Financial Market Contagion and the Effects of the Crises in East Asia, Russia and Latin America
Barrell, Ray, Dury, Karen, Holland, Dawn, Pain, Nigel, Velde, Dirk te, National Institute Economic Review
The Asian crisis has had a marked effect on the world economy over the past fifteen months. Private sector demand has collapsed in the affected economies and reinforced the effects arising from the deflationary forces in the Japanese economy at present. Up until this summer it did not appear likely that the world economy as a whole would slide into a full scale recession, although it was clear that growth had begun to slow in the industrialised economies. There were also important downside risks in our forecasts at that time; in particular the danger that a policy of monetisation in Japan would further weaken the yen and set in motion renewed disruption by enforcing a devaluation of the Chinese yuan against the dollar. It was also clear that profit margins were coming under pressure in the US economy, raising the possibility that future dividends would be somewhat weaker than implied by the exceptionally rapid growth in real equity prices since 1994. Neither a Chinese devaluation nor an equity price collapse were however part of our central forecasts.
The possibility of a global recession now appears much stronger than before, particularly if policymakers do not respond to the new deflationary shocks that have hit the world economy. Risk premia have risen sharply in emerging markets, particularly in Russia and Latin America, partly as a result of the forces put in motion by the initial events in East Asia. Equity markets have reacted adversely to recent events, and capital has flowed away from emerging market debt and equities into government debt in the major OECD economies. Long-term interest rates have fallen markedly as a result.
The events in East Asia were associated with a major reversal of capital flows and significant losses by US, Japanese and European banks. These losses have potentially damaged the balance sheets of some of these banks, and with a shrunken asset base they have had to reconsider the riskiness and size of their loan portfolios. Interest rates on foreign debt rose in emerging markets, with investors requiring a much higher risk premia than before. The marked decline in domestic demand in East Asia also brought further weakness in global commodity markets, reinforcing the downward drop in prices that had already begun as a result of excess supply by the middle of last year. Both these factors contributed to the emerging markets crisis this summer, along with familiar difficulties arising from persistent budget deficits, especially in Russia and Brazil. The adjustment of portfolios and the re-evaluation of risks by Western financial institutions was an important factor behind the withdrawal of capital from Russia in the summer, and the subsequent pressures faced by the Latin American economies. Several governments simply could not afford the higher cost of debt they were being asked to pay.
The recent instability in financial markets has led to signs of systemic pressures developing within parts of the financial system, with several large multinational banks having recently announced sizeable provisions against potential losses from these events. There are also some signs that the cost of funds for private sector investors in the major economies may have begun to rise significantly, as banks continue to adjust their books in response to the decline in their asset bases. A rapid contraction in demand could also bring further significant adjustments to equity markets.
Our main forecast in this Review does not encompass these additional factors as on the whole we think that they can be avoided. However, we think prospects for the world economy can currently be described by a bimodal distribution. The upper mode, with a significant slowdown, but no outright recession, is the one we consider more likely. But a further financial market collapse could cumulate and 'flip' the global economy to the other mode, with the US economy entering recession and the Japanese economy experiencing prolonged deflation. …