If the credit cycle has got out of hand, who is to blame?

• Fifteen years ago this month, Thailand at last allowed its currency, the baht, to fall against the dollar, abandoning a long, losing battle with market forces. “I haven’t slept for two months,” said the governor of the central bank on the day of the devaluation. “I think that tonight I’ll be able to sleep at last.” What followed was a five-year nightmare for emerging markets, as the financial crisis spread to Thailand’s neighbours, then to Russia and Brazil, before eventually claiming Argentina and Uruguay in July 2002.
• After the tossing and turning of 1997-2002, the next decade went like a dream. In 2003 China resumed double-digit growth; India’s economy expanded by 8%, a feat it would surpass in four of the next six years; Brazil’s new president, Luiz Inácio Lula da Silva, appeased the IMF and the bond markets by cutting public debt and achieving the first of five annual current-account surpluses. Goldman Sachs released the first of its 2050 projections (“Dreaming with the BRICs”, its catchy acronym for Brazil, Russia, India and China), suggesting that the big emerging economies would eventually inherit the Earth.
• The crisis-hit countries emerged from devaluation, default and distress with low expectations, cheap and flexible currencies, scope to borrow and room to grow. Global capital markets welcomed them back, buying their equities and their bonds, even when denominated in their own currencies. The popular emerging-markets stockmarket index compiled by MSCI rose by over 350% from the end of 2002 to its peak in October 2007.
• Rather than spend these capital inflows, emerging economies recycled them. They amassed foreign-exchange reserves as a guarantee against ever again succumbing to a currency crisis or the ministrations of the IMF. Some have even begun to help fund the fight against crises elsewhere. On July 10th Indonesia’s central bank confirmed it would buy $1 billion of the IMF’s notes, a poignant reversal of roles.
• But after a dream decade, something is amiss. China is now struggling to grow as fast as 8% (its GDP expanded by 7.6% in the year to the second quarter). India, a country that once aspired to double-digit growth, can now only dream of ridding itself of double-digit inflation. None of the biggest emerging economies stands on the edge of a dramatic financial precipice, like their counterparts in the euro area, or a fiscal cliff, like America’s. But their economic prospects have nonetheless started to head downhill.
• The MSCI emerging-market index is flat for the year and still 30% below its 2007 peak. Only 15 months ago, the IMF’s forecasters expected Brazil’s economy to grow by over 4% this year. This week their 2012 forecast was just 2.5% (see chart 1). Over the same period, South Africa’s 2012 growth forecast was cut from 3.8% to 2.6%.
• Some of this slowdown can be blamed on events elsewhere. Europe’s pain, for example, has spread far beyond its immediate neighbours. The European Union remains the biggest foreign market for many emerging economies, buying about 19% of China’s exports and 22% of South Africa’s. Euro-area banks have also begun to sell assets and withdraw lending. They account for about 45% of credit to emerging Europe and a substantial share of trade credit in Asia.
• Some of the slowdown was also orchestrated by governments nervous about price pressures or property bubbles. Poland’s central bank raised rates as recently as May to quell inflation, which persists above its 2.5% target. China’s premier, Wen Jiabao, fell into a game of chicken with the country’s 50,000 property developers, waiting for them to cut prices, even as they waited for him to lift restrictions on multiple home purchases. As growth slows, policymakers will ease in response.
• But there is more to this story. The slowdown is not simply a demand-side phenomenon, the result of weak exports and past tightening dragging growth below its long-run potential. The underlying rate of sustainable growth may also be less impressive than previously thought. As the IMF pointed out this week, the last decade or so may have “generated overly optimistic expectations about potential growth”.
• High commodity prices boosted some emerging economies, such as Brazil, Russia and South Africa. They also flattered emerging-market share prices. As Bank of America Merrill Lynch observes, natural-resource industries account for more than a third of the market capitalisation of the BRICs and over a quarter of the market cap of MSCI’s benchmark index.
