In explaining the differences between internal and external balances I came across an old textbook that I used at University – Economics by David Begg. It was described as ‘The Student’s Bible” by BBC Radio 4 and I certainly do refer back to it quite regularly. Part 4 on macroeconomics has an informative diagram that shows the impact of booms and recessions on the internal and external balances.
Internal Balance – when Aggregate Demand equals Aggregate Supply (potential output). And there is full employment in the labour market. With sluggish wage and price adjustment, lower AD causes a recession. Only when AD returns to potential output is internal balance restored.
External Balance – this refers to the Current Account balance. The country is neither underspending nor overspending its foreign income. For a floating exchange rate, the total balance of payments is always zero. Since the balance of payments is the sum of the current, capital, and financial accounts, saying the current account is in balance then also implies that the sum of the capital and financial accounts are in balance.
The top left-hand quadrant shows a combination of a domestic slump and a current account surplus. This can be caused by a rise in desired savings or by an adoption of a tight fiscal policy and monetary policy. These reduce AD which cause both a domestic slump and a reduction in imports.
The bottom left-hand corner shows a higher real exchange rate, which makes exports less competitive, reduces export demand and raises import demand. The fall in net exports induces both a current account deficit and lower AD, leading to a domestic slump.
In a downturn a more expansionary fiscal and monetary policy can hasten the return to full employment eg. Quantitative easing, tax cuts, lower interest rates. However one could say that today it doesn’t seem to be that effective.
Here is graph from the recent Westpac Bank Economic Overview. It shows how closely correlated the New Zealand and Australian economies are with regard to the % of GDP from the quake related reconstruction in New Zealand and the iron ore boom in Australia.
The Canterbury rebuild will peak around late 2016 and into 2017 although growth after this point will be fairly subdued. The falling exchange rate and lower interest rates will act as a buffer but the dwindling rebuild with become a drag on GDP in New Zealand.
Australia has also experienced a slow down with a reduction in mining construction amid falling iron ore prices. To stimulate growth the Reserve Bank of Australia has cut the cash rate from 4.75% to 2.0% and the Australian dollar has fallen about 30%. However high unemployment and low business and consumer confidence have been prevalent in the economy and growth prospects are very modest for the next few years. This is similar to what New Zealand can expect.
The growth and stability concerns about China and emerging economies have been well documented in the media of late. So why have these economies grabbed the attention?
According to the IMF emerging and developing economies (E&DE) have grown at more than twice the pace of advanced economies since 2000. The chart below shows that E&DE overtook Advanced Economies in terms of total output in 2008, and at the end of 2014 accounted for about 57% of global output. Advanced economies were the remaining 43%. Back in 1997, when Asia had its currency crisis, E&DE accounted for a lesser 42% of global output.
However concerns in E&D economies have been observed and they include:
1. Their economies have more government intervention and are less driven by the market
Although market forces don’t always result in good outcomes – GFC being a prime example – history suggests that markets are better at allocating factors of production like labour. The IMF and the Federal Reserve are of the belief that a significant amount of capital has been misallocated in emerging economies e.g. an underperforming State Owned Enterprises and a overvalued housing market in China
2. There is less transparency in government policy in that the exact reasons for actions are not obvious. The recent devaluation of the Renminbi caused a lot of uncertainty in markets. Was it a genuine devaluation to try and boost exports?
3. There are concerns over financial stability. If the US Federal Reserve hike interest rates the cost of funding for some countries will rise – Brazil, Turkey, Malaysia, and Indonesia to name a few.
A Positive Outlook – Continued Growth for Decades.
China continues to embrace market reforms; market reform has been a priority since the ruling Communist Party’s “Third Plenum” meeting in late 2013.
Many emerging economies have good support structures for their financial systems
Many have large amounts of FX Reserves – although the likes of Russia and Malaysia have already spent a good portion of their reserves in recent months supporting their exchange rates. China also retains considerable monetary and fiscal flexibility – although less than was the case during the 2008 financial crisis;
A final reason to be hopeful is that Emerging and Developing Economies “potentially” have a long way to run in terms of their development. The chart below shows that in 2014 the IMF calculates E&DE GDP per person was just 22% of those in advanced countries. If E&DE continue to evolve positively – not assured as the “middle income trap” experiences detail – then growth rates in these countries should broadly remain strong in the decades ahead.
