Hans Timmer's blog

As Greece’s debt crisis escalated, analysts and the media have so far mostly focused on possible spillovers to countries in Southwestern Europe and on weakening of the euro.

It is striking that for weeks, financial markets have not been exceptionally worried about strong contagion to emerging economies, even though there are vulnerabilities in emerging Eastern Europe and European banks are heavily invested in emerging economies all around the world.

So should financial markets be more worried? For now, the credit quality for most developing-country sovereigns have held up and indeed improved in 2010, with 15 upgrades and only 2 downgrades (as of end April 2010). This is another example of how, compared to 10 years ago, the source of economic problems and risks are shifting from developing to high-income countries. But will this resilience last? How susceptible are developing countries when the European turmoil continues?

To enable closer monitoring of spillovers from the Greek debt crisis to market sentiment across the globe, the Prospects Group constructed a so-called "contagion monitor" for internal use. Using daily data for 60 countries (31 high-income, 27 middle-income, and 2 low-income countries), the contagion monitor combines: changes in sovereign spreads; changes in domestic 3-month commercial interest rates; changes in stock-market indices; and changes in nominal exchange rates into a single  indicator that summarizes "market deterioration".

Each of the four indicators has been normalized (i.e. they are measured in deviation from the average change and divided by the standard deviation of those changes) to ensure that the four building blocks have a comparable contribution to the combined measure. The normalization also carries other advantages. For example, it makes exchange rate changes independent of the numeraire currency.

It is important to note that the resulting index:

• shows relative deterioration (if all countries experience the same worsening in the financial markets, the index will show no change for all countries);
• only measures recent changes in the markets, not the overall shape of financial markets. A country can still be vulnerable even if markets improved in recent weeks;
• is, unlike vulnerability indices, not designed to have predictive power. Instead, it registers changes in market sentiment that have already taken place.

There is no need in this blog to focus on individual countries (this is an attempt to observe the market, not to influence it….). But, taking end-March 2010 as a reference point for changes in financial indicators, a very interesting pattern emerges. I invite you to click on "play" in the beautiful illustration below, designed by David Horowitz.

 
The dynamic bar chart shows the relative deterioration in financial markets, with high-income countries in gloomy blue and developing countries in fresh green (but don’t read too much into the color scheme). Downward pointing bars show the relative deterioration of financial markets since end-March. The longer the bar, the worse the relative relapse. Upward pointing bars indicate relative improvement.

In early April the deterioration was almost completely concentrated in high-income countries. Almost without exception, developing countries were on the positive side of the spectrum. That remained the case throughout April.

But in May the situation started to change. A few developing countries showed pressure on their currencies, upward pressure on their interest rates or drops in their stock markets. And that only got worse as May progressed. The latest observation in the chart shows a much more equal distribution. That is partly because the situation in Europe has cooled down somewhat, but partly also because we can no longer assume that emerging countries are unaffected by Europe’s debt problems. It is one of the clearest signs yet that traditional fiscal stimulus has reached its limits and is increasingly becoming part of the problem instead of the solution.

European airports have finally reopened after ashes from Iceland's Eyjafjallajokull volcano shut down Northern Europe’s airspace for 5 days. This unprecedented disruption in European air travel (which isn’t over) highlights two interdependencies in today’s world:

• First, just-in-time logistics have become really global. Not only did the flight cancellations hit travelers from all over the world (for example, the World Bank put 150 staff who were stranded in Europe on buses to Madrid so they could fly to Washington in time for the Spring Meetings), but more striking is that already, about 1 million flowers in Kenya had to be destroyed. A quarter of all flowers in Dutch florists come from countries like Kenya, Ethiopia, Ecuador and Israel. And now also Kenyan flowers are being flown to Madrid to be trucked to Northern Europe. Moreover, within days, cell phone makers in Asia ran out of components that normally arrived just-in-time by air.
• Second, to stretch the argument a little, the European economy has been hit by a series of diverse shocks in small economies, which illustrates the diversity and interdependence within Europe itself. Iceland, with a population of around 300,000, caused a fallout in the rest of Europe with its banking collapse in October 2008. The double digit contraction of Baltic economies in 2009 and the current debt problems in Greece are other examples of the diverse shocks in the periphery of Europe that triggered questions about the desirability of bailouts by the center. Similarly, in the current situation some have already raised the possibility of support for the airline industry.

