gems - at the edge of order and chaos - the dynamics of global economic recovery

In this Report:Emergin• gMarkets’NewDynamismMountingGovernmentDebtsandRisks•DeflationversusInflation•AttheEdgeofOrderandChaos•

AttheEdgeofOrderandChaos:TheDynamicsofGlobalEconomicRecoveryBy Dr Yuwa Hedrick-Wong

Bellwether ReportJanuary 2011

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Turbulence as observed in fluid is one of the most difficult problems in classical

physics. Its dynamics is character-ised by chaos and its movement is virtually impossible to predict. The late Richard Feynman, a Nobel Prize-winning physicist, called it one of the most important unre-solved problems in physics. A story about another Nobel Prize-winning physicist, Werner Heisenberg of the Heisenberg Principle of Uncertainty fame, has him declaring that when he meets God he is going to ask him two questions: why relativity and why turbulence? And Heisenberg thought there is a better chance that God could answer the first question. The reason that the dynam-ics of turbulence are so complex is in part due to the cross currents involved in generating turbulent flows. Some cross currents, when they come upon one another, mix and merge smoothly into a larger flow. Some other cross currents, or the same cross currents but under slightly different circumstances, end up in a chaotic state when they mix. Turbulence then results. The state of the global economic recovery today has often been described as turbulent. This is an apt description, especially when we consider that there are a number of powerful cross currents at work in the global economy today and there is no guarantee that they will mix smoothly into a larger flow. Depending on how these cross currents interact in the unfolding

global environment, economic recovery could flounder in chaos or emerge with a new order. Three sets of cross currents are especially relevant in this context. The first is how emerging markets, having survived largely unscathed during the 2008-09 Global Financial Crisis (GFC), which is the result of a successful partial decoupling from the devel-oped economies, could continue to power ahead despite seriously weakened global demand. The role China plays in this process will be especially crucial. The extent to which China could rebalance its domestic economy is going to be a decisive factor. The second set of cross currents has to do with the trend of mounting government debts in the developed economies. Responding to the GFC, governments there acted rapidly and decisively to bail out the financial sector and subsequently the household sec-tor. Massive fiscal expenditures were incurred and continue to be incurred. It is clear today that such mounting debts will weigh on the recovery process. How they are eventually dealt with will affect both the recovery as well as the state of the post-recovery economies. The third set of cross cur-rents relates to global capital flow and is closely affected by the first and second sets of cross currents. Concerns over domestic rebalancing in emerging markets like China and mounting government debts in the US and Western Europe have

led to volatile and tsunami-like waves of capital flow from the latter to the former, creating havoc and disruption in their paths. Such capital flows are also perverse. The liquidity generated in the developed economies is meant to support investment and spending there. But instead, much of it rushes to seek better yields in emerging markets, fearing stagnation at home. The end result is a rising risk of defla-tion in the developed economies, matched by a rising risk of inflation in emerging markets. This perverse juxtaposition of deflation and infla-tion risks poses a real threat that could derail the global economic recovery. These three sets of cross currents intermingle today in the global economy, shaping the recovery process. However, unlike turbulence in nature which is com-pletely determined by the dynamics of the flow and the environment in which the cross currents interact, the global economy is also affected by one other important dimension which has to do with human intent; business and consumer confidence and government policy. In other words, what we choose to do or not to do, singly and collectively, could make a big difference in the outcome, possibly between order and chaos.

“what we choose to do or not to do, singly and collectively, could make a big difference in the outcome, possibly between order and chaos”



In assessing how these three sets of cross currents may affect the global economy, this report aims to shed light on how the global economic recovery could unfold, clarifying key risks that may derail the recovery process, especially in terms of inappropriate policies by governments and central banks; while identifying potential upside developments that could bring about a more robust post-crisis global economy.

Emerging Markets’ New Dynamism

The most comprehensive compilation of data available to date on the GFC is Carmen Rein-hart and Ken Rogoff’s This Time is Different1, which covers financial 1 Reinhart, C.M., K. S. Rogoff. 2009. This time is

Different: Eight Centuries of Financial Folly. Princeton and

Oxford: Princeton University Press.

crises going back to the 1500s. Their observations on the recovery process, based on analyses of all the financial crises since the end of the Second World War, are sobering. On average, equity prices declined by 56% over a period of three and a half years and housing prices declined by 35%, with the average duration of decline stretched out into six years.

The average increase in unemployment is about 7%, last-ing more than four years. As dire as these averages are, however, the magnitude of the initial collapse during the 2008/09 GFC is bigger than any of the post-War crises. In fact, the only comparable period in the last 100 years is the Great De-pression of the 1930s. In the Great Depression, the increase in unem-ployment in the first three years among the 15 largest economies

at the time reached an astonishing 17% and it took 10 years for these economies to regain their 1929 level of per capita income. The common assumption is that due to timely and decisive central bank actions, supplemented by massive fiscal spending by governments, the GFC was steered away from the pitfalls that created the Great Depres-sion. While many may argue that the jury is still out (and they have a good case), the fact remains that the catastrophic collapse of asset prices over the 2008/09 period was quickly arrested. Chart 1 compares the rate of decline of equity prices between the GFC and the Great Depression, setting year one in 2008 for the former and 1928 for the latter. As can be clearly seen in the chart, the initial decline in

GEMS©GEMS©Chart 1. The Great Depression & the 2008/09 Crisis Compared

* Stock Market Index:

(Reinhart & Rogoff, 2009, S&P)

