Subir Gokarn: Global rumblings

Last week, the consumer price inflation numbers in the US revealed a year-on-year increase of 3.1 per cent, a rate that was above most people's expectations.

Importantly, "core inflation"""measured by excluding food and energy from the index""was a significant driver of this acceleration, with hotel services, airline travel and apparel making the largest contribution.

This is not the only index that the US Federal Reserve evaluates in deciding its monetary policy stance. And, indications are that other indices will present a somewhat more moderate picture.

Nevertheless, the 3 per cent threshold for this index is seen by many as an indication that the Fed will take a more aggressive anti-inflation stance, raising interest rates faster than it has done in the last few quarters.

As against a widely held view that the benchmark federal funds rate would top out at around 4-4.5 per cent by the end of 2005, there is an emerging view that it could well cross the 5 per cent mark.

On the other side of the globe, the Chinese economy continues to resist the government's attempts to slow it down through restrictive fiscal and monetary policies. It grew at around 9.5 per cent in the most recent quarter, far exceeding the government target of 8 per cent.

Real estate development is a significant contributor, but perhaps the most important reason for the economy's resistance to soft landing policy is the continued momentum of exports, which grew at around 35 per cent. The ratio of exports to GDP is around 35 per cent, and so this is a powerful combination of share and growth.

The US is, of course, China's largest export market and the fastest-growing of its major ones over the last year. Any shift in US macroeconomic policy will inevitably have consequences for China through the export linkages. And, given the combined size of the two economies, these are very likely to spill over in numerous ways into large parts of the global economy.

Looking back over the last few years, one could make the argument that China's export performance has depended significantly on its exchange rate policy ""holding on to a fixed rate with the US dollar""which was inherently risky. While this policy may have paid off for some time, it left the Chinese economy in a state of vulnerability on at least two counts.

One, as the current scenario indicates, it is exposed to changing US policy, something it has no control over. Two, the accumulation of foreign exchange reserves in order to maintain the fixed exchange rates will, sooner or later, result in domestic monetary expansion.

There is a limit to how long any central bank can go on "sterilising" or buffering domestic money supply from foreign exchange inflows. China seems to have managed so far, accumulating over $500 billion in the process, but how long can it last?

Despite the risks associated with the exchange rate policy, China has persisted with it. In doing so, it has faced enormous pressure from the US and other countries with which it enjoys trade surpluses, to let its currency appreciate to a more realistic level.

One view of its persistence is that the economy is also terribly vulnerable to a sudden deceleration in exports. Not only will this slow down the rate of employment growth""it could render lots of people jobless""it will break the back of a fragile financial system, which is dependent on the cash flow generated by exports to maintain solvency.

Bailing out the system from mass default will impose a heavy fiscal burden. On balance, the risks associated with the fixed rate seemed less daunting than the turbulence that a float might have provoked.

However, with one of the external risks""a change in the US monetary stance""now looking like it will manifest itself, will China's domestic upheaval scenario materialise? If the Fed does accelerate interest rate increases, resulting in slower growth, lower employment, less consumer spending, and, of course, an appreciating dollar, there is little question that Chinese exports to the US will slow down.

Many of the potential consequences that the Chinese government may have considered while deciding to stick to the fixed rate will now take place. This may well exacerbate the burden of holding on to the rate.

If US growth slows, its aggregate imports will probably decline. However, since interest rates will be rising in this scenario, investments will flow back into the US, causing the dollar to appreciate against all currencies which float.

This will, other things being equal, benefit exports from such countries, leaving exporters like China at a disadvantage. China's dilemma is that, even if it were to let its currency float, the total inflow of foreign exchange, particularly through direct investment channels, may still be too large to let the renminbi depreciate significantly, if at all.

A combined US-China slowdown will have beneficial effects on some dimensions, harmful ones on others. Global demand for oil will certainly slow, providing some relief for oil-importing countries.

Softer oil prices will, of course, act as a counter force to tighter US monetary policy, requiring less tightening to achieve a given inflation control objective. To the extent that Chinese demand has been a major driver of commodity prices, a slowdown will ease pressure on the global markets for these items.

Producers will, of course, be disappointed but users will breathe a sigh of relief. In the net, however, global inflationary pressures will ease further as commodity prices soften.

Given India's relatively diversified economic structure, both the costs and benefits from the emerging scenario will flow to it. Some diversion of export demand from fixed- to floating-rate economies will arise (the SARS episode demonstrated just how quickly such substitution can happen).

Lower oil prices will help everybody, while lower commodity prices will help some. The portfolio outflow resulting from higher US interest rates will lead to a correction in stock markets.

However, the simple fact that India's exposure to the world economy is relatively less than that of any comparable economy will provide a buffer. Given that the domestic market will continue to hold its own, stock market fundamentals still look reasonably good and a meltdown does not seem likely.

The core message from this analysis is the shock-absorbing capacity that flexible prices provide the global economy. As attractive as fixing prices may seem in the light of specific objectives, it both increases vulnerability to forces beyond one's control and reduces the flexibility to deal with these forces.

The author is chief economist, Crisil. The views here are personal