Challenges of the World Economy: Sessions 5 and 6
Risks and side-effects of ultra-lax monetary policy
1. The ultra lax monetary policy reduces political incentives in euro area countries to carry out the necessary structural reforms (e.g. in Italy). Governments try to avoid unpopular reforms knowing that they are bailed out anyway by the ECB. 2. Because of tangible involvement in budget financing of EMU member states in the wake of QE the ECB is susceptible to political pressure. When it come to normalize monetary policy by rising interest rates the ECB's independence might be at stake as member countries are likely to put pressure on the ECB in order to avoid higher financing costs. 3. By means of QE the ECB inflates its balance sheet and amasses bond risks at expense of its shareholders (national central banks and governments; Germany's share: 18%). Since debt crisis 2010 gov. bonds are no longer a safe asset.
Risks and side-effects of ultra-lax monetary policy
4. Permanent low interest rates do not have tangible stimulating effects given the reluctance of banks to lend briskly and of enterprises to borrow due to muted business outlook as the upswing is likely to come to an end in the foreseeable future. 5. One reason might be that the allocation function of interest rates is impaired as low interest rates weaken return-oriented investments and innovation. On the other hand "Zombie" banks and enterprises are kept artificially alive and dampen productivity and growth. 6. There is an increased risk of bubble formation (in the real estate and equity markets) being a potential source for future financial crises. 7. Very low interest rates destabilise the financial sector as capital market business of banks is massively losing in yield and attractiveness and margins of new (and variable) bank credits are under pressure. Business models of many banks are under compulsion. It is argued that permanent low interest rates may pave the way for a new financial crisis. 8. The massive Quántitative Easing (QE) reduces the liquidity of European (gov.) bond markets, which are anyway much less developed than US bond markets making the euro area a less attractive place for international investors who prefer liquid markets. 9. The lack of interest income of households also dampens consumption. On the other hand it is also argued that consumers would spend more because of low interest rates. 10. The capital market-based schemes of old age-provision are under severe pressure (for instance pension funds and life insurance companies) because the effect of compound interest is missing in a low interest environment. 11. Very low interest rates require enterprises to increase their pension reserves in order to finance the defined contributions or defined benefit schemes of occupational pension systems. This implies higher costs for old age provision and less scope for productive investment. 12. Permanent low interest rates and the absence of compound interest require higher household savings rates in order to secure a certain (sufficient) level of private old-age provision thus dampening households' private consumption. 13. The ultra lax monetary policy increases the inequality of income and wealth without any democratic control). This is true for the relation (1) between the bond and bank deposit holders on the on hand (who do no longer receive a return in form of interest payments) and shareholders on the other hand (who benefit from higher share prices as a consequence of low interest rates at least for a longer period of time); (2) between savers (having zero yields) and debtors (enjoying low interest rates); (3) between the working people (who have to save more for their old age pension without the effect of compound interest) and the current pensioners. 14. The interpretation of ECB's policy contributes to confusion of financial markets. Uncertainty triggers several questions, for instance: (1) Is ECB at the end of the line to stimulate the economy? (2) What happens if no more ammunition of monetary policy is available if the euro area will slip into a real recession? (3) Why do the ECB not pursue a monetary policy of steady hand in times when the oil price decline has been the main cause for low inflation rates? (4) Financial markets participants guess that the ultra lax policy a signal for a weak state of euro area's economy. They suspect: Is a good economic situation deteriorating? 15. The ECB's mandate is priority to price stability. Now there is a risk of overburdening monetary policy with too many tasks: stimulating the economy, securing financial stability, supervising important bank and (de facto) facilitating budget financing of member states via QE, i.e. the massive buying of government bonds and the associated low yields. 16. Low government bond yield as a consequence of QE are an incentive for euro area governments to incur more debt and to spend more. Most of the German government bond yield curve has been in the negative area for quite some time. QE thwarts fiscal discipline of several euro area member states.
Fiscal policy can do the job stimulating the economy
A common, eurozone-wide budget is a bridge too far politically. And it likely to be not very effective as there is no euro area budget and if it were available it would be too small given the small size of the EU budget of 1% of GDP. • But a co-ordinated fiscal easing across the eurozone, which the IMF has shown delivers more bang for the buck, is within the realm of the possible. However, only those member countries of the euro area with a solid budgetary position (in terms of budget deficit and stock of public debt) should participate in a coordinated expansionary fiscal policy. • All in all an expansionary fiscal policy is likely to have a realistic chance only if the euro area's economy will slip into a real recession, which is not in the offing for the time being.
