photo: Nicolas Raymond
Key takeaway – The fundamental structure of the world economy is changing. While the contribution of services to global output is on the rise, investment and productivity remain stagnant, savings keep accumulating, and growth and inflation decline. Meanwhile, globalization has increased co-dependence: a rising number of countries can influence the world’s economic performance and its financial stability. Yet, the international monetary system is neither fostering an efficient allocation of global capital nor preventing currency volatility. As a result, the global economy is in the middle of a “lost decade”: emerging markets (EMs) struggle with slowing growth, a sizeable external debt, capital outflows and depreciating currencies. Europe’s economies suffer from stagnating growth, separatist politics, a heavy sovereign debt, unfavourable demographics, inflexible labor markets, a migrant crisis and religious divides. Until 2020, the price of oil will stay in the US Dollars (USD) 50-60 range. As the shortcut to recovery is an ‘unfair’ mix of orderly debt restructuring and mild inflation, monetary policy normalization will take longer than expected, buoying the financial markets. As a result, the financial system is reaching an unstable equilibrium. The global economy is weak, the markets are strong, but the trade-off between sustained growth and financial stability is likely to continue. While high volatility will favour traders, for fundamental investors returns are likely to be lower than in recent years.
- Is the fundamental structure of the world economy changing? Yes, the global economy is undergoing a long-term, structural transformation. First, in the past 30 years, the contribution of key sectors to global output shifted: agriculture fell, manufacturing declined, and services rose as shares of global value added and employment. Second, capital expenditures are declining. Service – i.e. tech, digital – companies need little investment to prosper. For example, the fast-growing “sharing economy” – by relying on the Internet – cheaply interfaces vast supply systems (where the costs are) with a large number of customers (the demand, where the money is); in other words, by inexpensively putting underutilized resources to use, it creates value with little capital costs. As a result, global net investment (gross investment minus depreciation, as a share of the total capital stock) is close to its lowest level since the Second World War. Third, demographic trends support a decline in investment and consumption, because: a) falling birth rates and a rising life expectancy are leading to aging populations, especially in developed markets (DMs); b) as the pool of working-age (15 to 64 years old) individuals shrinks in both DMs and EMs, firms deploy less capital – because there are fewer workers to hire; and c)as a result, labor-force participation rates decline and consumers refrain from spending.
- Why is productivity low, and savings keep rising? The productivity boost of the “new economy” – the post-manufacturing, service-based economic system – is lower than in past industrial revolutions. After the 2008 financial crisis, labor productivity growth fell across sectors in most OECD countries, where 45 million workers are jobless. While technological progress and business automation are making white collar jobs redundant, traditional middle-class jobs disappear. Savings keep growing: first, as inequality rises, a higher share of income goes to richer individuals, with higher-propensity-to-save. Second, since 2008 EMs have accumulated massive foreign-exchange reserves and the world’s main Central Banks (CBs) nearly doubled – from USD 10.1tn to USD 18.2tn – their combined balance sheets. Third, corporations relentlessly accumulate retained earnings. Fourth, this rising supply of savings is rather unresponsive to interest rates cuts; hence, lower CB policy-rates do not boost spending. As a result, and despite historically-low interest rates, economic growth stagnates, along with inflation. In many economies, with short-term interest rates close-to-zero and declining prices, achieving full employment becomes a real challenge. In line with the secular stagnation hypothesis, negative real interest rates might be needed to equate saving and investment with full employment.
- Has globalization increased co-dependence and systemic risks? Yes: rapid cross-border economic, social, technological exchange enhanced interconnections, increasing resilience, but also fragility. Capital has become an (often unpredictable) driving force, more influential and systemic than trade. The foreign exchange market grew to be the world’s largest market, with average daily trading volumes in excess of USD4 trillion (tn). Via macro-financial linkages, 25 economies – because of their size and connections with other countries – can have a systemic impact on the performance of the global economy and its financial stability, and need regular monitoring. As the scale of financial flows and their volatility rise in a context of lower growth and higher uncertainty, economic interdependencies increase risks rather than diminishing them, and financial crises became more recurrent. For example, the sudden unwinding of global imbalances (see 4. below) could work as a “crisis-transmission-mechanism”. Indeed, over the past six years, EMs – forced to invest their reserves in large liquid debt markets – kept financing deficits in large DMs; the holding of US sovereign debt by Brazil, Russia, India and China (BRIC) almost doubled from USD 1.0tn (December 2008) to USD 1.7tn (September 2015).
