As many commentators have outlined, there is currently a very high level of liquidity in the world economy, with risk premiums for emerging market bonds at low levels and high foreign investment in many countries. This can’t last, and serious fissures will open up when it changes.
Since 1995 the United States has been increasing money supply at a rapid rate, and enjoying a period of low interest rates and high stock prices. At the same time, it has been running a balance of payments deficit that in recent years has reached record levels both in absolute terms and in terms of the size of the U.S. economy. By this means, much of the liquidity that would have fueled inflation in the United States has been exported. Currently, around $750 billion per annum flows out of the United States, to fuel economic expansion, risky investment and inflation in the rest of the world – thus the United States has avoided much of the inflationary pressure that it would otherwise have felt, while the world as a whole has enjoyed strong economic conditions on the back of ample liquidity.
These very liquid conditions cannot last forever; indeed it is likely that they will not last long into 2006. U.S. short term interest rates are being steadily increased, and the apparent strength in the U.S. economy, combined with the modest resurgence in U.S. inflation, will insure that the increases are forced to continue. Once short term U.S. interest rates exceed long term rates, it is likely that the long Treasury bond market will be subject to waves of selling, as speculators unwind their positions.
This will have a knock-on effect worldwide. The U.S. trade deficit will diminish (probably accompanied by a sharp drop in the value of the dollar) and the flow of liquidity from the United States to the rest of the world will correspondingly dry up. While certain other countries, notably Britain and Japan, have central banks currently pursuing an easing monetary policy, it is unlikely that sufficient further easing will take place to absorb the slack (indeed, in both countries the next central bank move may well be to tighten.) Thus tighter money worldwide is inevitable; it’s simply a question of how much tighter and when.
In Latin America, we have not seen a significant debt crisis since Argentina’s collapse in December 2001, in spite of the large budget deficits, high debt levels and shaky public finances of most of the region. Indeed, so strong has been the demand for emerging market bonds that Argentina, after forcing international creditors to write off around 70 percent of their investment at the beginning of the year, was able to come back to the international debt markets in mid July, offering a $500 million issue of 7 year bonds. Thus no market penalty has been exacted for Argentina’s default. This is as far as I know a first; an appalling precedent that will make emerging market bonds a very shaky asset class indeed once world liquidity returns to normal levels.
Other Latin American borrowers are currently separated into two classes, oil and natural resource exporters, such as Venezuela and to a lesser extent Chile and Mexico, which are currently enjoying a boom on the back of high oil and metals prices, and the non-oil exporting countries such as Brazil and Argentina itself, which remain in some difficulty. For both these two classes, tightening liquidity represents a threat, because of their high levels of indebtedness and sloppy public finances, but their relative fate depends on the future path of oil and commodity prices.
In a world of tighter liquidity and at least moderate recession, one would normally expect that the price of oil and other commodities would drop. However, this did not happen in the period of rising real interest rates in the 1970s, and there seems good reason to suppose that it would not happen again. China and India, with huge populations, are likely to continue their emergence into the world economy, even if their rate of emergence slows. Since neither country is self-sufficient in oil, oil markets are likely to remain under strain and the price to remain high, or even increase in dollar terms as the dollar declines.
In that case, Venezuela, and to a lesser extent Mexico and Chile will be sheltered from the effects of tighter liquidity by high oil and commodity prices. However, Venezuela is currently demonstrating that such a windfall, far from benefiting economic development, is likely in Latin America to be used for two purposes: enriching the local nomenklatura and pursuing military aggrandizement and an anti-American foreign policy. This is less true under the current Mexican government; it seems almost certain to become true in Mexico also should the left’s candidate Manuel Lopez Obrador win next year’s presidential election.
Meanwhile, non oil exporters in the region such as Brazil and Argentina will find it impossible to continue expanding and rolling over their debts, and so will enter yet another default cycle. It is unlikely in a world of tighter liquidity that the international bond markets will again be so forgiving of default, so the succeeding decade for Latin America will be like the 1980s, a period of zero economic growth, political instability and mass impoverishment.
China and India are the big questions. Neither country has large international debts so tightening world liquidity will not affect them much directly. However, both countries have a serious domestic debt problem. In China, the state owned banks have been used to subsidize state owned industries, thereby accumulating close to $1 trillion of bad debts. The last couple of years, when speculative building projects have been springing up all over urban China, have exacerbated the problem.
If China simply hopes the problem will go away, the domestic banking system will eventually run out of money, which would cause hyperinflation and a collapse in confidence. Alternatively, since China currently has relatively small international debts, it could borrow much of the money needed to recapitalize the banking system – say $100 billion per annum for 5 years – from the international markets. This would largely solve China’s problem, at the cost of worsening the liquidity problem for everyone else. No doubt the current Chinese government wouldn’t care much about that.
