Egypt, Inflation, Revolution

Inflation is, among others, conceived to be the biggest risk facing the current economy around the world. Or policymakers think so. Egypt is not an exception. Protesters are ostensibly demanding the resignation of President Hosni Mubarak, who has ruled the country for nearly 30 years. But we have to think twice what angered Egyptian people.

It's not necessarily wrong to claim that Egypt's tumult has been just inspired by the ouster of Tunisia's President Ben Ali, who ran the country for more than 20 years, in response to the uprising of protesters. There wouldn't be no protesters on the streets in Egypt without Tunisia's overthrow. But more careful consideration would be required to figure out the true cause behind the scene. That's inflation.

Economics isn't always the cause of everything. Nonetheless, Egyptian's grumble over corruption and stagnation under the prolonged reign of the current president wouldn't reach the turning point without skyrocketing inflation in the country. In fact, prices rose 13.5% in 2008 in the Middle East, a 13-year high since 1995. Among them, prices jumped 16% in Egypt in 2009, the highest in the region.

This all happened despite the good track record of Middle Eastern economy, whose growth doesn't pale in comparison with ASEAN countries, or even excels South America. It wouldn't be difficult to imagine that higher inflation, which lessens real income, leads to people's discontent.

This "inflation theory" doesn't apply to Tunisia, whose inflation has recently been lower than the region. Nevertheless, world policymakers, especially those in dictatorship, might want to learn very important lessons from the crisis under way in the Middle East.

Decoupling of stock markets

It looks like Asia (Asia ex-Japan, of course) has been heading into a cycle of rate hike these days. The Bank of Korea, South Korea's central bank, raised its policy interest rate last week by 25bp to 2.75%, third rate hike since last year. In the same week, the Bank of Thailand, Thailand's central bank, also tightened monetary policy by venturing into the fourth increase of its benchmark interest rate by 25bp to 2.25% in a year.

What everybody is now watching very closely is, however, China, the second largest economy in the world. The country raised its reserve requirement ratio by 50bp last week, the seventh in a year. Fear of economic slowdown due to the rate hike dived the Shanghai composite, a benchmark index of China's stock, to a nearly three-month low of 2677.65 on Thursday.

Will China's economy slow down so soon this year? At least for now, it seems that the world markets read it as only China's problem, not themselves.

First, let's look at how China is big in the current world economy. China's contribution to the world growth has been increasing dramatically for the last ten years. Though it plunged in 2008 because of the recession after the Lehman crisis, the country's growth amounted one-third of the world growth in the same year. In addition, China's economy GREW more than 9% in 2009, whereas the world economy LOST 2%. It appears that China is now a sole locomotive driving the global economy.

Nonetheless, the world stock markets haven't responded to the decline of China's stock.

In fact, the S&P500 gained 6% since early December, while the Shanghai composite declined 5% in the same period. Does this mean a "decoupling" of China from outside world? Given that China's stock market is intrinsically different from other markets in the sense that it's driven more by politics than economics, it seems that a contrasting move of stock markets between two countries isn't surprising at all.

I have no definitive answer yet to why the world isn't responding to China's stock market slump, even though China's influence in the global economy is increasing exponentially. More time is needed to scrutinize it.

Manufacturing is too concentrated in China

It looks like Brazil is gaining an expertise of creating new rhetoric. According to a BBC report, Brazil's Finance minister Guido Mantega stepped up its warning on currency manipulation, saying, "This is a currency war which is turning into a trade war." Mantega went further to express a jittering voice against China's currency, yuan, adding that "China's 'undervalued currency' was also distorting world trade."

As my last post shows, Brazil's concern would be justifiable given the rapid appreciation of its currency, real. In the last two years, real has risen more than 30% in real terms, one of the biggest gains of all. Brazil's exports are only 13% of GDP, but it could still put a considerable pressure on exporters. On the other hand, yuan lost 4.5% of its value despite a double-digit growth of China's economy which has led the country to the world's largest exporter. Who could say that Brazil is overreacting?

China surpassed Germany as the world's largest exporter in 2009, which undervalued yuan probably had huge effects. Then, what is China exporting? Of course, it should be manufactured products. China is making a gigantic effort to be the world's factory, and estimated to replace the US as the world's largest manufacturer in as early as 2010. China's manufacturing claimed mere 1% among the world's total in 1970, one-twenty-fifth of the US. But now it's more than 17%, and close to the US's 20%. This is an amazing concentration of industrial power given not only developed economies but also emerging countries like Brazil and Russia are transforming themselves to service economies.

An important question should then arise: What if China goes bust? China is going to be the world's factory, but what would happen if the world's factory loses its motion and stops producing? It seems that the world has recently forgotten or is afraid to ask about the demise of China's economy, but the risk remains as to the excessive concentration of manufacturing on one country.

