Illustration: Jayachandran/Mint
Illustration: Jayachandran/Mint

Opinion | The rising stock of global economic risks

The sustainability of global growth will depend on how the emerging risks are managed

The International Monetary and Financial Committee of the International Monetary Fund (IMF) in its communiqué last week noted that risks to the global economy are skewed to the downside. This should worry policymakers around the world. The World Economic Outlook of the IMF, compared to its April projections, revised global growth forecast down for the current year and the next. A number of emerging market economies are under pressure because of factors such as rising trade tension, tightening of global financial conditions and the rise in crude prices. Further, the Global Financial Stability Report (GFSR) of the IMF highlighted risks in the global financial system. Downside risks were also reflected in stock markets around the world last week with a spike in volatility. It is likely that volatility will remain elevated in the near term because of a variety of emerging risks.

First, years of accommodative monetary policy pushed asset prices in various markets, including the US. As the GFSR noted, valuation in the US stock market continues to remain elevated despite rising trade tensions. The cyclically adjusted price-to-earnings ratio for S&P 500 is in excess of 31 compared to the historical average of about 17. A reversal in the US stock market because of higher valuations and rising risk-free rate will, among other things, affect sentiment in global financial markets and influence the flow of risk capital to emerging market economies.

Second, rising interest rates in the US and the tightening of financial conditions can expose the vulnerabilities of the global financial system. Easy availability of money has built excesses in various parts, both in the advanced and developing economies. For instance, as the latest GFSR showed, in economies with systemically important financial sectors, non-financial sector debt has gone up to about 250% of the gross domestic product (GDP). Although it can be argued that the world will not slip into another 2008 like crisis in the foreseeable future, rising interest rates will increase difficulties in these economies and push volatility in financial markets.

Higher interest rates in the US and tightening of financial conditions will also significantly affect capital flow to emerging market economies. According to an estimate put out by the IMF, emerging market economies, excluding China, could see debt portfolio outflow of over $100 billion over a period of four quarters. The magnitude, measured in terms of combined GDP, will be similar to the financial crisis.

Third, despite a long period of expansion, the global economy has not been able to build enough policy space to support growth in case of a downturn. Central banks in Europe and Japan are still working with crisis-era policies and the budget deficit is expanding in the US. With a significant rise in leverage, China will also not be in a position to support growth. It is likely that advanced economies will again need to use unconventional policies if growth falters. The fact that most of them may not be in a position to create sufficient policy space even in the foreseeable future shows the fragility of the ongoing recovery.

Fourth, rising trade tensions is a significant risk for the global economy, as it will affect investment and growth. In this context, the IMF notes: “According to model simulations, global GDP would fall by more than 0.8% in 2020 and remain roughly 0.4% lower in the long term compared with a baseline without trade tensions." Also, the risk is that a growth slowdown might prompt the US administration to take more protectionist measures. This would be a slippery slope. Further, the US is putting pressure on China to keep its currency stable. This is unlikely to ease the pressure on global trade.

Thus, the sustainability of global growth will depend on how the emerging risks are managed. However, one of the biggest problems at this stage is that the outlook for global cooperation and policy coordination is not very encouraging. Some of these risks are not been fully factored in asset prices.

India cannot escape these risks. Foreign portfolio investors, for instance, have sold Indian assets worth over $14 billion so far this year. More outflows will increase the pressure on the rupee at a time when the current account deficit is widening, largely due to higher crude prices. In the given situation, Indian policymakers would do well to minimize the impact of rising global risks with prudent macroeconomic policies. India also needs to push exports. Raising tariffs to reduce the current account deficit will not work in the long run.

What can India do reduce the impact of rising global economic risks? Tell us at views@livemint.com

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