l Global Research l

Global Insight | 14:00 GMT 22 July 2011

The Economic and Financial Outlook

A monthly analysis by Dr. Gerard Lyons, Chief Economist

Fears of a perfect storm

Concern about the world economy has returned to centre-stage in recent weeks. The reality is that this concern has never been too far from the markets thinking throughout the twoyear global recovery. In recent weeks, the focus has been on a combination of factors, particularly the crisis in the euro area, debt problems in the US and worries about a hard landing in China. Each of these, on their own, would be enough of a concern. Any combination would be a major problem. The current focus on all three has triggered genuine fears of a perfect storm: a set of circumstances that leads to serious events combining together to hit the world economy hard.
Gerard Lyons, +44 20 7885 6988
Chief Economist and Group Head of Global Research Gerard.Lyons@sc.com

No-one should underestimate the near-term downside challenges for the world economy. These are particularly intense for some of the major advanced economies. Of particular concern are the overhang of debt and the scale of deleveraging still needed in some of the economies hit hard in the financial crisis. These are most apparent in the euro area, but the US and UK are also affected. The euro area faces a growth problem or, more particularly, a lack-of-growth problem. One possible solution would be to form a two-speed euro area. In recent weeks, the combination of excitable markets and ineffective politicians has conspired to create the present problem. In essence, the deflationary bias in the euro area cannot succeed in the present economic environment. It compels the periphery into recession, bordering on depression. The claim that Greece and others need to make structural adjustments is correct. However, timing and scale need to come into the thinking. The time to have made the changes being demanded of Greece, and others, is when the economy was in good, or at least better shape. But the changes were not made then, just as other countries did not run budget surpluses when they should have, during the good times. To make such radical, structural changes now, when there is already a recession, is akin to being in a hole and digging deeper. Then there is the scale: deficit cuts of over 12 percentage points of GDP over five years are too much. Greece cannot cope. Hence, it faces a solvency crisis, its recessionary economy not generating sufficient tax revenues, while the cuts hit hard. Confidence will likely erode, for both Greeces citizens and international investors. Whether this will be Europes Lehman Brothers moment is hard to say. But the very fact that this risk exists suggests that it should be avoided. Help from the core is a necessity in order for the periphery to cope. Even then, it may not be enough. The fact the problems do not stop there is a worry. The US political brinkmanship ahead of passing the debt ceiling deal may not have been anything new these things can often go to the wire but it provided an opportunity, if it was needed, for the markets to focus on

Inside: First, an overview of the world economy with focus on the euro area which is facing an existential crisis (pages 1-4). It also includes a snapshot of Asia which remains resilient to external shocks. Next, a piece on the `south-south financial flows which summarises a paper presented at the OECD in Paris (pages 5-10). The third article appeared as part of the FT A-series and focuses on inclusive growth (page 11).

Important disclosures can be found in the Disclosures Appendix All rights reserved. Standard Chartered Bank 2011

