Grim economic situation calls for bold measures

The world is caught in a debt trap and this may yet destabilise a fragile global economy grappling with slowing growth and trade, financial volatility, capital flight and commodity collapse, warns Yilmaz Akyuz.

THERE is a significant degree of confusion about the state of the world economy. A number of people think that we are facing an imminent crisis. Some, like Soros, think that we are already in a crisis whereas policy makers as usual are quite optimistic. So is the International Monetary Fund (IMF); although it downgraded its projections for 2016 and 2017 compared to its past projections, it still thinks that 2016 and 2017 will be better than 2015. Now there is a concern that the crisis is moving in a third wave to the South after having moved from the United States to Europe. BRICS (Brazil, Russia, India, China and South Africa) are no longer seen as locomotives but as part of the problem pushing the world economy into a slump.

We have the weakest global growth since 2009. The level of economic growth in 2015 was the same as the growth in 2009 at the depth of the subprime crisis. The only difference is that at the time developed countries were in recession and many developing countries were still growing. Now we have the picture reversed. The growth slowdown is mainly in the South, not in the North.

Despite the poor performance in the North, actually the growth gap between us and the North is narrowing. Before the crisis, developing countries were growing 5 percentage points faster than advanced economies. Now it has dropped to less than 2 percentage points.

An important development is in China and I think we all agree the Chinese slowdown is not cyclical or temporary. It reflects structural imbalances - basically the absence of a strong domestic consumer market in China and hence the difficulties of sustaining export-led and investment-led growth. The key question for China is not whether it is going to slow down or not on a permanent basis - I think that's understood - but whether it can manage it in such a way that China will have a soft landing rather than a crisis.

Uneven developed-country growth

In the North growth is uneven. The US was the cause of the crisis but it has come out better than anyone else in the advanced world and better than many developing countries. During the crisis there was a widespread perception that this was the end of US hegemony and the end of the dollar as the major reserve currency. But when we look back now, we see that the US is strengthened a lot more as a result of this crisis. Not only vis-…-vis other developed countries - in Europe or Japan - but vis-…-vis developing countries including China, in economic terms. The status of the dollar as a reserve currency today is unchallenged because of the crisis in Europe. And the US has become so confident that it is trying to rearrange the global economic order according to its own priorities through bilateral investment treaties and free trade agreements such as the Trans-Pacific Partnership....

But the US economy is also fragile. Usually economic expansions are often followed by contractions. This is part of the capitalist system working - boom-bust cycles. The US has had 24 quarters of expansion since the beginning of the crisis. And usually recoveries age and die. Many people think, simply on this observation, that after 24 quarters of expansion, US recovery or growth will come to an end, on historical evidence. But apart from that? It's very difficult to get out of the policies that it introduced in response to the crisis. It doesn't know how to get out of the policy of easy money. It is very hesitant in raising interest rates. But on the other hand, if there is a slowdown in the US and a contraction and renewed instability, they don't have any ammunition to respond to it. Because they used all their ammunition to respond to the last crisis and they are still using it except in bond purchases.

Europe actually is hardly growing. Greece is back into recession. Italy is hardly growing. German growth is half of its potential. And Europe is facing a medium-term prospect of stagnation. European banks are highly fragile and they carry a lot of bad debt. Therefore there is potential instability, debt instability, in Europe. The prospect of Grexit [Greek withdrawal from the eurozone] is still with us, and on top of that, we have the British referendum [on its continued membership in the European Union], which is highly destabilising, not just for Europe but for the world.

In Japan, Abenomics is not working. It's stuck in a deflation. Now it's resorting to negative interest rates. This is a sign of desperation.