Source: National Australia Bank – Australian Markets Weekly – 31st August 2015
A HT to my good friend Kanchan Bandyopadhyay for this piece in ‘The Times of India’. Amid the global economic gloom, triggered by a slowing Chinese economy, most economists maintained that India’s growth prospects were brighter than those of other emerging markets. Here are a list of reasons:
1. GDP growth estimated at 8% in 2015-16. India considered a bright spot in global economy
2. Improving industrial output: Up 3.8% in June compared to 2.5% in May
3. Healthier government finances: Improved tax collections, led by indirect tax growth of 37.6% during April-July Lower subsidy bill due to falling oil prices; expected savings may be around Rs 1 lakh crore
4.Inflation, both retail and wholesale, under control. Retail inflation estimated at 3.8% in July; wholesale inflation at -4.1%, the ninth straight month of contraction
5. Better than expected monsoon rains; deficit of around 11% but distribution has been encouraging
6. Lower trade deficit due to a fall in import bill for crude petroleum, gold
7. Current account deficit appears more manageable at 1.3% of GDP in 2014-15 compared to 1.7% in 2013-14
8. Forex reserves at a record $355 billion
9. Early signs of increase in investment
10. Healthy demand in consumer sectors, uptick in consumption
Here is a very informative graphic – The Elephant v The Dragon.
I have mentioned the resource curse in previous posts especially those countries with natural resources. Below is an extract from a previous post.
Africa may have enormous natural reserves of oil, but so far most Africans haven’t felt the benefit. In Nigeria, for instance, what’s seen as a failure to spread the country’s oil wealth to the country’s poorest people has led to violent unrest. However, this economic paradox known as the resource curse has been paramount in Africa’s inability to benefit from oil. This refers to the fact that once countries start to export oil their exchange rate – sometimes know as a petrocurrency – appreciates making other exports uncompetitive and imports cheaper. At the same time there is a gravitation towards the petroleum industry which drains other sectors of the economy, including agriculture and traditional industries, as well as increasing its reliance on imports.
For New Zealand it seems to be working in reverse. New Zealand’s biggest export earner is dairy and with prices dropping by 23% since last year and the outlook of continued monetary easing from the RBNZ the dollar has dropped from US$0.77 on 27th April to US$0.67 today – a level not seen since 2010.
However, going against what the resource curse suggests, the weaker exchange rate will provide extra revenue for exports like the tourism industry which has been enjoying high numbers especially from Asia. Furthermore, there have been suggestions that it could surpass the dairy industry as the biggest earner of export receipts. There are further benefits for domestic companies competing against imports as the weaker dollar makes competing overseas goods more expensive relative to those produced in New Zealand.
It’s just the latest soft economic data point to come out of the country, which has been dealing with rising unemployment, inflation, and a weakening currency as its economy shrinks. The serious threat of stagflation is imminent.
“We’re running out of words to describe just how bad conditions are in Brazil’s industrial sector,” Capital Economics said in a note to clients. “The fall in production in April means that industry has now contracted in five of the past six months and that output has returned to the same level it was at the start of 2007.”
The Brazilian economy is in urgent need of sustained growth.
Unemployment – 6.2% and rising .
Growth – quarterly increase is around 0.3%
Investment and consumption is falling
Inflation at an 11 year high of 8.17%.
Source: The Economist
The Reserve Bank in its November Financial Stability Report noted four key risks that New Zealand’s financial system faces:
* high levels of indebtedness in the dairy sector
* the imbalances in the housing market,
* the potential effects of a slowdown in the Chinese economy,
* the banking systems reliance upon offshore funding.
Since the Financial Stability Report was published, risks in the dairy sector have increased due to the reduction in the current season’s forecast payout. International dairy prices are about a third less than they were a year ago, as a result forecast sector returns for the 2014/15 season are much less than the previous season. Fonterra’s latest Global Dairy Trade auction undertaken in early May reported a further 3.5 percent fall in international dairy prices on a trade weighted basis. The Reserve Bank warns that forced sales of farms could rise if dairy payouts remain low, though farmers would go to great lengths to keep paying their loans. Many highly indebted farmers are facing negative cash flow and lower milk prices will only accentuate the problem.
The graph below shows the actual milk price payouts for the largest New Zealand dairy companies for the last five seasons, along with the forecast payout figure for the current season.
Source: Monthly Economic Review May 2015 – NZ Parliamentary Review