research.standardchartered.com

Global Insight

the enormity of the US debt problem. Yet there appears little sign that this will be tackled and certainly not ahead of the Presidential election. The West may be hard-pressed to cope with a further shock The ability to address this issue depends, somewhat, on the extent of the economic recovery. The US hit a soft patch in Q2. Easing oil prices and tax-measures to boost investment before year-end may give growth a helping hand in H2, but the overall picture is of a subdued recovery. The challenge in the West is that the policy cupboard is bare. I keep stressing that, whichever economy one looks at, the economic outlook depends on the interaction between the fundamentals, policy and confidence. The West may be hard-pressed to cope with a further shock, or a series of shocks. But, across the emerging world (or far better to say, the faster growing economies) the policy cupboard is far from bare, and there is ample scope to cope with shocks. Given this, it is particularly important to keep western monetary policy accommodative. It is one thing tightening fiscal policy prematurely, quite another to do the same with monetary policy. Therein lies another challenge. The growing perception that western central banks will have to keep interest rates low for a long time plus the view that any policy change will be signalled well in advance has led to financial markets no longer pricing in risk properly. Sound familiar? It should. It was a common problem before the It is particularly important to keep western monetary policy accommodative financial crisis, although the dimension of it is far less now. There is no evidence of investors seeking out complex products on a sizeable scale. Through the year there has been a compression of spreads between lower and high-grade credits, although there has been some recent correction as worries surrounding Europe have risen. At the height of the financial crisis, it was evident that the so-called, and difficult to define, shadow banking industry was significant and that interactions between financial institutions were huge. Concern rose about the contagion from any credit events, wherever they occurred, giving rise to the ongoing attention on the euro area and the fear of contagion from other economies and across banking sectors. China concerns In recent months China concerns appear to have risen. Timing will also be a challenge in predicting any set-back there. It would be remarkable if China did not have a setback. After all, its economy is heavily imbalanced, skewed towards investment, as well as exports, although this years new 12th Five Year Plan makes clear the determination to boost private consumption and rightly so. While there is no magic level of investment, one can safely say that the present level in China is too high. Less easy to predict is when it will decline, or how. Ideally, the ratio will fall gradually, alongside a rise in private-sector spending. But the nature of these things is that adjustment is not always smooth or predictable. It would be remarkable if China did not have a setback The challenge is that investment is so high, around 45% of GDP, that even a mild correction, if it happened abruptly, could knock a considerable amount off of GDP growth. This is not the only issue. The increase in news stories about domestic unrest has led to an increased focus on next years political changes in China, and how the new set of leaders will handle demands for greater political freedom. The likelihood is that not much will change, which would also appear to be the case with macroeconomic policy. The Five Year Plan makes clear the goals. But even an eventual setback should not divert attention from Chinas strong underlying growth story. Concerns about China have been driven more by worries about domestic developments. But the events in Europe and the US
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could be the trigger, hence talk of a perfect storm. It does not have to be the case that any setback in the West impacts China, but it probably would. The immediate transmission Chinas room for fiscal manoeuvre is ample, in contrast to that in the West mechanism is via exports, but the bigger worry might be if investment plans were cut back, because of a more pessimistic view of global demand. And, of course, any slowdown in China, if it occurred, would hit both commodity exporters in many regions, as well as capital goods exporters such as Germany, highlighting the interconnections in the world economy. Of course, the flip side would be some easing in commodity prices and inflation, but that would not compensate for the overall hit to demand in this scenario. Despite this, perhaps not enough attention has been given to the fact that Chinas room for fiscal manoeuvre is ample, in contrast to that in the West. If things slow too much, expect some economic pump-priming. As Chinas economy grows, it becomes more difficult to manage, placing increasing pressure on policy institutions. For now, the policy environment has been handled well in China. Thus a hard landing does not appear imminent, notwithstanding the challenges. A soft landing appears more likely. I am reminded of a comment from a policy maker in a meeting a number of years ago, when the focus was on a soft versus hard landing. His comment then was that we are not having a landing, we are refuelling in mid-air. Even with recent data, this image fits the economy now. Yet the risks from the West should not be dismissed. This is a greater challenge elsewhere in Asia, where there are many small The interest-rate approach across Asia may start to see greater variance and medium-sized open economies and whose growth can be volatile, in reaction to trade flows. Asian rates A key focus will be monetary policy, not just in China, but across Asia, particularly India. There has been considerable