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Table of Contents From the Editorial Desk……………………….........................................................................................………....1 OVERHEATING: The threat faced by Emerging Economies By Nandini Duggal...............……………….....................................………………..................................................2 Overheating of the Emerging Economies: Much Ado about Nothing By Umesh Saha, Niranjana Mishra....……………….....................................………………....................................6 World Economy: Not Out of Danger Zone Yet By Saurav Lugria, Vibha Bharati................……………….....................................………………...........................11 Overheating of Emerging Market Economies and the role of Central Banks By Laveen Ramrakhiyani, Saurabh Surana, Ankur Choraria..............………………....................................... 15 The Decoupling Debate: Do Emerging Markets hold the key to recovery after crisis By Ankit Sinha............................................……………….....................................………………..........................22 Future of Asian Giants By Senthil Kumar V............................……………….....................................………………...................................25 Currency Dynamics in the Emerging Market Economies By Annapoorni C S, Tisa Annie Paul, Richa Gupta.......................………………...............................................28

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From the Editorial Desk The world economy has been recovering at a rate faster than what most economists forecasted just a year ago. And it is the emerging economies like China, India and Brazil which have taken the bull by its horns, leading to the revival of world trade and GDP. However, we must remember that India’s strength lies in

strong domestic consumption and China, which depends largely on exports, will have to re-focus on domestic consumption sooner rather than later. Therefore, such emerging economies face a huge risk, which is, the Overheating of their economies. The level of inflation in these economies, especially the BRIC countries, is already at an uncomfortable level. Most of these economies are highly dependent on commodities for their consumption and production. Recent trends show that price rise has been maximum in oil and agricultural products (India). The non-oil commodity price index has also risen very sharply in the last 6 months. This has given the economists and

financial experts around the globe another round of worry after the financial crisis, and has been the topic of discussion at every major forum. This is what the theme of the Journal is: “The Overheating of Emerging Economies and its effect on their recovery”. It remains to be seen whether the hue and cry is justified, or if it is another irrational fear that has gripped the world. Through the following articles, we have tried to cover both ends of the spectrum: 

That the growth in Aggregate Supply can sustain the increasing demand because of strong growth

fundamentals Or 

The current inflation level will persist and only a reduction in demand can prevent another recession.

Team FINAX

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VERHEATING: The threat faced by Emerging Economies Abstract The world is on the path of global recovery which is mainly being driven by growth in emerging economies. Owing to strong growth prospects and interest rate differentials, emerging nations are attracting large amount of capital inflows. However, the sudden surge in capital inflows could lead to overheating of these nations. This article discusses the concept of overheating, its signs, its transmission mechanism and possible policy measures to avoid it. Taking the case of India from emerging economies, this article discusses how Indian economy is unique from other emerging economies and its way forward in avoiding this risk.

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Figure 1 : Average Projected Real GDP Growth (2010-11)

economic growth, development of financial markets and diversification of risk, its sudden surge poses significant challenges for policymakers in three ways. 

Leads to overheating of economies showing signs of inflation and formation of asset bubbles.  Increases vulnerability due to sudden reversal of capital flows.  With increase in financial integration, autonomy for implementing policies, monetary autonomy etc. gets compromised. At this critical time, the threat of overheating in emerging economies presents itself as a significant macroeconomic challenge and could derail the process of economic recovery worldwide.

Emerging from the claws of recession, the world is on the path of economic recovery. The economic recovery continued to strengthen in 2010 with global activity increasing by 5.25 percent during the initial half of 2010. This economic recovery is largely being led by emerging economies with Asia leading the group with its projected growth rate for 2011 being at 6.7%.i

Emerging economies, especially Asia, have faced the economic crisis with firm resilience. Owing to strong fundamentals like economic growth, stable policy regime etc, there has been a shift in asset allocation with this part of the globe attracting large amount of capital inflows. While capital inflows come with a basket of benefits like meeting domestic demand, fuelling

Figure 2

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Overheating of Economy

of FIIs which leads to rise in stock prices and appreciation of rupee. If these inflows cannot be absorbed in the domestic economy, they can lead to overheating of the economy.

When there has been a prolonged period of high economic growth, it leads to high aggregate demand. In order to meet this high aggregate demand, aggregate supply needs to be increased. This is generally increased by over-employment of resources like human labor, machine hours etc. However, production by over-employment of resources is not sustainable for a long period of time. Thus, there is an inefficient supply allocation and high level of inflation leading to overheating of an economy.

The effect of overheating due to huge surge in capital inflows can be produced through following transmission mechanism.v  If a country maintains an officially determined exchange rate, in order to main its peg in the market, it will have to buy excess foreign currency which has entered the system in the form of inflows. It can do this by creating high powered domestic money.  The expansion in monetary base can lead to drop in interest rates and rise in prices, thus, giving rise to aggregate demand.  If there is a scope to increase capacity to meet increased demand, it is done by increasing economic activity which puts pressure on current account. However, this scope would be limited and once it is absorbed, the expansion in demand leads to rise in inflation.  The rise in prices will lead to appreciation of real exchange rate worsening the current account status.

The signs of overheating are particularly evident in the form of high inflation and formation of asset bubbles. Recently, when Inflation in India touched double digit figures at 10%iii, Gita Gopinath, the professor of economics at Harvard University, pointed out that it was a clear sign of an overheating economy. The increase in inflation is also reflected in sectors like real estate etc. with formation of asset bubbles. An asset bubble is formed when the prices of an asset rise sharply owing to excess demand. Currency appreciation, widening current deficit and huge credit expansion in the economy are other factors which can be looked at to determine whether an economy is showing any signs of overheating. Leading countries of emerging Asia like India, China, Indonesia etc, have grown at the rate of more than 8 percent in the initial half of previous year. As per IMF estimates, this region is expected to grow at the rate of 8.4% in 2011. Owing to strong growth aspects, large amount of capital inflows are flowing into this region. Moreover, increasing interest differential with advanced economies is further aggravating the situation by attracting more inflows. Large capital inflows mainly come through the route

Figure 3

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vi,

Source:The Institute of International Finance


To meet this threat, policymakers have several macroeconomic measures at their disposal which can be applied depending upon its overall suitability. The four major ways to handle it include use of tightening of fiscal and monetary policy, use of exchange rate policy and capital controls to restrict free movement of capital.

increasing interest rates to arrest the rise in inflation and reduce liquidity in market. In India, the policy has been particularly price centric as inflation reached double digits, signaling overheating ,with RBI having increased repo and reverse repo rates six times by November. To avoid the risk of crash due to overheating, China has also been gradually withdrawing stimulus measures. In early part of 2010, Chinese govt. increased bank reserve requirements and also asked banks to curb the lending rate.

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There exist two policy measures to counter the expansion in monetary base. These are sterilized intervention and increase in reserve requirements. Sterilized intervention has been used widely till date. It involves attempts to reduce the credit supply in domestic economy by indulging in open market operations etc. Fiscal contraction can also be used to reduce the expansion of aggregate demand. Tight fiscal stance can help to reduce inflationary pressures.

India: The way forward Among emerging market concerns, the Indian economy has some unique features which distinguishes it from other emerging economies. viii

First of all, the growth in Indian economy is driven by domestic demand in the form of

To reduce net inflows into the economy, various controls can be applied on inflows as well as outflows. Liberalization of capital outflows or repayment of public debt can be employed in order to reduce net inflows. For countries with fixed exchange rate, the most extreme option that exists is conversion to free floating economy. The appreciation of currency due to inflows will lead to current account deficit and reduce the net inflows. What is interesting to note is that the current economic situation demands a total contrasting response from policy makers when it comes to emerging economies as compared to advanced economies. The loose monetary policy in West is having spillover effects in emerging economies in the form of flows. While interest rates have been near zero percent level to stimulate demand in economies of advanced nations, the central monetary authorities in emerging economies like India have been

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Figure 5 : Capital flows in India in 2010-11 so far Source: RBI

consumption and investment. Indian economy has high savings rate and investment rate. Secondly, coming to deficits, India faces double trouble in the form of fiscal deficit and current account deficit. On the back of stimulus measures, fiscal deficit has reached dangerous proportions with Indian govt. trying to peg it at the level of 5.5 percent of GDP for the year

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2010-11. Unlike other emerging economies which have current account surplus, India has deficit in current account as well. Lastly, India suffers from severe infrastructural issues and is a supply constrained economy.