• The dream decade was also sweetened by rapid credit growth, according to the fund. The ratio of bank credit to GDP has risen steeply in many emerging economies over the past ten years. From trough to peak, it rose by over 20 percentage points in Brazil, China, the Czech Republic, Hungary, Malaysia, Poland, South Korea, Taiwan and Turkey. It rose almost as far in India and Russia.
• In some emerging economies, the upswing began late in the decade. In China, the credit ratio has risen by over 27 points since 2008 alone. In others, it has already ended: in South Africa, Hungary and South Korea, the credit ratio has fallen substantially since the financial crisis.
• A rising credit ratio may represent healthy “financial deepening” as the banking system does a better job of capturing household saving and reallocating it to its best use. But it may also reflect a potentially destabilising “financial cycle”, an upswing in credit and other financial variables, which overlays and often outlasts the swings in GDP and inflation that mark conventional business cycles.
• The upturn in the financial cycle may flatter growth, as easy credit encourages spending and speculation, boosting the value of collateral and thus easing credit further. This may have lulled emerging economies into thinking they could grow faster than they really can, just as permissive finance helped persuade the rich world that its growth was more stable than was actually the case.
• When credit booms show up in inflation, central banks are typically quick to react. But consumer prices often remain tame, because rising exchange rates and imports fill the gap between expanding domestic demand and supply. That allows the booms to grow dangerously large. Selim Elekdag and Yiqun Wu of the IMF have identified 99 “credit balloons”, episodes of fast credit growth over the past 50 years in rich and emerging economies alike. Of these balloons, 44 popped badly (resulting in a banking crisis, currency crisis or both) and another 13 very badly, with a 9% contraction of GDP on average.
• In Asia’s emerging economies, credit ratios have risen further and faster than they did before the Thai crisis, says Frederic Neumann of HSBC. Even so, the region’s central bankers need not lose too much sleep. Now, unlike then, bank loans have not outstripped deposits. And in most countries, domestic investment has not outstripped domestic saving. If foreign capital were to withdraw abruptly as it did 15 years ago, the effects would not be as ruinous. Most foreign-capital inflows come in the form not of debt but equity, which shrinks to fit an economy’s ability to pay. The debt of Asian economies is also now partly in their own currency, which would fall in a crisis, taking some of the strain. If foreign capital retreats, Asia’s surplus countries should have enough resources to replace it, although the switch may not be entirely smooth.
• The picture is different in Europe. In Poland, for example, credit to the private sector grew by an extraordinary 36.6% in 2008, contributing to a current-account deficit of almost 9% of GDP. The crisis interrupted these excesses but did not reverse them: the country’s external deficit remains over 5% of GDP. In recent months, the FDI and portfolio capital Poland requires to fill this gap has flowed in the wrong direction. That leaves the country uncomfortably “susceptible” to the euro crisis, says Raffaella Tenconi of Bank of America Merrill Lynch, if it prompts a further withdrawal of cross-border lending.
• If the credit cycle has got out of hand, who is to blame? Policymakers in emerging economies sometimes present themselves as powerless victims of vague global forces, such as the “tide of liquidity” supposedly sweeping across the globe, thanks to near-zero interest rates in America, Japan and the euro area. But research by Mr Elekdag and Fei Han, also of the IMF, suggests that such external factors explain only a small portion (16%) of the variation in credit growth in emerging Asia. By imposing curbs on domestic credit and allowing greater flexibility in their currencies, economies can regain greater control.

the current economic climate is likely to produce deep disparities

• The current economic climate is likely to produce deep disparities in economic performance over the long-term. Ultimately, while some countries will be far more adversely affected than the other, those that do (relatively) better will share three key characteristics: relatively low public debt, strong domestic demand-led growth and a robust democracy.
• The world economy faces considerable uncertainty in the short term. Will the eurozone manage to sort out its problems and avert a breakup? Will the United States engineer a path to renewed growth? Will China find a way to reverse its economic slowdown?