monetary tightening across a host of Asian countries. For now, in general, monetary policy may be put on hold as food and energy prices are off their recent peak, as growth worries in the West overhang Asia. That being said, monetary policy may still be too lax. Across Asia, one should certainly not just judge monetary policy in terms of policy rates. So-called unconventional measures are widely used. There is sufficient lending and credit growth in economies. This is keeping domestic demand firm, particularly in South East Asia and China. Given conflicting domestic and global pressures, central banks across the region need to retain a flexible approach to monetary policy. The domestic environment for many suggests firm demand and rising inflation risks, while the external situation suggests downside risks. Some, like the central banks in Thailand and Taiwan, are signalling their desire to keep tightening in response to events at home, but are making it clear they are vigilant against external risks. Although impacted by the same overall environment, the interest-rate approach across Asia may start to see greater variance. Perhaps the most interesting country will not be China, but India Perhaps the most interesting country will not be China, but India. There, the authorities have done a good job. But now the domestic economy faces some challenges. The mood in India has been relatively downbeat recently, owing to a combination of things. Rising inflation and monetary tightening have slowed the economy, while corruption issues have led some to comments that the relationship between politicians and business may be forced to change. At a time of rising global uncertainty, Indian markets may be hit by increased risk aversion yet at the same time, the economy tends to provide better protection from events elsewhere, largely because it is less open, being driven by domestic demand.
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Indian wholesale price inflation has been above 8% for the last year and a half. Supply and demand factors have contributed to this. And it seems set to stay stubbornly high, Our view is that the Reserve Bank of India will hike again possibly above 9% until the end of November. After that, year-on-year effects may push down the headline rate. There is a perception that previous monetary tightening will then take the heat out of inflation. In this environment, it will be interesting to see what the Reserve Bank of India (RBI) does. Since March 2010, the repo rate has risen 2.75 percentage points to 7.5%, market overnight rates have risen 4.25 percentage points, and other non-conventional monetary measures have been used. Our view is that the RBI will hike again, by 0.5% by year-end. The economy has slowed, but is still solid. Witness the 19% growth in advance corporate tax collection in the April to June period. Some sectors, such as cars, have slowed, but the slowdown is not broad-based. Also infrastructure progress has slowed, in power, roads and mining, largely because of environment regulations and land acquisition issues. Much attention will not just be on the immediate behaviour of the Reserve Bank, but also on whether policy paralysis eases. The new session of the Parliament, beginning August 2nd, will address some important legislation for the economy, covering a vast array of areas including the land acquisition bill, foreign direct investment in retail and insurance, and new manufacturing policy. Given Asias growing global importance, its demand keeps a firm floor under commodity prices Given Asias growing global importance, its demand keeps a firm floor under commodity prices. So, even though an easing of supply worries and firmer output has contributed to the recent easing in food and energy prices, there is every likelihood that these will firm again next year. This suggests a replay of the inflation worries seen earlier this year, and the need for Asian tightening to continue. Whether this transmits into currency policy remains to be seen. The intervention in, and manipulation of, currency rates satisfy an important domestic need across Asia, but complicates the global need for balanced growth, of which currency adjustment is one component. As the year has evolved, the G20 focus has shifted from a wide range of issues towards a few specific areas, of which currencies and commodities are key. Curbing speculation in commodity markets is welcome, albeit hard. On the currency front, it appears that the emphasis for the G20 has moved away from demanding immediate currency action, and more towards less controversial moves to include a wider set of currencies in the SDR (Special Drawing Rights) basket. Overall, the message is that the world economy has slowed but not collapsed. But there are considerable risks in Europe and the US and Asia will not be immune from these, We still expect solid growth in the East and a sluggish recovery in the West even though it has the policy room to cope. As policy easing in the West wears off, and as emerging economies tighten policy, the environment is becoming more difficult. But we still expect solid growth in the East and a sluggish recovery in the West. There are considerable near-term risks, with the euro-area situation being uppermost. And in the event of a new crisis of confidence, it is often those economies with large current account deficits that feel the pressure. Turkey and Vietnam are two in this category. Policy interest rates will diverge, staying low, even allowing for hikes by the European Central Bank (ECB) in the West, and further tightening in the East. Domestic demand is resilient across Africa, Asia, and parts of Latin America and the Middle East. Infrastructure spending is a necessity, attracting further inflows. The US dollar (USD) may firm near-term, if US growth picks up in H2 and euro-area problems persist. Asian currencies still appear undervalued.