Capital control measures – Till date, the use of capital control measures has not been very extensive. However, IMF has recommended use of capital controls as the part of policy mix for nations facing surge in capital inflows. Capital controls are measures taken to regulate the inflows and outflows into/out of the economy. They apply restrictions on free movement of the capital.

Figure 4

Capital controls are of two types: Administrative controls and Market based controls. Administrative controls tend to prohibit or apply quantitative restrictions on capital transactions. On the other hand, market based controls increase the cost of transactions by way of explicit taxes, indirect taxes etc. in order to make foreign investment options less attractive. Generally, administrative controls are less transparent when compared to market based controls.

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Keeping all these in mind, determining the way forward by striking right balance between growth path and warding off the macroeconomic risks in the form of inflation etc. becomes a very challenging issue for the Indian policymakers.

Analyzing the options available, implementation of capital controls could be the way forward for India to effectively thwart the risk of overheating and asset bubbles.

The various policy options in the form of fiscal and monetary measures available to avert the risk of overheating don’t appear to be wise moves in case of India. 

Thus, the policymakers of emerging economies have a critical responsibility of maintain the pace of global recovery and need to tread the path proactively and cautiously to avoid triggering of another crisis.

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If India doesn’t intervene in the forex market and allows rupee to appreciate, it puts significant downward pressure on current account deficit which is already high. Also, the rupee appreciation adversely affects the exports. Buying excess dollars and reduction in interest rates might lead to rise in inflation further. So, these responses appear to be flawed as well. Fiscal contraction can be applied but the extent to which it can control inflows remains doubtful.

About the Author Nandini Duggal is a student of MBA (International Business) 2010-12 at Indian Institute of Foreign Trade, New Delhi. She holds a degree in Bachelors of Engineering (Computer Science) from Panjab University, Chandigarh

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and has worked in Infosys Technologies for aperiod of 31 months as a software engineer.

Overheating of the

Email - nandiniduggal@gmail.com

Emerging Economies: Much Ado about Nothing

References

Abstract

i World Economic Outlook Oct 2010 Pg 81

The article refutes the proposition that the emerging economies are overheating. A comprehensive analysis across various macroeconomic metrics ranging from potential growth rate, actual GDP rates, inflation and deficits has been performed to infer that the growth in these economies hinges on strong economic fundamentals and not on availability of temporary liquidity. The changes in these economies would obviously lead to a global rebalancing. There would be a reallocation of resources with currency appreciation, growth in domestic demand and expansion in productive capacity sin these economies. Patterns of global investment and savings would change requiring deepening of financial intermediation and regulation.

ii World Economic Outlook Oct 2010 Pg 81 iiihttp://businessstandard.co.in/wef10/news/qagita-gopinath-professoreconomics-harvarduniversity/414837/ iv Macroeconomic and Monetary Policy Developments Scecond Quarter Review 2010 v IIF Research Note Capital Flows to Emerging Market Economies Philip SuttleAPil 15, 2010 vi Private capital flows to developing countries : The road to financial integration by World bank Pg No. 171-184 vii Private capital flows to developing countries : The road to financial integration by World bank Pg No. 171-184 viii Emerging Market Concerns : An Indian Perspective Duvvuri Subbarao speech RBI monthly bulletin Nov 2009 ix Macroeconomic and Monetary Developments Second Quarter Review 2011 x Macroeconomic and Monetary Developments Second Quarter Review 2011 xi http/www.icrier.org xii Finance and Development September 2010

Figure 1: Price Rise

The IMF says advanced economies will grow 2.7% in 2010 but emerging economies will jump

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7.1%.Emerging economies seem to be overheating as these have become the favored nations for investment inflows from the advanced economies. The developed nations are plagued by low growth rates coupled with concerns of sovereign debt default and prevalence of low interest rates leading to fund flow to emerging nations. The flows of funds are now directed to the emerging nations as these are currently the growing entities. The question staring in our face is “would these funds lead to creation of bubbles and are these real concerns”?

potential and actual growth rate are good indicators of overheating.

Understanding the “Overheating” Phenomenon

Investigation of various dimensions across the economies of the emerging nations gives a sense that there is no real overheating in these economies. There have been FII inflows into these nations but most of them have strong fundamental growth drivers and potential future plans for capacity expansion especially in infrastructure and real estate construction. The emerging economies fiscal balance trends also do not reflect overheating. The domestic consumption in some emerging countries is trending downward and the supply factors on the other hand are expanding. The difference between the actual and the potential output

Emerging Economies: Too Hot to Handle? A number of subject experts have asserted that “the emerging economic nations are slowly slipping into the grip of another imminent economic overheating”.…“the major threats to emerging markets will arise from, and be related to, their economic success”….“overheating rather than deflation will be the main threat”.

In the global economic scenario, we broadly define overheating as a phenomenon when the actual growth in the economy takes place at a rate significantly higher than the potential growth rates. Sometimes we refer to this as the ‘boom’ phase of the economic cycle where the demand outstrips the supply of goods and services. As economy grows, there is an increase in the consumption which creates excess demand. The actual increase in aggregate demand depends on size of the multipliers associated with each of the variables in the equation below:

The expansion in the demand gives rise to inflationary pressures and increased inflow of foreign capital in the form of FIIs and FDIs to reap excess returns prevailing in these economies. These flows cause appreciation of currency and intensify the overheating effect building speculation. Asset prices, inflation and difference between

has also been analyzed. Potential growth has Figure 2: Actual and Potential Growth (Singapore)

been accounted through the growth the labor productivity, total factor productivity and real

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Brazil’s Trends

capital stock. Overheating would reflect as a difference between the two rates.

In Brazil, there is a slight reversal in the story. Domestic demand is outstripping supply. But

The Singapore Story Singapore is witnessing a slowdown in personal consumption to 5.2%. It is the other productive factors of demand that are exhibiting growth mainly government consumption and fixed investment. On the supply side, all the sectors are expanding albeit the rates of expansion are small. A quick examination of the potential and the actual real growth rates show minimal difference between the two rates. The drivers of growth span across the sectors and are not dependent on external balance or liquidity. The domestic demand also has been depressed. There has been a decrease in the budget deficit although marginal. The budget deficit is now at 1% of the GDP. Singapore has healthy fiscal

Figure 4: Actual & Potential Growth (Brazil)

the government is putting contractionary fiscal and monetary measures in place. The country is in slightly unique position as it is undergoing a phase of political transition. The new government would need time to settle and initiate strict fiscal measures. The political uncertainty is critical in leading to inflationary tendencies. However, from 2009 the inflation has remained stable at 5%. An investigation of the differences in the actual and potential growth rates still reflects very little variance thus negating any evidence of overheating. The increase in domestic demand also has not increased dramatically over the last 5 years. In 2009, as expected, there demand almost showed zero growth. The current account deficit also is at 1.5% of the GDP currently; though it is projected to reach 3% which can be some matter of concern. However, the FII inflows flowing into the economy will be absorbed and neutralize the current account deficit. Brazil also has a diversified export base and a strong reserves position. The fiscal deficit has increased to 3.3% of the GDP. However, industrial production has expanded and employment rates have also exhibited signs of recovery. Analysts’ reports

Figure 3: Inflation Trends (Singapore)

reserves. The government has even withdrawn the stimulus packages in 2009. Singapore also does not depend on foreign flows to finance its public debt. Most of the public debt is denominated in Singapore dollars. The Consumer prices in the Singaporean economy increased almost by 10 % (cumulative) from 2006 to 2008, while it was just 3.2% (cumulative) from 2008 to 2010. Although it is on a rising mode but the magnitude is within a manageable limits and there is little indication of overheating.

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suggests that there is no strong indication of the possibility of the Indian economy on the verge of getting overheated. Moreover the inflation is mostly concentrated in food articles. The only concern seems to be rising asset prices in the country. But in most of the cities, demand of housing does not exceed the supply. In order to curb demand, the RBI has also has increased the rates of interest leading to a rise in housing loans.

Figure 5: Inflation in Brazil

seem to indicate the Brazil is growing currently at 7% which beyond its potential of 5%.However, the country seems to have tremendous potential to expand its production capacity through increase in infrastructure facility as would be hosting the FIFA WORLD Cup (2014) and the Olympic Games. Massive investments in the events would lead to creation of production capacity and absorb the excess demand.