If you look at world trade today, it is slowing. For the first time actually world trade is slowing relative to world income. In the past two decades, world trade grew twice as fast as world GDP. Today the growth of world trade is the same as the growth of world income. Why? People are puzzled by this because they are used to trade growing faster and think it was an engine for growth. Firstly, there is no big-bang liberalisation anymore. We have liberalised trade, at least in traditional areas, the last one being Chinese accession to the World Trade Organisation. Secondly, countries realise the limits of export-led growth. They are looking more to domestic markets for growth. Thirdly - and this is even less recognised - there is a slowdown in the so-called value chain trade. A larger proportion of demand is now met by home production. Take China, which is the hub of the value chain trade. Chinese exports in the 1990s and the early years of the new millennium required 60% foreign imports - parts and components. The proportion has fallen to 30% today. In other words, Chinese exports no longer require so many imported parts and components from Taiwan, Korea or Japan.

Now trade balances are moving against developing countries. Before the crisis, advanced economies had a combined deficit of $600 billion. They now have a combined surplus of $250 billion. The developing countries had a surplus of $700 billion. Now they have a deficit. China's massive surplus of 10% of GDP fell to 3%. And the eurozone is running a huge surplus vis-…-vis the rest of the world. One reason of course is the so-called currency war or competitive devaluation, wherein everyone [in the North] is seeking to lower its currency vis-…-vis the others and relying on export-led growth.

Financial instability

On the finance side, we have increased instability. We're seeing, since the beginning of the year, sharp declines in the prices of risky assets. With easy money, which is still with us, people borrowed at very low interest rates and put that money in highly risky assets including junk bonds, mostly energy bonds, and equities. Now they have been falling rapidly. The stock markets are in a bearish mood and people are debating whether stock markets can anticipate recessions. On the basis of historical trends, stock market declines do not always anticipate recessions except when they are big declines, like 40%. Almost every stock market decline of 40% or more was followed by recession. And the recent declines are coming close to that figure. We also have significant volatility in the exchange rates of the major reserve currencies - dollar, euro, yen. We have constant changes in the relative position of these currencies.

More importantly, after some 15-20 years of expansion of foreign capital entry into developing countries, we now have capital flight. The capital flight is happening even before the US started tightening its monetary policy in a significant way. In 2015, there were around $750 billion net outflows. Inflows by non-residents were still positive but there were massive outflows by residents of developing countries. This is the first time since 1988 that there were net outflows. And most of it is going from China. As a result, the international reserves of developing countries have been declining very rapidly. Their currencies have come under pressure and their stock markets are falling - many of them actually closed 2015 with double-digit losses.

The super commodity cycle has ended. This was partly due to the slowdown in China - slowdown in its demand for metals, minerals and energy. But there is also a massive excess supply. Because of the cheap money that we have had since 2009, there has been excessive investment in energy, metals and minerals. And even if the activity level returns to normal again, the excess capacity will remain with us. This is why we do not expect non-agricultural prices to recover soon.

Twin boom... then bust?

The current situation has an uncanny similarity to the 1970s and 1980s. You will recall that developing countries enjoyed a boom in commodity markets in the 1970s, which was accompanied by massive international lending by banks recycling [petrodollar] oil surpluses. This twin boom in commodities and capital flows to developing countries ended with a bust when the United States raised interest rates in 1979-80 under [then Federal Reserve chief Paul] Volcker. What we had was a debt crisis in Latin America.

The situation now is somewhat similar. We had a twin boom in commodity prices and capital flows and now we have come to the end of this boom, even without the US changing its monetary policy in a big way. And the question is: will the outcome be the same as in the 1970s?

I am not going to go into detail, but the outcome depends very much on how we managed the twin booms. In general, the record is somewhat better than in the 1970s but not really that good. We have allowed currency appreciation - unsustainable currency appreciation - we allowed consumption booms - unsustainable construction booms - in some countries. We accumulated reserves but these reserves came mainly from capital inflows rather than current account surpluses except in countries like China. Current accounts deteriorated despite the improvement in commodity prices. Only a few countries improved savings and investment but there was hardly any investment in non-traditional sectors. Sovereign debt increased in low-income countries and private debt increased in middle-income countries. We are highly vulnerable to [the reversal of] commodity prices and capital flows.

