I spent the past weekend in Istanbul at the seminar jamboree that precedes the IMF-World Bank Annual Meetings. Ministers of finance, central bankers, government officials and international civil servants all agreed on one thing: there would be no premature exit from quantitative easing, credit easing and other unconventional expansionary monetary policy measures such as the ECB’s enhanced credit support.
All those in a position of authority subscribed to the view that there was a major asymmetry between the risk of exiting too late and exiting too early: exiting too late would only cause minor overheating problems that could easily be corrected. Exiting too soon would cause irreversible damage, because after a too early exit, policy could not be re-activated again.
Nobody explained the analytics or empirics to support that view. It simply became an accepted truth. In the world of mathematics and formal logic, there are two modes of proof: deduction and induction. In economics, as in the other social sciences, we have three modes of proof: proof by induction, proof by deduction and proof by repeated assertion.
Be that as it may, the world is being flooded with official liquidity by the leading central banks of the overdeveloped world. Because of the depressed state of the real economy in most advanced industrial countries (large negative output gaps whose magnitude continues to grow, high and rising unemployment rates), this official liquidity flood is unlikely to generate an overall (private plus public) liquidity flood in the overdeveloped world. Commercial banks either hoard the newly injected central bank liquidity at the central bank in the form of deposits or use it to purchase safe liquid assets, such as the sovereign debt instruments of reasonably solvent nation states. This has the further advantage of keeping the regulators happy, even if it does not do much for would-be private borrowers from the zombified banking system.
Broad monetary aggregates are growing little if at all in the overdeveloped world and credit growth to the non-financial enterprise sector and to the household sector remains minuscule. We are therefore unlikely to see a credit boom or asset market frenzy any time soon in the advanced industrial countries, let alone any pick-up in domestically generated inflation for indices like the CPI. The massive injection of official liquidity by the Fed, the ECB, the Bank of England, the Bank of Japan and other central banks in the north-Atlantic region is much more likely to show up as credit and asset market booms, bubbles and – eventually – busts in those emerging markets that are growing rapidly again, that is, most emerging markets other than those in Central and Eastern Europe. China, Brazil, India, Indonesia, Singapore, Turkey and Peru are but some of the countries at risk.
The reason for this liquidity spill-over is the desire of many of the rapidly expanding emerging markets to prevent a large real appreciation of their currencies vis-à-vis those of the cyclically lagging advanced industrial countries. Such a real appreciation is desirable (up to a point) because it provides the proper incentives for emerging market economies with large external trade surpluses to switch domestic output towards non-traded goods and services and away from exporting and import-competing activities. Having achieved success with export-led growth in the past, the EMs are naturally inclined to persist in that strategy, even when it is becoming increasingly dysfunctional not just for the rest of the world but for the EMs themselves. The established exporting and import-competing industries in the emerging markets are obviously rather more effective lobbyists and pressure groups than the non-existent non-traded goods and services producers.
An appreciation of the real exchange rate can be achieved either by having higher domestic inflation than global inflation and\or through nominal exchange rate appreciation. With sticky domestic inflation, rapid real appreciation requires rapid nominal exchange rate appreciation. This is resisted by the authorities of these countries through foreign exchange market intervention. The accumulation of foreign exchange reserves that results is only partly sterilised.
The result is externally financed expansion of the domestic money supply and more rapid domestic credit growth. This will leak at least partly into domestic asset markets, creating the conditions for boom, bubble and bust.
China is especially at risk of booms and bubbles in its stock market, its residential housing market and its commercial and industrial property markets. That is because the externally funded liquidity injection resulting from Chinese attempts to keep down the external value of the yuan are reinforced by further domestic credit expansion associated with the Chinese fiscal stimulus.
China has engaged in a classical Keynesian fiscal stimulus financed in the short run through commercial bank credit and in the medium run by the central bank. Much of the fiscal expansion has been targeted at China’s past areas of comparative advantage: heavy export-oriented industry and infrastructure aimed at supporting those industries.
Much of this expenditure will turn out to have been misdirected from a structural or sectoral perspective, even if it met the short-run cyclical objective of boosting domestic demand. China is creating massive excess capacity in export-oriented industries (and indeed in some of the low-tech consumer goods where it no longer is the global low-cost producer). The bank loans that financed these misdirected expenditures will go belly-up before long with a high probability.
