KEY ISSUES IN THE

GLOBAL ECONOMY 2011

LECTURE TWO
AUGUST 2011
 KEY ISSUES IN 2011

1. The strength of the global recovery;

2. Will EMs drive the global economy?
3. Global economic imbalances
4. How robust is the global financial
sector?
5. The sovereign debt crisis
6. Food price and fuel price inflation.
GLOBAL GROWTH FORECAST
Region 2009 2010 2011f 2012f
World Trade -10.7 + 12.4 + 8.2 + 6.7
Oil Prices (US$) $62 $79 $106 $105
Non-Fuel -18.7 + 26.3 + 21.6 -3.3
Commodities
Manufactures - 4.2 0.7 -2.9 - 3.0
Inflation 0.1 1.6 2.6 1.7
Advanced Countries
Emerging Markets 5.2 6.1 6.9 5.6
 DOUBLE DIP?

Most indicators now suggest that the

recession is over, but there are still
many analysts who predict that a
double-dip a W-shaped recession is
still possible in some countries (like the
UK, Ireland, Greece, Portugal and
Spain) though probably not globally.
 GROWTH RECESSION

That said, there has been a global

slowdown since March 2011.
The US now talks of a growth
recession
This means that output will grow but
below its trend rate and unemployment
will not fall and quite possibly increase.
CHINA DOES BETTER THAN MOST

China handled the world recession far

better than most other countries. Why?
It does not rely on external financing
Its banks have been largely unscathed
by the international financial turmoil and
It had the fiscal and macroeconomic
space to implement forceful stimulus
measures
 EXPORTS

Above all, although its exports plunged

in 2008 they made a very strong
recovery.
World exports in 2010 (all countries)
grew 12.4% - thereby more than
recouping the 10% downturn in 2009.
 Spare capacity globally led to weaker
investment, less job growth, downward
pressure on prices of manufactures
redirection of exports to the home
market and import substitution.
For EMs as a whole, exports fell 12%
during 2009 but were back in positive
territory up 16% - in 2010.
 PRODUCTION

However, the exports of industrialized

countries were still 2% below their 2008
levels.
They were roughly the same as at the start
of 2007, implying zero growth over 3 years
In contrast, by the end of 2010 most EMs
were close to regaining full capacity.
 DIFFERENT SPEEDS

Industrial production in some EMs -

China, India, Nigeria, Sri Lanka was
10% ABOVE pre-crisis levels.
But industrial activity in high-income
economies was 5% below August 2008
levels.
 FDI - MUTED RECOVERY

The recovery in FDI flows has been muted.

Global FDI flows fell 40% between 2007
and 2009, recovering marginally in 2010
from $1.19 trillion to $1.24 trillion.
Flows to EMs peaked at $658 billion in
2008 falling 22% in 2009m recovering to
$573 billion last year still below the 2008
peak.
 Important change in the pattern of FDI
flows with South-South flows (intra-EM)
becoming much more important.
FDI outflows from EMs rose from $122
billion in 2005 to a record of $327
billion in 2010.
 EMs INVEST ABROAD

Some 44% of these flows were from

China and Hong Kong and three-
quarters from Asia as a whole, while
Latin America contributed 23%.
Russia was a major player with FDI
outflows of $51 billion number three
after Hong Kong ($76 billion) and China
with $68 billion
 EM SHARE GROWS

Outflows from advanced countries were

$935 billion or half their peak level in
2007.
In 2007 the advanced country share of
FDI outflows was 84%, but by 2010 it
had shrunk to 71%.
CONTEXT OF THE
RECESSION
How did things get so bad so fast?