- Why is international monetary system neither preventing currency volatility nor fostering an efficient allocation of global capital? Over the past few years, most currencies’ exchange-rates fluctuated at an unprecedented pace, hampering capital transfers and commercial activity. Overtime, uncoordinated competitive devaluations (i.e. currency wars) aimed at supporting and boosting national economic activity could foster protectionism. EM foreign-exchange holdings4, at two-thirds of the total, de facto reduce global demand. Indeed, while they should invest in their local economy, EMs end up lending cheaply to (wealthier) economies that need to save rather than spend. In other words, reserve accumulation increases global imbalances and – by pushing down long-term interest rates – sows the seeds of future financial instability. A major re-thinking is needed. To ensure capital flows, trade relations, and global prosperity, the monetary system needs a few internationally-trusted currencies – the so-called “global reserve currencies”. These currencies facilitate the setting of prices, the payment of goods and services in global markets, the holdings by governments and institutions of foreign exchange reserves, the denomination of balance sheets for both public and private actors, and the accumulation of savings and (central) bank reserves.
- Is the global economy in the middle of a “lost decade”? Yes: seven years into the 2008-crisis, the world still faces below-potential growth prospects. Low investments, ageing populations, and stagnant wages have weakened aggregate demand. In absence of a significant productivity boost led by innovation, global growth is likely to languish below potential for a few more years, dragged down by a deceleration in EMs and Europe’s chronic shortcomings.
- Are EMs in for a long period of low growth? Over the next few years, EMs are likely to struggle with slowing growth, a sizeable external debt, capital outflows, and currency depreciation. In 2015, global growth is declining to 2.6 percent (from 3.4 percent in 2014), hampered by China’s downturn – which in turn hit the price of commodities and specialized manufacturing equipment – and recessions in Brazil and Russia. Between 2009 and 2015, taking advantage of low interest rates in DMs, EM governments, banks and firms borrowed in USD at unprecedented levels. The combination of sluggish growth and high external debt (and its possible consequences on political volatility) is taking a toll on investors’ confidence: between 2008 and 2014, private capital outflows from EMs have increased significantly (from USD 0.73tn to USD 1.05tn), and in 2015 – for the first time since 1988 – EMs will suffer a net capital outflow of about USD 540bn. Between 2009 and 2015, all major currencies – with the exception of the Chinese Yuan – experienced significant depreciation against the USD. To support the exchange rate, CBs intervened in the currency markets and reduced their foreign exchange reserves by selling their DM-government bond holdings. This resulted in a reduction of total foreign exchange reserves of BRIC countries from USD 5.0tn (October 2014) to USD 4.2tn (October 2015). If a market-event – a US Federal Reserve (Fed) interest rates hike, a surging USD, a drop in commodity prices, a conflict – were to cause EM currencies to slide against the USD, the debt burden in local currency would rise even more: some borrowers would become unable to service their foreign currency debts and start missing interest payments; others could become unable to roll over principal and corporate defaults would ensue.
- Can Europe manage? Across the continent, countries with different economic, social, and political structures suffer from unfavorable demographics, inflexible labor markets, and a heavy sovereign debt. Most economies are frail: growth is stagnant, the productive potential is declining and unemployment is high. Politics is an arduous balancing exercise: while separatist political forces are on the rise, an unresolved migrant crisis divides opinions and is putting religious divides back on the agenda. There are no visionary leaders. The institutional structure and policy tools needed to manage shocks are absent. Asymmetric shocks are likely to put the monetary union under intolerable pressure, as long as it lacks a: 1) common fiscal policy; 2) smooth inter-country labor mobility; and 3) solid banking union. In times of “savings glut”, adverse demographic prospects increase the supply of savings, the lack of labor-market flexibility reduces investment demand, and low investments depress productivity. The Stability and Growth Pact – by imposing a public debt below 60 percent of GDP – calls for an aggressive debt-reduction via fiscal austerity; if carried out, this would: 1) further increase excess saving; 2) lead to a shortage of safe assets (see 10. below); and 3) bring about deflation. Instead, Germany – able to borrow at negative real interest rates – should build infrastructure at home, and allow other countries to suspend fiscal consolidations as long as politically unpalatable, but growth-enhancing, structural reforms are implemented. Easier said than done.
