America’s leading indicators have now declined for five months in a row. The Economic Cycle Research Institute has declared an official recession. Many are in the process of revising down India’s growth estimates for 2008-09 and Vietnam is set to miss its 9% growth target this year. The Japanese government has lowered its growth outlook and the quarterly survey of confidence among large and small manufacturers is expected to show a substantial decline. The global growth recession has begun. What are the lessons we can apply from the last worldwide economic downturn?
In the four years between 1989 and 1992, the world economy experienced below-average growth. In addition, many nations in the developed world experienced economic troubles. The mortgage bubble burst and there were seven consecutive quarters of economic contraction in the UK. The Finnish economy shrunk 10% on the disintegration of the Soviet Union. Economic growth in central and east European countries came to a halt for the same reason. The Berlin Wall fell and Germany experienced high inflation. The European exchange rate mechanism (ERM) came under strain as the pound sterling entered it at a high rate and other European nations wanted lower interest rates, not higher. Sterling was ejected and ERM had to be rejigged. There was the Gulf war when Iraq invaded Kuwait and the price of crude oil shot up. The US had a brief recession and the savings and loan crisis. The spectacular equity and real estate bubble in Japan peaked in 1989 and the yen began strengthening perversely.
It is reasonable to think the world economy can outlast the current turmoil if it survived such a formidable list of strains and crises. But there are crucial differences.
Then, the US had triumphed over the Soviet Union—the Cold War was over and America was still friends with the Soviet Union. A new era of détente had begun. The US was immensely popular in the free world. Its current popularity or the absence of it is too well known to bear repetition here. The global financial system leverage was much smaller then. Savings and loan institutions were not the same as big international banks. There were no hedge funds to speak of, then. Commodity prices came down sharply. Crude oil collapsed from $45 to $15 per barrel and Asian equities decoupled from the stocks in the developed world.
Now, more importantly, America is not the marginal price-setter for many commodities, including crude oil. It is China. In that sense, the balance of economic power has already shifted. China has to revalue the yuan, move away from capacity creation meant for exports and, thus, lower its demand for commodities, allowing their prices to come down. That would be the equivalent of a global tax cut. It would support growth in other countries where it is being slowly snuffed out by declining purchasing power caused by the rise in the prices of essential commodities.
Unfortunately, it is not so easy as it sounds. China views any suggestion to revalue the yuan with distaste. It has seen the devastation that a strong yen caused to the Japanese economy in the 1990s. Arguably, that dealt a more powerful blow to Japan’s economy and pride than the bombs that dropped on Hiroshima and Nagasaki—which probably wrecked Japan in the reverse order.
If yuan revaluation does not happen soon, the risk of a severe downturn in the world economy would go up significantly. Commodity prices would eventually collapse, but that would be too late to support growth near term. Already, base metals appear as bubbly as technology stocks did in late 1999.
However, the swift decline in commodities prices last week is not the real thing. The speed with which it happened raises more questions. Importantly, the more the world appears to be heading into a substantial slowdown, the greater the chances that all central banks fly the helicopter like Ben Bernanke is doing and drop currencies on their population to spend. The risk of an international inflation pandemic is real. The sell-off in agricultural commodities and precious metals is, thus, setting up interesting buying opportunities for the intrepid and clear-headed investor.
These considerations suggest that the outlook for New Zealand and Australian dollars is heavily tilted to the downside, particularly against the yen, the Swiss franc and the euro. These currencies have appreciated substantially against the US dollar but not yet against the currencies down under. The anti-carry trade trade has not yet begun. It would commence soon. Indian companies should take note.
It has been well documented that returns from the strategy of borrowing in low interest rate currencies and lending in high interest rate currencies have fat tails and are negatively skewed. That is, small positive gains are eventually wiped out by large losses. Disappointing that companies thought there was a free lunch.
V. Anantha Nageswaran is head, investment research, Bank Julius Baer & Co. Ltd in Singapore.These are his personal views and do not represent those of his employer. Your comments are welcome at firstname.lastname@example.org