In the year following the outbreak of the

U.S. subprime crisis in August 2007, the
global economy slowed as credit
conditions tightened
Advanced economies slipped into mild
recessions by mid-2008
But emerging and developing economies
continued to grow rapidly.
 The situation deteriorated rapidly after
the default by a large U.S. investment
bank (Lehman Brothers) and the rescue
of the largest U.S. insurance company
(American International Group, AIG).
Similar rescues and bailouts were
needed in many other advanced
economies.
 DELEVERAGING
The result was a flight to quality that led
to deleveraging by banks and financial
institutions across the world.
Liquid assets were sold very cheaply
and credit lines froze.
The net effect was a steep increase in
risk aversion by investors, bankers and
lenders.
Equity prices plunged.
 HOUSEHOLD WEALTH

The credit crunch generated by

deleveraging and the breakdown of
securitization, combined with falling
equity prices and continuing deflation of
housing bubbles, caused a massive
loss in household wealth.
In part, this was no more than
inevitable adjustment to past excesses
 Industrial production and merchandise
trade plummeted in the fourth quarter of
2008 and continued to fall rapidly for
much of 2009.
Purchases of investment goods and
consumer durables (cars and electronics
were hit by credit disruptions) and
inventories started to build rapidly.
 Global GDP which had grown 4% in the
final quarter of 2007, fell 6.5% in the
final quarter of 2008.
Commodity prices plunged, which
helped push global inflation sharply
lower.
 HOME BIAS

One effect of the financial crisis was a

flight to safety and rising home bias, as a
result of which global capital flows
contracted sharply.
These shifts affected the worlds major
currencies
 CURRENCIES

As the recession struck so the worlds

3 major currencies the euro, U.S.
dollar, and yen strengthened.
During 2009, however, the dollar
weakened, recovered briefly and then
fell in 2011 very close to its post-1945
low against the Japanese Yen.
 POLICY RESPONSES

The main policy responses were:

Monetary policy easing lower interest
rates
Fiscal policy relaxation tax cuts and
sharply increased govt spending
Bank bailouts and
Quantitative Easing, which needs to be
explained.
 Quantitative Easing very similar but
not identical to the printing of money by
central banks.
In fact, when you look at the money
supply data for the US, there has been
a very marginal growth in money
supply.
 By QE is meant substituting medium
term govt securities- average maturity
of four years, with immediate securities,
that liabilities that fall due immediately.
So the Federal Reserve restructures its
balance sheet by buying Govt debt
using created money, but that money is
part of the debt.
 In other words, strictly speaking, QE is
not printing money, but expanding the
Federal Reserves (or the Bank of
Englands) balance sheet, as a result of
which the debt increases.
However this is not always the case
as in Zimbabwe.
 Here, money was printed and where it
was added to the balance sheet, it was
inflated away by hyperinflation.
So the domestic debt was written off at
dollarization, but the foreign debt
remains.
 EFFECTS

These policy responses helped alleviate

the crisis, but bank credit has slumped
Banks may have money but they are
reluctant to lend it
Securitization has virtually disappeared
and
Wholesale bank loans are very infrequent
 WRITE DOWNS

Total expected write-downs on global

exposures are estimated at $4 trillion -
two thirds by banks.
The remainder, spread across insurance
companies, pension funds, hedge funds,
and other intermediaries.
To replace these write-downs, the IMF
estimates that US/UK banks alone will
need upwards of $1 trillion.
GLOBAL BUSINESS
CYCLES
 Little is known about global business
cycles.
Economists used to measure them on the
basis of performance by the advanced
economies accounting for =75% of GDP
Today, when their share has fallen to
55%, this no longer applies
At the same time feedback effects have
grown because of globalization.
 YARDSTICKS
Today recession is estimated by
looking at GDP per capita (globally), oil
consumption, industrial production,
trade, capital flows and unemployment.
Typically, global industrial production
and consumption start to slow 2 years
before the trough of the cycle is
reached and world trade and capital
flows one year before.
 Typically, unemployment rises steeply
during the recession year (2009) and
stays high thereafter, recovering more
slowly than output and trade.
 RECESSIONS

1975 1982 1991 2009

GDP per head - 0.33 - 1.08 - 1.45 -3.69
Industrial Prod -1.60 - 4.33 - 0/09 - 6.23
Trade -1.87 -0.69 -4.01 -11.75
Capital Flows 0.56 - 0.76 - 2.1 - 6.8
Oil Consumption - 0.9 - 2.87 0.01 - 1.50
Unemployment 1.19 1.61 0.72 2.56
 FISCAL BALANCES

