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Options in Dealing with Economic Depression

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The current global economy still maintains positive growth, and neither main advanced economies nor emerging economies have experienced economic recession, let alone worsened into a major depression. However, the sustainability of global economic growth is facing challenges, and the deterioration of the global trade war has exacerbated the slowdown in global economic growth. The economy of the United States has begun to show signs of slowing down, and many investment banks expect that the possibility of a recession in the U.S. economy is increasing. The recovery of the European economy has been relatively fragile. The economic growth of Germany and France has slowed down, while the economic “internal friction” caused by Brexit has further weakened the European economy. Meanwhile, the deterioration of the trade war has increased the downward pressure on China’s economy. If the trade war extends to science and technology, as well as the finance, it may also trigger China’s domestic economic conflicts and deep-seated economic structural problems, which will cause more troubles to the Chinese economy.

In the past century, the United States has experienced two long-term debt cycles, leading to the prosperity of the 1920s and the Great Depression of the 1930s. History repeated itself where the United States enjoyed prosperity in the early 21st century and experienced the financial crisis began in 2008. 11 years after the 2008 financial crisis, will there be another Great Depression? This remains to be seen. However, in the context of the current deterioration of the global trade war, the global economy is still unable to rid itself of the laws of the “Crisis Triangle” (Chan Kung, 2015). With the structural problems of global overproduction and excess capital, we cannot help but consider the economic downturn and the possibility of an economic depression.

When the economic depression is approaching, how should policies respond? In other words, how to manage economic depression through policy adjustments? From the perspective of dealing with the debt crisis, Ray Dalio, the founder of Bridgewater Associates, provides some policy management options in the face of economic depression: one is fiscal austerity, the other is debt default/restructuring, the third is debt monetization or money printing, and finally there is the redistribution of wealth (from the rich to the poor). Each policy choice has a different impact on the economy, and the key is for policymakers to find the right policy combinations.

When the economic and capital market bubbles burst, it is almost an instinctive response for the government to tighten fiscal policy, hoping to reduce the degree of the bubble and promote deleveraging. But in many cases, wrong choices would be made. Dalio believes that in an economic depression, the better way of managing is that the central bank should promote ample liquidity, such as rapidly reducing short-term interest rates to 0%; while bad management is slowing down and providing limited liquidity and tightening up prematurely. If the government is unwilling to take action at the beginning, this will make the economic depression worse. During the Great Depression in the United States in the 1930s and the Lost Decade of Japan in the 1980s, the governments of these countries were slow to act, which resulted in a long depression. However, when the financial crisis broke out in 2008, the U.S. government learned the lessons well and quickly moved to inject liquidity into the market, leading to a shorter economic depression.

To deal with the economic recession, an important task that cannot be avoided is debt restructuring. There are usually several approaches: The first is to provide liquidity, including bank liquidity and emergency lending. The second is to solve the debt problem of lenders, including debt restructuring, recapitalization, and debt nationalization. The third is to divest debts, including setting up asset management companies to absorb these debts. For example, in the late 1990s, China established four major asset management companies to absorb bad debts from banks. The fourth is sovereign default and reorganization. After the 2008 financial crisis, the United States nationalized some banks, which is also a common practice. In the short term, debt restructuring is intended to diversify the impact of the debt crisis, so that short-term debt pain is not unbearable; in the long run, policymakers must realize that institutional reforms must be carried out to solve the root cause of the debt problem.

During economic depressions, loan institutions, especially those that are not protected by ordered guarantees, often encounter “runs.” The central bank and the central government ordered the need to determine as soon as possible which institutions are systemically important and need rescue. Most importantly, the central government needs to do its best to ensure the security of the financial/economic system and minimize government/taxpayer costs. Part of the funds needed for rescue comes from the government (through budget allocations) and part from the central bank (money printing). In the process of alleviating the credit crisis and stimulating the economy, if the government finds it difficult to raise funds through taxation and borrowing, the central bank will be forced to increase the amount of money printed and provide more funds to purchase national debt. The central bank and central government’s response actions should focus on several key points: 1) provide debt guarantees to reduce panic; 2) provide liquidity; 3) support the solvency of systemically important institutions; 4) recapitalize/nationalize/cover loss of systemically important financial institutions.

When the economy is in depression, the gap between rich and poor will become huge, and might even cause serious social problems. From historical experience, if the rich and the poor share social resources and the economy is in recession at this time, there may be economic and political conflicts. At this time, both left-wing and right-wing populism will rise. How the people and the country respond to populism will determine whether the economy and society can smoothly survive the depression. At this time, increasing taxes on the rich often becomes a politically attractive policy choice, because the rich use assets and wealth to make more money, and the central bank’s purchase of financial assets also allows the rich who hold more financial assets to earn more. This will also be the time for the “left-leaning” political trend to accelerate the redistribution of social wealth. If taxes are increased, they will usually be increased in the form of income tax, real estate tax and consumption tax. However, tax increases should not reach the stage that drives the rich to transfer their funds to safer places, leading to the “hollow” policy of tax increases for the rich.

