Showing posts with label IMF. Show all posts
Showing posts with label IMF. Show all posts

Thursday, July 9, 2015

Global Financial Crisis, Contagion and Grexit



Introduction

    The worst Global crisis since the “Great depression”, hit the World in 2008.  The “Great recession” triggered by the Global Financial crisis(GFS) fundamentally changed the external environment, while the Euro countries continued to believe that the World was undergoing just another cycle like the dozens they had seen & dealt with in the post-war period. Thus in our view (as ED IMF 2010-12), their economic approach and solution to the fiscal problem, of putting overwhelming emphasis on austerity was fundamentally flawed and highly likely to fail in the absence of a quick return of the World economy to high growth and moderate inflation. A speedy return to higher growth, was however, made impossible by the flawed emphasis of the governments/politicians of the Euro Area, UK and the US on hard & immediate fiscal squeeze on their own economies, thus reducing global demand and exacerbating the global excess capacity in tradable goods and services. On the supply side China, continued to create new capacity in manufacturing by pumping credit into the economy, offsetting the natural process of depreciation and obsolescence that would have gradually reduced total capacity.

Greece Loan

  A number of High Income European Countries including Greece, were among the worst affected by the GFS & associated recession.  The IMF changed its rules, to make loans to Greece that were > 10 times the ratio limits applicable to loans made to developing countries during the previous 50 years. The only argument for making such an exception was to minimize the risk of contagion to other vulnerable European countries such as Portugal, Ireland and Spain. An IMF ED(a professional economist) pointed to the flaw in the economic analysis and projections underlying the Greek loan:  “The scale of fiscal reduction without any monetary policy offset is unprecedented… (It) is a mammoth burden that the economy could hardly bear.  Even if, arguably, the program is successfully implemented, it could trigger a deflationary spiral of falling prices, falling employment, and falling fiscal revenues that could eventually undermine the program itself.  In this context, it is also necessary to ask if the magnitude of adjustment…is building in risk of program failure and consequent payment standstill… There is concern that default/restructuring is inevitable.”[i]

Austerity or Fiscal Reform

   Our experience of the Asian & Latin American crises, had taught us that that the domestic private and international sovereign debt overhang had to be dealt with quickly and effectively, to stave of a “Balance sheet recession” and give the economy a chance to recover.  Further, that growth recovery depended critically on offsetting required Govt. expenditure compression (austerity) by expenditure switching (real depreciation and/or monetary easing). Clearly both the global demand situation and domestic supply side had to be conducive to produce a sustained increase in net exports and investment to stimulate and sustain growth.  In the absence of exchange rate flexibility in Greece (PIIGS), austerity could only work by reducing the real wage rate. Given the deflationary post crisis situation, austerity would reduce not just the nominal wage rate(w) but also the price level(p) thus having (at best) a small effect on the real wage rate(w/p). We concluded that restoration of Greek competitiveness within the euro zone would require a level of austerity that was socially and politically infeasible.   We therefore argued that in Greece(& contagion candidates) the focus should be on fundamental fiscal (tax and expenditure) reform, which would put it on a sustainable fiscal path through a gradual reduction in expenditures and increase in tax ratios, which follow from such reform(e.g. of Pensions). Instead of an immediate reduction of government expenditures, the focus should be on limiting and reducing the growth of expenditures, perhaps in some cases to zero and not on cutting everything drastically. The overemphasis of the Trioka on “austerity” distracted attention from more fundamental fiscal reforms that still remain unimplemented by Greece.

Lender of Last Resort

    There were three other issues critical to success of Greek macro adjustment.  The immediate problem for Greece and other Euro zone countries in danger of contagion was the absence of a normal Central Bank or lender of last resort. The European Central Bank was hemmed in by rules and constraints that kept it from acting like a normal Central Bank (FRB, USA; BOE, UK; RBI, India). We argued that contagion couldn’t be stopped unless the ECB got complete freedom to lend to illiquid but solvent Euro area Banks and financial institutions (Virmani(2011)[ii]  This problem was gradually solved after the appointment of Mario Draghi as the Head of the ECB in November 2011 and the risks of contagion have been largely eliminated due to ECB empowerment and tightened financial regulation. However, subsequent to the No vote in the Greek referendum, the ECB has raised the collateral requirements for providing liquidity support to Greek Banks. Greece is therefore effectively without a Central bank to fulfill the lender of last resort function for its Banks and payment system. If this support is not restored, Greece has no option but to reintroduce its own currency (Drachma) and Central Bank.
    The introduction of currency has two parts: Bank deposits(financial deposits), which can be converted instantaneously into Drachma, and by letting the market set a Drachma-Euro exchange rate. If a one to one conversion is done and the market exchange rate is 1.3 Drachamas to the Euro, say, then the implicit haircut on all deposits is 30%. The second part is for the Greek Central bank to get Drachmas printed and then offer to exchange Euro cash held by the public for cash in Drachmas, at the market exchange rate. To minimize disruption, the Euro would continue to be legal tender in Greece, but all  prices would have (gradually) to be specified in Drachmas.