Budget balances will deteriorate

globally lower tax revenues and
increased spending.
In advanced countries the deficit rises
to over 10% of GDP from less than 2%
while in emerging markets there is a
swing from near balance to a deficit of
4% of GDP
 Commodity prices fluctuate around
current (2009) levels and then pick up
in 2010.
One result is that global inflation
remains very low.
There are fears, however, that the
massive expansion in fiscal spending
and money supply will have a serious
longer-term impact on inflation.
 DOWNSIDE RISKS

The current outlook is exceptionally

uncertain, with risks still weighing on the
downside, especially as:
Policies will be inadequate to reverse the
downturn because, as activity contracts,
the risk of corporate (especially banks
and financial institutions) and household
defaults will grow
 HOUSING

A key concern is the US housing market,

which is where the slump started.
It is responsible for continuing losses in
the financial system, declines in
household wealth and falling construction
activity.
These three conditions are major drags
on U.S. economic activity.
 35% DROP
The IMFs baseline projections envisage
stabilization and turnaround in this sector
after a further 1015% drop in house
prices to leave them 35% below their peak
Construction activity would still be well
below previous troughs and about 20% of
mortgages would still be in negative
equity threatening many more
foreclosures.
 CORPORATE DISTRESS

Major housing market contractions are

also taking place in many EU markets
Ireland, UK Spain and further afield
(Australia, SA).
Since the onset of the financial crisis,
balance sheets of nonfinancial firms
across the world have weakened
significantly.
 SHORT-TERM BORROWING

When the crisis began in 2007, debt-

equity ratios in western Europe and the
United States rose as asset values fell
In emerging markets reliance on short-
term debt increased
especially in emerging Europe
and Russia.
 In the first year of the crisis liquidity and
profitability in the US and EU declined
as credit conditions tightened.
Corporate default rates rose across the
world with the greatest increase in
India, reflecting the over-borrowed
state of many Indian businesses.
 DEFLATION
The basic forecast shows prices falling
fractionally (0.2%) in rich countries
remaining stagnant (+ 0.3% in 2010), while
inflation slows to below 5% in emerging
markets.
Going forward there are considerable risks
of sustained very low inflation (below %),
moderate deflation risk in the United States
and EU and a significant likelihood of
deeper price deflation in Japan.
 Taken together these downside risks
suggest that there is a strong possibility
of the recession lasting longer than in
most current projections.
GDP could contract again in 2010
postponing the recovery until 2011
the reasons for this are examined later.
 TURNING POINTS
The slide shows when the last business
cycle peaked.
In the OECD area, the peak is put at
November 2007 but in China it is much
earlier (June 2007) and in Russia much
later (May 2008)
The table shows the duration from trough
to peak ranging from 4 years in India to 6
years in Russia.
 TRADE CYCLES

Country Peak Previous Duration

2003 Trough
OECD 2007: Nov Dec 2001 5 yrs 11 mths
Euro Area 2007: Oct July 2003 4 yrs 3 mths
US 2007: Oct Dec 2001 5 yrs 10 mths
UK 2007: Nov April 2003 4 yrs 7 mths
India 2007: April April 2003 4 years
China 2007: June Feb 2002 5 yrs 4 mths
Russia 2008: May May 2002 6 years
 LONGER TERM OUTLOOK
1. The top challenge will be that of
rebuilding confidence in financial
systems, which implies a lengthy
transition period. After being propped up
by massive government intervention:
Private capital must be rebuilt,
Government guarantees rolled back, and
The expansion of central bank balance
sheets reversed
2. A second challenge also in the
financial sector is the need to
overhaul regulation of financial markets
and institutions.
The regulatory system must be
strengthened with much stricter control
over bank leverage and improved risk
management.
 However this is done, rebuilding
institutions and markets will inevitably take
considerable time.
Bank credit expansion in the major
advanced economies will remain sluggish
through the middle of the next decade.
The recovery of securitization may also be
gradual.
 CROSS BORDER FLOWS
3. These changes in the global financial
system will dampen growth in cross-border
flows, reflecting reduced leverage and
increased home bias.
Tighter risk management and greater limits
on leverage will make it more difficult for
countries to finance very large current
account deficits or sustain overvalued
exchange rates.
FINANCIAL GLOBALIZATION SLOWS

