The impact of China's currency manipulation on emerging economies

The Times points to a recent IMF working paper which suggests that the era of high current account surplus driven external imbalance of the Chinese economy may be coming to an end. The IMF estimates that China's current account surplus, which topped 10% of GDP in 2007, had  shrunk to about 2.8% in 2011 and is estimated to decline to 2.3% in 2012, the smallest since 2001. 

Apart from rising labour costs and the natural shift upwards in the manufacturing value chain, the appreciation of the renminbi over the past decade too has been a contributory factor. Since June 2005, but for period of nearly two years during the 2008 financial crisis, China has allowed the remnminbi to trade in a daily band of 0.5% against the dollar. Since mid-April, 2012, it widened the band and now allws the renminbi to fluctuate up or down in value by as much as 1 percent against a fixed benchmark with the dollar during daily trading. But the central bank continues to set the benchmark for each day’s trading of the renminbi, and it has shown virtually no change this year.

The FT has an excellent interactive graphic that traces the change in the value of renminbi since 2000. It uses four distinct ranges, beginning with before China's WTO entry (January 2000), its first depeg from US dollar (June 2005), its second de-peg from US dollar after re-pegging it during the 2008 crisis (may 2010), and March 2012. The graphic below shows that the renminbi's nominal and real (inflation-adjusted) trade-weighted exchange rates (REER) relative to its major trading partners have appreciated. Further, this appreciation has been higher since June 2005.

However, this appreciation conceals variations. The renminbi has risen steadily against the US dollar, British Sterling, and Japanese Yen over the past decade, but its real appreciation against other currencies from the euro to Brazilian real has been far milder. Accounting for different inflation rates, in real terms while the renminbi has risen by 29% since 2000 against the US dollar, it has actually depreciated against all others - 0.7% against the Euro, 45% against the Brazilian Real, and 30% against the Indian Rupee.

This is also a reflection of the fact that the dollar itself has depreciated against the other major currencies during this period. Therefore, there may be a strong case now for many developing economies that, despite China's exchange rate flexibility since 2005, they are bearing the brunt of China's currency manipulation.  

In particular, India has been amongst the worst affected by China's currency manipulation. In real terms, the renminbi has depreciated by 30% since January 2000. In fact, despite, the rupee's significant depreciation against the dollar, the real rupee-renminbi exchange rate has held steady. In fact, but for India's much higher inflation rate, since 2005, the exchange rate between the two currencies has hardly budged.

In keeping with the trend with others, the renminbi has appreciated in real terms over the past one year. However, it may be premature to consider this as a decisive shift in China's exchange rate policy since this period also conicided with higher than normal inflation in China.

These trends are yet another reason for India to rally other developing countries around an agenda that focuses on China's currency manipulation and its beggar-thy-neighbour impact on other emerging economies. Apart from its substantive nature, this can also add a strategic dimension to India's foreign policy.    

The Swedish lessons for Europe

Fiscal austerity is the current buzzword in macroeconomic policymaking. Across Europe, despite very strong domestic political opposition, governments have embraced wildly ambitious fiscal adjustment targets in an attempt to rein in soaring public debts, restore market confidence, and thereby engineer economic recovery. 

However, evidence from nearly three years of such experimentation across Britain and the Eurozone economies has been dismal. Bond markets have remained unimpressed and sovereign bond yields continue to rise. Not only have the expected recovery not materialized, but these economies have slipped further down the abyss. And this has been the fate of economies within and outside the Eurozone. The latest casualty is Britain, which has officially slipped into a double-dip recession, its second recession in three years. It joins Belgium, the Czech Republic, Greece, Italy, the Netherlands and Spain who are already in recession.

As with Greece, Ireland, and Portugal earlier, Spain too is now experiencing the wages of the same austerity medicine. Amidst a contracting economy, its sovereign debt rating has been downgraded and cost of borrowing has been rising. One-in-four Spaniards are unemployed and half all Spanish youth are out of work, both the highest among advanced economies. Even with all the belt-tightening, Spain is expected to easily miss its target of lowering budget deficit from 8.5% of GDP to 5.3% in 2012 and do no better than 6.2% .   

As could have been anticipated, the blind embrace of austerity has had the effect of accepting the worst of all worlds. As economic growth has contracted, public debt-to-GDP ratios have gone up even higher and tax revenues have dipped sharply. In the absence of either the private sector or external sector stepping in top stanch the space vacated by public expenditures, it was natural that the economy would contract.