- Will the price of oil stay relatively low? Until 2020, oil prices are likely to remain in the range of USD 50-60 per barrel, according to the International Energy Agency’s World Energy Outlook. In 2013-2014, the oil market suffered fundamental supply-changes, as: a) shale-oil production flooded the market, particularly in the US; and b) unprecedentedly, Saudi Arabia’s decided to stop playing the role of OPEC swing producer. As a result, in mid-2014 – in just a few months – oil prices more than halved, and stabilized after a temporary overshoot. The large price drop caused supply destruction, as some energy producers, from both traditional and non-traditional sectors, became unprofitable. Consumers reacted slowly to lower energy costs, and demand adjusted only gradually. In 2015, OPEC – not to lose market-share – renewed downwards pressure on prices by adding almost two million barrels per day (bpd) to total production, almost half of global output growth. Big geopolitical losers from low oil prices include Venezuela, Russia, and Iran. In the summer of 2015, the global economy started weakening, especially in energy-intensive countries such as China and Brazil, as well as in energy-producing Russia. Going forward, if the price of oil remains under USD 60 per barrel, producers will cut their operating costs, shut inefficient rigs down and suspend new investments; production will decrease, especially in the US. Over the long term, two developments are likely: a) low oil prices will put pressure on the fiscal balances of OPEC countries, forcing OPEC to reduce output to increase the price; and b) if the price rises above USD 80, US tight oil production will grow by 1.5mn bpd to over 5mn bpd.
- Is the shortcut to recovery likely to be ‘unfair’? The most likely shortcut to a sustained recovery is an unfair mix of orderly debt restructuring and mild inflation. In other words, a transfer from creditors to debtors (debt restructuring) and from savers to borrowers (inflation) is the only way to clean up balance sheets whilst maintaining the integrity of the global financial system.
- How long it will take to normalize monetary policy? The upcoming tightening cycle is likely to be well below historical norms, and monetary policy normalization will take longer than expected. The pace of rate increases (“the how”) and the long-term “neutral” policy rate (“the end-rate”) are much more important for investors than the exact date (“the when”) of the first tightening move. Both are likely to be very measured, much lower than in past cycles. The European Central Bank (ECB) and the Bank of Japan (BoJ) are unlikely to normalize interest rates anytime soon. Once the Fed tightening cycle starts, the interest-rate differential between the US and key EMs will strengthen the USD and further weaken EM currencies, reducing the USD value of EMs domestic assets and possibly causing breaches in loan covenants. The markets should take notice: investors’ reaction depends on expectations, and a long period of low interest rates is not priced in. In the long run, equities will suffer, bond yields rise and commodities fall.
- The global economy is weak, the markets are strong. Is the financial system reaching an unstable equilibrium? Will it end in tears? The disconnection between (stock and bond) markets and fundamentals is due to abundant macro-liquidity and repeated CB intervention. After years of complacency, data signal risks ahead: across the world, growth is slowing; leading indicators point to a mild global recession, driven by an EM slowdown (see 5. above); volatility and financial stress are rising and macro-liquidity is not translating into consistent market-liquidity. Policy interventions are unlikely to be effective. In this context, CBs risk making policy mistakes and, eventually, losing credibility. The recent episode of market volatility was an early-warning: when CBs start tightening, a bear-market correction will ensue and asset prices will decline to match fundamentals. Capital preservation via a defensive asset allocation is priority. Yet, unusual portfolios – less liquid and more volatile – are likely to perform better than conventional ones.
- Are investment returns likely to be lower than in recent years? Not necessarily, because the tradeoff between sustained growth and financial stability is likely to continue, buoying volatility. On paper, financial markets should favor – with the orderly functioning of transnational financial flows – sustainable growth and financial stability. Over the past few years, however, economic growth could only be achieved via the build-up of debt and asset bubbles. This is likely to continue. In bond markets, regulators – by forcing institutional investors to invest in triple-A assets, while the supply of these assets has declined by 50 percent – are pushing real interest rate even lower. Yields on sovereign and corporate bonds, which pay a spread over government debt, have fallen in tandem. The quest for financial safety has brought about severe safe-asset shortages and, eventually, deficits in aggregate demand. Conversely, in the equity markets, historically-low real-interest-rates have pushed asset prices high and created asset bubbles, boosting investors’ returns via capital gains. However, as profits grow in line with the economy, investment income (the dividend yield) steadily declined. In sum, volatility will remain high going forward, and traders will perform better than fundamental investors.
