Friday, 20 August 2010

It’s easier to get into debt than out of debt


THE G20 has agreed at the Toronto Summit in June that their government deficits would be halved by 2013 and that their total debt levels would stabilise by 2016.

The position between the G20 advanced and emerging members could not have been more telling. In terms of growth, the emerging countries are averaging more than 6% per annum, whilst advanced countries are lucky to achieve more than 2%.

In terms of deficits, advanced G20 countries are running deficits at just under 9% of GDP, whilst emerging markets are running under 4%.

In terms of debt overhang, advanced countries have debt over 100% of GDP, whereas the emerging markets have debt less than 40% of GDP. There are two major reasons why the deficits and debt have run out of control for the advanced countries.

The first is the huge amount the advanced countries spent on bailing out their banking systems.

The second is the rising level of health care as their population ages. The emerging markets did not have the large banking crisis costs and their health care costs are lower due to their younger population.

What should the advanced markets do to get out of the debt? The Japanese again demonstrate how difficult it is to get back to fiscal rectitude.

In 1996, the Nakasone Government decided to try and rein in the fiscal deficits and raised the Valued Added Tax.

This plunged the Japanese economy back into a recession and the first failures of Japanese banks were the precursors to the Asian financial crisis of July 1997.

So, it is so much easier to print money and get into fiscal deficits than it is to reduce the debt. I must take my hat off to the new UK government for being brave.

In one of the most drastic spending squeezes of any country in recent memory, the new Chancellor of the Exchequer (British Minister of Finance) cut spending up to 25% for most government departments by 2014-15. He increased the VAT to 20% and imposed a US$3bil levy on the banking system. The area he did not dare to touch was cuts in the health expenditure.

Of course, the new Chancellor could easily blame the large deficits on his predecessor and hope that the spending cuts would restore market confidence in the UK and sterling.

He knows that if the markets lose confidence and the yield on UK government bonds increase, the rise in debt servicing would make the recovery even more slow, with stagflation as the most likely outcome.

Sterling could also suffer more devaluation, which could hurt inflation and also investor confidence in London as the premier global financial centre.

With a bold approach, private sector would invest and the UK economic recovery would come sooner than the other (less brave) advanced economies.

Unlike the Euro-zone countries, the UK can devalue its way out of a recession, since sterling has already depreciated nearly 25% from its peak.

Of course, if the UK economy is much more dependent on fiscal spending than previously thought, then the £40bil cuts would cause the economy to slow further, causing rising unemployment and in turn worsen the government finances.

No one knows how tough it could be to turn around a slowing economy. The G20 Summit papered over major differences between the key countries.

There was no mention of any agreement on specific bank capital increases, other than the language that bank capital should be kept at a level sufficient without further government intervention.

Furthermore, the US, Germany, UK and France back levies on the banks to pay for the crisis, whereas Canada, Brazil and India which did not suffer from bank losses, did not support any levies.

US Treasury Secretary Tim Geithner was right in that he pushed for growth to lift everyone out of further slowdown, as there is some fear that a double dip was in play. Germany, for example, is keen on austerity since it knows that as a major surplus country, it will have to bear the brunt of any adjustments in Europe and globally.

With almost all advanced countries having to deal with austerity, the only countries that have room to grow are the emerging markets. The emerging markets happen to have a different expenditure pattern from the advanced markets.

In the next two decades, the emerging markets will struggle with improving their infrastructure, because this was an area of gross neglect that the aid money and World Bank financing were cut back since the 1990s.

For example, in the last two decades, the World Bank switched resources out of infrastructure lending towards more lending for macro-economic and social spending.

This meant that project engineers were reduced in favour of macro-economists. Just when the emerging markets needed good advice on the viability and feasibility of infrastructure projects, the bank does not have enough project experts to advise them.

The real issue facing almost all emerging markets is where to put the scarce fiscal expenditure.
How do we get “more bang for the buck?”

It is very easy to increase non-growth generating expenditure, such as government debt interest servicing, military expenditure and more on bureaucracies.

In a time of scarcity, it is vital that governments spend money that will generate growth and employment.
This is exactly when spending on the rural infrastructure and raising rural income can change the mix of production from exports to domestic consumption.

Hence, it is only right that the recent World Bank capital increase accommodates more equity share by the emerging markets.

Given that most governments would be wary of cutting back the fiscal debt too quickly to hurt the growth recovery, one can be sure that a large fiscal debt overhang will be with us for quite a while yet.

The real fear is not too much debt, but that rising inflation and higher interest rates make the fiscal debt unsustainable.

The risk of that is not that high, but it is also not zero. The financial markets today are exactly reflecting the nervousness about the future.

Tan Sri Andrew Sheng is adjunct professor at Universiti Malaya and Tsinghua University, Beijing. He has served in key positions at Bank Negara, the Hong Kong Monetary Authority and the Hong Kong Securities and Futures Commission, and is currently a member of Malaysia’s National Economic Advisory Council. He is the author of the book “From Asian to Global Financial Crisis”.

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