The Standard and Poor’s downgrade of the U.S. credit ratings late last week, together with recent financial markets volatility has mounted a major challenge to the view that the first half of 2011 was a temporary soft patch in the economic landscape.
In the U.S., a set of fiscal austerity measures has (temporarily) reduced the debt-ceiling related uncertainties, but that has brought back focus to an economy in danger of falling into a growth recession (multiple quarters of below-trend growth).
Now, with long-term fiscal restraint becoming the path chosen by the U.S. government, little fiscal support can be expected as well. There is increasing realization that the U.S. is in danger of both a short-term loss of growth momentum and longer-term stagnation.
In the Euro area, only a fortnight after announcing yet another package to shore up the economies of Greece, Ireland, and Portugal, financial market strains have moved on to Italy and Spain, economies representing substantially greater systemic risk.
Unless more aggressive measures are announced (e.g. a much bigger expansion of the European Financial Stability Facility, EFSF), it is hard to see how market sentiment would be assuaged.
News out of Japan has not been comforting either. The economy continues to struggle with post-natural disaster recovery, while its twin problems of slow economic growth and a vast fiscal deficit remain. The Bank of Japan intervened to drive down the yen last week, a measure that can be described as anti-deflationary and an attempt to stem the impact of surging dollar liquidity. Japan is not alone among developed countries to take action last week; the Swiss National Bank took measures as well.
These developments reflect the deepening macroeconomic challenges worldwide; as both the U.S. and Euro Area address their economic difficulties, they are likely to maintain ultra loose policies for a prolonged period of time; which would push flows elsewhere.
How Will Asia Fare?
But the countries that receive those flows have their own problems too, especially as surging flows cause sustained exchange rate appreciation and thus erode export competitiveness.
Emerging market economies have been struggling with this situation for a while, but now some developed countries are joining the fray.
This unhappy nexus of poor news is hardly constructive for Asia. The best one can hope for is that at the rates space, the window of higher rates will now close as downside growth risks accumulate and inflation abates along with commodity prices. But the likelihood of rate cut is still remote and would require far greater downside to emerge.
The biggest challenge would be for countries like China and India, who have yet to see inflation pressures abate or growth slow substantially, but at the same time their policy makers cannot remain oblivious to external developments.
The last thing a central bank would want to do is raise rates at precisely the moment growth is collapsing. We are however not worried about such policy errors to manifest in a major manner. Neither the Reserve Ban of India nor the People’s Bank of China would hesitate to ease policies if global markets became as disruptive as they were in 2008.
On the exchange rate front, the first round impact of a rise in financial market instability is for investors to flee Emerging Markets assets, which tends to be Emerging Markets Forex negative. We have seen a manifestation of that risk this week. But looking beyond the immediate impact, the prospect for flows to continue to the Emerging Markets space remains bright, given their strong macro-fiscal fundamentals.
Hence if growth were to be anemic in the G3, that is in the U.S., Euro Area and Japan, for a prolonged period, Asian policy makers will have to be prepared to deal with sustained flows and appreciation pressures.
The only way to deal with this eventuality is to develop better absorptive capacity. Given their large domestic savings and mostly favorable demographic dynamic, there is no reason for emerging economies in Asia to continue to rely on G3 demand as the main engine of growth. The call to reorient policies toward stronger domestic demand has been long-standing, but the urgency of that has risen considerably as the medium-term prospect of the G3 dims.
Taimur Baig is the Chief Economist for India, Indonesia and the Philippines, Global Markets Research at Deutsche Bank AG. He is a regular guest on CNBC TV.