The above-mentioned four types of policy ideas to deal with economic depression provide a brief policy framework for decision-makers to choose when an economic depression occurs. It should be pointed out that although this framework has a certain degree of versatility, it is mainly built on the basis of a market economy with a relatively complete system, and is mainly from the perspectives of investment and of dealing with debt crises. In the real world, the Great Depression is often a systemic collapse of the economy and finance of the world or a country. To cope with this extreme and complex systemic crisis often requires more complex policy responses and economic and financial resources. In any case, thinking about extreme risk scenarios in advance will enable us to find more rational and forward-looking policy responses, thereby reducing risks and losses.

Final analysis conclusion:

The downward pressure on both global economy and Chinese economy is increasing. Although there is still a gap between the economic recession and depression, policymakers need to plan ahead, think ahead and prepare for policy measures when an economic depression occurs in the face of an increasingly uncertain world.

Mr. He Jun takes the roles as Partner, Director of China Macro-Economic Research Team and Senior Researcher. His research field covers China’s macro-economy, energy industry and public policy

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The Monetary Policy of Pakistan: SBP Maintains the Policy Rate

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The State Bank of Pakistan (SBP) announced its bi-monthly monetary policy yesterday, 27th July 2021. Pakistan’s Central bank retained the benchmark interest rate at 7% after reviewing the national economy in midst of a fourth wave of the coronavirus surging throughout the country. The policy rate is a huge factor that relents the growth and inflationary pressures in an economy. The rate was majorly retained due to the growing consumer and business confidence as the global economy rebounds from the coronavirus. The State Bank had slashed the interest rate by 625 basis points to 7% back in the March-June 2020 in the wake of the covid pandemic wreaking havoc on the struggling industries of Pakistan. In a poll conducted earlier, about 89% of the participants expected this outcome of the session. It was a leap of confidence from the last poll conducted in May when 73% of the participants expected the State Bank to hold the discount rate at this level.

The State Bank Governor, Dr. Raza Baqir, emphasized that the Monetary Policy Committee (MPC) has resorted to holding the 7% discount rate to allow the economy to recover properly. He added that the central bank would not hike the interest rate until the demand shows noticeable growth and becomes sustainable. He echoed the sage economists by reminding them that the State Bank wants to relay a breather to Pakistan’s economy before pushing the brakes. The MPC further asserted that the Real Discount Rate (adjusted for inflation) currently stands at -3% which has significantly cushioned the economy and encouraged smaller industries to grow despite the throes of the pandemic.

Dr. Raza Baqir further went on to discuss the current account deficit staged last month. He added that the 11-month streak of the current account surplus was cut short largely due to the loan payments made in June. The MPC further explained that multiple factors including an impending expiration of the federal budget, concurrent payments due to lenders, and import of vaccines, weighed heavily down on the national exchequer. He further iterated that the State Bank expects a rise in exports along with a sustained recovery in the remittance flow till the end of 2021 to once again upend the current account into surplus. Dr. Raza Baqir assured that the current level of the current account deficit (standing at 3% of the GDP) is stable. The MPC reminded that majority of the developing countries stand with a current account deficit due to growth prospects and import dependency. The claims were backed as Dr. Raza Baqir voiced his optimism regarding the GDP growth extending from 3.9% to 5% by the end of FY21-22. 

Regarding currency depreciation, Dr. Baqir added that the downfall is largely associated with the strengthening greenback in the global market coupled with high volatility in the oil market which disgruntled almost every oil-importing country, including Pakistan. He further remarked, however, that as the global economy is vying stability, the situation would brighten up in the forthcoming months. Mr. Baqir emphasized that the current account deficit stands at the lowest level in the last decade while the remittances have grown by 25% relative to yesteryear. Combined with proceeds from the recently floated Eurobonds and financial assistance from international lenders including the IMF and the World Bank, both the currency and the deficit would eventually recover as the global market corrects in the following months.

Lastly, the Governor State Bank addressed the rampant inflation in the economy. He stated that despite a hyperinflation scenario that clocked 8.9% inflation last month, the discount rates are deliberately kept below. Mr. Baqir added that the inflation rate was largely within the limits of 7-9% inflation gauged by the State Bank earlier this year. However, he further added that the State Bank is making efforts to curb the unrelenting inflation. He remarked that as the peak summer demand is closing with July, the one-way pressure on the rupee would subsequently plummet and would allow relief in prices.

