Poverty and Development Division
last updated : 20 December 1999
RECENT GLOBAL MACROECONOMIC TRENDS
In order to understand better the significance of developments in the advanced economies during 1998 following the crisis in Asia, it is appropriate to divide the year into two. In the first period, corresponding to the first half of the year, the threat to global growth from the Asian crisis still appeared to be limited, volatility in the financial markets and its attendant dangers for investor confidence notwithstanding. The crisis was actually expected to exert a modest disinflationary effect on the developed economies, thus reducing the risks from overheating in those economies which were operating close to physical capacity as recovery had begun earlier after the recession of 1992-1993. These were the United States of America, the United Kingdom of Great Britain and Northern Ireland and Canada. In the other developed economies, overall GDP growth was expected to continue at, or very near, its recent pace, with the notable exception of Japan, which was still having to grapple with severe domestic economic problems that emerged even before the crisis.
Indicative of this broadly positive prognosis was the continuation of the strong performance of equity markets which, by mid-year, had reached record highs in several countries. From a purely domestic policy perspective in the developed economies, therefore, the accent remained on preserving the momentum of growth and reducing unemployment within a stable financial environment.
In the three largest economies of the European Union, viz. Germany, France and Italy, such a straightforward policy objective appeared, however, to be somewhat complicated, in the short run at least, by other factors. This was because of the implementation of the third stage of Economic and Monetary Union, starting from 1 January 1999, in which the exchange rates of the participating countries would become locked prior to the issue of the euro.(3) In the interim, on the monetary front, consistent signs of convergence within the EU became apparent during 1998 with both differentials in short-term interest rates and the rates themselves tending to decline over the year.
In Japan, the problems during much of 1997 and at the beginning of 1998 were of a fundamentally different character and magnitude. A relatively robust recovery in 1996 had faltered badly in 1997. Towards the end of that year, there was a sharp increase in inventory levels, occasioned by the increase in the sales tax in April 1997 from 3 to 5 per cent and the elimination of special tax exemptions. During the first half of 1998, delays in the implementation of a new stimulus package that was expected to reinvigorate the pace of GDP growth became instrumental in causing private consumption to decline sharply. This decline greatly exacerbated corporate sector weaknesses as, for many corporations, a reduction in sales generated inevitable pressure on cash flow and debt-servicing capacity. These adverse developments, in turn, caused a severe and widespread loss of consumer and business confidence in the country. It thus became clear that the impending risks in the Japanese economy were strongly suggestive of a significant slowdown, possibly a recession, if no further corrective measures were put into effect by the government.
In the second period, which corresponds to the second half of 1998, the long-lasting nature of the Asian crisis and its adverse impact for the major economies of the world became progressively evident. In the United States, sentiment remained positive until well into the third quarter. This was so because, despite an unemployment rate of 4.6 per cent, the lowest since 1972, inflationary expectations, helped by a strong dollar and weak commodity prices, had begun to ease, thus reducing the likelihood of a rise in interest rates. Furthermore, for the first time in over two decades, the United States had succeeded in eliminating its budget deficit.
The continuing strength of the United States economy, in fact, eased the path of adjustment in several countries affected by the crisis in Asia and made the crisis less severe than it might otherwise have been. However, this was at the expense of a significant worsening of the external position of the United States economy. By mid-1998, signs of weakness on the trade front had begun to emerge, with slowing exports to Asia.
A potentially more serious weakness that began to come to light from mid-1998 onwards was a sharp slowdown in corporate profit growth in the United States economy. The stock market in the United States, buoyed by rising corporate profits, has provided a significant indirect boost to growth in the real economy over the last few years. The bull market was instrumental in doubling the measured wealth of households in the country over the past three years. Share ownership also increased and almost twice as many households in the United States currently own shares as in the mid-1980s.(4) This appreciably magnified the wealth effect of rising share prices in the economy and, as a result, savings declined and consumption increased. By the middle of 1998, personal savings in the United States had fallen to historic lows, while consumer spending was buoyant, rising at an annual rate of 6 per cent. Any major bout of share price weakness could therefore produce a significant impact on consumer spending and, hence, on the overall growth of the economy.
In the third quarter of 1998, driven by a series of corporate profit warnings, the unilateral debt freeze in the Russian Federation (an indirect result of the Asian crisis through its impact on oil and other commodity prices) and the emergence of losses in financial sector institutions, stock markets fell substantially virtually everywhere. The fall was led by the United States and all the earlier gains in 1998 were wiped out. Weakness in the equity markets then spread into corporate bond markets, sending United States treasury bond yields to historical lows through the phenomenon described as "flight to quality" as investors sought to offload investments in all but the highest rated corporate names and countries and shifted to comparatively risk-free treasury bonds. Extreme volatility became evident also in the foreign exchange markets, with the dollar-yen rate moving from 144 in late August to 124 in early October. Stock markets have since recovered a considerable part of their lost ground and exchange rate volatility has largely subsided. However, it is clear that deep underlying uncertainty persists, with both exchange and stock markets liable to overreact in an unpredictable fashion to any adverse developments.