Article based on material prepared for the keynote speech of the “2nd International Finance Conference: Currency markets. Global practices”, Moscow, November 2015.
 With market capitalizations in the billions, the most popular social media – Facebook, Twitter, and WhatsApp – do not need heavy investments, because they create no content. Alibaba, a large retailer, has no inventory. In just six years, Airbnb became the globe’s largest accommodation provider (with 17 million users and an inventory larger than that of the Hilton) but owns no real estate. Uber, the largest taxi company, owns no vehicles.
 In 2016, for the first time since 1950, the working-age population will decline in DMs – where by 2050 it will shrink by 5 percent – and in key EMs, such as China and Russia. At the same time, the share population over 65 will rise steeply.
 The proportion of working-age individuals either employed or actively seeking work.
 Between 1995 and 2012, the demand for foreign-exchange reserves rose steadily – from USD 1.3tn (5 percent of world GDP) to USD 10.7tn (15 percent). DMs hold less foreign exchange reserves than EMs. In 2015, DMs held USD3.97tn, compared with USD7.52tn for EMs. Brazil: USD 361.2bn (October 2015); Russia: USD 369.6bn (October 2015); India: USD 352.5bn (October 2015); China: USD 3,525.5bn (October 2015). Source: Trading Economics, 2015; IMF, 2015.
 The world’s main CBs have expanded their balance sheets significantly: in the US, from USD 2.2tn (December 2008) to USD 4.5tn (October 2015); in the EZ, from USD 2.4tn (December 2008) to USD 2.9tn (October 2015); in Japan, from USD 1.0tn (December 2008) to USD 3.0tn (October 2015); in the UK, from USD 0.3tn (December 2008) to USD 1.1tn (October 2015); in Switzerland, USD 0.2tn (December 2014) to USD 0.6tn (October 2015); in Brazil, from USD 0.4tn (December, 2008) to USD 0.7tn (October 2015); in Russia, from USD 15.8bn (December 2008) to USD 22.9bn (October 2015); in India, from USD 0.1tn (December 2008) to USD 0.2tn (October 2015); in China, from USD 3.4tn (December 2008) to USD 5.1tn (October 2015). Source: Trading Economics, 2015.
 The decline in the level of real interest rates investors are forced out of low-yielding cash, and a pull factor as the present value of future cash-flows from risky assets appear to rise.
 Examples abound: since 2009, monetary injections in open economies translated into core-to-periphery capital flows, which – while reducing volatility and giving the appearance of stability – further intertwined currency markets. In August 2011, a downgrade of US credit rating from AAA to AA+ by S&P led to a slide in global equity markets. In October 2011, the write-down of Greek-government debt played a crucial role in triggering the Cyprus financial crisis of 2012-13, with two of the largest banks losing approximately EUR4.5bn (more than 25 percent of Cyprus GDP), resulting in significant damage to the Cyprus economy. In August 2015, China’s economic sputtering brought about a global market correction.
 BRIC countries holding of US sovereign debt has increased from USD 1.0tn (December 2008) to USD 1.7tn (September 2015) – Brazil: USD 127.0bn (December 2008) to USD 251.6bn (September 2015); Russia: USD 116.4bn (December 2008) to USD 89.1bn (September 2015); India: USD 29.2bn (December 2008) to USD 113.5bn (September 2015); China: USD 727.4bn (December 2008) to USD 1258.0bn (September 2015). China was the biggest foreign buyer of US Treasury debt for six years until early 2015. Source: Bloomberg, 2015.
 Between 2005 and 2009, the growth differential between EMs and DMs remained in the range of 5-to-6 percentage points, but in 2015 it more-than-halved, dropping to less than 2 percentage points.