The MPC has retained the discount rate at 7% for the fifth consecutive time. The policy shows that despite a rebound in growth and prosperity, the threat of the delta variant still looms. Karachi, Pakistan’s busiest metropolis and commercial hub, has recently witnessed a considerable surge in infections. The positivity ratio clocked 26% in Karachi as the national figure inched towards 7% positivity. The worrisome situation warrants the decision of the State Bank of Pakistan. Dr. Raza Baqir concluded the session by assuring that despite raging inflation, the State Bank would not resort to a rate hike until the economy fully returns to the pre-pandemic levels of employment and production. He further assuaged the concerns by signifying the future hike in the policy rate would be gradual in nature, contrast to the 2019 hike that shuffled the markets beyond expectation.

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Reforms Key to Romania’s Resilient Recovery

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Over the past decade, Romania has achieved a remarkable track record of high economic growth, sustained poverty reduction, and rising household incomes. An EU member since 2007, the country’s economic growth was one of the highest in the EU during the period 2010-2020.

Like the rest of the world, however, Romania has been profoundly impacted by the COVID-19 pandemic. In 2020, the economy contracted by 3.9 percent and the unemployment rate reached 5.5 percent in July before dropping slightly to 5.3 percent in December. Trade and services decreased by 4.7 percent, while sectors such as tourism and hospitality were severely affected. Hard won gains in poverty reduction were temporarily reversed and social and economic inequality increased.

The Romanian government acted swiftly in response to the crisis, providing a fiscal stimulus of 4.4 percent of GDP in 2020 to help keep the economy moving. Economic activity was also supported by a resilient private sector. Today, Romania’s economy is showing good signs of recovery and is projected to grow at around 7 percent in 2021, making it one of the few EU economies expected to reach pre-pandemic growth levels this year. This is very promising.

Yet the road ahead remains highly uncertain, and Romania faces several important challenges.

The pandemic has exposed the vulnerability of Romania’s institutions to adverse shocks, exacerbated existing fiscal pressures, and widened gaps in healthcare, education, employment, and social protection.

Poverty increased significantly among the population in 2020, especially among vulnerable communities such as the Roma, and remains elevated in 2021 due to the triple-hit of the ongoing pandemic, poor agricultural yields, and declining remittance incomes.

Frontline workers, low-skilled and temporary workers, the self-employed, women, youth, and small businesses have all been disproportionately impacted by the crisis, including through lost salaries, jobs, and opportunities.

The pandemic has also highlighted deep-rooted inequalities. Jobs in the informal sector and critical income via remittances from abroad have been severely limited for communities that depend on them most, especially the Roma, the country’s most vulnerable group.

How can Romania address these challenges and ensure a green, resilient, and inclusive recovery for all?

Reforms in several key areas can pave the way forward.

First, tax policy and administration require further progress. If Romania is to spend more on pensions, education, or health, it must boost revenue collection. Currently, Romania collects less than 27 percent of GDP in budget revenue, which is the second lowest share in the EU. Measures to increase revenues and efficiency could include improving tax revenue collection, including through digitalization of tax administration and removal of tax exemptions, for example.

Second, public expenditure priorities require adjustment. With the third lowest public spending per GDP among EU countries, Romania already has limited space to cut expenditures, but could focus on making them more efficient, while addressing pressures stemming from its large public sector wage bill. Public employment and wages, for instance, would benefit from a review of wage structures and linking pay with performance.

Third, ensuring sustainability of the country’s pension fund is a high priority. The deficit of the pension fund is currently around 2 percent of GDP, which is subsidized from the state budget. The fund would therefore benefit from closer examination of the pension indexation formula, the number of years of contribution, and the role of special pensions.

Fourth is reform and restructuring of State-Owned Enterprises, which play a significant role in Romania’s economy. SOEs account for about 4.5 percent of employment and are dominant in vital sectors such as transport and energy. Immediate steps could include improving corporate governance of SOEs and careful analysis of the selection and reward of SOE executives and non-executive bodies, which must be done objectively to ensure that management acts in the best interest of companies.

Finally, enhancing social protection must be central to the government’s efforts to boost effectiveness of the public sector and deliver better services for citizens. Better targeted social assistance will be more effective in reaching and supporting vulnerable households and individuals. Strategic investments in infrastructure, people’s skills development, and public services can also help close the large gaps that exist across regions.

None of this will be possible without sustained commitment and dedicated resources. Fortunately, Romania will be able to access significant EU funds through its National Recovery and Resilience Plan, which will enable greater investment in large and important sectors such as transportation, infrastructure to support greater deployment of renewable energy, education, and healthcare.

Achieving a resilient post-pandemic recovery will also mean advancing in critical areas like green transition and digital transformation – major new opportunities to generate substantial returns on investment for Romania’s economy.