Fiscal policy can do the job stimulating the economy
A common, eurozone-wide budget is a bridge too far politically. And it likely to be not very effective as there is no euro area budget and if it were available it would be too small given the small size of the EU budget of 1% of GDP. • But a co-ordinated fiscal easing across the eurozone, which the IMF has shown delivers more bang for the buck, is within the realm of the possible. However, only those member countries of the euro area with a solid budgetary position (in terms of budget deficit and stock of public debt) should participate in a coordinated expansionary fiscal policy. All in all an expansionary fiscal policy is likely to have a realistic chance only if the euro area's economy will slip into a real recession, which is not in the offing for the time being.
A stronger US dollar exchange rate might cause trouble
A stronger dollar exchange rate is likely to be in conflict with President Trump's credo of "America first", e.g. the desire of Mr. Trump to foster US growth by stimulating US exports. In this context Mr. Trump also accuses Germany to manipulate the Euro/dollar exchange rate in order to stimulate German exports to the US. That is nonsense as Germany has no influence on the exchange rate, which is managed by the ECB while there is no exchange rate target. However, it is true that Germany has a structural current account surplus and that the relatively low euro/$ exchange rate has been benefiting German exports in recent years and contributed to the huge current account surplus of Germany (2018: 7.4% of GDP). As mentioned above it is also true that Germany has some fiscal policy room to stimulate domestic demand by an income tax cut in order to reduce the huge c.a. surplus. Anyway, there is a risk that a dispute about the right dollar exchange rate of the euro might reinforce protectionist tendencies in volatile US trade policy.
Euro area's growth gained ground after the debt crisis
After the European ("euro") debt crisis in 2010/2012 with weak economic growth, rising government and private debt and unemployment the euro area economy embarked on a moderate upswing in 2014. The economy has been growing continuously over more than 20 quarters. The peak was reached in the year 2017 with a annual GDP growth rate of 2.5%. As a consequence of the moderate upswing the (very) high unemployment in southern Europe has been gradually reduced over the years but is still relatively high in Greece (18.6%), Spain (14.5%) and Italy (10.5%, Dec. 2018 respectively). By contrast, the German economy reached full employment (3.2% Dec.2018). Inflation rate has remained close to 1.5%, i.e. well below ECB's inflation target of below, but close to, 2% over the medium term.
When seems a fiscal stimulus realistic? In which form?
At present fiscal stimulus is constrained by a narrative that public debt has become dangerously high in most countries of the euro area. One cause for hope for a fiscal stimulus is that the slowdown has swept up not only chronically weak countries like Italy, but also seemingly impregnable ones like Germany. They may be at opposite ends of the risk spectrum, but the global trade conflict has put these net exporters in the same boat. Thus, even Germany might be becoming receptive to policy stimulus. The voices calling for government to go beyond limited fiscal action it has taken to date now span the political spectrum.
The New Growth Model: Challenges of Change
China fundamentally redirected its economic model in 2013 away from export-led capital investment toward consumption, efficiency, and productivity. Since 2013 the country is about to move away from being the extended workbench for the world to a modern economy with competitive innovative structures in manufacturing and services and a strong integration into the world economy. The Chinese economy is in the middle of transitioning toward a new, more sustainable, growth model with slower GDP growth and a more balanced economic structure.
IMF's recommendation for China
China needs to increase productivity in order to boost competitiveness and to avoid middle income trap. This can be done by making better use of resources that are currently going to loss-making companies ("zombie"), overcapacity industries (e.g. steel, solar cells), and State- Owned Enterprises. IMF estimates that efforts could increase the contribution of productivity to growth by 1 percentage point over long term. Unlike a developed economy, China still has significant room to lift productivity through market-driven reforms while fostering innovation. The key will be to relax government control so as to allow market forces to play a bigger role in SOEs. China can successfully manage the transition to a productivityled growth model and shape its future as a global growth driver or the next Japan.