The (majority) state-owned banks that provided these loans knew that they were lending for likely dud projects, but went ahead anyway. First, you don’t argue when the Party tells you to lend, and second, you know that you will be bailed out when the loans go bad. In two or three years, when these loans will be going into default on a large scale, the central bank or the ministry of finance will recapitalise the banks, using a mixture of government debt, central bank domestic credit and foreign exchange reserves. This central bank financing-with-a-lag of a Keynesian spending stimulus makes sense, up to a point. It ceases to make sense if the bank credit ends up going into domestic speculation involving existing financial and real assets. Unfortunately, that is clearly happening.
The medium-term prospects for China are worrying, even if the short-term and long-term prospects are bright. The country has thrown everything it has as regards fiscal policy, monetary policy and credit policy at domestic demand to maintain growth at eight percent per annum or more despite the collapse of export demand for its products. The boost to domestic demand is overwhelmingly in the form of fixed investment, much of in the the wrong, old industries. Without a miraculous recovery of export demand growth, excess capacity will re-emerge with a vengeance in the export industries. Since the Chinese authorities fear the social unrest likely to be associated with a steep increase in unemployment, they will thrown the kitchen sink squared at domestic demand again.
But unless the composition of both domestic demand and domestic production are changed towards domestic consumer goods and non-traded goods and services, the Chinese authorities will find themselves in the unenviable position of having to throw more and more demand at the economy to prevent the emergence of excess capacity and unemployment in the traditional export sectors. There is not much evidence that the Chinese economy is moving demand and domestic resources towards its areas of long-run comparative advantage.
Other emerging markets too are likely to be faced with domestic asset market booms and bubbles, in particular the oil and gas exporting nations of the Gulf Cooperation Council (GCC). These countries still peg to or shadow the US dollar quite closely, despite a number of attempts, through basket-pegging and similar manoeuvres, to loosen their ties to the US dollar.
One aspect of the global forecasts of the IMF and Goldman Sachs (where I am an adviser) I have trouble with is the combination of high global growth for 2010 (just under 4 percent, using PPP measures of world GDP, in the IMF forecast and 4.1 percent in the Goldman Sachs forecast) and low, stable headline inflation and only modest increases in oil and other commodity prices. If we get 4 percent real growth for the world economy in 2010, I would expect oil prices and other commodity prices to rise sharply. The result would be higher global headline inflation and, key for my GCC story, rapidly rising balance-of-payments surpluses in the commodity exporting countries.
The resulting upward pressure on the exchange rate would be resisted in the GCC area, if these countries stick to their de-facto peg to the US dollar. Again, imperfect sterilization of the resulting reserve inflows and rapid expansion of domestic money and credit would cause spill over of advanced country credit growth into domestic asset markets.
The credit and asset market boom, bubble and bust I foresee for the rapidly growing emerging markets is not inevitable. It is a policy choice. If the emerging market countries in question are willing to let their currencies appreciate sufficiently against the US dollar and the currencies of the rest of the overdeveloped world, there will be no domestic monetary and credit expansion financed by imperfectly sterilized foreign reserve inflows.
For China, preventing excessive credit growth and asset booms and bubbles is more difficult, as in addition to the external liquidity injection, the government is, through the banking system, injecting massive amounts of domestic liquidity into the economy. This would become unnecessary if China were able to switch the composition of production and of domestic demand towards consumer goods and services and non-traded goods and services.
It is not clear that the instruments the authorities have at their disposal are well-designed to achieve this sectoral shift of consumption and demand. An authoritarian one-party state can single-mindedly and with amazing speed achieve simple objectives. That is a great advantage if the objective makes sense (the Great March, agricultural reform, the 2008-2009 demand stimulus). It is a great disadvantage if the objective is destructive (the Great Leap Forward, the Cultural Revolution). Changing the composition of production and demand away from what is tried, known and familiar towards unfamiliar goods and services may not be an easy task for the residual central planning apparatus of the People’s Republic of China. They will eventually get it right, but we are likely to see some credit and asset market dysfunctionality along the way.
The assertion, occasionally heard in the halls of the cynics, that the US and other chronic external deficit countries will not be able to redress their imbalances because they have nothing to export, is incorrect. They can export credit and asset booms and bubbles with the best of them.