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Has global recession arrived?

V. Ananth-Nageswaran

THE ANSWER must be yes, if recent headlines are any indication. Last Friday, The Economist (August 25, 2001) put recession on its cover and this Friday, it was the turn of Japan. The juxtaposition is hardly an accident. Japan defines the issue. Independe ntly, Financial Times got a leaked copy of the World Economic Outlook of the International Monetary Fund which is not due for release until some weeks from now.

The IMF had reduced its global growth forecasts for 2001 to 2.8 per cent from the previous estimate of little over 3 per cent. With eight months of the year behind us, it is little more than an extrapolation of the trends and not so much a forecast. By I MF yardsticks, global growth rate of about 2.5 per cent amounts to recession. This report was all about warning the policy-makers in leading economies that, in IMF's opinion, we are not too far off from a global recession, if we are not already in one.

Intense pressure on Japan

The `leak,' in the author's view, must have been a deliberate ploy on the part of the world's leading power. It cannot be seen as openly dictating (though that is what it did to Japan for the most of the 1990s and to no effect) to Japan its macro-economi c policy and hence, perhaps, is exerting pressure through other innovative means. Hence, the leak and the IMF's downward revision to its global growth estimate for this year have a strong policy dimension about them.

This column too has said in recent months that a lot depended on Japan, and had gone on to argue that, more than at any other time, there were reasons to hope that Japan would take decisive action. The premise was based on (a) the Prime Minister, Mr Juni chiro Koizumi, elevating reforms to the top of his agenda, and (b) the inescapable truth that Japan is fast running out of options.

However, hopes appear to have been belied. It is more than a month since Mr Koizumi won the Upper House elections for his Liberal Democratic Party on the strength of his personal appeal and yet, little by way of concrete policy action has emerged. Worse, Cabinet members and the Prime Minister talk in different tones. One wanted the central bank to adopt an inflation target only to find the Prime Minister shoot down the idea.

`Guilty' verdict on Bank of Japan

That brings us to Mr. Hayami, the central bank governor. Until very recently, he had steadfastly denied that the deflation that is endemic in Japanese society is due to lack of demand. He attributed it, amazingly, to positive restructuring and productivi ty improvements. In a speech last week, however, he admitted that deflation was due to weak private demand. If that is the case, he has a lot of explaining to do for his relative inaction all these years?

In any other country, probably, his sado-masochistic monetary policy stewardship would not have lasted this long. The Economist (September 1, 2001) in its leading editorial piece calls upon Mr Koizumi to take a strong personal interest in money supply. I t brooks no delay.

Inflation targeting is the most viable policy option

It is possible for the Bank of Japan to adopt a formal medium inflation target of about 2 per cent and declare that it would boost money supply until the whites of inflation pop out. A new study by Frederic Mishkin and Klaus Schmidt-Hebbel, National Bure au of Economic Research, July 2001, One decade of inflation targeting in the world commends this monetary policy objective as being better than (or less costly) than other alternatives.

The Economist,characteristically, argues that central bankers may have to explicitly reckon with other variables such as the exchange rate and asset price inflation. It has over the years consistently argued that central bankers weight asset prices in th eir monetary policy decision model. It has done so especially in the context of the US stock price bubble that emerged in 1999 and in the early part of 2000.

Mr Greenspan's legacy hangs in balance

Of course, it is easier said than done. The Fed chairman, Mr Alan Greenspan, has argued that a bubble is always recognised after it bursts and not before. Ever loyal to the philosophies of Ayn Rand, he had openly questioned the wisdom of substituting the judgment of few individuals in the central bank for the judgment of the market. Persuasive though it might have been for the Chicago School of Economics, it is by now well-accepted that financial markets are prone to alternating cycles of greed and some what worryingly, these alternating cycles have proved to be more frequent and more volatile than before.

Furthermore, having openly wondered whether markets were not vulnerable to irrational exuberance in December 1996, he left the monetary policy relatively stable throughout 1997 and 1998 (save for a rate hike in March 1997) until the Russian default and t he LTCM crisis struck financial markets. Now, if the US economy remains in doldrums even in 2002, many would question his stewardship of the economy and his failure to take asset prices into account, especially in 1997 and 1998, would come under sharp cr itical scrutiny. They would argue and with some justification that he had failed to smooth the path of the economy.

But, then, monetary policy making in the US faces an added complication of the Fed being reckoned the global central banker of sorts. Hence, in 1997 and 1998, Mr Greenspan's reluctance to tighten policy could have stemmed from the onset of financial and economic crisis in Asia. In the final analysis, it is easier to be outside and critical, than to be inside and decide.