19282007

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the GFC is much steeper, a drop of 41% by the end of year one of the GFC versus 10% in the Great Depression. But the decline was quickly arrested in year two of the GFC and it actually clawed back some of the decline by the end of that year, whereas the decline during the Great Depression was continuous for almost four years. A similar pattern is seen with respect to the decline in world trade in Chart 2. By the end of year one of the GFC the total value of world trade had dropped by 14%, versus 12% in the Great Depression. However, the value of world trade continued to decline by over four years in the Great De-pression, reaching the nadir of the collapse at 42%. In contrast, the total value of world trade started to recover in year two of the GFC

and by the end of year two it was down by only 5% from the pre-crisis level. More significantly, it is estimated by the World Bank that less than a fifth of the collapse in world trade during the GFC was due to an increase in tariffs and anti-dumping duties, over 80% of the decline simply reflected a drop in demand. In other words, there have been no serious counter-productive government policies in the aftermath of the crisis to further deter world trade, as was the case during the Great Depression. Apart from central bank ac-tions and fiscal spending by govern-ments in the developed economies, there is no question that emerging markets have made a huge differ-ence in mitigating the impacts of the GFC. This is made clear by Chart 3. The dotted lines represent

the rate of decline in real per capita income in the Great Depression, with the data arranged separately between Western Europe and the US, Canada, Australia and New Zealand, the “old” and the “new” world, as it were. In both instances, real per capita income declined continuously for about three and a half years before bottoming and the decline in real per capita income was much more severe in the new world than in the old. The solid lines in Chart 3 represent the rate of change in real per capita income in the GFC, contrasting the developed econo-mies with the emerging markets. As severe as the GFC was, real per capita income in the emerging mar-kets not only did not collapse, but grew by 2% by the end of year one and 5% by the end of year two of


* Value of World Trade

(Reinhart & Rogoff, 2009, IMF)

19302008

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the GFC. This came as a complete surprise to analysts and pundits whose common assumption was that, since most emerging markets are export-dependent (and China was seen as especially vulnerable in that regard), and as global demand for their exports evaporate, these markets would quickly be plunged into recession. Global demand for their exports did evaporate, declining by as much as 40% to 60% between the end of 2008 and mid-2009, nevertheless many emerging markets managed to avoid the widely predicted recession. As shown in Chart 3, their average real per capita income continued to grow, rising by 5% by the end of 2009, compared with a contraction of 4% in the developed economies. The fact of the matter is that emerging markets exported and

imported more during the GFC. Between 1Q 2008 and 2Q 2009, as illustrated in Chart 4, emerging markets saw their exports grow by 9% and imports by 12%, whereas among the developed economies their exports fell by 6% and im-ports by 11%. This is the best evidence of the partial decoupling of the emerging markets from the developed economies mentioned earlier. And it is due this extraordi-nary development that the decline in the value of world trade during the GFC was quickly stopped by the end of year one of the crisis. Not surprisingly China played a big role in this extraordi-nary development. Chinese im-ports from US, Japan, Germany, France, UK, Australia, Canada, Italy, Austria and South Korea com-bined, which accounted for 59% of

total Chinese imports in 2008, rose to 66% of the total in 2009, as seen in Chart 5. A similar pattern is also observed in India (albeit at a much lower level of total import value). Given that the value of total Chi-nese imports fell by a bit less than 10% between 2008 and 2009, the total value of China’s imports from these nine developed economies actually grew marginally over the same time period. Thus, counter-intuitively, it appears that emerging markets have functioned much like an anchor during the GFC, preventing a total collapse in world trade, even as external demand for their exports crumbled in the aftermath of the GFC. If emerging markets func-tioned as an anchor of the global economy during the GFC, then China functioned as an anchor

GEMS©GEMS©

Chart 3. The Emerging M arket Dif ference

* Real per Capita GDP:


19292008

Emerging economies

A dvancedeconomies

W estern Europe

US, Canada, A NZ

Great Depression (1929 = 100)2008/09 Crisis (2008 = 100)


* Value of World Trade


19302008

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among the emerging markets and commodity exporters. When it was becoming apparent that the global economy was heading towards a meltdown in the 1Q of 2009, Beijing moved overnight to mobilise every policy tool that it could muster in short order to bolster domestic demand. By 2Q 2009, some US$1.2 trillion of new bank lending was approved, fund-ing infrastructure projects of all shapes and sizes across the country, with a much stronger focus on the rural region and poorer provinces than before. Sizable subsidies were also authorised for households to purchase consumer durables and automobiles. Government spend-ing on health and education was massively increased. The end result was a rapidly revived economy, driven by an investment boom of an unprecedented scale.

China’s imports of com-modities and resources accordingly rose in tandem with the invest-ment surge, which in turn boosted commodity exporting economies like Australia, Indonesia, Malay-sia, Brazil, and Canada. African commodity exporters like Angola, Zambia and Nigeria also benefited significantly. China’s massive rollout in infrastructure also boosted capi-tal goods exporting to economies like Japan, Korea and Germany. Household spending, energised by stronger employment and income growth and incentivised by gov-ernment subsidies, expanded in double-digit terms from the end of 2008 through to the first half of 2010, leading to faster growth in imports of consumer goods ranging from electronics to luxuries, thereby lifting production in the exporters of these consumer goods in both Asia and Europe.

In early 2010, the proper-ty sector in China joined the party, fueled by abundant liquidity. This led to a massive property boom which ignited a second round of demand growth for imports in everything associated with residen-tial and commercial construction. In the first half of 2010, for ex-ample, China’s bilateral trade with ASEAN grew by 54.7% and with Brazil by 60.3%. In the aftermath of the GFC, a “China Cycle” has emerged to drive global economic growth. Domestically too, China’s demand side management has succeeded all too well. The overall impact on employment, for example, has been extraordinary. In early 2009, it was estimated that anywhere between 30 to 50 million migrant workers had lost their jobs in the coastal region due to the collapse of exports and

GEMS©GEMS©


* Divergent trends in trade growth: resilience in emerging markets

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-11%

+9%+12%

changes in exports by 2Q, 2010 changes in imports by 2Q, 2010

Advanced Economies Emerging Economies

1Q 2008 to 2Q 2010

(IMF Data)

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reportedly some 10,000 factories had shut down in the province of Guangdong alone. Less than a year later, average urban wages in the coastal region, adjusted for infla-tion, rose by 16% year-on-year in the first half of 2010. A series of industrial strikes (in foreign-owned manufacturing facilities) further highlighted how quickly the labour market had tightened. Apart from the dramatic turnaround in the labour market by the summer of 2010, adverse consequences of the liquidity-fueled growth were becoming very appar-ent in China. With inflation rising rapidly, Beijing started to shift into a tightening mode. The banking sector’s reserve requirements ratio was being nudged up repeatedly, coupled with specific instructions for banks to curb their lending to the construction sector. In Octo-ber, key interest rates were raised for the first time since the GFC. China’s economic growth is set to moderate further in 2011.