I recently returned from my first official trip to Romania where I met with country and government leaders, civil society representatives, academia, and members of the local community. We discussed a wide range of topics including reforms, fiscal consolidation, social inclusion, renewably energy, and disaster risk management. I was highly impressed by their determination to see Romania emerge even stronger from the pandemic. I believe it is possible. To this end, I reiterated the World Bank’s continued support to all Romanians for a safe, bright, and prosperous future.

First appeared in Romanian language in Digi24.ro, via World Bank

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US Economic Turmoil: The Paradox of Recovery and Inflation

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The US economy has been a rollercoaster since the pandemic cinched the world last year. As lockdowns turned into routine and the buzz of a bustling life came to a sudden halt, a problem manifested itself to the US regime. The problem of sustaining economic activity while simultaneously fighting the virus. It was the intent of ‘The American Rescue Plan’ to provide aid to the US citizens, expand healthcare, and help buoy the population as the recession was all but imminent. Now as the global economy starts to rebound in apparent post-pandemic reality, the US regime faces a dilemma. Either tighten the screws on the overheating economy and risk putting an early break on recovery or let the economy expand and face a prospect of unrelenting inflation for years to follow.

The Consumer Price Index, the core measure of inflation, has been off the radar over the past few months. The CPI remained largely over the 4% mark in the second quarter, clocking a colossal figure of 5.4% last month. While the inflation is deemed transitionary, heated by supply bottlenecks coinciding with swelling demand, the pandemic-related causes only explain a partial reality of the blooming clout of prices. Bloomberg data shows that transitory factors pushing the prices haywire account for hotel fares, airline costs, and rentals. Industries facing an offshoot surge in prices include the automobile industry and the Real estate market. However, the main factors driving the prices are shortages of core raw materials like computer chips and timber (essential to the efficient supply functions of the respective industries). Despite accounting for the temporal effect of certain factors, however, the inflation seems hardly controlled; perverse to the position opined by Fed Chair Jerome Powell.

The Fed already insinuated earlier that the economy recovered sooner than originally expected, making it worthwhile to ponder over pulling the plug on the doveish leverage that allowed the economy to persevere through the pandemic. The main cause was the rampant inflation – way off the 2% targetted inflation level. However, the alluded remarks were deftly handled to avoid a panic in an already fragile road to recovery. The economic figures shed some light on the true nature of the US economy which baffled the Fed. The consumer expectations, as per Bloomberg’s data, show that prices are to inflate further by 4.8% over the course of the following 12 months. Moreover, the data shows that the investor sentiment gauged from the bond market rally is also up to 2.5% expected inflation over the corresponding period. Furthermore, a survey from the National Federation of Independent Business (NFIB) suggested that net 47 companies have raised their average prices since May by seven percentage points; the largest surge in four decades. It is all too much to overwhelm any reader that the data shows the economy is reeling with inflation – and the Fed is not clear whether it is transitionary or would outlast the pandemic itself.

Economists, however, have shown faith in the tools and nerves of the Federal Reserve. Even the IMF commended the Fed’s response and tactical strategies implemented to trestle the battered economy. However, much averse to the celebration of a win over the pandemic, the fight is still not through the trough. As the Delta variant continues to amass cases in the United States, the championed vaccinations are being questioned. While it is explicable that the surge is almost distinctly in the unvaccinated or low-vaccinated states, the threat is all that is enough to drive fear and speculation throughout the country. The effects are showing as, despite a lucrative economic rebound, over 9 million positions lay vacant for employment. The prices are billowing yet the growth is stagnating as supply is still lukewarm and people are still wary of returning to work. The job market casts a recession-like scenario while the demand is strong which in turn is driving the wages into the competitive territory. This wage-price spiral would fuel inflation, presumably for years as embedded expectations of employees would be hard to nudge lower. Remember prices and wages are always sticky downwards!

Now the paradox stands. As Congress is allegedly embarking on signing a $4 trillion economic plan, presented by president Joe Bidden, the matters are to turn all the more complex and difficult to follow. While the infrastructure bill would not be a hard press on short-term inflation, the iteration of tax credits and social spending programs would most likely fuel the inflation further. It is true that if the virus resurges, there won’t be any other option to keep the economy afloat. However, a bustling inflationary environment would eventually push the Fed to put the brakes on by either raising the interest rates or by gradually ceasing its Asset Purchase Program. Both the tools, however, would risk a premature contraction which could pull the United States into an economic spiral quite similar to that of the deflating Japanese economy. It is, therefore, a tough stance to take whether a whiff of stagflation today is merely provisional or are these some insidious early signs to be heeded in a deliberate fashion and rectified immediately.

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