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Saturday, 18 December 2010

The world trichotomised


I AM often asked: What's happening to the world? Indeed, the world seems so messed-up we can't take anything for granted. It does look like the world is not simply just dichotomised anymore.

We are used to talk of north versus south, haves versus have-nots, developed versus developing. All this has changed since Friedman's (N.Y.Times) discourse that the world is flat; but we have since realised the world is not really flat (Ghemawat, Harvard).

What's going on? Why is there no convergence. What's in store for the future? Before we begin the new year, I intend to devote my last column for 2010 to throw some light on these important questions, and what we can look forward to in 2011.

State of the world economy

As I see it, the situation in the United States blows hot and cold.
By December, the US economy reached a crossroad as a flurry of data showed consumption may be recovering fast enough to sustain growth in 2011, despite weaker investment, continuing high unemployment and a gloomy housing outlook.

What's promising is inflation continues to fall (core personal consumption prices rose only 0.9% in October).
This prompted former Fed chairman Volcker to conclude the economic outlook is for continuing but limited increases in economic activity for the next year or more.

He added, inflation is not a problem next year, it won't be a problem for several yearsI see no possibility, frankly, that a deflation will take place. Over a period of time, price stability will be conducive to a strong economy.

Make no mistake, President Obama is worried: What is a danger is that we are stuck in a new normal' where unemployment rates stay high in the face of continuing high corporate profits where businesses learned to do more with less.

However, the tax package awaiting approval in Congress could give a noticeable boost to economic activity next year providing a second stealth stimulus package without antagonising lawmakers reluctant to spend more to spur growth.

The total package could amount to US$900bil (larger than the first stimulus package in '09) of spending and tax cuts over the next two years. In 3Q10, the economy was stalling at 2.5% (2.5% in 2Q10).

This gives us a chance to do what most people thought wasn't going to be possible in this environment which is to provide a real forward lift to the economy relatively quickly, according to Summers (director, National Economic Council).

Economists have since grown more optimistic, seeing a stronger expansion in 1H11, with growth picking up speed as the year progresses (as much as 3.5% next year).

Odds on a double dip recession are now cut to 15%. Data released in recent days point to recovery gathering steam in 4Q10 (shoppers' purchases were up 0.8% in November and core wholesale prices rose a milder 0.3%), pointing to growth of 3.5% in the final quarter.

Nevertheless, while 4Q10 is shaping-up rather decent, the Fed continues to view the pace of recovery as still too slow to bring down the 9.8% unemployment rate. Its US$600bil bond buying programme (QE2) is expected to continue.

The euro-area remains under siege. Greece and Ireland are in International Monetary Fund's intensive care.
The fiscal crisis threatens to engulf the peripheral PIIGs (Portugal, Ireland, Italy, Greece and Spain). Yet, for all its sovereign bond risk turmoil, overall, its real economy is stabilising.

The Organisation for Economic Cooperation and Development (OECD) think tank raised its forecast growth in the 16-member nations sharing the euro, to 1.8% for '10 (2% in 4Q10), slow by US standard, but acceptable for the aging continent.

Growth across the euro-bloc will soften before picking up again: it is expected to average 1.6% in '11 and 1.8% in '12. Euro-zone growth slowed markedly in 3Q10 as Germany's rapid growth spurt lost momentum, intensifying pressure on Europe's weakest economies.

This deceleration reduced opportunities for the PIIGs to grow out of the current crisis by exporting to its neighbours. It also showed euro-zone lagging behind the United States which is doing much better.

So, recovery will be modest in the next two years, as deficit reduction plans weigh in on growth, and large imbalances in the peripheral nations with high debt are wound down.

This fans concerns of a widening chasm between Germany's buoyant prospects and continuing struggles of the PIIGs economies.

It highlights a dualism in Europe between core countries mainly in northern Europe and the euro-zone laggards which have since become a source of serious concern. Although Germany is doing well, it may not be enough to save others in the euro-zone. This perception of the euro-zone drifting apart has been and remains a driver of the sovereign debt crisis.

Continuing market jitters about the situation is one of the main risks to play out in 2011.
The outlook for stronger growth in Europe faces two big threats.

First, fiscal tightening is expected to begin with vigour next year. But there are already enough signs of intensifying social unrest. Second, growing tension in Europe's peripherals (viz. PIIGs).

Ireland and Greece are in recession with debt overhang ratios exceeding 100%. The austerity required of them is unlikely to be readily met. Spain and Italy are barely growing and they too need to tackle their budget deficits, with ratios too high to be sustainable.

Portugal has only started to act on its deficit. Delays have kept its economy afloat but made bond investors rather nervous.

The PIIGs account for 35% of the euro-area economy (18% without Italy). Their fragility has not so far outweighed the strength of the entire region.

However, they have outsized effects on monetary policy simply because of their impact on confidence, especially in the bond markets. It is interesting Germany and the European Central Bank (ECB) have taken a tag team approach to keep the euro-zone afloat: the former supports the zone's economy and the ECB, its financial markets.

One key success of the euro has been its financial integration, so much so its banks are now heavily exposed to each other's debts. So, more trouble in the peripheral nations could easily spread with dire consequences for the euro-zone as a whole.

Since the great recession, the emerging economies have been by far the biggest contributor to global expansion.

From Guangzhou to Sao Paulo, from Bangalore to Incheon, the big emerging economies have been roaring ahead, even as United States and Europe were mired in deep recession.