The immediate direct cause of the end of the bull run in the financial markets was the exposed position of financial sector companies to events such as those in the Russian Federation, and their vulnerability to the high levels of gearing by which some of those companies, such as certain hedge funds, had been operating. But the fundamental cause undoubtedly was the hitherto underestimated risks of losses of transnational corporations in both the financial and the non-financial sectors as a result of the downturn in Asia. Another factor, initially overlooked, was the spread of market contagion outside the ESCAP region. Thus, within the space of a few short weeks, the balance of priorities in the United States economy had been transformed from the containment of inflationary pressures to the prevention of a growth slowdown. This prompted the United States Federal Reserve Board to cut interest rates three times in quick succession in October and November 1998.
It is noteworthy that one of the striking manifestations of the financial market uncertainty in the United States has been the extreme aversion to risk displayed by financial sector companies in that country. One result is that liquidity has dried up for all but the best borrowers. Likewise, at current costs there are few corporate entities, especially small and medium-sized ones, that can make new bond flotations as spreads between top-rated borrowers and slightly riskier ones have widened to unprecedented levels. Although spreads have stabilized and even narrowed in some cases, the danger of a generalized credit crunch remains.
In the EU, conditions have been different, partly because the major EU economies, with the exception of the United Kingdom, are at an earlier stage of the economic cycle. Another factor is that European households hold a smaller proportion of their wealth in shares; hence, any stock market weakness or volatility will have a smaller impact on the spending patterns of EU consumers than in the United States. Nevertheless, any weakness that developed in the United States economy would eventually transmit itself to Europe, essentially via trading links. In addition, European financial institutions were also heavily exposed in the emerging markets, particularly the Russian Federation, and such exposure could become part of a more generalized loss of investor confidence.
Within the EU, the United Kingdom economy was already slowing towards the middle of 1998 under the impact of an appreciating currency. Being ahead of the other EU economies in the recovery cycle, interest rates in the United Kingdom had, by the first half of 1998, risen higher compared with the rest of the EU and to the United States. As a result, the United Kingdom currency had tended to appreciate relative to most EU currencies, leading to a certain loss of competitiveness. The financial market turmoil of September 1998, however, highlighted the likelihood of a more rapid slowdown of the United Kingdom economy and brought three cuts in interest rates in its wake.
In September and October, and again in December 1998, the deutsche mark also tended to strengthen, especially vis-à-vis the United States dollar. The currencies of other EU countries likewise experienced real exchange rate appreciations, though of a smaller magnitude, during this period. Along with the decline in demand from Asia, this phenomenon will, in all likelihood, reduce demand for EU exports in non-EU markets in the near term.
The second half of 1998 showed up the weakness of the Japanese economy with particular force. The country's GDP contracted at an annual rate of 3.6 per cent in the third quarter of 1998 and unemployment climbed to a post-war high of over 4.3 per cent in September 1998. This was the fourth consecutive quarterly GDP decline, and consumer and business confidence effectively collapsed in the face of the deep-seated nature of the difficulties facing the financial sector. Unfolding evidence of the impact of the Asian crisis on Japan's economy, and on the financial sector in particular, badly dented business confidence. In September, the government announced that bad debts on the books of Japanese banks amounted to an enormous 87.5 trillion yen, or 11 per cent of total loans. As a result of these negative elements, the stock market declined to a 12-year low and the Economic Planning Agency downgraded GDP growth estimates for 1998, from a growth of 1.9 per cent to a contraction of 2.2 per cent, with unemployment staying at well above 4 per cent, the highest since the end of the second World War. More alarmingly perhaps, just after the third quarter of 1998, Japanese producer prices were falling, on an annualized basis, at the rate 3.7 per cent. Falling producer prices and negative earnings growth, taken together, bear the imprint of a potential deflationary spiral in the Japanese economy, led by a chronic inadequacy of domestic demand.(5)
Against this background, the Government of Japan finally succeeded in passing into law in October 1998 a series of measures to rebuild business and consumer confidence. These were essentially designed to rescue the financial system. The total package envisaged spending of 60 trillion yen ($500 billion) to recapitalize insolvent institutions, provide others with liquidity support and set up a mechanism for taking over and managing bad debts through a "bridge" bank.
In its efforts to regenerate growth, the government in November 1998 announced yet another package of tax cuts and additional public spending. At 24 trillion yen ($198 billion) this package would be the second during the 1998/99 fiscal year and the largest ever fiscal package. At the same time, an effort was launched to mitigate the liquidity crunch caused by the weakness of the Japanese banking system, with the Bank of Japan significantly expanding its CP (commercial paper) buying operations.