• The answers to these questions will determine how the global economy evolves over the next few years. But, regardless of how these immediate challenges are resolved, it is clear that the world economy is entering a difficult new longer-term phase as well – one that will be substantially less hospitable to economic growth than possibly any other period since the end of World War II.
• Regardless of how they handle their current difficulties, Europe and America will emerge with high debt, low growth rates, and contentious domestic politics. Even in the best-case scenario, in which the euro remains intact, Europe will be bogged down with the demanding task of rebuilding its frayed union. And, in the US, ideological polarization between Democrats and Republicans will continue to paralyze economic policy.
• Indeed, in virtually all advanced economies, high levels of inequality, strains on the middle class, and aging populations will fuel political strife in a context of unemployment and scarce fiscal resources. As these old democracies increasingly turn inward, they will become less helpful partners internationally – less willing to sustain the multilateral trading system and more ready to respond unilaterally to economic policies elsewhere that they perceive as damaging to their interests.
• Meanwhile, large emerging markets such as China, India, and Brazil are unlikely to fill the void, as they will remain keen to protect their national sovereignty and room to manoeuvre. As a result, the possibilities for global cooperation on economic and other matters will recede further.
• This is the kind of global environment that diminishes every country’s potential growth. The safe bet is that we will not see a return to the kind of growth that the world – especially the developing world – experienced in the two decades before the financial crisis. It is an environment that will produce deep disparities in economic performance around the world. Some countries will be much more adversely affected than others.
• Those that do relatively better will share three characteristics. First, they will not be weighed down by high levels of public debt. Second, they will not be overly reliant on the world economy, and their engine of economic growth will be internal rather than external. Finally, they will be robust democracies.
• Having low to moderate levels of public debt is important, because debt levels that reach 80-90 percent of GDP become a serious drag on economic growth. They immobilize fiscal policy, lead to serious distortions in the financial system, trigger political fights over taxation, and incite costly distributional conflicts. Governments preoccupied with reducing debt are unlikely to undertake the investments needed for long-term structural change. With few exceptions (such as Australia and New Zealand), the vast majority of the world’s advanced economies are or will soon be in this category.
• Many emerging-market economies, such as Brazil and Turkey, have managed to rein in the growth of public debt this time around. But they have not prevented a borrowing binge in their private sectors. Since private debts have a way of turning into public liabilities, a low government-debt burden might not, in fact, provide these countries with the cushion that they think they have.
• Countries that rely excessively on world markets and global finance to fuel their economic growth will also be at a disadvantage. A fragile world economy will not be hospitable to large net foreign borrowers (or large net foreign lenders). Countries with large current-account deficits (such as Turkey) will remain hostage to skittish market sentiment. Those with large surpluses (such as China) will be under increasing pressure – including the threat of retaliation – to rein in their “mercantilist” policies.
• Domestic demand-led growth will be a more reliable strategy than export-led growth. That means that countries with a large domestic market and a prosperous middle class will have an important advantage.
• Finally, democracies will do better because they have the institutionalized mechanisms of conflict management that authoritarian regimes lack. Democracies such as India may seem at times to move too slowly and be prone to paralysis. But they provide the arenas of consultation, cooperation, and give-and-take among opposing social groups that are crucial in times of turbulence and shocks.
• In the absence of such institutions, distributive conflict can easily spill over into protests, riots, and civil disorder. This is where democratic India and South Africa have the upper hand over China or Russia. Countries that have fallen into the grip of autocratic leaders – for example, Argentina and Turkey – are also increasingly at a disadvantage.
• An important indicator of the magnitude of the new global economy’s challenges is that so few countries satisfy all three requirements. Indeed, some of the most spectacular economic success stories of our time – China in particular – fail to meet more than one.
• It will be a difficult time for all. But some – think Brazil, India, and South Korea – will be in a better position than the rest.