Made in China 2025 Plan
China will strive to encourage growth in 10 high-end manufacturing sectors, including Information technology, Robotics, Aviation and marine equipment, Medical devices, Integrated circuits, Internet, Telecommunications,Nuclear power stations, Advanced urban rail systems, and Electronic equipment
China's Short Term GDP Growth
Chinese GDP growth for 2018 came in at 6.6%, the lowest growth rate in 28 years. Let's look at the export demand and then at the domestic demand in 2018 and beyond. The Chinese economy got off to a strong start in 2018. However, in all four quarter 2018 net exports contributenegatively to the Chinese GDP. Two messages: 1. domestic demand must be bigger than GDP the growth rate of 6.6% in 2018; 2. Surplus in trade and current account is shrinking. At the same time, the trade dispute with the United States escalated disrupting China's trade sector and weighing on Chinese business and consumer confidence. Slowing global demand is heightening those export pressures. From December 2018 to February 2019 both Chinese exports and imports shrank in nominal dollar terms.
China's Long Term GDP Growth
Chinese Government announced in 2012 to pursue a new growthmodel as of 2013, namely to shift the priority from fostering growth of exports and corporate investments (gross fixed capital formation) to focus on domestic demand, i.e. private consumption and services. Main insights: The policy switch led to lower annual growth rates. Real GDP growth rates fell from about 10% until 2012 to 6 to 7% thereafter. Consumption tend to gain in importance in line with rising wages. Corporate investments have lost in terms of share in GDP. Net exports have become negative at times implying that they are no longer pushing GDP growth but are being a dragging factor. Negative net exports are not a sign of declining competitiveness but a sign of dynamic development of imported consumer goods.
Green Investment
Control the consumption of energy and natural resources. Implement tighter rules on water and land use. Accelerating environmental-protection related infrastructure projects.
How did Chinese monetary and fiscal policy respond?
Due to the cooling economy and escalating trade conflict with the US Chinese government introduced or announced several monetary and fiscal stimulus measures in 2018. In contrast to large-scale measures since 2008 the focus has changed. While former stimulative actions focused on investment in construction of factories, infrastructure and housing the government now puts priority on consumption. This is in line with new Chinese growth model since 2013.
The EU's sentiment indicators are not so bad!
ESI of the euro area is stable and above long-term average. The ESI is a composite indicator made up of five sectoral confidence indicators with different weights: industrial confidence indicator (40%); construction confidence indicator (5%); services confidence indicator (30%); consumer confidence indicator (20%); retail trade confidence indicator (5%). • The Consumer Confidence Indicator (CCI) of the euro area and the EU is above long-term average and rising.
Cooling Domestic Demand in China
Exports have recently declined on the back of a slowdown in world trade, but also due to less demand from the US, probably also because frontloading effect vanished, i.e. the boosting of exports in anticipation of trade tensions with US. The parallel decrease in imports in 2018 is a clear signal of cooling domestic demand in China. The Chinese trade surplus has been shrinking. Domestic demand has been slowing down as lower growth rates of industrial production and retail sales in 2018 signal. Moreover, the property sector looks wobbly (drop in property sales since Jan. 2019). There had also been a crackdown on riskier lending pushing up borrowing costs, spurring bond defaults. This has made it harder for SMEs to get funding.
Financial Liberalization
Further opening up the domestic capital market. Relaxing individual cross border investment. Further deregulation of cross border.
Chinese Regional Governments and the Economy
However, China is highly decentralized in resource allocation & business activities Regional governments run the economy Most SOEs are under regional government control - Almost all firms in the non-state sector are under regional government control (regulation and resource allocation) • Regions (provinces, cities, counties) are relatively selfcontained providing conditions for regional competition and regional experiments. • The degree of decentralization varies over different periods but fundamental institutions have been stable.
Chinese Tax Reduction
However, investment growth in infrastructure has inched somewhat higher in the last few months as regulators fast-track infrastructure projects but it is still not far from record lows. More importantly, a broad tax reduction for households and companies was announced in 2018 and implemented in 2019. The tax cut comprises lower corporate and income taxation as well as a reduction of the VAT. The aim is to boost investment and consumption. The tax cut is likely to be associated with an increase of the fiscal deficit of the central government, which is officially assumed to increase from 2.6% of GDP in 2018 to 2.8% of GDP in 2019. This appears to be economically justifiable given the relatively moderate debt level of the central government in China (50% of GDP in 2018). Supported by a more expansionary fiscal policy, corporate investment growth has picked up in 2018 by 8 to 9% and is expected to remain solid at this level in 2019. The Chinese policy stimulus is expected to prevent a significant slowdown of the growth rate or even a hard landing of the economy. However, if the boosting measures will show too little impact in 2019 China watchers widely expect Beijing to roll out more monetary and fiscal stimuli in coming months to avert a sharper slowdown. China has even more manoeuvre to stimulate the economy.