In common with the rest of the ESCAP region, both Australia and New Zealand also experienced a marked deterioration in the external environment and an associated weakening of confidence. Of particular concern in both countries have been the large current account deficits, estimated at 5 and 6.5 per cent of GDP respectively for 1998. Weakening of the current account position, however, took place against the background of improved public finances in Australia, which should allow external adjustment to take place without too much disruption in domestic economic activity. In fact, the weaker external environment, by putting downward pressure on the Australian dollar, served to improve Australia's competitiveness and preserve domestic incomes. Australian GDP growth remained surprisingly strong during 1998. New Zealand, on the other hand, nearly slid into negative growth as it attempted to mitigate exchange rate weakness with higher interest rates. Lower commodity prices also significantly dampened growth in the economy.
Developing countries outside the ESCAP region faced a significant deterioration of the external environment owing to the spreading Asian crisis. Other than the generally negative impact on trade and commodity prices, several countries faced a worsening of conditions for access to external finance. Risk premiums rose and maturities shortened, making foreign capital prohibitively expensive in some cases.
Initially, in Latin America, the worst affected country was Venezuela, where, on account of weaker oil prices, the trade balance deteriorated sharply and the current account deficit widened. As a result, short-term interest rates tripled between October 1997 and October 1998. Similar pressures also affected Argentina, Brazil, Chile and Mexico during the 12 months to October 1998, as these countries sought to stave off capital outflows and pressure on their exchange rates. On the trade side, although direct Latin American trade with Asia is limited, with the exception of Chile, lower commodity prices generated pressure for a marked export slowdown and lower GDP growth.
The Asian crisis compelled several Latin American governments to take corrective, usually growth-reducing, measures, involving sharply higher interest rates and lower government spending to ensure exchange rate stability and avoid the kind of debt-servicing problems experienced by the Asian economies in crisis. In the case of Brazil, the largest economy in Latin America, much higher interest rates had to be buttressed with a substantial austerity package as pressure on the exchange rate intensified in the third quarter of 1998. Negotiations were concluded with IMF in November 1998 for a financing package worth $41.5 billion to avoid a large exchange rate depreciation and a debt default. Argentina also had to take similar steps to counter the effects of financial market contagion and negotiated an emergency package with the World Bank. The effect of all these measures, in the short run at least, has been to reduce further the pace of economic growth in the countries concerned.
Africa was initially unaffected by the Asian crisis as its trading and financial links are primarily with the developed countries, its economies are less open and it is mainly a recipient of ODA. However, weakening commodity prices, flat demand for traditional exports and loss of competitiveness in non-traditional exports on account of exchange rate depreciations in the Asian economies produced a growth-retarding effect on GDP over much of the continent. Growth was also adversely affected by weather-related difficulties in several countries.
Exchange rate problems were confined almost entirely to the South African currency, because of the more liberal external regime within which it operates. The rand came under considerable pressure in the aftermath of the Asian crisis. By mid-1998, as a result of the tight monetary conditions, industrial production and GDP growth had declined sharply in South Africa.
On a more positive note, despite these problems, as well as the ongoing political and military conflicts that have bedevilled life on the continent over a long period, African countries, by and large, continued to adhere to policies designed to improve macroeconomic balance and strengthen their financial sectors. The Asian crisis thus came at an inopportune time, when these economies were in the process of implementing a reform agenda designed to improve their long-term growth prospects. As a result, the crisis could have the effect of delaying the benefits of reform for some time.
West Asia witnessed a sharp slowdown of growth as the Asian crisis became instrumental in accelerating the downward trend in oil prices, which lost one third of their value in the first quarter of 1998 alone and continued to weaken for the rest of the year despite production cuts by OPEC. By December 1998, oil prices stood over 40 per cent below their level 12 months earlier and were, in fact, close to their level of the early 1970s. Lower oil prices, while undoubtedly weakening growth in the oil-producing countries of West Asia, proved to be something of a blessing for the oil-importing developing countries in all parts of the world. They have relieved pressure on their external positions to a considerable extent and allowed them to maintain other imports, thus mitigating the adverse effects of the crisis to some degree.
In the economies in transition, overall growth performance was more mixed. In eastern Europe, the Asian crisis had a limited impact. The continuing policy reforms and greater integration with the EU were instrumental in allowing these countries to keep their growth rates stable or even to improve slightly on their 1997 performance. On the other hand, in the Russian Federation and in several Central Asian economies, the decline in oil and other commodity prices had a serious impact in terms of reduced export earnings, increased fiscal deficit and widened current account deficits. The downturn in the Russian economy affected the export demand of the Central Asian countries, exerting contractionary pressures on a number of economies.
Most of the other developing countries of the ESCAP region were also adversely affected by the crisis, though to varying degrees. The severity of the downturn in the crisis countries during 1998 and its impact on the rest of the region overshadowed policy discussions during most of the year. The major developments and policy responses in the individual economies of the region are discussed in some detail in chapter II.
3. The European Central Bank, together
with the national central banks of EMU countries, will form the European
System of Central Banks to manage the introduction of the euro. The latter
has also been charged with the responsibility of achieving monetary convergence
alongside the Stability and Growth Pact signed earlier by these countries,
which dealt with fiscal matters.
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