oil prices on rollercoaster ride

• Broadly, two factors govern the price of oil. One is actual supply and demand, the other market sentiment about the state of the world. The fundamentals change slowly; the market’s mood is more volatile. Both have sent the price careering up and down in recent weeks.
• In March fears that the Iranians might do something dramatic in the Strait of Hormuz, cutting off supplies to global markets, helped to propel the price of a barrel of Brent crude to over $128. Since then oil has sagged by 30%, to a low of $88 a barrel on June 22nd, as intensifying worries over the euro-area debt crisis and fears of a sharp slowdown for China’s economy darkened prospects for demand.
• The supply side also weighed on prices. For some months Saudi Arabia has been pumping oil at its fastest rate in 30 years to make up for Iranian crude lost to American and European sanctions, which officially started on July 1st. Plenty of Libyan oil is also back on the market. Oil from America’s shale fields has all but plugged the gap caused by disruptions to supplies from Syria, Yemen and South Sudan.
• The emotional rollercoaster is now climbing again. On June 29th oil markets responded to the latest euro summit with undisguised, and unmerited, glee. The price of Brent crude leapt by 9%, the biggest one-day advance in three years, and has since risen to around $100 a barrel. The fundamentals and the fear factor suggest the price will remain there for a while.
• First, demand remains surprisingly perky even though Europe’s consumption dropped by over half a million barrels a day (b/d) in the first three months of the year. Japan’s thirst grew by 400,000 b/d (to generate electricity that nuclear power no longer supplies); Americans put more petrol in their tanks in April than they did a year ago, the first such increase for 16 months; and Chinese demand, despite a sluggish May, has grown by 2.6% in the first five months of the year compared with the same period in 2011.
• Demand is expected to strengthen in the second half of the year as a seasonal boost is buttressed by a recovery in China and the resumption of deferred infrastructure spending there. Most analysts reckon that worldwide consumption is set to grow by around 1m b/d in 2012.
• Second, the supply picture is looking less promising. Iranian sanctions could take more than expected out of the market—perhaps as much 1.4m b/d. The Chinese, hitherto regarded as likely to mop up the Iranian oil that no one else would buy, have joined other countries in promising to reduce imports in return for a waiver on sanctions from America. Countries like China will be obliged to take even less Iranian oil over time to continue to avoid American attention. Meanwhile, European action against Iran means that oil tankers insured by companies operating in the EU—as are nine out of ten vessels in the global fleet—and carrying Iranian oil will lose their coverage if they continue.
• There are signs, too, that Saudi Arabia has stanched the flow of oil a little of late, in order to prop up prices. The country’s oil minister, Ali Naimi, has said that $100 a barrel is fair. The Saudis are reckoned to need $80-85 a barrel to maintain a programme of lavish social spending designed to avoid an “Arab spring” in the kingdom. Iran, Iraq, Algeria and Venezuela rely on an oil price above $100 to keep spending on track and want the Saudis to cut production more. That they are unlikely to get their way should help to temper the market’s mood swings for a while.

the mounting risk of the eurozone’s total disintegration

• The eurozone crisis might break European leaders’ inherent resistance to compromise, collaboration, and common action. But the longer they bicker and dither, the greater the risk that what they gain in willingness will be lost to incapacity.
• When it comes to describing Europe’s ever-worsening crisis, metaphors abound. For some, it is five minutes to midnight; for others, Europe is a car accelerating towards the edge of a cliff. For all, a perilous existential moment is increasingly close at hand.
• Optimists – fortunately, there remain a few, especially in Europe itself – believe that when the situation becomes really critical, political leaders will turn things around and put Europe back on the path of economic growth, job creation, and financial stability. But pessimists have been growing in number and influence. They see political dysfunction adding to financial turmoil, thereby amplifying the eurozone’s initial design flaws.
• Of course, who is ultimately proven correct is a function of eurozone governments’ willingness to make the difficult decisions that are required, and in a coordinated and timely fashion. But that is not the only determinant: governments must also be able to turn things around once the willingness to do so materializes. And here, the endless delays are making the challenges more daunting and the outcome more uncertain.