Going forward, China will have to manage a domestic rebalancing act that substitutes both foreign demand and domestic investment with domestic con-sumption.2 The speed and extent to which this rebalancing is successful will have an immediate impact on all key regional economies in Asia, as well as affecting the momentum of global economic recovery. This is one of the consequences of the new “China Cycle”; when it goes into reverse all sorts of repercus-sions happen worldwide. How this is managed will also be tricky. Household consumption, even under conditions of strong employ-ment and income growth, typically rises only gradually. For instance, it will take at least several years for the domestic consumer market in China, as potentially promising as it is, to be able to fill the gap created by a slowdown in export growth. Meantime, export values have already recovered to above the 2 China’s domestic rebalancing and its implica-

tions will be the focus of a forthcoming GEMS report.

pre-crisis peaks in China, Korea, and Taiwan, for example, and there is clearly not much steam left in expanding global demand for Asian exports. The outlook for Asian exports is not promising because of the expectation that growth at best will be anemic in the devel-oped economies in the foreseeable future. A key reason for this is their mounting government debts.

Mounting Government Debts and Risks

Massive fiscal spending in virtually all the developed econo-mies in the aftermath of the GFC drove up government debts. The indicator that typically raises the alarm is the government debt to GDP Ratio. In fact, the IMF has issued specific guidelines on thresh-olds above which government debt to GDP ratio is considered danger-ous: 60% for emerging markets and 80% for developed economies.

GEMS©GEMS©


* Emerging markets now driving growth of exports in advanced economies

(IMF)

* US, Japan, Germany, France, UK , Australia, Canada, Italy, Austria, S. K orea

Share of imports f rom advanced

economies *2008 2009

China 59% 66%

India 42% 47%

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The government debt to GDP ratio, though simple and straightforward, is actually not the best measure to use in today’s global economy. To begin with, it is a very crude measure. Firstly, it states the position of the government’s “gross” indebtedness, ignoring the asset side of the equation. The difference between “gross” and “net” indebted-ness could be quite large if the government in question were in possession of a significant amount of valuable assets such as property, precious metals and the like, or productive assets such as profitable state-owned enterprises which could be sold in the markets at a profit. Secondly, the government debt to GDP ratio also misses the liability side of the equation. Many governments have very sizable explicit commitments in pension liabilities that are currently unfund-ed, sometimes amounting to 20%

to 30% of GDP. There are also other less explicitly stated future liabilities in the form of govern-ment expenditures on the provision of education, health, defense, and other welfare services, which are expected by members of the society even though these services may not be contractually committed to by the government. Adding up such explicit and implicit liabilities could quickly swell the debt level of government. In order to more accurately capture the reality of a government’s indebtedness, the really important comparison is therefore not with GDP per se, but against the gover-ment’s tax revenue.3 Such a debt to tax revenue ratio provides a more meaningful gauge of how the 3 An even more accurate measure is actually

the ratio of government debt to the tax revenue potential;

the extent to which the government could realistically raise

taxes without precipitating a collapse of productive economic

activities altogether.

government’s cash flow could (or could not) be managed. With a few simple assumptions, the govern-ment debt to tax revenue ratio could also provide a basis for making future projections - the extent to which future tax revenue may grow (or shrink) against the rate at which debt is rising (or drop-ping). If projected properly, discounting both the debt and tax revenue streams back to the present, one could actually arrive at a reasonable estimation of a govern-ment’s “net worth” position. Apart from government debt, another important dimension in today’s economic environment is household debt, which is measured in terms of household liability to average annual income. The household sector is important, especially in the developed econo-mies, because the household sector is typically very large as a percent-

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United StatesGovt. Debt / GDP

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93.02% 123.27% 494.33%

Source:

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US Treasury, BEA, FED

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Chart 6

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age of GDP there. Just prior to the GFC, for instance, household spending in the US accounted for close to 72% of GDP. Further-more, the GFC actually started as a subprime housing crisis, hence it is important to keep track of how much households are weighed-down by debts after their property values crashed, especially in light of persistently high unemployment. Taking account of these considerations, the situation of both government and household debts in the US is summarised in Chart 6, with historical data going back to 1929. By the end of 2Q 2010, the government debt to tax revenue ratio is estimated at an astonishing 494%, compared with a much less alarming reading of debt to GDP ratio of 93%. And the level of household liability to average annual income is estimated at 123%. At close to 500%, the government debt to tax revenue ratio is now the highest since the end of the Second World War. As we can see in the chart, the govern-ment debt to tax revenue ratio dropped very quickly in the years after the war ended. In fact, apart from a small up-tick in the early 1950s (due to the Korean War), the ratio fell continuously over the next three decades, before rising gradu-ally again in the 1980s. Might this not happen again today? And if so, why worry? To explain why one should indeed worry about the high level of government debts today, it is not enough just to say that now is different from then, which is an

obvious truism. Instead, it is important to understand how today is different structurally from yester-day, or more precisely, the post Second World War years. The massive rise of government debt to tax revenue ratio in the 1940s came as a result of funding a long war that was global in scope, and when American industries were producing not only to supply its own armed forces, but those of the UK, USSR, France, and a host of smaller allies. However, the American armed

forces, which stood at over 10 million at the end of the war, were rapidly demobilised once the fighting was over. Within a year its size shrank to less a million. Mean-while, the domestic economy was suffering from several years’ worth of pent-up demand due to war time rationing. Furthermore, house-holds were in a strong position to spend, their cash was literally burning a hole in their pockets; soldiers serving overseas had saved their pay and women entered the workforce during the war en mass, earning and saving as well. As we can see in Chart 6, the household liability to average annual income ratio was at an all time low in the late 1940s. With industries quickly turning their production capacity back to civilian production, the pent-up demand, funded by ample