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Growing south-south financial links

There are three parts to this paper: first, the economic context; second, what is
This is a summary of a paper given by Gerard Lyons at the OECD in Paris, on 8 July, at the EmNet (Emerging Market Network) meeting. The theme of the day was East and South: Bigger and Better? The paper formed part of the session on South-south linkages in the financial and investment arena.

happening; and third, the implications. First, the economic context The shift in the balance of economic and financial power is a key factor behind the increase in south-south trade and financial flows. In the wake of the financial crisis, emerging economies or perhaps we should now call them fast-growing economies, as many have emerged already have accounted for the bulk of the increase in world growth. This is not just explained by cyclical factors. We believe the world economy is in a supercycle, defined as a period of strong growth lasting a generation or more. In our view, this is the third super-cycle (Chart 1). The first was from 1870-1913, and saw the emergence of the US as a super-power and the adoption of technologies discovered during the Industrial Revolution but yet to be put to use. The second super-cycle was from 19451972; this was characterised by rapid growth, saw the emergence of Japan as a powerful economy and the rapid growth of consumer durables markets. Now, we are in the third, and it may have begun in 2000. This does not mean we are bullish about everything, and just as importantly it means it is essential not to underestimate the impact of debt deleveraging in the West and the possibility that Asian and other emerging economies could experience setbacks. The current problems in the euro area also highlight how vulnerable economies in the West are to further economic or market shocks. One of the key drivers in this super-cycle is new trade

Chart 1: The world is in its third super-cycle World GDP growth

corridors, something we have talked about for years. This is the increase in south-south trade and financial flows. It includes increased flows of goods, commodities, people and remittances, portfolio and direct investment flows.

10%
1946-1973: 5.0% 2000-2030: 3.5%

The drivers behind this are multiple, and they include the increasing demand for all types of resources arising from higher domestic consumption and investment in many of these economies; and both the catch-up potential and ability of many emerging economies to move up the value curve.

5%

1870-1913: 2.7%

0%
1820-1870: 1.7%

1973-1999: 2.8%
1913-1946: 1.7%

The drivers for increased financial flows are both state-led and from the private sector. Thus the drivers are both strategic and commercial, and in turn may be opaque or transparent. There are a number of drivers behind these global as well as

-5%

-10% 1820 1850 1880 1910 1940 1970 2000 2030

increased south-south flows. One is resource-seeking flows, largely from cash-rich to resource-rich countries. Currently, there are numerous state-led examples of such flows. Another is market-seeking flows, as firms seek to move up the

Actual world GDP growth

Average world GDP growth

This chart illustrates the super-cycles we believe that the world economy experienced, including the third, which it may now be experiencing.

Sources: Angus Maddison, IMF, Standard Chartered Research

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value curve in the face of tougher low-cost competition. Here, one might expect to see increased investment by firms at home, as well as overseas. Another is strategic asset-seeking flows; again, here, there is an attempt by firms to move up the value curve, as they purchase brands, technology and intellectual property. One might expect a significant proportion of these flows to be from the emerging into the developed world, but increasingly the south-south dimension should rise. The final explanation of flows is efficiency-seeking flows, where the driver is the need for greater efficiency and economies of scale. Here it may be possible to have joint acquisitions domestically and joint ventures as well as acquisitions overseas. These descriptions fit in with the needs and development agenda of many emerging economies. China is a leading example, and its involvement and the scale of flows has helped propel this issue to the fore over the last few years. China's growing importance is likely to become more evident. China's 12th Five-Year Plan (FYP), announced during the National Peoples Congress in March this year, is a significant development, highlighting Chinas desire to move up the value curve. This is likely to have profound implications for south-south, as well as global financial flows. Another important development this year is India's desire to shift its
Alternative energy Nuclear, wind and solar power Carbon emissions per unit of GDP to be cut by 40- 45% by 2020 from 2005 levels Electricity transmission and power metering infrastructure Power capacity to rise by 64% over next 5 years

Chart 2: Chinas USD 1.5trn spending plan in 2011-15 Chinas seven priority industries

economy more towards manufacturing, aiming to increase its share of GDP to around 25% over the next decade from the current 16%. This too could have profound implications for trade and financial flows. The context of Chinas FYP is important. The economy is strong but imbalanced, skewed towards exports and investment, with private consumption too low; and as the economy becomes bigger, it is harder to rule from the centre than before, placing greater emphasis on the effectiveness of China's policy tools and institutions. The challenges within the economy were identified by the president and premier a few years ago when they spoke of the five imbalances: urbanrural; coastal-inland; social; environmental; and international.

