the economic and financial outlook_22!07!11!16!02

8/4/2019 The Economic and Financial Outlook_22!07!11!16!02

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l Global Research l

Important disclosures can be found in the Disclosures AppendixAll rights reserved. Standard Chartered Bank 2011 research.standardchartered.com

Global Insight | 14:00 GMT 22 July 2011

The Economic and Financial OutlookA monthly analysis by Dr. Gerard Lyons, Chief Economist

Fears of a perfect storm

Concern about the world economy has returned to centre-stage in recent weeks. The reality

is that this concern has never been too far from the markets thinking throughout the two -

year global recovery. In recent weeks, the focus has been on a combination of factors,

particularly the crisis in the euro area, debt problems in the US and worries about a hard

landing in China. Each of these, on their own, would be enough of a concern. Any

combination would be a major problem. The current focus on all three has triggered genuine

fears of a perfect storm: a set of circumstances that leads to serious events combining

together to hit the world economy hard.

No-one should underestimate the near-term downside challenges for the world economy.

These are particularly intense for some of the major advanced economies. Of particular

concern are the overhang of debt and the scale of deleveraging still needed in some of the

economies hit hard in the financial crisis. These are most apparent in the euro area, but the

US and UK are also affected. The euro area faces a growth problem or, more particularly,

a lack-of-growth problem. One possible solution would be to form a two-speed euro area. In

recent weeks, the combination of excitable markets and ineffective politicians has conspired

to create the present problem. In essence, the deflationary bias in the euro area cannot

succeed in the present economic environment. It compels the periphery into recession,

bordering on depression.

The claim that Greece and others need to make structural adjustments is correct.

However, timing and scale need to come into the thinking. The time to have made the

changes being demanded of Greece, and others, is when the economy was in good, or at

least better shape. But the changes were not made then, just as other countries did not

run budget surpluses when they should have, during the good times. To make such

radical, structural changes now, when there is already a recession, is akin to being in a

hole and digging deeper. Then there is the scale: deficit cuts of over 12 percentage points

of GDP over five years are too much. Greece cannot cope. Hence, it faces a solvency

crisis, its recessionary economy not generating sufficient tax revenues, while the cuts hit

hard. Confidence will likely erode, for both Greeces citizens and international investors.

Whether this will be Europes Lehman Brothers moment is hard to say. But the very fact

that this risk exists suggests that it should be avoided. Help from the core is a necessity in

order for the periphery to cope. Even then, it may not be enough.

The fact the problems do not stop there is a worry. The US political brinkmanship ahead of

passing the debt ceiling deal may not have been anything new these things can often go

to the wire but it provided an opportunity, if it was needed, for the markets to focus on

Inside: First, an overview of the world

economy with focus on the euro area

which is facing an existential crisis

(pages 1-4). It also includes a

snapshot of Asia which remains

resilient to external shocks. Next, a

piece on the `south-south financial

flows which summarises a paper

presented at the OECD in Paris

(pages 5-10). The third article

appeared as part of the FT A-series

and focuses on inclusive growth

(page 11).

Gerard Lyons, +44 20 7885 6988Chief Economist and Group Head of Global Research

[email protected]


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Global Insight

GR11MY 22 July 2011 | [email protected] 2

the enormity of the US debt problem. Yet there appears little sign that this will be tackled

and certainly not ahead of the Presidential election.

The ability to address this issue depends, somewhat, on the extent of the economic

recovery. The US hit a soft patch in Q2. Easing oil prices and tax-measures to boost

investment before year-end may give growth a helping hand in H2, but the overall picture

is of a subdued recovery. The challenge in the West is that the policy cupboard is bare. I

keep stressing that, whichever economy one looks at, the economic outlook depends on

the interaction between the fundamentals, policy and confidence.

The West may be hard-pressed to cope with a further shock, or a series of shocks. But,

across the emerging world (or far better to say, the faster growing economies) the policy

cupboard is far from bare, and there is ample scope to cope with shocks.

