Overheating of Emerging Market Economies, and its Impact on the Recovery

Developed economies like US are under a liquidity trap where LM curve for the economy is nearly horizontal and no monetary policy can bring a positive impact on recession. Horizontal LM curve signifies that the economy is under liquidity trap. People are ready to accept all the money at such low levels of interest rates without spending on consumption. This money supplied through quantitative easing is pumped into the emerging markets instead of being invested back into the US economy because of the low interest rates. This increases the exchange rate and appreciates the foreign currency vis-à-vis US dollar. Emerging markets like China have started manipulating the currency against such inflow of foreign capital. China has devalued its currency to keep the exports level same as before. China does not follow the floating exchange rate policy and keeps Yuan at competitive levels vis-à-vis US dollar for exports.

To understand this a little better, lets talk about how this cycle all works about. Emerging nations have to face the double edged sword of rising inflation and on the other hand have to control the currency appreciation. In order to control the inflation if these countries use monetary policy and raise interest rates then the spread between their interest rate and the US interest ratesincreases leading to inflow of hot money into the capital markets leading to appreciation of domestic currency against dollar. The Federal Reserve announced an additional US$600 billion into the US economy to help keep a fragile recovery moving and ease high unemployment. To this end, South Korea, Brazil, Thailand, Turkey and many other countries have begun to regulate the capital inflows into their economy. Turkey for example has dilemma whether to reduce the interest rate in lieu of controlling the capital inflows from developed economies or to maintain the interest rates and avoid sending signals to the domestic market which otherwise may lead to runaway credit growth. Brazil on the other hand, a far more open economy than India and China, is facing more intense surge of capital inflows. It has the highest interest rates of any big economy, with a policy rate of 10.75 per cent a year, while inflation is just over 5 per cent. But the authorities fear to cut in case it boosts credit-fuelled domestic investment in asset bubbles.

Talking about the other two world’s leading emerging economies, India and China. In China, the policy rate rose in October for the first time since 2007 and is widely expected to increase again before the end of the year. In India, the central bank last month raised rates for the sixth time this year, to 6.25 per cent for policy lending, and another rise has been forecasted for the next month.

Justification for QE-II (Quantitative Easing-II) in the US comes from the slowing of the pace of expansion since beginning of the year 2010. The unemployment rate has remained close to 10 percent since mid-2009, with a substantial fraction of the unemployed out of work for six months or longer. Moreover, inflation has been declining and is currently quite low, with measures of underlying inflation running close to 1 percent. Although it was projected that economic growth would pick up and unemployment would decline somewhat in later months of the year, progress thus far has been disappointingly slow.

Trade flows are rising again. Strong growth in China and other emerging markets is helping to pull other countries out of recession. But at the same time, the risk of overheating and inflation is growing in the emerging markets. A boom-bust scenario cannot be ruled out, requiring a further tightening in countries such as China and India. The knock-on effect would be slower growth in the other regions. Exchange rate flexibility could ease some of the pressure on Chinese monetary policy and provide more scope for addressing domestic inflation.

GDP projections (% change from the previous year)

 Source: : OECD Economic Outlook

Instability in the sovereign debt markets poses another serious risk. It has highlighted the need for the euro area to strengthen its institutional and operational architecture. Bolder measures need to be taken to ensure fiscal discipline. Several countries are already taking early action to enhance the credibility of their fiscal consolidation plans.

Although economic activity is picking up, the growth in jobs is not keeping the pace. The number of unemployed has risen by 16 million in OECD countries in the past two years. The unemployment rate may now be peaking at an average 8.5% across OECD economies and is likely to fall only slowly in the near term. It adds pressure on the government, that governments must make room in their budgets for cost-effective labour market programmes that support workers at greatest risk of becoming long-term unemployed.

Unemployment rate (% of labour force)

Source: OECD Economic Outlook

Where does the future lie?

US Congress has approved the recent tax/fiscal stimulus deal, which will add about 1 percentage point to growth in 2011 relative to our earlier baseline, pushing the forecast to 4% over the four quarters of the next year.  Implementation of the deal, which could begin on January 1, will shift the mix of stimulus from monetary to fiscal policy. And it suggests that yields will gradually continue to move higher, to 4% by end-2011.

As widely discussed, the deal will extend the expiring income tax cuts for all the taxpayers for two years.  In addition to extending several other expiring provisions, it includes three key temporary elements which add new stimulus – a one-year payroll tax holiday for employees, a 13-month extension of emergency unemployment benefits, and full expensing of business investment outlays for 2011.  These will boost growth in 2011, partly at the expense of 2012. Along with other provisions, the new stimulus amounts to about $400 billion or about 1.3% of GDP in each year.

The fiscal stimulus enacted in the American Recovery and Reinvestment Act (ARRA) of February 2009 did not seem to add much oomph to the economy relative to its size; why should this smaller one produce more results? There are two reasons to believe this.  First, the nature of the stimulus matters: Most of the latest stimulus (about 0.7pp) results from the new proposed payroll tax holiday for employees.  Such cuts accrue mostly to the lower-income, budget-constrained taxpayers and show up quickly in spendable income, so they are more likely to be spent.

In contrast, the Making Work Pay (MWP) tax credit that was a key part of ARRA was disbursed slowly, and some empirical work suggests that taxpayers spent only about 13% of the incremental income, which partly showed up in withheld taxes and partly in rebates when taxes were filed.  Similarly, consumers spent about one-third of the one-time tax rebates in the 2008 stimulus package. Finally, outlays for the famously ‘shovel-ready’ infrastructure projects featured in ARRA took as much as a year to show up in spending.

A second reason why the current stimulus is likely to be more potent involves the state of financial conditions affecting households. The liquidity-strapped consumers, suddenly denied access to borrowing in the credit crunch, were more likely in early 2009 to save their tax credits and other forms of stimulus or use them to pay down debt.  In contrast, the deleveraging process for households and lenders in US is far more advanced today.

Due to Fed’s new asset-purchase program, financial conditions are gradually becoming easier.  Debt-to-income and debt-service-to-income ratios continued to decline in 3Q.  The Fed’s survey has indicated that banks are willing to lend to consumers and also the banks have eased lending standards for consumer loans.  The exception is that the mortgage credit is still tight; indeed, in 4Q banks signaled tighter standards for mortgage lending.

While November’s employment canvass was disappointingly weak in nearly every respect, including a downtick in the workweek, a broader perspective shows that rising hours have supported moderate gains in wage and salary income, and the improvement in a variety of labor market indicators – declines in jobless claims, rising job openings and surveys of hiring plans – points to renewed job gains. The continued slide in core inflation through October to 0.6% in terms of the CPI and 0.9% as measured by the Fed’s preferred gauge (the PCE price index) leaves it well below the Fed’s comfort zone.

References:

The above article has been written after reading articles from various sources:

http://www.morganstanley.com/views/gef/index.html

http://www.un.org/esa/policy/wess/wesp2011files/wesp2011pr.pdf

http://www.nytimes.com/2010/05/27/business/global/27oecd.html?pagewanted=2

http://www.allbusiness.com/economy-economic-indicators/economic-conditions-recovery/13372313-1.html

http://www.oecd.org/document/9/0,3343,en_2649_201185_45303817_1_1_1_1,00.html

By Nikhil Sabharwal, IIFT Delhi