Deflation in Japan may lead to a deeper recession

The economic woes for Japan, world's second largest economy after US, had deepened with the GDP for the last quarter of 2008 falling sharply, down by 3.3% from previous quarter and 12.7% annualized. This is the sharpest decline since 1974 oil crisis. This was the third consecutive quarterly decline in GDP. Japan has high dependence on exports and because of ongoing financial crisis in the US and European countries exports have fallen considerably.

Japan has been facing tough economic situation since more than a decade. It had seen consistent deflationary periods from 1999 to 2006. However GDP growth had picked up since 2003 and stood at a decent 2% in 2007. The year 2008 saw a fall in growth rate to 0.3% and in 2009 it is expected to be -2% (JCR projections).

The fall in global commodity prices has put downward pressure on inflation. According to the official data, the consumer price index for Japan in December 2008 was 101.3 (base year 2005=100), down 0.4% from the previous month, and up 0.4% year-on-year. A fall in prices will add on to the slowdown of economy. A period of deflation generally results in lower savings and investments. It may also lead to deflationary spiral in which fall in prices lead to lower production activities and hence lower wages leading to decreased purchasing power and lower demand. In history this kind of viscious deflationary spiral occured during the Great Depression.

Impending recession and the aftermath

The bearish movement in Indian stock market in last couple of weeks draws everyone’s attention towards the world economy again. In the era of globalization, any significant move in the economy of big players is going to have well spread impact (Article on Decoupling theory). And if the movement is there in US economy no country will be left untouched...

The movement in the US economy started in the month of September with the Subprime crisis followed by credit crunch in the US market. All the major banks in US reported huge losses and Federal Reserve had to cut the interest rate first time after 2003 by 50 basis points (0.50%). The complete effect of subprime crisis was yet to be realized and that was evident with further writing off bad debt by major bank in 3^rd quarter of 2007. The economy started slowing down, and financial market came under much stress. Fed had to intervene again within 4 months of earlier cut and the interest rate was dropped by 75 basis points to 3.5%. This was again followed by reduction in benchmark short-term interest rate by 50 basis points to 3% within 9 days of previous cut. This was the most aggressive movement in interest rates since 2001, and is expected to keep the housing slump and the credit crunch brought on by a meltdown in the home-lending market from pushing the broader economy into the red.

But even after all these measures, the consumer spending in the U.S. increased at the slowest pace in last six months. The unemployment insurance jumped, U. S. economic growth slowed to 0.6% annual rate in the 4^th quarter from 4.9% in the prior three quarters. All these facts indicate towards an impending slowdown and countries need to hedge the movement to all possible extent.

Countries like India has got major exports in U.S. and reduced consumption rate will certainly impact the export business heavily. While, the export industries are already suffering with appreciation in Rupees and it will get worsen with any slowdown in demand abroad; the crude oil price had come down after the speculation on reduced demand by the world’s biggest energy consuming country U.S. This will relax the Indian oil companies a bit with reduced subsidy (more about Crude oil price and its impact).

The significant cut in interest rate by Federal Reserve is aimed to avoid any credit crunch and after the RBI (Reserve Bank of India) decision not to cut the interest rate, heavy credit inflow is expected in coming month. The volatility in stock market reflects the suspicious and bearish environment. The GDP in the year 2007 grew by 9.6% and growth is expected to be close to 9% in FY2008. The government needs to be well prepared for any uncertainty and be ready with flexible policy to avoid any major impact.

How good is ‘Decoupling theory for India, China and other emerging economies?

The Decoupling theory is that emerging economies like China and India are decoupled from the US economy. The view is that the emerging economies on one hand and US economy are now very less related. How good is that assumption?

If we look merely at the GDP growth figures China and India are accelerating at 11% and 9% per annum, while US is in a slow growth phase an may even enter into recession in the coming year. This may help us in believing the decoupling theory and that China and India can keep on growing without getting affected from the US economic condition.