Given this, it is particularly important to keep western monetary policy accommodative. Itis one thing tightening fiscal policy prematurely, quite another to do the same with

monetary policy. Therein lies another challenge. The growing perception that western

central banks will have to keep interest rates low for a long time plus the view that any

policy change will be signalled well in advance has led to financial markets no longer

pricing in risk properly. Sound familiar? It should. It was a common problem before the

financial crisis, although the dimension of it is far less now. There is no evidence of

investors seeking out complex products on a sizeable scale. Through the year there has

been a compression of spreads between lower and high-grade credits, although there has

been some recent correction as worries surrounding Europe have risen. At the height of

the financial crisis, it was evident that the so-called, and difficult to define, shadow banking

industry was significant and that interactions between financial institutions were huge.

Concern rose about the contagion from any credit events, wherever they occurred, giving

rise to the ongoing attention on the euro area and the fear of contagion from other

economies and across banking sectors.

China concerns

In recent months China concerns appear to have risen. Timing will also be a challenge in

predicting any set-back there. It would be remarkable if China did not have a setback.

After all, its economy is heavily imbalanced, skewed towards investment, as well as

exports, although this years new 12th Five Year Plan makes clear the determination to

boost private consumption and rightly so. While there is no magic level of investment,one can safely say that the present level in China is too high. Less easy to predict is when

it will decline, or how. Ideally, the ratio will fall gradually, alongside a rise in private-sector

spending. But the nature of these things is that adjustment is not always smooth or

predictable.

The challenge is that investment is so high, around 45% of GDP, that even a mild

correction, if it happened abruptly, could knock a considerable amount off of GDP growth.

This is not the only issue. The increase in news stories about domestic unrest has led to

an increased focus on next years political changes in China, and how the new set of

leaders will handle demands for greater political freedom. The likelihood is that not much

will change, which would also appear to be the case with macroeconomic policy. The Five

Year Plan makes clear the goals. But even an eventual setback should not divert attention

from Chinas strong underlying growth story. Concerns about China have been driven

more by worries about domestic developments. But the events in Europe and the US

The West may be hard-pressed to cope

with a further shock

It is particularly important to keep westernmonetary policy accommodative

It would be remarkable if China did nothave a setback


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could be the trigger, hence talk of a perfect storm. It does not have to be the case that any

setback in the West impacts China, but it probably would. The immediate transmission

mechanism is via exports, but the bigger worry might be if investment plans were cut back,

because of a more pessimistic view of global demand. And, of course, any slowdown in

China, if it occurred, would hit both commodity exporters in many regions, as well as

capital goods exporters such as Germany, highlighting the interconnections in the world

economy. Of course, the flip side would be some easing in commodity prices and inflation,

but that would not compensate for the overall hit to demand in this scenario. Despite this,

perhaps not enough attention has been given to the fact that Chinas room for fiscal

manoeuvre is ample, in contrast to that in the West. If things slow too much, expect some

economic pump-priming.

As Chinas economy grows, it becomes more difficult to manage, placing increasing

pressure on policy institutions. For now, the policy environment has been handled well in

China. Thus a hard landing does not appear imminent, notwithstanding the challenges. Asoft landing appears more likely. I am reminded of a comment from a policy maker in a

meeting a number of years ago, when the focus was on a soft versus hard landing. His

comment then was that we are not having a landing, we are refuelling in mid-air. Even

with recent data, this image fits the economy now. Yet the risks from the West should not

be dismissed. This is a greater challenge elsewhere in Asia, where there are many small

and medium-sized open economies and whose growth can be volatile, in reaction

to trade flows.

Asian rates

A key focus will be monetary policy, not just in China, but across Asia, particularly India.

There has been considerable monetary tightening across a host of Asian countries. For

now, in general, monetary policy may be put on hold as food and energy prices are off

their recent peak, as growth worries in the West overhang Asia. That being said, monetary

policy may still be too lax. Across Asia, one should certainly not just judge monetary policy

in terms of policy rates. So-called unconventional measures are widely used. There is

sufficient lending and credit growth in economies. This is keeping domestic demand firm,

particularly in South East Asia and China. Given conflicting domestic and global

pressures, central banks across the region need to retain a flexible approach to monetary

policy. The domestic environment for many suggests firm demand and rising inflation

risks, while the external situation suggests downside risks. Some, like the central banks in

Thailand and Taiwan, are signalling their desire to keep tightening in response to events

at home, but are making it clear they are vigilant against external risks. Although impacted

by the same overall environment, the interest-rate approach across Asia may start to see

greater variance.

