As finance leaders from across the world gathered in Washington for the World Bank-IMF Spring Meetings last week, emerge85 lab co-director Afshin Molavi sat down with John Lipsky, the IMF’s former first deputy managing director, the number two position at the institution. Lipsky, a distinguished economist, has worked in both academic common rooms and Wall Street board rooms – from Stanford University and the Johns Hopkins School of Advanced International Studies to JP Morgan and Salomon Brothers.
At the 2017 Spring Meetings, an air of cautious optimism returned as the IMF raised its forecast for growth for the first time in six years, though Lipsky – speaking ahead of the meetings – warned about a series of clouds looming over the recovery, including China’s large debt pile, weak business investment, and potential threats to the post-World War II international economic and financial architecture.
Molavi: The global economy has been slowing, with some signs of improvement. There is much talk of the question: Are we facing a ‘new normal’ of sluggish growth worldwide?
Lipsky: I’m afraid that although global growth prospects are improving (Editor’s note: the April IMF World Economic Outlook foresees 3.5% growth in 2017, up from 3.1% last year), the big picture remains unsatisfactory. It is well understood that advanced economies have been underperforming their 30-year average growth rate of just under 3%, but more disquieting is that emerging economies also have slowed back to no better than their long-term average of just above 4%.
Following the onset of the 2008/09 financial crisis, advanced economies suffered a large output drop followed by a very quick return to their long-term average growth rate, boosted by an unprecedented, simultaneous implementation of stimulative monetary and fiscal policies in all G20 countries. Since then, however, advanced economy growth has been lacklustre.
Following earlier episodes, you would have expected a post-crisis period of above-average growth (that would have used up the excess capacity created by the recession) before returning to previous growth rates. It just never happened, and many observers have concluded, even now that advanced economy GDP has finally reached pre-crisis levels – a very recent event in many advanced economies – potential (and actual) growth will remain slower than in the recent past.
Of course, emerging economies decelerated from five years of growth that was nearly double their long-term average rate of more than 4%. In 2007/08, their growth slowed sharply and they suffered a brief and shallow downturn in late 2008 and early 2009. While [emerging markets] managed a quick bounce-back to nearly 8% growth in 2010, they have subsequently slowed back to their long-term average.
Molavi: So what’s going wrong?
Lipsky: Last fall, the IMF’s World Economic Outlook forecast document pointed to subdued demand as a key to sluggish growth. I can see this for commodities and the low price for energy and how this would affect many emerging economies.
But when you look to the advanced economies, consumer demand by and large has not been a problem. In broad terms, consumers have spent in a normal way relative to their income growth. The problem is that income growth has slowed.
So, why is income growth slowing? An easy answer might be that output growth has been slow. When you ask “What part of output growth has been notably weak?”, the answer is very clear: Business investment. This has been especially true in advanced economies, and it still remains the case.
Weak business investment has also been associated with a widely noted slowdown in productivity growth. This has not only affected advanced economies, but emerging economies as well. In particular, gross capital formation as a percent of GDP has been mediocre in advanced economies. For emerging economies it essentially has been flat since the end of the downturn.
The most notable aspect of this – and [one that is] somewhat worrisome, frankly – is that China continues to be completely disjointed from all other economies in terms of the percentage of GDP being devoted to investment.
If we look at emerging economies, excluding China, gross capital formation as a percent of GDP is about 25% or so. In China it’s just under 45%. That’s a huge gap.
China vs Other Emerging Markets’ Gross Capital Formation (% of GDP)
But if you look at the IMF’s figures for productivity gains, China’s productivity growth has slowed to the point where it is no better than the emerging economies’ average, despite investing twice as much of its GDP as other emerging economies.
In a nutshell, this raises two important issues. For everybody but China, the issue is: Why has investment growth been so slow? Is there some way it might accelerate?
For China, the need for economic reform is straightforward and, of course, this has been recognised by the Chinese authorities themselves. They have to invest more efficiently. Today, they’re just not getting much bang for their investment yuan. And, as you also know, while the efficiency of China’s huge investment effort has slowed, the accompanying growth of corporate debt has accelerated at a rapid pace.
Molavi: Yes, it’s about 250%?
Lipsky: Total debt.
Molavi: And about 150% of that is corporate. What you’ve painted is this picture of a new normal, and you’ve laid out why.
Lipsky: Well, I’ve pointed to a key source. Especially for advanced economies, it is not so obvious why investment growth has been so slow. What’s standing in the way of a return to faster growth? Just think about developments in the past couple of years in advanced economies. Obviously, the decline in commodity and energy prices has discouraged investment in the energy sector, but lower energy prices in broad terms have been good for everybody else.