Food prices and income level

According to the latest report of the Food and Agriculture Organization, UN's organ, food prices jumped to the all-time high in December last year, beating the previous high in June 2008 that "sparked deadly riots from Haiti to Egypt." As the current rise of food prices, coupled with high unemployment, has already provoked riots among Algerian youths, the likelihood is increasing that riots over high living costs spread to other countries. In fact, neighboring Tunisia has seen unrest over unemployment these days, claiming three deaths.

The Food Price Index compiled by the FAO started at the initial value of 110.3 in 1990. From then on, the index has gained more than 100% and hit 214.7 last month, surpassing the previous all-time high of 213.5 in June 2008. But the recession after the Lehman crisis plunged the index to a 22-month low of 139.0 in February 2009. It means that the latest figure has climbed more than 50% since a 22-month low in February 2009 and reached the new high in the same 22 months.

Setting the value in February 2009 at 100, two groups can be observed in the composition of the index. First, sugar has risen the most among five categories since February 2009, and oils and dairy follow. Sugar and oils are gaining more than 100% in nearly two years. On the other hand, cereals and meat have increased only around 30%, though the former rose starkly after losing nearly 15% in June last year.

What's interesting is the relation between consumer price index by country income and food prices. First, if looking at a level of consumer price index and food prices, all countries, irrespective of income levels, have recently strengthened the relationship between them. In fact, every income-level country, high, middle, and low, has more than 0.9 of correlation coefficient in 2000 to 2009, while a negative coefficient is observed in all three in 1991 to 1999.

However, if looking at the correlation between the growth rate of consumer price index and food prices, a different picture arises. The most striking is that the CPI growth rate of high income countries has increased its correlation with that of food prices in the recent decade. In fact, the correlation coefficient of high income countries has jumped from 0.11 in 1991 to 1999 to 0.72 in 2000 to 2009.

It's not clear why the correlation is going up in high income countries. It would be against the intuition that food has a larger part in low-income countries, which is expected to lead to a higher correlation in low income countries. It would, at least, mean that commodities including food have recently pushed overall prices higher in high income countries, although correlation has no clue on which leads which.

Bretton Woods II in a new guise

Talk on currency issues has not yet reached the limit. The title of the front page article in today's FT is more sensational: "Fears of currency war rise." Another article indicates that

Between September 27 and October 11, central banks in South Korea, Malaysia, Indonesia, Thailand and Taiwan collectively purchased $28.74bn, according to estimates by IFR Markets.

Simon Derrick at Bank of New York Mellon estimates that the scale of intervention from these central banks means they have accumulated foreign exchange reserves at between two and six times normal rates in recent weeks.

This article put an emphasis on Asian central bank's failure to stem the rise of their currencies, revealing that their currencies have climbed since intervention. Their failure to depreciate the currency is the direct result of the Fed's ultra loose monetary policy. What is worse for them is that the Fed is unlikely to reverse the current policy anytime soon. The minutes from September's FOMC released yesterday showed that

Many participants noted that if economic growth remained too slow to make satisfactory progress toward reducing the unemployment rate or if inflation continued to come in below levels consistent with the FOMC's dual mandate, it would be appropriate to provide additional monetary policy accommodation.

Lackluster employment condition in September would warrant the Fed's additional accommodation. So, it's highly likely that the Fed decides some additional accommodation, probably the purchase of Treasury, at the next FOMC meeting in early November.

Given that the Fed's additional accommodation is coming, what would happen?

According to BIS, emerging economies have borne the brunt of market forces which are driving their currencies higher. In real terms, the currency of Indonesia, Malaysia, India, and Thailand all appreciated more than 5% this year, while China's yuan gained mere 3% despite of its gigantic economic prowess. It's no less surprising that dissatisfaction has been mounting among emerging economies which also have to underpin the economy with export. The euro lost nearly 11% of its value mainly due to Greek or other European countries' economic crisis. It has recently regained its momentum though, reaching at the near $1.4. European authorities, especially Germany, would not be glad at that

Asian countries are not set to accept the rising currency, so I think that they continue buying dollars to depreciate their currencies. Familiar with that? Yes. Hefty purchase of dollars would sink the US interest rates, and hence the dollar would keep weakening due to compressed interest rates differentials among major economies along with the Fed's ongoing loose monetary policy.

Money cycles between Asia and the US. Here is Bretton Woods II in a new guise.

Failed attempt to stem currency wars

Headline tells everything.

Telegraph: IMF fails to strike deal over currency frictions

The International Monetary Fund on Saturday night failed to reach agreement on tackling mounting global "frictions" over exchange rate policies despite US calls to deal with the issue more forcefully.

New York Times: IMF doesn't press China on currency

The world's financial leaders failed on Saturday to reach agreement on how to contain an escalating currency dispute that has threatened to undermine global cooperation on economic recovery.

Christian Science Monitor: IMF leaves the question unresolved: Can world avert harmful "currency war"?

World financial leaders agree on the problem. They just don't have a ready solution to the risk that the global economic recovery will be undermined by nationalistic elbowing over exchange rates.