savings, could be met happily and profitably. As businesses expanded to meet rising demand, demobilised troops found employment, swelling the pay roll, and thereby raising government tax revenue. Furthermore, the millions of demobilised troops also started to get married and make babies and the so-called “baby boom” genera-tion resulted. As young families bought their first home and the first family car, consumer demand received yet a further boost. It is therefore not surprising that by the late 1950s unemployment fell to the low single digit level and that growth of government tax revenue rapidly outstripped that of govern-ment debt, leading to the observed sharp fall in government debt to tax revenue ratio. As a framework of compari-son with today, several key observa-tions are worth highlighting. The first and foremost is that the massive run-up in government expenditures during the war was quickly reversed as soon as the war ended. This is completely different from today’s situation where a great deal of future expenditure commit-ted to by the government, such as unfunded pension liabilities, cannot be easily “reversed”. The second is the stark difference in demograph-ics; the years after the Second World War swelled with young people, eager to marry and have children, whereas now the popula-tion is a lot older in the US. Out-side of the US, population ageing is even more pronounced with many developed economies less keen or capable of taking in immigrants. Japan is probably the extreme case,

“[...]spending US$800 billion to renew America’s sadly out-of-date infrastructure could boost economic growth in both the short and the long term.”



but the situation is no less chal-lenging in Western Europe and the Nordic countries. The third, and perhaps the most important, is that while productivity surged in the post-war years, there are legitimate reasons to worry about the robust-ness of future productivity growth, an issue that we will examine more closely below. Thus, the tremendous growth in government debt levels in the developed economies today is a seriously worrying trend. While many aspects of the current recov-ery remain difficult to fathom, one thing is certain; the government debt to tax revenue ratio is not going to come down as quickly as in the post-Second World War years. There is no question that the persistently high debt burden will weigh on the recovery, making it slower and more anemic than it would otherwise have been. Apart from their commonality of high government debts in the developed economies, however, there are significant differences in the debt dynamics

between them. The UK is often referred to, next to the US, as the other Anglo-Saxon economy that shares many of the same “vices” of low savings and profligate spending. But its government debt to tax revenue ratio stands at 245% in mid-2010, “only” about half of that of the US, as Chart 7 shows. The UK’s debt burden also seems a lot lighter viewing it in terms of government debt to GDP ratio, which is 68%, again significantly lower than that of the US. Where the UK stands out is in its house-

hold debt. Total household liability as a percentage of average annual disposable income is 153%, signifi-cantly higher than the US at 123%. Everything else being equal, this is likely to be the Achilles’ heel of the UK. Turning to the lightening rod of the Eurozone crisis4 – Greece – its government debt situation is clearly an unmitigated disaster, as illustrated in Chart 8. While government debt to GDP stands at ‘only’ 115%, the government debt to tax revenue ratio is a shocking 596%, reflecting not only the high debt level but also the Greek government’s chronic inability to collect taxes from its citizens and businesses. Greek households, on the other hand, have a much lighter debt burden, with a liability to average annual disposable income ratio of 71%. The US$150 billion rescue package provided to the Greek government earlier this year by the IMF and the European Commission carries the require-4 The Eurozone crisis and alternative scenarios of

how the crisis may be resolved is the focus of a forthcoming

GEMS report.

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United KingdomGovt. Debt / GDP



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68.10% 152.62% 245.47%

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Eurostat

GEMS©

Chart 7

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GreeceGovt. Debt / GDP



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115.10% 70.89% 596.29%

Source:

Most Current Value:

Eurostat

GEMS©

Chart 8

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ment that the Greek government will cut its deficit to 3% of GDP by 2014. It now appears that the Greek government is unlikely to meet the target. Apart from the fact that the government’s deficit in 2009 has been revised to 15.5% from 13.5% of GDP, the deficit in 2010 will likely come in at 8.9% instead of the targeted 8.1%. A potential crisis is therefore still looming, the rescue package has thus far merely pushed the crisis point further into the future. The debt situation of Portugal, another crisis country in the Eurozone, is shown in Chart 9. Again, while the government debt to GDP ratio is a relatively manage-able 77%, the debt to tax revenue ratio is an alarming 344%. The household liability to average annual disposable income in Portugal is also dangerously high at 135%. Signs of market nervousness became more evident last Novem-ber when the yield on Portuguese government bonds increased to over 7%, or 4.8% above the safe Ger-man Bund. Nevertheless, Portugal managed to complete its fund

raising for 2010 when it successfully sold US$1.7 billion of six- and ten-year bonds to the market on November 10. Ireland is another crisis country in the Eurozone and its debt situation is summarised in Chart 10. While its government debt to GDP ratio looks relatively harmless at 64% (below the IMF threshold of danger), its debt to tax revenue is at 296%. Ireland also has perhaps one of the highest levels of household debt, estimated at

197% of average annual disposable income. 2010 is Ireland’s third consecutive year of GDP contrac-tion. In spite of all the painful budget cutting that has been carried out in the two preceding years, by the end of 2010 the Irish govern-ment estimated an additional cut of some US$20 billion will still be needed in order to meet its deficit target. In fact the market grew so jittery about Ireland’s debt last November that the yield on Ire-land’s ten-year government bond jumped to close to 9%, some 6.2% above the yield on safe German Bunds. In the last week of Novem-ber, the European Commission issued public statements to urge Irish bond holders not to abandon Ireland and to assure them that the European Commission and the ECB would back Ireland come what may. A few days later, the Irish government confirmed that it has secured a massive loan of about US$100 billion from the EU. The debt situation of Spain, perhaps the most impor-tant of the crisis countries in the

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PortugalGovt. Debt / GDP



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76.80% 134.94% 344.35%

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Most Current Value:

Eurostat

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Chart 9

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IrelandGovt. Debt / GDP



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GEMS©

Chart 10

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Eurozone by virtue of the size of its economy, is shown in Chart 11. Its government debt to GDP ratio, at 53%, suggests no real cause for concern. But when translated into debt to tax revenue ratio, it balloons into 284%. Furthermore, Spain has a very high household debt to average disposable income ratio, estimated at 128% in 2008, largely due to a much bigger housing sector bust there during the GFC. Coupled with an unemployment rate of over 20%, Spain’s recovery will be seriously constrained by anemic private consumption for the foreseeable future. The last crisis country in the Eurozone is Italy, although the Italian government continues to deny that it is in any crisis. The data appear to disagree with the government, as seen in Chart 12. The government’s debt to GDP ratio is estimated at 116%, exceeding the IMF’s danger threshold by a large margin. But the debt to tax revenue ratio is a truly alarming 398%, making it the second worst in the Eurozone, just behind Greece. Leaving the Eurozone, Australia has a very different debt picture, as Chart 13 shows. Both the government debt to GDP and to tax revenue ratios are relatively mild, estimated at 25% and 109% respec-tively. But Australia has one of the highest levels of household debt, at 166% to average disposable annual income. While Australia did not actually suffer a recession during the GFC, thanks largely to its robust exports to the emerging markets generally, and to China in particular, its growth prospects today are cloud-ed by the huge household sector debt overhang.

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SpainGovt. Debt / GDP



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Chart 11

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ItalyGovt. Debt / GDP



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115.80% 56.57% 398.49%

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Chart 12

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AustraliaGovt. Debt / GDP



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25.27% 166.50% 109.36%

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ABS

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Chart 13

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Japan is perhaps the grand champion of government debt among the developed economies. It is well known that the level of government debt has been building there for over a decade. As Chart 14 shows, its government debt to GDP now stands at a shocking 184%. But this is dwarfed by its debt to tax revenue ratio, which is at an implausible 1,890%. In other words, at today’s rate, it will take almost 19 years for the Japanese government to pay off its debt assuming the government were to use its entire annual tax revenue each year to do just that and nothing else. The household sector in Japan is also heavily in debt, currently at about 107% of average annual disposable income, albeit it has been declining gradually from a decade ago. The debt situation in China provides a sharp contrast with those of the developed economies. As Chart 15 shows, both China’s government debt to GDP ratio and its debt to tax revenue ratio, 19% and 106% respectively, are very low. Its household sector is also relatively debt free, with a liability to average annual disposable income ratio of about 30%. India’s debt situation shows a different picture, however, as seen in Chart 16. Its household sector has little debt, at 12% of average annual disposable income.5 Its government debt to GDP ratio, at 72%, is much higher than China’s, and exceeds the IMF threshold. 5 This is estimated with data from the formal

sector, however. It is common knowledge that rural

household indebtedness is extremely high in India, which

is largely conducted in the informal sector, escaping both

government’s tax collection as well as statistics compilation.

300%

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2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

JapanGovt. Debt / GDP



(RHS)

183.75% 106.85% 1890.36%

Source:

Most Current Value:

CEIC

GEMS©

Chart 14

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80%

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2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

ChinaGovt. Debt / GDP



(RHS)

18.60% 29.56% 106.37%

Source:

Most Current Value:

CEIC, IMF

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Chart 15

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750%

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IndiaGovt. Debt / GDP



(RHS)

71.84% 11.94% 1006.41%

Source:

Most Current Value:

CEIC, IMF

GEMS©

Chart 16

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But its debt to tax revenue ratio, at 1,006%, is a cause for alarm. The persistent weakness of the govern-ment’s fiscal account is one of the key concerns regarding India’s longer term growth prospects.6 This overview of govern-ment debts in the developed economies should leave us in no doubt that not only is this a worry-ing trend, but potentially an adverse cross current that could derail global economic recovery. It is therefore not surprising that there has been an increasingly vociferous lobby for more fiscal spending cuts, especially in the US (the Eurozone crisis had prompted fiscal spending cuts there in early 2010). Against this clamour for “responsible” government and austerity is the opposing camp that urges more fiscal spending instead of less. Advocates in this camp, among them are some heavy-hitting economists, including Nobel Prize-winning ones to boot, fear that an immature withdrawal of the government’s fiscal stimulus could lead to a double-dip recession. In this cacophony of accusations and counter-accusations an essential truth is being drowned out – and this from my perspective, is the real threat to the global economic recovery. Economic history is clear on the point that in the aftermath of every financial crisis and reces-sion, government deficit inevitably goes up. The primary cause of the increase in government deficit, however, does not have much to do with whether the government is

6 This and related issues will be the topic of a

future GEMS report.

fiscally irresponsible or if the government is adopting austerity measures to cut spending. It has to do with the collapse of tax revenue due to economic contraction, which is, after all, the definition of a recession. So the key priority in managing economic recovery should be that of ensuring econom-ic growth to return as soon and as much as possible, instead of engag-ing in a fundamentally meaningless debate between austerity and fiscal spending. The debate is meaningless because, depending on how it is done, either austerity or fiscal spending could boost economic growth and productivity, therefore increasing tax revenues with a faster reduction in government debt as a result. Take for example the US$800 billion stimulus package that the US government rolled out in the aftermath of the GFC. Listening to the government’s rhetoric, one would expect the lion’s share of the package to be spent on infrastructure investment to renew America’s transportation systems, refurbishing its dilapidated airports, and replacing its two century old railways with gleaming high speed trains. Such spending would not only create jobs that employ immediately the idled construction workforce that has been left high and dry after the housing sector bust, but also significantly improve America’s logistics efficiency and productivity over the longer term. In other words, spending US$800 billion to renew America’s sadly out-of-date infrastructure could boost economic growth in both the short and the long term. So fiscal spending in this instance could

bring down government debt faster than without such spending. Instead, less than 8% of the US$800 billion package has been spent on renewing America’s infrastructure. A great deal more, on the other hand, has been spent on transfer payments. Among others, unemployment benefit was extended from 26 weeks to 99 weeks. Robert Barro at Harvard University has calculated that this extension of unemployment benefit alone has severely impaired the mobility of the US labour market. His estimate is that without this unemployment benefit extension, unemployment rate would have come down to around 6.8% by the 3Q of 2010, instead of being stuck at the 9.5% level.7 Worse still is the fact that longer unemployment benefit has the unintended conse-quence of prolonging the duration of unemployment. A longer duration of unemployment means workers lose more of their skills whilst unemployed, which in turn negatively impacts future produc-tivity. This then is exactly how a government should not conduct fiscal spending. The sad irony today is that the high unemploy-ment, at least in part created by the wrong kind of fiscal spending, is the justification cited by advocates of increased fiscal spending. Because,

7 “Obamanomics meets incentives”, Robert

Barro, Wall Street Journal, September 14, 2010.

