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Global expansion is alive

Instead of being concerned about global

growth prospects, Asian governments should work to create conditions for both a cyclical and a structural recovery in domestic demand. That would include not only accommodative monetary policy but also speedier structural reforms.

While East Asia can ill-afford a second crisis, a country such

as India may not be so fortunate to avoid one as it did the

last time around, says V. Anantha-Nageswaran.

THE YEAR 1999 was billed the year of global recovery after the Asian economic crisis nearly decapitated the developed world in 1998. One year later, emerging market bond spread to the 10-year US Treasury yield has widened in recent weeks. Y ields on investment grade and sub-investment grade bonds in the US have begun to increase. Corporate debt issuance has dwindled. Purchasing managers' indices in the US and in Europe reflect slowing in the traditional manufa cturing sector. Indeed, manufacturing output appears to be shrinking in the US. These are interesting parallels to 1998. For many analysts, it is time to worry about global hard-landing. Has something changed so dramatically in the real worl d of economics that they have started to mimic the rapid change in sentiment in the equity market?

Monetary policy is not accommodative but not tight

Between 1999 and 2000, what happened was that the Federal Reserve raised interest rates about 175 basis points, if one counted the rate increase from the crisis-induced trough of 4.75 per cent. Otherwise, the `real' increase was of the order of 100 basis points. Some held that this was insufficient to rein in the red-hot US economy. Now, the very same people who suggested it might take a lot more than a federal funds rate of 6.5 per cent to cool demand growth in the US, are openly discussing the possibi lity of rate cuts by the Fed next year.

During the same period, the European Central Bank also raised the repo rate from around 2.0 per cent in April 1999 to around 4.75 per cent. Despite this increase, the new single European currency has been consistently losing value against the dollar and the yen. The effect of one round of concerted central bank intervention undertaken in September has evaporated and the currency has plumbed new lows. Only a lower-than-expected growth rate posted by the US economy in the third quarter resulted in the cur rency making a recovery of sorts on Friday.

These spells of interest rate increases were deemed necessary as low interest rates were put in place to ward off the danger of global depression that never materialised. Japan kept its overnight call rate at zero per cent until quite recently and raisin g it to about 0.25 per cent could hardly be considered as tightening. In Asia, enfeebled financial systems ensured that the domestic demand growth stayed weak. Consequently, higher inflation anticipated as an inevitable consequence of depreciated currenc ies remained elusive. This enabled central banks to postpone any monetary policy tightening. Hence, the monetary policy has not given rise to the scenario of drastically lower global economic growth.

Higher price for oil is a crucial difference...

If monetary policy were not the culprit, then what was? There has been no widespread famine, other natural calamities or war. Yes, surely, something has changed. Hurt badly by falling price of crude oil, the Organisation of Petroleum Exporting Countries decided to stay disciplined and cut production in 1999 several times to the tune of nearly 4 million barrels per day. That this occurred even as global energy demand made a fast recovery from the depths of 1998 heightened the impact of the production cut s. Simultaneously, oil companies had postponed expanding refining capacity and undertaken some overdue maintenance of production facilities. The result was an unanticipated tripling of crude prices.

Higher energy prices raise input costs and cut into the disposable income available to households after they pay for their energy consumption deemed inelastic. Both simulation studies and anecdotal evidence suggested that the impact this time around on m ost nations was not so severe as it was at the last two major oil shocks (in the 1970s) and the mini-shock during the Gulf War in 1990. Central bank policies contributed to higher all-round inflation on both occasions and at the same time, higher input c osts curtailed economic output. Economists had to dust off the phrase, `stagflation' -- combination of output stagnation and higher inflation -- a deadly combination for asset markets.

...but growth has held up well and inflation stayed low

This time around, economic growth has held up rather well and inflation has crept up at the headline level as is to be expected. However, once we exclude the effect of higher energy prices, inflation appears tame. This suggests that higher energy costs a re not translating into overall higher input costs. Wages too are not rising in response to higher cost of energy as many had feared. Of course, developing nations (India, for example) are more vulnerable and likely to see lower growth next year. Even a relatively more advanced country such as Korea is vulnerable to higher oil prices as it nearly imports all of its oil requirement.

In Europe, the weak Euro had exacerbated the effect of higher oil prices on Europe's recovering economies. Some claim that the more recent advance of the dollar against other global currencies has been partly due to the steep ascent of the price for oil. Crude oil is denominated in dollars and, hence, oil importing nations have to buy more dollars to pay for their oil imports. This naturally results in weaker domestic currencies. It is important to note that there is no oil producer among the 11 member- countries of the euro zone. However, economic growth in the euro zone has held up rather well.

Corporate warnings on future profits raise alarms...

If it is not monetary policy and if it is not oil prices, what has given rise to speculation of another synchronised global economic slowdown next year? It is the effect of headline-grabbing warnings of lower profits made by some high-profile technology (and some non-technology sector) companies in the US. Arguably, Internet discussion groups and competition among television networks for viewer ratings exaggerate such warnings as heralding something more serious (or sinister) than company-specific issue s. Stock prices plummet than is warranted by the scale of warnings. The reality is that profits continue to grow, if at a slower pace. With 80 per cent of the companies in S&P 500 having reported their third quarter earnings, profits have increased by ne arly 20 per cent, compared to a year ago and about 60 per cent of the companies have beaten estimates while 11 per cent have missed -- in line with last year's results.

