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Lecture 5

ECON 203 Lecture 5: The world economy

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ECON 203

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The world economy Pulled back in The world is entering a third stage of a rolling debt crisis, this time centred on emerging markets Nov 14th 2015 | From the print edition   BY THE time the third film in a franchise comes around, it is not just audiences that may be getting restive; the characters themselves have been known to complain. It is his inability to put the sins of screenplays past behind him that gives Al Pacino’s Michael Corleone the most memorable line in “The Godfather: Part III”: “Just when I thought I was out, they pull me back in!” As with anti-heroes in sequels, so with the world’s debt crisis; seeming conclusions serve only to set the narrative off in new directions. Householders in America have struggled for years to work off the excess borrowing taken on during a global housing boom in the 2000s. The economy has suffered from a shortfall of spending as a consequence. The world economy was dealt a second blow, after 2010, when the delayed effects of that earlier boom were played out in a debt crisis at the fringes of the euro area, one that at several points threatened to break up the currency union. Related topics  Economic development  Federal Reserve (United States)  Brazil  International Monetary Fund (IMF)  India America has put that crisis behind it. Consumer spending is rising at a healthy 3% or so. Nominal wages are beginning to edge up in response to a tighter labour market, leaving the Federal Reserve poised to increase interest rates for the first time since 2006 (seearticl). And household debt looks as if it is bottoming out. Much the same is happening in Britain, which suffered a boom and hangover quite like America’s (see chart 1). Europe was slower in dealing with its debt and always tends to lag behind America and Britain in its economic cycle. Nevertheless it is having its best year of growth since 2011. It is for these reasons, among others, that the IMF is predicting that world GDP will pick up to 3.6% next year; not the sort of growth seen in the early 2000s, or when emerging markets were booming after the financial crisis, but not too shabby, considering the slowdown in the developing world that started a few years ago. Yet just as the rich world seems to be getting shot of its dodgy legacy of indebtedness, it risks being dragged back into the mire by a third leg of the debt crisis. The debt that built up in emerging markets after the American bust is still there. It has continued to grow even as the economies have slowed, and now overhangs them ominously. In the past, the rich world had the muscle to shake off such problems elsewhere. But emerging markets now make up most of the world economy (around 58% if exchange rates are measured at purchasing-power parity). They are quite capable of weighing down rich-world recoveries—especially if, as in Europe, they are already fragile ones. Taking full account of the effects of emerging-market debt makes the world economy look far less secure. The burdens of past opportunities The build-up of emerging-market credit began just as the rich world’s financial system started to creak in 2007. According to figures collated by J.P. Morgan, a bank, private-sector debt in emerging markets rose from 73% of GDP at the end of 2007 to 107% of GDP by the end of last year. These figures include loans made by banks and bonds issued by companies. Including the credit extended by non-bank financial institutions (so-called “shadow banks”) for the handful of emerging markets where such estimates are available gives a steeper rise and a higher total burden: 127% of GDP. The credit boom in emerging markets was in large part a response to the credit bust in the rich world. Fearing a depression in its richest export markets, the authorities in China brought about a massive increase in credit in 2009. Meanwhile a flood of capital escaping the paltry yields on offer in developed economies pushed interest rates lower in developing ones. This search for yield by rich- world investors took them to ever more exotic places. A dollar-denominated government bond issued in 2012 by Zambia, a copper-rich country with an average GDP per person of $1,700 a year, offered just 5.4% interest; even so, it was 24 times oversubscribed as rich-world investors clamoured to buy. The following year a state-backed tuna-fishing venture in Mozambique, a country even poorer than Zambia, was able to raise $850m at an interest rate of 8.5%. In contrast to the credit booms in America and Europe, where households were the main borrowers, three-quarters of the private debt burden in emerging markets is shouldered by businesses: corporate debt has ballooned from less than 50% of GDP in 2008 to almost 75% by 2014. Much of the lending was done in Asia, notably in China. But Turkey, Brazil and Chile also saw substantial increases in the ratio of company debt to GDP (see chart 2). Construction firms (notably in China and Latin America) increased their leverage a great deal. The oil and gas industry was a big player, too, according to the IMF’s latest Global Financial Stability Report. Growing debt in emerging markets is not of itself something to worry about. It may be that savings are getting into local capital markets more effectively or that there are more, better investment opportunities. Sadly, those happy possibilities do not seem to account for what is now going on. While corporate leverage in emerging markets has been going up, corporate profitability there has fallen, says the IMF. There is plenty of evidence to suggest that rapid debt build-ups are the hallmarks of periods of indiscriminate lending that eventually end in tears. David Mackie, of J.P. Morgan, has analysed 52 episodes in which the ratio of private debt to GDP increased by at least 20 percentage points over five years. He found that annual GDP growth falls by almost three percentage points in the three years after the debt ratio peaks. The impact is less severe in countries where the peak is not marked by a crisis of some sort. His finding is backed up by academic research. A paper by Alan Taylor and Oscar Jorda, of the University of California, Davis, and Moritz Schularick, of the Free University of Berlin, shows that in the rich world recessions preceded by unusually rapid bank-credit growth are followed by weaker recoveries. Looking at the way credit moves up and down as a proportion of GDP, they found that larger increases in credit on the upswing were correlated with deeper recessions and slower recoveries. Indeed, credit booms are among the most reliable signals that trouble is brewing. Research by Pierre-Olivier Gourinchas of the University of California, Berkeley, and Maurice Obstfeld, now the IMF’s chief economist, finds that credit booms have been one of the two best predictors of crises in emerging markets (the other is a rapidly appreciating real exchange rate). Increasing the credit-to- GDP ratio by nine percentage points is associated with higher probabilities of various misfortunes. In the subsequent three years the probability of a sovereign-debt default goes up by 11.5%, that of a currency crisis increases by 9.4% and that of a banking crisis by 6.4%. Taken together, such studies of the aftermath of credit booms strongly suggest that growth in emerging markets will be much slower than it was in the early 2000s and the early 2010s. With recessions already under way in Brazil and Russia, this should temper any expectations that growth in emerging markets as a whole is going to buoy up the rest of the world. There are reasons not to overdo the gloom. Evidence suggests that corporate-lending splurges, which account for most of what is being seen in emerging markets, are less damaging than big build- ups in consumer debt of the sort seen in America in the 2000s. A paper by Boris Cournède and Oliver Denk of the OECD, a think-tank, finds that corporate-debt booms are only half as damaging to subsequent growth in GDP per person as soaring consumer debt. Research from Atif Mian and Emil Verner of Princeton University and Amir Sufi of the University of Chicago Booth School of Business also suggests, albeit tentatively, that the link between rising debt and falling GDP growth is weaker where lending is to companies and not households. Declines in house prices might make busts in mortgage lending more damaging than corporate-debt crashes, because they depress the wealth of all consumers, and not just the indebted. Broader changes in the world economy militate against a repeat of famous emerging-market blow- ups at the end of the 20th century, such as Mexico’s “tequila crisis” in 1994 or the Asian financial crisis of the late 1990s. In the past rich-world banks lent to poorer countries in dollars. That meant that when things went pear-shaped wilting local currencies made debt burdens even larger. This time, though, much of the flood of capital has gone into
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