“Without rising productivity, economic growth will be at best anemic in the future, which could easily end in stagnation.”



they reason, the spending so far is clearly insufficient, otherwise unemployment would not be as high as it is. Advocates of fiscal austerity, on the other hand, often blithely assume that the more the govern-ment cuts spending, the faster government debt will come down.

There is, however, scant empirical evidence to support such a policy position. The IMF’s research has shown that, in developed econo-mies at least, fiscal spending cuts in the past have almost always led to economic contraction,8 although it appears that fiscal spending cuts are less damaging to economic growth compared with a tax increase.9 However, if fiscal spending cuts can be targeted at areas of government spending which have been shown to have serious deleterious effects on productivity, then a properly structured austerity programme could well boost economic growth, leading to rising tax revenue and therefore faster government debt reduction. Take for example the Greek government’s stated inten-tion to downsize the workforce in industries such as transportation, 8 “Will it hurt? Macroeconomic effects of fiscal

consolidation”. World Economic Outlook, IMF, October 2010.

9 “Large changes in fiscal policy: taxes versus

spending” NBER Working Paper No. 15438, January 2010.

Alesina, A. and S. Ardagna.

where public sector enterprises dominate. In many of these large state-owned and loss-making enterprises, wages account for up to 80% of their revenues. The state railway organisation in Greece, for instance, which is the biggest public sector loss-maker, has lost an astonishing US$1.35 billion a year on average in the past decade. It has been estimated that many of these enterprises could function just as efficiently with a 40% reduction in their workforce, which would also turn them into profit-making entities.10 Cutting government spending in these loss-making state-owned enterprises therefore cannot go wrong! It will immedi-ately reduce the government’s budget deficit, possibly improve productivity and certainly reduce future government debts. Similarly, when governments in the Eurozone try to change the retirement age, asking workers to retire at 62 instead of 60 instantly raises pension contributions while pen-sion claims decrease. This is especially useful in the long run given Europe’s ageing demographics mentioned earlier. Hence, well designed austerity programmes could actually raise productivity, inducing faster economic growth and reducing government debts faster. The real danger today is that the debate in the developed economies on issues related to government debt typically pits two politically charged opposites, i.e., those advocating more fiscal spending versus those for austerity. The central priority of raising

10 Hope, K. “Athens signals tougher stands on

austerity”. Financial Times. October 15, 2010

productivity simply does not get a proper hearing. Without rising productivity, economic growth will be at best anemic in the future, which could easily end in stagna-tion. The real policy debate about how to deal with mounting govern-ment debt should be around where, and how, to judiciously increase fiscal spending and where, and how, to target spending cuts, all with the ultimate goal of raising productivity, the only way that debt can effec-tively be brought down. Focusing on productivity today would therefore inject some sanity back into the political institutions in the developed economies. Failing that, the mountains of government debts will simply continue to rise, jeopar-dising the very prospects of a global economic recovery.

Deflation versus Inflation

Alongside the fiscal policy debate is an equally intense and contentious debate about monetary policy. In the aftermath of the GFC, central banks in the devel-oped economies acted fast to cut interest rates and since then rates have been kept low. In the US, the Federal Reserve, for example, has been keeping interest rates close to zero. The hope has been that the low interest rates would encourage more borrowing by businesses and households, thereby holding up demand, nudging the recovery along. However, when the policy rate is set close to zero, the central bank is effectively neutered since interest rates cannot be “set” to below zero. (A negative real interest rate comes about when it is exceed-ed by the inflation rate). The only alternative is the so-called quantita-

“American businesses and investors are more likely to seek better returns elsewhere [...] And they need to look no further than to the emerging markets.”



tive easing (QE), a process whereby the Central Bank buys government bonds with newly printed paper money, or more likely a touch on the key board to generate additional zeros on the bank’s balance sheet. The intended effect of QE is to increase the liquidity further in the market even when the interest rate is zero. QE is meant to lower long term interest rates which then helps businesses and consumers to borrow in order to invest and spend, thus driving up demand and economic growth. It is also meant to bid up asset prices, based on the so called “portfolio balance” theory, which states that when the Federal Reserve buys bonds (lowering bond yields), investors are then encour-aged to seek higher returns in other assets more risky than bonds.

The Federal Reserve did just this, and so did the Euro-pean Central Bank when it partici-pated in the bailing out of the Greek government earlier this year. However, as the US economy continues to underperform, with demand sluggish and unemploy-ment staying stubbornly high, the Federal Reserve has been asked to do more QE. The need for more QE has also been underscored by the rising risk of deflation. The spectre of the US following in the footsteps of Japan, plagued by persistent deflation and high unemployment in prolonged stagnation, now haunts the minds of many. On November 3rd last year, the Federal Reserve duly announced QE II, saying it would buy US$600 billion of long term

Treasury bonds over the course of the next 12 months. The problem with QE today is that capital is highly mobile; QE-based liquidity may be created in the US but it may not stay in the US. Indeed, with the mounting government debts and stagnant growth, American busi-nesses and investors are more likely to seek better returns elsewhere, where growth is more robust and demand is rising. And they need to look no further than to the emerg-ing markets. It is thus that elements of the first two sets of cross currents discussed above – the apparent decoupling of the emerging markets from the developed economies and rising government debt with anemic growth in the latter – come togeth-

GEMS©

Chart 17 Inf lation Vs. Def lation Trends

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Source: Eurostat and CEIC Note: CPI for all except for India which uses WPI