All this has raised unemployment rates and inflicted untold suffering on citizens across Europe. Economic hardship have triggered off pent-up social tensions. Political rebellions and protests have become commonplace in these countries. Many governments have lost power in the face of street protests and failures to push through the tough fiscal adjustment measures required to secure external funds. At last count governments in Greece, Ireland, Italy, Portugal, Spain, Netherlands, and now Romania have lost power due to the pains caused by spending cuts.     

In this context, it has become important that these economies abandon their dogmatic ideological embrace of austerity and fall back on policies that can get their economies growing. Robert Samuelson has a nice article which highlights the less-discussed economic turnaround of Sweden since its banking crisis induced economic recession in early nineties. In recent years, Sweden has emerged, along with Germany, as among the best performing developed economies.

Instead of being wedded to ideology-driven policies, Sweden embraced prudent policies that combined both the conservative and liberal social and economic agendas. For a start, it did not bail out its banks but forced them to take massive losses and virtually nationalized its banking sector. The real estate bubble that was inflated by the financial deregulation of the 1980s deflated in 1991-92. As pressure mounted on the krona, overnight interest rates spiked to 500%, and the Swedish economy contracted steeply and unemployment quadrupled in three years to 12%. After a series of bank failures, the government moved in swiftly with a series of measures,

In September 1992... the government announced that the Swedish state would guarantee all bank deposits and creditors of the nation’s 114 banks. Sweden formed a new agency to supervise institutions that needed recapitalization, and another that sold off the assets, mainly real estate, that the banks held as collateral. Sweden told its banks to write down their losses promptly before coming to the state for recapitalization. Facing its own problem later in the decade, Japan made the mistake of dragging this process out, delaying a solution for years...

By the end of the crisis, the Swedish government had seized a vast portion of the banking sector, and the agency had mostly fulfilled its hard-nosed mandate to drain share capital before injecting cash. When markets stabilized, the Swedish state then reaped the benefits by taking the banks public again.

This was followed with several far-reaching structural reforms that turned the largely statist economy into one of the world's most dynamic economies, without compromising on its social-democratic principles. The reforms drew from both the conservative and liberal playbooks,  

Sweden’s income tax base was broadened and tax rates were sharply reduced (marginal tax rates fell from 46% in 1996 to 33% in 2010). Spending was cut on old-age pensions, child allowances, unemployment benefits and housing subsidies. Union power over wages was reduced. Many markets (banking, air travel, telecommunications, electricity production) were deregulated. Low inflation and balanced budgets became broadly embraced popular goals...

Although Sweden trimmed social benefits, it hardly abandoned the welfare state. Overall government spending is still about 50 percent of the GDP, much higher than in the United States... To reduce income tax rates, the government raised other taxes. Gasoline and cigarette taxes were increased; so were taxes on dividends and capital gains, hitting the rich. Altogether, deficit reduction totaled a huge 12 percent of GDP from 1991 to 1998. Slightly more than a third of that came from higher taxes...

The aims were clear: to reward work by cutting income tax rates; to push people back into the labor market by reducing some government benefits; and to promote productivity by increasing competition. Productivity and “real” (after-inflation) wage gains improved markedly. Still, Sweden has less economic inequality than most advanced countries.

Sweden also benefited from favorable external economic conditions. Its recession coincided with a sustained period of economic strength across much of the world. Sweden could therefore export its way out of recession. A 25% devaluation of the krona boosted exports. Unfortunately, none of the peripheral European economices today can afford this luxury. None of the Eurozone economies have the freedom to undertake this policy route. See also this excellent presentation by Swedish Finance Minister Anders Borg.

The choices facing Eurozone governments are stark. Currently the austerity policies are merely pushing their economies down the hill, with no hope of finding an anchor that can drive economic recovery in the foreseeable future. It is necessary for all the Eurozone economies to start regaining their economic competitiveness for any sustained recovery to take hold. This can happen only with either a Eurozone exit and/or fiscal transfers from the Eurozone's center. There has to be some period of fiscal accommodation in the periphery and consumption increase in the center.

This is an opportunity to push through the tough labour market liberalization and industry dergulation policies that have for long contributed to sclerosis in Europe. More than that it is an opportunity for the Europen monetary union to become a loose political union, a necessary requirement for the continent to stave off similar situations in future, leave alone escape the current mess.   

