In this issue ...

• World trade 'collapses': Should we be alert? Or alarmed?
• No economy is in an island: 'Great Recession' slams everyone
• Flat is the new up: Is world GDP stabilising?
• Pump priming no free lunch: Fiscal stimulus raises sovereign risk
• Money too tight to mention: Capital controls on the rise
• Continuity and change: Elections in Indonesia, South Africa, India

World trade 'collapses': Should we be alert? Or alarmed?

World trade 'collapsed' in the last quarter of 2008, according to the OECD, with values falling by more than 20% in annualised terms (see chart).

Worse, the WTO is projecting a continuation of the slump in 2009, with trade volumes falling 9% for the year, due to three factors: the synchronised nature of the world downturn, a higher cost of trade finance, and the effect of international supply chains.

During the 'Great Moderation' of the two decades leading up to the global financial crisis, world trade growth outstripped GDP growth, and buoyed the world economy. But now the tables have turned: during the 'Great Recession' the contraction in world trade is outstripping that of GDP, and worsening the recession.

The influence of international supply chains (ISCs) on the world trade and GDP cycles is important and should not be overlooked.

In the pre-ISC era, when most of the value added in an export widget was created within the borders of one country, the following would happen. Say American demand for Chinese exports fell by $100. Then Chinese exports and GDP would each fall by $100. And world trade would also fall by $100.

Now, in the ISC era, when American demand for Chinese exports falls by $100, Chinese exports again fall by $100. But now goods are 'Assembled in China', not 'Made in China'. So Chinese exporters who are losing export orders cut their imports of parts, components and materials from Asian neighbours by $95. Result? Chinese GDP falls by $5. World trade falls by $195.

As the 'foreign trade multiplier' takes hold, there will of course be further rounds of export and import cuts, and corresponding GDP cuts. But the important point to note is: a given collapse of world trade no longer has the same impact on world GDP as it once did, because so much of trade nowadays consists of intermediate goods, rather than consumer and capital goods destined to meet final demand.

So the world trade 'collapse' is of concern, but needs to be kept in perspective.

No economy is in an island: 'Great Recession' slams everyone

One of the paradoxes of the current world recession is that export-dependent economies have been suffering worse slumps than economies at the epicentre of the financial crisis. So far at any rate. Why?

See the chart showing quarterly growth rates (or in most cases, rates of contraction) for December quarter 2008.

Notice how Asia's newly industrialising economies and many Latin American economies have entered deep slumps that would warrant the term 'depression' if they continue. Meanwhile, the advanced economies, many of which suffered the biggest financial implosions, are doing it tough, but nowhere near as tough as some of the emerging markets, which almost completely escaped the financial crisis - even countries like Thailand, where political risk has been escalating.

One reason seems to be the interconnectedness of the world economy. The crisis-hit advanced economies are deleveraging and cutting back their consumption and investment. Which means lower demand for exports, and consequently large setbacks for export industries in emerging markets. The result is: the day of reckoning is at least as bad for the thrifty suppliers of export goods as for the spendthrift customers, who have now had to tighten their belts. Many emerging markets are feeling aggrieved by this, arguing that they are innocent bystanders.

Still, there is reason to believe that they will bounce back fairly quickly from their horrible fourth quarter. The data suggest that, in response to the cut in demand from advanced economies, emerging economies cut export production even more severely, and ran down stocks. Once their destocking is complete, they will have to crank up production again.

Why are China, India and Indonesia managing relatively well? They are not as trade-dependent. And in China especially, the government is rolling out a big fiscal stimulus.

Perhaps the biggest surprise is the Philippines - an open economy heavily dependent upon workers' remittances and earnings from export industries like IT and business process outsourcing. Despite this, it has managed to outgrow every other economy. The Philippines will undoubtedly suffer further hits from the world recession this year, but does seem destined to perform well.

Flat is the new up: Is world GDP stabilising?

Several indicators suggest that the rate of contraction in worldwide production may be slowing - paving the way for an eventual resumption in growth (see chart).