GEMSSM

GEMS©

Chart 17 Inf lation Vs. Def lation Trends

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Source: Eurostat and CEIC Note: CPI for all except for India which uses WPI



er in forming the third set of cross currents: deflationary risk in the developed economies and inflation-ary risk in the emerging markets. This third set of cross currents has some very perverse outcomes. In the developed econo-mies, credit growth continues to be in negative territory and many surviving and viable SME busi-nesses, for example, are still starved of credit as banks are not lending and investors are staying away. Meanwhile, the massive liquidity created by low interest rates and QE is surging like a tsunami across oceans to the shores of the emerg-ing markets. Such speculative capital inflows, on an increasingly large scale, is driving up prices there, fueling asset bubbles, just as these markets are struggling to rebalance their domestic economies to mitigate weak exports. In other words, global capital flow today is leaving where it is most needed and crashing into places where it is less than welcome. The timing is especially bad for some of the major emerging markets like China, India and Indonesia; they are already growing at, or above, their trend rates of growth and inflation there is already rising. The capital inflows from the developed economies are like pouring petrol onto fire and it is no surprise that inflation is taking off in many of the emerging mar-kets. As Chart 17 shows with monthly data going back to January 2007, the price movements between the emerging markets and the developed economies started to diverge around the 3Q of 2009. Indeed, between then and October

2010, Japan and Ireland have had several bouts of deflation, while the US core inflation has declined to a record low of below 1% in recent months. In contrast, inflation in China and India started to rise. The monthly inflation rate in China in January 2009 was around 1%, yet by January 2010 this had risen to 1.5% and to 3.6% by September, and then a sudden leap to 4.4% in October. It became clear by the end of 2010 that a lot more monetary tightening would come in 2011 in China.

Inflation has been rising much faster in India. This is due to the fact that India has a fully convertible currency and an open capital account. In addition India’s government borrowing chronically crowds out private sector borrow-ing, forcing the latter to go overseas for capital, which in turn accelerates capital flows.11 India is therefore more vulnerable to the impacts of a sudden surge in speculative capital inflow (and eventually to a sudden outflow as well). In January 2009 India’s inflation rate, as measured by the wholesale price index (WPI) was around 5%, and by September 2010, it had risen to 8.6%. 11 India’s public sector finance and its potential

impact on economic growth is the topic of a future GEMS

report.

The WPI in India actually under states the severity of the inflationary trend from the con-sumer’s perspective. As shown in Table 1, the inflation rates for food items and for fuel, which directly impact consumer’s pocket, are much worse than indicated by the WPI. Using weekly prices, through the month of September into early October 2010, both food and fuel prices were rising in double digit terms, compared with the WPI’s September average of 8.6%. In fact, by the first week of October, 2010, food prices were rising at the

rate of 16.4%, and fuel prices at 11.1%. In response, many govern-ments in emerging markets have announced that they are either implementing capital control or contemplating doing so, in order to cope with the potentially destabilis-ing capital flows. Brazil, for exam-ple, tinkered with taxes related to foreign capital, hoping to discour-age further speculative inflows. In Asia, Thailand was the first in October, to impose a 15% with-holding tax on capital gains and interest payments for government and state-owned company bonds to discourage capital inflows, while removing limits on overseas invest-

Food Fuel WPISep. 4, 2010 15.1% 11.5%

September average: 8.6%

Sep. 11, 2010 15.5% 11.5%Sep. 18, 2010 16.4% 10.7%Sep. 25, 2010 16.3% 10.7%Oct. 2, 2010 16.4% 11.1%

(RBI) GEMSSM

Table 1. India’s Weekly Inflation Rates



ment and lending to encourage outflows. In November, Taiwan followed by imposing a limit on foreign holdings of long term government bonds, adding to its previous limits on short term investment. Indonesia and Korea also started to consider similar measures. These are, however, market distorting measures of uncertain effectiveness. A more appropriate policy option is to let the exchange rates of the emerging market currencies rise, which would make assets in the emerging mar-kets more expensive, while making imports in these markets a lot cheaper. The net result should be less speculative capital inflow, with lower prices of imports, leading to less inflation. To some extent this has already happened, as illustrated in Chart 18, which shows changes

in Asian currencies in trade-weight-ed terms between January 1 and October 27, 2010. Apart from Vietnam, all the key markets in Asia have seen their currency exchange rates increase since the beginning of 2010. Though an appropriate policy response, the net result of currency adjustment in Asia so far is nevertheless uneven. The currency of the country that should see a strong appreciation, China, has seen only a very mild increase of some 2.5% in nominal terms12, given its 12 Changes in exchange rates measured in

nominal terms are, however, not very meaningful. A more

precise measure requires that the relative inflation rates

between the countries involved be taken into account; and

not just inflation as generally measured (e.g. consumer price

index), but as real unit labour costs. This provides a very

different picture on China’s exchange rate movement in the

last several years, and this will be one of the topics addressed

tightly controlled exchange rate. To the chagrin of the US, China’s trade surplus has continued to grow through 2010. Japan, on the other hand, which is suffering from deflation, has seen the strongest appreciation of its currency. This is creating havoc with Japan’s export-dependent growth. Since Korean and Japanese exports tend to compete head-to-head in third markets, for example, Korea’s much milder currency appreciation compared with Japan’s means a jump in Korean export competitive-ness against Japanese exports. And it is clear that currency adjustment in Asia is not entirely market-driven, not just in China where the exchange rate is still tightly managed by the govern-ment. Ultimately all the emerging by a forthcoming GEMS report.

Chart 18. Changes in Asian Currency Exchange Rates

2.5%

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China India Indonesia* Japan Korea Malaysia Philippines* Singapore Taiwan Thailand

YTD Exchange Rate Appreciation against US$(4 January 2010 to 5 November 2010)

Source: Federal Reserve Board, Central Banks of Indonesia and Philippines * YTD is 14 October 2010, source is resepective central banks

GEMSSM



markets in Asia are concerned with their export competitiveness. Many of them are still mercantilist in spirit, if not in official policy statements. Hence a cheap cur-rency is still the preferred option for most Asian emerging markets to keep their export machines run-ning. This means the risk of infla-tion will remain a clear and present one in these emerging markets. In turn, rising inflation will at some point compel the Central Banks there to raise interest rates and curb credit growth, which could poten-tially put their nascent and still fragile economic recovery at risk. The G-20 meeting in November in Seoul tabled the issues of global imbalance for discussion, but without any concrete results. The G-20 governments merely pushed the issue to some unspeci-fied future date for negotiation. Those who see the glass as half full would argue that this is a big step forward, having raised the issue of global imbalance as requiring coordinated policy response. Those who see the glass as half empty, however, would point out any agreement on such a contentious issue is at best years away, hardly relevant to the current state of the fragile recovery.

