Risk Mitigation Strategies: Deeper role for policy as globalization amplifies impact of world cycles?

Vanessa ROSSI

While talking about the current crisis in Asia, people are very quick to understand the important implications of the problem. What is surprising is that it took quite a long time for some countries to realize the scale and impact of the recession in Europe. The initial analysis from many institutions in Europe was that the financial crisis would have more devastating effects on the U.S. and the UK because of the financial services sectors, but this missed the issue that the larger global impact came through trade of goods like investment goods and consumer durables like cars.

Many mistakes were made and many lessons are to be learned from the crisis. Alan Greenspan said that there seems to be a conundrum in the world economy of problems that are not easy to explain. Cycles also seem to be back - this is the end of the great moderation. Nevertheless, the predictions of the IMF are for relatively smooth recoveries. I have some concern that the future is highly unlikely to be so smooth. After a shock of this scale, second- and third-round repercussions over a number of years are likely to lead to further turbulence in the economy. It should not be assumed that this is a one-off problem that will go away. Further volatility and the problems caused by this should be taken into consideration.

While this crisis was caused by the problems of developed countries, the potential for emerging markets to create new problems should not be ignored. It currently seems as if the developing world is the mainstay of world growth, and while this is true in the short term, looking at the scale of development, it is much more likely to be that sometime in the next 5-10 years, there will be major problems and volatility could then emanate from the developing world.

The initial part of the crisis was mishandled in early 2008. By late 2008, the adjustments in forecasts were quite small, though the shock turned out to be far greater. While the developed world's recovery looks to be V-shaped at first glance, some factors are not so rosy. One factor is that the recession was caused by the collapse in world trade that has persisted into late 2009. Although there is now some improvement in world trade, most of the improvement is in Asia with very little improvement in Europe. And the types of goods in demand are beneficial for Asia.

Another point is that the GDP figures alone are a very poor metric by which to gauge the problems that have been seen. World GDP is likely to be down by 1-1.5 trillion dollars this year. Looking at the scale of the problem, GDP does not express how bad the problem is. Goods trade alone is likely to be down by 3-4 trillion dollars. This is why businesses are still saying that their revenues are down by 20-30%. There may be as much as 10-20 trillion dollars in lost sales across businesses worldwide. The total peak to trough losses in wealth was also very large - around 50 trillion dollars, nearly 1 year's global GDP.

The worldwide recovery is generally still weak. With such a large recession, there should have been a much bigger, stronger rebound in growth rates coming out of the recession. Though the U.S. bounced back to 8% growth rates after crises in the early 1980s, forecasts suggest that the U.S. economy will grow by far less than 4% in this recession's recovery. The likelihood of a W shaped recovery is very high. Emerging markets are proving to be robust, but much of that has to do with the ability of China to avoid the recession and spend its way out of a downturn.

It is important to look at where mistakes were made and differential performances across the world. Brazil showed a stable performance; the Russian economy was badly affected, primarily by the oil price drops; India is relatively stable because it has very little exposure to world manufacturing trade and a highly resilient services sector; China's losses on export performance were very large but this was overcome by huge fiscal and monetary easing in order to regenerate growth of 8-9%. Looked at in terms of volatility, Latin America's performance is extraordinary and has encouraged Brazil's popularity as a destination for currency carry trade. However, the emerging European situation can be compared to the Latin American of the past. And notably Asia excluding China and India shows quite poor performance due largely to export losses. In terms of trade being the engine of world growth, more care must be taken to ensure that countries can withstand shocks in trade performance.

The volatility in Eastern Europe is partly because emerging Europe covers a wide range of economies. There are different currency regimes and some are already embedded within the European Union. Poland is an Eastern European economy that withstood the crisis quite well due to securing its trade position and being able to devalue its currency. A euro peg was the worst position to take in the crisis, as the Baltic states did, because there was no euro-member security, nor was there any opportunity to devalue to gain a competitive advantage.

