Global Trends by Martin Khor

Monday 8 September 2008

Financial uncertainties dog the “real economy”

The decline of the ringgit, reversal of capital flows, and gyrations in palm oil prices in Malaysia are symptoms of a global phenomenon of financial uncertainties that are affecting the real economy, as revealed by a UN report.

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Uncertainties in the financial sector are having a negative effect in the real economy of production, growth and jobs. These finance-related uncertainties include gyrations in exchange rates, movements in capital flows, and speculation in the markets for currencies, oil and other commodities.

It is increasingly hard to assess the extent to which changes in prices of commodities and in exchange rates, or movements in capital flows, are caused by fundamentals or by speculation.

Last week the US dollar rose against many currencies, including the ringgit.  This is despite the continuing economic gloom in the United States.  It reported a big jump in the August unemployment to 6.1% (up from 5.7% in July).  Home foreclosures are at a record high and will get much worse.

The crisis at the two giant mortgage companies, Fannie Mae and Freddie Mac, is so intractable that by the end of last week the US government was reportedly planning a take-over of both.

Malaysia is not spared the effects of the financial uncertainties.  Last week the ringgit plunged against the US dollar.  It ended last Friday at 3.46, compared to 3.43 on Tuesday.

The ringgit’s fall is reportedly partly due to the rise of the US dollar generally, partly to regional problems (such as the Thai political crisis) and to domestic factors, such as the increased budget deficit and political uncertainties.

The vagaries of capital flows are also evident. In the past few years there have been substantial net capital inflows into Malaysia, which continued to the beginning of this year. However the flows have reversed recently.

Foreign funds are exiting Malaysia and other emerging markets, and moving their money to “safe havens” in developed countries, according to the CEO of HwangDBS Investment Management Bhd, Teng Chee Wai.

The big rise in the price of palm oil in the past few years and then its rapid fall in recent months is a sign of the big fluctuations in commodity prices.  This may partly be explained by real factors, but could also be due to financial speculation in the commodity markets.

Last Thursday, the UN Conference on Trade and Development (UNCTAD) released its Trade and Development Report (TDR) for 2008. The TDR is considered the United Nations’ most important annual report on the global economy.   

Its message is that growth prospects worldwide are dimming, but not disastrously.  Its main point is that the real economy is being hit by uncertainty and instability in international financial, currency and commodity markets.

It was also concerned about the direction of monetary policy in some major developed countries.  These two factors have led to a gloomy outlook for the world economy and present considerable risks for the developing world.

The TDR said that in mid-2008, the global economy is teetering on the brink of recession. This is due to the global fallout from the US financial crisis, the bursting of the housing bubbles in the US and in other large economies, soaring commodity prices, increasingly restrictive monetary policies in a number of countries, and stock market volatility.

Without strong and internationally coordinated action on macroeconomic policy, a full-fledged global economic recession seems unavoidable.  And although developing economies have been fairly resilient in the first half of 2008, there is mounting evidence they cannot escape the global slowdown.

UNCTAD predicted that world growth will decline to 3% in 2008 (or 1 percent lower than in 2007).  Developed countries’ GDP growth will be a low 1.5% while developing countries’ growth will be 6%.

The report also points to a strong likelihood of a sharp and prolonged downturn in the world economy.

Interestingly for Malaysia (and the rise and fall of our palm oil prices), the TDR 2008 highlights the role of speculation in recent huge swings in commodity prices.

It says that such speculation -- which pursues short-term profits at the cost of long-term stability – can cause turmoil, including abrupt exchange-rate adjustments and shifts in national current-account balances.

Many developing economies depend on the prices of their export commodities. In the past few years, there was the theory that commodity prices will remain high because of structural factors such as the growth of demand from China and India.

However, UNCTASD warns that some commodity prices may now weaken due to cyclical factors, the end of speculation on higher prices and delayed supply responses.

The financial turbulence, the speculative forces affecting food and oil prices, and the apparent failure of foreign exchange markets to bring about changes in exchange rates that reflect shifts in the international competitiveness of countries suggest that there is an urgent need for redesigning the system of global economic governance, says UNCTAD.

"A financial system that every three or four years is subject to a severe crisis that not only hurts actors in financial markets but also has repercussions on the real sector must be deeply flawed.”