12:05 PM Sep 18, 1996

WORLD ECONOMY SLOWING DOWN, DEFLATION DANGER

Geneva 18 Sep (Chakravarthi Raghavan) -- The slowing down of world economic growth is likely to continue for the remainder of 1996 and the deflationary danger to the world economy is no longer a fancy but is real and will affect the 'globalization' process and freeing of trade and payments.

In providing this assessment, the UN Conference on Trade and Development warns in its Trade and Development Report 1996, about the real risks of deflation, in the world economy, with consequent effects on trade and payments and risks of increasing protectionism in the North.

"Without sufficient growth," the TDR adds, "the adjustment to shifts in dynamic competitive forces associated with greater integration of markets and rapidly changing technology is much more difficult and thereby also the pursuit of the process of globalization and the freeing of trade and payments."

A major thrust of the TDR is on the East Asian development experience and its applicability to other developing regions, and particularly in the new trading environment of the rules of the WTO after the Uruguay Round.

The TDR's views about slowing down of growth (particularly in the OECD area), despite continued buoyancy of world trade, diverges from forecasts of other organizations which often project optimistic estimates only to reduce them in revisions or actuals.

While the variations in projections are partly due to the time when it is made, and the data available then, there is also an effort to project the positive. Both the OECD and the IMF in projections earlier this year had put the growth in 1996 as likely to be 2.0 percent.

But the IMF Managing Director, Mr. Michel Camdessus, in a speech in June at Lyon (during the G-7 summit process) had spoken of a downturn in the business cycle coming earlier in the decade than many expect.

However, Camdessus used this to press the usual IMF recipe of more 'adjustments', reduction of budget deficits etc, (which would aggravate the onset of recession and unemployment).

The endless belt-tightening, and recipes of labour market flexibility, cutting welfare etc usually though come from heads of international financial organizations and their economists and bureaucrats with well-protected job situations and benefits, from academics with virtual life-time tenurs, as well as leaders of governments and ministers.

As a letter writer in Tuesday's International Herald Tribune noted, these personalities themselves never have to face the prospect of finding themselves on the streets -- having lost their jobs, incomes and hopes (and sometimes even the houses to live). No Central Bank governor of any country, the letter writer pointed out, has been reduced to selling pencils on the streets, but at worse they are shuffled out with a golden hand-shake. "No, these gentlemen don't accept pain, they impose it!"

Unlike these advocates, the TDR clearly signals the need for all policies (in the industrial world) being geared to promoting growth. The authors of the TDR are clearly concerned that a slowdown in growth, at a time of large unemployment, would result in large protectionist pressures and responses, and it would all have a spiralling effect.

The UNCTAD Secretary-General Rubens Ricupero at a news briefing Monday on the report said this year's TDR echoed last years on need to resolve the unemployment and low-wage problems in the North and their effects on maintaining an open trading system.

"However," he added, "the report does not see many encouraging signs in that direction. Current macro-economic stances are too restrictive to accelerate growth and reduce unemployment. The deflationary gap has widened and unemployment has reached levels reminiscent of the inter-war years."

The report said that the slowdown in growth in the world economy is largely explained by the slowdown in the industrialized countries where growth fell to 2.0% in 1995 from a 2.8% in 1994.

And while growth in the developing world too slowed down in 1995, it was nonetheless almost double that in the industrial world.

Even this slowdown in the developing world was entirely due to development in Latin American region where as a result of the Mexican crisis and its ripple effects, there was a drop of four percentage points in the growth rate (from a five percent to one percent).

But Africa and Asia posted higher growth rates.

The Mexican crisis, the TDR says, has laid bare the fragility of fiscal balances and the financial systems in a number of countries, with few managing to avoid its adverse consequences.

In much of the Latin American region the challenge remains how to maintain price stability and a sustainable payments position, while achieving steady growth high enough to reduce poverty and catch up with more advanced countries.

Until the Mexican crisis, capital flows appears to provide a temporary solution, by enabling domestic investment to diverge from domestic savings and allowing time for completion of structural reforms.

But now there is much greater recognition, even in countries where there is once more a substantial net inflow, that this is not a viable solution in the long-run. External imbalances are being contained, but to bring deficits to sustainable levels and preserve stability, growth has been sacrificed. But maintaining stability depends on resuming growth which in turns means raising domestic savings, investment and increasing export competitiveness.