Perhaps the most interesting country will not be China, but India. There, the authorities

have done a good job. But now the domestic economy faces some challenges. The mood

in India has been relatively downbeat recently, owing to a combination of things. Rising

inflation and monetary tightening have slowed the economy, while corruption issues have

led some to comments that the relationship between politicians and business may be

forced to change. At a time of rising global uncertainty, Indian markets may be hit by

increased risk aversion yet at the same time, the economy tends to provide better

protection from events elsewhere, largely because it is less open, being driven by

domestic demand.

Chinas room for fiscal manoeuvre is

ample, in contrast to that in the West

The interest-rate approach across Asiamay start to see greater variance

Perhaps the most interesting country willnot be China, but India


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Indian wholesale price inflation has been above 8% for the last year and a half. Supply

and demand factors have contributed to this. And it seems set to stay stubbornly high,

possibly above 9% until the end of November. After that, year-on-year effects may push

down the headline rate. There is a perception that previous monetary tightening will then

take the heat out of inflation. In this environment, it will be interesting to see what the

Reserve Bank of India (RBI) does. Since March 2010, the repo rate has risen 2.75

percentage points to 7.5%, market overnight rates have risen 4.25 percentage points, and

other non-conventional monetary measures have been used. Our view is that the RBI will

hike again, by 0.5% by year-end. The economy has slowed, but is still solid. Witness the

19% growth in advance corporate tax collection in the April to June period. Some sectors,

such as cars, have slowed, but the slowdown is not broad-based. Also infrastructure

progress has slowed, in power, roads and mining, largely because of environment

regulations and land acquisition issues. Much attention will not just be on the immediate

behaviour of the Reserve Bank, but also on whether policy paralysis eases. The new

session of the Parliament, beginning August 2nd, will address some important legislation

for the economy, covering a vast array of areas including the land acquisition bill, foreign

direct investment in retail and insurance, and new manufacturing policy.

Given Asias growing global importance, its demand keeps a firm floor under commodity

prices. So, even though an easing of supply worries and firmer output has contributed to

the recent easing in food and energy prices, there is every likelihood that these will firm

again next year. This suggests a replay of the inflation worries seen earlier this year, and

the need for Asian tightening to continue.

Whether this transmits into currency policy remains to be seen. The intervention in, and

manipulation of, currency rates satisfy an important domestic need across Asia, but

complicates the global need for balanced growth, of which currency adjustment is one

component. As the year has evolved, the G20 focus has shifted from a wide range of

issues towards a few specific areas, of which currencies and commodities are key.

Curbing speculation in commodity markets is welcome, albeit hard. On the currency front,

it appears that the emphasis for the G20 has moved away from demanding immediate

currency action, and more towards less controversial moves to include a wider set of

currencies in the SDR (Special Drawing Rights) basket.

Overall, the message is that the world economy has slowed but not collapsed. But there

are considerable risks in Europe and the US and Asia will not be immune from these,

even though it has the policy room to cope. As policy easing in the West wears off, and as

emerging economies tighten policy, the environment is becoming more difficult. But we

still expect solid growth in the East and a sluggish recovery in the West. There are

considerable near-term risks, with the euro-area situation being uppermost. And in the

event of a new crisis of confidence, it is often those economies with large current account

deficits that feel the pressure. Turkey and Vietnam are two in this category. Policy interest

rates will diverge, staying low, even allowing for hikes by the European Central Bank

(ECB) in the West, and further tightening in the East. Domestic demand is resilient across

Africa, Asia, and parts of Latin America and the Middle East. Infrastructure spending is a

necessity, attracting further inflows. The US dollar (USD) may firm near-term, if US growth

picks up in H2 and euro-area problems persist. Asian currencies still appear undervalued.

Our view is that the Reserve Bank of India

will hike again

Given Asias growing global importance,

its demand keeps a firm floor undercommodity prices

We still expect solid growth in the Eastand a sluggish recovery in the West


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Global Insight


Growing south-south financial links

There are three parts to this paper: first, the economic context; second, what is

happening; and third, the implications.