Energy conservation and environmental protection

Biotechnology

20 genetically modified organism (GMO) crops have been approved for field trials Rare earths, indium (TV and computer screens), lithium (batteries) and high-end semiconductors

Advance materials

New IT

Nanotechnology, satellites, supercomputers and internet security

The aim then was to move from strong to sustainable growth. This remains a constant challenge within China, and is evident now, with the authorities trying to cap inflation and achieve a soft landing. We think this is achievable, although worries about a hard landing not our main view can never be dismissed. We expect China to achieve solid growth this year, and next, but the high share of investment as a

High-end equipment manufacturing

High-speed trains, wind turbines, solar panels, aerospace and telecom equipment

Clean energy vehicles

Fuel cells, compressed natural gas, liquefied petroleum and nitrogen gases (LPG, LNG)

proportion of GDP means that a setback to investment plans, for whatever reason, could have a profound impact on slowing the pace of growth.

Chinas 12 FYP details these seven industries, with particular emphasis on the green economy, which aims to move China up the value-curve.

th

Indeed, one of the lessons for China, from the Wests financial crisis was that it cannot rely on selling cheap goods to heavily indebted westerners. Chinas changing domestic
6

Sources: Draft of Chinas 12th FYP, Standard Chartered Research

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demographics (its overall population will start to age from 2014) will reinforce this. Indeed, the FYP reflects an ambition to move China up the value curve. A setback to investment plans could have a profound impact on slowing the pace of growth in China The focus of the FYP is on boosting domestic consumption by addressing many areas, and not just in terms of the quantity but also the quality, in areas such as scientific development, urbanisation and the service sector. A second priority is on social spending. A third is the green economy, including specific targets for reducing energy use. As a result of this third priority, the FYP identified seven priority industries (Chart 2): alternative energy; energy conservation and environmental protection; biotech; advanced materials; new IT; high-end equipment and manufacturing; and clean energy vehicles. The FYP also follows on from last year's State Council announcement to make Shanghai an international financial centre by including a shared chapter on Hong Kong, which is already of key importance in terms of China's financial flows and is also playing a central role in the internationalisation of the CNY through the growth of the CNH market. Second, what is happening? The second part of my talk focuses on what is happening in terms of financial flows. Ahead of the crisis, our view was that emerging economies were not decoupled but better insulated given their high reserves and sounder fiscal positions; so it proved. Now, we believe they are not decoupled but better diversified, given stronger domestic demand and increasing south-south links. These links are increasingly financial as well as trade related. Now we believe emerging economies are `not decoupled but better diversified There are many examples of deals in recent years that illustrate the growth in south-south flows. Let me cite a selection, quoting publically available and reported data. In June 2010, in the mobile telecoms sector, Indias Bharti Airtel completed its acquisition of Zain Africa, in a USD 10.7bn deal that was then the largest cross-border deal in the emerging market economies. In June 2008 in the retail sector Al-Futtaim Group of the UAE acquired a controlling stake in Robinsons department stores in Singapore for USD 363mn. To illustrate that these flows are two-way, Sembcorp Utilities of Singapore entered a USD 1bn joint venture with the Oman Investment Corporation. The first phase of the Independent Water and Power Plant (IWPP) in Oman was successfully completed this month. The process is ongoing and not just in energy or resources and not just involving China. For instance, Sinopecs USD 8.8bn deal to buy Swiss petroleum company Addax Investment flows from China are