IN a previous column, I wrote on how ironically the sovereign-risk “shoe” is now on the other foot (“The Kiss of Debt”, Feb 27). Historically, sovereign-risk concerns reflected profligacy in emerging market economies - Russia, Argentina and Pakistan were notable examples. Today, the money printing machines in the United States, Euro-zone, UK and Japan are running overtime to assume the “crown.” We all know there is no such thing as a free lunch. This time, severe crisis took their toll on those with a history of high living and fiscal indiscretion, ignoring reforms in good times. What a difference a generation makes.
The contrast is provided by BRIICs (Brazil, Russia, India, Indonesia & China). A year ago, with their fiscal and financial houses in good order, BRIICs were busy stimulating their economies. Their main worry then was to push for a “fairer global economic order.”
But, one year on, their situation is ironic: they share 3 things - they are big and growing fast, they have inflation, and they have strengthening currencies thrust upon them. These days, their concerns are on rising commodity prices, overheating, asset bubbles and inflation.
Workers dry cocoa beans in Makassar, Indonesia's South Sulawesi province. Last year, cocoa prices were at a 30-year high. - ReutersNow more than ever, the Greek tragedy points to gathering risks in the global economic outlook. As of now, global recovery remains anaemic, uneven, and in need of policy support. It is as though the world is still dichotomised but with a big twist. In developed economies, recovery is there but growth remains modest with high unemployment and large fiscal deficits. Having been at the epicentre, sluggish growth in the US can gather strength, but Europe will now come out of recession more slowly.
Of concern is excess global liquidity which will now grow even more, lifting commodity prices, bloating risky assets, and adding to inflationary pressure. Worse, scars of battered consumers remain in the face of strained and stressed fiscal dilemmas.
In emerging economies, especially BRIICs, the picture is amazingly different. Most are in a V-shaped recovery and many approaching normalcy. Asia ex-Japan is slated to grow 8% this year and prospects are for good times to continue. Despite it all, they have recovered with impressive speed.
China persisted and grew by 8.7% in 2009 (13% in '07); and by the 1Q'10, growth was already back up to 11.9%, prompting concerns of over-heating. India - the more self-contained of the lot, managed 7.2% in '09 and should comfortably clear 8% this year. As a result, inflation is gathering strength in many parts of Asia ex-Japan and in other BRIICs. Inflation in India is already up 10%; China, 3%; Brazil, 10%; Russia, 8%; Indonesia, 4%. Asset prices have also surged, earning the attention of policymakers especially in China and India. China would do well to keep inflation no higher than 5% in '10, and India, less than 8%.
Yet, in the lead-up to recession, emerging economies were already becoming increasingly hitched up to the US and European “shopping cart.” Asia's exports share of output rose to 47% (from 37%) over 10 years pre-crisis. This shows their growing dependence on external demand, not less. When much of this demand disappeared overnight at end '08, it didn't take Asia too long to be back exporting again. So much for decoupling. But this time, Asia found options.
Commodity exporters like Brazil, Indonesia, Russia & Australia, and commodity-importers, China, Japan, Europe and South Korea, found opportunities to reinforce one another. Such feed-back loops built greater interdependence. It seems Asia was only unruffled - not shaken, just stirred.
Commodities
Commodities posted in 2009 the biggest annual gains in four decades, led by doubling in copper, sugar and lead prices. Oil prices gained 78%. The S&P Index of 24 raw materials rose 50% in 2009, the highest since at least 1971. Many attribute this rapid price rise to the “super-cycle”, fanned by abundant global liquidity & strong demand from China and India in the face of 20 years of under-investment in raw materials production. The weak US dollar also played a part. Good times ended abruptly with the financial crisis. But the conundrum became more complicated when prices rebounded strongly, lifted by higher production costs and strong economic growth in BRIICs.
Prices of food commodities were also higher. According to experts, the food crisis has moved, from lunch and dinner to breakfast. Among the “breakfast commodities” only milk prices remained low. Last year saw tea prices at all time high; cocoa at 30-year high; sugar, 29-year high; coffee, near 11-year high; and orange juice, highest in 18 months. Sharp increases in these “soft commodity” prices contrast with relatively depressed prices for most agricultural commodities, including wheat, rice, soyabean and corn. Price divergences reflected fundamentals at play. Supply disruptions, not demand, were driving the rally. But longer term, food prices are on a rising trend, driven by compelling fundamentals: years of under-investment because of low prices prior to early 2000s; structural rise in demand because increased population demanded a diet richer in meat; and onslaught of biofuels.
With economic recovery, high food prices are here to stay. Unlike oil and base metals, supply response of agricultural commodities to high prices is speedy: farmers react each planting season. Farmers say there is no better fertiliser than high prices. In 2008, farmers prompt response was aided by good weather; consequently wheat, corn and soyabean output expanded and prices halved!
Until May this year, the Economist's overall commodity price index was up 22%, with food prices staying quite flat. Industrial commodities had risen 61%, non-food agriculture, 74%, and metals, 56%. The Greece crisis temporarily halted the rising trend. Experts say that over the next 18 months, commodity prices will resume rising with economic recovery, lots of cheap money, and rapid BRIIC growth. Like it or not, high commodity prices will persist.