While it is easy to explain the differences in performances across emerging economies, in some ways the greatest surprise was the difference between Germany and Japan versus the U.S. and the UK. Many initial analyses predicted that the U.S. and the UK would be the hardest hit by the crisis, and this has not been the case. In fact, the rebound of the U.S. has been stronger (and the recession shallower) than Germany and Japan. Comparing France and Germany the picture is even clearer: France was relatively insulated because it has a higher share of services, non-cyclical industries and state utilities, whereas Germany had a very high share of exports to GDP for a large mature economy (nearly 50%) and was embedded in the two worst sectors of the recession. The stability Germany has attained (in jobs and consumption) has come only at the cost of heavy government spending, which will obligate Germany to cut spending and pay down its debt in the near future. What is ironic is that while policy in Europe nearly always comes down on the side of stability rather than growth, some European economies saw the greatest instability in the current crisis.

The services sector had both a shallow dip into the recession and has rebounded quite quickly in both Europe and the U.S. The services sector in the UK has also helped to offset the problem of the large banking failures. The third quarter numbers for the UK economy are dubiously weak and could be revised up but essentially the broad economic performance of the UK this year is very close to that of the Euro area ? in spite of the bank bailout problem. Third quarter numbers show that growth in Germany and France remained relatively flat because of there being almost no growth in domestic demand in Europe. In contrast, the U.S. exit from recession in the third quarter showed improvements in domestic demand and increases in imports, thus spreading the effects of the recovery to other countries. However, this performance of the U.S. economy may not be stable, and early 2010 may show further problems as there is very little income growth and high dependence on the fiscal stimulus package, pointing to further turbulence to come.

Wealth losses in the U.S. have partly been recouped, but are still quite large. Also, consumers are retrenching with increasing savings ratios, though this is bringing down the consumer debt burden. Although problems remain, there has been a massive adjustment in the property sector and the end of the residential property overhang may be near as the build rate in the U.S. has gone down dramatically. The scale of the boom-busts in Spain and Ireland were far more dramatic than the U.S. case, and have led to a new surge in unemployment, in Spain to around 20%.

Though many of the figures are extremely grim, there is some hope of a recovery for U.S. industrial production is on an upturn, productivity is strong and the non-financial corporate sector has seen increasing profits. By the middle of next year, the corporate sector may begin creating new jobs since productivity growth cannot be kept up at these rates. Short term volatility is a particular concern, but looking out to mid-2010, the picture may look better. There has been little improvement in terms of industrial production in Europe and the poor performance continues for consumer spending. And imports are weak, holding back growth in other economies.

Optimism about Asia is being caused by an upturn in imports by China. Many figures are looking firm and prospects are good for China spending their way out of the recession through both 2010 and 2011. However, if there are continued problems in the U.S. and Europe into 2012, it will be much more difficult for China to grow fast.

Inflation numbers are set to turn up again soon in the U.S. and Europe. This will not be a big problem, but year-on-year rates will begin to be positive. The U.S. rate will jump to 2.5-3% on an annual basis by the beginning of 2010. With prices previously falling, there was no chance for concern over inflationary threats from easy policy to take hold, but if inflation picks up to positive territory, there will be more credibility for those who suggest that high inflation will return. Even with inflation back at a normal 2-3%, it makes the very low level of official interest rates look out of place. This unease will be more visible in Europe than in the U.S. The main issue holding the European Central Bank (ECB) back from raising rates is the euro, as the weakness in the European economy and weakness in trade means that Europe will not want to see a stronger euro. It remains to be seen how these tensions play out but they are quite likely to add to the risk of volatility in the New Year. It is quite remarkable that yield curves have been extremely steady for both the EU and the U.S. for so long - maintaining stability of this kind may not be easy over the coming months.

Exit strategies have long-term implications for all the major economies. Recessions generally have long-term impacts in terms of the losses in investment and productivity, and effects on physical and human capital, which all contribute to reducing medium to long term growth and GDP. This recession will see more long-term problems as governments struggle to reduce high government deficit and debt levels. While easy policies have alleviated the pressure in the short term for households, the costs will have to be paid back over the longer term. The age of the regulator will also increase the costs of banks' operations, and while it cracks down on financial risk, it is a potentially dangerous way of doing this due to impacts of higher credit costs and weaker flows of global finance. Two areas that are enlarging in Europe are bank supervision and the green movement but we should beware that both will create yet higher costs for businesses.

