INTERNATIONAL: Global Economy

Analysis

The fallout from the East Asian financial crisis is likely to depress global economic growth by between 0.5 and 1.0 percentage points in 1998. As a result, the IMF forecasts that world growth will fall back to 3.5% in 1998, from a revised 4.1% this year, with the brunt of the crisis likely to be borne by Japan. Elsewhere, the slowdown may forestall the emergence of inflationary pressures in the global economy, particularly in the United States.

Financial volatility. Capital market volatility is likely to persist into early 1998. While the bull run in US equity markets has probably ended, there is considerable uncertainty about whether corporate earnings and fundamentals will support current asset valuations. This uncertainty in turn reflects three factors:

The perceived overvaluation of equity markets in the advanced industrial economies.

Doubts about the future direction of macroeconomic policy in the United States, Western Europe and Japan.

The risk that the financial crisis in East Asia will spread to other emerging markets, notably Brazil and Russia.

Until a greater degree of stability returns, international investors are likely to focus on danger signals as much as earnings opportunities.

Advanced economies. Three events will dominate capital markets in the advanced industrial economies in 1998:

1. The direction of US interest rates. US GDP is likely to expand by around 4.0% in 1997, which is significantly faster than the long-run growth in potential output, estimated to be around 2.25-2.50% per annum. In the wake of the East Asian crisis, US economic growth is likely to fall back towards its long-run potential over the course of 1998, and price pressures will remain quiescent. However, the continued tightening of the labour market has been accompanied by signs that wage settlements are beginning to accelerate. If these start to feed through into consumer prices, the Federal Reserve may act to deflate demand more rapidly by raising interest rates.

Against this, the Fed has appeared reluctant to tighten monetary policy, fearing that an increase in short-term interest rates would trigger a further bout of volatility in East Asian financial markets and a collapse in US asset prices. Together with the strengthening of the dollar and the prospective deterioration in the US trade and current account deficits, this has created considerable uncertainty about the timing of any monetary tightening.

2. The advent of EMU. Financial markets appear to have accepted that Economic and Monetary Union (EMU) will proceed in 1999 with a broad grouping of eleven member states. The final decisions on membership and bilateral currency conversion rates are due to be announced in early May: an acrimonious debate over the Euro-area's initial membership could lead to financial market turbulence. In addition, there is likely to be pressure on EMU 'outsiders' to clarify the relationship of their currencies with the future Euro. Policy- controlled interest rates are likely to converge, with some EMU-inspired tightening of German rates possible. Nevertheless, volatility related to EMU may lead to some short- term adjustment of portfolios in favour of the dollar.

3. The reflation of the Japanese economy. Reflation will inevitably involve a fiscally funded restructuring of the banking system. The planned liberalisation of the financial sector is also likely to be partially delayed, pending the return of greater confidence. Any recovery, which will be dependent on exports, is unlikely to occur before the second half of 1998.

In combination, these factors will probably lead to some recovery in the yen's value against the dollar over the course of the year. Currencies in the prospective Euro-area are also likely to strengthen, albeit gradually. Realignments within the dollar-DM-yen triad may thus reduce the present overvaluation of the dollar in trade-weighted terms, although there will be considerable volatility around these trends.

Emerging markets. The massive real devaluations of East Asian currencies are likely to be followed by a boom in the region's exports in 1998. In contrast with the early 1990s, when export growth was driven by intra-regional trade, these exports will be directed towards markets in Western Europe and North America. This return to the trade patterns of the 1980s, with East Asian exports penetrating OECD markets, is likely to foster protectionist sentiments, particularly in the United States.

Poor export performance, fragile banking systems and inadequate fiscal consolidation will leave a number of other emerging markets vulnerable to adverse shifts in capital market sentiment in the coming year. This vulnerability is likely to focus on two weak points:

Brazil. While Latin American equity markets and currencies appear to have survived the immediate backwash from the crisis in East Asia, the wider region remains vulnerable to pressure on the Brazilian real's link to the dollar. In the event of the real's devaluation, or a severe recession in Brazil, Argentina's currency board in particular would come under intense pressure.

Russia. A financial crisis in Russia would be more serious than one in Latin America, posing a significant risk to the stability of the international financial system. The country's weak political and corporate structures are ill-prepared to withstand a collapse in confidence, and a Russian financial crisis could unleash contagion effects across Europe.

Flows of short-term portfolio capital towards emerging markets are likely to decline as institutional investors become more risk-averse. These flows will be replaced by the flotation of large sovereign debt issues on US and European capital markets as East Asian governments seek to replace short-term emergency loans with cheaper long-term debt and raise funds to recapitalise domestic banking systems.

Central bank objectives may shift towards the stabilisation of exchange rates rather than that of domestic prices. Consequently, there is likely to be increased interest in inter-governmental and inter-agency cooperation at a regional level, particularly in Latin America and Asia.

