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--- insight777 (5/8/2012)
THE world economy appears to have found a fragile equilibrium. There are weaknesses in key economies balanced by pockets of growth elsewhere. More notably, the worst fears of the last three months of 2011 have not materialised. The last six weeks in particular have shown signs that the global economy has avoided imminent disaster.

In the euro zone, the threat of a major crisis has receded, at least for now. A deal has been struck on the second Greek bailout package, allaying fears of a messy default situation. The European Central Bank's (ECB's) two tranches of Long-Term Refinancing Operation, or LTRO, amounting to more than €1 trillion (S$1.65 trillion), has provided euro zone banks much needed liquidity to meet their funding needs.

In the United States, the risk of a double-dip recession has waned. Employment data has surprised on the upside. New orders for both manufacturing and non-manufacturing continue to indicate higher levels of activity for the next six months.

In China, the odds have improved in favour of a soft landing. While economic growth has continued to ease in the face of weakening external demand, domestic demand has been holding up well. Inflation appears to have peaked, providing monetary policy more latitude to support growth if necessary.

But the outcome for 2012 is by no means assured. Significant risks remain on the horizon:

First, resolution of the sovereign debt situation in the euro zone is still a work-in-progress. With Europe sliding into recession, sovereign and banking vulnerabilities will remain a protracted concern.
Second, the sustainability of consumer spending in the US remains critically dependent on further improvements in the labour and housing markets - both of which are uncertain.
Third, a sharp spike in oil prices could potentially derail global economic growth. Oil prices, which have already started rising, are highly vulnerable to geopolitical developments in the Middle East.
Barring these potential shocks, the International Monetary Fund projects the global economy to grow by 3.3 per cent this year. The euro zone will experience a mild recession. The US and Japan will have positive growth, but below trend. Developing Asia is expected to grow by 7.3 per cent. Under these conditions, the growth forecast for the Singapore economy at 1 to 3 per cent this year remains on track.

But it is not this year's growth that policymakers or asset managers should be most concerned about. It is the medium-term growth and inflation outlook that matters. There are several structural challenges facing the global economy. I want to elaborate on two key driving forces that will shape the medium-term outlook in both the advanced and emerging economies: deleveraging and monetary expansion.


FROM around 1990, debt levels began to rise rapidly in most advanced economies. Governments ran persistent fiscal deficits that were financed by borrowing. Total government debt in the Organisation for Economic Cooperation and Development economies grew relentlessly, from 58 per cent of gross domestic product (GDP) in 1990 to 98 per cent in 2010. Households went on a consumption binge, financed by easy borrowings on the back of rising property prices and housing equity. Household debt in the developed economies also climbed, from 62 per cent in 2000, to 76 per cent in 2010.

Deleveraging is the process by which this excessive debt is brought down to more sustainable levels. This will be long-drawn, only because the build-up of leverage took place over such a long period of time.

The deleveraging process that is unfolding across the advanced economies is taking place across three fronts.

First, deleveraging by governments in the US and the European Union. The public finances of the US, the United Kingdom and the euro zone countries have substantially deteriorated, due to pre-crisis fiscal profligacy and post-crisis discretionary stimulus. These countries have now embarked on fiscal adjustment programmes to varying degrees, primarily through austerity measures. Fiscal consolidation is expected to shave off a cumulative 2 to 2.5 percentage points from GDP growth in the US, UK, and the euro zone over the next three years.

Second, deleveraging by US households. Since the bursting of the credit bubble in 2008, US household debt has declined by 5 per cent in absolute terms and 15 per cent as a percentage of disposable incomes. More than two-thirds of the reduction in debt stock was due to default of mortgage and other consumer debt. It is hard to tell what is a sustainable level of household debt, but most estimates suggest that US households are just about a third to halfway through the deleveraging process. This means probably another three to five years of subpar household consumption growth in the US.

Third, deleveraging by euro zone banks. There are two factors at work here. One, the quality of euro zone bank assets has come under pressure. Two, euro zone banks are required to improve their capital adequacy positions so as to buffer against shocks. In particular, European banks are required to achieve a minimum core Tier 1 capital ratio of 9 per cent by June this year. To the extent that banks cannot achieve the target capital ratios through retained earnings and capital raising, they will have to reduce their balance sheets. They can do this by selling assets or reducing lending. Both will have a dampening effect on economic activity. Given the global footprint of many euro zone banks, the effects will be felt not just in Europe but elsewhere in the world.

Impact of deleveraging on Asia

EMERGING Asia will not be immune to this synchronised deleveraging in the advanced Western economies. Fiscal consolidation and household deleveraging in the US and EU will have significant spillover effects on Asia, principally through the trade channel. Asia excluding Japan exports about a quarter of its goods to the US and Europe. Already, Asian export growth has decelerated from 25 per cent at the beginning of 2011 to 10 per cent in the last quarter of the year.

While Asian economies have started to restructure their economies towards increasing domestic demand, and intra-regional trade within Asia has been growing, these trends will, at best, cushion only part of the fall in demand from the West. Rebalancing of demand is a long-drawn process. It is unrealistic to expect Asia to become the main engine of growth for the global economy over the next few years.