The estimates for longer term growth are inevitably falling. Europeans are more inclined to mark down their longer term growth rates than the U.S. - indeed European growth rates are looking more like Japan's. Behind these growth rates are questions over what kind of recovery strategies are taking place. Will crisis losses be recovered, with previously estimated potential output growth being maintained, or will crisis losses not be recovered indicating that potential output growth will be permanently downgraded? Emerging markets believe they can do the first ? full - recovery, partly as this is what happened during and after the Asian Financial Crisis.

The Europeans are moving to the lower growth scenario - in which there is an ever widening gap versus pre-crisis expectations for GDP. This means that previous investment plans, based on expected growth pre-crisis, will turn out unprofitable and excess capacity may have to be scrapped. Europe's rapid move to a lower growth assumption for the future is also a source of concern because this will get embedded into policy. It will mean that it is even harder to get back to the target debt to GDP ratio and that monetary policy could be more aggressive if the estimate for the non-inflationary growth rate drops. There will also be negative effects on unemployment and social policy. Europe needs at least 1.5-2% GDP growth rates just to stabilize the employment market and the unemployment rate. Unemployment could surge and continue to rise under a scenario of just 1% per annum growth.

Returning to the issue of the trade effects seen in this downturn, it must be kept in mind that while globalization is an overall booster for world growth and productivity - more choice of goods at lower prices - in an economic downturn, it amplifies the impact of global industry cycles and may create excessive volatility in economies that host the most cycle-sensitive manufacturing industries. This raises questions over acceptable (affordable) scale of industry concentration and the appropriate form of risk mitigation strategies. It is common now to say that small countries cannot afford banks - or rather that the banking sector risk has to match a country's ability to support it in a crisis - but in effect the same rule applies to other industries. Iceland could not have afforded a global car manufacturing plant just as it could not afford a global banking sector. Choices must be made as to whether to live with the risk of volatility or try to reduce the cyclical risk by boosting the presence of non-cyclical sectors. At a global level, is industry concentration (good for productivity and low prices) to be pursued in spite of the risk this may pose to countries hosting these concentrations - or should diversification be seen as a strategy to damp the risks even if there are some costs attached (a form of insurance policy)? These are complex choices.

For example, Germany is a country that desires stability, but has built itself on an export driven growth model, raising its dependency on international trade. This is a choice that brings inherent volatility and Germany has no way to control global demand cycles. Germany also seems content to target flat consumer spending. Whatever growth the German economy has achieved in the last decade has been due to export performance - leading to a high trade surplus. Yet this has not brought stability - in the face of a global shock, German GDP dropped sharply and employment has only been saved by costly government support that will now have to be paid back - as Germany also dislikes running deficits and raising debt. There appear to be real inconsistencies in preferences here.

Even a relatively large economy has risks when it has a high concentration of a global scale, cyclical industry. There are times when the domestic economy simply cannot absorb global downturns in demand and the industrial base has to virtually shut down. Supporting such a cycle can be difficult. There are ways of coping with this, for example, the scale of financial provisioning can be increased. This comes with costs for businesses (just as high levels of capital provisioning costs banks), but it may prevent the bill going to the taxpayer. More flexible fiscal and monetary policy can also be exercised - but countries have to tolerate this. And, finally, high-risk strategies could be avoided by encouraging a different sectoral mix in the domestic economy and creating stabilizers.

Q: On the UK, if the service sector includes the financial sector, why does the service sector show a rise? Should the financial sector not have pulled that number down due to the large amounts of support it has received from the government?

Why are you pessimistic about emerging markets?

Vanessa ROSSI
Regarding the UK, the financial services sector has been far more robust than people believed it would be. Governments are backing restricting pay since the financial services industry bounced back faster than expected and this is a populist move. It is notable that clawbacks are the quickest area for new financial regulation. This emphasizes the fact that the service sector has been more resilient than people thought. The financial services industry comprises many different people, groups and businesses, and not all of them were involved in the areas that caused the crisis. The broader swathe is involved in the legal, accounting, basic banking and financial advisory fields, among others. The number of jobs in the trouble segments is not so significant.

