Globalization & Monetary Policy Institute
International Economic Update
Global Stability Will Require Short-Term Sacrifice
March 29, 2013 · Update in PDF
Immediate risks to the global economy remain concentrated in advanced economies. A prolonged recovery has damaged investor confidence, making financial markets vulnerable to a sudden reversal of capital flows. Doubt stems from the unsustainable government debt that has accumulated in advanced economies. Though fiscal austerity could further dampen growth, it is necessary for long-term stability.
Emerging economies continue to outpace the advanced economies and have become influential contributors to global growth. However, to achieve sustained development, emerging economies will need to strengthen domestic demand, which current fast-paced growth strategies are neglecting.
Financial Markets Respond to Monetary Stimulus
In response to low bond yields, more investors are entering equity markets, causing equity prices to rise (Chart 1). Low yields are a result of investors’ risk preference and monetary stimulus. In times of economic uncertainty, investors gravitate away from risk, causing demand for bonds to rise, which negatively affects bond yields. Through government bond purchases, central banks have been able to continue monetary accommodation and aid the recovery in advanced economies. This has caused a further decline in yields.
Attempting to increase returns, investors have developed a higher risk tolerance and an increased demand for equities. The rise in equity demand can stimulate economic growth: As equity prices rise, wealth increases, which spurs domestic demand. However, if the adjusted investment strategy does not accommodate the accumulation of riskier assets, financial distress could result from a decline in equity prices.
Though equity prices have increased, foreign exchange-rate fluctuations support a fall in risk appetite. The U.S. is perceived as a safe haven, so as investors become more risk-averse, they increase their holdings of U.S. dollars, causing the currency to appreciate. The U.S. dollar has appreciated against the currency of advanced foreign economies (excluding Japan) since February (Chart 2). Movement in the Japanese foreign-exchange markets exaggerates investor sentiment. The rapid devaluation of the yen is a result of aggressive monetary stimulus by the Bank of Japan.
Government Austerity Must Accompany Japanese Inflation
To achieve a 2 percent inflation rate, the Bank of Japan expanded its Asset Purchase Program. Following a sustained period of declining prices, the Japanese economy has begun to stagnate (Chart 3). Persistent deflationary pressures have dissuaded private investment, necessitating government expenditures to bolster the economy.
Current-account surpluses have generated domestic funding and enabled persistent government deficits. A large amount of government debt has accumulated in Japan; in third quarter 2012, general government gross debt represented 233 percent of gross domestic product (GDP). However, Japan’s current-account balance has fallen to record lows, maintaining a negative balance for three consecutive months, starting in November.
Private savings, once a large contributor to Japan’s current-account surplus, is declining due to an aging population. The currency depreciation resulting from the Bank of Japan’s asset purchases helps stimulate export demand, but the improvement to net exports has been offset by the rising cost of imports. If a current-account surplus is no longer achievable, the government will be forced to limit expenditures. Negative current-account balances along with increasing interest rates make it more difficult for the government to honor debt obligations. If government expenditures decline, private investment must become a larger contributor to economic growth. Inflationary pressures should facilitate this structural change by providing investment incentives.
Politics Delay Reform in Europe
On March 16, 2013, Cyprus requested a bailout of 10 billion euros to rescue the economy’s two largest banks. To secure the bailout funds, the Cypriot government was responsible for generating a payment of 5.8 billion euros, but disagreement arose over the financing method of this payment. With each day that passed without a resolution, banks in Cyprus remained closed and investors grew more anxious. By March 22, negotiations had become strained, prompting the European Central Bank (ECB) to issue an ultimatum. If a resolution was not met by March 25, the ECB would terminate the emergency funding being provided to the Cypriot banks; the resulting financial collapse could force Cyprus to exit the euro area.
To maintain emergency funding, Cyprus agreed to restructure its banking system by closing the economy’s second-largest bank, Cyprus Popular Bank, and downsizing the economy’s largest bank, Bank of Cyprus. The bailout payment will be financed by the banks’ large depositors (those holding more than 100,000 euros) and bondholders. Restructuring the banking sector will be costly for Cyprus. A pronounced economic contraction is expected, but its effect on the euro-area economy should be limited. Even so, the inability to provide a swift resolution has aggravated tensions within the euro area, where political disputes have delayed structural reform.
In Italy, growing opposition toward fiscal austerity has hindered the government’s ability to impose the structural reforms necessary to restore economic growth. Italy continues to suffer from high unemployment, though limited progress has been made to mitigate rising labor costs and restore competition among euro-area economies (Chart 4).
With inconclusive elections implying further reform delays, investor confidence has waned. Capital flight from Italy picked up in February, and outflows reached levels not seen since March 2012. If a liquidity strain reemerges and financial aid becomes necessary, stipulations set by the ECB will require Italy to enroll in structural and budgetary reform programs, which would be impossible without a political consensus.
Income Equality Lags Behind Growth in Emerging Economies
Though necessary for structural reform, fiscal austerity restrains economic growth. As a result, underperformance is expected to persist in advanced economies. However, the effect on global growth will be partially offset by emerging economies’ increased contribution. Overall activity in the global economy is measured by the weighted performance of individual economies. The emerging economies’ combined share of global GDP is expected to surpass that of the advanced economies in 2013 (Chart 5). Thus, global growth prospects will become more hinged on the performance and development of the emerging economies.
Even as leaders of global growth, emerging economies have been unable to catch up to the living standards of advanced economies (Chart 6). Sustained development will require structural transformations that will promote income equality. Export-oriented growth strategies are common among emerging economies because low labor costs allow inexpensive export production. As the standard of living elevates, wages will rise. This will increase the price of exports and eliminate the economy’s competitive edge. Increased domestic demand must be able to compensate for the declining growth contribution of the export sector.
About the Author
Mack is a research analyst in the Globalization and Monetary Policy Institute at the Federal Reserve Bank of Dallas.