not just into emerging economies but also into the developed world Petroleum (with drilling rights in Kurdistan, Gabon and Nigeria) was Chinas largest-ever outbound investment in the oil and gas sector. It also highlights that the investment flows from China are not just into emerging economies but also into the developed world. There is also much focus on the role that China's sovereign wealth fund, the CIC, can play in overseas investment. But the CIC is just part of the story. There are four sovereign entities that play a role here: China's vast foreign exchange reserves which continue to rise; the government pension fund; the sovereign wealth fund itself; and state-owned enterprises, some of which are alluded to above. There were three Chinese deals in the top 10 largest direct global sovereign wealth fund investments of 2010 (Monitor, 2011).
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One was in real estate: CIC's USD 2.3bn investment in US General Growth Properties, completed November 2010. The second was a domestic acquisition by the National Social One should expect increasing examples of cross-border south-south flows in financial instruments Security Fund, a USD 2.2bn investment to take an undisclosed stake in the Agricultural Bank of China, completed in July 2010. A third was in infrastructure, when CIC bought a 15.82% stake in AES Corporation a US power-generation and transmission company for USD 1.58bn in March 2010. One should also expect increasing examples of cross-border south-south flows in financial instruments. As one example, China's holding of Korean bonds rose from USD 1.6bn at the end of 2009 to USD 6.7bn at the end of Q1-2011, moving China from the 11th to fourth-largest holder. South-south flows, particularly from China, still have a large strategic and resource-linked element to them. Chinas loan-for-oil type deals help illustrate how these flows have evolved. China Development Bank, a state bank, has played a key role. In recent years the number of overseas deals it has been involved in has risen. Examples include a USD 15bn and a USD 10bn 20-year deal with Rosneft and Transneft of Russia, respectively, in 2009; a USD 10bn, 10-year deal with Petrobras of Brazil in 2009; and a USD 20.6bn, 10-year deal Infrastructure is a cornerstone aspect of some south-south flows with BANDES of Venezuela last year. There are many others. Once a development bank seen largely, almost solely, as funding infrastructure in China, China Development Bank has moved into areas such as helping China develop its financial sector and support its international expansion, particularly into resources. Infrastructure is a cornerstone aspect of some south-south flows, as deals that secure resources in return for increased funds available for infrastructure spend can be seen as win-win situations. This was also seen in May when the second India-Africa summit took place in Africa. Some 15 African leaders and the Indian premier attended. To date, India's involvement in Africa

Table 1: Receipt of remittances 2010

Size of inflow, USD bn All developing economies East Asia and Pacific South Asia LatAm and Caribbean Middle East and North Africa Europe and Central Asia Sub-Saharan Africa 324.7 92.5 81.2 57.6 35.6 34.9 21.9 Growth, % y/y 5.6

has been largely private-sector-led. The scale of its bilateral trade with Africa of around USD 40bn is far less than that of China. This summit was an attempt by the Indian government to get more involved and to boost trade and other commercial flows. Central to this is Indias offer of infrastructure loans. One
7.4 8.2 1.7 6.2 1.3 5.5

important

part

of

increased

south-south

flows

is

remittances. This is a natural consequence of people moving in search of jobs and opportunities and sending money back home. According to World Banks Migration and Remittances Factbook 2011, the top 10 economies with the highest remittance outflows together account for 63% of the total sent. In order, these are the US, Canada, the UK, Germany, France, Saudi Arabia, the UAE, Spain, Australia and Hong Kong. In turn, the top 10 recipients receive half the money and these are, in order, India, China, Mexico, the Philippines, France, Germany,

This table shows regions receiving most remittances.