 According to the Bank for International Settlements (BIS), since the global financial crisis the outstanding USD-denominated credit to non-bank borrowers outside the US rose from USD 6tn to USD 9tn. The main debtors – some are countries where the currency is under downward pressure – are: China (USD 1tn), Brazil (more than USD 300bn), India (USD 125bn), Malaysia, South Africa, Turkey, and Latin America’s financially open economies: Colombia, Chile, Peru, and Mexico. EMs have witnessed a significant increase in their total external debts since the financial crisis. In Brazil, from USD 198.3bn (December 2008) to USD 343.2bn (September 2015); in Russia, from USD 480.5bn (December 2008) to USD 521.6bn (September 2015); in India, from USD 229.7bn (December 2008) to USD 482.9bn (June 2015); in China, from USD 390.2bn (December 2008) to USD 863.1bn (December 2014). During the same period, DMs have also witnessed a considerable increase in their external debt levels. In the US, from USD 4.0tn (December 2008) to USD 6.7tn (June 2015); in the EZ, from USD 13.1tn (December 2008) to USD 13.6tn (June 2015); in Japan, from USD 1.7tn (December 2008) to USD 2.7tn (June 2015). Source: Central Bank of Russia, 2015; Trading Economics, 2015.
 The total external debt of BRIC countries increased from USD 1.4tn in December 2008 to USD 2.3tn in December 2014. Between end-2007 and end-214, according to J.P. Morgan, EM private-sector debt rose from 73 to 107 percent of GDP. Over the past 10 years, according to the Institute of International Finance (IIF), indebtedness of EM non-financial corporations increased more than fivefold, to USD 23.7tn.
 Brazil: private capital outflows increased from USD1bn in 2008 to USD44bn in 2014. Russia: private capital flows declined from USD239.5bn in 2008 to USD127bn in 2014. India: private outflows declined from USD23.7bn in 2008 to USD17.2bn in 2014. China: the country registered a steep increase in private capital outflows, from USD144.4bn in 2008 to USD383.9bn in 2014. Source: Institute of International Finance, 2015.
 In particular, foreign investor flows into EMs will fall to USD548bn (a lower level than in 2009, at the height of the global financial crisis). Private outflows from EMs (combined with accelerating outflows from resident investors) will amount to more than USD1tn. For EM investors, it has been a tough half decade for: buyers of the MSCI EM index in end-2010 have lost 27.1 percent of their money, while the DM equivalent has returned a gain of 32.5 percent, with most of the losses coming this year. Also contributing to EM outflows are portfolio flows. Investors in equities and bonds are estimated to have withdrawn USD40bn in the third quarter, the worst quarterly figure since the last quarter of 2008, at the peak of the global crisis. Global market turbulence has triggered the biggest outflows from emerging market equities in more than a year. Investors removed USD9bn from stocks and shares across Africa, Latin America, Eastern Europe and Asia in October, according to figures from the Institute of International Finance, which tracks all cross-border investment into developing countries by non-residents.
 From March 1, 2009 until November 24, 2015, the USD index rose by 11.9 percent (89.0 to 99.6), the Euro depreciated by 15.3 percent (1.258 EUR/USD to 1.066 EUR/USD), JPY depreciated by 26.0 percent (97.210 USD/JPY to 122.500 USD/JPY), Brazilian Real (BRL) depreciated by 52.0 percent (2.435 USD/BRL to3.701 USD/BRL), Russian Rouble (RUB) depreciated by 80.7 percent (36.183 USD/RUB to 65.398 USD/RUB) and Indian Rupee (INR) depreciated by 28.1 percent (51.800 USD/INR to 66.338 USD/INR). While, CNY appreciated by 6.7 percent (6.844 USD/CNY to 6.388 USD/CNY). The currencies of Malaysia, Indonesia, South Africa, Turkey, Colombia, Chile, and Mexico have been repeatedly hitting record lows. From March 1, 2009 until November 24, 2015, the Malaysian Ringgit (MYR) depreciated by 13.8 percent (3.726 USD/MYR to 4.242 USD/MYR), hitting 17-year low of 4.456 USD/MYR on September 29, 2015; Indonesian Rupiah (IDR) depreciated by 14.4 percent (11,985 USD/IDR to 13,705 USD/IDR), hitting 17-year low of 14,715 USD/IDR on September 29, 2015; South African Rand (ZAR) depreciated by 33.3% percent (10.513 USD/ZAR to 14.015 