After a steep drop in 2009, capital flows

to emerging and developing economies
will regain momentum but remain well
below the peaks reached in 2007/8.
4. Public Finances in advanced
countries will have to be consolidated
and it will take until 2014 to bring budget
deficits back to around 4% of GDP.
 PUBLIC DEBT

Despite this, public debt grows from

about 75% of GDP in 2009 to 110%
by 2014 and possibly even as high as
140% if some of more severe
downside risks take effect.
The situation is better in emerging
markets, but the deterioration in rich
countries means Aid inflows will fall.
 SAVINGS

5. Savings rates both household and

corporate will rise and stay higher in
advanced countries for a long period.
Households will have to rebuild their
savings after the huge loss in net wealth
while corporates will have to rebuild their
balance sheets and rely more on retained
earnings for investment in the future
because of tight credit markets.
 PRODUCTIVITY

In emerging markets investment levels

will fall as a result of reduced savings
and capital flows.
To maintain GDP growth productivity
will have to rise (as happened in Asian
after the 1997/8 financial crisis).
 COMMODITIES

Commodity markets have recovered

much more strongly than was generally
anticipated.
The slide shows that by the end of
2009 they had regained most of their
earlier losses, except for oil.
 COMMODITY PRICES
250
2003 2008 2009-Dec 2010-Dec 2011-June

200

150

100

50

0
Non-OIL ALL Food Metals Oil
 OIL & FOOD
Initially, it was forecast that commodity
prices would stabilize in 2011/12 rather
than make major new advances with two
exceptions - oil and food prices.
The two are increasingly correlated and
both are expected to increase over the
next 2 years mostly reflecting supply
shortages and in the case of oil, market
manipulation by OPEC.
 In the event, far from stabilizing non-
fuel commodity prices rose 26% last
year and are forecast to rise a further
21% in 2011.
So far this year, commodity prices have
surged ahead reaching a high point in
February 2011 and then falling back
 SPECULATION
Initially they boomed because the
world economy, led by Asia, appeared
to be recovering faster than expected
by many analysts.
But as the world economy including
Asia and China slowed from March
2011 so a speculative asset bubble in
commodities developed.
 ASSET BUBBLES

By asset bubble is meant a situation in

which prices diverge from underlying
fundamentals they occur in
commodities, in currencies, in equity
and bond markets and in real estate.
When they burst, the consequences
can be both severe and long-run.
 BUBBLES ALWAYS BURST

It was the bursting of real estate asset

bubbles, not just in the US, that
provoked the 2008 global financial
crisis (GFC).
Today there are asset bubbles in gold,
in some other precious metals like
platinum, in currencies like the Yen and
the Swiss Franc.
 IMBALANCES

These speculative bubbles reflect two

underlying imbalances in the global
economy:
(a) Undervalued Asian currencies that
lead to BOP surpluses in Asia that are
then recycled elsewhere, gold, some
currencies and real estate being
obvious examples.
 (b) Mistrust of paper (fiat) currencies.
Investors, including govts and SWFs,
prefer to hold gold or Swiss Francs as
a hedge against US $ or Euro
depreciation.
In part this relates to the debt crises in
these regions the EU and US.
LESSONS FROM PAST
RECESSIONS
FEWER, SHORTER DOWNTURNS

Recessions in advanced countries in

the last 25 years have become milder
and less frequent than in the past while
expansions have lasted longer.
But recessions associated with
financial crises tend to be both longer
and more severe than those caused by
other problems.
 SYNCHRONIZATION

Where recessions are synchronized

across countries and not confined to
one or two regions, they tend to be
more severe and last longer.
The current recession qualifies on both
counts it is the result of a financial
crisis and it is highly synchronized.
 HISTORY

Accordingly, it is expected to last longer

than normal and the recovery is likely
to be sluggish.
On average, industrial countries have
experienced six complete business
cycles since 1960.
In a typical recession GDP falls 2.75%
but in the upswing GDP rises 20%.
 A typical recession lasts a year while a
typical upswing goes on for 5 years. An
economy typically recovers to its previous
peak output in less than a year.
A study of 122 recessions in different
countries finds that only 15 are
associated with financial crises while
more than half are linked to exogenous
shocks, frequently oil price shocks.
 Recessions associated with financial
crises are generally longer and more
costly than others.
Most financial crises follow a period of
over-valued asset prices especially
equities and houses.
A key reason recessions associated
with financial crises are so much worse
is the decline in private consumption.
 In the recovery phase, the weakness in
private demand persists in the upswing
and private consumption typically grows
more slowly than during other recoveries.
Private investment continues to decline
after the recession trough with residential
investment taking 2 years merely to stop
declining.
 SYNCHRONIZATION AGAIN