Such has been the depth of the slump that economy-watchers now look only for signs of easing weakness, rather than outright strength in the world economy. Three groups of indicators indicators fall into this 'less weakness means more strength' category.

• In the March quarter Chinese GDP accelerated to around 5% (q-o-q annualised) from 1-2% in the December quarter. Growth is being supported by a substantial increase in bank lending and government spending.
• US consumption rose in the same quarter and there are tentative signs that the housing market is touching bottom.
• Worldwide, business and consumer confidence has edged off record lows, and importantly measures of bank stress have eased.

Is a recovery around the corner? Sharemarkets seem to think so, rising by more than 30% since early March. Some increase in output is likely as companies restock after sharply reducing their inventories. But a strong and sustained recovery? This will be more difficult to achieve, because a root cause of the current crisis is big global imbalances that will have now have to be unwound - excessive financial deficits and indebtedness in advanced economies and corresponding surpluses in many export-driven emerging economies. None of this will happen overnight. Still, for the first time in a while, the world economy could actually start to turn in performances that exceed the consensus forecasts, rather than fall below it.

Pump priming no free lunch: Fiscal stimulus raises sovereign risk

Many countries have been adopting expansionary fiscal policy to combat the 'Great Recession' (see chart), but the cost has been stretching budget deficits. Across the OECD, deficits now average 8% of GDP and public debt is rising sharply. This is raising concerns about 'fiscal sustainability'.

Several investment grade countries (the ones that are supposedly 'safe for widows and orphans'), including Iceland, Spain, Ireland, Portugal, Greece, Thailand and Russia, have already received ratings downgrades. China's sizeable fiscal resources put it in a strong position, but the surge in bank lending - Chinese banks extended over US$750b in new loans in the first four months of 2009, more than in the whole of 2008 - does raise the risk of a big bad debt hangover.

Governments will be hoping that their spending will foster private demand, which can then enable them to phase out the stimulus. But borrowing constraints and a prolonged downturn may force consolidation earlier than is ideal. Ireland and Hungary have already run into these constraints, tightening policy into the recession.

Money too tight to mention: Capital controls on the rise

Net private capital inflows into emerging economies looks set to fall steeply in 2009 (see graph). Such declining capital flows are making some emerging economies nervous that they won't be able meet their external financing needs - and prompting them to impose capital controls.

Iceland, Ukraine, Argentina, Nigeria, Venezuela, Indonesia, and Zambia have already placed restrictions on foreign exchange availability, though to varying degrees. In Kazakhstan, a bill is before the senate allowing the president to force exporters to exchange their foreign currency earnings for tenge at an administered rate.

However, there is some good news. The G20 provided an increase in IMF funding to US$750b from US$250b. As a result, the Fund is now able to provide finance through traditional standby arrangements and its new Flexible Credit Line (FCL). The FCL, available to 'fundamentally sound' emerging markets with minimal conditions, has proved very popular. Mexico, Poland and Colombia have already requested FCLs. The Asian reserve pooling system under the Chiang Mai Initiative (US$120b by end-2009) will provide additional liquidity support in Asia if needed.

Continuity and change: Elections in Indonesia, South Africa, India

Elections have recently taken place in three prominent emerging markets: South Africa, the predominant economy in Africa; India, the world's largest democracy; and Indonesia, the world's largest Muslim-majority democracy. The government in South Africa has held onto power, although its grip has been weakened. In Indonesia, President Yudhoyono's party has actually strengthened its hold. In India the result is more open.

South Africa: politics become more contestable. As expected, the ANC held onto power in the 22 April elections, although it lost its two-thirds majority. ANC leader Jacob Zuma will be sworn in as president on 9 May, after prosecutors dropped a corruption case against him. Opposition parties made modest gains, with the Democratic Alliance increasing its share of the vote to 17% from 12%, and taking control of government in the Western Cape province with more than 50% of the vote. The ANC splinter party, the Congress of the People, fell short of expectations, taking only 7% of the vote, though it will be the official opposition in several provincial administrations.