As has become a custom, economists are already estimating the impact on GDP of the ash cloud. The most plausible conclusion of those exercises is that the impact on GDP will be in terms of decimal points. While certain activities are disrupted, other activities are stimulated. And, unlike other cases of airline disruption (Avian flu, 9/11), it is unlikely that this volcanic disruption will cast a cloud over confidence indicators.

That doesn’t mean that we shouldn’t be worried about European GDP or that the question of when Europe will rise from its ashes is an irrelevant one. The origin of that question is just much broader, and unrelated to the volcano eruption. Europe was hit by the global crisis much harder than the United States, and more importantly, the recovery is more subdued (see graph).

Among the reasons behind this dismal performance are the European economy’s heavy reliance on the banking sector and the vulnerability of many countries in emerging Europe. According to many forecasts, including ours, European GDP in 2011 is expected to be still below its 2007 level. For sure, Europe will recover, but the recovery is way too slow. But perhaps we should not be that impatient. The Arabian Phoenix continued to rise from its own ashes in a 500 year cycle...

I am this week at a Sustainable Development retreat sponsored by the World Bank’s Sustainable Development Network and run by the University of Cambridge Programme for Sustainable Leadership. 

The focus is on environmental sustainability. So far, we’ve heard many speakers from diverse backgrounds. It was fascinating to see how everyone used the need to avoid environmental degradation (including climate change) to strengthen their core business.

“Green geeks” in advocacy groups see the threat to the planet as a trigger to change economic paradigms. Businesses see sustainable development as an effective marketing campaign to improve their bottom lines. Urban planners plan on changing the world by innovating cities.

Although it might seem like it, these are not selfish approaches to big global problems.

Sustainability isn’t something outside of what people are already doing; but it requires that everybody takes new constraints into account in their core businesses. They use their comparative advantages, let incentives unleash innovation, and come up with creative solutions. 

That realization is important for the World Bank. There is no contradiction between our core objectives (alleviating poverty through fast development) and sustainability.

Fast development creates the dynamics, the technology, and the income to find solutions required for sustainability.

The fastest growing countries are coming up with the most advanced ways of saving energy at the moment. China is experimenting with clean transport systems, and Indian IT companies are tracking their impact on the environment. The fast growing parts of the developing world are most concerned about sustainability, because they want to ensure that their development path can continue into the next decades. Once externalities are better priced, then the rate of innovations will only speed up further.

To answer my title question: There is no real development without sustainability, and there is no sustainability without development. It’s like asking, are sports cars fast?

I’ll end this postcard from this beautiful English town with this week’s highlight: a visit to the British Antarctic Survey, where scientists showed us ice columns about 3km long that gives them a look at 800,000 years of climate history. Together with the aquarium (where they keep fish that live in the Antarctic seas, living a much slower life than tropical fish) this is a fascinating place to visit if you have the opportunity.

The Economist this week led with this subheader: Action on climate is justified, not because the science is certain, but precisely because it is not. The underlying argument is that immediate action is akin to taking an insurance policy—you can’t wait until you have hard evidence in hand, because by that time, you can no longer protect yourself against a catastrophe.

This stresses an important point that nevertheless is often forgotten: Policy makers always make decisions under uncertainty. Only under special circumstances can they assume certainty equivalence, which would allow them to ignore uncertainty around central projections. But in most cases optimal decisions cannot be based solely on a central forecast. The character of decisions can change dramatically if uncertainty has to be explicitly taken into account. For example, it might be optimal to opt for policies that work relatively well in all possible scenarios. These are so-called no-regret policies. Or it can be optimal to follow cautious policies that prevent extreme scenarios. Taking uncertainty into account can also lead to the conclusion that you have to act soon (to prevent extreme scenarios) or, on the contrary, that it is optimal to postpone decisions (until uncertainty is reduced).

