Monthly Archives: April 2014

Recovery in Europe?

Greece has returned to the bond market, issuing $4.2 billion of five-year bonds at an interest rate of 4.95%. The government’s ability to borrow again is a “reward” for posting a surplus on its primary budget (although the accounting that produced the surplus has been questioned).  This has been viewed as a sign, albeit fragile, of recovery. Portugal has also sold bonds and hopes to exit its bailout program this spring. But what does recovery mean for these countries, and is it sustainable?

Growth for these countries reflects a rise from a brutally harsh downturn. Greece has an unemployment rate of 26.7%, with much higher rates for its youth. Portugal’s unemployment rate of 15.3% was achieved in part by emigration.

A look forward indicates that the debt that drove these countries to borrow from their European neighbors and the IMF will fall in the next five years but continue at elevated levels. The latest Fiscal Monitor of the International Monetary Fund forecasts gross government debt to GDP ratios for these countries, as well as for the Eurozone:

2015 2016 2017 2018 2019
Greece 171.3 162.5 153.7 146.1 137.8
Portugal 124.8 122.6 119.1 116.6 113.8
Eurozone 94.5 92.6 90.4 88.1 85.5

Even if the debt/GDP ratios above the Reinhart-Rogoff 90% threshold do not pose a threat to growth, it is noticeable that the Eurozone’s debt does not fall below it until 2018, while debt/GDP in Greece and Portugal will be in triple digits for many years.

These debt levels become more worrisome in light of fears of deflation in the Eurozone. Greek consumer prices have been falling, and inflation in the Eurozone is below its 2% target level. European Central Bank head Mario Draghi has downplayed these concerns, pointing to rising prices in other Eurozone countries.  But IMF economists Reza Moghadem, Ranjit Teja and Pelin Berkman point out that even low inflation can also pose problems. Deflation and less than expected rates of inflation increase the burden of existing debt. Greece’s debt will become more of a burden if it rises in real terms. Low inflation also makes wage adjustment harder to achieve.

The ECB would (presumably) respond if the prospect of deflation became more likely. But would it be able to stave off falling prices through its version of quantitative easing? There are concerns that large-scale purchases of assets by the ECB might not be as effective as anticipated. Interest rates have already fallen and are unlikely to fall further. Moreover, the decline in borrowing costs for Greece and other sovereign borrowers may have already have factored in ECB intervention.

Draghi’s pledge in 2012 to do “whatever it takes” to protect the euro undoubtedly lowered concerns about a collapse of the Eurozone. But, as I have argued before, the confidence within the Eurozone inspired by the ECB’s powers could vanish, particularly if there were doubts about the ECB’s ability to actually accomplish whatever it takes to avoid deflation. Lower borrowing costs based on faith in the ECB will ease conditions in the Eurozone crisis countries. But they need to be backed up by improving economic fundamentals before they are seen as justified. Until then, purchasing sovereign debt is a high-risk proposition, no matter what the interest rates signal.

China’s Place in the Global Economy

Last week’s announcement that China’s GDP grew at an annualized rate of 7.4% in the first quarter of this year has stirred speculation about that country’s economy. Some are skeptical of the data, and point to other indicators that suggest slower growth.  Although a deceleration in growth is consistent with the plans of Chinese officials, policymakers may respond with some form of stimulus. Their decisions will affect not just the Chinese economy, but all those economies that deal with it.

The latest World Economic Outlook of the International Monetary Fund has a chapter on external conditions and growth in emerging market countries that discusses the impact of Chinese economic activity. The authors list several channels of transmission, including China’s role in the global supply chain, importing intermediate inputs from other Asian economies for processing into final products that are exported to advanced economies. Another contact takes place through China’s demand for commodities.  The author’s econometric analysis shows that a 1% rise in Chinese growth results in a 0.1% immediate rise in emerging market countries’ GDPs. There is a further positive effect over time as the terms of trade of commodity-exporters rise. Countries in Latin America are affected as well as in Asia.

These consequences largely reflect trade flows, although China’s FDI in other countries is acknowledged. But what would happen if China’s capital account regulations were relaxed? Financial flows conceivably could be quite significant. Chinese savers would seek to diversity their asset holdings, while foreigners would want to hold Chinese securities. Chinese banks could expand their customer base, while some Chinese firms might seek external financing of their capital projects. A study by John Hooley of the Bank of England offers an analysis of the possible increase in capital flows that projects a rise in the stock of China’s external assets and liabilities from about 5% of today’s world GDP to 30% of world GDP in 2025.