First, the economic context

The shift in the balance of economic and financial power is a key factor behind the

increase in south-south trade and financial flows. In the wake of the financial crisis,

emerging economies or perhaps we should now call them fast-growing economies, as

many have emerged already have accounted for the bulk of the increase in

world growth.

This is not just explained by cyclical factors. We believe the world economy is in a super-

cycle, defined as a period of strong growth lasting a generation or more. In our view, this

is the third super-cycle (Chart 1). The first was from 1870-1913, and saw the emergenceof the US as a super-power and the adoption of technologies discovered during the

Industrial Revolution but yet to be put to use. The second super-cycle was from 1945-

1972; this was characterised by rapid growth, saw the emergence of Japan as a powerful

economy and the rapid growth of consumer durables markets. Now, we are in the third,

and it may have begun in 2000.

This does not mean we are bullish about everything, and just as importantly it means it

is essential not to underestimate the impact of debt deleveraging in the West and the

possibility that Asian and other emerging economies could experience setbacks. The

current problems in the euro area also highlight how vulnerable economies in the West

are to further economic or market shocks.

One of the key drivers in this super-cycle is new trade

corridors, something we have talked about for years. This is the

increase in south-south trade and financial flows. It includes

increased flows of goods, commodities, people and

remittances, portfolio and direct investment f lows.

The drivers behind this are multiple, and they include the

increasing demand for all types of resources arising from higher

domestic consumption and investment in many of these

economies; and both the catch-up potential and ability of manyemerging economies to move up the value curve.

The drivers for increased financial flows are both state-led and

from the private sector. Thus the drivers are both strategic and

commercial, and in turn may be opaque or transparent.

There are a number of drivers behind these global as well as

increased south-south flows.

One is resource-seeking flows, largely from cash-rich to

resource-rich countries. Currently, there are numerous state-led

examples of such flows.

Another is market-seeking flows, as firms seek to move up the

This chart illustrates the super-cycles we believe that the world economy

experienced, including the third, which it may now be experiencing.

Sources: Angus Maddison, IMF, Standard Chartered Research

1820-1870:1.7%

1870-1913:2.7%

1913-1946:1.7%

1946-1973:5.0%

1973-1999:2.8%

2000-2030:3.5%

-10%

-5%

0%

5%

10%

1820 1850 1880 1910 1940 1970 2000 2030

Actual world GDP growth Average world GDP growth

Chart 1: The world is in its third super-cycle

World GDP growth

This is a summary of a paper

given by Gerard Lyons at the

OECD in Paris, on 8 July, at the

EmNet (Emerging Market

Network) meeting. The theme of

the day was East and South:

Bigger and Better? The paper

formed part of the session on

South-south linkages in the

financial andinvestment arena.


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Global Insight


value curve in the face of tougher low-cost competition. Here, one might expect to see

increased investment by firms at home, as well as overseas.

Another is strategic asset-seeking flows; again, here, there is an attempt by firms to

move up the value curve, as they purchase brands, technology and intellectual property.

One might expect a significant proportion of these flows to be from the emerging into the

developed world, but increasingly the south-south dimension should rise.

The final explanation of flows is efficiency-seeking flows, where the driver is the need

for greater efficiency and economies of scale. Here it may be possible to have joint

acquisitions domestically and joint ventures as well as acquisitions overseas.

These descriptions fit in with the needs and development agenda of many emerging

economies. China is a leading example, and its involvement and the scale of flows has

helped propel this issue to the fore over the last few years. China's growing importance is

likely to become more evident.

China's 12th Five-Year Plan (FYP), announced during the

National Peoples Congress in March this year, is a significant

development, highlighting Chinas desire to move up the

value curve. This is likely to have profound implications for

south-south, as well as global financial flows. Another

important development this year is India's desire to shift its

economy more towards manufacturing, aiming to increase its

share of GDP to around 25% over the next decade from the

current 16%. This too could have profound implications for

trade and financial flows.

The context of Chinas FYP is important. The economy is

strong but imbalanced, skewed towards exports and

investment, with private consumption too low; and as the

economy becomes bigger, it is harder to rule from the centre

than before, placing greater emphasis on the effectiveness of

China's policy tools and institutions. The challenges within the

economy were identified by the president and premier a few

years ago when they spoke of the five imbalances: urban-

rural; coastal-inland; social; environmental; and international.

