The year 2016 requires tough decisions

Recently, the US Federal Reserve raised interest rates by 25 basis points, taking the first step away from its near-zero interest rate policy. Although the Fed sought to defuse market tensions by signaling a “gradual” pace of rate hikes to come, markets tumbled on global worries.

Advanced economies are coping with secular stagnation. Brazil’s equity market lost a whopping 40 percent in US dollar terms last year. Russia seeks recovery despite renewed Western sanctions. Led by consumption, India’s growth prospects are better but it remains vulnerable, due to current account deficit. In China, growth is decelerating but rebalancing toward consumption and innovation is moving ahead.

In 2016, net capital flows for emerging economies will be negative, for the first time since 1988. With worsened outlook and the sharp plunge of energy prices, commodities-reliant emerging economies will be hit particularly hard, while geopolitical risk will escalate in fragile states.

In the US, rising rates will reward investors but increase the borrowing costs for consumers amid the earnings and revenue slump, and sluggish growth. Rate hikes will boost the sharp plunge of energy prices, while sending the US dollar climbing.

In the emerging economies, the Fed’s tightening has a dark history. But what looms ahead may prove worse.

History of collateral damage
Over the past three decades, the Fed’s rate hikes have reduced US employment and output far more than anticipated, while causing “collateral” damage across the world. In the early 1980s, Paul Volcker, then Fed chief, resorted to harsh tightening that devastated US households. In Latin America, it resulted in a “lost decade”.

Later, Alan Greenspan’s rate hikes undermined the struggling savings and loans associations, forcing Washington and US state governments to bail out insolvent institutions. In the early 1990s, Greenspan again seized tightening but then reversed his decision, which undermined expansion. In the first case, global growth decelerated to less than 1 percent; in the second, it plunged to 4 percent below zero in developing nations.

In the 2004 to 2007 period, the rate hikes by Greenspan and his successor Ben Bernanke contributed to the Great Recession across the world. However, in low-income economies, growth stayed at 5 to 7 percent, thanks to China’s contribution to global growth.

In the coming months, the adverse impact of the Fed’s tightening on energy-producing emerging economies will be amplified by the collapse of the energy prices. According to the International Energy Agency, more cheap oil could cause the OPEC revenue to plunge from the $1 trillion average in the past five years to $550 billion.

Without participation by big producers outside OPEC, Saudi Arabia will not engage in production cuts, despite its deficits. Riyadh believes that a sharp oil price recovery could revive some US shale production, which would displace OPEC crude. OPEC still accounts for some 40 percent of total output worldwide.

Today, the crude price hovers around $36. But there’s worse ahead. Since US dollar and oil have an inverse relationship, and as the Fed’s rate hikes will boost the dollar, oil prices tend to come down or stagnate.

In the coming months, the Fed’s tightening is bound to increase turbulence in emerging economies that are reliant on oil exports.

High growth is history
Half a decade ago, as major advanced economies drifted into a liquidity trap and traditional monetary policies were exhausted, central banks opted for new rounds of quantitative easing (QE). That, in turn, drove “hot money” short-term portfolio flows into high-yield emerging markets, which had to cope with asset bubbles, elevated inflation and exchange-rate appreciation.

Today, as QE continues in Europe and Japan, US tightening will attract “hot money” outflows from emerging markets, which must face asset shrinkages, deflation and depreciation.

When the Fed began its rate hikes about a decade ago, Nigeria lived in a different world. The economy was about one-fifth of what it is today, with living standards about a fourth lower than today. The country was growing at 6-8 percent annually and a magnet for foreign direct investment (FDI). US dollar was about 130 naira.

Politics was fairly stable. While President Obasanjo was in office, economic growth rate doubled to 6 percent, thanks to higher oil prices. After Obasanjo and Yar’Adua, Goodluck Jonathan assumed presidency but his administration remained haunted by allegations of widespread corruption. Security threat was still negligible. Boko Haram was led by Mohammed Yusuf and violence had not spread across the northeast.

Today, Nigeria is extraordinarily vulnerable. The GDP is approaching $600 billion but in the past two years growth rate has halved from 6 percent to barely 3 percent, mainly due to the halving of the oil price.

With rapidly rising political, economic, corruption and security risks, President Jonathan’s administration fell under broad discontent, which ensured Muhammadu Buhari’s election victory last March. During the Jonathan era, complacency allowed Boko Haram, which is now led by Abubakar Shekau, to further expand and escalate terror and join the Islamic State.

In his six months in office, President Buhari has struggled to stabilize the economy, defuse political tensions, fight corruption and neutralize Boko Haram. Unfortunately, the Fed’s tightening will significantly complicate these efforts.

Time for tough decisions
Stabilization has been fairly effective. Record-low oil prices will result in tighter monetary and fiscal policy, which will weigh on consumption and credit. The anti-terror struggle is likely to boost military spending but reduce investment. Recently, emerging market currencies slumped to 15-year lows. Naira is no exception.

As the oil prices have plunged, US dollar soared to more than 200 naira on the official market a year ago. On the parallel market, naira firmed to 266 to the dollar around Christmas, but only after the central bank (CBN) sold dollars to exchange houses and demand for the US currency slowed.

Governor Godwin Emefiele has said the CBN will use additional measures to boost Nigeria’s economy and stabilize the naira. Yet, monetary policy alone cannot resolve economic challenges that are fueled by external forces. In this status quo, naira weakness is likely to eventually result in devaluation and structural adjustment, which currently seems to amount to 20-25 percent of the currency.

Today, the world economy is more fragile than ever since World War II. The Fed’s rate hikes will complicate the challenges and contribute to the risks. In the coming months, the Buhari administration must reassess its initial agenda, in light of the diminished global prospects.

In the foreseeable future, the nation requires not only harder security policies and anti-graft measures, but also tough decisions in fiscal, monetary and foreign affairs. In these tumultuous times, leadership is imperative.

DAN STEINBOCK
Steinbock is Research Director of International Business at India China and America Institute (USA) and Visiting Fellow at Shanghai Institutes for International Studies (China) and the EU Center (Singapore)