Strong Fundamentals of Emerging Economies The growth fundamentals of the emerging markets are robust. Their debt-to-GDP ratios are comfortably below any danger mark and these countries also possess foreign reserves to tide over any crisis situation. Equity valuations do not seem to be unreasonable. According to HSBC, the MSCI emerging-market index is below the 20 year average at a forward price/earnings multiple of 11.

The India Way An analysis of the Indian Economy shows that labour productivity and growth of real capital stock contribute significantly to the real growth in output. Thus the high rates of growth are buttressed by strong macroeconomic fundamentals and real productivity gains. The fiscal deficit has declined from 6.2% of the GDP in 2006 to about 5.6 % of the GDP at present. The deficit fell to Rs 1,86,522 crore thus showing a 39% reduction in April-November period as compared to the same period last year .This was mainly due to increase in the government revenue receipts.

Figure 6: Actual and Potential Growth (India)

Data Source: EIU

One of other primary indications of overheating is rising of inflation rate. However the trend depicted in the figure aside Consumer Price Index (CPI) for India is showing a declining trend in 2009 to 2010 as compared the increasing trend in the period 2006 and 2008. This

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Demystifying the FII inflows trends

investments. The increasing trend of urbanization in the emerging economies would lead to creation of homes, roads, power plants, airports in these countries. Investment would continue to rise so for almost a decade especially in Infrastructure. According to the McKinsey Report, global investment projected to touch $24 trillion around 2030.Consequently, there would be a lowering of savings. Although the saving in the developed nation would rise, as is evident now, on an average, the global saving rate will decline. The gap in investment and savings will further increase the future cost of capital leading to permanent changes in revenue models. Investor strategies can get affected as long term interest rates would surge. Finally, the role of the government would become crucial in all economies in creating more depth and breadth in the emerging market financial economies.

Figure 7: Inflation Rate (India)

Though the emerging economies contribute 47% to the world GDP, they are still underrepresented in the investment holdings of the OECD countries. These FII inflows mostly are mostly reallocating investments to a higher equity returns in these countries. The inflows might lead to currency appreciation which however would provide an incentive to stimulate domestic consumption especially in economies like China. The emerging nations would hinge on their domestic demand rather than on the fragile and declining export demand from the advanced economies.

Implications There are some signs of irrational exuberance: issuance of the 100 year bond by Mexico and booming corporate bond debt. However, overall the growth has strong foundations. The changes in the emerging market economies will change the structure of the global finance architecture. Emerging markets would account for most of the world’s investment as well as savings.

Figure 8: Cost of Capital

About the co-authors: Umesh Shankar Saha: Umesh is currently pursuing MBA from ISB, Hyderabad. He has a BTech from the IIT, Kharagpur and has worked with reputed firms in the Maritime industry in India before joining ISB. Nirajana Mishra: Nirajana is currently pursuing MBA from ISB, Hyderabad. She has a Masters degree in Economics from Delhi School of

From the present trend of economic growth in emerging economies, one can observe that there will be a persistent increase in global

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Economics. She has worked with American Express and GE Capital in their Retail Banking Division prior to joining ISB. At ISB, she is the Knowledge Initiative Coordinator of the Finance Club.

World Economy: Not

References:

Abstract

Emerging Markets Information Service

Bloomberg Business Week

The Journal of Commerce, Jan 2004

Economist Intelligence Unit

http://online.wsj.com/article/SB400014240527487043615 04575552011451494830.html

http://www.forbes.com/2010/12/20/forbes-indiaeconomy-overheating-reality-check.html

McKinsey Quarterly Journal , Dec 2010

Out of Danger Zone Yet

The International Monetary Fund and the Organization for Economic Cooperation and Development have highlighted the challenges of a two-speed recovery: emerging markets racing ahead and advanced economies slogging along. One of the challenges was coming from the financial imbalances globally, especially in current accounts but there were also positive signs of growth and rebalancing in China and the US.

Growth and Balance How well would the positive signs of growth and rebalancing in US and China prove to be actual boost to the global economy is to be waited and watched. Many forecasters have given their revised estimates of growth in the US and Europe which are pretty disappointing. The resurging US trade deficit together with China’s refusal to allow any further currency appreciation make growth and rebalancing more difficult. The world economic revival needs the current account surplus countries to have greater fiscal stimulus and the East Asian countries should appreciate their currencies. In the US, there was an economic slack and hardly any inflation and yet US failed to expand its short term fiscal and monetary stimulus. Here, other economies of the world need to step in to ensure a global recovery. The policymakers face the tough task of balancing and attaining both internal and external equilibriums. The output levels in the developing countries should match the

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proportions of the rise in unemployment cannot be assigned to the natural rate. Talking about the US economy, the inflation is flat and would probably remain flat for next ten years. The spread between inflation-indexed bonds and the government bonds also show that inflation would remain flat. What have led to policies being ineffective are the fears which misguide the policymakers. The feeling that US would soon be touching the tipping point of debt has tied the fiscal policy. True that US has fiscal problems which are mostly long term in nature, but these are due to increased spending and not raising revenues from taxes and on top of these all, there was the recession and the tax cuts in 2001 and 2003 which blew up the fears. As documented by Ostry et al, US can still go for fiscal stimulus in the short term. In case of a medium-term issue, a countercyclical fiscal policy would form a solution with a plan for medium-term fiscal consolidation.

Figure a World Current Account Balances (% of GDP)

potential GDP and remain consistent with the non-accelerating inflation. Also, the current accounts in countries like the US should match the country’s development and fiscal policies. This is a challenge that the policymakers have to take up to ensure growth.

Developed Economies The developed nations, particularly the US, are the key to economic revival but the policymaking has not been effective for the growth and rebalancing of the world economy. There has been much ado about overheating in the US with the IMF projecting 2010 output gap of only about minus 4 percent of GDP, OECD minus 5percent and the Congressional Budget Office projecting minus 6 percent of GDP. After the US GDP was revised by almost one percentage downward, the output gap in absolute terms seems to be even larger than those estimated by various organizations.

How well could the US support rebalancing, is difficult to judge as when we talk about the global economy, there are a lot of other factors relating to other countries. The current exchange rates, particularly with China, and that Europe is not expanding much, supports that the US current account deficit is increasing. The whole view could be changed if the US dollar depreciates. With the fact that oil accounts for a large portion of the trade deficit, and that there is hardly anything being done about the reduction in oil imports means that the trade deficit in the US is highly susceptible to a bounce in oil prices.

Now, this makes it seem less important and urgent for the policymakers to tighten the fiscal policy. This is how the policies could not be effective in bringing about good signs for global growth and rebalancing.

If US households seem to be controlling spending more than had been earlier anticipated, household saving rates have not declined. Therefore, aggregate demand will not have any upward push from domestic sources

The natural rate of unemployment is thought to have increased suddenly due to the mismatch between labor and output resulting from the change in the composition of output. But large

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making a slack even more likely than overheating, meaning imports will not increase. Thus what helps one achieving one target hinders in achieving another.

China plays a key role in global current account imbalances. We can look at this issue through the conventional “elasticities� view, where the impact of Chinese currency misalignment is assessed in a partial equilibrium approach. Has China’s misalignment of the Yuan driven the surge in its trade surplus? The fact that the Yuan appreciates even as the trade balance surges does not invalidate the proposition that exchange rates can have an impact. As countries experience rapid economic growth exchange rates typically appreciate. Still, the empirical evidence regarding the strength of exchange-rate effects on Chinese trade is not definitive. Studies using Chinese data predating the recent recession find some effects of the exchange rate on Chinese exports, but do not typically find correspondingly large and statistically significant effects on imports.

The Emerging-Markets If we talk about the emerging economies, the problems facing them are quite different. The current account balances of Brazil, Russia, India and China are depicted in Figure b. What stands out is China, which is projected to resume expansion, and also Russia whose current account balance is projected to plummet close to zero. What the danger is that the emerging economies may overheat. At around 3 percentage points in 2007, Brazil, India and China all had substantial output gaps before the global recession (see figure 6). But except for Russia, which has been negatively affected by the slump in energy prices, forecast output gaps for 2010 are all in the positive range. The trajectory of the output gap for India, which is slated to rise to above 5 percentage points by 2012, is one worrisome feature.