Eurozone's rebalancing challenge

Regaining external competitiveness dented by a decade of massive external capital inflows, asset price bubbles, and investment booms, is arguably the biggest challenge facing many of the beleaguered Eurozone economies. Martin Wolf, quoting two Goldman Sachs research papers, “Achieving fiscal and external balance”, points to the magnitude of this re-balancing challenge facing the peripheral economies.

To achieve a sustainable external position, Portugal needs a real depreciation of its exchange rate of 35 per cent, Greece one of 30 per cent, Spain one of 20 per cent and Italy one of 10-15 per cent, while Ireland is now competitive. Such adjustments imply offsetting appreciation in core countries. Moreover, with average inflation of 2 per cent in the eurozone and, say, zero inflation in currently uncompetitive countries, adjustment would take Portugal and Greece 15 years, Spain 10 years and Italy 5-10 years. Moreover, that would also imply 4 per cent annual inflation in the rest of the eurozone.

But the danger is that even if the required inflation environments can be sustained for long periods, the austerity policies being followed by these economies could choke off any growth and push them down a contractionary spiral. Spain's targeted fiscal correction by 5.5% of GDP over two years, with 3.2% adjustment proposed for 2012, from its fiscal deficit of 8.5% of GDP for 2011, is one of the biggest fiscal adjustments ever attempted by a large industrial country. Such severe austerity threatens economies with large unmeployment rates, debt-ridden banks, and fiscally constrained governments. Predictably, as with the case of Spain, the markets have reacted with alarm driving up Spanish bond yields and CDS spreads.

The return of Iceland?

Amidst all the gloom surrounding Europe, Iceland's apparent recovery from the depths of despair should be a cause for some celebration.The FT has a nice story that chronicles the Icelandic saga over the past five years.

Iceland's story till its meltdown in 2008 is classic Bubble Economics 101. The aggressive financial deregulation of early 2000s led to massive capital inflows and over-leveraged local banks. Asset prices inflated, construction activity boomed, businesses borrwed heavily in foreign currency and purchased assets abroad. Then the music stopped and the bubble burst, leaving the banks heavily leveraged, especially with foreign loans.

Iceland's recipe for restoring normalcy was to let its banks collapse and default on their loans. In contrast to countries like US, UK, and Ireland which injected billions to prop up their too-big-to-fail banks, Iceland let its inflated banking sector collapse. In 2008, the three biggest banks by assets – Kaupthing, Landsbanki and Glitnir - defaulted on $85bn of debt. This led directly to the collapse of the currency, the government and much of the economy. While the domestic assets of Iceland’s lenders were protected – costing the state 20% of GDP, according to the IMF – the lion’s share of the collapse was borne by foreign creditors.

Capital controls were introduced to prevent money leaving the country. The kroner underwent over 50% devaluation against the euro in 2007-08, which contributed towards restoration of national competitiveness. A rebound in tourism and fishing exports, boosted by the devaluation, have been critical drivers of the recovery. 

Iceland's economic recovery has been slow but unmistakable. As Paul Krugman has pointed out, the contrast with Latvia, which followed the orthodox prescription of fiscal consolidation and austerity, is stark.

On every parameter, the Icelandic economy has been making slow progress. In February, Iceland’s debt was upgraded from “junk” to investment grade by Fitch, the rating agency.

The FT article writes approvingly,

In August, Iceland completed a three-year IMF-supported restructuring programme, including loans of $10bn, and has started borrowing again on global credit markets. It has been held up by the IMF as a model of crisis management. GDP is set to expand by a respectable 2.5 per cent this year – which, added to last year’s 2.5 per cent, solidifies the sense of a country on the mend. The figures contrast with the 0.3 per cent contraction the European Commission expects in the eurozone this year.

But normalcy is still some distance away. The households and business balance sheets remain over-leveraged and it will be sometime before consumption and business investment will return to normalcy.  

The average household has suffered a 30 per cent fall in purchasing power since 2008. The private sector remains heavily indebted, with household debt levels exceeding 200 per cent of disposable income and corporate debt 210 per cent of GDP, according to Fitch. Partly because of this, domestic companies are reluctant to invest.

No light at the end of the tunnel - fiscal austerity Vs currency devaluation

I blogged a few days back about why currency devaluation is the most effective route to regain competitiveness. David McWilliams has an excellent graphic that captures the power of external devaluation.



