World economy heading downwards, warns UNCTAD

by Chakravarthi Raghavan

Geneva, 24 Apr 2001 - - The world economy seems to be heading downwards, unless the major economies adopt bolder policies and cooperate with each other, the UN Conference on Trade and Development warned in its Trade and Development Report 2001 (TDR-2001) released Tuesday.

“A quarter is a long time in economics,” UNCTAD Secretary-General Rubens Ricupero notes in an overview, pointing to the “upbeat mood” at Prague in September last - with the series of financial shocks in emerging markets shrugged off, the US economy continuing to forge ahead, Europe showing robust recovery and Japan beginning to emerge from prolonged recession.

“The mood is different today,” says Ricupero. “There are concerns about how far and how fast the US economy will slow down and whether traditional macro-economic instruments can manage a rapid recovery; how vulnerable the dollar is; whether the nascent recovery in Japan will be nipped in the bud; whether the European locomotive can pick up sufficient speed to keep the world economy on track and if not what a global downturn might mean for the still fragile economies in Asia. The oil cloud on the horizon last year has dissipated, prices had already peaked at the time of the Prague meetings.  “Conventional economic analysis is not, it seems adopting as well to the gyrations of a globalizing world.”

The TDR-2001, and overview, were written in February. And all indications are that the world economy is in further trouble - even if apocalyptic visions are out of place in intergovernmental reports and forecasts.

Since the report was readied for issue, the overall situation has deteriorated and there is a need for concerted action by the major economies, the TDR’s chief author and officer-in-charge of the UNCTAD division on globalization and development strategies, Mr. Yilmaz Akyuz said last week.

The greatest scope for action lies with the European Central Bank, he added.

The ECB is due to meet on 27 April. At its last meeting on 29 March, the ECB confirmed its ‘wait and see’ attitude, and the ECB chairman and some others in the EU, have been resisting the call from the US (latest by US Treasury Secretary, Paul O’Neill), the IMF and others for the cut in interest rates.

Will the ECB respond now or stay on its course (to prove its independence perhaps)? This weekend will provide some answers.

But whether the ECB will ignore pleas from outside (and even inside) and whether this will plunge the world into a major crisis or merely a serious downturn or nothing will happen and the ECB will be proved right will be seen in the next few days and weeks?

The last seems improbable, given the much boasted globalization of the world economy. A downturn and some crisis perhaps seems likely if the ECB does not act, though whether it will lead to moves for systemic reforms is not clear either.

In his overview, Ricupero says:

“The UNCTAD Secretariat has been warning for sometime that excessive financial liberalization is creating a world of systemic instability and recurrent crises.  A common response has been to blame such crises on misguided policies and crony investment practices in emerging markets. Whether similar accusations will surface as financial excesses and wasteful investments are exposed in the US by the economic slowdown remains to be seen, but they would no more helpful than they were in the aftermath of the Asian crises.

“Markets can and do get it wrong, and for developing and developed alike. The onus is still on policy-makers to find preventive measures and appropriate remedies. The task of fashioning appropriate remedies is difficult in a highly integrated world economy. But multilateral financial rules and institutions were established precisely to prevent a repetition of the inter-war economic chaos linked to persistent payments and currency disorders and excessive reliance on short-term capital flows.

Adds Ricupero in the overview, “Since the breakup of the Bretton Woods system, the world has been ill-prepared to deal with re-emergence of such problems. Talk of far-reaching reform of the international financial architecture, after the Asian crises, has proved to be no more than that. However, if a strong wind does pick up from the North, the consequences for the world economy will be much more chilling than those of the wind that blew in from the South. It is to be hoped that this threat will suffice to breathe new life into the reform efforts.”

But what would be UNCTAD’s advice to the developing world to meet such crises?

“Global solutions, through change in financial architecture would still be the best solution. But in its absence, developing countries must take national actions to safeguard themselves: by being cautious and not enter into commitments visavis their capital accounts and liberalization at the IMF, or in undertaking commitments at the WTO that would interfere with their ability to protect their finances on capital accounts,” said the UNCTAD economists at a press launch in Geneva.

In releasing the TDR in Geneva, UNCTAD deputy secretary-general Carlos Fortin, said the world economy needed concerted action by all the major economies, and the ECB could cut its interest rates, without fear of inflation, and test the potential for growth of the euro area, which UNCTAD believes is about 4%(and not the ECB’s 2-2.5 percent estimate).

While welcoming the cut in US interest rates, by two percentage points over a four month period, Fortin said there were limits to the extent to which the US alone could provide growth impulse through use monetary policy, without others taking similar action.

Fortin agreed that further cuts by the Federal Reserve could affect the US-Euro rate and inflows of foreign funds now financing the US trade deficits, and this could affect other economies too.