The challenges associated with uncertainty go far beyond these examples of optimal government policies. I realized that last week when I joined the final session of the workshop Economic and Environmental Consequences of Large-Scale Biofuels Expansion, organized by Dominique van der Mensbrugghe and Govinda Timilsina. The workshop brought together research that was sponsored by the Knowledge for Change program and based primarily on simulations using our ENVISAGE model (Environmental Impact and Sustainability Applied General Equilibrium Model).

The workshop focused on the economic viability of biofuel production, on the consequences for food prices, and how that all would be influenced by changes in policies and changes in oil prices. The closing discussion stressed the crucial role of uncertainty. Even if biofuel production is on average economically viable, there might be significant periods during which production is not profitable. Even if in the long run biofuel production does not threaten food supply, it can do just that in the short run. 

I came away with two conclusions from that discussion. First, governments should not only take uncertainty into account when they design their policies, but they should also aim to reduce uncertainty for other agents by making their policies stable and predictable. Second, modelers should try to deal better with uncertainty. Not only by designing alternative scenarios, but also by exploring how unpredictable short-run volatility can influence individual behavior and market behavior.

So, uncertainty is a call for action, not only for policy makers as The Economist rightly observed, but also for modelers.

For the third day it is very sunny here in Washington DC, after we had our fair share of rain over the weekend. Spring is coming and the popular saying that “after the rain comes the sun” is once again firmly confirmed.

The economic equivalent of this saying might well be “after destocking comes restocking”. Destocking was a crucial factor in the collapse of production during the crisis, as it is during every recession. And restocking is a key element during the recovery, albeit in a complicated way. So, it is not a surprise that the world economy is waiting for that restocking.

As demand fell, and uncertainty increased, inventories were sharply reduced during the crisis. That meant that producers met part of the remaining demand by depleting stocks. As a result, production fell much faster than demand.  Partly because of the destocking the rain turned into a torrent.

From there on the inventory dynamics became (as usual) a bit more obscure, but actually quite fascinating. Even as the rundown of inventories continued, the negative impact on production growth quickly dissipated. That is always surprising, but the explanation is based on a simple mathematical rule: growth of production depends on the change in stockbuilding, or the change in the change of inventories. If the inventories continue to fall, but at a more moderate rate, then the impact on production growth actually turns positive. That is what indeed happened during the latter part of 2009 in many countries.

Korea provides a nice illustration. The numbers are shown in two graphs below. The first one shows the level of inventories and the stockbuilding (i.e. change in stockbuilding). The level of inventories is actually not observed, but it is easy to derive at a plausible estimate. The graph shows the sharp decline in inventories at the start of the crisis from around 50% of GDP to 35% of GDP. Stockbuilding was strongly negative, but the rate of decline in the inventories was slowing during the last two quarters of 2009.

The (perhaps surprising) impact on the growth of Korea’s GDP is shown in the second graph. First a sharp negative impact, but then GDP growth was temporarily boosted as the destocking slowed. The wait is now for an additional boost in GDP growth. That one comes when destocking completely stops and restocking starts. That is when the real sun breaks through the data. I will follow this story in this blog as more data becomes available. In the mean time, let me enjoy the sunshine in Washington DC.

In a recent IMF Staff position note Olivier Blanchard and Gian Maria Milesi-Ferretti provide a useful classification of current account imbalances. They argue that deficits and surpluses on current accounts are "good" if they reflect optimal allocation of capital across time and space. That is the case, for example, when savings ratios differ across countries because of different ageing profiles or when investment ratios differ because of different productivity trends.

