IMF's bold recipe for recovery

T T Ram Mohan, ET Bureau Sep 1, 2011, 01.29am IST

Tags: IMF| European Central Bank| Debt crisis

How to prevent a slide into another recession is the question that is engaging the world's policy-makers. At the meeting of central bankers at Jackson Hole in the US last week, all eyes were on the holy trinity of international economic policy - the chairman of the Fed, the president of the European Central Bank and the managing director of the IMF. Surprise, surprise, it was the head of the notoriously conservative IMF who came up with the boldest proposals for tackling the present crisis. At the same venue last year, Bernanke had indicated plans for another bout of quantitative easing. Many expected a similar indication this time. The Fed chief disappointed them. Bernanke said that the Fed had committed itself to "exceptionally low levels" (meaning, close to zero) for the short-term interest rate until mid-2013, implying he did not intend to do more right now. To those looking for a way out for the faltering world economy, Bernanke's stark message was, "Hang in there".

The president of the European Central Bank, Jean-Claude Trichet, did not offer any comfort to nervous investors either. Trichet's discourse on the long-term factors that drive economic growth, structural reforms and price stability may have enthused students of Economics 101 but one could not see investors cheering wildly. Enter the recently appointed IMF chief and former French finance minister, Christine Lagarde. The IMF chief outlined a menu of tough decisions the world' s leaders need to take if the present recovery is not to be derailed - and she did so in plain English. One item in the menu stands out: the "urgent recapitalisation" of banks in Europe. Private capital was welcome, Lagarde said, but we should not shy away from using public funds if necessary. The European Financial Stability Facility could be used to directly capitalise banks in Europe. This would "avoid placing even greater burdens on vulnerable sovereigns." Regulators and bankers in Europe were rattled. Urgent recapitalisation? European banks have enough capital to cope with a possible crisis, they said. In the most recent stress tests, only nine out of 91 European banks tested had failed, with a core tier one capital ratio of less than 5%. The problem at European banks today was lack of liquidity, not lack of capital. This is sheer quibbling. All of us know that in a bank, a problem of liquidity can quickly turn into a problem of solvency. This happened in 2007-08 and it can happen again. There are concerns about solvency because European banks are holding large amounts of government debt. Some of this debt has to be written off if the weaker economies of Europe are to return to growth. Banks will face significant losses as a result.

Lagarde's proposal faces up squarely to the inevitability that European debt has to be restructured. It ensures that the banking system is not caught up in a crisis when that happens. The present economic crisis flows from a financial crisis. It is the prospect of another financial crisis that is giving the markets and businesses the jitters and stalling the recovery. Lagarde's proposal thus provides a basis for recovery in Europe while containing the fall-out on its fragile financial sector. Lagarde was equally forthright in addressing the issue of reviving the US economy. The key was "halting the downward spiral of foreclosures, falling house prices and deteriorating household spending." This would involve writing off some of the debt of mortgage owners, again with help from the government. Thirdly, governments in both Europe and the US must balance long-term fiscal consolidation with the need for short-term fiscal stimulus. The two are not contradictory, indeed they can be "mutually reinforcing". The long-term fiscal risks are rising pensions and healthcare. If these are tackled, there will be space to support growth in the short-run. One element is common to the three proposals made by the IMF chief: public spending. Most people are of the view that fiscal stimulus has run its course; whatever little can be done for shoring up the recovery falls in the realm of monetary policy. Lagarde has taken a refreshingly different line. She clearly accords primacy to fiscal policy in the present scenario. This is interesting. The IMF, which was a staunch advocate of fiscal austerity not long ago in the East Asian crisis, favours public spending as the answer to the present crisis. In recent years, the IMF has moved away from its long-held position on the free flow of capital. Are we now seeing a shift in its position on fiscal austerity in times of crises? The head of the IMF is a lawyer and politician by training, not an economist. And yet she has come out with a clearer enunciation of steps needed to bolster the global economic recovery than the heads of the world's two leading central banks and indeed most professional economists. Whatever happens to the world economy, it does look as though the world of economic policy-making is in for a shake-up.

India's high savings rate and forex reserves will weather global economic troubles: Swaminathan S A Aiyar
Swaminathan S A Aiyar, ET Bureau Aug 14, 2011, 06.41am IST

Tags: US Fed| US credit rating downgrade

Given the global financial turmoil, India faces three possible outcomes - slow global growth, a borderline recession, and a financial crunch resulting in serious recession. I put the chances of slow growth at 65%, of borderline recession at 25%, and of serious recession at 5%. So, despite evident risks, stock market investors should treat the current turmoil as a buying opportunity rather than a signal to flee. That makes me an optimist. The Economist feels there is a 50% chance of a recession. Ruchir Sharma of Morgan Stanley, who is a regular Economic Times columnist, feels the world will slide in and out of recession - the borderline scenario.