The graphic reveals both the reality and the counter-factual. After it sharply devalued its currency in late 2008, Iceland's wages fell sharply and it quickly regained its labour competitiveness. The counterfactual - if Iceland had remained within Eurozone - is indicated by the Icelandic wages with respect to Euro, which would have remained very high. So McWilliams advocates an exit from Eurozone for Ireland as the "least extreme option".

"Iceland in one sharp devaluation has achieved what Ireland and Latvia are supposed to achieve over years of grinding down wages. If we are supposed to achieve Icelandic levels of wage competitiveness, we will have to shrink the economy over the next few years. By having their own currency the Icelandics did in a few weeks what we have been trying — unsucessfully — to do over four years... no economy in the world has ever emerged from a recession like ours without changing its exchange rate. The reason is that it simply can’t be done. There is no evidence anywhere, ever, that shows that a country can operate a successful “internal devaluation” — particularly an economy carrying as much debt as we have."

The belief that fiscal austerity would generate contractionary expansion is yet another example of failure to think beyond stage one. In fact, McWilliams himself provides the explanation as to why internal devaluation cannot work,

"When people are laid off, it is very difficult to get a new job because no one is spending in the economy. The government is not spending and the people are not spending. But what about the the much heralded export-led growth which postulates that foreigners will buy loads of Irish goods, more than compensating for the fall in domestic spending?

Well it doesn’t happen, partly because Irish wages don’t fall as we can see in the chart, so Irish goods are no more competitive than they were a few years ago. Yes, exports have risen, but nowhere near enough to offset the local contraction. This is why unemployment has trebled in three years and why emigration is running at over 1,000 people a week. It is not that the policy of internal devaluation is not working, it can’t work. It has never worked anywhere, ever."

Massive cuts to public expenditure and social protection, wage freezes, and tax increases mean that Ireland has been subjected to one of the most severest austerity programs. As Guardian reported, fiscal adjustment in Austerity's Child is the equivalent of €4,600 per person, the largest budgetary adjustments seen in the advanced economic world in recent times. Annual adjustments of €3-4 bn are proposed until 2015. The evidence in favor of contractionary expansion is surely missing.

News from Spain, another country experimenting with fiscal austerity, too is dismal. Spain's plight is a representative of the slippery slope associated with fiscal austerity. As austerity bites, aggregate demand slumps, and public revenues fall, the deficit widens and the debt-to-GDP ratio increases. Another danger is that once the fiscal consolidation targets are announced and if governments fail to meet them, the bond markets will react adversely, thereby raising the yields on sovereign bonds.

Spain’s new prime minister, Mariano Rajoy, last week admitted that the country faced wider than expected budget defict (it is estimated to be atleast two percentage points higher above the government's target of 6%) and announced a further package of austerity involving tax increases and spending cuts amounting to $19.3 billion. This is deemed necessary to maintain bond market confidence.

Though it is on target to cut the budget deficit by €16.5bn (£14bn) in 2012 through sweeping cuts, it is now being estimated that the economy will contract up to 0.3% in the final three months of 2011 and again in the first quarter of the new year. Its unemployment rate at 21.5% is already the highest in Europe and youth unemployment rate is at a whopping 45%.

Spain's problems come from the serious budget shortfalls faced by its 17 autonomous regions which have spent recklessly in the past decade and continues to do so. As a Times report writes, in recent years, the regions and municipalities have racked up debts, offering generous public services and investing in a wide range of projects, some of them bordering on the ridiculous. The Bank of Spain recently announced that regional debt had surged 22% to $176 billion in September from $144 billion the year before. And there is a strong feeling that there remain tens of billions of dollars in 'hidden' regional debt yet to be discovered.

Why devaluation is the most effective route to regain competitiveness?

As many Eurozone economies face their winter of discontent, there is an intense debate about the best possible route to recovery. Since, the underlying problem is one of eroded competitiveness, its recovery can be achieved either through internal (austerity and wage freezes) or external (currency depreciation) devaluation.

Paul Krugman points to this brilliant description of why external devaluation is a far superior alternative from Milton Friedman's 1953 essay, "The case for flexible exchange rates".



How I wish I could have written that!

However, as Krugman and Matt Yglesias write, some like John Cochrane prefer the ciomplicated solutions.

Update 1 (26/12/2011)

Paul Krugman has this graphic which shows how Iceland could let its currency devalue and achieve a quick 30 percent fall in wages relative to the euro zone.

