July 19, 2011
With less than six months of 2011 remaining, it is time to peek around the global financial corner. What can we expect in the near economic future? Tony Addison, Chief Economist and Deputy Director of UNU-WIDER, considers the surprises that could lie ahead.
♦ ♦ ♦
Eminent twentieth-century American economist John Kenneth Galbraith once said that economic forecasting was invented to make astrology look respectable. So, without making “predictions”, here are six things to watch for during the upcoming months, as 2012 quickly approaches.
The US dollar fell against other major currencies over the first half of the year. Meanwhile, the managers of reserves in central banks continued to diversify away from dollars. This included China, one of the biggest buyers of US treasuries. So it might seem unlikely that the dollar will bounce in the second half of 2011.
However, currencies are relative prices. The euro is in trouble and the pound is under water. A stronger dollar would be good news for all those developing countries that hold a large chunk of their reserves in US treasuries. A currency appreciation would boost their otherwise miserly return on holding US debt (two-year notes yield less than half a percent for investors, way below the long-term average).
The US’s debt-to-GDP ratio is now close to what it was in the exceptional days of the Second World War. Some big institutional bondholders took fright earlier in the year and dumped US treasuries (a bad bet as it turned out; treasuries rallied in the spring). Much depends on what will happen in Washington in early August. Congress has until then to make up its mind on whether to raise the US debt ceiling. Yet the debate is fractious, and you can expect some wobbles along the way.
As a reserve currency, US debt is in demand (especially by worried Europeans) and will likely remain so, even if it is downgraded from triple-A by the bond ratings agencies. Furthermore, while US debt is high, Japan’s debt is even higher (although this debt is mainly owned by the Japanese, which makes Japan less vulnerable than the US, where half the debt is owned by foreigners). China’s debt appears to be much bigger than earlier estimates, once the profligate spending by local authorities is included. What’s more, the Eurozone will end up issuing more debt to sort out the banks if Greece defaults. So maybe the debt of Uncle Sam and the dollar don’t look so bad after all.
The low cost of borrowing over the past few years has kept many firms and households afloat, despite being awash in debt (US household debt is higher today than five years ago). The US Federal Reserve (the Fed) has dumped some US$2 trillion on the markets since late 2008 — buying up bonds to increase money in circulation (“quantitative easing”, or QE2 for short). That debt-buying will end very soon, if we can believe recent statements by the Fed. Still, unless something dramatic occurs in the bond market, borrowing costs could still remain low for a few more years, if not as low as recently. This would be good for any developing country selling its own sovereign debt, offering yields that are more attractive than US treasuries. However, it may lure countries into borrowing on easy terms, only to face difficulties once global interest rates really do return to normal.
All that you would ever want to know (and more) about the Greek economic crisis is now public. The information is already priced-in, if financial markets are efficient. And the prices of Greek debt certainly do reflect a view that there is a high probability of default. So, if default does occur, financial markets might just be prepared enough to bear the pain.
But aside from those teaching economics in Chicago, there aren’t many economists these days that believe in efficient financial markets (although they are certainly good at increasing the wealth of the already wealthy). Thus, the Greek sovereign-debt crisis has the potential to become the mother-of-all banking crises.
Debt crises used to be largely confined to developing countries. The big ones, such as Latin America’s crises in the 1980s and Argentina’s crisis in 2000-01, taught us that there is only so much pain that debtors can take. The pain comes in the form of expenditure cuts and tax increases. Eventually debtor governments prefer default to repayment, putting the interests of their citizens before foreign creditors.
The scale of the punishment (such as being locked out from more borrowing) rarely fits the “crime” of default. Countries can regain access to sovereign borrowing remarkably quickly, judging by past debt crises (Uruguay around 2002, for example). This is one of the many paradoxes of financial globalization. So a default by Greece might not be the big story it seems. We shall see.
More fundamentally, many investors might ask themselves why they are buying the bonds of rich countries with poor growth, and not the bonds of poor countries with strong growth (including plenty of commodities that are in demand). Ghana is a case in point, especially once its oil revenues grow. Might we see a rush to buy Africa’s sovereign paper? African governments will need to be careful; borrowing to invest productively is fine, borrowing to fund a bloated public sector is a route to disaster, as Greece shows.
By the time the International Monetary Fund (IMF) sits down for its annual meeting in September, the Fund’s new boss, Christine Lagarde, will have had a few months in the chair. She will have plenty to do. International economic governance is shaky these days. Nationalism rather than internationalism seems to rule. Will a new IMF director bring a new era for the Fund?
For ideas, Lagarde could take a look at the 2010 UNU-WIDER Annual Lecture given by José Antonio Ocampo on “Reforming the International Monetary System”. The lecture reflects on the financial mess of the last few years and what can be done to introduce a more effective (and fairer) system of international monetary governance. José Antonio urges a transition to a fully Special Drawing Rights (SDR)-funded IMF, for example. This is just one proposal that could start a new era in the Fund.
Commodity price indices reached two-year highs in May, before falling back. Many academic economists who work on commodity markets believe that prices follow a “random walk” (they are essentially unpredictable). However, for believers in a commodities “super-cycle”, the recent price softening is a mere blip on a long-term upward trend of rising prices driven by emerging market growth (especially in China). These investors are not taking a random walk. They believe themselves to be on an upward march of ever-higher prices, albeit with market corrections along the way.
Time will tell whether the academics or the investors are right. But this has got me thinking about one of the most influential theories in development economics of the last half a century. In the 1950s, Raul Prebisch and Hans Singer came up with the idea that the terms of trade of developing countries would be in long-term decline , if they remained exporters of commodities and importers of manufactured products. The theory and empirics have taken some knocks over the years, yet the Prebisch-Singer hypothesis remains compelling, not least because it draws attention to the big questions underlying the global economy, including the distribution of economic power.
With the upward momentum of commodity prices, is it now time to reverse the Prebisch-Singer hypothesis and make the claim that the terms of trade of poor countries are now in an era of sustained improvement? I don’t think we’ll have the answer by the end of the year (or any time soon), but this question keeps me thinking.
The great and the good of the aid world gather in Busan, South Korea, in November for the High Level Forum on Aid Effectiveness. These events usually focus on such worthy topics as aid coordination. This is OK in itself (if only donors would coordinate more). Yet the bigger picture is often missing. That includes food prices, which are on the rise again. Higher food prices played a role in igniting the “Arab Spring”, itself one of the big surprises of the first half of 2011. Much of Africa imports its food (40 out of 53 countries are net food importers) and Africa’s central bank governors worry about food-price inflation. Furthermore, climate change is relentless and will only accelerate when the rich world returns to growth. Will Aid Ministers and their advisors take the time to think harder about the bigger picture at Busan?
Two recent UNU-WIDER working papers might help. From UNU-WIDER’s work on climate change, a very topical paper by UNU-WIDER researcher Imed Drine on climate change risks in North Africa is now out. Likewise, Paul Chinowsky and others discuss the impact of climate change on Africa’s road infrastructure, and the likely cost. Two essential readings while on the road to Busan.
• ◊ • ◊ •
This is a slightly edited version of the article “Surprises Ahead?” that originally appeared on June–July edition of the UNU-WIDER newsletter WIDER Angle.