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KIM Deuk-Kab

Slack Needed for Coming Global Downturn

KIM Deuk-Kab

Sept. 5, 2008

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The global economy has entered a downturn, ending a four-year Goldilocks phase characterized by high growth and low inflation on the back of US consumers and China's hyper production. Structural global imbalance, which is generally immune to policy solutions, lies at the heart of slowdown. Today, a global credit crunch, inflation and geopolitical tensions are whipsawing economies, and evidence is mounting that the fallout from the US economic turmoil has spilled over. European economies and Japan are cooling rapidly and emerging economies are also feeling the pinch more and more.

This year's global GDP growth will likely be only 3.1%, lower than 3.7% annual average between 2004 and 2007. The G-7 economies may grow by a mere 1% this year, while emerging economies, including China, could suffer a 1-2 percentage point drop in annual growth this year.

The adverse conditions, of course, will weigh down the prospects of many global corporations as they see their overseas markets weaken considerably. International trade will likely slow down as the global economic slowdown weakens overseas demand, while calls for protectionism will likely intensify due to the failure of Doha round of trade negotiations. Moreover, as financial institutions refrain from investing in high-risk financial products like mortgages, overseas investment by businesses, including mergers and acquisitions, are also predicted to decline.

What about next year? As of now, we should expect to see a modest recession in the world economy, with growth reaching about 2.8%. The US, Japan and Eurozone will likely expand by only around 1% while emerging economies like China and India will see softening growth momentum. Still, there's solace in the fact that the downturn will be less painful than the recession earlier this decade. This is due in part to expanded intra-regional trade and a shift in the main poles of global economic growth; the decoupling effect will provide some shelter.

Lofty commodity prices have sparked fears of galloping inflation accompanying the global contraction, creating stagflation conditions. However, there appears to be little danger of repeating the debilitating stagflation of the 1970s. The commodity price surge has receded as investors anticipate weaker demand for energy, grain and raw metals due to the global contraction. The softening expectations have prompted an exit by speculators, who were key players in the huge run-up in prices.

The US investment bank Lehman Brothers projected oil prices will drop below US$100 a barrel in the first half of 2009. Falling oil prices naturally would ease inflationary pressure and give central banks room to loosen monetary policy, including interest rate cuts. However, it will take time for economies to stabilize prices and gain traction, and the effects of the credit crunch will linger. Accordingly, predictions that the global economy will swiftly recover once oil prices fall are unwarranted. While the recession will be mild, a truly robust recovery in the world economy remains a somewhat distant prospect.

Then can we expect global financial markets to stabilize next year? In a word, no. The credit crunch in the financial markets is seeping into the prime market. The default rate of prime mortgages is on the rise, while financial institutions are strengthening their lending criteria against prime mortgage loans and consumer credit. The insolvency crisis at Fannie Mae and Freddie Mac, US government-backed mortgage financing companies, shows that instability in the US housing financing market is expanding.

As the housing market recession in the US and Europe continues, losses at commercial banks and investment banks will expand. Write downs of bonds related to US, European, and Asian banks' mortgage loans has now surpassed US$400 billion, while the amount of capital raised is far short of this amount.

Aside from global international market instability, the degree of policy response and global imbalance in accordance with inflationary pressure will cause some emerging markets to destabilize. As financial instability in industrialized countries spreads, emerging markets will suffer negative flows of capital as increasing losses in global financial institutions will lead to withdrawal of liquidity in global markets. Meanwhile, policy responses and global imbalances will threaten to exacerbate the instability and inflationary pressure will limit monetary policy tools. In short, 2009 will be a year in which the global economy will suffer from recession and instability. Hopes for a lull in the financial turbulence will have to be deferred for another year.

Under these uncertain economic conditions, flexibility and creativity are crucial to the health of businesses. A company that lacks any slack to blunt headwinds could be forced to reorganize, constrain costs and reshape its workforce. But a company with flexibility can avoid some cutbacks and pursue M&A, R&D investment and market expansion despite the weak economic environment. This will enable them to grasp future growth opportunity before others.

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