A tale of two worlds

GERARD IYONS | Wednesday July 28, 2010 00:00

Across a growing number of emerging market economies, central banks are becoming more concerned about how soon and how fast they should tighten monetary policy.

 Perhaps most telling are the recent rate increases in India and Brazil, two major developing economies where prospects look good. But there are many others who are tightening as they face the challenges of economic recovery. In Asia, in the past month alone, South Korea, Taiwan, Thailand and Malaysia have joined India in raising rates. Of these, it was the first rate hike in the cycle for Taiwan, South Korea and Thailand. In contrast, India and Malaysia have been hiking for some time.

 This does not mean that central banks in the West should tighten too; far from it. They face downside, not upside risks. The US, the UK and the euro-zone need to keep rates as low as possible for as long as possible. Indeed, given the fragile state of their recoveries, the central banks in the West may have to do even more, through quantitative easing. The contrast with the emerging world could not be starker.

Whichever country one considers, the outlook tends to depend on the interaction between the fundamentals, policy and confidence. The fundamentals in the East are far better than in the West. Meanwhile, the current pressures on both policy and confidence contrast significantly.  There are, of course, some emerging economies where monetary policy is being eased, Sri Lanka and Ghana being examples, and South Africa looks set to ease further. And even across Asia there is speculation that Vietnam, who were amongst the first to hike, late last year, may need to ease. So, local factors clearly need to be taken into account. But even allowing for this, the broader picture is one of differences between the West and the East.

In the West, a double-dip recession is the worry, as the impact of last year's policy stimulus is fading and the private sector is not taking up the slack. To add to the gloom, the tightening of fiscal policy across Europe may ease market worries about sovereign risk but, possibly, at the expense of making a double-dip more likely.

The world economy has been recovering since facing the abyss in the spring of last year. Global trade has also rebounded sharply since hitting bottom last May. Yet, an economic correction in the second half of this year always looked likely as the policy boost of last year wore off and as the  inventory correction that has been taking place ran its course.

 As a result, this is what one might call a below-par recovery. Normally at this stage of a recovery, momentum builds up and confidence rises. Instead, in the West, the summer has seen a period of uncertainty, triggering volatility across markets. Although it is important not to panic, tightening fiscal policy is a risk. A double-dip in the global economy is not guaranteed but one needs to recognise the contrasting challenges facing different parts of the world. The overhang of debt and the scale of deleveraging will constrain growth in the West for some time. The emerging economies, especially those driven by exports, are not decoupled from events in the West, but they are better insulated. Indeed this is what we saw during the crisis as Asia, for instance, was hit by the slump in global trade but has since rebounded. Growth opportunities in the East look far better.

Perhaps most attention will be focussed on China, given its influence on global trade and on commodity prices. In China, the impact of previous tightening of bank lending is feeding through, slowing the economy.

One can draw an analogy between controlling China's economy and turning the shower knob in a hotel. It is unlikely you will get the temperature exactly right the first time. Turn the knob too much in one direction, and the water turns too hot, turn it the other way, and it gets too cold. Eventually you get it just right.

Similarly, with Chinese policy. Eighteen months ago the central bank eased monetary policy by relaxing lending controls. Bank lending almost doubled to just under 10 trillion yuan in 2009. At the start of this year, the authorities tried to cool things, slashing the lending target to 7.5 trillion yuan for 2010 and imposing other restrictions.

These measures are taking effect and thus we should not be surprised by news of a slowdown in China. Yet, policymakers may soon decide that they have gone too far in cooling and, by the year-end, they may try and warm things up, giving the economy a boost as it enters 2011. The bottom line is that China, like the rest of Asia, is an economy with different challenges - those of success.

 Add in the recent move by the Chinese to let their currency appreciate - albeit gradually - and the immediate outlook may well be one of Asian currency appreciation. It may also not be too long before the worries of only a few months ago - namely how to control capital inflows - return to the centre-stage. There is a need to see through the present market uncertainty, and recognise the signals from recent data and policy actions. We must not under-estimate near-term downside risks in the West. Whilst it may be a sub-trend recovery across the globe, emerging economies look set to experience stronger growth rates

Dr Gerard Lyons is Head of Global Research and Chief Economist at Standard Chartered Bank