Financial regulation. The contagion effects of the East Asian financial crisis have highlighted the increasing integration of national capital markets. The number and scale of international financial interventions in 1997 are unprecedented. Financial assistance totalling around 111 billion dollars has been extended to Thailand (17 billion dollars), Indonesia (37 billion dollars) and South Korea (57 billion dollars). This is far in excess of the 50 billion dollar bailout organised for Mexico in 1995, and is almost double the annual flow of development assistance from rich to poor countries, which amounts to some 60 billion dollars per annum.

Given the rising costs of bailouts ex post, questions about the adequacy of regulation ex ante are likely to assume a high profile in 1998:

The rationalisation of the global financial services industry into a relatively small number of major institutions operating on a global scale has placed considerable strain on regulatory systems, which continue to be based at a national level. Attempts to strengthen cross-border supervision of financial intermediaries will centre on implementing the 'Core Principles for Effective Banking Supervision' drawn up by the G10's Basle Committee on Banking Supervision, in conjunction with regulators from the leading emerging markets.

For wholesale transactions, prudential regulation based on capital requirements will continue to be replaced in the advanced industrial economies by regulatory oversight of intermediaries' own internal risk management systems. Retail investors will be covered by consumer protection safeguards.

The focus of regulation in emerging markets will move away from macroeconomic fundamentals such as growth and inflation towards problems of banking sector fragility and corporate borrowing. The IMF is drawing up a framework for financial stability, based on the Basle Committee's core principles, under which the Fund would assume an enhanced role in surveying member countries' banking systems, supply technical assistance to national regulators and extend conditionality to borrowers' policies on banking supervision. The proposed amendment to the IMF's Articles of Agreement to promote capital account liberalisation would deepen the Fund's involvement in this area.

However, inherent volatility within the triad will hinder attempts to strengthen the capacity of either the IMF or the Bank for International Settlements to stabilise global capital flows. This will be compounded by the continuing hostility of the financial services industry to the idea of an international regulatory regime.

Long-term adjustment? The longer-term consequences of increased international capital market volatility and the global transmission of shocks are difficult to determine with any degree of certainty. However, a number of shifts may become apparent in 1998:

1. External factors are likely to assume a greater role in US monetary policy. Policy-makers -- at the US Treasury and the Securities and Exchange Commission, as well as the Fed -- will have to take into account external shocks from global capital markets and the need to stabilise the dollar alongside traditional concerns about domestic inflation and unemployment. The need to react to the emergence of the Euro as a global currency, the reorganisation of the Japanese economy and a prospective deterioration in the US trade balance will further reduce the autonomy of US monetary policy.

2. Doubts about equity-based pension funds are likely to rise among small savers in the advanced economies. These are likely to centre on the skills and apparent 'herd behaviour' of fund managers. In this vein, the credit rating agencies have already been excoriated for failing to anticipate the sovereign risk inherent in misaligned exchange rates in East Asia.

3. The structure of international monetary arrangements may be reassessed. While rescue packages for Thailand, Indonesia and South Korea were assembled under IMF auspices, they have reflected US policy objectives. The Clinton administration has sought to protect US investors in the region while simultaneously maximising the pressure on East Asian countries to open up their financial services markets to US banks and insurance companies. In doing so, it has exploited and -- to some extent -- inspired the Fund's attempts to make emergency financing for countries in the region conditional upon capital market liberalisation.

The reluctance of East Asian governments to cede ownership of domestic financial intermediaries to foreign investors has led to renewed interest in regional arrangements for monetary cooperation. At least in the short term, the US administration has successfully sidelined proposals to create an Asian Monetary Fund with an emergency financing facility independent of the IMF. Washington is anxious to ensure that regional monetary arrangements do not undermine the IMF's role by circumventing the conditionality attached to the Fund's own lending.

However, the US Congress remains unenthusiastic about enhanced international financial cooperation, even if it is centred on the IMF. In November, Congress declined to approve funding for the 3.5 billion dollar US contribution to the IMF's New Arrangements to Borrow (NAB). Moreover, although Fund members agreed a 45% increase in quotas in September, it remains unclear whether the US Congress will appropriate funds for either the NAB or the quota increase in 1998. Given the absence of congressional backing, the US administration has blocked proposals to raise quotas by 70-80% to ensure that the Fund's resources remain adequate in the aftermath of recent bailouts.

4. The role of volatile international capital flows in economic development strategies is likely to be reassessed by governments in emerging markets. In many cases, governments may adopt a more selective attitude towards external finance. Policy responses are likely to focus on managing the overall volume of inflows more actively, as well as discriminating between short-term and long-term sources of finance. The regulation of capital flows is likely to take the form of reserve requirements and taxes on short-term inflows, while offshore borrowing by local corporations will be subject to more stringent controls. However, attempts to restrict capital flows are likely to lead to frictions with Washington and the IMF.