India's software sector and exchange rate fluctuations

In the second half of 2010, spurred by capital inflows, the rupee appreciated substantially against the dollar. Infosys CFO V Balakrishnan then called for urgent intervention by the RBI to stabilize the currency,

"The RBI should intervene right now to halt heavy speculative inflows through the FII (foreign institutional investments) route to reduce the currency volatility, which is currently ranging from 10-15 percent... With a trade deficit of $13 billion, such a wide currency fluctuation is unsustainable for the country as well as the software services sector, which depends largely on export revenues. We hope the central bank (RBI) will step in to ensure the quality of inflows."

Now, with the opposite trend playing out and rupee falling sharply, thereby boosting the rupee value of software exports, Narayana Murthy finds nothing amiss and finds it a general phenomenon,

"Value of rupee keeps fluctuating. This is normal. At some point of time value of Rupee was at 39 against a dollar."

The two contrasting, or opportunistic, remarks provide an insightful peek into India's software industry. The software sector, while undoubtedly globally competititive, benefits from substantial government support. It continues to enjoy most of the benefits extended to it as a sunrise industry in the nineties. The industry has lobbied intensely to retain the tax breaks given to exporters located inside the Software Technology Parks. The sector has the lowest effective tax rate of 15-18%, compared to the statutory corporate tax rate of 34%, and lobbies hard against removing tax exemptions.

Used to double digit growth rates for decades now, it is important that India's software sector adjust to the vagaries of global market place. Instead of relying on free lunches resulting from cheap labour, low tax rate or weak currency, the industry should seek to raise its competitiveness by increasing productivity and moving up the value chain.

Australia's "Dutch Disease"?

The outback economy of the world, Australia, has been one of the strongest performing economies in the developed world for nearly three decades now, even managing the buck the Great Recession. But the strength conceals some areas of concern, which have been amplified by economic trends of the past decade. The biggest concern, as a recent FT op-ed suggested, may be the possibility of an affliction of the Dutch disease, driven by its recent commodities export boom.



The Dutch disease refers to the phenomenon, which has origins in Holland following the discovery of natural gas in the North Sea in the 1960s, wherein the domestic currency appreciated dramatically in response to a surge in exports of gas, thereby making the other exports extremely uncompetitive and adversely affecting the long-term health of the country's economy.



The FT has an excellent analysis which writes that Australia may be facing much the same situation, on the back of a commodities export boom driven by China's insatiable appetite. The share of commodities in merchandise exports have ballooned since the middle of the last decade, with the source of this demand being East Asia, mainly China (it takes up 26% of Australian exports).











It does not require much analysis to detect signs of concern from this trend, especially for a less diverse economy like Australia. There are several signatures of imbalances creeping in. It is estimated that though the natural resources sector only represents 10% of the economy, it sucks up 70% of capital expenditure. Mining projects worth A$ 832bn, or 60% of GDP are currently under execution or consideration. The structural impact of these investments could be staggering. And finally, there is the big external risk that such dependence, especially to one country, poses to the Australian economy. The FT writes,

"Booming sales of iron ore and coal have meant the country has hitched its fortunes to China like no other developed nation. That intimacy exposes it to the whims of a communist Asian power that could readily dump Australia if cheaper commodities were to be sourced elsewhere.



In the immediate future, the China-fuelled boom and the growing might of the mining industry are destabilising Australia’s economy by propelling the currency upward, squeezing trade-exposed industries ranging from manufacturing to tourism and boosting inflation. A shortage of workers for big resources projects has led to wage spikes that threaten to spill over into less buoyant industries.



Just ask manufacturers trying to export and those industries trying to compete with imports made cheap by the local dollar, which – long weaker than the greenback but this year bouncing either side of parity – reached a nearly three-decade high last month of US $1.10."

The graphic below shows that Australian dollar has been appreciating steadily against the US dollar since the turn of the millennium, coinciding with the spectacular growth of demand for commodities from China. After the recession indiced blip in 2007-08, it has been rising again since January 2009.







The rising Australian dollar is starting to impact manufacturing and agriculture, apart from the country's other major source of revenues, tourism. Recently, BluScope Steel, the nation's largest steel manufacturer, closed down "one of only three of the nation’s blast furnaces as part of an overhaul to cope with a surging local currency". Interestingly, for a country which is among the largest iron ore exporters, Australia does not have a strong steel industry.