At the Edge of Order and Chaos

The three sets of cross currents described in this report, especially in how they mix and interact, will determine to a very large extent how the global economic recovery may unfold in 2011 and beyond. Should governments’ policies turn out to get things more right than

wrong, and with some good luck, a new order could emerge from the recovery, leading to a more robust post-GFC global economy. In this scenario, domestic consumption in emerging markets, led by China, will expand at a pace that could begin to fill the gap left by weak exports. Intra-regional trade in Asia will become more a trade of end products for domestic consumption instead of components for exports to outside of Asia. In the devel-oped economies, the net effects of governments’ fiscal spending and budget cuts will turn out to be pro-ductivity-boosting and growth-pro-moting. This will lead to stronger growth and faster job creation, thus improving the governments’ balance sheets, thereby ameliorating worries over future government debts. And both the deflationary and inflation-ary risks in the developed economies and emerging markets respectively will subside after peaking in early 2011. However, it would not take much to upset the delicate balance upon which the global economic recovery is uneasily perched today. Things could turn out horribly wrong. The global economy could yet be plunged into a state of chaos. For instance, ever more severe aus-terity measures imposed on some of the crisis countries in the Eurozone may lead to voter rebellion, default and debt restructuring. This could again seize-up the money markets, not only in Europe, but globally. Crashing Eurozone economies would hammer the already weak exports in emerging markets, Asia in particular and governments’ panic reaction could lead to coun-ter-productive competitive currency

devaluation, risking runaway infla-tion. In the US, the government may cut the wrong kind of spend-ing (the productivity boosting kind) and increase transfer payments (the kind that reduces incentives to work and invest), thereby dooming the economy to a prolonged period of stagnation. GEMS will closely moni-tor these potential developments and future GEMS reports will cover key topics in greater details and will consider their implications for international businesses throughout the course of the year.

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the accuracy of the content and analysis

contained in this report, neither The Insight

Bureau Pte Ltd nor the GEMS Editor

accepts any liability for the consequences

of any actions taken on the basis of the

information provided.

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ANNEX:2010Forecasts2008 2009 2010 estimate 2011 forecast

AustraliaNominal GDP (US$ trillion) 1.05 0.99 1.24 1.49Real GDP Growth (%) 2.2 1.2 3.3 3.8Investment Growth (%) 9.0 -1.1 6.8 10.4Private Consumption Growth (%) 1.9 1.7 3.2 4.0ChinaNominal GDP (US$ trillion) 4.52 4.99 5.76 6.50Real GDP Growth (%) 9.6 9.1 9.8 8.2Investment Growth (%) 14.3 23.7 12.0 9.0Private Consumption Growth (%) 9.8 10.8 11.0 8.7Hong KongNominal GDP (US$ trillion) 0.22 0.21 0.23 0.24Real GDP Growth (%) 2.2 -2.8 7.4 5.0Investment Growth (%) 0.8 -1.8 8.1 5.5Private Consumption Growth (%) 1.8 2.4 2.8 1.2IndiaNominal GDP (US$ trillion) 1.21 1.31 1.57 1.89Real GDP Growth (%) 6.7 7.4 8.5 8.1Investment Growth (%) 4.0 7.2 10.8 12.7Private Consumption Growth (%) 6.8 4.3 8.1 7.8IndonesiaNominal GDP (US$ trillion) 0.51 0.55 0.72 0.82Real GDP Growth (%) 6.0 4.5 6.2 5.7Investment Growth (%) 11.9 3.3 9.5 12.8Private Consumption Growth (%) 5.3 4.9 5.1 5.4Japan Nominal GDP (US$ trillion) 4.89 5.07 5.39 5.68Real GDP Growth (%) -1.2 -5.2 2.8 1.5Investment Growth (%) -2.8 -14.0 -2.0 1.6Private Consumption Growth (%) -0.6 -1.1 2.3 2.0KoreaNominal GDP (US$ trillion) 0.95 0.84 1.02 1.12Real GDP Growth (%) 2.3 0.2 7.0 5.5Investment Growth (%) -1.9 -0.2 6.5 4.0Private Consumption Growth (%) 1.3 0.2 4.2 5.5MalaysiaNominal GDP (US$ trillion) 0.22 0.19 0.24 0.27Real GDP Growth (%) 4.7 -1.7 7.6 4.3Investment Growth (%) 0.7 -5.6 11.5 8.0Private Consumption Growth (%) 8.5 0.7 8.2 6.0PhilippinesNominal GDP (US$ trillion) 0.16 0.16 0.19 0.21Real GDP Growth (%) 3.7 1.1 7.8 4.7Investment Growth (%) 2.7 -0.4 21.0 12.0Private Consumption Growth (%) 4.7 4.1 5.3 4.5SingaporeNominal GDP (US$ trillion) 0.19 0.18 0.22 0.26Real GDP Growth (%) 1.8 -1.3 15.3 5.0Investment Growth (%) 13.6 -3.3 6.5 5.6Private Consumption Growth (%) 2.7 0.4 5.0 4.8TaiwanNominal GDP (US$ trillion) 0.40 0.38 0.43 0.47Real GDP Growth (%) 0.7 -1.9 8.3 5.5Investment Growth (%) -11.2 -11.0 23.0 0.8Private Consumption Growth (%) -0.6 1.4 2.6 4.8ThailandNominal GDP (US$ trillion) 0.27 0.26 0.32 0.36Real GDP Growth (%) 2.5 -2.2 8.6 4.2Investment Growth (%) 1.2 -9.0 13.8 8.7Private Consumption Growth (%) 2.7 -1.1 5.6 4.5

gems - at the edge of order and chaos - the dynamics of global economic recovery

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set of cross currents

sets of cross currents

global economic recovery

global economy

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postrecovery economies