``The most recent evidence shows that growth in emerging economies has started to moderate—partly in response to lower U.S. demand for their exports, and partly in response to the 2008 second-quarter tightening in monetary policy, designed to offset higher inflation pressures. This slowing has served to crystallize what, to date, has been an oversimplification of the debate about the evolving relationship between emerging and industrial economies. The debate should be framed not in terms of decoupling versus recoupling, but whether the decoupling is "strong" or "weak."- Mohamed A. El-Erian, A Crisis to Remember
In 2008, it became fashionable to debunk the so called “decoupling” theme. The kernel of the argument was that since world economies revolved around the US, which functioned as the only major source for “aggregate demand”, a slumping US economy would synchronize the slowdown everywhere. This phenomenon would naturally reflect on global financial markets. Of course, from the single dimensional perspective, they were right.
The salad days of the US debt driven consumption boom was buttressed by globalization, a trend which integrated trade, finance, investments to even labor-migration flows. This occurred because of concerted policies to “open” the national economies, although at varying scale.
Importantly, the boom conditions had been powered by the US Federal Reserve’s monetary policies which was transmitted to the rest of the world via the currency mechanism-dollar links, pegs, and “dollarized” economies and through its current account deficits, which allowed the US to export financial products in exchange for goods and services from the rest of the world.
Moreover, the plethora of credit, from the US and other advance economies, resulted to a diffusion of easy credit in the emerging markets. And because of the profusion of liquidity, capital flowed to rest of the world in search of higher yields (see Figure 1).
Figure 1: Institute of International Finance (IIF): Private Capital Flows
According to the IIF, the world's only global association of financial institutions with 375 members from 70 countries, ``In the previous two expansion phases (1978-81 and 1990-96) there was a dominant region that attracted more flows than other regions. In the early 1980s, the dominant region was Latin America. In the early 1990s, lending to Latin America surged once again, although this was tempered by the Mexican crisis in 1994-95 and its aftermath. Following that, lending surged to Emerging Asia, setting the stage for the Asian crisis in 1997-98. This time around, lending surged to all regions in 2007, before contracting sharply to all regions in 2008 and, most likely, in 2009.” (bold highlight mine). Thus financial markets across the globe and across diverse asset classes simultaneously zoomed.
So the operating framework of the recent globalization boom essentially encompassed liberalized trade and investment policies and fueled by an easy money “inflationary” environment emanating from the US.
From Globalization to Deglobalization
Now that the debt driven consumption bubble is unwinding, some of these trends are being reversed. Here are some of the contributing variables:
One, Forcible liquidations from Debt deflation. Since the center of capital flows came mostly from the US and advanced economies, a global ‘margin call’ from the debt deflation dynamics prompted the simultaneous forcible liquidations across asset classes.
Two, temporary scarcity of the US dollar. The imploding debt markets had been mostly denominated in the US currency, hence payment or settlement of these closed positions increased the demand for US dollars.
Besides, the severe losses in the in the US banking system accounted for as a financial “black hole”. This vacuumed out the US dollars in the system at a greater intensity than had been replaced by the US Federal Reserve.
Hence, the shortages of the US dollars exposed the internal deficiencies of many emerging markets (Korea, Russia, Pakistan etc.) and exacerbated the deteriorating economic outlook. To allay this predicament, the US Federal Reserve entered into currency swaps with most of the world’s major central banks [see How Does Swap Lines Work? Possible Implications to Asia and Emerging Markets]
Three, dysfunctional US banking system. As mentioned in last week’s What Posttraumatic Stress Disorder (PTSD) Have To Do With Today’s Financial Crisis, like the traumatic 9/11 tragedy, the world basically was rendered dumbfounded or “shocked and awed” as the US banking system froze late last year. Trade and production fell from the cliff as credit windows were shut.
Four, dislocation of trade channels. The emergence of barter as a form of trade signified both the ongoing disorder in the operations of the global banking system and incipient signs of distrust over the present financial architecture.