The lens of saving and investment balances, which highlights the fact that the current account is related to the budget balance and the gap between private saving and investment, is another way to look at the issue of Chinese rebalancing. This perspective shifts the focus to Chinese private saving as well as to government saving. Recent analyses have focused on the elevated levels of all three components of household saving, corporate saving, and government savings as against the mid-2000s, when the surge in corporate savings was identified as a key factor. The trend decrease in the share of labor income in Chinese GDP is part of the reason for this. And along with the relatively high household saving rate, it means that merely trying to raise the household saving rate (by improving the social safety net and increasing access to consumer credit) cannot in itself solve the problem. So, rebalancing involves a rebalancing

Figure b Current Account (% of GDP)

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of the domestic shares of income away from capital.

References:

The bottom-line is that the Chinese government has a lot of scope to accelerate rebalancing through its policies. And this involves faster currency appreciation in the short term while over the longer term, it will require allowing state-owned enterprises to pay dividends, reducing the monopoly power of state-owned corporations and accelerating the development of a social safety net that will reduce incentives for household saving, while decreasing government saving.

Policy Implications With the likelihood of a two-speed global recovery becoming quite apparent, the possibility of overheating is more pronounced in emerging markets. On the other hand, there is little chance of overheating in the short term in the advanced countries. Rather, the greater risk is of deflation, combined with stagnant growth. With the current policies all over the world, global adjustment of current account balances is not proceeding with the speed it should. The failure of countries with current account surplus, like China, to resume currency appreciation has basically resulted in quickest means of effecting some adjustment being put on hold. But it cannot be held back forever. High unemployment combined with burgeoning trade deficits, at some point, will increase the likelihood of a destabilizing trade conflict. About the Authors: 1) Vibha Bharati-Indian Institute Management Bangalore

of

2) Saurav Kumar Lugria-Indian Institute of Management Bangalore

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World Bank, 2010b, Global Economic Prospects (Washington, DC: World Bank).

IMF, 2010, “Chapter 4: Getting the Balance Right: Transitioning Out of Sustained Current Account Surpluses,” World Economic Outlook, April 2010.

World Economic Outlook, October 2010

Chinn, Menzie, Barry Eichengreen and Hiro Ito, 2010, “Rebalancing Global Growth,” paper prepared for the World Bank’s Re-Growing Growth Project (August)

Chinn, Menzie, and Hiro Ito, 2008, “Global Current Account Imbalances: American Fiscal Policy versus East Asian Savings,” Review of International Economics 16(3): 479-498


was no need to raise rates. But the prices were lower because of massive cheap imports of goods and services from China, India and other emerging economies. Thus the US consumption was being fuelled by emerging economies and the US trade deficit was at record high levels. This would normally lead to devaluation of the currency and make the imports costlier. But there was huge appetite for dollar reserves from China and Middle-East. Thus the slide of USD was not much pronounced and imports continued to grow.

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verheating of Emerging Market Economies and the role of Central Banks Abstract In the aftermath of the Great Recession, the developed world is striving to reduce its current account deficit. Private consumption and capital expenditure in the emerging economies is very high. As recovery picks up in the west, commodities are becoming dearer leading to inflation in the developing world. Emerging markets fear overheating. Their central banks want to slow down growth. Liquidity is being dried and rates are being increased to avoid formation of asset bubbles and runaway prices. But US unemployment and the EU debt concerns still haunt them. They need to closely monitor economic data and keep their tools handy for any situation.

An important distinction between open and closed economies is the fact that the effect of fiscal stimuli significantly different for both models. In a closed economy, fiscal stimulus can increase aggregate demand which can give a boost to real GDP in the short term when prices are sticky or constant. But for an open economy, growth in aggregate demand can be satiated by increase in imports which has no effect on GDP. US being the most open economy fuelled growth in many emerging markets since 2001 but hasn’t been able to raise its own GDP vis-a-vis its private Consumption. This was a period of jobless growth and sluggish real wage growth. Thus private savings were getting depleted and loan repaying capacity had slowly decreased to alarming levels. But financial models which were based on statistical models and historical behaviours could not capture this. Also with the complex derivative products like CDOs, risk was passed on to the higher level. Asset bubbles formed in real estate and equity markets. Commodities too were at all time highs in 2007 before recession hit. All this eventually led to large scale defaults and collapse of the Lehman Brothers, AIG and all.

Global Financial Crisis After the dot.com bubble burst in 2000, the developed countries went into a mild recession. To shorten the time taken for reversal and to alleviate the pain caused by it, US Fed reduced interest rates to unprecedented levels to boost consumption. This led to a global shift in Aggregate demand which boosts GDP growth albeit in the short term. These rates were not increased although the economy was on track. Indeed, the real (inflation-corrected) funds rate was negative for 31 months (from October 2002 to April 2005). The argument against raising rates was that inflation was low and so there

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growth in the developing countries was back to pre-crisis levels. G20 the consortium of twenty largest economies of the world in their meeting decided as one of the most important action to be taken to bolster economic recovery: ‘In advanced G-20 economies, internal rebalancing is advancing, albeit slowly.’ The focus of the meet was to reduce dependency of the world on demand from the developed world. As the private savings are at an abyss, there is little demand left. Also, huge trade deficits of the developed world will have to be reduced. This will need to be done through export promotion and import substitution by the developed world. The US wanted demand to come from India, China and other emerging economies to substitute for the lack of demand in its own territory. With newer rounds of Quantitative easing, the US was putting a lot of greenback into the market which would put downward pressure on the USD.

Figure 3: Growing consumption in the US during the 1 boom years despite stagnant real wages, 2006-2007

Steps taken by economies of the world to contain the effects of the Great Recession: To avoid the catastrophic collapse of the financial markets and real economy, the governments intervened in the following three ways:   

Bailouts and injections of money into the financial system to keep credit flowing Cutting interest rates to stimulate borrowing and investment Extra fiscal spending to shore up aggregate demand

But export oriented economies need a strong political will power to move from exporting to consuming economy. China which had pegged its currency Yuan since the advent of the Great Recession is still reluctant to let its currency appreciate. This will help shield itself from the decline in exports considering the untested domestic demand. Private savings in China are not high in the first place as most Chinese workers work at the lowest possible wages. There have been attempts by the Unions (urged by the government) to increase the daily wages of the workers which will increase disposable income. All these measures have raised demand. But the extent of easing by the government is questionable.

These measures have sought to prevent further economic deterioration and ultimately keep workers in jobs where possible and help create new jobs to provide opportunities for the unemployed. 48 countries provided fiscal stimulus packages. Collectively, the fiscal stimulus packages account for 3.9 per cent of world GDP (as measured in 2008) and 4.8 per cent of their national GDPs. 20 out of the 48 can be classified as developing countries. Stimulus packages helped in averting a disaster. But the effects of the stimulus were different for the developing and the developed world. Developed world continued to struggle with low growth and high unemployment whereas

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Figure 4: Real Contribution to World Consumption

1

bottom of the pyramid thus boosting demand in these economies.

Figure 5: BRICS Income per Capita

Other countries with floating currencies have also taken a cue from China and have undertaken measures to depreciate their currency to safeguard their exporters. As a result, we see the following two major themes playing out: 



Rise in commodity prices

Social Policies impact demand

Through policies such as NREGS in India, raising Minimum Wages in China, etc there was tremendous increase in the demand at the

1GS

liquidity

in

emerging

As the currency is undervalued and emerging economies are poised to grow, the global capital is finding its way into these economies. This hot money sought to take advantage of this arbitrage opportunity. As a result there is ample liquidity in these markets and the central banks have had a tough time sucking this amount of liquidity out of the system. For example, Reserve bank of India raised interest rates and cash reserve ratios many times before the commercial banks actually raised rates. This liquidity was also giving rise to many asset bubbles like in the real estate sector in china. Equities were performing ever so well. But these economies are capital deficient and need capital to support their capital expenditures. It is extremely difficult for governments to distinguish between hot and real investments. With ample liquidity, there is

As the USD weakens (oversupply of dollars), commodities rise collectively as an asset class. As the emerging market currencies are undervalued, the commodities are costlier for them as well. In an economy which is completely free of any manipulation, this rise would have been negligible as the currency appreciation would have countered the rise of commodity prices in dollar terms. These prices are causing the core inflation to be high. The central banks have not been able to control prices as the rally is happening globally. 

