World Should Prepare for US Policy Shift

EghtesadOnline: International Monetary Fund’s chief economist suggested the world economy prepare for shift in US policy and warned of possible rising protectionism following exchange rate fluctuations resulting from the shifting.

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22 December 2016

“The (US presidential) election marks a shift in the US policy regime with potentially even bigger future effects on prices and activity abroad,  as well as in the United States,” said IMF chief economist Maurice Obstfeld in an IMF blog posted on Tuesday, Xinhua reported.

Following the US election, the US longer-term interest rates, the US dollar and market-based measures of long-term inflation expectations all went up sharply, on the expectation that the new administration would cut tax substantially and boost government spending.

The US Federal Reserve officials also anticipated a steepened rate hikes ahead. According to their economic projections updated in December, Fed officials forecast three rate hikes in 2017, while in their September projections, they expected only two rate hikes.

Although it’s still early to know how the US fiscal policy will change, one thing seems clear that it will turn more expansionary through some combination of more spending and lower tax rates, said Obstfeld.

In view of the US low unemployment rate and little slack in the economy, the expansionary policy might push up inflation pressure noticeably, which in turn could result in faster increases in US interest rates, said the chief economist.

According to Obstfeld, the more rapid increases in interest rates and tax incentives for US companies to repatriate their profits held abroad could push up the dollar, while further dollar appreciation could lead to a widening US current account deficit.

International Challenges

Obstfeld also warned of international challenges ahead, saying that emerging market economies with strong dollar-denominated debt could witness reduced liquidity or worsened balance sheets due to the rising US dollar interest rates and domestic currency depreciation.

“If sharp exchange rate shifts and growing global imbalances follow the US policy regime change, protectionist pressures become a major risk,” said Obstfeld.

In view of the advanced economies’ efforts to revive their manufacturing industry, “it is most likely that emerging market economies are the main targets for higher trade barriers erected by advanced economies,” he added.

Triple Whammy in South Asia

Trump’s protectionist policies, which will have global ripples, are bound to affect the financial stability of South Asian economies.

As a region, South Asia has been late in coming into globalization. Even as other regions of the emerging world, particularly in East Asia and Latin America, produced growth miracles of varying quality and sustainability, ostensibly as a result of opening up to global market forces starting in the 1970s, South Asian economies remained locked into slow growth and low incomes, according to Financial Tribune.

Trump comes into office with the promise of a huge fiscal stimulus to the US economy–big cuts in taxes and large increases in spending on infrastructure and defense–aimed at raising growth and creating jobs at home.

The spill-over from the Trump fiscal stimulus will manifest itself through a variety of channels. First, looser fiscal policy in the US will mean tighter global financial conditions, higher bond yields and increased interest rates in South Asia at a time when the region is looking to raise investment activity through lower interest rates and softer bond yields.

Second, stronger growth in the US will likely put upward pressure on commodity prices, particularly of oil, which again will hit South Asia disproportionately because of its larger dependence on commodity imports.

Third, the slashing of corporate taxes will make domestic investment a more attractive option for US corporates, thereby inhibiting foreign direct investment into emerging markets. This too will hit South Asia more than other emerging regions as the former’s plans for faster growth and job creation are based on larger flows of FDI. Besides, lower foreign direct investment which is more stable, will increase South Asian dependence on portfolio flows in managing their balance of payments.