Sunday 23 October 2016

Smaller countries with heavy debt burdens like us are at the mercy of international markets

Published 30/08/2015 | 02:30

CRASH: A Chinese day trader watches a stock fall at a local brokerage house as the crisis hit hard early last week
CRASH: A Chinese day trader watches a stock fall at a local brokerage house as the crisis hit hard early last week

The Irish economy is one of the few in Europe enjoying any kind of recovery, partly down to some good luck on energy import prices and the weaker exchange rate. The recent nervousness about economic prospects in China is not the principal threat to that recovery. The bigger threat comes once again from the international financial situation. With the eurozone architecture unreformed, external conditions pose a permanent threat to any small member with a heavy debt overhang.

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If the latest instalment of the Greek crisis has not done so, the jittery performance of world financial markets over the last few weeks should remind everyone that the international economy remains fragile. Securities markets and exchange rates are jumpy, world trade is sluggish and the long-predicted slowdown in China has finally materialised.

There may be a vigorous recovery under way in Ireland but it is exceptional, and external events could see it derailed very easily. In the eurozone, the dysfunctional response to the crisis in Greece is further evidence that the reforms necessary for a durable monetary union have not been undertaken.

In the longer view, it was always likely that Chinese growth would slow at some stage. The extraordinary performance since 1980, with annual growth rates regularly exceeding 10pc, has seen China's share of world output grow from 2.2pc to an expected 18pc next year. This has been achieved through an unprecedented commitment to capital formation. China has invested over 40pc of annual output for the last 40 years, matched by domestic saving. There is plentiful evidence that some of this investment avalanche has been misallocated. Politically there is inevitable pressure for a switch from investment to consumption.

China's population has risen from under 1 billion in 1980 to around 1.38 billion today. This growth, allied to the reservoir of underemployed rural labour, staffed up the manpower requirement of the great push to industrialisation.

But the population expansion has run out of steam with little further growth expected in the decades ahead: indeed, India could eventually overtake China as the world's biggest nation.

More immediately, the Chinese population is ageing and rising wages are already directing manufacturing activities offshore to more labour-abundant countries elsewhere in Asia.

If China slows to a more sustainable growth rate as it reaches developed country status, this means slower growth in world trade. China is such a large component of the world economy, approaching the share of the USA, that a Chinese slowdown will diminish export growth everywhere else.

But it is a mistake to exaggerate the direct reliance of Ireland on exports to China. Merchandise exports to that country fluctuate between 1 and 2pc of the total, the same share as Northern Ireland. This country exports about 80pc of its merchandise total to Europe and North America. Only about 8pc goes to the whole of the Asia-Pacific region, which includes Japan, South Korea and Australia. A Chinese slowdown will have a very limited direct effect on Irish trade.

The indirect effects would matter a lot more if they weaken economic prospects in Europe and North America, and especially if they contribute to financial instability. And there has been plenty of financial instability to go around in recent weeks and months, unrelated to the hiccups in the Chinese stock market or the modest decline in China's exchange rate against the dollar.

The combination of near-zero official interest rates with very low inflation is historically a most unusual pattern. Some European governments have even been able to borrow on the bond markets at negative cost earlier this year - investors actually paid the treasuries to take care of their money for a few years. There are two reasons for this unusual pattern. Central banks in the USA, Britain, Japan and, more recently, the eurozone's ECB concluded that inflation was too low and likely to stay there, and that economies were depressed and needed easy monetary policy. Many central banks have formal or informal inflation targets around 2pc. If inflation dips below this figure, and it has been zero or thereabouts in several eurozone countries including Ireland, there is no relief from the burden of debt. Inflation, even at a modest rate like 2pc, helps to erode debt burdens over time.

The pace of economic recovery has also been disappointing, with many governments unable (or unwilling) to boost demand through budget relaxation. So the central banks, reluctantly in the case of the ECB, have cut official interest rates close to zero and have been pumping out funds through purchasing financial assets, so-called quantitative easing or QE.

The idea is to raise the price of financial assets, which should reduce borrowing costs for business and industry and stimulate overall demand.

This has been the policy setting in Britain and the USA since the early days of the crisis, but the US Federal Reserve called a halt to asset purchases late last year and has signalled that the next move in US interest rates will be upwards.

The Bank of England is likely to follow suit. Both central banks are seeking a 'return to normality', which they perceive as inflation back at 2pc or so and official interest rates higher again, restoring the traditional margin between interest rates and inflation.

The first move upwards in US rates could come as early as September 16, when a key rate-setting meeting is scheduled. Even if there is only a small increase before the end of the year, the US authorities have embarked on a course likely to see interest rates rising by 2 or 3pc over the next cycle, with something similar happening in Britain.

The ECB has only recently copied the QE asset-buying strategy and will be slower to follow suit.

This timing mismatch could lead to more volatility in bond and foreign exchange markets but no matter how long the ECB takes, and it could be a year or more, it is already clear that the next move in European interest rates is also going to be upwards.

This means higher borrowing costs for government, for those on tracker mortgages and for bank customers generally. It is worth remembering that the last time things were supposedly normal, back before the 2008 financial crisis, official interest rates in the eurozone were regularly in the 3 to 4pc range.

There is a broader problem. Ultra-low interest rates can create financial instability, encouraging financial intermediaries to borrow cheaply from central banks and to chase earnings through holding riskier assets.

Sometimes the risks are concealed and there is no shortage of Cassandras worried that another financial sector time-bomb is under construction.

The total stock of debt borne by governments, households and businesses around the world continues to rise and the world economy is still highly leveraged and thus vulnerable to an interest rate rise.

In Ireland, the electoral cycle is seen as an excuse to defer the return to budget balance. Unfortunately, Ireland is exposed to the policy responses of the ECB, and the Greek experience shows that eurozone policymakers do not attach a high priority to the interests of small indebted members. Managing a small trading economy with high debt and no national currency requires extreme caution and risk-aversion.

Sunday Independent

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