The Great Suppression: What should LAC Expect in the New Year?

shutterstock_25065250-300x200The performance of the world economy has been disappointing to say the least.  After the Great Moderation came the Great Recession, but since 2009 the world has been suffering from a Great Suppression (GS).  In Japan, growth is being suppressed by a liquidity trap with interest rates firmly at the zero bound.  In the Eurozone, high debts and private sector deleveraging are suppressing growth.  As the European Central Bank (ECB) continues to ponder the efficacy of unorthodox monetary expansion, inflation remains low and even negative in some parts of the common currency area.  The US is recovering but not enough to pull the world out of the GS.  Average growth for the last 5 years in Advanced Economies is around 1.8%, a full 1% lower than the 5 years leading up to the global economic crisis.[1]

Moreover, the World Economic Outlook (WEO)October projections already look somewhat optimistic. Recent forecasts for the Eurozone and Japanese growth for 2015 are if anything below the IMF’s figures, continuing the trend of advanced economies performing below expectations (see Figure 1).  Most likely, the January WEO update will again argue that the world is recovering but not as fast as expected.  The Great Suppression is further fueled by lower investment and lower consumer optimism with feedbacks to lower than anticipated growth.[2]

Figure 1: Projections for World Growth at Different Dates

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China is now the second largest economy in the world and a major contributor to world growth. But while China is growing rapidly, the pace has slowed.  Growth is expected to be around 7-7.5%, not the dizzying rates north of 10% in recent years.  And there are also risks to those projections.  Signs are that the credit boom is abating, and while China has many tools to ensure this will not be a crash landing, the risks of a bumpy one persist.

Suppose the Eurozone, China and Japan grow at just half a standard deviation of their growth rates less than the WEO October baseline. The impact on the US would be significant.  Instead of the US growing at an average 3% for 2015 and 2016, it would grow at about 2.6%—a negative impact of about 0.4% of the largest economy’s GDP for each of those years.[3]  While the US is a relatively closed economy it is not immune to lower growth from the other major world economic powers.

Finally let’s add commodity prices to the mix.  Virtually all commodity prices have fallen over the last two years, in part due to suppressed growth in advanced economies and slower growth in commodity intensive China and in part by more commodity specific developments in supply.  Metals fell first and hardest as China slowed but prices may be buoyed because surprisingly supply has not boomed. Foods fell as supply soared to record levels just as demand began to fall.[4] Finally, oil prices collapsed as demand waned,  Saudi Arabia surprisingly decided not to attempt to stabilize prices, Iraq and Libya boosted exports significantly, and innovations in production—namely horizontal drilling and new supplies from shale—came online. History tells us major commodity booms come to an end precisely due to this mixture of generally weaker demand and global liquidity and more commodity specific stories regarding supply responses. The two largest collapses in the 20th century (1921 and 1975) followed this pattern.[5]  Worryingly for commodity exporters, both collapses ended up with commodity prices lower than the previous equilibrium relationship between commodity prices and manufactured unit values.[6]

How does all this impact Latin America and the Caribbean?  The IMF’s WEO October projections have the region growing at 2.5% for the 2014-2017 period.  Considering the scenario of half a standard deviation growth shortfall for the Eurozone, Japan and China, growth in the region would be just 1.6%.  Moreover, virtually every country in the region would suffer.  As the US is not immune to the Great Suppression, Mexico and Central America would also be affected.  Table 1 gives growth estimates for 2014-2017 for selected countries and regional averages.

Table 1: LAC Growth Rates According to the October WEO Projections and given Shocks to the Eurozone, Japan and China Growth Rates

Table1-1024x393

Source: IMF and IDB simulations. First column is average 2014-17 growth rates as per the IMF’s WEO Baseline. Second column is that baseline but with a half standard deviation shock to Eurozone growth. Third column is the same baseline subject to a half standard deviation shock to Japanese growth. The fourth column is the same baseline but subject to a half standard deviation shock to China growth. The fifth column is the same baseline but subject to all three half standard deviation shocks (in China, the Eurozone and Japan) and the final column is the impact of that shock (ie: the final column minus the first column).

