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INTERNATIONAL ECONOMIC ANALYSIS 9 IS IT THE END OF ECONOMIC PROSPERITY?

The 9th session of the FAES Economic Forum took place on July 9, 2007, during the opening of the FAES campus summer course called “Evaluating the Economic Future.” The forum was attended by Jaime García-Legaz, Secretary General of FAES and course director, Fernando Fernández, Vice-Chancellor of the University of Antonio de Nebrija, José Luis Feito, President of ASETA, Luis de Guindos, President of Lehman Brothers in Spain and Portugal, and Juan José Toribio, Professor at IESE. The participants analysed the principal factors affecting the international economic situation in the context of interest rate hikes, which have major reper- cussions on the international financial markets. José Luis Feito opened the debate with a comment about the key international economic indicators, which point to the end of an eco- nomic cycle of intense growth and low rates. Luis de Guindos followed with an analysis of how these new situations can affect the financial markets, and particularly the credit markets. Juan José Toribio described four strategic challenges for the economy in the future. Fernando Fernández ended the speeches with an analysis warning of the imminent change in the eco- nomic cycle.

José Luis Feito, Juan José Toribio, Fernando Fernández, Luis de Guindos and Jaime García-Legaz. OBSERVATORIO9 ingl:OBSERVATORIO 24/10/07 13:36 Página 2

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TThe end of cheap money in the US and to a lesser extent in Europe, In the last few years the international eco- started rising again and this trend intensified nomic arena has been characterized by in 2006 and in 2007, and spread to all long strong economic growth driven by uncharac- and short term interest rates. teristically low interest rates, which have held steady for a long time in comparison with The big question is whether these high previous historical periods, since they have interest rates mean the end of the economic not gone in tandem with widespread infla- expansion cycle, and as in previous periods, tion. The world has grown at an unprecedent- an increase in interest rates leading to the ed pace since the Second World War, and end of economic growth and a slowdown in this with hardly any inflation. the economy, along with an increase in unemployment and a reduction in consump- The absence of inflation in goods and tion. services, which is key during this period of negative rates, is based on two factors: on The increase in interest rates has initially the one hand, the increase in world produc- impacted on the U.S. economy. The first to tivity in all sectors, followed by the globaliza- start raising rates was the U.S., which has tion phenomenon, with major production in been greatly affected by an increase in the China and India, according to IMF data, which cost of borrowing, and growth has shifted has reduced world inflation by more than 1%. from over 3% in 2006 to a clip of under 1% in the first quarter of 2007. This was accom- Nevertheless, the persistence of negative panied by macroeconomic variables that real interest rates has led individuals and demonstrate an important slowdown driven companies to build up their borrowing to very by a sudden drop-off in the construction sec- high levels and this has had an effect on the tor, which was most directly affected by the prices of certain assets, specifically real rate increase. The general consensus among estate investments, which have risen sharply analysts is that the U.S. will recover from this and disproportionately in relation to their slowdown if the construction sector crisis expected economic performance. does not spread to the private consumer sec- tor. These imbalances produced by low inter- est rates, and a period of monetary expan- At the same time there are other impor- sion have manifested themselves unevenly tant factors in the U.S. economy. First of all depending on different world zones and a slip in the economy’s productivity, which assets examined: real estate property, finan- has also been increasingly less able to grow cial assets, bonds, certain nations’ debt, without inflation, and secondly, dollar weak- commodity prices, housing prices, higher lev- ness, which turns out to be an added compli- els of corporate risk, etc. cation, since it implies that interest rates will not be at liberty to fall, and therefore it is However, since the end of 2004 interest more likely that this may affect consumption rates have stopped falling off and then, first and increase the risk of recession.

“The world economy has had the highest four-year period of growth since the Second World War and a correction is normal.” (Luis de Guindos)

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“Stepping in to act on the cost of borrowing does not necessarily mean changing growth cycles.” (José Luis Feito)

Is it the end of a growth period? general terms it does not have great financial The slowdown in the U.S. economy will not imbalances. be key for the rest of the larger world economies. 2006 economic growth in the Japan, the second largest world economy, U.S. resulted in a 12% increase the world presents an anomalous situation with interest economy, a very low figure compared to that rates at nigh on 0%, driven by negative infla- of China and India combined, which was tion and a currency which has progressively 47%. According to all the analysts, a sharp depreciated more than 30% from what is con- slowdown in the U.S. economy would have sidered its normal level as measured by pur- limited repercussions in Asia, which progres- chasing parity rates. This situation has sively has more internal demand versus its spawned the so called ’carry-trade’ whereby traditional reliance on exports. Specifically in the debts acquired in yen can be used to China, with growth rates of over 10%, a U.S. finance higher-return assets in other countries recession by itself would not pare these and in other currencies. Japan has become a down by more than 3%. supplier of world liquidity and generates great vulnerability in the international financial mar- Europe taken together faces only the kets, given that should interest rates have to beginnings of this crisis with a very increase in that country or the yen strengthen, favourable economic situation, given that in the financial system would be visibly rocked.