As a result, output growth is sluggish and

unemployment rises for longer and by
more than usual.
Asset prices, especially houses, are
generally weaker.
In addition to the 2009 downturn there
have been 3 other globally-synchronized
recessions in 1975, 1980 and 1992.
 They are more severe than ordinary
recessions and output takes 50%
longer to recover to its previous peak.
Since 1960, 6 recessions have been
BOTH associated with a financial crisis
and synchronized with general
downturns .
 On average these recessions (all of
them in EU countries) lasted longer (2
years rather than one) and were more
severe with GDP falling 4.75% from its
peak rather than 2.75%.
The lessons from all this are relatively
discouraging, suggesting that we could
expect:
 CONCLUSIONS

A longer recession nearer 2 years

than one
A deeper recession nearer 5%
output decline than 2.5% to 3%, and
A longer, slower recovery
 In fact the actual recession appears to
have lasted 15 months from peak to
trough.
However in some countries there was a
subsequent temporary peak early in
2010, but the slowdown was very short-
lived and we are back in expansion
territory today.
 ACTUAL TURNING POINTS
Country-Region Peak Trough Duration (mths)

OECD FEB 2008 MAY 2009 15

US FEB 2008 MAY 2009 15

JAPAN MARCH 2008 APRIL 2009 13

CHINA JAN 2008 FEB 2009 13

INDIA MAR 2007 FEB 2009 23

RUSSIA APL 2008 MAY 2009 13

FINANCIAL STRESS
 The IMF has developed a financial
stress index (FSI) covering 17 industrial
countries, accounting for 80% of
industrial country GDP, since 1981.
It measures stress in such areas as the
banking and financial markets and the
foreign exchange market.
 In seven previous episodes (before the
2009 downturn) financial stress
affected 50% of the industrial countries
in the sample, but since early 2008
virtually all industrial countries have
experienced exceptionally high levels
of financial stress.
 FINANCIAL STRESS

Financial stress crises have two events

in common:
(a) They occur very suddenly and
(b) They affect many sectors of a
countrys financial system they are
systemic
 The transmission of stress:
Schematic depiction of effects

Financial Stress
EMERGING
ECONOMIES
Global factors Country specific factors
Commodity prices Vulnerabilities
Global output Economic characteristics
Global interest Financial linkages
rates Trade linkages
ADVANCED
ECONOMIES
Financial Stress
OUTLOOK 2011-2012
 OUTLOOK- 2011

There is considerable disagreement

over where the world economy is
headed.
In two articles on the same page of
the New York Times in mid-2009 two
eminent economists made
diametrically-opposed predictions.
 WHO IS RIGHT?

Paul Krugman, who won the Nobel

prize in 2008, predicts a 10-year
depression, certainly in the US
economy.
But Allan Meltzer, a leading
monetarist economist warned of
serious inflation.
 WHICH WAY?

This prompted a US comedian to write

a rhyme.
Inflation or Deflation?
Tell me if you can.
Will we become Zimbabwe?
Or will we become Japan?
 CONTRAST

For over a decade Japan has

experienced deflation very low
inflation, or even falling prices
accompanied by very sluggish growth.
Zimbabwe had hyperinflation, with a
dramatic fall in output of 40% to 50%.
 THE SPLIT

Forecasters are divided.

