OF SUBSTANCE AND SPIRIT
Two columns ago, we sounded the alarm about another ball in the air. This is the US Federal Board jacking up interest rates at least four times this year. We derived this conclusion from the IMF’s warning to emerging economies (EEs) earlier this month about the adverse implications of monetary tightening in the US due to the sharply rising prices and the labor market squeeze. EEs are particularly vulnerable because they have already been hit by rising inflation due to higher oil prices and disrupted supply chain.
Another dampener on the EEs is the extraordinary pile up of public debt due to funding requirements of pandemic mitigation and economic recovery. Bloomberg at the beginning of 2021 quoted the Institute of International Finance estimate of $19.5 trillion in 2020 alone. There was no alternative to borrowing, so it seems that Fed Chairman Jim Powell described it as a “bridge” across the economic chasm of lockdowns and lost jobs.
These gathering shocks are highlighted by capital reversal from the EEs which remain accommodative of growth through lower interest rates and weakening of their currencies. Unless we see a rethink of their macroeconomic policies, market confidence is bound to dissipate. Market jitters, in fact, have started to build up. Asia share prices are already showing signs of concern. Oil prices are now approaching $90 per barrel from a year-ago average of around $70.
That is not to be the end of causality. From the big economies to the EEs is just one way but from the EEs, there could be spillover risks to other EEs and developed economies, and extracting exorbitant costs to both parties.
This much is our take away from a very timely working paper released last December 2021 “Spillover risks from emerging economies’ loss of confidence: Insights from the G-Cubed model simulations” by the BSP written by senior economist Jean Christine A. Armas of its department of Economic Research.
Ms. Armas recognized that “given the increasing integration of emerging markets into the global economy, any shocks to their economies would inevitably have cross-border spillover consequences.”
Abstracting from the computation of the model used and the simulation results, the economic shocks that lead to loss of confidence subsequently gives a lift to the risk premia of various shocked EEs away from the baseline. This negativity affects economic agents’ risk premia so households, firms and even international investors would find it more expensive to borrow. The initial effect is output loss.
With higher risk premia, both a stock market decline and drop in foreign portfolio investment are likely. With currency depreciation, the real interest rate may rise. The real sector would be hamstrung by lower capital stock and investment. For rational households, they would have to reduce their consumption and increase their savings.
Almost the reverse happens in the non-shocked economies. With capital inflows from the shocked EEs, risk premia and real interest rate go down, stock market perks up. Output grows but only in the short run. With wealth effects, rational households scale up their consumption while saving goes down.
The BSP working paper also dwelt on the trade and commodity impact which amplifies the domestic and cross-border effects of higher risk premia. This channel illustrates the increasing trade partnership between shocked and non-shocked economies. The financial negatives of the shock to the EEs are exactly their positives in trade. Currency depreciation brings about greater external competitiveness, mitigating both their trade and current account positions.
Now, here’s the rub for the non-shocked economies. If they were the recipients of everything that was good in the initial phase of the adjustment, this is not long-lasting. First, we see the shocked EEs’ effective demand diminishing, commodity prices dropping and the terms of trade faltering. Next, their output growth slows down and public finance may run into trouble because revenues are also commodity-dependent.
But the spillover effects to the non-shocked economies are not something they can simply brush off. As their currencies strengthen, they also lose big on their trade and current accounts.
The BSP paper clarifies that “financial markets and trade channels act as important stabilizers for both shocked and non-shocked economies where the negative financial capital outflows in emerging economies are tempered by a temporary improvement in their trade balance.”
What we also like about Ms. Armas’ paper is her suggestion that managing risks should remain the more important concern of the authorities, rather than focusing on regulation of cross-border capital flows. There is some beauty in the usual stabilizing adjustment process in the trade and capital markets. Our authorities need to be ever vigilant and conscious of any potential threat to market confidence and risk premia.
In the Philippines, this calls for attentive ears to the other day’s IMF downgrade of global and ASEAN growth forecasts for 2022, based on the analysis that “as advanced economies lift policy rates, risks to financial stability and emerging markets and developing economies capital flows, currencies, and fiscal positions — especially with debt levels having increased significantly in the past two years — may emerge.”
We cannot afford the same blunder in managing the pandemic.