Another area of concern is the apparent lack of plan to take a share in the windfall profits that are coming out of this boom and filling the coffers of mining giants like BHP and Rio TInto. Unlike the example of Norway and many Middle Eastern economies which have established rainy day funds or sovereign Wealth Funds financed out of resource booms, Australia does not have any and proposals to impose some windfall taxes on the minerals extracted have fallen by the wayside. In fact, and in a testament to the power wielded by the increasingly dominant mining lobby, a proposal to introduce a mining super tax was among one of the reasons for the exit of the previous government of Kevin Rudd. The watered down version proposed by the Gillard government is still awaiting Parliamentary nod.

Rebalancing China's savings-investment imbalances

One of the biggest macroeconomic challenges for the world economy in the years ahead lies in the manner in which China's economic growth is managed as its economy moves into the next stage of growth.

Over the past decade-and-half, China's spectacular economic growth has pulled hundreds of millions of Chinese out of poverty and provided the engine for global economic growth itself. This growth was was driven by a massive export-led industrial and infrastructure investment boom, that channelized the very high domestic savings rate and huge foreign direct investments.

Whenever, economy threatened to slowdown the government further boosted its fixed investment share of the GDP. In fact, the decline in exports during the recent global recession, the government increased the fixed-investment share of GDP from 42% to 47%, and increased further in 2010-2011, to almost 50%. Nouriel Roubini who feels that such growth is unsustainable, describes the results

"No country can be productive enough to reinvest 50% of GDP in new capital stock without eventually facing immense overcapacity and a staggering non-performing loan problem. China is rife with overinvestment in physical capital, infrastructure, and property. To a visitor, this is evident in sleek but empty airports and bullet trains (which will reduce the need for the 45 planned airports), highways to nowhere, thousands of colossal new central and provincial government buildings, ghost towns, and brand-new aluminum smelters kept closed to prevent global prices from plunging.

Commercial and high-end residential investment has been excessive, automobile capacity has outstripped even the recent surge in sales, and overcapacity in steel, cement, and other manufacturing sectors is increasing further. In the short run, the investment boom will fuel inflation, owing to the highly resource-intensive character of growth. But overcapacity will lead inevitably to serious deflationary pressures, starting with the manufacturing and real-estate sectors."

The only way out of this is to prune down investments and increase domestic consumption, which remains the lowest among any major economy. I have blogged earlier about China's savings paradox (massive savings, when interest rates are so low) which has generally been attributed to the uncertainty Chinese feel about their income and the market-oriented nature of Chinese reforms. It has been argued that an extensive social safety net, universal medical insurance, reduced cost of higher education, and expansion of public services would lower the uncertainty and get Chinese consumers to spend more.

However Roubini feels the challenge goes beyond this, and requires more fundamental structural changes. He argues that these structural factors contribute towards a massive transfer of wealth from households (through their savings) to corporate sector. It is natural that domestic consumption was just 35% last year, since the share of GDP going to household sector is less than 50%, again among the lowest in all major economies. These structural factors and their impacts are

1. Low interest rates - means that the returns for savings are very low, and corporates enjoy negative real rate on their borrowings. This constitutes one of the biggest direct transfer of spending power from savers to borrowers or households to corporates.

2. Artificially deflated exchange rate - Works in two dimensions. One, it increases export competitiveness. It encourages businesses, already benefitting from artificially suppressed wages and lower cost of capital, to over-invest in facilities for exports. A build-up of imbalances and excesses in export-oriented manufacturing is the result. Two, it lowers import competitiveness. Therefore, domestic consumers are prevented from enjoying cheaper imports and are forced to pay higher prices to buy lower quality domestically manufactured goods. This adds an inflationary dimension to the consumers spending, thereby reducing their real effective purchasing power.

3. Low rate of corporate taxation - This too keeps the cost of production artificially low. Higher taxes would generate higher revenues, which could be used to fund a comprehensive social safety and welfare system, besides expanding the coverage of public services. This also would dis-incentivize over-investments, apart from transferring wealth from coporates to governments and then to consumers.

4. Low wage growth - Labour repression, with policies like the household registration (hukou) system and overt arm-twisting of labor groups, have kept labour wages low. Businesses benefit by way of lower cost of production, whereas workers do not get to share proportionately the gains of higher economic growth.

5. Repressed financial markets - This is one of the most under-stated and less discussed issues, and a critical determinant of how China addresses its structural challenges. Greater depth and breadth to its financial markets would provide much higher returns to savers, who could then use it to increase their purchasing power. It would also provide a more efficient channel for the Chinese government to raise resources and invest their surpluses.

