Developing Countries and Deflation - Essay Example

BRICs and Deflation Introduction In October of 2002, one of Morgan Stanley's chief economists, Stephen Roach, wrote and published "The Factor of China", a report documenting China's alleged transfer of deflation to the world through the export of its commodities. The report argued that coinciding with China's rapid growth was a significant decrease in local consumption causing deflation but with its continuous export of cheap commodities to the world's markets, it has rendered the countries producing the same commodities weaker in their production capacity. Moreover, China's exchange rates, the Renminbi (RMB) to the US dollar and other foreign currencies have pushed its export commodities prices much lower, which in turn have boomeranged to the other countries' currencies. This vicious cycle prompted Roach to conclude that "China is one of the sources of current world deflation" (People's Daily, 2002). A year after Roach's controversial report, Goldman and Sachs published a Global Economics paper entitled "Dreaming with BRICs: The Path to 2050". In this report, the authors surmised that given the 'right' growth conditions and a lot of luck, four of the biggest developing countries namely Brazil, Russia, India and China (thus forming the BRIC acronym) could become the largest economic force in the world in 50 years possibly even surpassing the G6 economies (US, Japan, UK, France, Italy and Germany). Like China, the economies of Brazil, Russia and India have influenced the decline of consumer prices in the world. If there is any empirical basis on the notion of China's alleged spread of deflation, would it not be reasonable to suggest that the rest of the BRICs could have the same effect on the world's economy This paper aims to examine if such generalization regarding deflation shifting could indeed be applied to all of the BRICs as the world's largest developing countries. The discussion will revolve around the main arguments involved in China's reported propagation of deflation as applied to the three other members of BRIC. It is hoped that by the end of the discussion, a conclusion as regards the validity of such argument would be achieved. How deflation happens At its most fundamental, deflation happens when price levels decline continuously as determined by aggregate measures such as the Consumer Price Index (CPI) or the Gross Domestic Product (GDP) deflator (Kumar et al, 2003). In such a case, economic activity and consumer spending are significantly reduced, which in turn cause a decline in prices, profits, trade, employment and productivity in general (Guardian Unlimited, 2006). The decline in price levels could either be due to a demand shock (a significant fall in the demand of goods and services) or a supply shock (significant increase in outputs while demands remain constant). In case of the former, a vicious cycle of declining asset prices, rigid financial policies and reduced nominal interest rates are likely to result. The situation could become more problematic if the expectation for even lower prices prompt consumers to postpone their spending. An extreme effect of this would be companies going out of business or severely cutting down on labor and production due severe inability to sell their goods or services, realize revenues and/or pay off outstanding loans. This perpetuates an even lower demand for goods and further decline in prices. Supply shocks, on the other hand, can result from more 'positive' events such as technological advancements, trade liberalization gains, productivity growth and strengthened confidence in the long-term effects of perceived political and economic stability. Under such circumstances, deflation could not be as costly as that in the demand shock effect since the price decline could only be a manifestation of temporary adjustment to a new equilibrium brought about by external, productivity-enhancing changes, e.g., IT revolution and deregulation, (Kumar et al, 2003). Deflation in history There are two periods in history when deflation occurred in alarming rates. One was during the post- World War I period in the 19th century and the second was during the early 20th century, just before the World War II ensued. These historical accounts are very important in providing valuable insights for assessing the current predicament of widespread deflationary pressures. The first occurrence in the 19th century was assessed to be largely induced by the Gold Standard constraints vis--vis high monetary demands brought about by technological innovations and rapid population growth while gold supplies remained at fixed levels. Also, the period was characterized by massive social and political unrest as businesses got burdened with financial liabilities and various uncertainties that made it difficult to achieve sustained growth. The second historical account of deflation in the 20th century was quite shorter than the first but had more pronounced deleterious effects. The reported major cause of the deflation then, which coincided with the Great Depression, was