True to form, analysts downgrade stocks after the companies have warned of slowing growth themselves and after investors have bailed out of the stocks. Profit estimates for the fourth quarter have been lowered. In doing so, overpaid analysts confirm the lack of usefulness of their analysis in gauging the future but only in predicting the past. Now, that is a separate topic in itself. However, the analogy is that economists may be taking their cue from their counterparts in equity research -- in waking u p to reality after it has occurred.

... but the concern is overdone...

A look at the components of the just-released third quarter growth estimates in the US shows the two main engines of growth in recent years -- personal consumption growth and investment in equipment and software by US businesses -- remain in good shape. Clearly, higher cost of energy has slowed some technology spending (this component's contribution to growth was only half of what it was in the second quarter) but growth in spending over the previous quarter is still a healthy 8.5 per cen t.

The UK-based Centre for Global Energy Studies (www.cges.co.uk) in two of its reports (the October monthly report and Oil Market Prospects) states that the crisis in East Asia should have no impact on the supply of oil from Arab nations and that the longe r term outlook for oil was one of oversupply. In their own words, ``OPEC will need to respond to market signals more promptly than it has done in the past if it is to avoid a price collapse in 2001.'' Given this, it is unlikely that the slowdown in techn ology spending by businesses would be sustained.

...as the US housing market rebounds

Residential investment has subtracted nearly 40 basis points from growth. However, going forward, this component is unlikely to remain a drag on growth in the fourth quarter of the year. One of my favourite indicators is the Housing Market Index of the N ational Association of Home Builders in the US. This index has a strong and stable correlation to US growth. This index that reflects present and prospective conditions in the housing market bore the brunt of interest rate increases and signalled weakeni ng housing market conditions in the summer months. However, that proved to be short-lived. The decline in mortgage rates has rekindled housing market activity and the index has edged up quietly in recent months.

In 1998 too, analysts focussed too hard on credit market conditions and ignored the boom in the housing market that was building up, in the wake of abnormally low long-term interest rates. Obviously, neither the boom is that strong nor are interest rates that low now. However, rates are low enough and housing market strong enough for us not to fret too much over an abrupt cooling in the US economy next year.

Every silver-lining has a dark cloud and that comes in the form of the US electorate voting the same party to power both in the Congress and in the White House. That creates a risk of substantial fiscal easing with consequent higher bond yields and falli ng equity prices. Hence, for the sake of their own networth, US voters should prefer gridlock.

European business confidence poised to improve

In Europe, the German economy is showing remarkable resilience to the impact of higher energy costs. Capital spending by businesses increased in the first half of the year and tax reform measures, due to come into effect next year, would put more money b ack in the hands of households after several years of rising tax burdens to finance German unification costs and to meet the Maastricht criteria on fiscal deficit for membership in the economic and monetary union in 1999. There is not enough appreciation of this factor in the somewhat gloomy forecasts for European growth next year.

In France, a far-reaching reform of the labour market has largely gone unnoticed. The Government threw its weight behind an agreement between the employers' federation and moderate labour unions that would link the continued contribution to unemployment insurance by employers to an active search for and acceptance of jobs by the unemployed. Anxious to maintain its three per cent growth rate of the last few years, the Government chose not to antagonise employers further after its infamous introduction of a 35-hour workweek. Therefore, it is reasonable to assume that the recent slide in business confidence in Germany and in France would be arrested.

Japan experiences a meaningful recovery

In Japan, household spending growth in September was better than expected and manufacturing inventories continue to drop. The ratio of inventories to shipment has continued to drop in recent months and this is a reliable indicator for contemporaneous gro wth. The ratio of jobs to applicants has climbed in recent months. From about four jobs for every ten applicants, there are six jobs now. Of course, it is almost impossible to predict if Japan could continue to grow, given its rapidly ageing population a nd its `closed' society which is not accepting of large-scale immigration and its assimilation. For the time-being, however, Japan is proving to be less of a drag on global growth than before.

Asia (ex-Japan) has no time to lose

The prospect for growth in Asia (ex-Japan) is dimmed by the lack of credit growth and weak domestic demand while the environment for their exports may remain somewhat favourable if not strongly supportive. That would be a benign influence on US inflation next year enhancing the deflationary impact of lower oil prices. That might trigger an easing of monetary policy and boost both technology spending and asset prices too.

Therefore, instead of being concerned about global growth prospects, Asian governments should work to create conditions for both a cyclical and a structural recovery in domestic demand. That would include not only accommodative monetary policy but also s peedier structural reforms. While East Asia can ill-afford a second crisis, a country such as India may not be so fortunate to avoid one as it did the last time around.

(The author is the Regional Head of Investment Consulting in Credit Suisse, Asia-Pacific. He writes here in his personal capacity. Feedback may be sent to nageswar@singnet.com.sg)