On the one hand we have the market
analysts (or many of them) and the
politicians, talking the economy up as
best they can.
On the other we have a large number
of cynical and skeptical economists.
 THE ARGUMENTS

Only with hindsight in 2012 or even

later will we know who was right.
But at this juncture, we need to look at
the arguments being deployed by the
two main groups of protagonists.
 The China factor

Many optimists have put their faith in

China and Asia leading the global
economic upswing.
In fact total world GDP growth (4.4%)
in 2009 and 2010 came from the EMs.
It was minus 0.2% for the rich countries.
 EMs DOMINATE

In 2011, the EMs will contribute 68%

of the growth of global GDP, leaving the
industrial countries with less than a
third.
In fact, since the start of the recession,
the EMs will have accounted for 85% of
global GDP growth and rich countries
only 15%.
 Chinas money supply is greater than
that of the US but its economy is only
about a third of the US in size..
This underlines the dangers of high
inflation and bubbles in the real estate
and equity markets.
In fact at the end of 2010 there were 64
million homes that have been built but
not sold.
 HOW SUSTAINABLE?

Much of China's growth over the past

decade has come from lending to the
United States to finance US imports of
Chinese products
The country suffers from real
overcapacity.
 BAD LOANS?

In 2009/10 growth in several parts of

the world was achieved through
borrowing
Inevitable some of the loans will turn
bad and cause problems later
But more important is the quality of
growth.
 CAUTION

The balance of risks is more heavily

weighted to the downside than the
upside.
In mid- 2011 the main threats to the
global recovery are:
(1) The spectre of currency instability,
primarily concerns over the US dollar
and the Euro
 DOWNSIDE RISKS
2.The sovereign debt and banking crises in
industrialized countries
3. The threat of bubbles in EMs, and in the
commodity markets.
4. The threat to inflation and political stability
posed by rising fuel and food prices;
5. The unstable and weak housing markets
in many countries.
 POLITICAL INSTABILITY

6. The region-specific threats of political

instability in the Middle East and North
Africa.
Although these are region specific they
have knock-on effects on oil prices,
for instance, but also the potential
contagion and domino effects.
 DOMINO THEORY
When the Tunisian and Egyptian revolutions
broke out, there were fears that they were
just the beginning of wider turmoil across
Middle East oil producing states.
Why should these uprisings be confined to a
few states ?. Will they spread to the worlds
largest oil producer, Saudi Arabia, to Iran
and to many countries in Sub-Saharan
Africa?
 INTERDEPENDENCE

This analysis highlights the

interdependence of economics, politics,
finance and investment affecting the
entire globe.
 All of these topics, other than the real
estate/housing market, will be
discussed in more detail in the module.
But a few comments on housing are
appropriate.
How has the boom and bust in the
house market evolved?
 HOUSE PRICES

The latest estimates suggest that real

estate prices are still over-valued in
most countries.
This comparison is based on so-called
fair value estimates.
 Fair value is based on comparing the
current ratio of house prices to rents
with the long-term average.
By this measure, Australian house
prices are the most overvalued.
 HOUSE PRICES
REGION LATEST: % 1997-2010 UNDER (-) OR
CHANGE ON `A OVER (+)
YEAR AGO VALUED
AUSTRALIA 20 211 + 61
HONG KONG 29 -11 + 54
SPAIN -5 162 + 50
SWEDEN 11 167 + 39
UK 9 185 + 34
FRANCE -5 133 + 39
US 2 58 -7
CHINA 12 n.a. + 17
JAPAN -4 -37 - 35
GERMANY -2 n.a. - 15
 Significant comparisons in the table
are:
Japan deflationary period
China surprisingly little inflation
Germany substantially undervalued
Most others substantially overvalued
suggesting there is more pain to come.
 The latest concern about housing
prices comes from China.
New Chinese data show that in 2010
fixed investment made up 70% of GDP
The comparable investment figure at
the peak of the boom in 2006/7 in the
US or UK was in the range of 16% to
18%
 The bulk of this- we dont know exactly
how much was real estate investment
building new homes.
Some 65 million homes in China are
already unoccupied because people
cannot afford the prices or rents.
 There is no sign of a slowdown in this
investment and
Possibly more worrying hopes that
Chinese consumption spending would
rise and investment fall appear to have
been misplaced.
 Worse a large element in consumption
spending appears to be real estate-
related.
That is people buying carpets or
furniture or TVs for their homes.
So China could be experiencing a real
estate bubble.
 LIKE IRELAND?
What is really worrying is the similarity
with Ireland
This is because Western banks have
been lending to (or investing in)
Chinese Banks.
The latter have in turn lent to the
housing market helping to fuel the
property bubble and raising the risk
exposure of banks.