Author: Mauricio de la Cuba

Summing up of Nouriel Roubini’s Presentation at a Meeting on “Where is Global Finance Heading?” (Cusco, Peru, July 2009)

Published in “La Moneda” Magazine, Central Reserve Bank of Peru (Spanish)

Three years ago, when the U.S. property bubble started to unwind, Nouriel Roubini foresaw the severe recession that would spill over to other developed countries and seriously affect growth in emerging economies. This and other predictions about the international financial crisis have turned this Harvard economist and NYU professor into one of the 50 most influential people in international financial markets.

In the opening presentation at a seminar on “The International Monetary System and the Situation of Emerging Economies”, Roubini posed central questions about the world economy, its prospects, and dilemmas going forward. He also advanced some key forecasts on the following five subjects: (i) current developments and outlook; (ii) risks to the growth scenario; (iii) China’s decoupling; (iv) the impact of the crisis on emerging economies; and (v) the international financial system.

Economic Growth and Perspectives

There is consensus that, for its size and duration, the current financial crisis is the most severe since the Great Depression and the worst recession in the last 60 years. At the same time, there is a lack of consensus about the outlook for, and duration of, a recession that started at end-2007according to NBER estimations. The most recent economic indicators have been relatively favorable, and the expression green shoots has emerged to describe many economists’ perception that the worst of the crisis is over and that recovery is around the corner. However, Roubini gives a different reading to the very same indicators: rather than green shoots, we will still have lots of yellow weeds. He predicts that the recession will finish towards the end of the year.

However, beyond the questions of how long will the recession last and what form it will take, Roubini suggests that the key issue is how vigorous or weak the recovery will be. In Roubini’s view, in the case of developed economies the recovery will be relatively modest and below trend. He foresees growth at around one percent in the U.S. over the next two years. High indebtedness, not only in the private sector, is an element that will bear on growth once the recession is over. This is not only a liquidity crisis, an “animal spirits” crisis: it is mainly a leverage crisis. […] The need to dismantle it will imply lower consumption growth and a slowdown in spending capacity.

Medium-Term Risks and Challenges

One of the main sources of uncertainty and risk is inflation. Inflation can compromise the implementation of countercyclical policies, while deflation can postpone expenditure and thus aggravate recession.

Currently there is a debate about how prices will evolve. On one hand, fiscal and monetary stimulus can create upward pressures; on the other hand, excess capacity and the labor environment can create downward pressures. According to Roubini, at least in the short run, the latter two factors will prevail. Activity is extremely low in the labor market, where workers lack the ability to fix prices and have to accept lower salaries as a way to share in their companies’ pains. […] Thus, low activity in the goods and labor markets creates massive deflationary pressures.

However, in the medium term the situation can be different. There is an inflation risk, not only in the U.S., because high fiscal deficits are partially being monetized directly or indirectly by central banks. Roubini stresses that debt monetization will boost expected inflation, even before actual inflation increases. These inflationary risks lead, in turn, to the question of what is the optimal exit strategy from monetary and fiscal countercyclical policies.

If monetary and fiscal stimulus is withdrawn too soon it can lead to recession, as in Japan. At the same time, if high fiscal deficits are allowed to continue, concerns about medium-term debt sustainability and the long-term inflationary impact of debt monetization can drive interest rates up, which can in turn affect private spending. It will be difficult to figure out the exact way out of monetary and fiscal over-indebtedness without falling into recession or inflation, says Roubini.

China’s  Decoupling

Against the possibility of a weak U.S. recovery, China’s performance will be fundamental to improve the world’s recovery prospects. Therefore, the main question is to what extent China and other emerging economies can decouple from developments in advanced economies.

Unlike other crises, the current one originated in the developed world (the U.S., the UK, and continental Europe) and not in emerging economies. When the U.S. property bubble started to unwind, many economists expected emerging economies to be seriously affected.

The decoupling hypothesis lost validity soon after, particularly after the bankruptcy of Lehman Brothers. It also eroded -through the known commercial and financial channels- emerging economies’ fundamentals. The resulting slowdown was far greater than expected, and some economies even experienced open recession. However, thanks to fiscal and monetary stimulus, growth expectations in many emerging economies (including China and India) have improved.