Additionally, the problems in the banks in the U.S. were embedded in the mortgage and derivatives markets, and the derivative markets were also a big problem for Swiss banks. In the UK, the biggest problems were in the loans to domestic companies. It seems that the percentage of non-performing loans in this segment is as much as 80-90% for the worst affected banks. The particular pockets of problems need to be examined carefully as governments often encourage lending to particular areas for non-economic reasons.

Regarding emerging markets, if there is low growth in the developed world, that means that there are less export opportunities for the emerging markets which damps down growth. This does not immediately cause disasters, however. The other problem is that somewhere in the future, bubbles and cyclical problems will emerge in one of the big emerging market economies. If China met a big cyclical problem, it would cause a large shock through the world economy. This has not always been true, as was the case in the Asian Financial Crisis, but now that economies are bigger, the chances are that it would cause a world cycle.

Q: While you have many suggestions on how to mitigate risk using fiscal and monetary policy, what role does trade policy play? Is there a trade policy that can be taken to diversify trade risk in terms of the economy's cyclical nature?

Vanessa ROSSI
This is very difficult. It is hard to avoid problems when there are huge cycles in world demand. If you look across world demand, it is true that some exporters have done better than others because they have had geographic spread or they have had other kinds of good mixes. The problem is that it is difficult to diversify the sectors that an economy follows. Companies have tried other strategies in terms of increasing geographic spread but it would not have saved an economy from this kind of shock that hit trade on a global basis. The structure of trade is not as much of an issue as the structure of the economy. However, there are very good reasons to look at geographic and goods diversity because it will avoid idiosyncratic risk. Most leading companies know how to do this. The problem was the systemic risk in a global downturn.

Mechanisms could be put in place to help out during the crisis, which was done in this crisis. Instruments like credit swaps, export credits, alleviating problems for workers and other policies helped. These are, however, examples of risk mitigation rather than avoidance.

Q: How can global economic imbalances be dealt with in the future? The reliance on the Chinese economy may be a strength now, but it is not an answer to resolving global imbalances. How can a balance be kept between alleviating global imbalances and promoting global growth?

Within the EC, what is the role of monetary policy? The monetary policy of the ECB has allowed for coping with the financial crisis, but Europe's economic situation may vary by country. In this situation, a uniform monetary policy by the ECB can enhance the growth of the EC.

Vanessa ROSSI
These two questions are related because while there are global balance problems, there are also balance problems within Europe. When regions are compared, Europe looks very balanced, but the diversity in Europe reveals that it is part of the problem. The weakness in German consumer spending has repercussions everywhere - export competition becomes tougher among European states. This also creates a trade surplus for Germany and big deficits in countries such as Spain. This has not been helpful to Europe or the world economy, and it is ignored because comparisons generally only look across regions which always make people point to China rather than Europe as the problem.

That said, it is quite difficult to achieve balances. Going back to the fundamental problem, looking at the balance of growth, this would help to be the key. Going back to look at the root of the problem, it can be seen that other imbalances are present. Savings ratios decreased in the U.S., but the other side of the coin is that savings ratios in Europe are as high as 10-15% of GDP. Japan has rates of a healthier 2-3%. The big puzzle is why Europe persists with its high savings rates when its economies have greater social security and job guarantees. This situation in Europe has led to underperformance in consumer spending. Looking back at the U.S.'s current account problem, the year when it began to deteriorate sharply was 1999-2000. Previously, the U.S. current account deficit had been between 0-4% of GDP. The sharp deterioration came after 1999-2000 and almost precisely correlates with the period when Germany's surplus began to rise sharply and the euro was extremely weak. This was well before China's surplus began to increase.

Lessons from this are that balances in terms of savings rates need to be considered and periods of very excessive under- or overvaluations of currencies need to be avoided. Currency targeting is difficult, but one should know when a currency is seriously under- or overvalued. Managing such factors better will make current account balances more manageable. Emerging economies are growing their own demand for imports, and after a period of time, the process of world trade cycling around will bring greater equilibrium to world trade. Trying to speed up this process by pushing currencies too far in one direction or the other is not helpful and only creates unnecessary turbulence.