That is why UNCTAD believes an appropriate response to the situation of the world economy now is “coordinated action on the part of all reserve currencies,” and the ECB could and should cut interest rates and test the limits of the potential growth in the EU economy which UNCTAD thinks is about four percent (without fear of igniting inflation), Fortin said.

On the cuts in US rates including the latest a few days ago for a two full percentage points in four steps (two cuts in between regular meetings of the Federal Reserve) in the last four months, Akyuz appeared to agree with those who believe that Greenspan has more information than is available to outsiders, and has acted boldly, though it was not clear whether it would help the US avoid a recession.

Written before the latest cuts in rates, the TDR raised questions about whether there would be a swift response to the cut in interest rates and warned that “if households and the business sector were to simultaneously limit their spending to current earnings, there could be a significant decline in GDP.”

Given the high level of private indebtedness, the extent of unviable investments in the information and communications technology sector sustained by the venture capital boom and the stock market bubble over the past few years, as also the uncertainties surrounding the dollar, “there should be no underestimating the magnitude of the policy change,” UNCTAD says.

The Federal Reserve has done all it could in terms of monetary policy, and if the economy still does not turn around, it is because of the structural weaknesses, including high private debts, household and corporate sectors, Akyuz said.

Other observers have noted that the cut in interest rates has helped stock markets, particularly of the ‘old economy’ (the manufacturing and related sectors) to recover, and may help consumer confidence and buying, and the manufacturing sector by stimulating demand.

However, the dotcoms, and the technology sectors, and the other parts of the ‘New Economy’ (and its permanent contribution to competitivity and productivity increase for the US, that Greenspan belatedly, but ardently, embraced last year and praised as late as January this year), which raised money from capital markets without any possible returns (on basis of profitability and rational expectations seem unlikely to be able to recover.

Though there are still some voices about their ability to restructure and recover, it seems fairly certain that all these ‘investments’ based on ‘virtual assets’ have to be wiped out through bankruptcy—a remedy that the US Treasury and IMF preached to the Asian economies, except that in the US case now, no foreign or domestic buyer can buy these companies without any real assets, and the consequences of such bankruptices in middle America and the political fallout will be serious.

And any further deep cuts in the US interest rates are bound to affect the value of the dollar and the confidence of foreign investors who keep on shovelling money on short-term US investments (that help finance US trade deficits).

[Meanwhile, in Geneva, the chief economist and acting Deputy Executive Secretary of the UN Economic Commission for Europe, Mr. Paul Rayment, added the ECE’s voice to the chorus of calls on the ECB, and urged the ECB to cut its interest rates. Previewing in a press release, the ECE’s Economic Survey of Europe, due to be published on 10 May, Rayment said: “There can be little doubt that a lowering of interest rates would be a help for economic growth.” Challenging the ECB view about balance of risks between higher inflation and lower growth being ‘evenly balanced’,Rayment said “there would now appear to be a strong case for a sharp reduction in euro area interest rates in order to tip the balance towards stronger growth in Europe and offset the effects of weaker net exports to the rest of the world.”

[In London Monday, the EC monetary affairs Commissioner Pedros Solbes, reacted strongly against O’Neill, who questioned the EU view that it could continue to grow, without the US slowdown having a negative impact. Solbes said acerbically in London, “we probably have a little bit more information than O’Neill.”]

In response to other questions, UNCTAD’s senior economist, Andrew Cornford said there was a continuous stream of information from the US economy and while earlier reports suggested that the downturn was confined to some regions and sectors, later information showed that other sectors of the economy and regions too were being affected.

The TDR sees little hope of any action from Japan to take the slack from the United States, and sees the only hope lies in Europe.

While Europe has not slipped down, it is not as robust as implied by the ECB (after its last meeting) and the EU’s monetary commissioner, Pedro Solbe’s remarks to media in London Monday.

The EU’s dependence on exports to the United States and its contribution to the GDP may appear much less on basis of trade data, and thus a US downturn may seem less serious.

However, some of the major EU economies like Germany depend on exports to the United States and they would be affected by a US downturn. Also, the TDR points out that the sales of German and UK affiliates in the US is roughly five times their exports to the US, and this figure is double for smaller EU economies like Netherlands.

And other EU corporations (the financial sectors) have large investments and operations in the US, and a downturn in demand and fall in stock values on Wall Street (much more on the dotcoms, new economy and technology stocks reflected on Nasdaq than on old economy and manufacturing sectors), and will be reflected in due course in their earnings and profits, and thus their stock-market valuations. And the dollar-euro levels will have a bearing on the bookvalues and profits (in euro) of these corporations in the US.

The major contribution to providing a growth impulse for the world economy now lies with the European Union and the European Central Bank, which could cut interest rates and raise demand, output and investments, without any fear of stoking inflation or affecting the exchange rate of the Euro, according to Akyuz.