Roubini has some doomsday predictions for the Chinese economy,

"But boosting the share of income that goes to the household sector could be hugely disruptive, as it could bankrupt a large number of SOEs, export-oriented firms, and provincial governments, all of which are politically powerful. As a result, China will invest even more under the current Five-Year Plan. Continuing down the investment-led growth path will exacerbate the visible glut of capacity in manufacturing, real estate, and infrastructure, and thus will intensify the coming economic slowdown once further fixed-investment growth becomes impossible."

In this context, the findings of a recent NBER working paper by Barry Eichengreen and others on economic slowdowns in fast-growing economies is instructive. They use international data since 1957 and find that

"International experience suggests that rapid-growing catch-up economies slow down significantly, in the sense that the growth rate downshifts by at least 2 percentage points, when their per capita incomes reach around $17,000 US in year-2005 constant international prices, a level that China should achieve on or soon after 2015. Our estimates suggest that high growth slows down when the share of employment in manufacturing is 23 per cent; while current data on employment shares in China are not readily available, observation and extrapolation suggest that China is nearly there. Our estimates similarly suggest that growth slows when income per capita in the late-developing country reaches 57 per cent of that in the country that defines the technological frontier, a level that China is likely to reach only somewhat later... Most provocatively, slowdowns are more likely and occur at lower per capita incomes in countries that maintain undervalued exchange rates and have low consumption shares of GDP."

They find that countries which are more open to trade are able to maintain higher growth rates for a longer period of time. However, higher old-age dependency ratios make growth slowdown more likely, and China will have a higher old-age dependency ratio in the not-too-distant future.

Dollar graph of the day

Interesting graphic in the Economist which tracks the fortunes of dollar since the abandonment of the Bretton Woods system in the early 1970s. The dollar has halved since 1985.



But is the falling dollar a cause for concern? As the report points out, though the weaker currency is good for America's export competitiveness, it adversely affects America's creditors. They face the combination of low yielding US Treasury Bonds and a depreciating currency.

However, as Paul Krugman recently blogged, the dollar's position as the preferred global reserve currency (exorbitant privilege) confers certain advantages on the US with a depreciating dollar. Since all its debts, including external, are denominated in its own currency, any currency depreciation benefits the US by reducing the real debt burden. Further, it also means that its households do not have to face balance sheet problems arising from excessive exposure to foreign currency debts.

Macroeconomic challenge of the decade - economic growth in debt-laden economies

The sub-prime mortgage crisis and the resultant Great Recession has had a damaging effect on the fiscal balances of most developed economies. These economies have been squeezed on both the revenues and expenditure sides. On the one hand, they have had to face the cost of financial bailouts and fiscal stimulus spending, while on the other, the weak economy has affected the tax and other government revenues. From all available evidence, it is clear that the former (declining revenues) is the major contributory factor to the increased debt vulnerability.

The stagnation or weak recoveries in these economies have meant that the debt-to-GDP ratios and deficits have been on the rise. In other words, the same debt is now financed with smaller revenues. This forces governments to either cut back on investments (which in turn slows-down growth during recessions, and thereby reduces revenues still further) or borrow more (thereby increasing the debt-to-GDP ratios and also forcing up deficits). Either way, the GDP share of debts and deficits go north. All the major western economies and Japan face the prospect of a long period of grappling with rising deficits and debts.

Then there are the more damaging macroeconomic imbalances generated by this trend. Typically governments facing massive debts and deficits are vulnerable to both domestic and external pressures. On the home-front, debt financing eats into the resources available for productive purposes and also crowds out private investments. The result is a weak economy. Further, an excess supply of domestic debt can potentially generate inflationary pressures.

On the external front, economies like the US and peripheral European countries, which have considerable foreign debt exposure, rely on external financing to meet a considerable portion of their deficits. This in turn puts upward pressure on sovereign yields and domestic interest rates. Then there is the vulnerability to exchange rate fluctuations - if the domestic currency weakens in the face of these troubles (as is to be expected), the real burden of external debts rise.

Hitherto, the ultra-low interest rates prevailing in most western economies and the continuing global savings-glut, manifested in the surging foreign exchange surpluses of the emerging economies, have mitigated the real burden of the rising debts. However, with China already showing signs of paring down its dollar asset exposures, cheap and plentiful credit may soon become history.