The aim then was to move from strong to sustainable growth.

This remains a constant challenge within China, and is

evident now, with the authorities trying to cap inflation and

achieve a soft landing. We think this is achievable, although

worries about a hard landing not our main view can never

be dismissed. We expect China to achieve solid growth this

year, and next, but the high share of investment as a

proportion of GDP means that a setback to investment plans,

for whatever reason, could have a profound impact on

slowing the pace of growth.

Indeed, one of the lessons for China, from the Wests

financial crisis was that it cannot rely on selling cheap goods

to heavily indebted westerners. Chinas changing domestic

Chinas 12th

FYP details these seven industries, with particular emphasis onthe green economy, which aims to move China

up the value-curve.

Sources: Draft of Chinas 12th FYP, Standard Chartered Research

Nuclear, wind and solar power

Carbon emissions per unit of GDP to becut by 40- 45% by 2020 from 2005 levels

Alternativeenergy

Electricity transmission and powermetering infrastructure

Power capacity to rise by 64% over next5 years

Energy conservation andenvironmental protection

20 genetically modified organism (GMO)crops have been approvedfor field trials

Biotechnology

Rare earths, indium (TV and computerscreens), lithium (batteries) and high-endsemiconductors

Advancematerials

Nanotechnology, satellites, super-computers and internet security

New IT

High-speed trains, wind turbines, solarpanels, aerospace and telecom equipment

High-end equipmentmanufacturing

Fuel cells, compressed natural gas,liquefied petroleum and nitrogen gases(LPG, LNG)

Clean energyvehicles

Chart 2: Chinas USD 1.5trn spending plan in 2011-15

Chinas seven priority industries


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Global Insight


demographics (its overall population will start to age from 2014) will reinforce this. Indeed,

the FYP reflects an ambition to move China up the value curve.

The focus of the FYP is on boosting domestic consumption by addressing many areas,

and not just in terms of the quantity but also the quality, in areas such as scientific

development, urbanisation and the service sector. A second priority is on social spending.

A third is the green economy, including specific targets for reducing energy use. As a

result of this third priority, the FYP identified seven priority industries (Chart 2): alternative

energy; energy conservation and environmental protection; biotech; advanced materials;

new IT; high-end equipment and manufacturing; and clean energy vehicles. The FYP also

follows on from last year's State Council announcement to make Shanghai an

international financial centre by including a shared chapter on Hong Kong, which is

already of key importance in terms of China's financial flows and is also playing a central

role in the internationalisation of the CNY through the growth of the CNH market.

Second, what is happening?

The second part of my talk focuses on what is happening in terms of financial flows.

Ahead of the crisis, our view was that emerging economies were not decoupled but better

insulated given their high reserves and sounder fiscal positions; so it proved. Now, we

believe they are not decoupled but better diversified, given stronger domestic demand

and increasing south-south links. These links are increasingly financial as well as trade

related.

There are many examples of deals in recent years that illustrate the growth in south-south

flows. Let me cite a selection, quoting publically available and reported data.

In June 2010, in the mobile telecoms sector, Indias Bharti Airtel completed its acquisition

of Zain Africa, in a USD 10.7bn deal that was then the largest cross-border deal in the

emerging market economies.

In June 2008 in the retail sector Al-Futtaim Group of the UAE acquired a controlling stake

in Robinsons department stores in Singapore for USD 363mn.

To illustrate that these flows are two-way, Sembcorp Utilities of Singapore entered a USD

1bn joint venture with the Oman Investment Corporation. The first phase of the

Independent Water and Power Plant (IWPP) in Oman was successfully completed this

month.

The process is ongoing and not just in energy or resources and not just involving China.

For instance, Sinopecs USD 8.8bn deal to buy Swiss petroleum company Addax

Petroleum (with drilling rights in Kurdistan, Gabon and Nigeria) was Chinas largest -ever

outbound investment in the oil and gas sector. It also highlights that the investment flows

from China are not just into emerging economies but also into the developed world.

