Long-Term Uncertainty

According to initial estimates, global GDP reached $71.3 trillion last year. More than half of this total came from twelve developed countries: the United States, the United Kingdom, Belgium, Germany, Japan, France, Canada, Greece, Ireland, Portugal, Spain, and Italy. But as is well known, all of these nations are burdened with significant external debt, with the amount varying from 83% of GDP in the case of Germany, to 236% for Japan. Several small economies such as Cyprus and Iceland, as well as a number of less prosperous countries, can be added to the list of big debtors.

The short-term growth prospects for most of these countries aren’t terribly optimistic. Longer-term forecasts, however, are rosier if rather uncertain. Regardless of how much Japan’s economy can grow this year following announcements of a new round of economic stimulus, its debt-to-GDP ratio will continue to increase on account of the country’s budget deficit – which may again surpass 9% of GDP. The U.S. and U.K. will also be faced with a large budget deficit (compared to growth rates), as will practically all of the above-listed countries except Germany and resource-rich Canada. Furthermore, it’s clear that some economies, such as several in southern Europe, will continue contracting this year. As a result, the debt burden – at least for the countries constituting half of the world’s economy – will increase this year. This means that a tightening of fiscal policy in the largest debtor economies – the U.S. and eurozone in particular – is not likely any time soon. In terms of the U.S., Federal Reserve Chairman Ben Bernanke made that quite clear at the end of May.

Soft monetary policy with the aim of supporting low bond yields amid growing debt-to-GDP ratios (specific policy may vary country to country) is expected not just from the Fed, but also from the European Central Bank (ECB) and the central banks of Japan and the U.K. Economic theory doesn’t give a clear answer to the question of what’s going to happen next, or how and when to curtail quantitative easing programs, nor is it clear what the consequences of such an action would be, or whether debt-laden economies can even return to a trajectory of growth. By the same token, it’s hard to anticipate exactly how the economies of developed countries, and the financial markets, will in the future react to a continuation of quantitative easing. Perhaps due to this uncertainty, the term ‘contrary to forecasts’ has been appearing more and more in research reports and commentaries in recent years – either growth or inflation keeps ending up above or below forecasts.

At any rate, it seems that the monetary authorities of developed countries will continue to manipulate the government debt markets. This will for the time being support stock markets, but will by no means guarantee stable economic growth or even stability in the markets themselves – at least in certain countries. Financial markets will likely continue to be volatile.

One of the problems is that economic systems develop faster than the economic theory that is supposed to describe them. As such, recommendations based on widely accepted economic axioms are sometimes inappropriate and incorrect.

Two good examples of this are Cyprus today and Argentina ten years ago. When Argentina defaulted on its sovereign debt at the end of 2001, the global financial community (and Argentina’s creditors in particular) weren’t too thrilled. Leading up to the default, the Argentine government had applied the standard set of measures – the same ones recently employed by Cyprus: freezing dollar-denominated bank accounts for a year and limiting withdrawals. If creditors were none too pleased by the actions of Argentina’s government then, they now, however, generally support the measures being taken by the Cypriot authorities. Another case in point is the recent restructuring of Greece’s debt (in essence a managed default), which didn’t encounter any serious objections from creditors – basically the same creditors who were lending to Argentina over a decade ago. Clearly, the various forms of quantitative easing in use aren’t among the traditional recipes of economic policy.

Argentina, Greece and Cyprus have something else in common: not one of these countries ran its own monetary policy. The pegging of the Argentine peso to the U.S. dollar in the 1990s was one of the main reasons for the excessive flow of capital into the country and high (by the standards of the day) debt-to-GDP ratio. (In 2001, Argentina’s ratio of government debt-to-GDP was 53.6%, with moderate budget and current account deficits.)

The transition to a single currency in Europe allowed the region’s weaker economies to more actively attract capital, including debt capital. But this significantly increased these countries’ indebtedness. The difference between Argentina and the outlying European countries is that, following its default and the nearly four-fold devaluation of the peso in the first half of 2002, the Argentine economy began to grow again in 2003 and experienced growth ranging from 8% to 9% per year until 2007. In 2008, Argentina’s growth slowed a bit, as was the case around the world. However, in 2009, unlike many countries, Argentina managed to avoid a downturn. In 2010-2011, the nation’s economy was again showing 9% growth. Although growth slowed in 2012, it nevertheless remained positive and will remain so through year’s end thanks to a gradual weakening of the peso. This partially compensates for high inflation. Although now having a weaker currency, Argentina’s per capita GDP was $11,600 last year, which is significantly higher than the pre-crisis maximum of $8,500 in 1998. The debt-to-GDP ratio last year came in at around 45%.

Despite economic institutions that are far from ideal, Argentina’s economy continues to grow. (This year growth is expected at 3–4%, which is on a par with the entire South American region.) Meanwhile, Greece and Cyprus, which have higher-quality economic institutions, but do not control their own monetary policy and are under the pressure of a massive debt burden, have found themselves unable to cope. It’s unlikely that in the current macroeconomic environment these countries will be able to demonstrate noticeable growth rates in the near future. Despite the austerity measures and recession, the per capita GDP of both countries remains relatively high: approximately $22,000 for Greece and $25,000 for Cyprus in 2012. As a result, the goods-producing sectors of these countries are comparatively small and uncompetitive.