In the developing world, prospects are for improvements in 1996 - with Latin America regaining some of the ground lost. Growth in East Asia, including China, is expected to slow down, but still well above the rate of growth of the rest of the world.

Growth in Africa has been favoured by improvement in many commodity prices, which accounted for a ten percent increase in export earnings. But private capital flows, including FDI, continued to fall.

But with commodity prices expected to slide, prospects for Africa remain uncertain, and even under optimistic assumptions levels of wellbeing reached in the past will not be quickly restored: those countries that performed well in 1995-1996 will need to sustain their high rates of growth for more than a decade in order to bring real per capita incomes back to their levels of 20 years ago.

Most Asian countries, including those in South Asia, have continued to grow fast. But in most East and South Asian countries, fast growth has been associated with a widening current account deficit and a moderate acceleration of inflation. The balance of payments situation has been a matter of concern, particularly in some South-East Asian countries where debt servicing and profit remittances associated with FDI came on top of trade deficits which had been widening due to a slowdown in exports. The payments gap was financed by continued FDI inflows and liquid funds attracted by relatively high domestic rates.

In the industrial world, the current recovery has been slower than in previous two cyclical expansions. The deflationary gap has widened further and unemployment has risen by about a third since the beginning of this decade. Even for the employed, real earnings have not been rising for several years and no real improvement is in sight for 1996, when growth in these countries is expected to fall on average below two percent.

The US has continued to enjoy its third longest cycle of postwar expansion, though the economy has slowed down considerably in 1995. But the overall performance is markedly better than in Japan which has been confronted with the challenge of adjustments to shifts in international competitiveness. The US growth is also better than that of the European Union. In recent years the Japanese economy has encountered a number of serious difficulties. The challenge for Japan is how to make structural adjustment needed to avoid further rises in unemployment while shifting from the present dependence on external demand to dependence on demand from the home market.

Success will require switching from investment in manufacturing to investment in infrastructure and technology intensive services, and allowing wages to rise relative to profits so as to stimulate consumption.

Referring to the contractionary fiscal stances in the industrialized world, the TDR notes that under current plans there will be an elimination of budget deficits in the US by 2002. In Western Europe, fiscal retrenchment has put downward pressure on employment and growth and the low growth has enlarged the budget deficits. But these are not allowed to act as automatic stabilizers. Instead expenditure cuts are being made to meet the convergence conditions for the third stage of the European Monetary Union. Hence recourse to monetary policy will be necessary to offset effects on aggregate demand.

The TDR clearly frowns on the efforts to achieve the Maastricht criteria and meet the convergence conditions, and points out that in France, for example, the attempt to achieve a one percentage point improvement in the budget deficit ration would bring about a percentage point reduction in GDP growth from the baseline forecast.

If this relationship were to hold good generally, "it implies that policies aimed solely at achieving deficit targets would bring growth to a temporary halt. It thus provides a rough indication of the burden that would fall on other policies (in most countries primarily monetary policy) in order to ensure growth continues."

In recent years, monetary policy in the major industrial countries generally paid relatively little attention to unemployment, except when it was falling, or to growth except when it was accelerating. Such an approach might have been initially justified, in view of the prevailing inflation. But price stability is now the norm and inflation has settled to its lowest level for over 30 years.

Nonethless, the tendency to dampen upturns quickly, while leaving downturns to work themselves has continued, the TDR complains.

Referring to the US example when in 1994 monetary policy was tightened early to preempt inflation. But subsequently, unemployment fell by atleast one percentage point, below the level considered compatible with stable inflation, creating three million new jobs, but with inflation remaining steady.

This experience suggests that the rate of unemployment compatible with price stability may be well below that generally assumed by monetary authorities.

"Financial markets," the TDR says, "are often said to limit monetary expansion. However, monetary policy itself exerts a major influence on behaviour of these markets. Bond prices tend to fall when employment prospects improve, not so much because markets themselves anticipate inflationary pressures as because they believe that monetary authorities will do so and hence push up interest rates. Because of the greater integration of financial markets, rising interest rates in expanding economies tend to be transmitted even to countries that lag behind, making it very difficult for them to initiate recovery, as has been the case in the 1990s."

"The risk of deflation is real if monetary policy continues to focus on combating inflation while attempts are made to improve fiscal balances. Without sufficient growth the adjustment to shifts in dynamic comnpetitive forces associated with greater integration of markets and rapidly changing technology is much more difficult, and thereby also the pursuit of the process of globalization and the freeing of trade and payments."