Infusion of economies

2

Global ECS Research

2GS

17

Global ECS Research


always a shift in Aggregate demand and as such the prices started rising. 

The USD and Euro are depreciating against the Asian currencies since the last two decades and the momentum will continue. As a result, exports by emerging economies will also not pick up to pre-crisis levels. Moreover, with the focus of the US to reduce trade deficit will also result in more imports into the emerging economies.

Reluctance of Emerging market Central banks to increase rates fast

Rates in the US were at all-time lows. Raising rates in emerging economies at such a juncture could have caused arbitrageurs to put more money into emerging markets and add to the liquidity. Hence the rates were raised slowly which meant asset bubbles were given a free ride till then.

In such a scenario, there can be a deceleration of growth in export oriented emerging economies. It may cause unemployment and reduce domestic demand further. As a result, demand from both domestic and international markets may dry up further putting pressure on the growth prospects. We may not see these economies replicating the runaway growth that we witnessed during the last decade.

Thus we see that overall demand is greater than the supply could match. We also see asset prices slowly inching towards pre-crisis levels. These are signs of overheating in the economy. Demand is growing faster than supply putting pressure on prices. As the interest rates were low to avoid massive capital inflow, the consumers had a negative real rate of interest scenario and as such their propensity to save became lesser and to spend higher. The demand for automobiles in the emerging markets is at an all-time high to take an example. This coupled with ample flows into the economy and the buoyant equity markets encourage the businesses to expand production to meet demand. Supply will finally want to catch up with this demand. But is the demand here to stay?

Course of Action to be taken by the Central Banks As the private investment is growing to accommodate the overheating demand, base metals prices are growing at an alarming rate. The central banks which co-ordinated by providing simultaneous stimulus packages must now prevent asset prices to balloon especially crude and base metals. The recent growth in the last few decades has created a strong middle class with considerable amount of disposable income. Hence there is an upward pressure on food prices as well. Labour wage rates have increased substantially too. Inflation is a very important political concern for the governments too. Food prices constitute a major portion of their income and as such food inflation can cause political tensions in the developing economies. Central banks and governments must now look to reduce the money supply and roll back fiscal stimulus packages. This may increase unemployment but will also cool off labour wage rates. Food prices

With green shoots of recovery in the US and relatively stable Europe (barring a few sovereign default scares), the hot money will eventually shift out of the emerging economies back to the west. The demand in these emerging economies which was largely liquidity backed will dry up. Additional capacities created during this boom may hurt the economy as there is a possibility that the additional capacity will remain idle.

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have been increasing steadily since 2005 levels barring a blip in 2008. Thus, food price inflation may be a result of supply concerns as well as increases demand. Steps should be taken to increase the supply of food grains to bring food prices under control.

About the authors Ankur Choraria graduated from National Institute of Technology, Jaipur in 2007 and joined Cognizant Technology Solutions. He worked as an analyst in Banking & Financial Services domain. He is currently pursuing Master of Management program at the SJMSOM, IIT-Bombay. His email id is: ankurchoraria@gmail.com

Another major aspect that the central banks need to control is the credit growth. As the liquidity was ample many companies went on capital expenditure spree to meet the rise in demand. It can cause upward pressure on commodity prices. Emerging markets must try to cool down. It will help in checking asset bubbles and create an environment more sustainable long term growth.

Laveen Ramrakhiyani graduated from Dhirubhai Ambani Institute of ICT (DAIICT) in 2009 and has 1 year experience with Infosys and Mu sigma (Analytics). He is currently pursuing Master of Management program at the SJMSOM, IITBombay. His email id is: laveen10@gmail.com

Signals from the developed world have been mixed. The G20 meet too recognized threat to global recovery. The major reasons could be:  

 

Saurabh Surana graduated from Mumbai University (KJ Somaiya College of Engineering) and has 2 year experience with Tata Consultancy Services Ltd. He is currently pursuing Master of Management program at the SJMSOM, IIT-Bombay. He is interested in finance and macro economics. His email id is: saurabh2986@gmail.com.

Renewed pressures in the U.S. housing market Spill-overs from renewed turbulence in sovereign debt markets, notably in Europe The lack of credible medium-term consolidation plans Financial and trade protectionism and currency instability

References 1. Brazil, India, China may be overheating, says Roubini. (2010, June ) Retrieved from http://economictimes.indiatimes.com/news/economy/BrazilIndia-China-may-be-overheating-says Roubini/articleshow/5996621.cms2)

This has kept the possibility of double dip still on. Thus fiscal and monetary expansion cannot be rolled back in a jiffy. But the impact of overheating can be equally disastrous for the developing world. Hence, central banks need to take a balanced approach under current scenario. They should also learn from the previous scenario where excess liquidity caused monetary transmission to be perilously slow. Central banks need to keep the liquidity under tight control so that any change in the policy will affect the economy swiftly.

2. India needs tighter policy to prevent asset bubbles: OECD. (2010, Nov 18). Retrieved from The Economic Times: 3. Meeting of G-20 Finance Ministers and Central Bank Governors. (2010, October 21 - 23). Retrieved from http://www.imf.org/external/np/g20/pdf/102110.pdf4) 4. Moodys cautions against overheating of economy. (2010, Dec 18). Retrieved from ReportLinker: http://news.reportlinker.com/n04101071/Moodys-cautionsagainst-overheating-of-economy.html5) Rowley, A. (2010, Oct 10). 5. Asia overheating risk looms – IMF. Retrieved from Emerging Markets: http://www.emergingmarkets.org/Article/2690778/Asiaoverheating-risk-loomsIMF.html

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Decoupling” in this new book, Fiscal Hangover: How to Profit from the new global economy. As the world witnesses some signs of recovery from the crisis, the supporters of decoupling thesis believe that emerging markets hold the key to this recovery.

T

he Decoupling Debate: Do Emerging Markets hold the key to recovery after crisis?

Defining Decoupling There has been no standard definition of decoupling. It is more appropriate to conceive of decoupling as an idea rather than a strictly defined term. The idea that Asian markets could perform differently than developed counterparts suffers from two major weaknesses:(Foster, Decoupling, Further Defined, 2010)

Abstract The Decoupling thesis has been a contentious issue since its origin. It advocates that Asia’s emerging markets can be insulated from the global economy, especially during the period of recession. After the global financial crisis, emerging markets of Asia showed signs of strong recovery while US economy was limping. This provided further impetus to the decoupling theory and proponents of the theory believed that Asia will pull the world out of crisis. However, critics argue that real decoupling is not possible and current recovery is only due to monetary and fiscal stimulus.

Are the financial markets decoupled or the ‘real’ economies? The movements of these two need not be the same.

The time period of observation for decoupling to be evident. Should it be measured over days, months or years?

A better definition of decoupling, which takes into account its long term nature, is based on three pillars: Resilience, Uniqueness and Independence.(Foster, Decoupling, Further Defined, 2010)These pillars should be interpreted as the necessary conditions for decoupling to materialize. There is growing evidence to support the existence of these pillars. Bond markets have gradually developed in Asia with domestic investors playing a significant role. The growth of intrinsically domestic service industries presents a unique opportunity and shields the region from global imbalances.

Introduction The issue of ‘decoupling’ of emerging Asia has always been at the center of much debate in the economic circles. It refers to the thesis that emerging Asian economies have become selfcontained entities and can maintain their own growth independent of the trends in the markets of the developed countries. The theories of decoupling gained much emphasis during the first decade of 21st century. However, these theories received a strong setback with the onset of the global financial crisis, when the tremors were felt throughout Asia.

History of Decoupling Debates

The theories of decoupling again gained impetus as the world recovers from the crisis. Keith Fitz-Gerald advocates the term “The Great

Developing countries did not figure significantly in the macroeconomic policy considerations in

20


the developed economies before the 1980s. The concept of decoupling evolved with the independence of Asian economies from developed economies and “strong domestic demand and confident consumer from Asia were hallmarks of 1980s.”(Liang & Qiao, 2007) However, 1980s were turbulent times for the US economy with housing woes, large current account deficits and weakening currency. Decoupling thesis received a setback with the Asian financial crisis of 1997-98. The domestic weaknesses of the Asian economies made them increasingly dependent on US demand, boosted in 1990s by IT revolution.