the flawed and restrictive monetary policies that prevailed over major economies such as in the U.S., Sweden, and Japan. These policies disrupted monetary flows which led to a shortage in money supply. Stubborn adherence to the Gold Standard, as exhibited by the U.S. was also seen as an important factor that contributed to the widespread deflation. Unlike Sweden and Japan, which abandoned the Gold Standard in 1931 to save their economies from further price plunges, the U.S. clung unto it until 1933. Sweden's adoption of a price level target and Japan's issued bonds underwritten by the Bank of Japan coupled with the Gold Standard breakaway led these two nations to recover from persistent deflation faster than the U.S. could (Kumar, et al, 2003). Thus, the important lessons gained from these experiences are that deflation could happen quickly resulting from flawed and restricting financial policies, socio-political unrest and growth effects (e.g., technology developments and population expansion), could cause detrimental economic shifts and could be alleviated through the implementation of sound and determined local policies. China and its deflation In January of 2004, the Board of Governors of the Federal Reserve System published a report entitled, "Is China Exporting Deflation" with the aim of providing a comprehensive analysis of the theoretical and empirical basis of such a long-standing controversy. The arguments both for and against this allegation were highlighted. The global deflation supposedly perpetuated by China could have been prompted by the following factors: 1. Exponential growth in Chinese exports despite deceleration of world trade due to the economic slump, which enlarges China's share of world markets; 2. Sustained savings from surpluses thus making China appear to be increasing the supply more than the demand. 3. China's own deflation which has been ongoing for quite some time together with its decreasing export prices, and 4. China's exceptional performance in certain exported products, i.e., toys, clothes, and electronics, to name a few, has placed much pressure on the prices and market share of competitors elsewhere in the world. 5. Evidence of deflation in the advanced economies (Kamin, Marazzi, and Schindler, 2004). Not everybody agreed with the above stipulations, however. The authors pointed out that the main contentions against the allegation were: 1. China's exports only accounted for about 5% share of global exports, which was quite small to have any deleterious effect on world prices; 2. China's exceptional growth in the export industry was not unique; Hong Kong and Korea experienced the same amount of growth during the '80's and '90's but they were never perceived to be the causes of global deflation; 3. China's rapid growth in the field of exports has been complemented with growth in the import sector at the same rate thus balancing the supply and the demand sides; 4. The surpluses gained from cheap production of goods and services were by no means large enough to account for a significant share in the global GDP (Kamin, Marazzi, and Schindler, 2004). These opposing views, albeit sound in their assertions, have not provided clear and scientific grounds to support their stipulations, as the authors have suggested. To compensate for this, the authors provided a more structured analysis of China's possible impact to global prices and activity based on an identified framework. The conclusions of their work were noteworthy: 1. In terms of the impact of China's exports, the analysis yielded only a 0.3 annual reduction on global inflation, a small but statistically significant impact of China's annual increase in share of U.S.' imports bringing the latter's price inflation to 0.8 percentage point decrease on average per year, and a 1/10 to percentage point decrease since 1993 in the inflation of large economies other than the U.S. (whose inflation has been decreased by 1 percentage point). 2. The pressure placed on the prices of other exporting countries were found to be due to the substitution of expensive imported goods from foreign countries with cheaper goods from China and the significantly low prices of China's goods as compared with those imported in other countries. 3. China's exports did not have a significant effect on the U.S.' domestic producer prices which could be due to any of the following: substandard goods from China could not replace U.S. products; the Chinese goods have not yet totally penetrated the U.S.' markets and the increase in the share of imports from China could just be offsetting decrease in other countries' shares. These findings imply that while China has been experiencing rapid and exponential economic growth primarily through its export industry, its overall impact to the developed countries and to global economic activity is still quite small and therefore cannot support the claim that it is the major source of the worldwide deflation that the large economies have been experiencing for the past several years. As shown in Box 1 below, China's worldwide market share for