Avoid a permanent trade conflict with the US
Irrespective of the outcome of the bilateral trade negotiations between US and China trade tensions with the US are likely to continue to be the biggest risk of Chinese economy for the time being. Although progress is allegedly achieved in US-Chinese trade talks after the negotiating deadline of early March elapsed a comprehensive agreement to end the trade dispute is seen as unlikely, given the number of highly divisive and politically sensitive issues on the table. Those issues include in particular: (1) The lack of protection of Intellectual Property Rights (IPR), (2) Cyber-Theft, (3) Industrial policies protecting domestic stateowned firms in China by subsidies (e.g. solar cells), (4) unfair obstacles to FDI (requesting joint ventures and a unilateral transfer of know how) and (5) aggressive strategies to take over western high-tech enterprises by Chinese state-owned enterprises in order to exploit available technical know how abroad more quickly. (6) The US argues that the huge bilateral trade deficit between the US and China (2018 totalling $419 bn) is the result of an "unfair" trade relationship, i.e. discrimination of US exporters in China. A bilateral trade deficit, which is based on millions of market decisions, is economically meaningless. Yet, it is defined by President Trump to be a political problem for US. Fact is that exports still are a key contributor to Chinese GDP. Thus, exports are much more important for China than for the US and the pressure to reach a deal is greater for China than for the US. Whether there will be a comprehensive trade deal between the US and China is an open question.
Italy is still a risk factor to the upswing
Italy is the problem child of the euro area with a weak EU-sceptical government and weak growth. The third largest economy accounts for 15.6% of euro area's GDP, i.e. it is systemically important as source of spill overs as the country has hardly any buffers to absorb shocks. The growth rate has weakened (1.6% in 2017, 0.9% in 2018 and 0.1% in 2019) inter alia due to a lack of structural reforms, the budget deficit is too high (2018: 2.1% of GDP; 2019: 2.4% of GDP), the huge public debt has stagnated at 132% of GDP during the upswing since 2014), the government has problems with the banking system, which is vulnerable due to a huge amount of non-performing loans. Recently some ailing smaller regional banks got state aid (while the government denied to implement the Single Resolution Mechanism (SRM) of the European Banking Union). The Italian right/left government emanating from the March 2018 election recently came to terms with EU regarding the Italian demand to increase the fiscal deficit 2019. The compromise achieved with the European Commission has dampened the risk of rising government bond yields.
Focus on environmental protection
Many forms of pollution have increased as China has industrialised causing widespread environmental and health problems. For instance, air quality in cities such as Beijing and Shanghai has been an issue for many years. China's government has recently changed priorities. It now considers environmental protection a major driver of economic transformation and sustainable development for the country. The 13th Five-Year Plan, which covers the period 2016-2020, promotes a more sustainable economy, with strong commitments to environmental management and protection, clean energy, emissions control, ecological protection and security. Moreover, with the introduction of the amended Environmental Protection Law on January 1, 2015, China fundamentally restructured its approach to environmental regulatory enforcement. The new philosophy is: "We need not only economic growth but also a good ecological environment, and we prefer a good ecological environment to economic growth. In fact, a good ecological environment is itself a valuable asset." But there are still economic limits ...
European Monetary Policy
Monetary policy is announced to remain ultra-expansionary. The ECB argues that it will not embark on a less expansionary monetary policy for the time being given geopolitical factors and uncertainties about protectionism, the Brexit and the vulnerability of many EM. Nevertheless, ECB President Mario Draghi argues that business activity is continuously supported by favourable financing conditions, rising employment and wages, which should help stoke consumer spending in future. The euro area is also likely to continue to benefit from global growth. There is still hope of reaching a soft landing and to avoid a recession.
Chinese Fiscal Policy
On the fiscal side, the Chinese government announced more public investments in infrastructure and fiscal stimulus measures. For instance, the government plans to accelerate urban infrastructure spending and ease restrictions on public-private partnerships. Moreover, requirements for bond issuance for local governments were reduced in order to facilitate local infrastructure investments.
Chinese Monetary Policy
On the monetary side, the Chinese Central Bank (People's Bank of China, PBC) has reduced the reserve requirements for banks four times in 2018 and increased the liquidity in the financial system in order to stimulate bank credits to non-financial companies. These measures are planned to be continued throughout 2019. However, the PBC is expected to keep its benchmark lending rate unchanged at 4.35% through this year.