How will the three scenarios impact India? Consider first the worst scenario, a serious double-dip recession. Such recessions are rare, and usually brought on by strong-arm government action, wittingly or unwittingly. For instance the 1980-82 double-dip recession was deliberately engineered by US Fed chief Paul Volcker to crush inflation out of expectation no matter what the cost in lost jobs and output. Political Worries Ben Bernanke, head of the US Fed, has proved that he will throw the full weight of monetary policy behind preventing a double-dip recession. So, that battle is half won already. The Republicans want to squeeze government spending, but any such squeeze will be mild. Only if all OECD countries go for austerity simultaneously is global demand likely to dip sharply enough to engineer a serious recession. The only other driver of recession could be a truly ugly European financial crisis, leading to major bank failures. This is not impossible, but is very unlikely. Banks are better capitalised and much less leveraged than in 2008.

Political bungling is more likely to create a borderline recession. Continued political squabbling in the US over the government debt ceiling could spook investors and inhibit investment. So could European political squabbling over the future of the euro and the 17 countries using this common currency. European politicians are understandably reluctant to let the eurozone shatter by allowing Greece and weaker countries to go bust. Yet the eurozone can be saved only if Germany, Holland and other fiscally strong countries agree to permanently help out regions in trouble, such as Greece and Portugal. This economic price is necessary to maintain the political vision of a unified Europe. This alone will cut to sustainable levels the interest rate on government bonds of Greece and other weak members. Voters in northern Europe don't want to keep bailing out countries whom they regard as lazy and incompetent. One possible solution is to allow the issue of eurobonds guaranteed by all eurozone members, up to 60% of the GDP of each member. Such eurobonds will carry low interest rates because they are effectively guaranteed by Germany and other strong members. Beyond 60% of GDP, government bonds will be unguaranteed, and so carry higher interest rates. This solution will mean a significantly higher interest rate for eurobonds issued by Germany, and this interest premium will be a non-transparent subsidy which transfers cash to weak members like Greece. This nontransparency may fool voters into thinking that guaranteed eurobonds are different from constant rescues.

Political uncertainties in the US and Europe will certainly discourage entrepreneurs and fuel fears of consumers, thus creating a simultaneous decline in private investment and consumption even as governments seek to stimulate these. This could be a recipe for a borderline recession. Yet the most probable outcome is a slowdown, not recession. When all governments know the danger of a double-dip and want desperately to avoid it, the chances of it happening are not very high. The travails of Greece and Portugal were initially ascribed to excessive spending and populism, yet their attempts at austerity have not solved their fiscal problem - the fall in government revenue caused by austerity can overwhelm spending cuts. The UK has shown that austerity need not mean a double-dip recession, but it does mean slow, unconvincing growth. Besides, some economic indicators suggest that gloom and doom are being over done. The latest employment data in the US are better than expected, and so are retail sales. Growth in the first half of 2011 has been well below expectation, yet that low base makes it easier to grow in the second half. India Response What should India do in the light of the three scenarios? Nothing much needs to be done if there is slow global growth or even a borderline recession. There will be some impact on exports and FDI, and portfolio inflows into stock markets may dry up. The RBI has been tightening monetary policy to tame inflation, sacrificing growth for India's own internal reasons. An additional downward nudge from the global economy may actually help. However, the government must speed up decision-making, prune wasteful subsidies, and speed up land acquisition and environmental clearances that have stalled many projects. The Doing Business series of the IFC/World bank show that India comes only 165th of 183 countries in ease of starting a business,

177th in ease of getting a construction permit and 182nd in enforcement of contract. Action is desperately needed on all three fronts. If there is a serious recession, the government will have to consider a fiscal stimulus as in 2008-09. A deep recession will push down global prices and solve the inflation problem, so monetary policy can become looser too. India's high savings, high forex reserves and modest current account deficit mean it is well placed to survive a double-dip recession.

But it will certainly mean slower growth and distress for outward-oriented companies. Exports will suffer, foreign investors will pull out of stock markets, and Indian companies will find it difficult to borrow abroad. India should be able to cope with these problems, as it did in 2008-09. Swaminathan S Anklesaria Aiyar is Consulting Editor, The Economic Times