The vulnerability to commodity prices nevertheless varies among developing countries because different types of commodities [fuel, non-fuel, food and agricultural raw materials] fell at different rates. . First, there are countries exporting services and manufactures and importing fuel and non-fuel commodities. They stand to benefit from the commodity price declines. These countries include China, India and my own country, Turkey. You see the current account of these countries improving.

Second, there are the exporters of fuels. These are the countries which are hard hit. . These countries benefit from the declining agricultural prices to the extent they import these goods. But since the decline in their export prices is much deeper than the decline in their import prices, these benefits do not really cover the losses.

Finally, there are the exporters of non-fuel commodities and importers of fuel. Ironically, although these are commodity-dependent economies, they benefit from the recent change in the commodity price configuration. This is because they import fuel, whose prices fell more rapidly than the prices of their agricultural exports. . Therefore, we have quite different impacts of the commodity price changes on developing countries according to these three categories.

But in external financial vulnerability there is no variation. Everybody is vulnerable. Some developing countries benefit from commodity price declines but no developing country would benefit from tightening of the external financial situation. Now we cannot count on reserves. Traditionally we look at the reserve adequacy in terms of the volume of reserves relative to short-term external debt. But in the past 15 years - and we examined that in some research papers in the South Centre - there has been a very large increase in the presence of foreigners in domestic equity, bond and deposit markets of developing countries. And it is they who are exiting. Therefore, your reserves may be adequate to meet your short-term debt but if there is a massive exit from domestic bond, equity and deposit markets, then your reserves will not be enough. This is because you accumulated these reserves in the first place from their entry into your economy.

We haven't had a serious debt crisis in an emerging economy in the past 10-12 years.  But the risks are very serious now. The world is caught in a debt trap today. Why? Because the resolution of the European and American crisis - which was a debt crisis - required cutting debt. But what we've seen is that the policies implemented to resolve that crisis have given rise to the accumulation of additional debt. In the US, the ratio of public plus private debt to GDP increased from 200% to 280%, in Japan it increased to 500%, in the eurozone and China it doubled. And in developing countries today it is close to 200% of GDP on combined private and public debt. I believe that in the next global downturn - that is, when your income drops significantly - an important part of this debt will be unpayable. When you lose half of your income, you cannot keep on meeting your mortgage or consumer debt, particularly if interest rates have risen.

Unfortunately policy space is much more limited today in developing countries than it was in 2009. At the time we had a very comfortable fiscal position because of the previous expansion. We had a very comfortable balance-of-payments position, reserve position. Now we don't have any of these.

And monetary policy now faces a major dilemma. In order to stimulate demand and growth, we have to cut interest rates, but if you cut interest rates, you can trigger capital outflows. So you have a dilemma between growth and stability. So if we face a liquidity crisis - that is, we no longer have enough reserves to meet our imports and stay current on our debt payments - what do we do? Business as usual? Borrow from the IMF? Keep the capital account open? Continue allowing capital to run out, using reserves and the borrowing from the IMF and using austerity?

Now I think there is a strong misgiving vis-…-vis the IMF among the developing countries. And I am sure they will do their best to avoid going to the IMF in the event of a serious liquidity crisis. I am not referring to a solvency crisis - default - I'm talking about a simple liquidity crisis when you don't have enough foreign exchange to meet your current account needs and debt payments. Then what do you do? Of course, the unorthodox response is you use your reserves to support your economy - imports - not to support capital outflows. Are we prepared to impose controls over capital outflows? Are we prepared to impose temporary debt standstills? Are we prepared to impose austerity on creditors and investors rather than austerity on the people? These are the issues.

Are there alternatives to the IMF in the provision of international liquidity? We have had some initiatives in the past two decades. One is the Chiang Mai Initiative in Asia. The other is the contingent reserve arrangement established by BRICS. But when I look at their design and size, they are both inadequate. They are very small. No one has ever used the Chiang Mai facilities. And they are actually designed as a supplement, not as a substitute, to IMF facilities; in fact, they require IMF programmes in order for countries to access these facilities.