In the recent tour of Europe, China’s Premier Wen Jiabao ``urged the international community to set up a new global economic system (bold emphasis mine)” (China Economic Net)
Five, national financing seems likely to turn inward.
Current account imbalances are likely to improve as deficits narrows in a LOW oil price global recessionary environment. In a HIGH oil price recessionary environment deficits might not materially improve. And deficit economies as the US will have to increasingly secure financing from its taxpayers than from previous vendor-financing scheme.
From Richard M. Ebeling of the American Institute for Economic Research, ``…the Chinese are becoming increasing leery of lending to the American markets. At the recent international meeting of bankers, businessmen, and bureaucrats in Davos, Switzerland, Chinese officials made clear their dissatisfaction with the American market, where they have suffered significant losses in banks and other financial institutions into which they had invested. In the last five months of 2008, the Chinese sold off almost half of the $46 billion is Fannie Mae and Freddie Mac bonds that they had purchased in the earlier part of the year.
``If foreign lenders do not come to the rescue, Uncle Sam will have to rely far more than in the recent past on the financial markets at home to finance its deficit spending dollars. A lot of new bank lending--with perhaps some of the billions already given by Washington to bailout many of these banks--will have to end up covering the federal government’s expenditures, rather than being available for private sector investment and employment creation.”
Meanwhile, current account surplus economies with huge forex surpluses will likely be used to defend national (e.g. Russia) or regional economies (China, Japan, and South Korea extend currency swaps to Indonesia-Bloomberg) than recycled to the US.
Another important noteworthy development is that China will be providing the currency swap arrangement with Indonesia with its own currency the remimbi, instead of the US dollar (WSJ). Combined with the recent attempt to use its currency as medium of exchange for the settlement of trade with ASEAN nations, China seems to be flexing its economic and financial muscles, which eventually may turn out to be the region’s currency standard.
Sixth, economic structures built upon unsustainable debt are being cleared. This will be reflected on reduced global trade which is expected to decline by 2.1% in 2009.
Lastly, there are budding signs of protectionism or the reversal of trade liberalization. See figure 2.
Figure 2: WSJ: Putting Up Walls
According to the Wall Street Journal, ``Countries grappling with global recession have enacted a wave of barriers to world commerce since early last month, scrambling to safeguard their key industries -- often by damaging those of their neighbors.
``The World Trade Organization is gathering nations in a special meeting Monday to try to stem the rising tide, just two weeks after saying protectionism was largely under control.”
In short, globalization seems being deglobalized.
Of course, deglobalization as a trend is likely to increase or intensify economic risks or worsen the current dilemma. The trade protectionism from the Smoot-Hawley Tariff Act in the US during 1930s was a major contributing factor which transitioned a recession to the Great Depression.
But unlike the Great Depression era, governments today seem likely to be aware of the negative consequences of such policies. The recent actions seem to signify knee jerk reactions out of domestic political exigencies. Hopefully, the actions undertaken by the WTO to mediate could help avoid the aggravation of such trends that risks a reprise of the 30s.
Structural Difference In A Deglobalized World
Nonetheless the collective government policies aimed to address today’s recession is to throw money at the economy. In other words, inflationary actions by governments will remain a pivotal force in driving asset markets and economic outcome.
Now if the essence of deglobalization is centered mainly on the market clearing of global credit bubble economic structure (and not on increasing trends of protectionist barriers) then once the portfolio outflows from forcible liquidations subside, excess capacities directed at the bubble demand are closed or bankrupted and surplus inventory are reduced, the likelihood is that all the convergent inflationary pressures applied by governments could have a distinct impact based on the nation’s capital or production structure.
Take for example the credit structure of major world economies, see figure 3.
Credit as percentage of GDP is seen dissimilarly distributed across economies. For instance the UK and US has the highest household credit exposure, brought about by the recent boom in the securitization financed real estate bubble.