European Monetary Policy
On the occasion of the Press conference on March 7, 2019, ECB President Mario Draghi announced his policy conclusions: (1) The key interest rate (main refinancing operations rate (MRO)) is to remain unchanged until the end of 2019 (i.e. zero). (2) The ECB intend to continue reinvesting, in full, the principal payments from maturing securities purchased under the asset purchase programme (APP) for an extended period of time past the date when the ECB will start raising the key interest rates in order to maintain favourable liquidity conditions. (3) ECB decided to launch a new series of quarterly targeted longer-term refinancing operations (TLTRO-III), starting in Sept. 2019 and ending in Mar. 2021, each with a maturity of two years. It will help to preserve favourable bank lending conditions. Message: "exit" be postponed for the time being.
Boost competitiveness and productivity
Policymakers should also seek to limit preferential treatment of the state-owned sector and reduce regulation for private sector to encourage a level playing field for all market participants. For example, even though private investors have been permitted since 2005 to establish airlines, to date that sector has been dominated by state oligopolies, because the government sets a floor on airline ticket prices. This has forced many private companies out of the airline market. Despite the dominant role of SOE in many sectors, the private economy has flourished. Today, private companies contribute more to create new employment than the SOEs, accounting for 75% of all jobs and two-thirds of GDP. Private companies are also much more productive than SOE, as illustrated by return on assets. Private sector obviously absorbs workers laid-off by SOE.
Euro area's growth gained ground after the debt crisis
Positive sides of the upswing are: • Inflation and interest rates remained low. The inflation rate was about 1.5% in Jan./Mar. 2019, i.e. there is still some room to move the inflation rate upward to the inflation target (of 1.8%). • Unemployment in the euro area had fallen to 7.8% in 2/2019. • Growth drivers during the upswing since 2014 had been resilient private consumption - backed by rising employment and wages - and dynamic export growth due to global growth. • Investment has been relatively buoyant due strong global demand over the years and favourable financing conditions. However, rising US protectionism and Brexit have created more economic uncertainty and damage to international trade.
Balanced Growth
Public services provision to lean towards rural and remote area. Pushing forward urbanization, especially household registration based urbanization. Equal access to public services for rural and urban citizens.
Consumption in China (short-term view)
Sentiment indicators also become more negative especially on the side of manufacturing. Official Purchasing Manager Index (PMI) and the (economic newspaper) Caixin Manufacturing PMI fell in December 2019 below the neutral level of 50 usually indicating a contraction in the period thereafter. By contrast, services and consumption grew briskly by over 7% in 2018 and will continued boost the economy in 2019 spurred by continued solid wage growth for skilled workers. The inflation rate continues to be moderate: 2.1% in 2018 and 2.4% this year. The Chinese government plans to maintain a 3% consumer inflation target for 2019 as in the previous years. All in all, China's economy is expected to cool further in 2019 as domestic demand weakens and exports are hit by U.S. tariffs.
China's Inconsistent Trinity
Since 2015 China pursues a policy of cautious managed floating of the yuan with the aim not to kindle the trade conflict with the US. Currently, any devaluation of the yuan against the dollar would raise the anger of the US Administration arguing that China is not interested in reducing its large (bilateral) trade surplus towards the USA. China would like to open itself fully to capital flows in order tocreate a modern financial system, in which market forces playa bigger role. However, China faces the position of a inconsistent triangle (or: inconsistent trinity) meaning that it is impossible to have a fixed exchange rate, monetary policy autonomy and free capital mobility at the same time. According to the impossible trinity, a central bank can only pursue two of above-mentioned three aims simultaneously.
China's Managed Exchange Rate System
The Chinese central bank (People's Bank of China/PBC) has progressively adapted its exchange rate management approach to meet the needs of an increasingly open Chinese economy. Until 2005, the renminbi was pegged to the dollar (1$ = 8.28 Yuan). Since 2006 China's exchange rate policy is based on a strategy allowing the exchange rate to float in a narrow margin around a fixed base rate determined with reference to a weighted basket of 13 important currencies. The ensuing up-valuation against the dollar by 20% to 25% was deemed necessary to counter the US argument of an undervalued yuan giving China a competitive advantage. China shook financial markets in Aug. 2015 by a sudden small devaluation. There were fears that China's industrial sector would export deflationary forces to the rest of the world by means of devaluation. PBC sold more than $1 trillion of the more than $4 trillion in foreign exchange reserves in forex markets since June 2015 and introduced new capital restrictions in order to stem against capital outflows and to stabilize the exchange rate. A considerable devaluation of the yuan could be avoided.