The deleveraging of euro zone banks will impact Asia mainly through the financial channel, in the form of tighter credit. Euro area banks as a whole provide 36 per cent of global trade finance loans, and French and Spanish banks together account for more than two-fifths of trade finance loans in Asia.

To date, the impact on Asia of deleveraging by euro zone banks has been quite limited. Through most of last year, many euro zone banks substituted the drying up of interbank funds in Asia with increased inflows from head office, which enabled them to continue funding activities in Asia. But towards the end of 2011, there was a discernible pullback in trade finance, project finance, and syndicated loans by several euro zone banks. Specialist lending lines like shipping and aviation also experienced cutbacks.

Well-capitalised global and Asian banks with strong liquidity positions have, however, stepped in to fill the gap. For example, Asian banks' market shares of export bills for Singapore-originated trade activities rose from 36 per cent before the crisis to 55 per cent in the last quarter of 2011. A similar pattern can be observed for trust receipts, where Asian banks' market shares rose from 55 per cent to 64 per cent over the same period. In fact, aggregate trade finance activity has continued to grow.

2012 will be more challenging though. On the positive side, the funding situation for euro zone banks has improved, in the wake of the ECB's LTRO. In January this year, there were net inflows from head offices to the Singapore branches of euro zone banks.

But deleveraging by euro zone banks is far from over. At the same time, the capacity of Asian banks to fill the trade financing gap is limited. First, the US dollar loan-to-deposit ratios of Asia ex-Japan banks are already at elevated levels and could be a constraint. Second, Asian banks may be more selective about the risks they want to take on, given the uncertain global growth outlook. Third, Asian banks which are generally smaller may be constrained by counterparty limits from taking over the trade finance lines of the large European banks. Fourth, Asian banks will take time to build expertise in areas such as structured trade finance that the euro zone banks have specialised in.

Deleveraging is a process not to be avoided but to be managed.

The world as a whole has lived beyond its means in the years preceding the global financial crisis. Many advanced economies grew rapidly on the back of easy fiscal policies, low interest rates, and excessive credit expansion. The emerging economies benefited from this growth through exporting to the advanced economies.

The world must now work off these past excesses. Debt in the advanced economies must come down to more sustainable levels before these economies can return to a balanced growth trajectory. This must mean lower consumption and higher savings for some time.

Emerging economies, especially in Asia, must increase domestic demand to help offset some of the impact of the slowdown in the G-3 economies. But they will not be unaffected. They too will see slower growth.

Monetary expansion

A SECOND driving force in the global economy is the widespread phenomenon of easy money.

Since the beginning of the financial crisis in 2008, central banks in the US, UK, and the euro zone have embarked on unprecedented monetary expansion. With fiscal policy constrained by sovereign debt concerns, the burden of supporting growth and ensuring financial stability has fallen disproportionately on monetary policy. With interest rates close to the zero bound, central banks have been relying heavily on unconventional measures, especially large-scale asset purchases aimed at lowering long-term interest rates and spurring economic activity. Unconventional as these measures may be, they have been effective in preventing financial crisis and preserving market stability.

While this unprecedented monetary expansion may be necessary in the context of the current situation in the advanced economies, it is neither without risk nor contagion. The key risk is that if monetary stimulus is not withdrawn at the right time, inflationary pressures could rapidly build up.

Monetary expansion in the G-3 economies also has significant cross-border contagion effects. Low interest rates in the advanced economies, coupled with relatively favourable growth prospects in emerging economies, have triggered bouts of large and volatile capital flows to the latter. Easy monetary conditions are appropriate in the advanced economies given the stage of the business cycle they are at, with significant negative output gaps.

But emerging economies, especially in Asia, are at a different stage of the business cycle. Capacity utilisation is above pre-crisis levels in many Asian countries. Labour markets are tight. The output gap in many Asian countries has closed and turned positive, although the recent easing of exports has reduced the gap somewhat. Partly due to the tightening of monetary policy earlier on, inflationary pressures in many Asian countries have subsided. But as long as monetary conditions in the advanced economies remain easy, the risk of disruptive capital flows and surges in inflation, especially in asset prices, remains real.

The challenge facing Asian policymakers is this: how to adjust policy settings to cope with slower economic growth while inflation has not been entirely tamed? While there has been some normalisation in policy rates over the past two years, real interest rates remain generally low to negative in the region. Credit growth is strong and bears watching.

Persistent low real interest rates can distort savings-investment decisions and lead to a misallocation of resources. Risks may build up in specific sectors, like real estate for instance.

Asian economies have mostly coped with these pressures by complementing standard macroeconomic responses - such as raising interest rates and allowing some currency appreciation - with a variety of so-called macroprudential tools, such as tightening credit standards and lowering loan-to-value ratios for property purchases. These unconventional measures have been fairly effective to-date in easing asset price inflation. But like unconventional monetary policy in the advanced economies, these measures are also not without risk.

The effects of deleveraging and monetary expansion will be with us for some time. They pose twin risks: lower economic growth and higher inflation.

But the Asian growth story remains intact.

The writer is managing director, Monetary Authority of Singapore. This is an edited extract from a keynote address delivered at the Investment Management Association of Singapore 13th Annual Conference yesterday.

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