If we look slightly deep into it and look at two major sources of GDP: consumption & investments, we will find that although US economy has experienced a slower growth, its consumption is in healthy growth phase, and the slowdown in overall growth is mainly because of slowdown in investment activities from US firms. The reason may be that a lot of money is moving in the form of FII and FDI to India and China. Even China and India export heavily to US, so a slowdown in consumption in US is bound to affect these countries, though the extent of the damage may be different.

Investors who believe in decoupling theory think a well diversified portfolio across Asian and American countries can give good returns even in the case of US recession. That may be too optimistic assumption and this is one of the factors behind the huge rally that was seen in the Chinese and Indian stock markets in the past year. But the recent tremors shook the belief and markets all over the world fell sharply in two days following news on US economic recession.

Earlier during the subprime crisis the decoupling theory got seriously challenged. The credit crunch that followed was not a US only phenomenon, though US was hard hit. The decoupling theory also underestimates the fact that economies are in era of globalization, and recession in one big economy is bound to cause some pain in other economies.

If we look at world economy, US constitute about 22% of world GDP, while China is about 11%, India 4.6% of world GDP. So if the world economy has to grow, a recession in US economy has to be countered by a bigger increase in other economies. The decoupling theory also suffered some blow when World Bank issued that Chinese and Indian economies are smaller than that estimated earlier.

The year ahead will only tell us how independent these emerging economies are from US and whether their growth can compensate for the world slowdown if US economy goes into recession.

Economic Fundae - Fiscal Policy

The big question that our finance ministry will face is how to react to the global recession and our stock market crash. Although these are issues which need correction from various economies, let us see what tools are at hand to control the economic fluctuation. Last year -2007 although we saw our GDP grow more than 8%, we were facing with issues like inflation. The Reserve Bank of India which is the principle organization in command of our economy was taking numerous measures to curtail inflation. What essentially were they doing? What is the role of government in these situations?

Fiscal Policy is use of government spending or tax policy to control aggregate demand-
The taxes that we pay are essentially the source of funds for our government. Now what kind of taxes we pay? Where does the money go?

To understand this we will revisit the equation which is worth remembering
GDP = C + I + G -NX

The G – Government spending composes of two components, the purchases of goods and services & government transfers – which include government spending on individuals without expecting any goods or service. In India we can think of this as the spending towards to rural development and poverty alleviation. But targeting government expenditures simply to reduce poverty is not sufficient; government needs to stimulate economic growth to help generate the resources required for future government expenditures. This becomes the rationale for a budget deficit.

The government can influence the consumer spending by controlling the taxes and the transfers. This is sensible because the more the tax we pay the less is our disposable income – which is our revenues minus the taxes (total income available to spend).

Now why would our government want to control aggregate demand? This is just to control the effects of recession – “Refer Economic Fundae – Business Cycle” or inflationary pressure.

What could it possibly do?
1. Increase government spending
2. A tax cut
3. A increase in government transfers.

This could be the opposite when our government has inflationary pressure.

But remember it is not that easy and it is not that fast to bring in a change. There is also a concept of multiplier to the effect of government spending- it is the ratio of the change in GDP to the change in aggregate spending. In simple terms if you sow Rs 100 you may end up reaping 200!

This multiplier effect may not be there if the government policy is to cut taxes or increase government transfers. This is because not all of the tax benefit you get may be spent, which is given by the marginal propensity to consume.

Now the budget is just a few weeks ahead, we often hear the terms like budget deficit (at least in my generation I have not heard of a budget surplus). What it means? Whether budget deficit is good or bad?

The budget balance is equal to the government savings which is governed by the following equation
S = T – G – TR
T- tax receipts
TR – Transfers

In general, the government runs budget deficits, when there is a recession and surplus when there is economic expansion. In India we have seen the politicians have the habit of wooing the voters by having a tax cut and hence a deficit budget. By doing so, Indian government have run in deep debts. Remember the interest payments for these debts, which are also funded by the taxes that we pay.

