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Rebalancing the World

December 4, 2010 Leave a comment Go to comments

It seems we are currently witnessing a largely one-way flow of capital, as money moves from countries of disinflation or deflation to countries with inflation, possibly perpetuating the situation for both. Most developed economies are still mired in slow growth, prompting measures to kick-start their domestic economies such as continued loose monetary policy, quantitative easing and government bailouts, while deficits are spiraling out of control.

The rapid growth in money supply stemming from these expansionary policies is leading to rising commodity prices as investors have higher inflation expectations and thus invest in commodities and equities. This, of course, pushes up domestic prices since the value of raw materials is increasing. As a result, authorities in emerging economies with high growth, such as Brazil, China and India, are trying various methods to prevent their own economies from overheating.

For example, a few weeks ago, the U.S. Federal Reserve launched its second round of quantitative easing or QE2, and more recently, the European Union and the International Monetary Fund bailed out Ireland. Meanwhile, several months ago, Brazil, a country that already saw hyperinflation in the past and is very concerned about inflationary pressures, imposed a tax on foreign inflows. The Indian government has gradually tightened monetary policy for most of this year, and the Chinese authorities have also selectively tightened policy to battle inflation. With commodity prices on the rise, I believe inflation is going to be a continuing challenge for a number of high-growth emerging countries.

In order to “equalize” these opposing economic trends—deflation and inflation—I believe that we need to see a gradual restriction in monetary expansion, an elimination of non-productive spending (reducing government activities) and less borrowing on the part of deficit nations. To combat inflation without endangering economic growth, we need to see investments made in high-productivity industries and services. If productivity goes up then prices move down or stay steady. However, if investments are made in unproductive or even counter-productive activities such as increased government regulatory agencies and high-cost regulations, then productivity will suffer and inflation will ensue.

In the near term, central banks in emerging countries are likely to buy dollars to prevent their currencies from rising too fast. For now, capital flows into emerging stock markets are being counterbalanced by capital raised in new and secondary stock sales. If capital keeps pouring in and companies that have raised cash begin using it to buy assets, prices could be pushed up in a snowball effect.

Therefore, for long-term equilibrium, we need to see a rebalancing of the world economy. In recent history, financial authorities in the developed world have encouraged a period of easy credit and loose monetary policy, driving a debt-fuelled rise in consumption. Meanwhile, the household savings rate in many emerging markets continues to be at very high levels, and is projected to grow. There needs to be more ‘balance’ in the world economy, so high-savings countries should spend more and develop their own vibrant domestic market as we see in the U.S. I’ve seen this shift gradually take place in China and India. However, in order to encourage people to spend there needs to be pension systems, health care systems and free schooling, so that people do not need to save so much for such services.

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