However, imbalances are “bad” if they reflect distortions that cause suboptimal saving or investment behavior. These distortions may range from lack of social insurance (creating too much household savings) or poor firm governance (creating unwarranted corporate savings) to excessive public borrowing or excessive build up of foreign exchange reserves. A widespread distortion is that borrowers commonly underestimate the volatility of capital flows and the related risks and consequently over-borrow.

So far, so good. But, as B&M acknowledge, it is far from easy to determine the character of actual imbalances.  Were global imbalances over the last decade good or bad? B&M provide an interesting assessment of the past and (predicted) future imbalances. And it shows indeed that such an assessment is not straightforward, as also their judgment is both defendable and debatable. But let’s not go into that now.

Let me state a more obvious point: You don’t have to be a fan of spaghetti westerns (but who isn’t?) to realize that something is missing in the analysis. If there is a good one, and a bad one, then there must be an ugly one, too. Which dimension is missing in the paper of B&M?

In my opinion the missing dimension is the imbalance between global demand and supply of goods and services. If a country runs a current account deficit (that means that, for either good or bad reasons, spending exceeds income) then that imbalance can easily get ugly if global spending already exceeds global production capacity. Conversely, in a situation of insufficient global effective demand current account surpluses are likely the ugly ones. More specifically, over the last decade the U.S.  current account deficits (underpinned by ample creation of liquidity) would be ugly if there was already more than enough effective demand in the world. The surpluses in some European countries, in oil exporting countries, and more recently in China would be ugly if there was a chronic lack of effective demand.

To determine which imbalance was ugly we take the World Bank’s measure of global capacity utilization and add that to Figure 1 in B&M’s paper, which contains current account imbalances over time.  (see chart below)

The increase in U.S. deficits since 2003 coincided with a tightening global real economy, as reflected in our measure of global capacity utilization, which could also be illustrated with low unemployment numbers and which ultimately showed in sharp increases in commodity prices. In that period the deficits looked a bit uglier than the surpluses. That changed obviously in 2008 with the global crisis. Surpluses in oil-exporting countries and in China came down sharply, but they became uglier too, because concerns dramatically shifted to lack of global effective demand.

This third dimension not only provides a more complete description of the character of imbalances, it is also a crucial element of the policy debate. U.S monetary or fiscal policy should tighten if one worries about the U.S. current account deficit, but also if one worries about too much global demand. China should stimulate domestic demand if one thinks that China’s current account surplus is unwarranted, but also if one worries about insufficient global demand.

In that regard the discussion about exchange rate policies is an intriguing one. It is often presented as a way to reduce current account imbalances. The story goes as follows. If a country stimulates domestic demand, which would decrease its current account surplus, then the price of domestic goods must rise relative to the price of foreign goods. To prevent domestic inflation, a smooth way of achieving that relative price change is through appreciation of the nominal exchange rate. (By the way, as they compare two possible future scenarios, B&M argue that if in China increased domestic demand is not accompanied by appreciation of the currency, then the reduction in the current account surplus will not occur. That is unlikely. More likely is that it would lead to domestic inflation.)

In that sense the exchange rate is related to adjustments in current account, albeit in an indirect way.

However, the situation is very different if we see exchange rates as an independent policy instrument, independent of more fundamental changes in domestic demand. Then changes in nominal exchange rates have a lot more to do with stimulating or slowing down the economy.  For example, an appreciation of their currency does not necessarily decrease a country’s current account surplus. An appreciated currency makes a country less competitive and production will slow. As a result, the investment ratio will fall and a current account surplus has a tendency to increase. Conversely, countries can stimulate their economy through depreciation, which could create a boom, higher investment rates, and a decrease in their current account surplus, or an increase in their deficit.

From a global perspective, merely changes in exchange rates do little to stimulate or slow down the economy. The advantage of one country is the disadvantage of another country. That is why a focus on changes in domestic demand is more important than changes in nominal exchange rates, not only to correct good or bad current account imbalances, but also to restore equilibrium in the global markets for goods and services, and thus make the world economy less ugly.

 Source: World Bank and IMF