Wednesday, December 14, 2011

Shattered illusions

Andy Xie forecasts escalating volatility in the global economy next year as the West begins to pay for its past excesses and the emerging economies, led by the BRICS, try to pick up the pieces after the credit bubble bursts

Andy Xie
December 14, 2011

Next year may be the most volatile year in two decades. A political crisis may engulf major countries in transition. The financial crisis that began in the United States and is now raging in Europe could take down some major emerging economies that have been relatively stable.

The BRIC economies may experience serious difficulties next year. Some may suffer an old-fashioned currency crisis. The major central banks in the developed economies loosened monetary and fiscal policies to cope with the financial crisis in 2008. A significant chunk of the money has flowed to emerging economies, especially the BRIC countries. The hot money has sustained their growth so far. Unfortunately, the growth is mostly an old-fashioned credit bubble.

Three forces are bursting the hot-money bubble in the BRIC countries. First, the dollar is on the rise. The Washington gridlock is limiting US fiscal expansion, and the dollar is rising as a result. Second, the overextended European banks are shrinking by trillions of euros and swallowing up massive amounts of liquidity. The European Central Bank has yet to increase liquidity sufficiently to offset it. Third, China's property bubble is bursting, bringing down commodity prices that have been supporting growth in emerging economies.

If the ECB and the US Federal Reserve launch substantial quantitative easing soon, the hot-money bubble in the BRIC countries could be restored. But, I suspect that it would come too late and the amount would be insufficient. Next year may turn out to be when the BRIC bubble finally bursts. BRIC is one word that launched a thousand hedge funds and a gigantic hot-money bubble. Only the dotcom craze a decade ago had the same impact.

Brazil and India could experience significant currency depreciation. If handled badly - for example, by propping up their currencies with their limited foreign exchange reserves - they could experience a full-blown currency crisis as soon as their foreign exchange reserves are exhausted. Despite favourable terms of trade, Brazil and India have run substantial current-account deficits. Nevertheless, they have amassed significant foreign exchange reserves, thanks to hot-money inflows.

India runs a trade deficit of about US$10billion per month, or 7-8per cent of gross domestic product. The deficit is financed by service exports to the West, overseas income of Indian labour and hot-money inflows. All three financing sources are drying up: the West isn't in a position to buy Indian services like before; India's labour income is threatened by the turmoil in the Middle East; and, of course, the flow of hot money is reversing. India's foreign exchange reserves of about US$300billion could be exhausted quickly to fund hot-money outflow; the stock of hot money in India is probably twice as much as its foreign exchange reserves. When the run on the rupee begins, India's reserves could be exhausted in days.

India's best defence is to let the currency go, rather than defending it, as Indonesia did during the Asian financial crisis. India's foreign exchange reserves relative to GDP are about the same as Indonesia's before the 1997 crisis.

Despite its declining industries, Russia has been kept afloat by its energy exports. The Putin-era prosperity is due to the global energy boom. If the boom ends, Vladimir Putin's Russia won't have the money to buy the loyalty of the population in its vast hinterland. Among all the commodities, energy has the best fundamentals. Russia could be lucky again. However, the global recession could bring down energy prices, even temporarily. Russia doesn't have a big cushion in its model for social peace.

China's foreign exchange reserves are 10 times those of India. Its capital account is not open. Hence, hot-money outflows are unlikely to overwhelm the renminbi. But the mainland's property bubble is bursting. The bubble has exaggerated growth and grossly distorted money allocation. Normalisation will be protracted, possibly lasting through 2014, and the rebalancing may cut the real economic growth rate by half. Also, the bubble supported the vast grey income, possibly 10 per cent of GDP. When the bubble bursts, it will be impossible for the real economy to support the burden. If history is any guide, China is about to launch a vast anti-corruption campaign as a necessary component of the normalisation to ease the burden on the economy.

The West will be marked by political crisis next year. Its loss of competitiveness to emerging economies and an ageing population will cause living standards to drop. This need was postponed by the debt bubble for a decade. Even Europe and the US stabilise their financial systems for now, leaders will still need to deal with the reality of cutting living standards - and this is tricky politically.

In the US, the presidential election next year may turn out to be as tumultuous as the one in 1968. The Democrats will probably campaign for fairness; the Republicans for smaller government. The political positions of major interest groups are irreconcilable. While the US economy seems to be holding up for now, a crisis of confidence over the political fighting could set the economy back again.

The European elites seem to be consolidating behind Germany to save the euro through austerity. But selling the solution to their people may not be so easy. It is hard to imagine that such a big cut in living standards could be accomplished without upheaval.

The economic improvement since 2008 is largely a mirage, fuelled by unsustainable government assistance in the West and bubbles in the emerging economies. Both will unwind next year. The mirage will be unmasked. If you think 2008 was bad, fasten your seat belt for 2012. The world may not end, but your wallet will take a hit.

Andy Xie is an independent economist


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