And the present financial crisis is forcing a market based “deflation” adjustment to such disproportionate levels of debt. Hence, under current conditions UK and US household debt levels will have to contract during the life of this crisis. Paradoxically, this unsustainable debt structure is what their governments have vigorously been trying prop up.
So unless the US and UK succeeds in destroying its currency to reduce the real value of debt, we can’t see material credit growth to produce the expected inflation based economic growth.
Now since global interest rates are being forced to approach to zero levels, which of these economies are likely to assume more debt?
The answer is that debt take up is likely to occur in emerging markets and Asia than on advanced economies, because of their low levels of exposure.
Plainly put, Asia and emerging has the capacity to absorb more debt than its contemporaries in the advance economies. Hence any bubble that could surface under the present negative interest rate regime will probably be in emerging markets and in Asia. Such assumes that the pangs of the adjustments (production and inventory) from the recent bubble structures have culminated.
Nonetheless to buttress our argument that Asian economies have the capacity to absorb more debt, the recent data on writedowns on bank losses and capital raised should illustrate the ongoing divergence in the underlying strength of global financial institutions (see figure 4).
Figure 4: ADB Bond: 3rd Quarter writedowns and Capital Buildup
But the message is very clear, Asia’s losses is a speck compared to both Europe and America. This means Asia’s banking system is hardly impaired by the recent crisis and could function normally relative to its peers across the globe once the recession fears subside.
So seen from the demand side, there seems to be a huge room for growth as the household and corporate sector have low credit coverage. From the supply side, the well capitalized, apparently healthier banking system in Asia, may oblige to fulfill such potentials.
Overall, the prevailing policies seem to present itself as an auspicious condition for the next bubble-here in Asia and or in emerging markets.
Government Financial Bubble=Banana Republic?
However, in contrast, the bubble taking place today is progressing under government finance, especially in the US, UK and the Euro zone, where governments have been absorbing the private sector losses in a seemingly futile attempt to support an indefensible bubble structure.
Yet oblivious to the proponents of the “inflation driven” economic growth model, for this to paradigm to successfully operate requires a vicious expansion of the leverage feedback loop cycle-leverage which will require further or larger leverage to support a reverse pyramid shaped bubble framework. We will need to bring back 20:1, 30:1, 40:1 and so forth leverage in the system.
Instead of allowing for debt to fall to the levels where the economy can sustain them, the popular underlying belief is to print money away to contain a deflating bubble. Yet sustained operations of the printing press are likely to cause even greater problems.
So we can expect more bailouts or stimulus to come on stream as earlier efforts fail to achieve the goals. The end result will be an untenable government financial bubble. And a reality check means ultimately, all bubbles meet their comeuppance.
London School of Economics Professor Willem Buiter has a better narrative (bold highlight mine), ``In a world where all securities, private and public, are mistrusted, the US sovereign debt is, for the moment, mistrusted less than almost all other financial instruments (Bunds are a possible exception). But as the recession deepens, and as discretionary fiscal measures in the US produce 12% to 14% of GDP general government financial deficits – figures associated historically not even with most emerging markets, but just with the basket cases among them, and with banana republics – I expect that US sovereign bond yields will begin to reflect expeted inflation premia (if the markets believe that the Fed will be forced to inflate the sovereign’s way out of an unsustainable debt burden) or default risk premia.”
So like Iceland, maybe the US and UK will unwittingly enlist itself in the membership roster of the third world economies or disparagingly, the Banana Republics. Or how about the Philippinization of America and England since the Philippines seems to be a Keynesian paradise?
P.S. there has been much chatter about the merits/demerits of adapting the bank nationalization model of Sweden, including some of our so called local experts.
One caveat everyone seems to miss, Swede banks dealt with traditional mortgages while US banks are stuffed with securitized or structured finance instruments. Put differently, the former has recoverable or redeemable future value while the latter’s future value could be permanently ZERO.