Asset bubbles
In emerging countries, there is growing concern about too much liquidity (domestic and global) driving asset prices, which can lead to bubbles and inflation. So much so Brazil and Taiwan introduced capital controls to better manage capital inflows. The International Monetary Fund (IMF) had since concluded advanced countries may be responsible for creating bubbles in stock markets in emerging nations: its studies found (i) a positive link between domestic liquidity (money) and stock values; and (ii) an even stronger relationship between stock values and global liquidity (hot money). There is also a strong link between liquidity (money) and house prices in all countries. However, role of foreign money inflows doesn't appear significant. Hot money has little to do with China's frothy property market; it's homemade, it seems.
As someone who knows the going-ons in China, my friend Prof Fan Gang (National Economic Research Institute, Beijing) expressed concern about rising commodity prices and food supply disruptions, even though he views the inflation outlook with limited immediate risk. Consumer prices rose 2.2% in 1Q'10 and 2.8% in April. But real estate prices are more worrisome - land prices more than doubled in 2009 and property prices, up 12.8% in April 2010. China's massive stimulus plus explosive credit expansion resulted in a 31% rise in money supply in April. Even so, liquidity conditions are expected to remain easy. Simply because balance sheets of consumers and enterprises remain healthy, with prudent leverage, even though more savings have moved into real estate. Most observers regard properties as not yet bubbly.
Even so, Chinese authorities raised banks' reserve requirements (ratio of deposits kept at central bank) three times to moderate bank lending. Also, directives were issued to calm markets, including prohibiting developers from accepting deposits on uncompleted properties. China is not alone in this. Countries like Canada, Australia, India and Singapore have similar concerns. In emerging economies, central banks readily use non-traditional “macro-prudential tools” to do the job, including credit allocation, arm-twisting (moral suasion), and favouring some with credit and discriminating against others. There is no shortage of ideas to fix property bubbles.
Inflation and the quantity theory of money
Over the past 30 months, the global economy has been subject to two major shocks: (i) the build-up of enormous unutilised capacity. Global output had fallen by 5%-6% since 2008. As expected, inflation in developed nations fell from about 4% in '08 to less than 1% in '09. It has since started to act up with rises in commodity prices. IMF still thinks global inflation will remain low in '10. (ii) But, the crisis also injected enormous amounts of low-cost liquidity (money) into the global system. Fiscal stimuli and quantitative easing (printing money) in the United States, Europe, Japan, China and India together pumped-in liquidity estimated at 4%-5% of global GDP. Isn't all this money inflationary?
Many are familiar with the Quantity Theory of Money (QTM) - this principle states simply that the general price level will rise in proportion to the increase in supply of money (i.e. cash and bank deposits in private hands). So if money supply rose by (say) 5% last year, inflation is likely to increase by about 5% this year (i.e. with a lag). But Lord Skidelsky (a noted Keynes biographer) reminds us that QTM only works at full employment. If there is unutilised productive capacity, part of the rise in money supply is absorbed to produce new goods and services, instead of spending on existing output. That is non-inflationary.
Furthermore, flooding the economy with lots of central bank money does not necessarily mean private deposits (generated from spending or bank lending) will rise by the same proportion. Japan in the 1990s had lots of money pumped into the economy; yet, money supply rose by only 7%-8%. Hence, the lost decade of no growth and no inflation (even deflation). We see similar trends in recent experience with quantitative easing in the United States and Europe.
The lesson is clear: what matters is not the printing of money but spending it. Once spent, the bundle of paper money is activated to produce goods and services. Any central bank can create money but it can't ensure money will be spent or loan-out. Private money locked up in banks doesn't increase the needed money supply; new money simply replaces the old sterilised by recession. So, pump priming should be allowed sufficient time to work through the real economy; first, to use up existing capacity (hence, little or no inflation) and then, build new capacity to propel new growth. That is why any premature exit of fiscal stimuli just damages the recovery process.
We already see results of successful money creation in BRIICs and many others. Asymmetrical recovery demonstrated that, away from the epicentre, emerging economies were able to translate money they print into money spent. At this stage of the growth cycle, presence of significant output gaps means there is little pressure on resources, since firms can readily raise output and look to higher volumes instead of prices. Rising Asia is experiencing the “sweet spot” of the cycle as output and profits rise, while inflation remains under wrap.
As recovery proceeds, monetary policy needs to tighten, removing loose policy settings put into place during recession. Rising interest rates should not constrain the performance of risk assets driven in an improving economy. As I see it, risk of policy error tends to be “too little too late,” erring on the side of policy that is too loose for fear of choking off recovery prematurely, or unsettling markets (and vested interests) ill equipped to handle change.
WHAT ARE WE TO DO
BY TAN SRI LIN SEE-YAN
>Former banker Dr Lin is a Harvard educated economist and a British chartered scientist who now spends time writing, teaching & promoting the public interest. Feedback is most welcome; email: starbizweek@thestar.com.my.
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