Though the European Central Bank believes that the EU is growing at the underlying non-inflationary long-term growth rates, there is much greater potential capacity for higher growth rates, which Europe needs anyway for tackling its unemployment, and the ECB should be bold enough to test this, as the US Federal Reserve did a couple of years ago, says Akyuz.

The scope for action lies in Europe, which has established the ECB, successfully established the Euro as a common currency, and bringing down inflation even in the high-inflation members of the EU, and its members have a comfortable budget and balance-of-payments position.

But the EU still has a legacy of high unemployment, and this can be reduced only with higher growth rate. With bold actions to cut interest rates, Europe can grow at an annual 4-5 percent rate for half a decade or more and eliminate its backlog of unemployment, without fear of inflation, according to Akyuz.

Japan, the other major economy, after a brief spurt of growth last year has again registered negative growth in the third quarter of last year, and seems in danger of its recovery being cutting off before it gathers any momentum.

Its political uncertainties seem to rule out any immediate actions. Though Prime Minister Mori (who announced his resignation some weeks ago) is now set to be replaced by grass-roots, pro-reform candidate, Junichiro Koizumi, the legerdemain of Japanese politics suggest that no short-term results can be expected from any bold actions, and its ability to turn the economy around into a fast growth path.

When the ‘goldilocks’ US economy, and with it the world economy, took a downturn in the closing weeks of last year (impelling the US Federal Reserve to suddenly cut interest rates in December), it took almost everyone by surprise.

For until last year, the only cloud on the horizon seemed to be the oil price (and OPEC actions).

As late as last September (for the Prague Fund-Bank meetings) the IMF was projecting some optimistic figures of growth. And even in January, Greenspan was talking about the New Economy and its productivity gains, a view that the United Nations in its world economic survey in 2000 also accepted.

But the down-turn has come as a result of the ‘unwinding of the hi-tech boom’ in the US, as UNCTAD’s TDR and press release put it in some mild language.

However, the economists at UNCTAD have been bucking the fashion of the ‘new economy’ and its miracles, and had warned in TDR-2000, (issued in September) of the US economy slowing down.

In the latest report, the UNCTAD economists have done a difficult job of tight-rope walking - of raising alarm signals, without painting an apocalyptic vision which, even if it turns out to be true, the ‘vision’ and those who foretell it would be blamed.

Hence the repeated assertions by UNCTAD economists, including at the press launch, that UNCTAD is not in the forecasting business, but is hoisting the cautionary signals of a storm ahead to press for concerted global actions.

Nevertheless, the TDR points out (on page 11) that according to recent estimates, euro-growth elasticity with respect to the US to be as high as 0.4, which would mean that the decline in US growth rates of more than 3 percentage points from its average over the last five years could cause a decline of 1.5 percentage points in EU growth, bringing it below 2 percent.

In looking at the future, UNCTAD cautions that the fact of the unprecedented nature of the long period of expansion in the recent period, makes for caution in assessing the current slowdown in the US. But on balance the various conflicting pressures point to an uncertain future, where any abrupt shifts in sentiment or policy could still make for a deeper downturn than many are expecting, and could prejudice a swift recovery.

Due to the pivotal role of the US in recent years in bolstering global demand, the prospects of the US economy are a matter of worldwide concern. The increasing integration of the world economy means both real and financial shocks are transmitted much more rapidly across regions, countries and sectors.

And the inter-twining of finance and production means that such shocks can have unexpected consequences - as demonstrated by the financial crises in Asia in 1997.

Since both trade and finance and currency markets are channels for contagion, the US slowdown is expected to have some differing impacts across the developing world.

In Asia slower growth in hi-tech exports played an important in building up the extreme fragility, and the subsequent financial shock was amplified through trade - and strong export growth led to recovery in 2000, the prospects for 2001 are much less favourable, as a result of the US slowdown.

While falling interest rates in the US could result in redirecting capital flows to emerging markets, the US slowdown could also accentuate the bearish sentiment in global financial markets, raising liquidity premiums on dollar assets and the risk spread on emerging market borrowing, thus wiping out benefits of lower US interest rates. This would result in capital flows to the developing world scarcely exceeding their disappointing levels of 2000, says the TDR.

TDR suggests that the US slowdown is likely to affect different developing regions differently.

In 2000, all developing regions picked up, posting an overall rate of 5.5% growth. Only Africa failed to register significant increase in per capita income.

There seems little likelihood of the robust performance of some of the fastest growing developing economies being repeated in 2001. The crises in the emerging markets brought benefits to the industrial economies in recent years - in terms of cheap imports of commodities and consumer goods.

But there will be no such equal symmetry from the US slowdown, UNCTAD comments.  Prospects in the developing world depend very much on how countries are plugged into the global economy.

But all are vulnerable to a sharp global slowdown.