Take the US. Corporate profits have reached historic highs as a percent of GDP, profit margins are extremely high, corporate debt levels and debt service levels are extremely low, and corporate cash hoards are extremely high. In short, US corporations are in good financial shape and consumer demand is doing just fine. In fact, some sectors like autos are at a historic high, while the housing sector is getting back to where it was.
At the same time, interest rates have been at record lows, both in real and nominal terms. So, what’s the problem? Why hasn’t there been a stronger investment response? Looking at the US equity market offers one clue: The share price of corporations that have announced big capital spending plans clearly have underperformed; those who have, instead, used their profits to fund share buy-backs. In other words, investors have particularly rewarded firms for giving cash back to their investors.
What would explain that? Well, one potential explanation has been that the memory of the shock of the downturn has been very long-lived. But the Dow has recently hit record highs. That doesn’t sound like investors have been excessively cautious.
Rather, investors don’t seem to have confidence in the ability of corporations to wisely spend on new capital formation. Or, possibly, this might reflect an aging investment population. That is, savers who are getting close to retirement, on average, might be more interested in income and less interested in capital gains. Perhaps they now prefer lower-risk over higher-risk investments. Why else would they be willing to buy and hold so many government bonds, sometimes even at negative rates? But credit spreads – the interest rate premium paid by riskier borrowers – hasn’t pointed to a big change in views on this.
Another possible explanation for weak investment is that regulatory reforms have inhibited financial institutions’ willingness to expand credit. But there has been a fairly substantial divergence since the downturn between the growth performance of European economies and that of the US. And there is a big difference between US and European capital markets: Europe’s financial sector is dominated by traditional banks, whereas in the US, financial sector activity is dominated by securities markets.
Securities markets, by definition, revalue assets on a daily basis – and valuation changes can be brutal. Banking markets can potentially delay recognising changes in asset values – or ‘ pretend and extend’. (Editor’s note: Extending an endangered loan, for example, and pretending that the borrower can either pay it back or that the asset value will rise.) Many observers and analysts have concluded that the sluggishness with which the European banking system has written down balance sheet valuations and re-capitalised banks has inhibited their recovery.
And, of course, European bank markets are more fragmented along national lines than US markets are geographically.
Finally, another possible clue to the sluggishness of both GDP growth and business investment has been the sluggish growth in world trade.
Molavi: Yes, five years of stagnation in world trade. (Editor’s note: the most recent IMF-World Bank Spring Meetings noted a modest pick-up in global trade.)
Lipsky: For the nearly three decades before the crisis, growth in global trade was substantially faster than overall GDP growth. Since the crisis, it has been the other way around. Trade growth has lagged GDP growth. In other words, from having been a major spur to economic growth, trade has become more of a drag. This is especially true for emerging economies.
There are two or possibly three big reasons why. One is what we just [spoke] about, the relative sluggishness of growth in advanced economies and a weakness of their investment. This has been one of the factors that has helped produce a slowdown in commodity price growth and energy prices, although there are others.
Second has been a factor noted only recently – that the Chinese economy’s long period of strong growth has sucked in imports, especially from Asia.
Back in 1997, as the Asian crisis unfolded, I authored a piece titled “Globalisation is Regionalisation” that concluded: “If you ask the data if the world is becoming more globalised, the data tells you yes.” [On the other hand]: “If you ask the data if the world is becoming more regionalised, the data tells you yes.”
And nowhere was that more true than in Asia. Around here the focus was on the growth in US-Asian trade, and especially US-Chinese trade. But in Asia, the dominant development was the growing regional integration of manufacturing – as well as trade in energy and commodities. During the last few years, this has gone into reverse. China has substantially reduced its import demand relative to its GDP, not just of commodities and energy, but also of manufacturing inputs.
And what is also interesting is that is a phenomenon especially of multinational corporations, not Chinese corporations, that have tended to vertically integrate their production within China.
This is going to be a challenge for Asia. The recent paradigm of regional integration has been that China demands and the neighbours supply. But that is ceasing to be true, at least to the degree that it was. The issue isn’t that Asian integration is going to stall, but rather that it is going to have to take place on a different basis.
The nature of the challenge is especially clear if you accept that the Chinese authorities do what they say they’re going to do as described in their current plan: Which is to move towards a floating exchange rate, or certainly a more flexible exchange rate, a more open capital market, and a more market-driven economy.
In this case, China’s neighbours are going to have to decide how they are going to conduct their own financial and economic policies. Of course, an important consideration will be the pace at which the Chinese pursue their reform efforts.
Molavi: Where are you on the China economy debate today? Slow-landing, medium-landing, hard-landing?
