A stuttering global economic recovery is now faced with a fresh round of challenges. The sub-prime mortgage crisis has revealed to the world the fragility of the market, in what some observers have termed in hindsight, the ‘age of risk’. The magnitude of these challenges is multiplied by the flux of a constantly changing world. It’s a world that is as unsteady and wobbly as a ship sailing across the rough Atlantic sea.
The US was perceived as the engine of the global economy, consuming exports from around the world and fostering the growth of the peripheral emerging economies. These emerging markets initially were Japan and Western Europe in the 1960s. But as Europe and Japan grew prosperous, China and India filled the gap left by them.
Low consumer confidence, high fiscal deficits, a falling dollar, capital flight and the crippling lack of credit are some of the obvious features of the US economy today. However, being the center of the global economy and the overwhelming dominance of dollar, the US still enjoys the power to manipulate monetary flows in a world which is characterised by globalisation and decentraisation of financial markets.
The sheer scale of growth exhibited by developing economies, particularly the ‘Asian tigers’ caused a serious imbalance in the global economy just as the financial crisis set in, and set in motion a return to equilibrium in the mechanism of global trade flows.
Weak demand and fears of a repeat of the Japan style debt-deflation cycle led the US and the Eurozone to consider unconventional monetary policies. In a bid to bolster liquidity and growth, interest rates were deliberately kept low. The focus is now on achieving sustainable levels of domestic demand and growth through export competitiveness.
The Eurozone’s progress remains shaky, given the disparity of interests amongst members of the European Union (EU) with a mood of insecurity prevailing. This uncertainty is largely rooted in a chain of sovereign debt defaults triggered by Greece earlier this year.
Emerging markets which have grown mainly on the strength of external competitiveness through exports suffer as a result of the climate of monetary easing. A major feature of the competitive strategy of export oriented countries is a relatively low priced currency designed to attract export orders.
China, in particular, has now amassed nearly $2,650 billion in foreign exchange reserves, earned mainly on the strength of its exports and capital inflows. These developments have sparked a currency war, between major developed economies and the emerging markets, with the US and China leading the charge on opposing sides.
China is blamed by the US for manipulating the Yuan, its currency, in an attempt to bolster exports and prevents the currency from reflecting its true market value. China’s commitment to undervalue its currency infuriates the US as it is determined to transform itself from a net consumer to a net saver.
Competitive devaluations across the board are at best, detrimental to the prospect of economic recovery and at worst, lead to a situation where a full-blown trade war becomes a very real prospect. The question is whether the structure of the global economy is adjusted in a way the US wants or whether international cooperation from China, amongst others, could deliver stability.
Recently, we have seen a tremendous rise in the emerging markets capital inflows; as they risk an overvaluation of their currencies and interest rates, many analysts fear, it might trigger sustained stagflation in the medium term.
In an effort to avoid this grave distortion of markets, many countries are beginning to impose strict capital controls on these speculative inflows also dubbed ‘hot money’. Notable among such measures, include a 15 percent withholding tax imposed by Thailand on capital gains and interest payments on Thai-denominated debt. South Korea is keenly considering the imposition of a similar withholding tax.
Brazil last week doubled its tax on speculative foreign inflows in Brazilian denominated debt, in a bid to avoid overvaluation. Similar fears were raised by Chile as the Peso continues to strengthen against the greenback. Many others including Indonesia and Malaysia are likely to follow, as fears of an asset bubble, spread across the region.
Emerging markets have been caught in the middle of a seemingly intractable dispute over exchange rates and capital flows between the US and China. It must also be noted that capital inflows in emerging markets may lead to reckless lending in credit markets as well. It is not only the inflow of hot money that causes the problem. Where the money goes is, instead, the primary issue.
Fears of a repeat of the 1997 “Asian Financial Crisis,” when excessive inflow of hot money led to increased speculative lending, is quite possibly the reason emerging world seems wary this time around. The ‘lost decade’ in Japan is a case in point, a situation in which excessive liquidation fed the credit crisis during the 1980s.
Significant interest rate differentials and rumours of more quantitative easing are fuelling these trends. In a meeting of the IMF this past weekend, capital controls were endorsed as a savior. However many analysts are skeptical whether such restrictions are effective at all. These inflows also greatly benefit the emerging world as they form the capital base for most of the small-scale manufacturing.
Small-scale manufacturing forms the platform for real growth in most major developing economies. Capping capital inflows will likely take the wind out of the sail of small-scale manufacturing. On an analytical level, capital controls should prove to be a measure of last resort.
The outcome of this currency battle seems to be tilted in the direction of the US. For the US victory lies in the complete control over the amount of liquidity it bears. The greenback remains the main prospect of a reserve and a safe currency in the global economy.
Cooperation from both parties is essential for stable recovery. Returning to equilibrium is not an easy process. It involves firm commitment and is dependant on the strength of regulatory actions. This balancing act involves the US morphing into a net exporter, with some fiscal consolidation.
On the other hand, China must behave responsibly and look inwards and develop domestic demand, but on terms agreeable to both parties, so that rebalancing can remain smooth. China can do this gradually over the medium term, by investing in areas that could enable it to achieve higher consumption levels, sufficient to replace export led growth.
However, emerging markets like India raise no concerns on the amount of capital flowing into its economy. India is a different case altogether, with sufficient space and a large enough economy to sustain any speculative asset formation. Besides India is characterized by high inflation, so a strong Indian rupee should help moderate inflationary levels of growth.
The world of tomorrow is different from the world emerging at the time of the “East Asian Bubble”.
These economies are supported not only by a robust industrial expansion but also by resources which provide sustainable comparative advantage in global trade. As the west continues to support prospects of monetary easing, one can expect capital inflows in the emerging world to remain strong in the medium run as well, as both market sentiment and market expectations are relatively long lasting.
Regarding currencies, a globalised world must behave maturely. Currency wars will eventually force stability on nations as they strive to achieve sustainable growth; otherwise a slide into an unfathomable abyss seems to be around the corner.