Debt Sustainability

     The second important problem was Greece’s Sovereign debt.  It was very clear to us in 2010, that Greek debt was unsustainably high i.e. there was no credible time path of nominal GDP growth that would result in a sustained & continuing decline in the Debt-GDP ratio (Virmani (2011) op cit). Without a substantial debt restructuring, resulting in an effective reduction in the present value of outstanding debt, any delay in debt reduction/restructuring would worsen the debt problem. Thus we argued that IMF, Euro and other sovereign loans would merely result in repayment to private lenders and a substitution of private by public debt.  Those who facilitated Greek government profligacy would get away without bearing the consequence of their bad decision or sharing in the pain of adjustment. This is precisely what happened.  The debt crisis reappeared as predicted and a partial debt write-off occurred in 2012, with a Trioka mediated agreement between private lenders and the Greek government.  It was too little too late. The Debt-GDP ratio moved back to its earlier peak, triggering the loan default to the IMF and the latest crisis of 2015.  Any agreement that does not reduce the present value of Greek debt, will constitute another postponement of the inevitable (i.e kicking the can down the road).

Structural Reform.

   Finally there was and still is the problem of broader economic reforms to improve the competitiveness of the Greek economy.   It is often alleged that the Greek economy is riddled with monopolies and oligopolies. The policy & regulatory structures that encourage monopolies and oligopolies must be reformed urgently to encourage new entrants and promote competition in product markets. This includes privatization of State owned companies.  Labor reforms, including anti-work incentives in the pension rules must be modified to make labor markets more flexible. Whether Greece remains in the Euro or leaves it, fiscal and economic reforms will be essential for restoring economic growth.[iii]

Effect on India

        The Greek crises, being a mixture of economic and political factors (dozen Euro countries) has created great uncertainty in the investing community. This uncertainty affects most of the World including India, and is likely to continue for the duration of the crisis. Normally such financial uncertainty leads to heightened liquidity needs in Europe, the sale of Indian equity and an outflow of capital and exchange rate depreciation. This time there is an offsetting factor.  If the crises slowed EU recovery, as is likely, the expected outflow of capital from India to the EU could be inverted. Thus as I predicted a week ago, India could have a rise in equity markets cum capital inflow on one day and the opposite another day, for the duration of the Greek crisis.[iv]
        From a medium term perspective, the conventional Wisdom is that the Greek economy is too small a part of the Euro area, the EU and the World to have any effect on the economy.  In my contrarian view the Greek crisis, is likely to slow Euro recovery and thus affect India’s exports to it.[v]  Further a setback to EU recovery would also affect its exchange rate with USA and other countries. This could be a factor in the US FRB’s decision on the QE program in September. If Euro growth slows sharply, leading to capital inflow into US and USD appreciation (indicating a natural tightening of monetary policy) the FED could effectively moderate the anticipated rise in interest rates. This would offset any negative effects on Indian exports and growth from the Euro slowdown.
   The main long term lesson of Greek crisis for India is to eliminate its revenue and fiscal deficit and thus eliminate the major policy driver of the increase in net external indebtedness. Cyclically adjusted revenue deficit should be reduced to zero by 2020 and the cyclically adjusted fiscal deficit should be reduced to zero by 2025.


Conclusion

  For a permanent solution of the Greek crisis there are five things that have to be set right simultaneously: (1) Structural reforms of markets to improve the competitiveness of the Greek economy, (2) Fiscal reforms: Including revenue neutral tax reforms that lead to an improvement in the tax GDP ratio over time and expenditure reforms that increase the ratio of investments to transfers and reduce expenditure-GDP ratios over time. (3) A debt reduction that puts debt-Gdp ratios on a sustained downward path given realistic projections of nominal GDP (4) Austerity light: A let up by moralists on imposition of pain on the Greek people, which will actually reduce nominal GDP growth and raise GDP ratio back to higher levels.  (5) Complete liquidity backup of Greek banks by the ECB (ie monetary policy).
     Creditors are right to insist on (1) and (2), as Greece cannot revive within or outside the Euro area without them. Creditors are wrong to oppose (3) and (4) as without them the Euro crisis will be back within the next three years.  Without (5) Grexit is effectively already here, as the banking and payments system cannot survive without a central bank to provide liquidity.

