A New Crossroad

A New Crossroad

The global financial crisis is in its fifth year since the outbreak of the U.S. sub-prime mortgage fiasco of 2007. Despite efforts—conventional or otherwise—by the world’s major economies to curb the crisis and stimulate growth, the global economy recovery still lags. The world economy is now at a crossroad similar to that in 2008. Lou Jiwei, Chairman of China Investment Corp., shared his views with Caijing magazine. Edited excerpts follow:

ECB’s role

In mid-June, Greece elected a new government that supported austerity measures and a bailout plan. In July, the euro zone approved the 100-billion-euro bailout for Spanish banks. The pressure of a euro zone collapse, which would dramatically impact the global financial markets, seemed to wane. European Central Bank (ECB) President Mario Draghi’s pledge to “do whatever it takes to preserve the euro” at the end of July and the recently announced Outright Monetary Transactions (OMTs) further reduced the risks of potential collapse.

Through OMTs, the ECB is committed to intervening in the sovereign debt market with infinite firepower if necessary, with the aim of stabilizing the financial system and safeguarding an appropriate monetary policy transmission. This means that if the crisis further intensifies, the ECB will act.

The ECB will assume the role as the final creditor, which is of vital importance to maintaining financial stability. It should not only be the final creditor to the banking system but also the final creditor in the government bond market.

A country that can make independent decisions on monetary and fiscal policies can ensure a liquidity demand of payment for any sovereign debt in its home currency, implicating the role of the central bank as the final creditor in the government bond market. It also implies that such a role can be played only when an economic crisis

occurs and the government faces huge difficulties.

But in the euro zone, various member states have the same currency, yet different fiscal policies. This means the central bank cannot be the final creditor. Therefore, the sovereign debt markets within the monetary union are more fragile to the impact of a liquidity crisis.

From the intermittent and opaque Security Market Program to the clearly infinite OMTs, the ECB has made active steps toward being the final creditor in the sovereign debt markets of its member states. Since Draghi’s speech at the end of July, the debt returns rates and market fluctuations in the periphery countries have seen a marked decline, reflecting a positive response in the market to the ECB’s policies.

Will the European debt crisis reach a turning point? Further observations are needed.

Getting back on track

The cause of the European sovereign debt crisis is largely due to the structural imbalance of euro zone member states. That is, each member state pursues an independent fiscal policy despite sharing a common currency.

A successful monetary union requires identifying differences in how the economies are structured among member states. Member states differ in terms of economic development, politics and culture. Before the crisis, the monetary policy of the euro zone was too relaxed in the southern states, leading to an excessive accumulation of debt in both the public and private sectors. In these countries, demand expanded excessively and labor costs increased while competitiveness declined, eventually leading to the European sovereign debt crisis.

Two solutions are needed to fundamentally solve the crisis. First, problematic countries must strengthen structural reforms in the labor market to enhance their competitiveness. Second, the euro zone must accelerate its integration process and establish a more uniform European fiscal union.

Although structural changes may take time, the market cannot wait. The huge pressure of the sovereign debt market and the continual decrease of bank deposits in periphery countries indicate that the euro zone cannot wait until reforms are complete. In creating policies to cope with the crisis, euro zone governments have been unable to catch up with market developments, creating more pressure on the ECB.

SAVE EURO: A picture of a euro displayed in Brussels, Belgium. The euro zone is fighting to avoid collapse

Another difficulty facing Europe is how to manage the economic and social consequences of austerity. The core of structural reforms is to improve the flexibility of the labor market, cut redundant staff and reduce salaries, welfare and public spending. Austerity will then bring in lower revenue and slow the pace of reducing fiscal deficits.

To break the vicious circle, the euro zone needs to not only relax its monetary policy, but also increase investment and maintain economic growth. Therefore it is of vital importance to attract investment from the private sector. In this respect, we have seen some signs of improvement.

Changes to come?

The slowdown of economic growth in China casts a shadow over the future of the global economy. Although it is believed to be cyclical rather than structural factors that have caused the current economic downturn, the Chinese economy is sure to face significant challenges in the next three to five years.

Structural challenges come from both supply and demand. In terms of demand, the 2008 financial crisis and the following stimulus package caused a shift from external demand to domestic demand, and China’s trade surplus dropped from 9 percent to 2 percent of the GDP in 2011. Rapid growth in domestic demand over the last few years was mainly driven by massive investments in infrastructure and real estate projects, which is hard to sustain in the long term.

In order to maintain solid growth in the next 10-15 years, an increase in domestic consumption brought on by mass urbanization is needed.

In terms of supply, growing labor costs could hamper competitiveness. Rising incomes could help fuel domestic spending, but increasing labor costs could curb further economic growth.

Labor cost increases could ultimately change the face of the Chinese industry. The government—through education, training and investment—must find ways to improve productivity in the face of growing labor costs while maintaining flexibility to changes in the labor market.

The U.S. economy has its own challenges.

Since the outbreak of the sub-prime crisis in 2007, the U.S. economy has changed significantly. After years of deleveraging, the proportion of individual debt to disposable incomes has declined to the 2004 level. Benefiting from the ultralow interest rate policy set by the Federal Reserve, the proportion of debt payment to income is also reaching a historic low. In the past year, individual loans have recovered remarkably, indicating that individual debt is no longer a major obstacle blocking economic growth. Also, for the real estate and banking sectors, which were heavily pummeled by the crisis, the worst seems to be over.

Despite the above structural improvements, fiscal problems will still likely restrict U.S. economic growth.

U.S. public debt has surpassed $16 trillion. At this point it is premature for the country to tighten its fiscal policy. But in the next three to five years, once the economy sees steady recovery, improving its fiscal health should be of the highest importance.

Because of the U.S. dollar’s status as an international reserve currency and minimal risk taking due to the European debt crisis and worldwide low interest rates, the U.S. Government can now finance at extremely low costs. Therefore when the global economy picks up, the most strenuous period for the U.S. economy may follow.