Nobody had even a slight anticipation of cooperation reached at the IMF meeting on how to stop currency war now under way among major economies. So, this result should be no surprise. Even at the G20 meeting later this month, it would be disastrous to expect that the world's major economies cuts an agreement to stem the tide of currency devaluation. No new Plaza Accord, whatsoever.

No countries can escape the responsibility of policy bungle during the early 2000's. Over-consumption supported by the ultra low interest rate and housing bubble in the West held sway in the world. Don't forget that emerging economies took full advantage of it to export their way by depreciating their currencies and buying US bonds, hence lowering the US interest rates. The US is in no position of scolding China for its currency policy.

China, the second largest economy in the world surpassing Japan, shouldn't be an eternal victim of the evil West and Japan. Now is the time to take a responsibility of stewarding the world economy. But as is shown in the Nobel Prize for Peace mess, it would be far away from that position, unfortunately.

On Dani Rodrik's article

Dani Rodrik is right.

In the early days of the global financial crisis, there was some optimism that developing countries would avoid the downturn that advanced industrial countries experienced. After all, this time it was not they that had engaged in financial excess, and their economic fundamentals looked strong. But these hopes were dashed as international lending dried up and trade collapsed, sending developing countries down the same spiral that industrial nations took.

But international trade and finance have both revived, and now we hear an even more ambitious version of the scenario. Developing countries, it is said, are headed for strong growth, regardless of the doom and gloom that has returned to Europe and the United States. More strikingly, many now expect the developing world to become the growth engine of the global economy. Otaviano Canuto, a World Bank vice president, and his collaborators have just produced a long report that makes the case for this optimistic prognosis.

There are many reasons why such optimism is not unreasonable. Most developing countries have cleaned up their financial and fiscal houses and do not carry high debt. Governance is generally improving along with the quality of policymaking. The possibilities of technology transfer through participation in international production networks are greater than ever.

Moreover, slow growth in the advanced economies need not exert a drag on developing countries' performance. Long-term growth depends not on foreign demand, but on domestic supply. Sustained rapid growth is the result of poorer countries catching up to rich countries' productivity levels – not of growth in the rich countries themselves. For most developing countries, this "convergence gap" is wider now than it has been at any time since the 1970's. So the growth potential is correspondingly larger.

But the good news stops right about there. Sustained growth requires a growth strategy, and most developing countries do not yet have one that would put them irrevocably on the path of economic convergence.

For too many of these countries, economic growth in the last two decades relied on a combination of two factors: a natural rebound from previous financial crises (as in Latin America) or political conflicts and civil war (as in Africa), and high commodity prices.  Neither can be relied on for the productive transformation that developing countries need. 

Consider, for example, Latin America's growth model of the last two decades. Global competition has whipped many of the region’s industries into shape and fostered significant productivity gains in advanced sectors, but these gains have remained limited to a narrow segment of the economy.

Worse still, labor has been displaced from more productive tradable activities (in manufacturing) to less productive informal activities (services). In most Latin American countries, structural change has served to reduce rather than promote economic growth.

Because Asian governments have tended to support their modern, tradable sectors to a greater extent, most Asian countries have managed to avoid this malady, and have done much better as a result. But even the Asian model may be reaching its limits.

China, in particular, needs to confront the fact that the rest of the world will not allow it to run a huge trade surplus forever. An undervalued currency, which serves to subsidize China's manufacturing industries, has been a key driver of the country's economic growth for the last decade. A significant appreciation of the renminbi will reduce or even eliminate that growth subsidy.

Regardless of developing countries' growth prospects, there is a deeper question. Will a world economy in which developing countries have substantially greater weight foster the kind of global governance that sustains a hospitable economic environment? Emerging-market economies have not yet shown the kind of global leadership that suggests an affirmative answer to this question.

The global institutions of our day – the International Monetary Fund, the World Bank, and the World Trade Organization – are still largely the creation of American leadership at the end of World War II (though they have obviously undergone considerable change since then). These institutions reflected American interests, but they also codified certain norms of behavior – rule-based decision-making, non-discrimination, multilateralism, transparency – which eventually came to constrain American power as well.

Countries like Brazil, China, India, and South Africa, however, have so far shown little interest in contributing to the construction of global regimes, preferring to remain free riders. Jorge Castañeda, a former foreign minister of Mexico, goes further, arguing that these countries have systematically opposed global rules, in areas ranging from climate change to international trade.

Lest we be too harsh on developing countries, however, let us also remember that political scientists have long worried that greater diffusion of economic power would produce a less stable world economy. If the world economy's center of gravity shifts substantially toward developing countries, this will not be a smooth – and possibly not even a benign – process.

We can be certain of two things: only those countries that adopt growth strategies based on stimulating domestic structural change will do well, and the conundrum of global governance – how to manage a world economy that has become unruly – will almost certainly get worse.

This is one of the most comprehensive assessments ever on the current global economy that I have read. I have nothing to add. But you might want to add Japan to the list of countries which "have so far shown little interest in contributing to the construction of global regimes, preferring to remain free riders." Also, Turkey, a country where the author Dani Rodrik was born, would be willing to be listed.