Chinese Public versus Private Companies
The Chinese economy is a mixture of state-owned and private enterprises. It is also a mixture of centralisation and decentralisation. There are many doubts whether it is a market economy. It combines market elements with strong interference of government into the real economy. • China is highly centralized in personal controls and mass media controls. • Provincial level officials are directly controlled by the central government. • Government controls, for instance the four largest state-owed banks. A prefential treatment of SOE regarding bank credits is a daily occurrence.
China is the great unknown concerning economic model
The Chinese economy is still in the transition of its economic model from an export- and investment-led economy to a consumption- and serviceoriented economy. This has been likely to cause growth to weaken in due course. Growth rates are lower since 2013 (6 to 7% instead of 10%) At present, it is also very important that US protectionism and the escalating trade conflict between the USA and China in 2018 have considerably dampened economic dynamics in China. Whether ongoing trade negotiations between the US and China will bring a breakthrough and a sustainable outcome remains to be seen. The growth rate of China's GDP decreased slightly from 6.9% in 2017 to 6.6% in 2018. The Government forecast is 6% to 6.5% for 2019. The IMF forecast is 6.3%, which is based on the assumption of a (much more) expansionary monetary and fiscal policy in China. Much will depend on China's ability to kick-start growth.
Future Role of the Renminbi as an international currency
The Chinese exchange rate policy went hand in hand with a partly rising role in international use of the yuan as trade and reserve currency. The future role of the renminbi as a fully fledged international Currency, which serves simultaneously as trade, investment, reserve and anchor currency depends on many determinates. They include the economic size, the growth dynamics, the degree of openness of the real economy, dismantling of international capital restrictions and the quality and liquidity of financial markets. The international use of a currency is confidence-based. It cannot be decreed by government and it is likely to be a market-driven process.
Growth rate for China's GDP
The Chinese government expects a growth rate between 6% and 6.5% for 2019, the IMF forecasts 6.3%, and Deutsche Bank 6.1%. The forecasts for 2020 tend to be even lower: IMF: 6.1%, Deutsche Bank 6%, Rabo-Bank: 5.8%.
ECB continues doing the job of stimulating the economy
The burst of the real estate bubbles has triggered the Financial crisis in 2008. Asset price inflation might also take place in stock markets. Low interest rates are an incentive to invest in more riskier assets in order to get a higher return. Stock prices have benefited from low interest rates. Yet, we do not see a problematic bubble in real estate market of euro area. The crucial question is whether the ECB will have even more firepower when negative (deposit) interest rates exist and the key interest rate is already zero and a huge portfolio of bonds on the books of the ECB. A further crucial question is to identify and solve the many problems caused by the risks and side-effects of a permanent low-interest rate policy.
Case 6: How to support the economic growth in the euro area?
The economic growth in the euro area has recently lost momentum. The growth rate is forecast to fall to 1.6% in 2019 after 1.8% in the previous year and a peak of 2.4% in 2017. Unemployment is declining slowly but the biggest challenge is the still too high unemployment rates in southern Europe. Inflation has remained low and ECB's monetary policy has been very accommodative.
The world economy continues to expand
The euro area benefits from the fact that the USA is on a satisfactory growth path: 2017: 2.2% 2018: 2.9%, 2019: 2.3% stimulated by an expansionary fiscal policy of President Trump (large tax cut for enterprises and moderate temporary income tax cut, increased spending on defense). The large tax cut will continue to boost US growth but also public debt and inflation. While tax cut is a fiscal stimulus to business investment it also increases budget deficit and pushes up public debt. The tax cut is not self-financing but would raise public debt to GDP ratio. For instance, the self-financing quota of the tax cut is estimated by US Congressional Budget Office (CBO) to be 70% given unchanged policies. The US federal budget deficit is expected to rise from 3.8% of GDP in 2018 to 4.2% of GDP in 2019 (status April 2019). US inflation rate (2/2019: 1.5%; 12/2018: 1.9%, average 2018: 2.4%) will face two opposite forces. There will a continuously good GDP growth and an upward impact on inflation in a fully-employed US economy (3.8% unemployment rate, Febr. 2019). US import tariffs are also likely to feed the inflation rate. By contrast, rising inflation rates will lead to rising interest rates. This in turn is likely to push the dollar exchange rate, which will dampen US inflation. The euro area also benefitting from buoyant growth in emerging market and developing economies. Their GDP growth came to 4.5% in 2018 and are forecast to 4.4% in 2019 and 4.8 % in 2020. Main growth contributors: India and Asean countries, but also China with (a bit) more moderate growth and recovery in Brazil and South Africa.