Most economies of East Asia and South-East Asia had experienced strong recoveries in 1999 (after the shocks of 1997 and 1998), and growth accelerated in 2000. But the current combination of declining sales in US, and falling semi-conductor prices, has resulted in terms of trade losses and loss of export earnings for these countries. Growth is hence expected to fall throughout the region, with intra-regional trade linkages amplifying the negative impact of the shocks, and triggering a further round of destabilizing exchange rate swings across the region.

The Chinese economy is also sensitive to the developments in the USA, which now absorbs 20% of China’s exports. China’s difficult of striking the right policy balance is also being complicated by the “protracted, as yet unfinished, negotiations over accession to the WTO,” says the TDR. But the prospect of Chinese accession is also a matter of concern among some of the smaller labour-intensive exporters in Asia, who fear losing competitiveness when their export prospects are dampened by the weakening import demand in the US.

As for Latin America, the TDR notes the recovery in the region, at 4% overall, was stronger than earlier forecast. But the aggregate picture hid considerable variations.

About 85-90 percent of Mexico’s exports are tied to the US. This, and the rise in the price of oil, helped Mexico grow strongly around 7% last year. But it is unlikely that the Mexican economy can escape consequences of the US slowdown, though lower US interest rates could help. Mexico, along with central American and Caribbean have concerns about greater competition from China (in the US market) after Chinese entry into the WTO.

Latin America has weaker trade links with the US, but heavier dependence on capital inflows. In the absence of significant spread in risk spreads, lower US interest rates should help Latin America - in reduced borrowing costs and debt servicing. Countries that have opted for a currency board or dollarised economy, fall in US rates and weaker dollar would help.

Somewhat surprisingly, UNCTAD has predicted that Argentina may turn out to be a big winner on both counts (lower interest rates and weaker dollar) - and emerge from vicious circle of stagnation and deflationary adjustment to external shocks. Brazil should also benefit, the TDR adds.

However, this was written in February, and before some recent events and developments, as a result of which the Argentine economy currently seems to face a risk premium of 10 percentage points over US interest rates (according to one report Tuesday). And the US-Argentine differences (after the appointment of Cavallo as the economic czar of Argentina) has also created uncertainties - given their large trade and mutual dependence. Some very recent problems on the political front, and the leadership in the Brazilian Senate, also appear to be complicating Brazilian President Enrique Cordoza tasks.

At the Geneva launch, UNCTAD market expert, Andrew Cornford, suggested that the large risk premium on Argentine bonds could be a temporary phenomenon, as a result of market reactions to some recent moves and statements of Mr. Cavallo, and things could return to a lower level soon. It was too early to judge the results of risk premiums in a volatile market situation.

And it will also be too early to assess, and the absence of market information related to the particular countries made it more difficult, in relation to the outcomes for Ecuador and some of the Central American countries who have opted for dollarisation, he added.

Earlier in relation to the US dollar - Euro rates and likely effects, and the effects on the rest of the world, Kozul-Wright another UNCTAD economist and one of the authors of the report, said in a world driven by financial capital and a globalization process driven by finance, one could expect some kind of a herd behaviour and irrationality in markets of the industrialized economies too, as had happened for the developing world during the Asian and the subsequent Russian and Brazilian crises.

Hence UNCTAD’s view that there is a common interest between the industrial and developing economies in ensuring rationality in the markets through international financial architecture as a whole, and that such a reform was not something only in the interests of the developing world.

Asked about the Quebec summit meeting of the Americas and the Free Trade for Americas Agreement signed there, UNCTAD deputy secretary-general Carlos Fortin noted that the Quebec document was a declaration of a political intention, and the FTAA had not started yet. Many difficult things remained to be negotiated before it could become a reality, and it was hence difficult to say what would be the effect of the FTAA and such agreements on the world economy.

However, said Mr. Cornford, several of the remarks and issues about trade and finance raised in the report are relevant to the FTAA. For example, he said, he could not see how such an agreement could function without guarantees of international financial backing. It would not be possible, added Mr.  Kozul-Wright, to talk merely about trade and investment in the context of such accords.

Did economic history provide any insights for such accords involving a strong economy and many weak or developing economies?

It all depended on how far back one went, the two economists suggested.

In terms of the British response of the late 19^th century and early 20^th century (to the crises it faced), by moving to imperial preferences, and free trade, and the arrangements put in place, India’s experience showed that this resulted in de-industrialization, and ultimately it did not help Britain either.

But it would be difficult to conclude that this had parallels for the proposed FTAA.

However, in terms of the considerable unequal economic strengths and capacities and development of the varying sizes and numbers of countries in the Americas to be brought under the FTAA, any unequal relationships without counter-balancing arrangements for financing and transfers would create problems. – SUNS4882

The above article first appeared in the South-North Development Monitor (SUNS) of which Chakravarthi Raghavan is the Chief Editor.

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