Vansteenkiste reported that business cycles of Emerging Asia moved independent of US business cycle. This is mainly due to China, which experienced strong growth independent of its trading partners. They also estimate that 1 percentage point decrease in US GDP would decrease GDP of emerging Asia by 0.23% from baseline. (Dées & Vansteenkiste, 2007)Some authors even supported decoupling thesis at the beginning of the crisis. (Rossi, 2008) The notion of decoupling gained acceptance by large investment banks such as Goldman Sachs and Morgan Stanley. Liang and Qiaowrote in Asian Economics Flash “China, together with emerging Asia, stands a very good chance of outperforming and decoupling from the US economy in the coming few years.” (Liang & Qiao, 2007)However, decoupling was not always observed as a result of inherent strength of Asian economies. For example, a strong performance of equity markets outside US could have been attributed to a $54 billion inflow to emerging market funds.(Prakash, 2008)

Decoupling thesis gained prominence once again after the bursting of dot com bubble and September 11, 2001 attack in US. Emerging economies like China and India maintained high GDP growth while US and Europe tethered on brink of recession. In 2002, while GDP of US and Europe grew by 1.8% and 0.9% respectively, that of developing Asia grew by 6.9%.(IMF, 2010). “The ‘decoupling’ thesis… [became] a popular theme in Asian policy circles in the first decade of the new millennium…”(Athukorala & Kohpaiboon, 2009)

Evidence from Crisis The global crisis in 2008 delivered a strong blow to the decoupling thesis. Dooley and Hutchison argue that “emerging markets responded very strongly to the deteriorating situation in the U.S. financial system and real economy”.(Dooley & Hutchison, 2009)They analyze the crisis in 3 phases: Phase I runs from February 27, 2007 to May 18, 2008; Phase II runs from May 19, 2008 to September 14, 2008; Phase III runs from September 15, 2008 to February 2009.

US growth slowed down again in 2005 providing further impetus to decoupling theories. This was brought out by IMF World Economic Outlook 2007. Anderson claimed that “The bottom line, as we’ve argued many times before, is that there’s no reason to argue over whether the mainland is “decoupling” from the global cycle – as far as macro growth is concerned the economy is and always has been effectively “decoupled”, and China has little to fear from a global demand slowdown.”(Anderson, 2007)Dees and

21


Figure 1: U.S. and emerging market equity prices

Figure 2: U.S. corporate and emerging market bond spreads. Note: the two vertical lines mark the dates (May 19, 2008 and September 15, 2008) that separate the three phases of the subprime crisis

The 16 month period February 2007 to May 2009 presented strong evidence in favor of decoupling of emerging economies from developed countries. The MSCI emerging markets outperformed the S&P 500 by nearly 40%. (Figure 1)The EM currencies also gained value against the dollar by approximately 10%. This appreciation against dollar can also be attributed to carry trade inspired by high yields in emerging economies. The investors clearly did not anticipate that the events in US will negatively impact the earnings in emerging economies. Thus, in the early part of the crisis, emerging markets were more or less decoupled from the developed economies. This is also underscored by the comparison of credit markets in US and emerging economies. Figure 2 compares CDX EM, an index of credit-default spreads for emerging market sovereign bonds and an index of US investment grade corporate bonds over US treasuries. In the early phase of crisis, spreads in emerging markets declined while the US index did not change by any significant amount.

decoupled markets also fell relative to the dollar. Thus, during phase 2, there is little evidence to support the fact that emerging markets had not been affected by the collapse of financial system in US. The third phase also emphasis a recoupling of the emerging markets with the US. The world trade froze across all economies in the world, and imports and exports fell about 30% after September 2008 in most countries. Dooley and Hutchison studied correlations between S&P 500 and indices of emerging markets and found that they increased significantly during the second and third phases of the crisis. An event analysis also indicated that “U.S. news significantly moved CDS spreads in selected emerging markets.�(Dooley & Hutchison, 2009)

Evidence after Crisis The support for decoupling thesis again gained ground as the world saw greens shoots of recovery after the crisis. In 2009, the economies of US and Europe remained weak while India and China showed signs of rebounding. IMF predicted growth rates of 5.4% and 8.5% for

During Phase 2, from May 19, 2008 to September 15, 2008, the MSCI EM index fell and gave up its outperformance related to S&P 500. The currencies of the earlier assumed

22


India and China respectively. Mohamed ElErianpointed out, “With the ongoing normalization of the financial system, the decoupling camp is again in strong ascension today. It is buoyed by the developing pick-up in economic activities and the fact that equity valuations are now back above the pre-Lehman levels.”(El-Erian, 2009)

During each financial crisis of the last decade, Asian equity markets have shown signs of recoupling. This can be seen from Table 1.(Foster, Decoupling, Further Defined, 2010)

Decoupling a Myth? With increasing globalization, it is often hard to believe in full decoupling of Emerging markets from the developed ones. Substantial evidence is present to prove that decoupling theory is premature. Decoupling is particularly applicable for emerging economies, with headline exports comprising of 70% of individual GDPs. The share of exports in GDP has risen over the past decades. The most popular evidence of decoupling was the increasing intra-regional trade in Asia, especially the rise in exports to China. “China is the biggest export destination of Japan, Australia, South Korea, the Association of South-East Asian Nations, Brazil and South Africa; and the third biggest export market of the United States, the European Union and India.”(Xinzhen, 2010)

MSCI US Index

MSCI World Index

MSCI AC Asia ex Japan Index

Tech Bubble Dec. 99- Dec. 2001

-23%

-28%

-38%

SARS Crisis, Nov. 2002-Mar. 2003

-9%

-10%

-13%

Global Financial Crisis, Oct.2007Nov. 2008

-41%

-47%

-60%

Table 1: Cumulative Total Returns, Index performance during 3 most prevalent financial crises

The ‘currency wars’ have also demonstrated that the economies of the world are linked to a great extent. With all the economies connected by trade, no wonder all countries wish to devalue their currencies to make exports competitive. Taimur Baig, Deutsche Bank’s chief economist for India, Indonesia and the Philippines says that “the reason for the tight attachment is not surprising. There exists remarkably close linkage between regional exports and consumption. Even investment looks to follow the export cycle closely. In recent years this linkage has not waned, underscoring why the East Asia region remains a strong beta to G3 growth.”(Baig, 2010)

Since Q2 2009, Asian economies have been on a rebound. However, this can be attributed to the fiscal and monetary stimulus by the governments. China unveiled a CNY 4 trillion ($586 bn) package in November 2008 to counter financial crisis (Menza, 2008) and India also introduced a similar package. Critics of decoupling argue that any economy will grow if backed by such substantial amount of money supply. At best, this signifies the macroeconomic strength of the governments. The increase in exports to China is also not any measure of decoupling.

Conclusion From the above discussions, it is evident that more research is needed to fully examine the validity of decoupling thesis. It remains to be seen if the current recovery will be a decoupled

23


one. Some of the likely scenarios in a decoupled recovery are: (McDonald, 2010) 

Commodity price pressures for industrial inputs

Rising inflation leading to higher interest rates in Asia. This will to higher interest rates in US to attract funds from Asia for government debt.

About the Author

A differential of 4% or more between Asian growth rates and that of West

and China should be asking is: Do we want to be decoupled from the global economy?

Ankit Sinha is a 2nd year PGP student at IIM Bangalore. He has done his graduation in Chemical Engineering from IIT Kanpur. He interned with Nomura in FX Options and Rates trading. He can be reached at ankit.sinha09@iimb.ernet.in References Anderson, J. (2007). Is China Export-Led? UBS Investment Research.

An increase in intra-regional trade in Asia leading to weakness in global shipping levels

Athukorala, P. C., & Kohpaiboon, A. (2009). Intra-Regional Trade in East Asia: The Decoupling Fallacy, Crisis, and Policy Challenges. ADBI Working Paper Series, No.177.

Stronger M&A activity within Asia Baig, T. (2010). The Markets in 2011. Deutsche Bank.

The increased globalization has also raised the question if any decoupling is possible at all. Asian economies are largely export driven, and private consumption is still not a major portion of GDP. The currency wars demonstrate that emerging economies continue to rely on exports to boost their growths. This raises doubts on their ability to pull the world out of recession and the dream of a decoupled world seems still out of reach.