USD/ZAR) and hit a record low of 14.395 USD/ZAR on November 13, 2015; Turkish Lira (TRY) depreciated by 66.2 percent (1.729 USD/TRY to 2.874 USD/TRY) and hit low of 3.058 USD/TRY on September 14, 2015; Colombian Peso (COP) depreciated by 19.2 percent (2,588.1 USD/COP to 3,084.8 USD/COP) and hit a record low of 3,243.1 USD/COP on August 24, 2015; Chilean Peso (CLP) depreciated by 17.3 percent (605.9 USD/CLP to 710.7 USD/CLP) and hit a record low of 715.0 USD/CLP on November 18, 2015; Mexican Peso (MXN) depreciated by 7.4 percent (15.347 USD/MXN to 16.484 USD/MXN) and hit a record low of 17.157 USD/MXN on Aug 26, 2015. The J.P. Morgan Emerging Markets Currency Index, which tracks a basket of currencies, fell by 12.9 percent in the first eleven months of 2015. In 2015, the Brazilian real has depreciated 39.8 percent. The Turkish lira, the South African rand and the Malaysian ringgit have lost 23.2, 21.6 and 20.3 percent, respectively, plunging to the weakest levels in many years against the USD. Source: Bloomberg, 2015; Reuters, 2015.
 The aggregate BRIC CB balance sheet size as a share of BRIC GDP was 39.6 percent in October 2015, lower than 42.5 percent in December 2008. China has suffered a significant reduction in its balance sheet size as a percentage of GDP, while other BRIC countries have witnessed an increase: Brazil: 22.0 percent (December 2008) to 43.6 percent (October 2015), Russia: 0.95 percent (December 2008) to 1. 40 percent (October 2015), India: 8.8 percent (December 2008) to 10.8 percent (October 2015), China: 74.3 percent (December 2008) to 51.2 percent (October 2015). Source: Trading Economics, IMF, 2015.
 According to the IIF, currency depreciation has increased corporate debt in Brazil by an amount equal to 7.3 per cent of gross domestic product, and 6.2 per cent in Turkey.
 US-denominated debt would, in sequence: a) become a bigger burden when measured in local currency; b) push international lenders to demand new collateral or loan repayment; c) impair local borrowers (governments, banks and firms)’s access to credit; and d) force these to allocate to debt servicing a larger share of their local-currency revenues. The higher demand for USD will foster further exchange-rate depreciation and further reductions in the USD value of the collateral.
 For years, 15 of the 28 EU members have had unemployment rates above 10 percent. In Greece and Spain, unemployment is above 22 percent. Youth unemployment is above 40 percent in Greece, Spain and Italy.
 This forecast relies on three key assumptions: a stable Middle East, oil producers aiming at maintaining their market share (i.e. OPEC – which accounts for about 30 percent of world’s crude production – not responding to low oil prices by reducing output) and strong performance from US oil producers.
 In the US, hydraulic fracturing techniques enabled the extraction of oil and gas from shale rock areas. As a result, production of oil rose by four million barrels per day (bpd) to almost 10 million bpd, and from 6 to about 12 percent of global oil output.
 Until that moment, the Kingdom had lowered production when prices were falling, and increased output in response to price surges.
 On December 15-16, 2015, the US Federal Reserve (Fed) will take a difficult decision: to hike rates for the first time in nearly a decade – or wait. Yet again, it is a close call: US domestic economic conditions could justify tighter policy but remain fragile. While the GDP is growing, inflation is below the 2 percent target. Employment has improved, but wage growth and participation are low. Housing sector growth is buoyant but consumption is frail, with consumer confidence below expectations. Industrial production is sluggish and manufacturing is weak. Yet, non-manufacturing indicators are close to historical highs. In addition, the trade deficit narrowed and the USD has strengthened. At the same time, the global context looks increasingly weak: global growth is decelerating and leading indicators point to a slowdown. In most countries, retail sales are losing pace and – led by geopolitical concerns – stock markets are on a downturn. Going forward, via trade and financial links the US economy will suffer. As a result, the Fed is likely to postpone the beginning of the tightening cycle to 2016.