exports is still considerably low to propagate any significant deflationary risk factor. But since China belongs to the alleged future 'economic force' referred to as the BRICs, the overall picture may be changed. The next question would therefore be on the potential of BRICs (if taken altogether) in perpetuating current deflation rates across the major economies. Box 1. China's share in global exports (Marubeni, 2003) BRICs and deflation The projections made in the report "Dreaming with BRICs" were based on the current growth rates prevalent in these economies. Essentially, the report surmised that economic activity, combined with the sound policies could propel these countries to overtake the major economies today. As it is now, the economies of BRICs taken together comprise only less than 15% of the global market share (Wilson & Purushothaman, 2003), a rather small figure to cause any generalized deflation effects around the globe. In terms of potentials, one of the advantages of BRICs is their cheap labor force which brings them more returns on capital. Another is that they are capable of utilizing available technology to develop their production capacities and eventually catch up with the advanced economies whose growth rates have already achieved a slowdown. These factors could further lead to increase in the spending power of citizens from BRICs that would lead to a significant increase in the overall US dollar spending which in turn, could lead to a rise in exchange rates, thereby offsetting any effects that could be brought about by possible deflation transmissions. Moreover, if the projections are accurate, the rise in spending power coupled with sustained population growth rates could lead to an increase in aggregate demands, thereby compensating for any output gaps that characterize demand shocks and deflation. The report emphasized, however, that the projections could be realized against a backdrop of sound macroeconomic policies and strong and stable political institutions (Wilson & Purushothaman, 2003), conditions which have been proven to be critical factors in deflation incidents experienced in history. Conceptually, if the BRICs economies become a major force in forty or fifty years surpassing even most of the G-7 countries today, they could be very well in a position to transmit widespread deflation should it ever affect them in any way. As it is now, however, their share of the world's market is still miniscule to propagate such effect, compared to the economic sizes of the G-7 countries. Conclusion There is no doubt the there has been observable deflation trends for the past several years. Appendix I show falling prices in the G-7, Asian, and other emerging economies measured in CPI and GDP Deflator factors. It is thus evident from the different charts that deflation is currently occurring in both advanced and developing countries. Also, some deflation rates are more pronounced in certain countries (i.e., Japan and Hong Kong) than in others (e.g., Brazil and Latin America). This is because, as the IMF study has shown, and that the effects of deflation depend upon a nation's vulnerability to risk factors such as global and local deflationary pressures. How a nation responds to such pressures determines the extent and sustained effects of deflation. Thus, the issue is largely a matter of state affairs rather than of productivity growths from emerging economies. References Angang, H., 2003. Is China the Root Cause of Globat Deflation [Online] Available at: http://www.iwep.org.cn/wec/2003_5-6/hu_an_gang.pdf Kamin, S., Marazzi, M., and Schindler, J.W., 2004. Is China "Exporting Deflation". Board of Governors of the Federal Reserve System International Finance Discussion Papers. [Online] Available at http://www.federalreserve.gov/pubs/ifdp/. Kumar, M.S., Baig, T., Jorg, D., Faulkner-MacDonagh, C. and Feyzioglu, T., 2003.Deflation: Determinants, Risks, and Policy Options - Findings of an Interdepartmental Task Force. International Monetary Fund. [Online] Available at http://www.imf.org/external/pubs/ft/def/2003/eng/043003.pdf Ryan, P., 2003. 'Is China Exporting Deflation Globally, Hollowing-Out Japan'. Marubeni economic reports, Marubeni research institute. [Online] Available at http://www.marubeni.co.jp/research 'Theory of China Exporting Deflation' not Conforms to Fact, 2002. People's Daily Online. [Online] Available at http://english.people.com.cn/200212/25/eng20021225_109068.shtml Today's issues: deflation, 2006. Guardian Unlimited. [Online] Available at http://www.guardian.co.uk/theissues/article/0,,959334,00.html Wilson, D. and Purushothaman, R., 2003. Dreaming with BRICS: The Path to 2050. Global Economics Paper: 99. http://www.gs.com/insight/research/reports/99.pdf Appendix I-A (Kumar, et al, 2003) CPI and GDP Deflator in G-7 ( (percent change from a year earlier) Appendix I-B (Kumar, et al, 2003) CPI and GDP Deflator in Developing Asian Economies (percent change from a year earlier) Appendix I-B (Kumar, et al, 2003) CPI and GDP Deflator in other Emerging Economies (percent change from a year earlier) Read More