India: change? India's month-long parliamentary elections began on 16 April and results will be announced on 16 May.

Change is probable. The contest is a three-way race and the existing Congress Party-led coalition government could well lose. A new 'Third Front' of small regional, leftist and caste-based parties, including communist parties, is challenging the traditional dominance of Congress and the Hindu nationalist BJP. Pre-poll surveys suggest that both Congress and the BJP will lose seats. Whatever happens, no one party is likely to get a majority, so a coalition government is likely. The smaller coalition partners of Congress and the BJP have deserted them to await poll results before deciding new allegiances. This sets the stage for a large and unwieldy coalition government. A Congress- or BJP-led government is most likely, but a 'Third Front' government can't be ruled out.

Indonesia: continuity and change. The 9 April legislative election saw Susilo Bambang Yudhoyono's Democratic Party (PD) make large inroads into the support of its two major secular rivals, Golkar and the PDI-P, and Islamic parties. The PD tripled its vote to almost 21% compared to the last election in 2004. Support for Golkar fell to 15% from 22% and for the PDI-P to 14% from 19%.

The total vote for Islamic parties slipped below 30%, the lowest ever. Only nine of 38 parties contesting the election were able to get above the minimum 2½% of the vote needed to take seats in parliament, compared to the 21 parties in the current parliament.

Despite its gains, the PD did not clinch a majority. So it will need to form alliances to pass laws. In the last parliament, it cooperated with Golkar, but this may not happen in the new parliament now that the Golkar chairman and current vice president, Jusuf Kalla, has decided to contest the July presidential election against Yudhoyono.

The election hasn't been without mishap. Inaccurate voting lists and wrong ballot papers have surfaced, giving losing candidates grounds to contest the results. But this is unlikely to upset the election process, nor to challenge the general view that the poll has been a successful one - indeed, the third successful poll since the fall of the Suharto regime, a poll that further establishes democracy in the country, and one in which the electorate has clearly moved to the centre, rejecting both Islamists and authoritarians.

Contenders for president must have endorsement from a party or group of parties with at least 20% of parliamentary seats or 25% of the vote. PD is the only party to have crossed that line, enabling it to nominate Yudhoyono without coalition support should it choose. Negotiations are underway to determine which parties will support which candidate - ahead of a 16 May nomination deadline.

Opinion polls show Yudhoyono has a strong chance of winning the election. If no candidate wins more than 50% of the vote in the first round election on 8 July, the two leading candidates will contest a second round on 8 September. If Yudhoyono wins a second (and final) term, he is expected to continue pursuing some populist policies, but within the bounds of a prudent macroeconomic policy.

Implications. India looks to be the country likely to undergo the most electoral change.

There is tacit agreement between the Congress Party and the BJP on economic and foreign policy, with both committed to cautious economic liberalisation and an independent foreign policy. A Third Front government would be the most unsettling for financial markets and the economy. For one thing, it would be unlikely to survive its five-year term. Second, its members have few common policies. Finally, the communists are anti-liberalisation.

The Indian economy is projected to weather the world economic crisis reasonably well, with growth softening from its 8¾% average over the past five years to around 5% in 2009. But if the new government were to introduce reckless policies, this growth setback could become larger as sentiment and capital inflow waned and the fiscal deficit rose above its already high level of 10% of GDP (for federal and state governments combined). There is also the danger of a sovereign credit downgrade.

Of the three economies, South Africa is the most vulnerable to the world economic crisis because of large external financing needs stemming from a big current account deficit. There is some concern that policy under Zuma could take an irresponsible macroeconomic turn, thereby destabilising the economy, though markets do not seem unduly disturbed at this stage, keeping the rand steady during the election period.

Of all three economies, Indonesia has the healthiest public finances and balance of payments, and so is the least vulnerable to the world economic crisis. Only if global risk aversion rises significantly again might it find itself confronting an external liquidity problem. This is a far cry from its position during the 1997-98 Asian financial crisis, when it fell into a deep crisis and slump.
 

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