But these estimates do not take into account important additional features. Flexible exchange rates in the larger economies of the region may well be able to act as a shock absorber. However, inflation remains close to the top of the band in some countries and there may be concerns regarding currency mismatches in the private sector given significant recent dollar issuance, likely restricting the attractiveness of large exchange rate depreciations. Moreover, US policy interest rates are expected to rise in 2015 and the impact on longer term rates, emerging economy spreads and capital flows remains uncertain. Another important factor is the fall in oil prices, which may give the global economy a boost. However, the fall in commodity prices including oil, will negatively affect commodity exporters and those countries that depend on Petrocaribe financing.[7]

Moreover, during the Great Recession, many countries in the region responded with expansionary fiscal policy.  At the time this was labelled anti-cyclical policy but in many countries the fiscal expansion became permanent and fiscal expenditures rose to new levels.  Most countries in LAC have weak automatic fiscal stabilizers and thus used discretionary policies, including boosting social programs and public sector salaries. The political economy inherent in such programs made such changes impossible to reverse.  They therefore cannot be considered as anti-cyclical, as by definition such policies should be reversible.  The upshot has been a marked deterioration in fiscal positions.[8]

Moreover, if baseline growth forecasts decline and longer term US interest rates rise, the required primary fiscal balance to stabilize debt ratios will increase. Several countries already need to make significant fiscal adjustments to avoid debt levels increasing further.  The typical country in the region around July 2014 had debt to GDP of around 45%, a real interest rate of 4.5% and medium term growth prospects of around 3.5%.  These figures imply a primary fiscal surplus of about 0.5% to stabilize the debt ratio and the typical country actually had a deficit of about 0.8%.  Now, debt and real interest rates have risen and growth has fallen back.  At a debt level of 50% of GDP, a real interest rate of 5.6% and medium term growth of 3%, the required fiscal surplus to stabilize debt levels becomes 1.3% implying a more than 2% of GDP adjustment from current levels.

Very few countries in the region are in a strong position to contemplate any type of anti-cyclical fiscal policy in the event of a negative shock to baseline medium-term projections.[9]  And those with fiscal space would be advised to consider policies very carefully indeed to ensure that they are truly anti-cyclical. While under current circumstances, a sharp fiscal adjustment program may be counter-productive in most countries, there is surely space to enhance the quality of public spending to obtain a greater bang for each fiscal buck and to boost growth through particular country-specific interventions.[10]

Figure 2: LAC Growth Rates comparing the WEO October 2014 Projections,
a Negative Scenario and Reform Scenarios

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The coming year is then likely to be a tricky one for LAC to negotiate.  While superficially, the change in external conditions is reminiscent of the end of the 1970s with falling commodity prices, a strong dollar and US interest rates on the rise, there are several important differences.  The Great Suppression in Europe may allow for lower cost financing in Euros. And most importantly, LAC fundamentals are much stronger than at that time. Still countries will need to manage policy skillfully, take advantage of floating exchange rates where feasible, and pursue reforms and other interventions to boost growth where opportunities present. Indeed further simulations (see Figure 2) suggest that if the two largest economies (Brazil and Mexico) could boost growth to the tune of one half a standard deviation of their growth rates then, given positive spillovers between countries, this would counteract the scenario of negative shocks from Europe, Japan and China.  And if all countries could boost growth in the same way, then LAC growth could reach 4% by 2017 even in the face of such a prolonged global Great Suppression.

Andrew Powell is the Principal Advisor in the IDB Research Department

References

Cesa-Bianchi, Ambrogio; M Hashem Pesaran, Alessandro Rebucci and TengTeng Xu  “China’s emergence in the world economy and business cycles in Latin America”, Economía, Volume 1, Issue 2 Pages 1-75

Crespi, Gustavo; Eduardo Fernandez-Arias and Ernesto Stein (Coords.) “Rethinking Productive Development” Development in the Americas, Inter-American Development Bank Flagship Report 2014http://www.iadb.org/en/research-and-data/dia-publication-details,3185.html?id=2014

Deaton, Angus and Guy Laroque (1996) “Competitive Storage and Commodity Price Dynamics” Journal of Political Economy, 1996, vol. 104, no. 5.

Mariscal, Rodrigo and Andrew Powell (2014) “Commodity Price Booms and Breaks: Detection, Magnitude and Implications for Developing Countries” January 2014, IDB Working Paper No. IDB-WP-444,http://198.62.77.13/en/research-and-data/publication-details,3169.html?pub_id=IDB-WP-444

Powell, Andrew, (1991) “Commodity and Developing Country Terms of Trade: What Does the Long Run Show?” Economic Journal, Royal Economic Society, vol. 101(409), pages 1485-96, November.