There is also much focus on the role that China's sovereign wealth fund, the CIC, can play

in overseas investment. But the CIC is just part of the story. There are four sovereign

entities that play a role here: China's vast foreign exchange reserves which continue torise; the government pension fund; the sovereign wealth fund itself; and state-owned

enterprises, some of which are alluded to above. There were three Chinese deals in the

top 10 largest direct global sovereign wealth fund investments of 2010 (Monitor, 2011).

A setback to investment plans could have

a profound impact on slowing the pace ofgrowth in China

Now we believe emerging economies are`not decoupled but better diversified

Investment flows from China are not justinto emerging economies but also into the

developed world


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Global Insight


One was in real estate: CIC's USD 2.3bn investment in US General Growth Properties,

completed November 2010. The second was a domestic acquisition by the National Social

Security Fund, a USD 2.2bn investment to take an undisclosed stake in the Agricultural

Bank of China, completed in July 2010. A third was in infrastructure, when CIC bought a

15.82% stake in AES Corporation a US power-generation and transmission company

for USD 1.58bn in March 2010.

One should also expect increasing examples of cross-border south-south flows in financial

instruments. As one example, China's holding of Korean bonds rose from USD 1.6bn at

the end of 2009 to USD 6.7bn at the end of Q1-2011, moving China from the 11th to

fourth-largest holder.

South-south flows, particularly from China, still have a large strategic and resource-linked

element to them.

Chinas loan-for-oil type deals help illustrate how these flows have evolved. China

Development Bank, a state bank, has played a key role. In recent years the number of

overseas deals it has been involved in has risen. Examples include a USD 15bn and a

USD 10bn 20-year deal with Rosneft and Transneft of Russia, respectively, in 2009; a

USD 10bn, 10-year deal with Petrobras of Brazil in 2009; and a USD 20.6bn, 10-year deal

with BANDES of Venezuela last year. There are many others. Once a development bank

seen largely, almost solely, as funding infrastructure in China, China Development Bank

has moved into areas such as helping China develop its financial sector and support its

international expansion, particularly into resources.

Infrastructure is a cornerstone aspect of some south-south flows, as deals that secure

resources in return for increased funds available for infrastructure spend can be seen as

win-win situations.

This was also seen in May when the second India-Africa

summit took place in Africa. Some 15 African leaders and the

Indian premier attended. To date, India's involvement in Africa

has been largely private-sector-led. The scale of its bilateral

trade with Africa of around USD 40bn is far less than that of

China. This summit was an attempt by the Indian government to

get more involved and to boost trade and other commercial

flows. Central to this is Indias offer of infrastructure loans.

One important part of increased south-south flows is

remittances. This is a natural consequence of people moving in

search of jobs and opportunities and sending money back

home.

According to World Banks Migration and Remittances Factbook

2011, the top 10 economies with the highest remittance

outflows together account for 63% of the total sent. In order,

these are the US, Canada, the UK, Germany, France, Saudi

Arabia, the UAE, Spain, Australia and Hong Kong. In turn, thetop 10 recipients receive half the money and these are, in order,

India, China, Mexico, the Philippines, France, Germany,

Size of inflow,

USD bn

Growth,

% y/y

All developing economies 324.7 5.6

East Asia and Pacific 92.5 7.4

South Asia 81.2 8.2

LatAm and Caribbean 57.6 1.7

Middle East and North Africa 35.6 6.2

Europe and Central Asia 34.9 1.3

Sub-Saharan Africa 21.9 5.5

This table shows regions receiving most remittances.

Sources: World Bank, Standard Chartered Research

Table 1: Receipt of remittances

2010

One should expect increasing examplesof cross-border south-south flows in

financial instruments

Infrastructure is a cornerstone aspect ofsome south-south flows


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Global Insight


Bangladesh, Belgium, Spain, Nigeria and Pakistan. These figures include countries and

their territories.

In terms of regions (Table 1), in 2010 East Asia and the Pacific received the most (USD

92.5bn) and South Asia grew the most (8.2% year-on-year to USD 81.2bn).

This is leading to innovative financing tools leveraging on migration and remittances. A

good example is diaspora bonds. These are sovereign bonds that target investors who

have emigrated to other countries and the relatives of those emigrants.