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“The persistence of higher rates in the U.S. will prompt a drop-off in consumption.” (José Luis Feito)

On the world stage the persistent negative come from an interest rate rise. The scope of interest rates have resulted in a certain such an adjustment remains to be seen and, in imbalance: first of all the savings rate has short, whether a recovery in the U.S. and a cor- fallen drastically and has made for higher- rection of imbalances will enable a return to leveraged economies, given that borrowing markets with lower interest rates. has become profitable. Furthermore, this increase in debt has sparked a dispropor- Financial market risks and corrections tionate increase in the value of assets and The macroeconomic imbalances have pro- finally, the market has enticed investors into duced major uncertainty about immediate altering their risk-return profile in such a way world economic growth and generated risks as to accept higher levels of risk than would for financial markets. The biggest danger is have been prudent. of a sharp correction in credit, and that this may drive up real interest rates. Finally, the world economy presents increas- ing risks due to the imbalances that have been In the last few years there has been created and a correction is needed, which will excess liquidity, which has allowed the

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“The economic outlook is good for this year, but it is not exempt from major risks.” (Luis de Guindos)

already continuous and steady rise in price of climbed by 20% ahead of GDP in the U.S., assets: bonds, stocks, real estate property, producing a wealth effect and justifying and financial assets, etc. An increase in indebtedness even further. Finally, another interest rates implies an abrupt adjustment key factor is the expectations companies in the credit market, restricting and therefore have and their assessments of the immedi- increasing the cost of capital, which would ate future of the economy, which are first of all affect debts entered into and con- extremely positive in the U.S. as well as in sequently trigger a downward correction in Europe. The outcome of this has been a dis- the cost of assets. torted valuation of companies in relation to expected sustained growth that may prove There are certain indicators that warn of illusory, and the need for debt for acquisi- this risk. First of all the world’s combined cur- tions and increased corporate activity. rency in circulation has increased in the US at a pace higher than 10% in the last few The international economy will, in the next years. In addition, the central banks in Asian few months, live through a period of adjust- countries, favoured by their economies’ lean- ment during which the tendencies of the last ing towards exports, have built up their cur- few years will be corrected. Basically this will rency reserves considerably, and have turned come from three factors: hikes in central out to be the biggest holders of U.S. bonds. bank rates, an increase in long-term rates, Another important figure is the personal and growth in risk differentials, among wealth to borrowing ratio which, stimulated assets, in order to “justify” investor deci- by the rise in the value of assets, has sions.

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“Energy, supplying it and its cost will be key to how the economy performs.” (Juan José Toribio)

It remains to be seen how this correction Another major question for the near future in world economic growth will pan out, and if is the demographic changes which are occur- it will result in a soft landing for rate rises so ring in the world. According to the United another period of growth can start later, or if Nations, we are, for the first time in history, it will be an abrupt and lasting adjustment near to witnessing a decrease in world popu- that will slow down all world economies. lation during peaceful times. This population decrease would come about in an imbalanced Future factors manner and, as a matter of fact, it is already Currently the world economy is going through affecting the developed economies, such as a series of unusual historical circumstances Japan and Italy. The growing age of the popu- which will shape developments to follow. This lation and demographic changes will affect is an increasingly internationalised economy productivity in numerous economies, and that is over 65% services-based. affect the financial commitment of administra- tions, which will have an added repercussion First of all, it is important to highlight the on the migratory flows that will intensify in fact that the risks that affect the economy those countries that need labourers. have supranational characteristics. It has been noted, for example, how with “carry- Similarly, the generalized indebtedness of trade” one country can pump liquidity into European and U.S. economies and the the entire world system and neutralise spe- increase of reserves in China and other cific monetary policies. This contrasts with Asian countries pose an added risk to the the fact that all the instruments we have for economy. It is estimated that Asian countries using on the economy are basically national, and energy exporting countries possess and the international institutions, such as more than 70% of world monetary reserves, the IMF, are currently not truly able to set and have turned into the foremost lenders to economic policy. developed countries, thus financing their indebtedness. This accumulation of reserves In second place, energy will increasingly may not be a sustainable phenomenon and have an important impact on the economy could develop into a payment crisis or a and international policy. Currently the coun- changing dollar exchange rate. On the other tries that supply primary energy are very few hand, these currency reserves are increas- and are very concentrated in specific geo- ingly managed through less traditional instru- graphical areas. This fact arouses uncertain- ments, given that these have given way to ty, which will intensify as the demand for oil other investment tools, such as sovereign increases and the capacity to supply it dimin- funds and entities which invest in internation- ishes. The consequence will be an increase al markets. It can be simply stated that this in prices and this will spread generalized accumulation of savings in Asian countries is inflation to all markets and slow down any similar to export credit in developed coun- possibility of growth. Diversification of energy tries, and also a rational consequence of the sources is necessary, as well as coordinated decision to invest in markets with more con- implementation of policies, which guarantee solidated property rights, with more transpar- efficient and economical supply. ent regulations, and legal guarantees.

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“Emerging countries have long financed the debt of the wealthiest countries” (Fernando Fernández)

Finally, we must highlight the other factor quences of the increase in China and India’s in the world economy, and that is the pro- income are yet to be determined in a few gressive integration of China and India, not years, as well as the impact of their only in the goods and services markets, but demands on the world’s raw materials, also in the financial markets. The conse- goods, and services.

“There is a lack of international institutions that can face up to the risks of a globalised economy.” (Juan José Toribio)

© FAES Fundación para el Análisis y los Estudios Sociales and the authors. FAES Fundación para el Análisis y los Estudios Sociales does not necessarily hold the opinions expressed in the texts it publishes.

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