Dooley, M., & Hutchison, M. (2009). Transmission of the U.S. subprime crisis to emerging markets: Evidence on the decoupling– recoupling hypothesis. Journal of International Money and Finance, Vol. 28, Issue 8, 1331-1349. Foster, A. (2010, December). Decoupling, Further Defined. Retrieved january 2, 2011, from Asia Insight: http://www.matthewsfunds.com/perspectives-on-asia/asiainsight/default.fsIMF. (2010). World Economic Outlook Reports. Retrieved January 2, 2011, from International Monetary Fund: http://www.imf.org/external/pubs/ft/weo/2010/02/pdf/tables.p df Prakash, A. (2008, February 12). Decoupling or Recoupling? Retrieved January 2, 2011, from Business Standard: http://www.business-standard.com/india/news/akash-prakashdecoupling-or-recoupling/313393/

Another issue which might be of interest to policymakers is whether decoupling is desirable. A decoupled economy is less prone to exogenous shocks, but is also bereft of the positive effects of global investment. Myanmar and North Korea are the most isolated Asian economies, which has led to them being “worstoff countries in the region”. With their significant trade with China, they are decoupled from the benefits of global recovery but are vulnerable to effects of recession.(Emerging Markets Monitor, 2009) The question that India

Rossi, V. (2008). Decoupling Debate will return: Emergers dominate in long run. Chatham House, IEP BN 08/01. Xinzhen, L. (2010, december 27). The Engine of the World. Retrieved january 2, 2011, from Beijing Review:

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Future of Asian

largest economyi. But the doubt rises if these factories would run out of steam soon.

Indian Scenario

Giants

India experienced its highest FII inflow of $28.4 billionii this year. Better corporate earnings and higher growth rate of the net income led to increased foreign investments and the SENSEX increased by16.74 % over the previous year. The influx of the funds is also attributed to the higher returns from the developing nations than the returns from developed nations. But fear grips as the economists wonder whether this growth is a bubble and may burst anytime soon.

Abstract China and India showed resilience when the developed nations were struggling hard. But higher inflation rate and excess capital inflows into these countries raise fear about possible asset price bubble that may burst sometime in the future. Quantitative easing measures by USA and the bleak state of affairs in Euro zone adds further apprehensions about the future growth of these Asian Giants. These countries have beaten the earlier forecasts and with further reforms in India and structural changes in China by fulfilling the domestic needs they would continue to prove others wrong by growing at higher rates in the future too.

The price of assets including the equity, gold price and real estate properties are increasing and the inflation rate is also high. Gold increased by nearly 10% last year and increased by further 20%iii since April this year. Real estate prices have also peaked and even surpassed pre-crisis levels in several places. The more demand in the boom period would cause the asset price to increase and if the supply couldn’t be matched to the aggregate demand, then this would lead to overheating.

The west nations turned to their east when they heard the roar of the tigers from the east. When the world was in crisis, the two countries grew and showed their economic prowess. The Question if the future of the world is in these two countries remains to be answered. Will they become the new super powers or else this is just be an exaggerated story which may not bring the dreams of the 2 country with more than a billion people to come true.

The growth – inflation dilemma is a common paradox that every central bank deals with. And RBI made the right move to follow tightening monetary policy to fight inflation even though it hurts the growth. The repo and reverse repo rates have been increased from 5 to 6.25% and 3.5 to 5.25 respectively and the following graph shows the actual rates from March 2010 to December 2010.

The emerging economies in the world include China, India, Brazil, Russia, South Africa and Mexico among others. The two most populous countries in the world were truly shining in the last few years and were bringing the emerging economy into the world stages. Chinese GDP grew at a rate close to 11% and India grew over 8% in 2010. Chinese beat Japan in the second Quarter output and thereby becoming the 2nd

Following the RBI hike in the repo rate, the banks increased the deposit rate and base rate. (Base rate is the minimum rate for lending).SBI increased its base rate by 40 basis points to 8%, ICICI Bank and Kotak Mahindra Bank also

25


followed SBI in hiking the lending rateiv. SBI and IDBI also increased their deposit rate to encourage more people to deposit and thereby improving the liquidity in the systemv. These measures helped in taming the inflation rate to around 9% from over 15% in the beginning of the year in the countryvi as the cost of borrowing money is kept higher so the demand for the goods is reduced.

dollar flow in the system. These excess funds flow into the developing nation in the form of FII’s. These funds could be withdrawn anytime and hence they make the capital market system in developing country unstable. Exposure of these FII’s in Indian capital market is high and hence there would higher volatility in the stock price movement.

Policy rates in 2010

Chinese Scenario 8 6 4 2 0

Inflation also hit China and the Chinese central bank is fighting against it with tightening monetary policy. The real estate price is also soaring high to a dangerous situation. Chinese Government resorted to increase the level of reserves the banks must hold to curtail the credit growth and increased the interest rates so that people would save the money instead of creating excess demand. But the Chinese growth is attributed to its export driven economy. The domestic needs are not met and the country focuses more on exports. This is unlike India which has current account deficit implying higher level of imports than exports.

Repo rate

Reverse Repo rate

Fear of default of sovereign debts in euro zone is on the raise. Greece and Ireland were bailed out and the fate of Spain and Portuguese is not encouraging. Portuguese would be the first country this year in Europe to go for raising money through bonds and the debt raising has become difficult for them. The borrowing cost of Portuguese increasing as the yield of the 10 year bond jumped from4.065% to 6.683% in 2010viii.

Yuan is kept at a very cheaper rate to promote export and the domestic demand in China is not met and the developed nations are exerting enormous pressure on China to strengthen its domestic currency. Strengthening of Chinese Yuan would hurt the exporters and hence would affect Chinese growth.

Collapse of one economy would affect the others leading to a cascading effect of affecting all the nations. This fear could also hurt the growth of the India and China as foreign players would hesitate to invest in these nations and the outflow of FII’s would be higher because of the economic crisis in Euro zone.

International Factors Federal Reserve resorted to the Quantitative easing in US in last November for the second time since recession to keep its dollar at its lower rate and to create liquidity in the system. The central bank planned to buy $600 billionvii in long-term Treasuries thereby increase the

26


Future Outlook

About the author

These countries should keep in mind the Asset bubble in Japan that collapsed in 1991 and it severely affected the nation’s growth for more than a decade. Consumer demand and private investment in India would keep the economy growing and the Asian development Outlook predicts India’s GDP growth for next year to be around 8.7%ix.

Senthil Kumar V is a second year PGP student in Indian Institute of Bangalore. He completed his BE in the field of electronics & communications in college of engineering, Anna university and can be contacted at senthil.kumar09@iimb.ernet.in Contact number: 9916058201 References:

Both India and China should implement reforms that boost the productivity and increase competitiveness of the firms. Growth of FDI instead of FII should be encouraged in these countries. These countries should grow domestically and the growth and profits from the domestic firms would spur the growth of the country.

1

http://www.newstatesman.com/economy/2010/08/japan-chinagdp-economy 1

http://www.livemint.com/2010/12/23182411/Record-FII-inflowin-2010-wil.html?atype=tp 1

http://www.thehindubusinessline.com/2010/11/03/stories/2010 110352250100.htm 1

http://www.moneycontrol.com/news/economy/banks-hikerates-loans-to-cost-more_509832.html 1

http://www.deccanchronicle.com/business/banks-hike-depositrates-362

If the country’s productive capacity is able to keep pace with growing demand, then the high levels of inflation could be avoided. Chinese do have the structural problem of having too much investment and too little domestic demand. Sooner or later, it should stop relying on domestic investment and external demand. To keep FII inflows within the absorptive capacity of the economy and to have stable currency valuation, India could follow some of the developing countries such as Thailand and Korea to impose capital controls by levying tax on foreign capital inflows.

1

http://www.tradingeconomics.com/Economics/InflationCPI.aspx?symbol=INR 1

http://finance.ryahoo.com/news/Quantitative-easing-2-is-herecnnm-1729089799.html?x=0

The debate on overheating of economies is not new. The debate is there for the last 4 years and both the countries have proved that they have removed the doubts of the investors and they have grown fast in the hard times and have become further stronger and they would still continue to do so in the future as well.