Spare capacity was rapidly used-up and fear of bubbles (from capital inflows following continuing monetary easing in US and Europe) was replaced by broader overheating and fear of inflation.

China and India led the way with sustainable high growth rates and with even higher imports.
As did Brazil, where rising consumer demand packed shopping centres, and imports in November surged 44%. But inflation lurks.

Nowhere has the economic mood been so ably lifted as in emerging East Asia (North-east Asia plus Asean 6), led by China. Emerging East Asia's gross domestic product (GDP) grew by 8% annually since 2004 (9% in '10) and is expected to continue to rise by 7% in 2011.

China will expand by 10% this year (+9.1% in '09) and 9% next year.

Similarly, Asean 6 according to the ADB will grow by 5% in 11 after expanding 7.5% in '10 (1.3% in '09).
In contrast, growth in the United States in '10 is expected at 2.8% (-2.6% in '09) and 3% in '11.

Euro-zone GDP contracted by 5.2% in '09, and set to recover by 3.2% this year, with growth of 1.4% in '11.
But inflation worries are causing a policy dilemma.

High food and energy prices plus capacity constraints in the face of the Fed's quantitative easing (QE2) will force central banks to raise interest rates more aggressively. But higher interest rates to fight inflation will attract even more funds. Inflation is highest in India (9%) and Brazil (6%): in China, 4%, S. Korea, 4%; Indonesia, 5.7%; Malaysia, 2%.

To ensure interest is kept at rates appropriate to their particular circumstances, some emerging Asia economies have resorted to selective controls to offset the impact of continuing inflows of cheap monies.
Manufacturing activity strengthened significantly in China and India in November, underlying a widening gap between two of Asia's largest economies and the rest of the region.

Not unlike Europe, Asia is being dichotomised into two economic camps as growth streams ahead in China and India, but grows at a slower pace in much of emerging Asia or stays relatively flat, as in Japan. But unlike Europe, where its life-wire (Germany) is moderating, emerging Asia's big brothers are pushing ahead: China recorded in November its 7th successive month of manufacturing expansion.

Similarly, India registered a blistering 8.9% growth in 3Q10, its third in a row exceeding 8%.
Their continuing expansion is fuelled by rapidly rising demand within the Asian community, thus sharing prosperity through reversing the tide in the directional flow of goods and services.

Focus has sharply swivelled to Asia: Before, we mainly worry about the Christmas and New Year seasons in the United States and Europe. Now we also look at Ramadhan, Deepavali and Chinese New Year.

There is a clear surge in intra-regional trade in Asia which grew at an average annual rate of 13.4% from 2000 to 2009, valued at US$1 trillion. Nearly 50% of Asian exports (ex Japan) now go to other Asian nations, more than the current demand for Asian exports from the United States, Europe and Japan combined.

Another 17% goes to rest of the world, meeting largely Russian and Brazilian demand.

The main driver of this drama: China and India. In 1916, Nobel laureate Tagore (Indian poet) roamed from Calcutta to Tokyo in search of one Asia. The poet's vision was misty. Yet, by end of the century, Asia is knit together in a value adding manufacturing supply chain stretching 5,000km from Seoul to Penang to Bombay.

Importing pessimism

As I see it, the world has changed, and dramatically since the great recession. The outlook for 2011 and beyond rests on what happens in three great areas: the United States, Europe and emerging economies.

Fair enough Japan is still an economic heavy weight but it has ceased to be dynamic and unlikely to surprise. Unfortunately, all three are heading in different directions with different growth prospects and having non-compatible policy choices.

The outcome depends on how increasing chances for friction play out. The United States and Europe avoided depression by working together with a shared economic philosophy.

Now both are preoccupied with clear domestic demands. They have since adopted wholly opposite strategies to deal with them: the United States continuing to stimulate until recovery is secured (i.e. falling unemployment) before tackling its fiscal and debt issues; euro-zone is dead-on fiscal austerity and consolidation, subjecting profligate members to tough fiscal adjustments now in exchange for assistance.

The United States continuing loose monetary policies and euro-zone concerns with sovereign debt defaults both encourage a continuing flow of virtually costless funds to emerging economies in search of higher returns.
Such massive capital inflows infuriates large emerging economies' central banks which are reluctant to raise interest rates (and attract even more such funds) so needed to dampen rising inflation.

Therein lies the policy dilemma for each of the three.
Bear in mind that over the next five years, emerging economies are expected to account for one-half of global growth, but only 13% of the increase in net global public debt.

This simply means that given divergent goals of policy, the world economy is unlikely to give any priority to global rebalancing (which is so badly needed) in favour of more of the same.

The consequence: widening the gap between debt ridden US and Europe and thrifty big emerging nations.
It need not be this way, of course. The United States and Europe can work out a deal to better regulate the financial system; with the United States starting early enough to put its fiscal house in order and Europe, institutionalising the euro and putting its banking system on a more sustainable footing.

On its part, major emerging economies can start rebalancing their macroeconomic policies, including adjusting the exchange rate to better reflect underlying market conditions.

This, of course, is the best case scenario. But I won't bet on it. I see continuing friction ahead, leading to more uncertainties in terms of policy actions but little effective international collaboration and co-ordination. That's life I guess.

In times of stress, subjecting national interest to the noble greater global interest is asking too much. So Asia, stand ready for another year of importing pessimism.

Former banker, Dr Lin is a Harvard educated economist and a British Chartered Scientist who now spends time writing, teaching and promoting the public interest. Feedback is most welcome;