Sources: World Bank, Standard Chartered Research

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Bangladesh, Belgium, Spain, Nigeria and Pakistan. These figures include countries and their territories. Diaspora bonds and remittance-backed bonds can finance infrastructure and development projects In terms of regions (Table 1), in 2010 East Asia and the Pacific received the most (USD 92.5bn) and South Asia grew the most (8.2% year-on-year to USD 81.2bn). This is leading to innovative financing tools leveraging on migration and remittances. A good example is diaspora bonds. These are sovereign bonds that target investors who have emigrated to other countries and the relatives of those emigrants. Several countries have introduced diaspora bonds in recent years, or are in the process of doing so. Examples include India, Israel, Ethiopia and Nepal. Some are more successful than others. Given the volume of remittance flows, diaspora bonds and remittance-backed bonds are being viewed as potential sources that can finance infrastructure and development projects at lower cost and longer maturities than conventional government bonds. The Tourism is also another huge flow, often overlooked, but already growing rapidly size of these flows is hard to gauge fully. The World Bank estimates that annual diaspora savings of USD 400bn in developing economies, which innovative financing instruments can potentially tap into. These savings, as a share of GDP, is estimated to range from 2.3% in middle income countries and from 9% in low-income countries. Tourism is also another huge flow, often overlooked, but already growing rapidly and likely to increase as income levels rise across the emerging world. The US is the dominant country in terms of global tourists. China is growing rapidly but from a very low level, although its impact may be seen much more so regionally, across Asia. Given I am speaking in Paris, according to the latest global tax-free shopping trends published by Global Blue, Chinese tourists have become the highest-spending
USD bn % regional GDP 2.4 9.0% 2.3%

Table 2: Estimated annual diaspora savings 2009

shoppers in France. Last year, Chinese tourists spent EUR 650mn (USD 910mn) in French shops, accounted for 16% of all non-EU tourists, and spent EUR 1,300 (USD 1,820) on average per tourist, compared with EUR 880 (USD 1,232) by Americans and EUR 850 (USD 1,190) by Japanese. Third, implications

All developing economies Low income countries Middle income countries LatAm and Caribbean East Asia and Pacific Europe and Central Asia South Asia Sub-Saharan Africa North Africa Middle East

397.5 34.4 363.1 116.0 83.9 72.9 53.2 30.4 22.3 18.9

2.9 1.3 2.8 3.3 3.2 4.3 3.5

Third, I focus on the implications. Expect new trade corridors to continue to grow. Increasingly, south-south flows will be financial as well as trade linked. Emerging economies need to focus on the need for greater depth and breadth in their domestic financial markets. This is important in a number of ways. It will reinforce the desire to shift towards greater domestic-driven growth, as people can borrow against future income as well as channel their savings into more effective areas, and as firms are able to raise finance for domestic investment. It will also enable more emerging economies to absorb inflows into their domestic markets. Such inflows, last year, fed asset-price inflation, and in some countries, such as Brazil, fed currency appreciation, leading to

The World Banks Migration and Remittances Unit estimated the size of diaspora savings based on the assumption of 20% savings rates amongst migrants.