Boost competitiveness and productivity
The government should focus on reducing its interference in the economy by resuming the SOE privatization process and introducing greater market competition by reducing private-sector regulation and state protection of SOEs. Given SOEs' significance in the state's socialist system, a practical approach to privatization would be to advance the mixed-ownership reforms outlined in the 2013 Third Plenum: State monopolies or oligopolies in competitive industries should be broken up and the barriers to entry lowered. Corporate governance reforms should limit the government's interventions. Together, these policies would bolster SOE efficiency by increasing market disciplines and encouraging further diversification of SOE ownership structure through share subscriptions, equity stake purchases, and convertible bonds
Protectionism in US trade policy is a big risk
The protectionist US trade policy is a substantial risk of the euro area creating uncertainty and causing damage for global trade and growth. That argument is directly relevant in the bilateral trade conflict between the USA and the EU, but also indirectly if the US - Chinese trade conflict causes damage to Chinese growth and imports. We must not forget that China has contributed one third to the growth of world's GDP in recent years. US protectionist threats to the EU and the euro area are still on the table. Although the US-Chinese trade conflict is looming large the trade dispute of the US with the EU is likely to go on as well. In particular the Germans are not off the hook. While US administration has narrowed its protectionist attacks towards China during the (ongoing) negotiation process, tariffs being imposed on EU's car sector remain a 2019 possibility. The subsidies for the airbus project is a new bone of contension.
Euro area's growth gained ground after the debt crisis
The related continuously deflationary fears led to the long-lasting ultra-lax monetary policy of ECB. Negative interest rates (deposit rate) were introduced in June 2014, a massive QE was launched in 2015 and key interest rate sank to 0 in March 2016. Several member countries (e.g. D, Sp., NL, IRE) used the upswing to reduce public and private debt ratios ("deleveraging"). It's good governance to use the upswing in order to create fiscal buffers for bad economic times by moving to a restrictive orientation of fiscal policy during the upswing. Especially euro area countries with a high government debt-to-GDP ratio need to do more than simply let automatic stabilisers do their work. For instance, Italy is a budgetary sinner (with an unchanged debt ratio of 132% of GDP since 2014). By contrast, D's "black zero" policy since 2013 brought down debt ratio from 81% to 60% of GDP.
Fiscal policy can do the job stimulating the economy
Then a highly indebted country runs the risk of a return of a procyclical fiscal policy, namely to pursue a restrictive fiscal policy during the economic downturn. • Italy has weak growth but there no room for fiscal manoeuvre with an unchanged debt ratio of c. 132% of GDP since 2014. There is also potential risk of financial contagion taking hold. • France is still close to 100% and Spain close to 90%. The room for action is also limited in both countries. • On the other hand, Germany has achieved a budget surplus since six years (2018 e.g. 1.7% of GDP) and can afford a fiscal stimulus after having lowered the debt/GDP ratio to about 60% in 2018. • That would also justified by the fact that German economy is expected to cool down further in 2019 (IMF: 0.8% status Apr. 2019: Five Wise Man (SVR): 0.8%; (Status March 2019). • A fiscal stimulus in Germany could increase domestic demand and GDP, benefit euro area partner countries via higher German imports and lower huge current account surplus (2018: 7.4% of GDP; 2019: 6.5% of GDP). A lower CA surplus would be good news for US President Trump. • However, there is no change of German fiscal policy in the offing. German government continues to pursue a policy of "black zero" in the federal budget.
Fiscal policy can do the job stimulating the economy
There has been marked progress in deleveraging of governments, corporates, households during upswing of the euro area since 2014, i.e. debt ratios have sunk and returned to more sustainable levels. According to the ECB, gross corporate debt to GDP is now back to pre-crisis levels in several countries. In vulnerable countries like Spain and Italy it has even reached lower levels. For households, gross indebtedness has come down just below the level of mid 2008, i.e. just before financial crisis. The upswing of the euro area since 2014 has also led to lower budget deficits and declining public debt ratios, which also contributes to rising confidence. The budget deficit/GDP ratio stood at minus 1% at the end 2016 and minus 0.5% in Qu3 2018 compared with minus 6.2% in 2010 and minus 2.6% in 2014. The public debt to GDP ratio of euro area declined to 85.1% in Qu3 2018 from 92% at the end of 2014. Fiscal policy can do a bit. Background: Implementing the rules of Stability and Growth Pact (SGP) would generate an appropriate change in fiscal stance for the euro area in 2019. Fiscal policy should become anticyclical, i.e. expansionary in order to compensate for the slowdown in growth since 2018.