Roubini highlights certain points of concern regarding China’s recovery. If China grew at high rates, it was to a great extent because during the last decade the U.S. became the world’s greatest consumer. Currently, with subdued U.S. consumption (and unflattering recovery prospects once the recession is over), there is a risk that growth in emerging economies, in particular in China, might create excess supply. To avoid this, production growth in China should be coupled with an expansion of domestic demand. Much of what China is doing now is spur growth on the supply side, granting money and credit to state-owned firms. According to Roubini, the Chinese government’s efforts still seem insufficient to boost domestic demand, and longer-run reforms are required, in particular in social security, public health, and education, which are key to promote consumption in a country where it barely represents 35 percent of GDP.

Emerging Economies and the International Crisis

As has been pointed out above, a key conclusion is that the crisis affected all emerging economies and not only those with weaker fundamentals -e.g., several economies in emerging Europe, where high current account and fiscal deficits were accompanied with short-term financing and currency overvaluation.

However, in this new context, there was a development, in many cases unprecedented, in emerging economies: the application of countercyclical policies in economies that had implemented responsible macroeconomic policies during the period of high world growth. Roubini emphasizes that there are several Latin American economies among those that in the last decade introduced macroeconomic and financial reforms and built a policy credibility that allowed them to deal with the crisis more appropriately.

In connection with the latter, it is important to note that, in the current crisis, countries have used reserves as self-insurance. A lesson from the crisis is: keeping more reserves is better that keeping less. In addition, credit facilities have strengthened in the last decade -notably, swap lines between central banks, both in advanced and emerging economies, and the creation by the IMF of a new flexible credit line, which provides substantial financial resources without conditionality to emerging economies with good macroeconomic and financial fundamentals. Support to economies in problems has also been enhanced. Roubini provides the following example: in 1997, Korea, a large country, obtained barely $ 10 billion from the IMF, and only a very small part of it was frontloaded. In contrast, a small economy like Romania, probably one-tenth of Korea, has received $ 20 billion from the IMF; and if we look at IMF programs in Latvia, Romania, Hungary, Ukraine, and Pakistan, clearly their size as a percentage of quota has been much higher than in the past.

These developments have enhanced the ability to resist the crisis, even though the optimal response in the face of financial requirements remains a pending issue. Regarding the latter, Roubini underscores another difference with previous crises: emerging economies’ financing needs in foreign currency were more centered in the private sector, in particular the corporate sector -and not in the public sector, like in other experiences- due to the buildup of foreign currency loans extended by banks.

Global Imbalances, the Future of the Dollar and the International Financial System

There is consensus that global imbalances contributed indirectly to the unwinding of the crisis. Excess saving in China, the rest of Asia, and other emerging economies, among other factors, contributed to keeping low long-term rates, even when the FED started to withdraw monetary stimulus gradually in 2004. This caused financial leveraging to continue. Roubini wonders if the recent fall in the U.S. trade deficit is due only to cyclical factors, and if it is possible that recovery will bring a new increase in imports, together with important imbalances. To this we must add the apparently paradoxical fact that capital flows have gone from emerging economies to developed ones, particularly the U.S.

In this connection, he posed a question that was fundamental along the seminar: the dollar;s perspectives as reserve currency. Roubini pointed out that the fall of the dollar, in case it happened, would occur over the next decade or later. Any change will not happen overnight, but surely there is a growing concern about the world financial system, which is dominated by the U.S. dollar and by countries that sustain high current account and fiscal deficits. Failure to correct global imbalances entails a risk for world growth and for the dollar.

The future of the dollar, and its eventual replacement by other currencies or by the Special Drawing Right (SDR) was a central part of the discussion during the two-day Seminar. The debate developed in a broader framework: the reform of the international financial system. According to Roubini, the latter should include not only changes in the currencies that could take on a role as store of value, but also in the governance of international economic policy, in which emerging economies’ voice should be in line with their growing participation in world GDP. There was also a debate on the reform of supervision and regulation of financial institutions to avoid boom episodes followed by periods of financial crisis.

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