Facing the global heat

Global central bankers had colluded last week to reset monetary policy to meet the threat of recession and deflation. European Central Bank had cut its basic policy rate by 25 basis points. The same day, the Chinese central had also cut its interest rate as much. Earlier, the Federal Reserve of USA had continued its easy money policy and further injection of liquidity into the system through its 'Operation Twist'.

These moves are meant to kick start the growth process in the stagnating economies. However, the situation in Europe and advanced economies is quite different from that of China.

In the advanced economies, there are three fundamental problems. First is the problem of distressed banks. It started in Ireland and Iceland and now has spread to many other countries, the latest being Spain. The second problem is that of excessive government debt and threat of default by sovereign borrowers. The scene here is dominated by Greece. The third problem is the dire possibility of renewed 'market attack' on smaller and weaker economies in the west. This was raised by the eminent economist turned politician, prime minister Mario Monti of Italy.

These three problems are of course not separate and they are intertwined. One problem feeds into the other. Thus, to help the distressed banks, national governments have refunded them or shored up their capital base. This affected their debt situation. On the other hand, distressed government situation threatens solvency of banks which have exposure to these governments.  

Faced with these threesome issues, countries have generally embarked on austerity drives, This has further complicated matters and austerity resulted in lower spending and lower demand in the domestic markets and thereby resulted in shrinkage of their economies. In turn, this further raised their debt burden. The newly elected French president, Francois Hollande, therefore gave a call for renewing EU’s strategy into giving a push to growth drives and not emphasise austerity.

The central banks’ decision to cut interest rates should be viewed against this background of the shift in the strategy for tackling the crises in Europe. It may be recalled that the European leaders had launched a growth pact for pushing up economic growth in Europe.

However, the question is will cuts in interest rates bring about any change and give a fresh push to growth impulses. Will cut in interest rates encourage consumption in the advanced countries, as it is supposed to do?

And here is the glitch. Because the prevailing interest rates are so low in the advanced economies that cuts have become meaningless. With the current cut in interest rate, the basic interest rate in Europe comes close to zero. In effect, the real interest rate in the advanced economies of Europe is negative. This is how.

The inflation rate in the advanced economies is slightly above 2.5 per cent, against which policy interest rates are around 0.75 per cent – so that you have a situation where you pay lower interest on your borrowings than the inflation rate or the rate at which your savings are depreciating. Since, countries are at the same time, releasing fresh liquidity or cash into the financial system, here is a situation of what economists call a liquidity trap. That is where cuts in interest rates could become a non-event and therefore interest rate ceases to be an instrument for influencing decision making.

Once again, by doing these changes, European economy managers are trying to deflect attention from some fundamental structural issues. It is becoming increasingly apparent that Greece, for example, cannot be perpetually bailed out. The country is again looking out for some help. However, for countries like Greece, the real option should be to get out of the Euro system, face the consequent changes and make a come-back through the hard way. That would be the market driven approach for restructuring the Greek economy rather than seeking aids from other members of the Euro.  

For the Euro system also to survive, it must now be able to devise ways of allowing orderly exit. All members of the Euro cannot carry on within the Euro system without serious repercussions for all members. Either Euro countries must coalesce into a single fiscal entity and follow a virtually common budget than carry on within a loose currency union only.

For China, the issues are yet again very different. China is gradually slowing down, although even at its slow pace its remains one of the fastest growing economies. However, China is facing increasing heat. China is facing serious problem in keeping its massive production structure working in the absence of global demand for its products as previously. As its exports are facing shrinking market, China’s productive units are finding it difficult to maintain their production tempo. This is because China had altogether ignored domestic demand.

By curtailing interest rates – which it has done once before within a month –China is trying to encourage domestic spending and consumption. However, its high savings rate is a structural factor which cannot be changed all of a sudden.

Besides, Chinese authorities have created such huge production capacity, that even if domestic consumption increases, the overall capacity cannot be engaged. Take for example, Chinese steel production capacity. At over 600 million tonnes China has world’s largest production capacity and it is not able to consume that much steel. Inevitably, China tends to dump its steel all over. With recession in the west and similar conditions elsewhere in the emerging and developing world, China is therefore hard put to even dump its steel or other products which it produces in far excess.

If anything, some of these fundamental imbalances and issues will have to be sorted out before the global economy can again look forward to smooth sailing.
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