India’s problem is less well recognized, but may be more serious. The country consistently runs a large budget deficit, of close to 10 percent of Gross Domestic Product. This is financed domestically, and in a period of rapid economic growth has proved only a moderate constraint on capital formation and the expansion of Indian business. Under Atal Bihari Vajpayee’s government, the budget deficit was being slowly reduced, and the problem seemed under control. However the unexpected victory of a Congress Party-led coalition in May 2004 puts this relative success, and the future growth of the Indian economy, seriously into question. While prime minister Manmohan Singh and his economic team are committed to private sector growth in India, and to a sound budgetary policy, Congress is dependent for its majority on left wing elements such as the local Communist party (which is in reality no more than leftist social democrat) and the Manmohan government has committed to sharp increases in rural subsidies. Further, a number of regional parties, also part of the Congress coalition, are sinks of corruption, existing largely to increase public spending as far as possible and deploy it in personally profitable or politically attractive ways.
The resulting pressure on the Indian budget is fairly easily financeable in the current high liquidity world, since India has little private sector foreign debt. In a world of lower liquidity, India’s ability to finance sharply increased budget deficits must be seriously in question. Any resulting pressure on the Indian domestic capital market will quickly affect the country’s private sector, hence its economic growth, and hence will make the public sector deficit problem itself worse.
The solution is for India to elect a government fully committed to economic reform and to the elimination of rural subsidies and uneconomic state industries. That cannot happen before 2009, and is quite unlikely to happen then.
Elsewhere in Asia, the emerging market countries that suffered through the shock of 1997-98 are likely to be relatively unaffected by tightening liquidity this time around, because they have got their trading and fiscal houses in order. Indonesia and the Philippines are exceptions, but in Indonesia’s case the country is oil rich, and likely to continue benefiting from high oil prices. Only the Philippines is therefore likely to suffer severely from a tight credit market. Given the unstable and inept nature of Philippine governments, this could however result in serious problems, possibly involving resurgent Moslem terrorism.
In Europe, a tightening in world credit conditions is likely to have most effect on countries such as Spain, Ireland and Britain that have enjoyed an easy money-fueled real estate boom. Britain is most likely to suffer badly, because it is already running an unsustainable public sector deficit, and has a government uncommitted to spending restraint. It is likely that the next few years will see a sharp increase in British taxes, followed by a crisis similar to that of 1976, as the country’s budget deficit and balance of payments deficit call its entire economic position into question. Real estate, particularly in the South East, will go into severe decline, very good news for all save the most overextended homeowners.
In this context, the Bank of England’s reduction in interest rates by ¼ percent last week was ill-advised – it is likely to re-inflate the damaging housing bubble and increase consumer spending at a time when inflation is a risk and belts must be tightened. The British public will pay for it later, probably many times over.
If politicians, stock analysts and most of the media are to be believed, there are no beneficiaries of tighter money. If their policy prescriptions are followed, monetary policy is always inflationist – thus the high current reputation of Federal Reserve Chairman Alan Greenspan. In reality, there are always beneficiaries of tight money, although in the current situation, when easy money has persisted worldwide for so long, there are few of them. Two countries in particular stand out as beneficiaries: Japan and Germany.
Germany has not enjoyed a housing boom in the last few years, because German mortgage finance is provided on a much more conservative basis than in Britain and the United States, with downpayments of a minimum of 25 percent of principal amount. Further, its stock market bubble burst in 2000, and was in any case relatively smaller than the bubble in the United States. Monetary policy since the adoption of the Euro has been tighter in Germany than in other parts of the Eurozone because German inflation rates have been lower. Hence tight money will have little negative impact in Germany in the short term. In the long term, it will make Germany’s pension and old age obligations easier to finance from current savings, and reduce the country’s current demographic burden.
Japan’s real estate bubble burst in 1990, and the country has suffered through 15 years of real estate deflation since then. A world liquidity crunch will tend to drive money towards Japan because of its lack of a real estate overhang and relatively sound economic position. As in Germany, higher interest rates will also be helpful in surmounting Japan’s demographic problem from its old age obligations. The only downside for Japan is its very high public debt, currently close to 150 percent of Gross Domestic product. However, the careful administration of prime minister Junichiro Koizumi has made good progress in reducing excessive infrastructure spending, so Japan’s budget position is on an improving trend. Further, Japan’s high level of savings will produce higher investment income (and taxes thereon) as interest rates rise, thus further stabilizing Japan’s fiscal position.
For most of the world, the coming period of tight money will be a wrenching experience. Let us hope that the pain to come will have a searing effect on the world’s policymakers, so that never again will the world’s monetary system be managed in such an irresponsible manner as in the last decade.
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
This article originally appeared on United Press International.