correction. And once one bubble begins to deflate there could be a stampede by geared investors to cover their positions, leading other bubbles to burst at the same time.
See www.roubini.com for a closer analysis of the assets and currencies in the carry traders’ spotlight.
Incomplete deleveraging. The recently-revealed financial troubles of the Greek government and the state-owned property developer Dubai World suggest that the process of deleveraging triggered by the global financial crisis still has some way to run and will contain more surprises. In both instances, lack of transparency and disclosure figured prominently – with the new Greek government announcing that the fiscal deficit for 2009 would come in at 12½% of GDP, more than double what the previous government had forecast, and Dubai World suddenly saying that it would need a debt standstill after previously assuring investors that all was well. Both episodes are a reminder that credit wasn't just showered upon American 'ninja' borrowers.
Investors and rating agencies are now watching closely the efforts of Athens to meet its very large public sector borrowing needs and whether it will need – and get – emergency support from the EU or IMF. In these circumstances, other governments with large borrowing needs such as the Baltic countries, Spain and Ireland will also need to be watched carefully.
Great unwinding. The global financial crisis has set off a ‘great unwinding’ – of trade and economic imbalances and of highly geared balance sheets – around the world. But the process is incomplete. Steps that thwart it could set the world economy on another path of unbalanced and unsustainable growth. Those steps could come from the government or the private sector, and include such things as the continued pegging of East Asian exchange rates, tardy (or premature) attempts to wind down fiscal stimulus programs, and the US$-based carry trade. Even if these threats don't materialise, the great unwinding is likely to claim further reckless borrowers and lenders as victims in the coming year.
So despite the recovery underway, there are still plenty of ‘macro-financial’ risks to worry about in 2010.