Several countries have introduced diaspora bonds in recent years, or are in the process

of doing so. Examples include India, Israel, Ethiopia and Nepal. Some are more

successful than others.

Given the volume of remittance flows, diaspora bonds and remittance-backed bonds are

being viewed as potential sources that can finance infrastructure and development

projects at lower cost and longer maturities than conventional government bonds. The

size of these flows is hard to gauge fully. The World Bank estimates that annual diaspora

savings of USD 400bn in developing economies, which innovative financing instruments

can potentially tap into. These savings, as a share of GDP, is estimated to range from

2.3% in middle income countries and from 9% in low-income countries.

Tourism is also another huge flow, often overlooked, but

already growing rapidly and likely to increase as income levels

rise across the emerging world. The US is the dominant country

in terms of global tourists. China is growing rapidly but from a

very low level, although its impact may be seen much more so

regionally, across Asia. Given I am speaking in Paris, according

to the latest global tax-free shopping trends published by Global

Blue, Chinese tourists have become the highest-spending

shoppers in France. Last year, Chinese tourists spent EUR

650mn (USD 910mn) in French shops, accounted for 16% of all

non-EU tourists, and spent EUR 1,300 (USD 1,820) on average

per tourist, compared with EUR 880 (USD 1,232) by Americans

and EUR 850 (USD 1,190) by Japanese.

Third, implications

Third, I focus on the implications. Expect new trade corridors to

continue to grow. Increasingly, south-south flows will be

financial as well as trade linked.

Emerging economies need to focus on the need for greater

depth and breadth in their domestic financial markets. This is

important in a number of ways. It wil l reinforce the desire to shift

towards greater domestic-driven growth, as people can borrow

against future income as well as channel their savings into

more effective areas, and as firms are able to raise finance for

domestic investment. It will also enable more emergingeconomies to absorb inflows into their domestic markets. Such

inflows, last year, fed asset-price inflation, and in some

countries, such as Brazil, fed currency appreciation, leading to

USD bn% regional

GDP

All developing economies 397.5 2.4

Low income countries 34.4 9.0%

Middle income countries 363.1 2.3%

LatAm and Caribbean 116.0 2.9

East Asia and Pacific 83.9 1.3

Europe and Central Asia 72.9 2.8

South Asia 53.2 3.3

Sub-Saharan Africa 30.4 3.2

North Africa 22.3 4.3

Middle East 18.9 3.5

The World Banks Migration and Remittances Unit estimated the size ofdiaspora savings based on the assumption of 20% savings rates

amongst migrants.

Sources: World Bank, Standard Chartered Research

Table 2: Estimated annual diaspora savings

2009

Diaspora bonds and remittance-backed

bonds can finance infrastructure anddevelopment projects

Tourism is also another huge flow, oftenoverlooked, but already growing rapidly


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Global Insight


a general reassessment of capital controls. So far, growth in domestic bond markets

across emerging economies is still heavily focused on a few countries, such as Brazil,

India, China and South Korea. There is much more to be done to develop domestic

financial markets.

There are likely to be increased portfolio and foreign direct investment flows, tied in with

financial market development. There is a strong correlation between rising market

capitalisation and increasing income per head. This is not necessarily a causal

relationship.

Deepening domestic markets can be linked into the current G20 agenda, which has

shifted this year to focus on addressing speculation in commodity markets as well as on

currency issues. While the anti-speculative focus of the G20 is welcome, it is important to

recognise that high food and energy prices in recent years have also highlighted the lack

of investment in many commodity-producing economies. As prices have risen, the

economic as well as strategic rationale points to increased future flows, many of which will

be south-south, into energy, commodities, food and even virtual water, the latter as

countries face up to water challenges by seeking to invest in and import water-intensive

crops and even manufacturing as opposed to production at home.

We expect to see patterns of outflows from China change, away from investment into US

Treasuries and agency debt into investment in a wider range of assets. We expect more

of these to be privately owned as China liberalises its capital account.

This too can be linked to currency issues. Passive diversification is already taking place,

as countries build reserves and seek to place less of future funds into US dollars (USD). It

is not active selling of the USD, and indeed a significant proportion of new funds still go

into USD, but this ratio is likely to decline hence passive.