Lipsky: Well, let me just point out that there is a subtlety to that debate that is often missed. And that is: What is potential growth in China in the next few years? Which is to say: What can reasonably be expected? Policies should be judged relative to what you think is possible. For example, is it realistic to expect that China will be able to sustain growth rates around the current pace of 6-7%?
Chinese demographics imply that [the country’s] labour force probably is going to shrink somewhat over the next few decades. In this way, [its] demographics look more like those of an advanced economy than an emerging or a developing economy. The contrast with India is dramatic. These are economies of roughly similar population, but with a very different near-term trajectory with regards to the prospective changes in their labour force, since the underlying components of GDP growth are growth of the labour force, capital stock, and the productivity of that capital.
So over the coming years, China will [see] little or no increases in [its] labour force. We have discussed already that the [Chinese] have a problem in that their very large investments more recently are not producing the kind of productivity gains [as] in the past
China’s Labour Force Growth (1995-2030)
So, an important issue for China’s economic future is, first: Can [it] make investment more efficient? Second: Can [it] manage, through continued migration from the rural to the urban sector, and through increased levels of education and training, to develop more effective and productive workers?
Thus, the speed of China’s productivity growth is going to make a difference to the world. Hopefully, it will be able to implement reforms that will produce much greater efficiency of investment. If it accomplishes this, it will leave room for stronger consumption growth and continued regional integration.
Molavi: It seems that the emerging world, particularly Asia, was really, shall we say, “addicted”, or at least dependent, on China’s growth. Thus, this dependency means that Chinese reform is vital to the world.
Lipsky: Can we say the emerging world would benefit greatly from successful Chinese economic and financial reforms?
Molavi: Yes. And so, this could potentially have a spiral effect. Are we seeing it? Will we see it over the next five to 10 years? Is it going to be much harder for other countries in Asia, and some of the big commodities producers that were riding high on Chinese demand?
Lipsky: For sure.
Molavi: Like Brazil, Argentina, and other places, to continue to grow at levels they were growing at as China slows?
Lipsky: I think so, but it will require economic reforms there, as well. And here is where we could turn to Latin America for a moment.
This is a region where you have a seemingly geographically associated dichotomy of policy focused on the Pacific coast – including Chile, and more recently Peru, Colombia, and Mexico – where policies have been focused on promoting efficiency-driven, open-economy models for development. In contrast, on the east coast, you had the regional colossus of Brazil, Argentina, or, to some degree, Venezuela, which were following import substitute development models and benefitted substantially post-crisis from very high export prices. [This occurred] while they followed policies that would be unsuitable and unsustainable if their export prospects were to weaken. And that’s exactly what has happened.
And so on one side of the continent was Mercosur, with its highly dirigiste approach to economic integration, [and on] the other side, the countries named above that formed the Pacific Alliance [and which] followed much more open-economy style policies.
Given the dramatically poor current performance of all key Mercosur economies, the new governments of Brazil and Argentina are seeking to reorient their policies in a westward direction, if you will. This will be very interesting because they both possess a huge intellectual legacy of support for import substitution as their dominant development model. It will represent a very large change if they really open their economies and move towards a model that would on one hand probably produce greater effective efforts towards regional integration, but certainly, hopefully, a return to stronger growth.
Molavi: What are some of the bright spots you’re seeing in Latin America right now?
Lipsky: Well, let’s say more potential bright spots. The potential bright spots are the ones I just named. Argentina and Brazil seem to be moving towards more – a sense of a more open economy, market-driven response. And, of course, my views are illuminated, among other things, by the kind of work done by the [global policy group] Commission on Growth and Development, under the direction of Nobel Laureate Michael Spence. The commission concluded in 2008 there [was] no example of an emerging economy producing sustained growth and sustained and significant increases in per capita income that did not follow an open economy model.
So let’s hope that the policy changes that could be underway in these two big Latin countries is going to be sustainable politically long enough to start producing results.
The lesson of Chile’s remarkable development over the past thirty years is that sensible macroeconomic policies – sustained over periods that include governments of different political persuasions – produce highly positive results. Policies that are sensible and sustained create confidence that in turn drives investment that in turn drives new growth. Call it a virtuous cycle. It’s not that hard to conceive, but, obviously, it’s not that simple to achieve.
Molavi: Maybe we can go back to Western advanced economies. A new narrative has emerged in the political mainstream, one that is highly suspicious of globalisation and [that] advocates for protectionism. Does this worry you?
Lipsky: Yes, it worries me, but let’s just take one example that we haven’t talked about much yet: The US. We experienced a significant rise in inequality in the 1980s, while a big rise in trade imbalances occurred in the 1990s and the early 2000s. It wasn’t that no one noticed. It was noticed. It was discussed. But why didn’t it produce the kind of political response of dissatisfaction and controversy that we see now? I think the answer is fairly straightforward.