Risks and side-effects of ultra-lax monetary policy
There is also an intense controversy about the risks and side effects of this ultra-expansive monetary policy which may cause economic disadvantages, in particular in the longer term. The ECB is heavily criticised for incurring the following risks: • It was argued that it would be useless, as the euro area is experiencing a liquidity trap; more liquidity does not mean more bank lending if profitable investments are lacking. • It would not take into account the existence of long and uncertain time lags of monetary impulses into real economy; • the ECB would violate its mandate set by trying to raise the inflation rate artificially instead of revising its inflation target; • the ECB would lose its credibility.
Protectionism in US trade policy is a big risk
US tariffs being imposed on EU's car sector would be a big problem for Germany with its important car exporting power. Germany is still protectionist target of President Trump because of the country's big bilateral trade surplus vis-à-vis the US ($68.3 in 2018 and rising) and a huge but shrinking overall current account surplus (7.4% of GDP in 2018, 6.5% in 2019) compared with US current account deficit of 2.5% of GDP in 2018 and 3.5% in 2019. A disequilibrium in bilateral trade or current account balance does not matter as long it is the result of millions of independent private sector decisions (enterprises/households) based on a competitive economy and a country is able and willing to incur debt to buy German goods. That is the case in the US. However, it would be fair to say that Germany should do more to stimulate its economy. Germany has some fiscal policy room to spur domestic demand by an income tax cut in order to expedite the reduction of the current account surplus.
Avoid a permanent trade conflict with the US
USA and China are bearing the brunt of the costs of their trade war. These costs would roughly double if the US imposes a 25% tariff on an additional $267 bn of imports from China and if China responds with 25% tariffs on all US exports. The USA and China, however, do benefit in the short term, as households and firms in China and the United States substitute away from the higher-priced imports, now subject to tariffs, to imports from other countries and sources. Over time, as Chinese and US households and firms are able to source domestically more of the goods that were previously imported, the benefits to other countries disappear...
China's Managed Exchange Rate System
Until 2005, the renminbi was pegged to the dollar (1$ = 8.28 Yuan). Since 2006 China's exchange rate policy is based on a strategy allowing the exchange rate to float in a narrow margin around a fixed base rate determined with reference to a weighted basket of 13 important currencies. The ensuing up-valuation against the dollar by 20% to 25% was deemed necessary to counter the US argument of an undervalued yuan giving China a competitive advantage.
Euro area's growth is losing momentum
While there was satisfactory US growth in 2018 (c. 3%) the euro area's economic dynamic lost momentum in 2018 (GDP: 1.8% after the peak of 2.5% in 2017). After a strong start in 2018 euro area's economy lost steam in second half due to plunging confidence and dampened export demand which suffered from rising protectionism, Brexit and related uncertainty. Part of the weakness seen in second half of 2018 was also due to one-off effects in Germany, France and Italy. Germany's Crucial automobile sector struggled to adjust production to new emission standards; 'gilets jaunes' protests in France disrupted activity late last year; Italy's domestic demand (I and C) suffered from the dispute about higher govt. debt and rising bond yields.
Case 5: Comment on the growth prospects of Chinese economy!
Why is China's macroeconomy weakening and what are the challenges?
Rule of 70
number of years to double = 70/annual percentage growth rate
Fiscal policy can do the job stimulating the economy
• Nevertheless, an anticyclical fiscal policy in Germany is recommended and would be possible without problematic increase in government debt or a violation of the debt brake in German Constitution. • One option would be to aim at a no surplus budget. • Another option would be to incur a small deficit of say 0.5% of GDP (corresponding to an amount of €17 billion). • There should be a mixture of a tax cut (e.g. complete abolition of the Soli/ solidarity surcharge) and an increase in investment spending in infrastructure (in particular in transportation, education and digitalisation).
China has to master the hallmarks of modern economy
•replacing capital with productivity, •encouraging domestic consumption for its expanding middle class and providing its people security and services in a safe urban setting, •continue the catching-up process by moving up the manufacturing value chain, and being competitive in the digital era. • manage rising impact of structural change on labour market including lay-offs in SOE. How reliable is the constant unemployment rate of 4%? Private enterprises are likely to absorb the jobless of SOE.
