Risks in systemic economies
How fragile is the global economy today? Or as former United States Treasury Secretary Timothy Geithner puts it, “Where is the dry tinder?” And how well placed are key economies to mitigate of economic or financial shocks through the use of macroeconomic policy?
Up front, I should note that immediate risks appear to have eased over the last year, and particularly in the last six months. Growth in the largest economies has strengthened somewhat, risks of deflation have receded, and firmer commodity prices have assisted many emerging and developing economies. But just as you don’t wait until you see smoke to assess fire risk, so it is important to assess the global economy’s risk profile separately from immediate indicators. Indeed, if the recovery strengthens it will be critical to use the breathing room to mitigate the longer term risks which are the focus of this blog.
Any assessment of underlying global economic risks needs to start by evaluating risks located at the core of the global economy. Each of the major advanced systemic economies—the U.S., Eurozone, and Japan—still face legacy risks from the crisis. On most counts, the others are significantly more fragile than the U.S., and have even less macroeconomic firepower. And new risks are still growing in China commensurate with its weight in, and linkages to, the global economy. Political risks are also elevated both in individual economies, particularly the Eurozone, and globally, including from the risks associated with a less predictable approach from the U.S. administration on trade and macroeconomic policies.
In Europe, slow nominal growth has exacerbated weakness in the financial sector and imbalances across the eurozone. Recent signs of growth picking up, while welcome, will ease but not substantially remove this risk. While increased capital buffers and financial regulation and oversight is much improved on the pre-crisis situation, parts of the banking system retain legacy weaknesses of bad debts and poor profitability. The insurance sector faces long term solvency issues. As with the U.S., regulatory changes aimed at ending “too big to fail” have also likely reduced flexibility to manage a crisis. And significant financial and fiscal vulnerabilities remain in Italy and the peripheral states.
In total, these weaknesses ensure that the eurozone will remain a potential source of global risk for some time. Monetary policy normalization is some way off. While some parts of the eurozone have fiscal room to move—Germany in particular—others are highly constrained.
Brexit will add to both political and economic risks in the eurozone. Even a cooperative outcome will reduce potential growth over time given the likely negative impacts on trade. If handled poorly it could produce some unpleasant surprises which add to existing geopolitical and financial risks.
The Japanese financial system faces ongoing stress from low nominal growth and stretched macroeconomic settings. These settings, while probably necessary for the moment, are not sustainable. This raises risks of corrections at some point. Again recent signs of growth ease slightly the immediacy of these risks but do not substantially remove them. And Japan has almost no macroeconomic policy space to respond to a worsening of conditions.
Probably the most important emerging global risk relates to the Chinese financial system. It is exhibiting familiar warning signs from previous instances of financial crises—rapid growth in non-bank financial activity and corporate debt, signs of mispricing risk, capital outflow pressures. Chinese regulatory arrangements are scrambling to catch up with market developments, raising the risks of mistakes.
China has some macroeconomic policy space to respond to adverse developments, though monetary policy is constrained by the need to rein in credit, and exchange rate policy constrained by a variety of political and market factors. Fiscal policy probably has some room (including to backstop parts of the Chinese financial system), though this is diminishing with rapid growth in debt at all levels of government.
The new U.S. administration’s approaches to fiscal, structural, trade and currency policies add new unpredictable elements to the mix, both positive and negative.
While the Chinese financial system is not closely integrated internationally, financial spillovers are increasing due to the growing weight of the Chinese economy in global demand and therefore asset valuations, tightly linked trade, and leakages from the system of tightly regulated capital flows (and some limited opening of the capital account). This financial risk is coming on top of the inherent difficulty in managing several difficult transitions in the structure of the Chinese economy. Experience and modelling suggests that the spillovers from a slowdown in China on the Asian region and globally would be large.
The new U.S. administration’s approaches to fiscal, structural, trade and currency policies add new unpredictable elements to the mix, both positive and negative. This also comes at a turning point in the monetary policy cycle, which can be associated with volatility as expectations adjust.
Remaining vulnerabilities in key emerging economies
Risks also exist in major emerging economies outside China, though there has also been important progress that mitigates global risks in important ways.
On the positive side there has been a general improvement in the macroeconomic frameworks and financial regulation in many large emerging economies (EMEs). Large Asian EMEs (including India and the ASEAN economies) have established generally sound monetary and fiscal policy frameworks, improved financial regulation and oversight, and retained some room to move macroeconomic levers in response to shocks. Large commodity exporters, such as Russia, Saudi Arabia, and Pacific-facing Latin American countries, are withstanding large economic shocks without generalized financial distress. Mexico is drawing on its strong macroeconomic framework to absorb some of the risks arising from uncertainty in the U.S. policy stance. Most EMEs are operating with reasonably strong levels of reserves.
Important watch points remain though. Corporate debt is high in many major EMEs. The banking sector in India has important weaknesses which need to be addressed to support growth and reduce risk. Brazil and Argentina are in the midst of difficult but necessary policy reform exercises. Others, such as Turkey and several in South East Asia and Latin America, have high levels of foreign currency denominated corporate debt, which poses a vulnerability particularly if the U.S. dollar strengthens. And some major EMEs retain important political uncertainties which could continue to produce inconsistent or delayed policy responses to growing imbalances or risks (e.g., Turkey, South Africa, Nigeria). The size and volatility in gross international capital flows introduces an ever present risk that existing buffers come under pressure if there are significant economic and market events. And developments in China and the US provide a major source of uncertainty, including the interaction of these.
Risks and limited response options
The international economy continues to provide ample, though thankfully not uniform, “dry tinder.” Sustained effort will required to both reduce factors and rebuild macroeconomic policy capacity.
U.S. policy choices will be important in mitigating rather than exacerbating the risks in other major advanced and emerging economies (with potential ‘spillbacks’ to U.S. growth).
This suggests we are in for an extended period where both global risks are elevated and macroeconomic policy responses are constrained. The global community will need to make the most of its limited macroeconomic firepower in the event of a negative shock by coordinating responses. U.S. policy choices will be important in mitigating rather than exacerbating the risks in other major advanced and emerging economies (with potential ‘spillbacks’ to U.S. growth). Individual countries (that are able) need to “self-insure” where possible, in particular carefully building solid macro-economic and financial buffers as circumstances allow.
In these circumstances, having sound global “emergency response options” is all the more critical to limit the damage from possible economic shocks. The adequacy of these—including global safety nets such as those available through the International Monetary Fund and regional and bilateral financing arrangements—is the subject of the last part of this blog.