The road to recovery

When a patient suffers a traumatic shock the normal practice of doctors is to treat each problem as it appears in a symptomatic fashion without asking questions about causes or even consequences. First keep the patient alive, then stabilise his vital signs and only after that, start diagnosing and treating the underlying causes.  Where are we with the sick men of the global economy -- the OECD countries?

The OECD economy is probably past the first emergency stage and, even as the real economy continues to deteriorate globally (side-effects of the medication for financial irresponsibility?), we can now start thinking about the policies that can move us beyond survival to revived growth. 

The road to recovery will go through several stopping stations. The first step has to be the stabilisation of global banking activity, followed by the normalisation of trade and the revival of trade and economic growth and perhaps only then, by the resumption of medium- and long-term international capital flows to a more normal level.  

The steps towards the stabilisation of banking systems have been taken, but largely from a national perspective.  According to the IMF, US banks suffered 57 per cent of the financial sector losses on securitised debt originating there, and European banks suffered 39 per cent and Asian institutions bore only 4 per cent of the loss.

As of now 23 of the largest 50 banks in the US and 15 of the largest 50 in Europe have received public funding. The primary focus has been to prevent banking failure and restore confidence in the banking system rather than the revival of lending activity. 

It would appear that the combination of new capital, the flow of profits and government insurance for defaults should help banks get rid of the toxic assets in their books. The commercial paper market in New York seems to have revived and, with the measures due to be instituted this month, the securitisation market may also show signs of life.

But with the continuing fall in house prices and the impact of the recession in the real economy the balance sheets of these transatlantic banks will remain under pressure. That is why the Fed is undertaking a stress analysis of banks to identify the problems that could arise as the economic situation deteriorates.

All this is to the good; but there are signs of financial protectionism with public authorities in the US and Europe emphasising the revival of domestic lending.

A recent IMF survey suggests that trade credit is more costly and more difficult to get and there have been stories about problems in rolling over credits that have matured. In part this is the result of the shrinking of bank balance sheets because of deleveraging from asset write-offs, the financial impact of the recession and higher risk aversion.

But in part it is the priority being given to domestic borrowers even when safe options for foreign lending are available. Hence, even though the banking system in India may not be as directly affected by toxic assets, Indian exporters and ECB borrowers are victims of this retraction from globalism by the transatlantic banking system.

The fall in global trade shown in the year-on-year trends at the end of 2008 is much larger than the fall in global growth. The 10-20 per cent decline in exports, which is what Asian economies are reporting in the end-2008 year-on-year figures, cannot be explained by a fall in demand due to the recession in the OECD countries where the projection for 2009 is a negative 2 per cent decline in GDP.

The choking of trade credit lines and inventory reductions may be part of the answer. If so, this will work itself out relatively quickly and trade growth should revive, provided protectionism does not rear its ugly head. There are ominous signs as legislators, who have provided an average of 5 per cent of GDP for various bailouts, talk about protecting domestic jobs.

The message at the G-20 for both financial and trade protectionism must be that it will delay a full global recovery by hitting at the one quick return option for demand expansion which is rapid growth in India, China and other developing countries.

When will the patients start walking on their own? The fiscal stimulus in the G-20 economies averages to about 1½ per cent of GDP, well short of the fall in GDP growth.

A lot depends on getting the financial system moving ahead at full steam, and assuming that happens soon, economic recovery is expected to begin in 2010. In the countries coping with a mortgage crisis this depends also on the stabilisation of house prices and the revival of housing demand -- and this may take longer than a year.

But note also that the fiscal deficit and the debt-GDP ratio in the OECD economies is going to deteriorate quite sharply and, at some point, worries about inflationary pressures and loss of confidence in public debt will roil the revival. The first signs of fiscal conservatism reasserting itself can be seen in the differences between eurozone countries and the US about a further fiscal stimulus.

In India the scope for a budget-led stimulus is limited as we did not use the good times to correct the fiscal or current account deficit. The main available option is the revival of corporate investment, which had been a major driving force of the high growth we saw after 2003.

Public investment in infrastructure and some corporate tax concessions may help. An investment-led growth acceleration in India will also be good for the global economy; but it does depend on a revival of global capital flows. Net private capital flows to emerging economies had dwindled at end-2008 and are now projected to be $165 billion in 2009, 82 per cent below the 2007 level.

The revival of these flows to anything like the boom time levels will probably come last in the recovery process, particularly with the tendencies towards financial protectionism.

All of the steps towards a global economic revival will require the OECD countries to follow policies directed not just at the protection and revival of their economies but at the impact on the global flows of trade, investment and finance. That is the message that Manmohan Singh must deliver at the G-20 meeting in April.