The Fed chairman did not use the opportunity he had in the Federal Reserve annual symposium in Jackson Hole, Wyoming on Friday, to speak about the current state of the economy. Since the Federal Reserve dropped the funds rate to 3.25 per cent in August, equity prices have declined further. Financial markets were looking for a shoulder to cry on. He did not lend his and devoted his speech to the issue of how the wealth effect influences consumption decisions.

Preliminary findings of ongoing research at the Fed, as he chose to put it, point to realised capital gains having more of an influence on consumption decisions than unrealised capital gains. Per contra, could it mean that unrealised capital losses do no t lead to a severe retrenchment of consumer spending? Experience this year seems to confirm such a hypothesis. However, in July, personal income rose 0.5 per cent whereas personal spending rose only 0.1 per cent, resulting in a reasonably high monthly po sitive personal savings rate.

If this is the beginning of a trend, then discretionary fiscal policy has to be loosened further. The US government would be right, under the current circumstances, to relax fiscal policy further and not be overly concerned with fiscal surpluses as the E urope is, with its stability and growth pact that puts a fiscal straitjacket on European governments even during cyclical downturns.

Now, asset prices are not a hindrance for the Bank of Japan to ease policy further. If any, even asset prices call for more decisive monetary policy expansion as the Nikkei 225 index has slid below 11,000 and appears poised to break below 10000 as well. There is some sort of a catch-up here between the Nikkei 225 index, the Dow-Jones Industrial Average and Hong Kong's Hang Seng index.

The unrelenting slide in the Nikkei has naturally adverse implications for the health of the financial sector. Banks find their direct holdings of share prices marked down as well as the value of their collateral. The bad is getting worse. Japan has clea rly no more time to lose and some action has to emerge in the next fortnight.

ECB eased but can do more

It is in this context that the decision of the European Central Bank (ECB) to lower its short-term policy rate by 25 basis points almost comes as a relief, for it came after a day of confusing rhetoric from the German Bundesbank President, Mr Ernst Welte ke. Financial markets would have fared worse than they did had the ECB chosen to remain passive. Though the ECB did not give any hint of its policy bias in the press conference that its President held after the meeting, it is likely that it would ease at least one more time, if not further. European short-rate futures and short-dated bonds are priced for further policy ease from the ECB.

In the next few weeks, the world needs to see more drastic and decisive action from the Japan Government and the Bank of Japan. Room for further action from the Federal Reserve is limited and the ECB is, by habit and by constitution, likely to move slowl y. Hence, the burden falls on Japan and its record gives rise to concern and not hope. The world is waiting with a prayer on its lips.

Dollar likely to remain under pressure

As investors began to worry about the global downturn, the dollar concurrently began to slide against most currencies including, perversely, the Japanese yen. Next week should see some intervention from the Bank of Japan, as it is openly concerned about the yen hovering below 120 against the US dollar.

In the meantime, though long-term fundamentals still argue for the dollar holding its own against global currencies, it is likely to remain under pressure against the euro and the yen, as long as global risk appetite is weak. This is nothing new. It happ ened in 1998 between July and October when the dollar slid precipitously in value against the German mark and the Swiss franc, for example.

The US dollar domestic high yield bond spread to the 10-year Treasury note is admittedly a crude proxy for global risk aversion but it suffices. Higher the spread, higher the risk aversion and vice-versa. It is clear that whenever the spread is high as i n 1994-95 and again in 1998, the dollar weakens and when the spread drops, the dollar strengthens as in 1993 and between 1995 and mid-1998.

The spread had begun to widen again (the tail of the thicker line turned up towards end-July and has continued to rise in August and so has the dollar but in the opposite direction. However, once the global environment improves (the timing remains uncert ain yet), the dollar would find its feet. Over the medium-to-long-term, it is still an uphill battle for Europe to establish its superiority over the dollar.

An extract from the article by Martin Wolf, a reputed columnist in Financial Times, is a useful place to start and sets the stage for a detailed exploration of the issue in my next column: ``...This, in turn, bears on the last question: what is the poten tial economic role of the euro-zone? Can it be a pole of growth and source of dynamic demand, as the US has been over the past few years? It looks unlikely... Monetary and fiscal stability, though important, are not enough. Economies must also embrace ch ange. Maybe, this is now beyond much of Europe. If so, what is happening this year is more than temporary and, in itself, relatively unimportant event. It is a harbinger of a feeble future for a senescent continent.''

(The author is the Regional Head of Investment Consulting in Credit Suisse, Asia-Pacific. These are his personal views. Feedback is welcome at nageswar@singnet.com.sg)