The role of the state is likely to remain important in south-south flows. In the case of

sovereign wealth funds this has led to dialogue to address issues, resulting in the

Santiago Principles. Wider issues linked to the role of the state will persist, including

those of commercial versus strategic and the need for transparency as opposed to

opaqueness.

Countries will need to diversify funding resources to finance rapid economic growth. This

points to developing deep, efficient and reliable funding sources to keep pace with

economic expansion. And, finally, on the policy side, the shift towards bilateral free-trade

agreements has gathered such pace that it is unlikely to reverse, despite the lip-service

paid to seeking a multilateral trade deal through the Doha round. The challenge that

needs to be addressed through this proliferation of bilateral trade deals is that many are

limited to preferential tax cuts on a limited range of products. Most make little headway in

terms of non-tariff regulatory barriers, which impede regional integration. In turn, business

can spend much time learning about and adapting to free trade agreements, thereby

raising transition and business costs.

In summary, the issue of south-south financial flows is likely to become increasingly

important. It is a reflection of the shift in the balance of economic and financial power from

the West to the East. A key aspect of this is the growth in new trade corridors, reflecting

increased flows of goods, commodities, people and remittances and of portfolio and direct

investment flows.

Strategic rationale points to increasedfuture flows into energy, commodities,

food and even `virtual water

We expect to see patterns of outflowsfrom China change, away from investment

in US Treasuries to a wider rangeof assets

The role of the state is likely to remainimportant in south-south flows


11/12

Global Insight


Inclusive growth in the Middle East

Inclusive economic growth is a necessity for the Middle East and North Africa. Mark

Malloch-Brown rightly highlights the vital role of economics, although his conclusion that

we should put "our money, or at least our loans, behind real change in the region" is only

part of the answer.

The biggest challenge in proposing economic policies for the region is that one size does

not fit all. Not only are there wide economic differences, but the combination of social,

political and religious issues means that potential solutions are complex. There is no easy

or quick answer. Moreover, it is no use outside countries offering help unless local

populations want it or need it. Ideally change must come from within.

Given this, what region-wide agendas should be pushed?

First, policy needs to be geared to diversifying local economies. There are growing young

populations. Without jobs this demographic dividend could become a disaster. Youth

unemployment is already the biggest regional problem.

Diversification means boosting the service sector. Even the energy-rich nations need to

recognise that their capital-intensive nature does not provide the much-needed jobs. They

must diversify too. This is already happening in some countries.

Diversification also means encouraging the private sector. The old economic model where

the public sector was expected to provide graduate employment no longer holds.

Second is the need for institutional change. Here the best help multilateral organisations

can offer is technical assistance and co-operation.

More money may help, but can create problems if they are not part of a wider reform.

Take even the cash-rich Gulf countries. They have pumped huge sums into their

economies. That is good, but now the break-even price of oil necessary to balance their

domestic budgets is sky high. Even they can only pump in money for so long.

For others, more money, in the absence of political reform, might be destabilising. Across

Africa, for instance, money pumped into economies was mostly wasted because of weak

governance, corruption and political instability. Thus institutional change is needed, not as

an ultimate goal, but for any money spent to have a real impact.

Third, inclusive growth can only be achieved with a vibrant domestic economy. This

requires other features to be put in place, including social safety nets, more women in the

workforce, help for small and medium-sized firms as they are key for job creation, and

developing local financial markets to channel savings into investment.

All of these take time, suggesting the need for patience and to manage local expectations.

Given the need to keep everyone on side there is a case for economic plans with clear

goals and measurable targets. Central to this would be a stable tax, regulatory and policy

environment for business and a social contract between government and the people. With

these changes in place, good economics may become good politics.

This article appeared in the

Financial Times A-list series of

opinion columns on the

newspapers web site, in

response to an article by Lord

Malloch-Brown.

Policy needs to be geared to diversifyinglocal economies

There is need for institutional change

Inclusive growth can only be achievedwith a vibrant domestic economy


12/12

Global Insight


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Document approved by

Gerard Lyons

Chief Economist and Group Head of Global Research

Data available as of

14:00 GMT 22 July 2011

Document is released at

14:00 GMT 22 July 2011

the economic and financial outlook_22!07!11!16!02

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