World economy teeters on brink of deflation trap
‘We need to be extremely vigilant,’ warns IMF’S Christine Lagarde
LONDON
— Half the world economy is one accident away from a deflation trap. The International Monetary Fund says the probability may now be as high as 20 per cent.
It is remarkable that the G2 monetary super powers— the U.S. and China — should both be tightening into this risk, though perhaps they are already damned either way given the level of asset speculation.
“We need to be extremely vigilant,” said the IMF’s Christine Lagarde in Davos. “The deflation risk is what would occur if there was a shock to those economies now at inflation rates below target. I don’t think anyone can dispute that eurozone inflation is way below target.”
The shock is already before our eyes as Turkey, India, and South Africa hit the brakes, forced to defend their currencies as global liquidity drains away.
The World Bank warns that withdrawal of stimulus by the U.S. Federal Reserve could throw a “curve ball” at the international system.
“If market reactions to tapering are precipitous, developing countries could see flows decline by as much as 80 per cent for several months,” it said. They may need capital controls to navigate the storm.
William Browder of Hermitage Capital Management says that is exactly where the crisis is leading, and it will be sobering for investors to learn that their money is locked up — already the case in Cyprus, and starting in Egypt. The chain-reaction becomes selffulfilling. “People will start asking themselves which country is next,” he said.
Roughly $4 trillion of foreign funds swept into emerging markets after the Lehman crisis, mostly by then “momentum money” late to the party.
The IMF says $470 billion is directly linked to money printing by the Fed. “We don’t know how much of this is going to come out again, or how quickly,” said an IMF official.
One country after another is now having to tighten into weakness. The longer this goes on, the greater the risk that it will morph into a global deflationary shock.
Turkey’s central bank took drastic steps on Tuesday to halt capital flight, more than doubling its repurchase rate to 10 per cent. This will bring the economy to a standstill in short order. South Africa raised rates Thursday by half a point to defend the rand, and India acted the day before, all forced to grit their teeth as growth fizzles. Brazil and Indonesia have been tightening for months to stem a currency slide.
Others are in better shape — mostly because their current accounts are in surplus — but even they are losing room for manoeuvre. Chile and Peru need to cut rates to counter the metals slump, but dare not risk it. Russia has a foot in recession but cannot take action to kick-start growth because the ruble has fallen to record lows against the euro. The central bank is burning $400 million of reserves each day to defend the currency. Ukraine, Argentina and Thailand are already spinning out of control.
China is marching to its own tune with a closed capital account and $3.8 trillion reserves, but it, too, is sending a powerful deflationary impulse worldwide.
Markets have a touching faith that the same Politburo responsible for a $24-trillion credit bubble — 1.5 times larger than the U.S. banking system — will deflate it gently with a skill that eluded the Bank of Japan in 1990.
Morgan Stanley says that China’s central bank is trying to deleverage and raise rates at the same time, which “amplifies risks to growth,” Moreover, China is struggling to keep its industries humming at the current exchange rate. Patrick Artus from Natixis says surging wages and falling productivity mean it now costs 10 per cent more to produce the Airbus A320 in Tianjing than in Toulouse, France.
The implications are obvious. China may at some stage try to steer down the yuan to hold on to market share, and in doing so stop Japan stealing a march with its 30 per cent devaluation.
Eurostat data show that Italy, Spain, Holland, Portugal, Greece, Estonia, Slovenia, Slovakia, Latvia, as well as euro-pegged Denmark, Hungary and Bulgaria have all been in outright deflation since May once taxes are stripped out. Prices have been dropping in France since August.
Those who think deflation harmless should listen to the Bank of Japan’s Haruhiko Kuroda. Corporate profits dried up. Investment in technology atrophied. Innovation fizzled out. “It created a very negative mindset in Japan,” he said in Davos.
Any such outcome in Europe would send Club Med debt trajectories through the roof. It would doom all hope of halting Europe’s economic decline or reducing mass unemployment before democracies go into seizure. So why are they letting it happen?