Now a novice person like me would think what if the government would print more money to fund the debts. Remember there is always a problem with the inflation.

Now you are all set to think in terms of the finance ministry tools. In the next article we will see how the central bank controls inflation.

Is India's growth rate slowing down?

India touched GDP growth rate of 9% last financial year. It is a big achievement for the country and initially people were apprehensive of sustaining over 8% growth rate for reasonable time. For the last three years India has continued to grow at more than 8% and last year it recorded 9.3% growth. All the while people have been talking of signs of heating of the economy. This fiscal year the growth has slowed down a bit but is still above 8% level. This slowdown has been indicated by Reserve Bank of India (RBI). According to the report a slowdown in the growth of demand has led a slow down in the growth of sales in the first half of 2007-08.

According to Moody's India's growth rate will come down to 8% in 2008 due to the tighter monetary policies taken by RBI to curb inflation. Goldman Sachs has also lowered India's growth to 7.8%.

Recession in United States of America is not likely to have any significant effect on the India's GDP growth as it is mainly domestically driven growth and the fundamentals are very strong.

The growth in the industrial production numbers jumped significantly in 2006-07 which had a major contribution in the GDP growth rate. Now, since the demand had decreased because of rising interest rates the industrial production index is feeling the direct pinch and has recorded slower growth. Automobile sales has shown very little growth over last year and the housing activities have also shown a slowdown.

Though these activities appears to put a lot of pressure on growth rates and may even be successful in short run. India's story is a long term and it has just started. One can easily bet on the long term growth prospects of the country.

Goldman Sachs & Merrill Lynch comment on recession of US economy

According to a report from Merrill Lynch, US economy is already in recession. It refers to the employment report as an confirmation of recession. The unemployment rate of 5% in December was supportive of this view. The housing market is already falling and consumer spending is also lower.

While Goldman Sachs declined the recession in the US economy, it predicted that recession is very close and US economy may see it in 2008.

Goldman Sachs beleives that the slowdown in the US economy will affect the interest rates, since Fed bank may choose the option of lowering rates from 4.25% to about 2.5%

Goldman Sachs cautioned the investors to stay away from banking and finacial sector and increase their holdings of healthcare and consumer-related stocks.

World Bank says China and India are 40% smaller

According to a preliminary estimate by World Bank, economies of the two highest growing countries, China and India, are over estimated by about 40%. This estimate is based on purchasing power parity (PPP).

The Chinese economy's new estimate is 5.3 trillion dollar where as it was valued at 8.8 trillion dollars earlier. China is still the second largest economy of the world second only to US and ahead of Japan, Germany and India. China's share of World's GDP is estimated to be 9% which was earlier estimated to be 14%. Japan with 7% of World's GDP is third largest economy.

US contribution to World's GDP has dropped to 23% from 29% using exchange rate data. Still its far ahead of the second largest economy, China.

India's GDP estimate has been reduced from 6% to 4% of World's GDP. Earlier India was ranked fourth, now it has come to fifth with small gap with UK and France. World's economy was also overestimated. Together top five countries comprise of more than half of World's GDP.

The new ranking by World Bank is based on prices of 1000 goods and services. World Bank said that the earlier estimates were less reliable and for the first time China has participated in the World Bank’s International Comparison Program and India has done so first time after 1985.

This is the first major global comparison of this kind using data based on PPP. World Bank President Robert Zoellick, in Beijing, warned that even the new estimate is not totally correct and only reflects prices in the cities. He also said that this should not be used to measure poverty levels. "One has to be extremely careful about trying to draw judgements about poverty based on these statistics," said Zoellick. World Bank said, "These results are more statistically reliable estimates,... ...It was the most extensive and thorough effort ever to measure PPPs across countries." "We're working with the Chinese government to refine that work and as I think that will be out some time next year," he said.