Powell, Andrew (Coord.) “Global Recovery and Monetary Normalization: Escaping a Chronicle Foretold?” Latin American and Caribbean Macroeconomic Report, Inter-American Development Bank 2014.http://www.iadb.org/macroreport

Summers, L. (2014) “U.S. Economic Prospects: Secular Stagnation, Hysteresis, and the Zero Lower Bound” Business Economics Vol. 49, No. 2. http://larrysummers.com/wp-content/uploads/2014/06/NABE-speech-Lawrence-H.-Summers1.pdf

USDA (2014) World Agricultural Global Supply and Demand Estimates, Dec 10th 2014. Available athttp://www.usda.gov/oce/commodity/wasde/latest.pdf


[1] Advanced economies grew at an average of 2.8% from 2004-2008.

[2] See for example Summers (2014) on the so-called “secular stagnation” hypothesis.

[3] This simulation comes from a Global Vector Auroregression (G-VAR) model developed in the IDB’s research department, see Cesa-Bianchi, A, M.H. Pesaran, A. Rebucci and T. Xu (2012) and Powell (2014) for further details regarding the model.

[4] Consider these extracts from USDA (2014) World Agricultural Global Supply and Demand Estimates, Dec 10th 2014. “Global wheat supplies for 2014/15 are raised 1.9 million tons with increased production offsetting lower beginning stocks. World wheat production remains record high and is raised 2.3 million tons led by a 1.8-million-ton increase for Canada…”, and “Global coarse grain supplies for 2014/15 are projected 1.1 million tons higher. Higher corn production for China and EU, higher rye production for Russia, and higher oats production for

Canada, more than offset lower expected corn and barley output for Argentina..”, and finally “Global oilseed production for 2014/15 is projected at a record 530.7 million tons, up 1.8 million tons from last month.”

[5] Both booms were fueled by strong demand coupled with what have been regarded as speculative bubbles, although the seminal Deaton and Laroque (1996) demonstrates how such prices may be strongly non-linear.

[6] See Mariscal and Powell (2014) for a discussion of the recent boom and breaks in long term commodity prices updating Powell (1991) with new econometric techniques.

[7] Petrocaribe extends concessional financing to several countries that import oil.  The amount of the loans depend on the difference between the actual price of oil and a benchmark price such that if the actual price falls then the volume of the loans extended will decrease. This means that if oil prices fall, while this may be good for an oil importer in terms of “solvency”, it means its financing for the coming year may be less and so harms “liquidity.”

[8] See Powell (2014) for an analysis.  It is estimated that structural fiscal deficits increased by at least 2% of GDP for the typical country in the region.

[9] The standard advice is not to consider anti-cyclical fiscal policy to boost growth from a medium term or “potential growth” baseline but only in the face of negative shocks to that baseline.  But interventions that truly boost growth may actually create fiscal space and are a different matter indeed.  The challenge is to find and be able to implement such interventions successfully.

[10] For a discussion of potential public policy interventions to boost growth, please refer to Crespi et al (2014).

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Updated: March 11, 2015 — 7:04 pm

The Author

Andrew Powell

Andrew Powell

Andrew Powell is the Principal Advisor in the Research Department (RES). He holds a Ba, MPhil. and DPhil. (PhD) from the University of Oxford. Through 1994 he dedicated himself to academia in the United Kingdom as Prize Research Fellow at Nuffield College, Oxford and Associate Professor (Lecturer) at London University and the University of Warwick. In 1995, he joined the Central Bank of Argentina and was named Chief Economist in 1996. He represented Argentina as a G20/G22 deputy and as member of three G22 working groups (on crisis resolution, financial system strengthening and transparency) in the late 1990’s. In 2001, he returned to academia, joining the Universidad Torcuato Di Tella in Buenos Aires as Professor and Director of Graduate Programs in Finance. He has been a Visiting Scholar at the World Bank, IMF and Harvard University. He joined the IDB’s Research Department in 2005 as Lead Research Economist and in 2008 served as Regional Economic Advisor for the Caribbean Region until returning to the Research Department as the Principal Advisor. He has published numerous academic papers in leading economic journals in areas including commodity markets, risk management, the role of multilaterals, regulation, banking and international finance.

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