By Taimur Ahmad
World central banks’ failure to stem market panic this week reflects deeper uncertainties about the extent of the damage to financial markets – and fears of an inescapable global economic slump
Central banks around the world on Wednesday cut interest rates in unison, in a desperate bid to limit economic damage from the worst financial crisis in 80 years.
The U.S. Fed, China, the European Central Bank and central banks in Britain, Canada, Sweden and Switzerland all slashed rates in a coordinated response after days of outcry from investors and world leaders alike.
But their dramatic intervention appears to have had limited impact on investor sentiment: as Emerging Markets went to press, world markets continued their steep decline.
“The mood is pretty much the same around the world – a lot of concern, bewilderment at what’s going on,” says Stephen Roach, chairman of Morgan Stanley Asia. “There are a lot more questions than answers. “
The timed action by central banks coincides with worsening macroeconomic news: this week the International Monetary Fund issued its most dismal forecast in years, saying the world economy was set for a major downturn with the U.S. and Europe heading into recession.
The fund says the world economy will grow by just 3% in 2009, on the back of continued growth from Asia’s key emerging economies, China and India, which are forecast to expand by 9.3% and 6.9% respectively.
“The major advanced economies are already in, or close to recession, and although a recovery is projected in 2009, the pickup is likely to be unusually gradual, held back by continued financial market deleveraging,” the IMF said in its World Economic Outlook.
View from beyond
The view from emerging market policy chiefs has also shifted sharply in recent weeks – from relief that the damage appeared confined to developed markets to, more recently, profound concern over the likely spillover effects.
“No one will escape from the impact of the global crisis. There is now a decline in the price of commodities and an increase in global financial costs,” Brazil’s finance minister Guido Mantega tells Emerging Markets. “Emerging markets will have to slow down the pace of economic growth to correct unbalances and address bottlenecks. What is at stake is to slow down without aborting the dynamism of emerging markets.”
His concerns are echoed by former IMF chief economist Ken Rogoff, who puts it more starkly: “We’re going into a significant recession, commodity prices are going to be dropping, spreads are going to be rising and emerging countries that don’t adjust quickly are going to run into trouble, despite coming from such a favourable position,” he tells Emerging Markets.
“Today, all indicators that measure tensions in the financial market indicate a high level of tension,” says Guillermo Ortiz, Mexico’s central bank chief.“Commodity prices are falling and deceleration is a reality and will probably lead to further declines in commodity prices,” he tells Emerging Markets.
But the true extent of the crisis is only just beginning to dawn on the rest of the world. The $700 billion package approved last week by US lawmakers to rescue ailing banks failed to rally markets. Central banks were forced to repeatedly inject liquidity into money markets, also without success.
“The idea there was that the Fed always had the ammo to clean up the mess in the post bubble world. Well, we’re in a heck of a mess now and it’s not clear the Fed does have that ammo,” says Roach.
In the encompassing mess, an equity sell-off has wiped out some $12.4 trillion of global stock market wealth in the past year, according to the market capitalization loss on MSCI’s main world equity index.
“The ramifications [of the US crisis] have been unprecedented,” Duvvuri Subbarao, India’s central bank governor tells Emerging Markets.
But he notes that “the world has to get used to occasional financial ‘shake outs’, just as it has to business cycles.”
“We have not been able to eliminate business cycles; we have only managed to smoothen them somewhat. Similarly, we may not be able to eliminate financial shake outs, but may want to learn to reduce their frequency and intensity.”
Forecasts
The IMF pointed out this week that the financial crisis “has deepened further in the past six months, and entered a tumultuous new phase in September.”
“The impact has been felt across the global financial system, including in emerging markets to an increasing extent. Intensifying solvency concerns have led to emergency resolutions of major US and European financial institutions, and have badly shaken confidence,” the fund said.
Of the developed economies, the US is expected to verge on recession in 2009, growing by a 0.1%, while the world’s second-biggest economy, Japan, should see 0.5% growth, with Germany stagnating, the fund said.
But some experts argue that traditional calculations are insufficient to grapple with the full impact of the US financial crisis the real economy. “In the past we would have asked ‘what is the growth effect [on the rest of the world]?’. But now it’s very different,” says Mohamed El Erian, co-chief executive of Pimco.
“I don’t think that we know enough to be confident about global transmission mechanisms. Which is another way of saying that other countries have got to hope for the best but plan for the worst. Because this is really a new world right now.”
The China factor
A key part of the global growth story is China. As the credit crisis unfolded over the past year, China’s ability to power through regardless at double-digit growth rates seemed to be one of the enduring certainties.
But now, with Wall Street in ruins and G7 economies faltering, questions are again being asked about whether China too might stumble. The economy is clearly slowing. And lower growth in China will mean slower growth for many other emerging economies, from trading partners in Asia to commodity exporters in Latin America.
A fifth consecutive quarterly decline in Chinese growth is now likely, pushing the rate into single digits. A recession in the U.S. and EU, which absorb 40% of China’s exports, is a principal factor, while China’s imports of several commodities have slowed too. And the worry is that domestic consumption may be insufficient to balance growth, especially as housing prices ease.
Rogoff believes that the odds of a significant growth recession in China – at least one year of sub 6% growth-in the next couple of years are 50:50.
Raghuram Rajan, another former IMF chief economist, is similarly concerned about China’s growth prospects. “There is a real concern about a sharp slowdown, with growth coming down to 5% or even less.” he says. “There are a lot of things masked by high growth and when growth slows sharply, skeletons get unearthed.”
China’s government has already cut interest rates and further fiscal responses or asset market interventions are likely as it tries to maintain employment growth. But its monetary policy options are limited, as inflation, which peaked at 8.7% in February before falling to 4.9% in August, remains a fear. Zhou Xiaochuan, head of the central bank, said this month: “Inflation has indeed slowed over the past several months, but we cannot relax because the rate may rebound.”
Beijing has more room on the fiscal front to boost short-term growth, especially by accelerating infrastructure spending to make up for slower private investment; tax cuts are another policy option.
Ultimately, says Rajan, China’s fate will be decided by how well authorities manage the downturn. “The issue is whether economic turmoil translates into political turmoil,” he says. “That’s where you have the biggest risk.