While the study points out that financial liberalization by China would allow more asset diversification, it also acknowledges that world financial markets would become vulnerable to a shock in China’s financial system.  Martin Wolf warns that the down-side risk is quite large. He cites price distortions and moral hazard as possible sources of instability, as well as regulators unfamiliar with global markets and an existing domestic credit boom. Similarly, Tahsin Saadi Sedik and Tao Sun of the IMF in an examination of the consequences of capital flow liberalization claim that deregulation of the Chinese capital account would result in higher GDP per capita and lower inflation in that country, but also higher equity returns and lower bank adequacy ratios, which could endanger financial stability.

There could be another result. A sizable Chinese presence in global asset markets would lead to even more scrutiny of Chinese monetary policy. A policy initiative undertaken in response to domestic conditions would affect financial flows elsewhere, and foreign policymakers most likely would voice their unhappiness with the impact on their economies. The Peoples Bank of China, accustomed to criticism from the U.S. over its handling of its exchange rate, might find the accusation of “currency wars” coming from other emerging market countries.  The price of a successful integration of Chinese financial markets with global finance will be calls for more sensitivity to the external impacts of domestic policies.

Capital Liberalization and Inequality

Inequality, which has drawn a great deal of comment and analysis following the publication of Thomas Piketty’s Capital in the Twenty-First Century, has sometimes been seen as a byproduct to increased international trade. But now other international economic linkages are being investigated. The International Monetary Fund’s Managing Director, Christine Lagarde, has acknowledged the need to take distributional consequences into consideration when designing IMF policy programs. Moreover, Fund economists have contributed to the research on the linkages between financial globalization and inequality.

Davide Furceri and Prakash Loungani of the IMF have investigated the effect of capital account liberalization on inequality. They looked at 58 episodes of capital account reform in 17 advanced economies, and found that the Gini coefficient (a measure of inequality) increased by about 1% a year after liberalization and by 2% after five years. One channel of transmission from the capital account to inequality could be the Increased borrowing by domestic firms that allows them to hire skilled workers, who pull ahead of the less-skilled workers.

A similar impact was found by Florence Jaumotte, Subir Lall and Chris Papageorgiou, also of the IMF. They analyzed the effect of financial globalization and trade as well as technology on income inequality in 51 countries over the period of 1981 to 2003. They reported that technology played a larger role in increasing inequality than globalization. But while trade actually reduced inequality through increased exports of agricultural goods from developing countries, foreign direct investment played a different role. Inward FDI (like technology) favored workers with relatively higher skills and education, while outward FDI reduced employment in lower skill sectors. Consequently, the authors concluded, while financial deepening has been associated with higher growth, a disproportionate share of the gains may go to those who already have higher incomes.

Jayati Ghosh of Jawaharlal Nehru University of New Delhi has examined the role of capital inflows in developing countries. She maintains that the inflows appreciate the real exchange rate and encourage investment in non-tradable sectors and domestic asset markets. The resulting rise in asset prices pulls funds away from the financing of agriculture and small firms, hurting farmers and workers in traditional sectors. Eventually, the asset bubbles break, and the poor are usually those most vulnerable to the ensuing crisis.

After the Asian crisis of 2007-08, Barry Eichengreen of UC-Berkeley analyzed some of the other linkages that could tie inequality to capital account liberalization. He dismissed claims that capital mobility hinders the ability of governments to maintain social safety nets or to use macroeconomic policy to stabilize output. He agreed that developing countries were more likely to suffer the negative effects of capital mobility. But the problem lay in the combination of an open capital account and inadequate institutions and regulations.

The global financial crisis demonstrated that weak regulation and volatility in financial flows are not unique to emerging markets and developing countries. Moreover, while the U.S. economy now shows signs of increased growth, the long-term unemployed are not sharing in the recovery.  The U.S. Senate has passed a bill that would extend benefits to this group of workers, but it faces opposition in the House of Representatives. On the other hand, those households that own substantial financial assets have benefited greatly from the increase in their value since 2009, which is due in large part to monetary policy. Similar patterns can be found in Europe.

Those most hurt by the outcome of financial instability should be the first to benefit from government policies intended to mitigate its impact. But we know that politicians are much more responsive to their more affluent constituents, who hold financial assets. The uneven recoveries that follow financial crises injure those least capable of dealing with misfortune, thus exacerbating the disparity between those at the top of the income distribution and those at the bottom.