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A shorter version of this article appeared on the editorial page of the Indian Express on Thursday July 9, 2015 under the banner, “Trojan Loans,” http://indianexpress.com/article/opinion/columns/trojan-loans/


[ii] Arvind Virmani, “Averting A Euro Meltdown: Sharing Global Responsibility,” December,  2011 https://docs.google.com/viewer?a=v&pid=sites&srcid=ZGVmYXVsdGRvbWFpbnxkcmFydmluZHZpcm1hbml8Z3g6MjE0NmYyY2U2N2YxMDg
[iii] Interestingly many of these reforms are similar to or parallel those suggested for India in the 1990s.
[iv] DD News,Mark Lynn, 10 pm Monday June 29th & TV Today, Karan Thapar, 30th June 2015.
[v] Op cit

Wednesday, April 29, 2015

India-China Growth Reversal & GDP Gap



Introduction

      The long anticipated deceleration in rate of the growth of China’s economy is under way. Even normally conservative World Bank and IMF, are confirming that China’s growth is slowing down and is likely to fall below 7%.  Even those analysts who had forecast a deceleration in China’s growth were unsure about when exactly the slowdown would start. The author had estimated in the 2000s that China’s growth would decelerate below 8 per cent, around the middle of the decade starting 2010.  The global financial crisis of 2008 sharply raised the probability that the slow down would occur within the following decade, despite risky efforts by China to prop up growth.

      In contrast India was forecast to achieve its potential growth rate of about 8 per cent, given its Export-import neutral growth model. The surprise in India’s case was the sharp slowdown from 2011-12, largely attributed to complacency and domestic policy mistakes. Despite these mistakes, however, India’s growth rate from 2002-03 to 2013-14 was among the ten highest in the world (using the old data series).  Though, the correction of these mistakes, may no longer be enough to restore growth to earlier levels, India can and must restore growth to the average rates achieved earlier. Again, this has been recognized by both the World Bank and the IMF.     These two developments taken together, imply that India trend growth rate is poised to  exceed that of China’s in the next few decades.

GDP Levels vs Growth rate

    This will start the long, slow process of closing the GDP gap with China, which was 1.4 times India’s real GDP in 2013.  There is a common tendency to confuse relative levels of GDP with growth rates, so it is important to understand that China’s real GDP, measured at Purchasing power parity in 2011 international dollars, is now 2.4 times that of India's GDP. China's GDP PPP was 1.1 times India's GDP PPP in 1990, with the two economies almost equal in size in the mid-1980s. During 1990 to 2013, China's growth averaged 9.9% per year, 3.4% points faster than India’s average GDP growth rate of 6.5%.  Even if the growth differential was inverted and China's GDP henceforth grows an average 3.4% points slower than India's GDP (say 5% - 8.4% = -3.4%),  it would take 30 years to eliminate the GDP gap, about the time it took to open it.

Previous Growth Forecasts

    The basic theory and empirics of growth, show that fast growing economies like Japan, S Korea, Singapore and Thailand, which grew fast when they were at low or middle income levels of per capita GDP, maintained growth at high levels for one to two decades and then slowed down as their per Capita GDP approached that of the (lower end) of the High Income economies.  The surprise in the case of China was that it maintained an average growth of almost 10% for thirty years, despite reaching middle income levels of per capita GDP about a decade ago.  Many analysts, whose predictions about China's growth slowdown had been proved wrong in the 1990s, became much more cautious thereafter. Those of us who were willing to take a reputational risk, have been proved right, as China’s economy slowed below 8% in 2012 and is now projected to slow below 7% by the multilateral institutions.
    The global financial crisis ensured that growth of World trade would slow sharply below the very high growth seen in the previous decade, aided by a correction of the bubble like growth seen just prior to the crisis.  This meant that China’s (net) export-investment model was no longer sustainable and would produce slower growth in the 2010s.  To delay this slowdown China pumped large amounts of credit into the economy, with the official Debt-Gdp ratio rising from 55.2% of GDP in 2008 to 88.1% in 2013, an average increase of 6.6% points of GDP per year. Analysts have estimated that the debt in the shadow banking system may have increased by an equivalent amount, with total debt rising to dangerously risky levels.  Based on historical experience of such debt bubbles, some analysts predict that this bubble is now likely to burst and reduce China’s growth rate to the 3% to 4% range. Analysts who have greater confidence in the ability of the Chinese Communist party to manage economic crisis, nevertheless predict a deceleration of the trend rate of growth to a range of 6% to 7%. A safe intermediate prediction is a gradual growth slow down to 5 to 6 per cent rate over the next 10 years.