When the economy was growing relatively strongly, when people felt that the tide was rising at a significant pace – even if some boats were rising at a faster rate than others – it didn’t produce the kind of friction that we see now. It appears that sustained weak growth has produced this sense of conflict and dissatisfaction as a side product, and one that threatens to be quite troublesome to the factors that seem to have explained the earlier, better, performance.
So, where does that leave us? There is no simple answer, but it seems to me that the strongest period of global growth ever recorded was under the post-war system in which the fundamentals were driven by principles that had been established through the work of a group of multilateral institutions. These institutions were charged with the creation of a rule-based, non-discriminatory international system that would promote more open and more reliably open economies with an international financial system to match.
In other words, the starting point at the end of World War II was a system of extreme trade barriers; in many cases, still a legacy of the Depression. But also, it is forgotten [that] one source of the Depression was the breakdown of the international financial system in which it became very difficult to finance cross-border transactions, including trade in goods and services.
So from that point of view, the two critical innovations were the General Agreement on Tariffs and Trade, now the World Trade Organisation (WTO) – created to reduce trade barriers on an ongoing basis – and IMF, which was intended to produce an open, non-discriminatory international financial system that would create confidence in the resilience of the international payments system. This stands in contrast to one popular view – that it was intended to establish a system of fixed exchange rates.
It is my contention that this simply was seen at the outset as a means to the broader goal, and not the key element of IMF’s key task. The more radical reality was that by becoming an IMF member – that is, by signing the fund’s Articles of Agreement – it was accepted that, in principle, it was illegal to obstruct access of a member country’s citizen to foreign exchange for balance of payments purposes.
In other words, it is consistent with the fund’s articles for a country to ban a specific import (e.g., for safety reasons) or to subject it to a tariff, but it is not permissible in principle to tell a citizen they are not allowed to obtain the foreign exchange needed to pay for a permitted import simply because the government wishes to preserve its foreign exchange holdings. Instead, member governments were directed to conduct their policies in such a way that would make such growth-inhibiting policies unnecessary.
At the time IMF was created, of course, such foreign exchange controls were typical, not exceptional. By today, such controls have become exceptional, not typical. The notion that a citizen in an advanced economy, or even most emerging and developing economies, needed to obtain special permission to obtain foreign exchange in order to engage in permitted international transactions would seem weird – an anachronism. So what was the rule has become the exception – and in the context of unprecedented growth in both international trade and global GDP.
But it strikes me that the last few years, not just now, have witnessed a clear deterioration in political and popular commitment to the kind of a rule-based, multilateral international system only a few decades into its most complete existence. After all, although the key post-war institutions were intended to be universal, it is only after the collapse of the Soviet Union and the entry of China and India much more fully into this system that it became more fully elaborated.
It seems to me that we have moved – with regard to trade policy – away from a commitment to new advances under the WTO towards regional and now, more recently, bilateral trade deals. Naturally, one wonders whether all key members will still take seriously their commitments under the WTO. And I think it’s reasonable to be concerned.
On the financial side, the opening of markets has given way to what we saw very clearly in the wake of the financial crisis. The 2008/09 crisis produced a retreat from a commitment to open global markets in favour of national authorities “ring-fencing” their financial system.
In the wake of the 1997 Asian crisis, advanced economies agreed on the creation of the Financial Stability Forum (FSF), with membership restricted to the governments of the G-10 advanced economies. The FSFs task was to reach voluntary agreements on how to repair the financial system that had demonstrated some serious fault lines in that crisis.
But why was the FSF needed? Why wasn’t the task given to – for example – the IMF? Because the biggest players wanted to make sure these discussions took place in a venue in which no ‘pesky’ little country’s representatives were present. And they didn’t want an organisation that would pre-empt their ability to make independent decisions regarding their own financial rules and regulations.
Following the 2008/09 crisis, it was recognised that both the G-7 and FSF were too narrowly based to be able to accomplish their goals. In response, the G20 Summit process was created. The G20 mandated the creation of the Financial Stability Board (FSB), which expanded the FSF to include the G20 countries that were not already in the FSF.
In contrast to IMF, for example, FSB is a voluntary, limited-membership grouping whose decisions don’t have the force of international law. Despite strong leadership and serious efforts, it’s hard to conclude that the board has fully attained the financial sector reform goals originally set by the G20. I certainly don’t want to suggest the FSB has not done good work, with good intentions, but it’s hard to say that the global financial playing field has been made level, or that there has been a full restoration of the openness and liquidity of markets that existed before the crisis.