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How will the global economy survive multiple crises?

Last updated on: March 28, 2011 16:13 IST

How will the global economy survive multiple crises?

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A V Rajwade in New Delhi

The earthquake in Japan, the third-largest economy in the world, has come at an awkward time for the global economy.

It adds to the uncertainties and volatilities on the back of the extremely tense situation in West Asia and North Africa.

The conflict in Libya remains unresolved at the time of writing, but Arab support for the Nato action seems to be waning since the move will surely hit the civilian population, however carefully the missile and bombing attacks are targeted.

Incidentally, analysts are arguing that a disruption of oil supplies from Libya may not matter too much since it accounts for just about 2 per cent of the global consumption.

It is, however, worth recalling that there is little proportionality to changes in demand-supply gaps and price changes, the latter generally being far more volatile than the former.

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Photographs: Reuters
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To add to uncertainties, terrorist attacks in Jerusalem have started again after a long gap. And, could the preoccupation of the West with Arab countries tempt Israel to take the opportunity to destroy Iran's suspected nuclear capabilities?

So, do not rule out the possibility of oil going up to, say, $150 (or even more) a barrel (the latest Brent crude price is $115.30).

Nor is the overall economic picture any more stable in the West. The US seems politically too divided to put in place any definite plan to curb its twin deficits: fiscal and external.

In Europe, the Portuguese government fell last week and the election uncertainties will surely add to the country's already serious sovereign debt problem.

At the time of writing, there is no news of whether the European Union Weekend Summit has succeeded in hammering out an agreed solution to Europe's problems.

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Chances are that, in typical Euro style, some compromise may well have been hammered out in the early hours of Sunday.

The world's second-largest economy, namely China, recently came out with its latest five-year plan. The twin objectives seem to be to bring inflation down and simultaneously boost wages to increase consumption, as long demanded by the G7.

The plan aims at a lower growth to achieve this but, unlike our experience at home, the Chinese economy always seems to achieve growth well above the planned target, just as projects often get completed before their scheduled time.

The Japanese triple tragedy earthquake, tsunami and the very dangerous situation in the nuclear power plants has also brought into sharp focus how the effectiveness of complex supply chains, which are at the heart of globalisation of output, is crippled if there is a crisis in a large manufacturing or high-technology economy.

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Though Japan has outsourced a lot of manufacturing, critical components continue to be made within the country. A disruption of supplies will affect manufacturing output in other countries.

The post-earthquake yen-dollar movement reminded many people of what happened in the wake of the Kobe earthquake in 1995: the yen had surged from around 100 to less than 80 against the US dollar in the following four months. (One incidental consequence was the tsunami which hit Barings Bank: Mr Leeson's naked bets on the Nikkei index suffered so much loss as to make the 300-year old bank worthless.)

Just before the recent earthquake, the yen was trading at around 83. Immediately after the scale of the earthquake became known, the currency started strengthening sharply and at one stage had hit an all-time high of 76.25 against the dollar.

The expectation that drove the market was that the loss claims would force Japanese insurance companies to liquidate their foreign investments and repatriate the money to their home country.

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Photographs: Reuters
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Given that the Japanese market had fallen sharply, liquidating foreign investments was probably better than selling domestic assets.

In as much as markets work on expectations, this logic led to traders/speculators buying yen. The yen's rise surely hit stop losses of any short yen players, which forced them to buy the Japanese currency, in a text book example of feedback loops.

It is interesting that the yen surged less than a week after Japan reported an all-too-rare deficit on trade account for January, and a halving of the current account surplus.

The G7 intervened heavily, selling yen on a massive enough scale ($25 billion?) to take it close to its pre-earthquake level.

Since then it has risen a bit in dollar terms, to 81.30 at the time of writing. And the euro has risen to $1.4158, despite the problems in Portugal.

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Photographs: Reuters
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The third domino in the eurozone could well fall, with Portugal joining Greece and Ireland, sooner rather than later.

So far, the Japanese tragedy and the probable loss of output for at least a few months have not impacted commodity prices.

Also, chances are that the economic impact of the natural disaster may be short-lived. As the World Bank says, "If history is any guide, real GDP growth will be negatively affected through mid-2011. Growth should pick up in subsequent quarters as reconstruction efforts accelerate."

 



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