In general, it appears that the economic situation in the eurozone will not improve significantly. In certain respects, the eurozone is reminiscent of the Soviet Union. As is well known, during the Soviet era Russia directed enormous funds towards subsidizing the outlying southern republics. This was indirectly a consequence of the extremely distorted price structure for domestic goods: Moscow supplied the republics with cheap energy while purchasing goods at inflated prices. It’s not surprising that after the collapse of the U.S.S.R. the per capita GDP of Russia became one of the highest in the region. It’s currently comparable to that of the Baltic states, although Russia’s foreign debt is one of the lowest, while debt levels in the Baltic nations are fairly high. As for the eurozone, it’s no secret who is subsidizing the weaker countries, providing them with loans, and it’s also clear what risks this entails.

It’s hard to predict how things in the eurozone are going to play out, and whether European political unity will strengthen. Right now, however, it’s more or less clear: the economic situation is such that different countries in the currency union are operating with different levels of economic efficiency, and the use of a single currency combined with the lack of independent control over monetary policy among the weaker countries will continue to suppress growth in the eurozone.

The artificial support of the exchange rate presents a serious threat to the economies of countries such as Ukraine, Kazakhstan, and Belarus. Russia, meanwhile, despite slowing growth and having economic institutions in need of improvement, has an essentially floating exchange rate and is favorably positioned relative to many countries in the region. Its economic policy, however, has suffered due to one serious mistake – the budget rule†, which officially takes effect this year but actually partially began to be applied last year. This year, however, it appears to be dying a quiet death.

The excessive, unnecessary, and expensive debt obligations that the Russian government has taken on with the goal of raising funds to replenish the Reserve Fund ended up forcing other players out of the market and limiting the potential for economic growth last year. This policy led to liquidity problems which the government planned to solve this year by converting rubles, raised through the domestic debt, directly into foreign currency on the open market, which would then go into the Reserve Fund. Theoretically, this could facilitate a return of liquidity to the system and a lowering of interest rates, although ultimately it may lead to excessive volatility in the currency market and an increase in speculation, due to the fact that through such transactions the government will essentially be driving capital out of the country. However, this will probably not come to pass, and the budget rule will likely be quietly forgotten, as it was never completely applied in a strict manner anyway. The planned budget expenses for this year turned out significantly higher than the rule requires and, despite relatively high oil prices, no money was transferred to the Reserve Fund for the first four months of the year.

Fairly sensible economic policy had been a relative strength of Russia’s, which partially compensated for the well-known institutional problems. But the worsening of economic policy last year quickly affected growth, and this year Russia may end up being the slowest-growing country in the BRICS bloc.

In terms of longer-term prospects, economic growth in Russia and the BRICS countries is either completely unhindered by debt constraints, or at least such constraints are lower than in the above-mentioned developed countries. The ratio of government debt-to-GDP in Russia is just a bit over 10%. In China it’s around 22%, whereas in Brazil and India debt represents between 60% and 70% of GDP. Due to this, the latter two countries could face substantially more problems if, for whatever reason, interest rates across the globe rise, thus raising the cost of servicing debt.

Interest rate growth may occur in the future not only due to a gradual moving away from quantitative easing, but for other reasons, for example if China’s economy expands and its financial markets are liberalized.

Despite economic institutions that are far from ideal, Argentina’s economy continues to grow. (This year growth is expected at 3–4%, which is on a par with the entire South American region.) Meanwhile, Greece and Cyprus, which have higher-quality economic institutions, but do not control their own monetary policy and are under the pressure of a massive debt burden, have found themselves unable to cope

Last year, Chinese economic output came in at 52% of that of the U.S. (the GDP of the two countries was $8.2 trillion and $15.7 trillion respectively). If the Chinese economy maintains last year’s growth rates of about a trillion dollars annually (or even a little less), in a few years it will be on par in terms of size with the U.S. economy. And this may happen even quicker if the Chinese authorities remove barriers to capital flows and allow the yuan to float freely, a move that is bound to occur sooner or later. If this does take place, the direction of global capital flows may change. In addition to flows of foreign direct investment, China (and perhaps other fast-growing Asian countries) are experiencing a strong inflow of investment into financial markets, first and foremost in the government and corporate bond markets, where yields will be a lot higher than in developed countries and the risks will drop; theoretically this could happen with Russia as well. Interest rates for debt instruments in developed countries will start rising and the bubble that has formed in the sovereign debt markets of developed countries will start to subside or perhaps even burst.

At this point, it’s difficult to anticipate the effects of this, but a transition to a freely floating currency would likely boost the attractiveness of the Chinese currency, which may make it the third most popular reserve currency after the dollar and euro. China’s model of economic growth is starting to change even more quickly. To the extent to which its economy grows and the financial markets are opened up, the country will become an increasingly popular destination for investment in financial assets. If among the BRICS countries economic ties are strengthened and trade within the bloc grows, the other members of the group will also benefit. Right now we can separate three regions that are roughly equivalent in terms of economic scale: the U.S. (GDP in 2012 $15.7 trillion), the eurozone ($16.6 trillion), and the BRICS ($15 trillion). But there are only two primary reserve currencies. The emergence of a third one, and the overhaul of the global financial markets, is only a matter of time.  

† Restrictions on government spending depend that on the average price of oil over a certain period.