Comparative Growth

   Based on World Bank, World Development Indicators data till 2013 (till which year India's GDP base 2004-5 was fully available), we can examine and compare the growth rates of China & India. A plot of these rates shows that the growth rate difference has been narrowing since 1990, due to a gradual deceleration of China and a stronger acceleration of India. Underlying this narrowing growth difference are variables that are drivers of or correlated with, GDP growth and productivity. These include FDI and exports, which are indicators of competitiveness and Imports which reflect openness.
     The difference between China and India’s FDI-GDP ratio has been on a declining trend, from about 3.5% of GDP in 1990 to a little over 2% of GDP in 2013. Underlying this is slow but steady progress in attracting technology and risk capital to India, with a milder decline in China’s attractiveness. China’s Export GDP ratio which was 8 per cent points higher than India’s in 1990, rose 10% points to an average of 18% during 2005 to 2007. It then narrowed rapidly to about 1% in 2013, indicating that India’s exports have held up to the global decline in world trade since 2008, much more effectively than China’s. The difference between China and India’s Import-GDP, which fluctuated around an average of 7.1% points between 1990 and 2007 declined dramatically to -5.2% by 2011-13, indicating that the Indian economy is now significantly more open than China’s.

Base Change Implications

       Analysis and forecasting of Indian growth has been confounded by the appearance of a new GDP series (2011 base) which has made some fundamental changes in methodology and data sources used.  As this new series provides less than three years of growth data it is impossible to estimate the underlying trend growth rate using this series.  After the mid-year 2014 budget I had written that “The measures taken in the budget will be sufficient to increase growth by about 1 per cent point over the last year’s 4.7% to 5.7%. Actualization of some of the measures indicated in the budget will however be necessary to raise growth to the 6.5 to 7% range in 2015-16.”  Given that the average growth rate as per the new data is about 1% point above that, using the new data, a projected growth rate of 7.5% to 8% is quite conservative. This seems to be the reasoning underling the World Bank’s and IMF’s  projections for India’s growth in 2015 and 2016.
      The CSO has however projected a growth rate of 7.4% for 2014-15 and a growth acceleration to 8% in 2015-16 would not be wildly optimistic.  As many observers have pointed out however, high frequency data, such as the Index of Industrial production for manufacturing, quarterly results for companies and tax revenues from excise and corporate income tax, do not appear consistent with these high growth levels. The author has argued in the policy paper, “Indian Growth Puzzle,” ( Policy Paper No. WsPP 3/2015, New Delhi, April 2015 ) that the global financial crisis (GFC) and the consequent global demand recession and excess capacity, have affected not only the export led Chinese economy, but also the globally competitive and connected corporate (GCC) sector of India. Post GFC, the GCC corporations will lag overall recovery, instead of leading it, as they did in 2002-3 to 2007-8. Thus all indicators connected with these companies, such as IIP, corporate profits, corporate & excise tax revenue would also lag the GDP recovery. The Indian Government needs to be aware of this issue and be prepared to manage central government expenditures subject to a slower recovery in tax revenues.

Conclusion

    Based on the theory and empirical evidence provided by high growth economies, some analysts had predicted since the 2000s, a slowing of the Chinese economy during the decade of the 2010s to rate of growth below that of the Indian (“China-India growth Projections” and other papers at https://sites.google.com/site/drarvindvirmani/growth).  By making the export-investment led strategy of development unviable, the global financial crises made this highly likely if not inevitable. It was also assumed in the forecasts that the Indian government would continue to carry out the minimum reforms necessary to maintain India’s growth rate at an average of the previous decade. Because of complacency and policy mistakes by the Indian Government between 2010 and 2012, the Indian economy, faltered seriously. The corrections introduced in the last two years, have restored some of the momentum.
    Sustained growth of 8 to 8.5% over the next few decades, however requires implementation of the reform agenda and continuing sensitivity to shocks that can derail growth, given that the World environment is far from conducive to sustained high growth.  If this is done we should expect to see India growing faster than China and beginning to close the wide gap that has opened between the per capita GDP of the two countries. This has implications for China and India's foreign policy towards each other, that need to be kept in mind. Given the wide Gap between the GDPs of the two countries, it is however, likely to take at least 30 years for India to eliminate the GDP gap with China.
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A version of this article appeared as the Lead article in The Hindu dated 29th April 2015 under the banner. "Tracking Two Growth Stories" :