There is also the issue of private and government debts. In many of these economies, apart from the governments, corporates and households too are heavily indebted. Many of the peripheral European corporates have significant external debt exposures. It is therefore natural that corporates and households use a greater share of their incomes to pay-off debts. This in turn means that investments and consumption spending take a back-seat.

In simple terms, the dismal economic prospects and stagnant aggregate demand means that there is no engine room available for the debt-laden private sector to drive any economic recovery. However, governments, the only other agency capable of providing some boost to the economy, too is facing steep debts and deficits. So what is the way ahead? How far is the light at the end of the tunnel?

As I have blogged earlier, economic growth, and earlier the better, is the only way out of such huge debt burdens. All other options - inflating away domestic debts, exchange rate depreciation (to lower the real cost of external debts), and sovereign defaults - are too costly and have very adverse long-term consequences for the economy. Exporting the way out of debt is not an option available for many of these economies, except maybe Germany.

Kenneth Rogoff argues that there is no short and easy way out of this mess. A long and painful period of tight-rope walking is inevitable. On the one hand, the balance sheets of all the three players - governments, corporates and households - have to be repaired and their debt burdens lowered. At the same time, the economy has to grow, so as to prevent the debt-burdens spiralling out of control.

In their latest paper examining debts in developed economies, especially in the aftermath of banking crises, Rogoff and Carmen Reinhart find that,

"A buildup in government debt has been a defining characteristic of the aftermath of banking crises for over a century, with government finances deteriorating to produce an average debt rise of 86 percent... Public debts in the advanced economies have surged in recent years to levels not recorded since the end of World War II, surpassing the heights reached during the First World War and the Great Depression. At the same time, private debt levels, particularly those of financial institutions and households, are in uncharted territory and are (in varying degrees) a contingent liability of the public sector in many countries. Historically, high leverage episodes have been associated with slower economic growth and a higher incidence of default or, more generally, restructuring of public and private debts."

Managing this twin challenge - maintaining economic growth while repaying the huge debts - will be the biggest macroeconomic question facing economists and policy-makers across many developed economies over this decade. What should be the government's policy responses to address this twin challenge? How much responsibility should governments shoulder in leading the depressed economies down the recovery path? What are the policy options that are likely to be effective? When should the government exit from their interventions?

Re-coupled global financial markets

Even as the emerging and developed economies appear to be de-coupling from each other, there is growing evidence that their financial markets are getting more closely synchronized. Have the global financial markets become too-interconnected to fail? Are financial markets no longer useful in risk diversification?

An recent study by HSBC draws attention to the growing correlation between different markets and asset classes - equities, bonds, forex instruments, commodities etc - since the onset of the sub-prime crisis. They argue that the financial markets have become entrapped into a binary state of "risk on-risk off" strategy - all the financial market segments have been swinging in unison, believing that either the future is bright ("risk on") or that it is bad ("risk off"). Risky assets move up or down together. They characterize the present market conditions thus,

"1. Risk on – risk off must be the foremost consideration in any trading activity today.
2. Financial markets, and in particular portfolios, are not as diversified as they once were. Risk takers may be holding more risk in their portfolios than they realise.
3. In current market conditions, there is little point trying to understand the nuances between different asset classes, or the relative value within asset classes. Commodities behave like bonds, which behave like equities. They are no longer easily identifiable, uncorrelated trades, which should be borne in mind when developing new trading strategies."

While synchronization of disparate markets and "risk on-risk off" strategy is a feature of financial markets in the immediate aftermath of a major financial crisis, it persistence for an extended period now is causing concern among market participants. It is argued that the depth of blow suffered to the economic confidence has been so massive that the markets are taking much longer to recover its normal features.

The HSBC researchers use heat maps to identify the changes in correlations between different categories of asset classes. The dark red indicates strong positive correlation while dark blue is strong negative correlation, while green and yellow represents weak (or uncorrelated) negative and positive correlations respectively. The heat map below represents the normal and generally uncorrelated markets in 2005-06. At this time, correlations were strong only between same types of assets and the large share of assets were uncorrelated.



However, with time, the correlations have strengthened and we now have a strongly correlated market landscape. Observe the more widely dispersed streaks of red - indicating much increased correlations across disparate asset categories.



These correlations are far from static and are evolving over time in response to various triggers that move the markets. The changes in the market can be tracked by observing the changes in this heat map. The HSBC report argues that when normalcy returns, relative valuations between aseet classes will make a comeback and asset allocation and diversification will return.