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Deflationary trend in the world economy

Falling prices and declining growth in China and Europe is adding further uncertainty in the fragile economic landscape.

China’s Consumer Price inflation figure rose to a measly 1.5 percent for December 2014, nearing a five year low. This was considerably lesser than the 3.5 percent rise expected by the government. Elsewhere, official inflation figure for the Eurozone was hovering in the negative at minus 0.2 percent, slipping the large economic area into a deflation. These, along with the falling oil prices, triggered a market collapse across the world.

Wait, falling prices are good right? Well, not quite and not for everyone. Signs of falling prices in India would indeed be greeted by great cheer, but that is because we have had an average CPI inflation rate of over 9 percent for three years running. However, falling prices in China or Europe is not necessarily a good sign.

For China, which has been showing sluggish growth in the past few quarters, reduced inflation rate means weak demand in the domestic economy. The phenomenon of a long-term decline in prices can cause consumers to sit on their money in the hope of lower prices to come, depressing the dynamism of consumption, investment and consequently, economic growth. Consumers are not willing to spend their money on goods and services, which will affect the sales and thus, profitability of the manufacturing sector. They will, in turn, reduce investment and job creation. This will ultimately lead to further reduction in growth. It is not as dire as this for China yet, but the low inflation number has sparked concerns in this direction.

Back in Europe, falling energy prices and a slight decline in Germany’s manufacturing sector has started a deflationary trend and correspondingly, a falling Euro. Deflation in Europe (along with massive debts) brings back nightmarish visions of Japan’s debt deflationary period in the 1990s and 2000s, which is often referred to as the ‘lost decades’.

Declining prices and a falling currency is bad news for the debtors. While prices and incomes might be falling, the debt does not. With the amount owed remaining the same, a household with falling income feels the burden of the debt much more. In the same vein, governments can fall prey to the same trap. If the prices and incomes are falling, so is the tax revenue, with which it was hoping to repay the debt.

Without resorting to stating the plain obvious, there is a lot of debt going around in Europe.

Add to that the fact that deflation brings along currency depreciation along with it. For countries with large international debt (debt denominated in foreign currency), such as Greece, the debt burden increases further. Greek’s foreign debt is 252 percent of its GDP (or a staggering € 400 billion). The government debt to GDP ratio is 166 percent. It is fair to say that Greece is in a soup and it will only worsen if the deflationary trend continues. Now, Greece has to pay a higher amount of Euros to convert them to, say, dollars to repay the debt.

What’s to be done? The People’s Bank of China has an easier solution than the European Central Bank. Current policy interest rate in China is hovering around 5 percent, which gives it ample flexibility to lower rates. Apart from that, the central bank is aiming to play a more proactive role in the economy by influencing lending rates by banks to businesses and by credit rationing into selective channels. It has also repeatedly made short term injections into the money market at the slightest hint of liquidity tightening.

The ECB on the other hand cannot possibly lower rates any more as real rates are already in the negative territory. The only viable medium term solution is to follow the footsteps of the Federal Reserve and have a go at Quantitative Easing (QE). QE refers to a process where the central bank of a country buys certain financial assets from the commercial banks in order to increase the monetary base and decrease the interest rates in the banking system. The Federal Reserve, after lowering the policy rate to zero percent, resorted to buying Treasury Notes and Mortgage Backed Securities from the commercial banks in the aftermath of the 2007 recession. With no significant impact on the economy, the Fed was forced to increase its monthly purchases of assets from $30 billion to $85 billion, until it had accumulated around $4.5 trillion in assets.

I shall reserve my thoughts regarding the effectiveness of QE as a policy instrument to another day. For now, good luck to the Greeks.

Anupam Manur is a Research Associate at the Takshashila Institution. 

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