Then we have swaps. Do we have swaps among central banks of developing countries? The only country that has swaps with other developing countries is China. China has about 30 swaps but most of them are with advanced economies. And only one of them, the swap in Argentina, is designed to supplement reserves if Argentina comes under attack. All the other swaps that China has are designed to facilitate Chinese exports and investment abroad.

Can we thus do it without borrowing from the IMF? One way of doing it is through a massive allocation of Special Drawing Rights (SDR). We had it in 2009. In the South Centre we advocated this even before it happened. We can have a massive SDR allocation but the question is whether the major shareholders of the IMF would agree to it.

In conclusion, even if we avoid a fully fledged financial crisis, the prospects are for sluggish, erratic growth and heightened instability in the global economy. Why? Because of the financial excesses we have had in the past 8-9 years. And you cannot easily restructure your balance sheets; that is the problem.

We need to have a better policy mix than we have been using. I have basically four [suggestions]. Firstly, stop relying on easy money - which is no good except for speculation in advanced economies. Abandon fiscal orthodoxy, invest in infrastructure and create jobs and create demand. Secondly, we need better control over international capital flows, not only by recipient countries but also by source countries. They are most destabilising and are at the heart of the current difficulties that we face. Thirdly, we need a mechanism for adequate provision of international liquidity. And finally, we need effective and equitable debt resolution mechanisms.

These issues should be studied and debated extensively, particularly at the current juncture. But unfortunately the Bretton Woods institutions are not the best place to do that - neither to understand the fragilities nor to resolve the problems. The IMF missed one of the most serious crises in the world since the Second World War, the subprime crisis.

The IMF at the secretariat level is not very efficient in providing early warnings to countries about the global economic situation. This is not just a technical expertise issue; it's also a political issue, because such an early warning - an effective projection of the difficulties in the world - requires a critical examination of the policies of countries which exert significant impact on the world economy. That means it would require criticising US and European economic policy. The IMF secretariat cannot do that. That is why they cannot really predict these kinds of difficulties, warn countries in advance and warn them during the expansions so that they do not get into trouble. When we were writing that the rise of the South was a myth, in 2008-09 the IMF was proclaiming that the South was becoming a locomotive for the world economy. And they changed their mind only in 2013.

Secondly, the IMF is not very bold in innovation. These difficulties are serious ones and you need bold measures. They are not bold in the reform of the international financial architecture. Why? Because the IMF is itself part of that very architecture. . If you look at the record of the institution in these matters, they have not put forward any significant proposal regarding reform of the international reserve system except the inclusion of the Chinese renminbi in the SDR currency basket [which is not really a significant part of the reform of the reserve system].

The IMF was also very late in recognising the role of capital controls in macroeconomic management - at least 15 years behind UNCTAD [UN Conference on Trade and Development]. And when they saw the need, they were willy-nilly about it. Why? Because they were proposing to control capital flowing from the North to the South. The IMF was again some 20 years behind organisations like UNCTAD in seeing the debt problem and the need for international debt workout mechanisms.

So I believe that these matters should be discussed and debated among developing countries and in other fora such as UNCTAD, which has a much better record in anticipating these difficulties and providing proposals which eventually became part of the mainstream. The IMF is five years behind governments. And we in the South Centre remember [UNCTAD's founding Secretary-General Raul] Prebisch saying he wanted a secretariat five years ahead of governments.                          

Yilmaz Akyuz is Chief Economist of the South Centre. The above is an edited transcript of his presentation at a seminar on 'Current global economic trends and conditions and the international development policy context after 2015' held at the Palais des Nations in Geneva on 23 February 2016. The original transcript, as well as the audio and video recordings of the presentation, were first published on the website of the Real News Network.

*Third World Resurgence No. 307/308, March/April 2016, pp 15-18