• Experienced observers remind us that crises, rather than vision, have tended to drive progress at critical stages of Europe’s historic integration – a multi-decade journey driven by the desire to ensure long-term peace and prosperity in what previously had been one of the world’s most violent regions and the site of appalling human suffering. After all, the European Union (including the eurozone’s 17 members) remains a collective of nation-states with notable divergences in economic, financial, and social conditions. Cultural differences persist. Political cycles are far from synchronized. And too many regional governance mechanisms, with the important exception of the European Central Bank, lack sufficient influence, credibility, and, therefore, effectiveness.
• Left to its own devices, such a grouping is vulnerable to recurrent bickering, disruptive posturing, and disagreement over visions of the future. As a result, progress towards meaningful economic and political integration can be painfully slow during the good times. But all of this can change rapidly when a crisis looms, especially if it threatens the integrity of the European project.
• That is where the eurozone is today. A debt crisis that erupted in Greece, the eurozone’s outer periphery, has migrated with a vengeance towards the core, so much so that the survival of the eurozone itself is at stake.
• The more the policy response has lagged, the broader the set of questions about Europe’s future has become. Maintaining a 17-member monetary union is no longer a given. Talk of countries exiting, starting with Greece (the “Grexit”), is now rampant. And only hard-core idealists dismiss altogether the mounting risk of the eurozone’s total disintegration.
• Nonetheless, many veterans of the European integration project see a silver lining in the dark clouds massing over their creation. For them, only a crisis can stop politicians from just kicking various cans farther down the road and, instead, catalyze the policy initiatives – greater fiscal, banking, and political union – that, together with monetary union, would ensure that the eurozone rests on a stable and sustainable four-legged platform.
• But this view is not without its own risks. It assumes that, when push comes to shove, political leaders will indeed do what is necessary – the willingness question. It also presumes that they will have the capacity to do so – the ability question. And, over time, uncertainty concerning the latter question has risen to an uncomfortable level.
• Today’s eurozone is beset by an unprecedented degree of rejection – on economic, financial, political, and social grounds – by citizens in a growing number of countries. The longer this persists, the harder it will be for politicians to maintain control of their countries’ destinies and that of Europe’s collective enterprise.
• Private-sector activity is slowing, and it is nearing a standstill in the eurozone’s most vulnerable economy (Greece), where a bank run is in full swing. Elsewhere, too, depositors are beginning to transfer their savings to the strongest economy (Germany) and to safe havens beyond (Switzerland and the United States). Weaker companies are shedding labour, while stronger firms are delaying investments in plant and equipment. And global investors continue to exit the eurozone in droves, shifting countries’ liabilities to taxpayers and the ECB’s balance sheet.
• No wonder that social unrest is evident in a growing number of countries. No wonder that fringe political movements are gaining traction throughout the eurozone. And no wonder that voters in almost two-thirds of eurozone countries have turned out the incumbents in their most recent elections.
• All of this serves to undermine the effectiveness of government policies – by reducing their credibility, clogging their channels of transmission to the economy, and making it difficult to offset the withdrawal of private-sector capital and spending. As a result, the market-based economic and financial systems that prevail in Europe, and that, not so long ago, were a source of significant strength, are losing their vibrancy.
• I, too, am fond of metaphors. During a trip to the continent last week, I heard one that captures very well the key dynamic in Europe today.
• The eurozone’s leaders are on a raft heading towards a life-threatening waterfall. The longer they wait, the more the raft gains speed. So the outcome no longer depends only on their willingness to cooperate in order to navigate the raft to safety. It also hinges on their ability to do so in the midst of natural forces that are increasingly difficult to control and overcome.
• The message is clear. The current crisis might indeed eventually break eurozone leaders’ inherent resistance to compromise, collaboration, and common action. But the longer they bicker and dither, the greater the risk that what they gain in willingness will be lost to incapacity.