Sources: World Bank, Standard Chartered Research

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a general reassessment of capital controls. So far, growth in domestic bond markets across emerging economies is still heavily focused on a few countries, such as Brazil, India, China and South Korea. There is much more to be done to develop domestic financial markets. Strategic rationale points to increased future flows into energy, commodities, food and even `virtual water There are likely to be increased portfolio and foreign direct investment flows, tied in with financial market development. There is a strong correlation between rising market capitalisation and increasing income per head. This is not necessarily a causal relationship. Deepening domestic markets can be linked into the current G20 agenda, which has shifted this year to focus on addressing speculation in commodity markets as well as on currency issues. While the anti-speculative focus of the G20 is welcome, it is important to recognise that high food and energy prices in recent years have also highlighted the lack of investment in many commodity-producing economies. As prices have risen, the economic as well as strategic rationale points to increased future flows, many of which will be south-south, into energy, commodities, food and even virtual water, the latter as countries face up to water challenges by seeking to invest in and import water-intensive crops and even manufacturing as opposed to production at home. We expect to see patterns of outflows from China change, away from investment into US Treasuries and agency debt into investment in a wider range of assets. We expect more of these to be privately owned as China liberalises its capital account. We expect to see patterns of outflows from China change, away from investment in US Treasuries to a wider range of assets This too can be linked to currency issues. Passive diversification is already taking place, as countries build reserves and seek to place less of future funds into US dollars (USD). It is not active selling of the USD, and indeed a significant proportion of new funds still go into USD, but this ratio is likely to decline hence passive. The role of the state is likely to remain important in south-south flows. In the case of sovereign wealth funds this has led to dialogue to address issues, resulting in the Santiago Principles. Wider issues linked to the role of the state will persist, including those of commercial versus strategic and the need for transparency as opposed to opaqueness. Countries will need to diversify funding resources to finance rapid economic growth. This points to developing deep, efficient and reliable funding sources to keep pace with economic expansion. And, finally, on the policy side, the shift towards bilateral free-trade agreements has gathered such pace that it is unlikely to reverse, despite the lip-service paid to seeking a multilateral trade deal through the Doha round. The challenge that needs to be addressed through this proliferation of bilateral trade deals is that many are limited to preferential tax cuts on a limited range of products. Most make little headway in terms of non-tariff regulatory barriers, which impede regional integration. In turn, business The role of the state is likely to remain important in south-south flows can spend much time learning about and adapting to free trade agreements, thereby raising transition and business costs. In summary, the issue of south-south financial flows is likely to become increasingly important. It is a reflection of the shift in the balance of economic and financial power from the West to the East. A key aspect of this is the growth in new trade corridors, reflecting increased flows of goods, commodities, people and remittances and of portfolio and direct investment flows.

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Inclusive growth in the Middle East

Inclusive economic growth is a necessity for the Middle East and North Africa. Mark
This article appeared in the Financial Times A-list series of opinion columns web on site, the in newspapers Malloch-Brown.

Malloch-Brown rightly highlights the vital role of economics, although his conclusion that we should put "our money, or at least our loans, behind real change in the region" is only part of the answer. The biggest challenge in proposing economic policies for the region is that one size does not fit all. Not only are there wide economic differences, but the combination of social, political and religious issues means that potential solutions are complex. There is no easy or quick answer. Moreover, it is no use outside countries offering help unless local populations want it or need it. Ideally change must come from within. Given this, what region-wide agendas should be pushed?

response to an article by Lord

Policy needs to be geared to diversifying local economies

First, policy needs to be geared to diversifying local economies. There are growing young populations. Without jobs this demographic dividend could become a disaster. Youth unemployment is already the biggest regional problem. Diversification means boosting the service sector. Even the energy-rich nations need to recognise that their capital-intensive nature does not provide the much-needed jobs. They must diversify too. This is already happening in some countries. Diversification also means encouraging the private sector. The old economic model where the public sector was expected to provide graduate employment no longer holds. Second is the need for institutional change. Here the best help multilateral organisations can offer is technical assistance and co-operation.

There is need for institutional change

More money may help, but can create problems if they are not part of a wider reform. Take even the cash-rich Gulf countries. They have pumped huge sums into their economies. That is good, but now the break-even price of oil necessary to balance their domestic budgets is sky high. Even they can only pump in money for so long. For others, more money, in the absence of political reform, might be destabilising. Across Africa, for instance, money pumped into economies was mostly wasted because of weak governance, corruption and political instability. Thus institutional change is needed, not as an ultimate goal, but for any money spent to have a real impact. Third, inclusive growth can only be achieved with a vibrant domestic economy. This requires other features to be put in place, including social safety nets, more women in the workforce, help for small and medium-sized firms as they are key for job creation, and developing local financial markets to channel savings into investment.

Inclusive growth can only be achieved with a vibrant domestic economy

All of these take time, suggesting the need for patience and to manage local expectations. Given the need to keep everyone on side there is a case for economic plans with clear goals and measurable targets. Central to this would be a stable tax, regulatory and policy environment for business and a social contract between government and the people. With these changes in place, good economics may become good politics.

GR11MY 22 July 2011 | Gerard.Lyons@sc.com

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GR11MY 22 July 2011 | Gerard.Lyons@sc.com

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