27


Currency Dynamics in

what is required to prevent a replay of financial crisis.

the Emerging Market Economies

Monetary policy should aim at domestic price stability while letting exchange rate float freely. A strong domestic currency retains its purchasing power by maintaining a low rate of inflation. A competitive currency also requires that other countries should not implement policies that artificially depress its value in order to promote their exports and deter their imports. This gives enough reason for the US to force China to set the Renminbi to float freely. China’s position is that, to avoid the negative impact of a stronger Renminbi on China’s exports and hence employment, appreciation must proceed in an autonomous, gradual and controllable manner. But resisting the US can result in hot trade disputes between the two nations. China’s large and persistent current account and capital account surpluses imply that the Renminbi is highly undervalued. Renminbi appreciation should have started when China’s trade surplus was much smaller and when its economical growth was much less dependent on exports. Owing to the financial crisis, China’s export growth in 2009 dropped by 34%. This drop makes the Chinese government even more hesitant to let its currency float free.

Abstract Many of the emerging economies have outperformed the advanced economies in its recovery from the global economic slowdown. As nations world over look to come out of this economic shock as quickly as possible, the epicenter of economic growth is surely shifting into the hands of all the emerging nations. As the world economic canvas is torn into two camps with contrasting goals and growth objectives, this article looks into the policies employed by the various nations, including India, with respect to their currency and foreign exchange policy, as they look to assume increased importance in the world economic scenario.

Across the Globe The sheer enormity of the present day world economy requires deep and liquid market in multiple currencies. This view is consistent with history. Prior to 1914, reserves of central banks were majorly held in British Pound, French Franc and the German Mark. Dollar and Pound then shared primacy till 1930. Today, currencies other than the Dollar account for more than 40% of international reserves. In the coming years, the Dollar, Euro and Renminbi will share the roles of invoicing currency, settlement currency and reserve currency. This will make the world a safer place financially as a decentralized international monetary system is

In order to peg the currency, the People’s Bank of China buys Dollars and sells Renminbi. But the rapid deterioration in America’s fiscal deficit and the continuous deterioration in its external balance may tempt the US to inflate away its debt burden and hence makes the Chinese government hesitant to accumulate Dollars. This dilemma is worsened by the overall increase of price levels in China, causing Renminbi to strengthen. If the Renminbi is allowed to float, the net capital outflows will rise drastically, pushing it upward, very similar

28


to what Japan experienced after the Plaza Accord in 1985 and hence can prove disastrous to the economy.

ensuring that India was able to come out of the crisis scenario majorly unscathed. Emerging economies have been the pivot point, playing a major role in reviving the economy, and India has played a vital part in leading the world into this path of resurgence. The RBI has won the respect of major economists world over for having maintained austere policies prior to the recession, and for having taken quick corrective action in order to restrict the damage to its bare minimum.

Though the American economy is adversely affected by China pegging its currency, it cannot expect to attain balance by a weakening Dollar. The basic cause of the US imbalance is overconsumption and over-borrowing. A weakening Dollar may result in panic in the capital markets, thus requiring higher risk premiums on Dollar denominated assets, leading to a further weakening of the Dollar and an economic slowdown. Though the Renminbi appreciation may displace Chinese goods sold in the US market, if the US fails to narrow its savings gap, its current account deficit will not reduce. Thus what the American economy needs is strengthening of the domestic economy.

However, the woes of the Indian Central Bank are far from over, as it looks to align its policies to cater to conflicting goals of roping in the constantly increasing inflation and parallel ensure unbridled growth of the economy. As the developed nations look to escape from the abyss of recession by pumping in money into their economy through quantitative easing, the emerging nations, including India are faced with increasing inflow of funds into their economy, as foreign investors are attracted by the higher interest rates in the EMEs, and gain increasing confidence in their growth potential as well. The outflow of cash from the developed nations might not have much of an impact on the developed countries, which are huge economies. However, the volume of inflow might be huge from the EME’s perspective, given the smaller size of its economy. Given the sudden spike in the inflow of money, the inflation scenario of the country has remained high throughout the financial year, with food inflation rising to a 23-week high of 18.32% during the last week of December, and registering an overall inflation of 7.48% in November. Given the ever-increasing inflation rate, the RBI has been forced to increase its policy rates numerous times over the past year.

But it is conventional wisdom that it is impossible to fix both exchange rate and domestic monetary conditions simultaneously. The Asian financial crisis of 1997-1998 convinced the world that economies which maintained exchange rates were able to sail through better than those that did not. Maintaining controls requires a high level of reserves and higher reserves lead to higher inflation related risk of the reserve currency. Highly comparable to the Chinese economy in terms of growth is the Indian economy. The huge inflow of capital to the economy poses a challenge in terms of the economy’s capacity to absorb it. In the present scenario, it is important that the RBI policies be such that the overheating of the economy is curbed.

In India The expertise displayed by the Indian Central Bank in handling the economy during the economic crisis of 2008-09 was instrumental in

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All other emerging economies, including ones like Brazil, have responded to this continuous inflow by introducing this capital control policies. The Indian Central Bank has been criticized for being complacent regarding taking a stance to prevent this excessive inflow. Excessive capital inflow can be a cause of concern as it can

world by Goldman Sachs. This is because a majority of the investors look for long term investing opportunities, and thus such steps would prove useless in such a case. The other possible course of action is by intervening in the foreign exchange and trying to control the Rupee from appreciating. This can be highly relevant for India, especially for the services sector, which is highly dependent on exports for its growth and revenue. On the flip side, such an intervention of pegging the currency could cause an expectation of appreciation in the future and thus attract further future inflows. The logic is as follows: If the Indian rupee is currently to be valued at 1$ to 40 rp, and is instead pegged at 1$ to 45 rp, an investor would invest further in the economy expecting the rupee to appreciate to a value of 40 rp per dollar in due course, thus giving a return of more than 1$ to the investor. Thus, even though in the short run, pegging the currency could seem as a good option, this could harm the country in the future and cause further inflation.

 Cause currency appreciation  Cause increase in asset prices In addition to this, there also remains the danger of inflow reversal as a lot of this inflow could be short termed. The million dollar question still remains as to how much of capital inflow the economy can actually absorb and whether inflow regulations are as yet required. Given the projections of the growth of the Indian economy, the RBI believes that there is enough growth potential in India to take in the capital inflow. However, the concern remains that major of the inflows have been in the form of FIIs, which are a lot more volatile than its stable counterpart, i.e, FDIs. This has been the major point of contention as far as the necessity of control measures is concerned.

Given these complex scenarios, RBIs current policy stance seems to be the best one to adopt, as it has let the exchange rate absorb most of the capital inflow volatilities. Large scale interventions have been indulged in by countries like China, as it hadn’t been proactive enough to do the regulation when its dependence on trade balance was lesser. Since such currency appreciations were not allowed in the small scale, the increasing inflow amount seemed too huge to handle, and further interventions had to be made.

The possible actions that the RBI can take to counter this are 

Introduce restrictions on capital inflows, like charging a percentage of tax

Prevent currency appreciation by indulging in foreign exchange transactions

These steps, though they seem to be effective at first glance, have their own negatives. The introduction of capital controls haven’t been effective and Brazilian currency has been named as the most overvalued currency in the

The current challenges facing the RBI include balancing its policy to meet the dual goals of Inflation control and sustained economic growth, while also looking to maintain the

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liquidity deficit value, as stated as one of its additional objectives. These goals, though in a way conflicting, need to be given equal importance, as India aims to come out of the recession dip completely and take the lead as the dynamics of the world economic power has been shifting away from the established leaders, into the hands of the emerging economies.

has won awards for excellence throughout her academic career. She is currently pursuing her masters in management at MDI, Gurgaon.

References [1] The Mint Report dated October 29, 2010 [2] www.rbi.org.in [3] www.project-syndicate.org

About the Authors Annapoorni C S Email - pg10annapoorni_c@mdi.ac.in An engineer from Cochin University of Science And Technology with outstanding performance throughout academics, Annapoorni was an active participant in extracurricular activities. She worked as a software engineer in Nokia Siemens Networks for 11 months and is currently pursuing her masters in management at MDI, Gurgaon. Richa Gupta Email – pg10richa_g@mdi.ac.in Richa Gupta is a BE in Instrumentation and Control from NetajiSubhas Institute of Technology, Delhi. She worked in AricentTechnolgies Ltd as software engineer for 8 months and as Design Engineer in Freescale Semiconductors Ltd for 4 months and is currently pursuing her masters in management at MDI, Gurgaon. Tisa Annie Paul Email – pg10tisa_p@mdi.ac.in a

A BTech in Electronics and Communication from National Institute of Technology, Calicut, Tisa worked for a year in Deloitte Consulting. She

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