Economic Research:

Why The Global Economy Is Set To Perform Better Than Its "Angst Meter" Implies Chief Global Economist and Head of Global Economics and Research: Paul J Sheard, New York (1) 212-438-6262; [email protected]

Table Of Contents Unhappy New Year A Busy Year-End For Central Banks China's Steadily Evolving Monetary Architecture China: The Epicenter Of Global Market Angst China: Trusting The Numbers A Washington, D.C. Footnote European Union: More Flaws Revealed Davos And "Mastering The Fourth Industrial Revolution" Related Research Notes

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Economic Research:

Why The Global Economy Is Set To Perform Better Than Its "Angst Meter" Implies (Editor's Note: The views expressed here are those of McGraw Hill Financial's chief economist. While these views can help to inform the ratings process, sovereign and other ratings are based on the decisions of ratings committees, exercising their analytical judgment in accordance with publicly available ratings criteria.) It has been a turbulent start to the year for the global financial markets, the dominant trend being sharply falling equity prices, bond yields, and commodity prices. For instance, year to date (as of Jan. 19), the S&P 500 is down 8%, the Nasdaq is down 11%, and the Shanghai Composite Index is down 15%; 10-year U.S. Treasury yields have fallen by 21 basis points (bps) (to 2.06%), 10-year Japanese government bond (JGB) yields have dropped 4 bps (to 23 bps), and 10-year U.K. gilts are down 26 bps (to 1.70%); and the Brent spot oil price is down by $8.46, falling below $30 for the first time in 12 years. Does the markets' dyspeptic start to the year presage a global economic downturn? We doubt it. Short-term market movements--and we're only talking about three weeks here--are largely "noise" when it comes to inferring longer-term trends. Of course, when an economic downturn does occur, it will be preceded at some point by the kind of market moves that have occurred so far this year. Occasionally, there are important "signals" in the noise, and market participants and forecasters are constantly, and somewhat obsessively, trying to divine them. Overview • Recent market moves probably overstate the likelihood of a slump in global growth this year. • Major central bank moves in December may have disappointed or unnerved markets, but monetary policy continues to provide a tailwind to economic expansion. • China's growth is set to slow, but not collapse, as policymakers attempt to rebalance and reform the economy while digesting a debt and investment overhang. • Now that China is the center of global financial market attention, it needs to communicate better, including by improving the quality of its GDP statistics. • The refugee crisis has exposed yet another flaw in the architecture of the EU: nation-states retaining sovereignty over their foreign affairs, national security, and defense, but not having control of their borders.

Unhappy New Year In the six and a half years or so since the global economy started to recover from the Great Recession that followed the global financial crisis, it has grown in real terms at an average of about three-and-a-half percent annually. We expect that trend to continue, penciling in 3.6% for global growth in 2016. The biggest (obvious) source of downside risk in the global economy, however, is China, because of its size, its hitherto high growth rate, and its manifest economic challenges. We expect real growth in China to continue to trend downward, but to end up at about 6.3% this

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year, after growing by 6.9% last year (and 7.3% in 2014). Growth in most of the developed world and even much of the developing world stands to be a bit higher this year than last, which adds up to a decent outcome for global growth. Excessive pessimism is probably not warranted. Financial markets are "discounting machines." Investors' decentralized but collective decisions on how to position their portfolios determine market prices and thereby "move markets." Investors are constantly using the new flow of information they receive--which is incessant and includes movements in market prices themselves--to infer things about the future path of the economy and, the thing they care about most, market prices. To make matters worse, not only do financial markets discount and in a sense "predict" the future, they can also influence the future, usually in self-fulfilling good ways but occasionally in self-fulfilling bad ways. To borrow George Soros's term, it is a very "reflexive" system (1). The start of a new calendar year is a focal point for markets: It is the intersection of a process of many investors and other market participants (including prognosticators) coming back from holidays and catching up on the news, and traders and investment committees making decisions about the initial positioning of their portfolios of investments for the year. Judging by the start to the year, the collective judgment of investors would appear to be downbeat about prospects for the global economy this year. Based on that perspective, it might be useful to review and analyze some of the major developments in the global economy since the beginning of December. What was the "raw material," so to speak, that has been fueling the market discounting process in recent weeks? It is impossible to be exhaustive, and I will not review the economic data flow, other than to note that our global economics team has not reported any major shift in the trend of economic data--even in China, the epicenter of global market angst. Recent market moves appear to be more sentiment- than data-driven (the oil price is a bit different as the fall in spot prices reflects changing supply fundamentals, notably more oil coming to market relative to short-term demand).

A Busy Year-End For Central Banks On the monetary policy front, December proved to be an eventful month. The net effect of the major monetary policy moves may have been a bit disappointing for investors, although it's worth bearing in mind that the job of central banks is not to please investors or help them make money: It is to achieve their policy goals of returning the economy to (or keeping it at) full employment with low, stable inflation (and a few other things, such as operating the settlements system and maintaining financial stability) (2). As expected, the Federal Open Market Committee (FOMC) of the U.S. Federal Reserve raised the target range for the federal funds rate to 25-50 bps from the zero to 25 bps range it had maintained since December 2008. By the time it happened, this was probably the most well-telegraphed move in recent monetary policy history and was therefore very well discounted. But that doesn't mean it could not be feeding some angst in financial markets, for at least two reasons. First, even though the Fed's move was "well discounted," it doesn't mean it was perfectly discounted. For any anticipated event, there is always some prior distribution of expectations in the market, and when the event does occur, that distribution collapses to a single point: a probability mass of one, "destroying" in particular the tails. As

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former Federal Reserve governor Jeremy Stein has cogently pointed out, that process can move markets (3). Second, and related, an event like the Fed's rate hike in December, if it is significant enough, can be a focal point for investors to reconsider their views, and this process can produce new market outcomes. The market moves on, so to speak. Make no mistake, the Fed's move was historic, and the jury is still out as to whether it was the right thing to do (and it may not become clear for some time). Solid arguments can be made on both sides (or in fact, on three sides--not just that the move was premature or that it was just right, but that it was overdue, perhaps considerably so). I won't go into them here. The Fed's move was historic and significant for a number of reasons. For one, it was the first time the Fed had raised the federal funds rate since June 2006 and the first time it had initiated a rate-hiking process since June 2004. This is uncharted territory for many (younger) market participants. For another, this was the Fed's first move away from what, for seven years, it has taken to be the effective zero interest rate bound: Similar initial interest rate hikes either before or since the global financial crisis have not gone well for other central banks and were subsequently reversed (for example, the Bank of Japan's interest rate hikes in August 2000 and then July 2006 and January 2007, and the European Central Bank's rate hikes in July 2008 and in April and July 2011). This is uncharted territory for the Fed too. And third, while the Fed did not exactly sing this from the rooftops, its decision in December marked a shift in the monetary policy regime, from one in which the size and composition of the balance sheet (quantitative easing) had been the marginal tool of monetary policy to one in which the federal funds rate (and the associated interest rate paid on reserves) is. With this important monetary policy decision and associated regime shift traversed, it was natural for investors to start to focus more on the expected future path of the federal funds rate--that is, the pace of monetary "tightening." The December "dot plot" of FOMC participants of their assessments of the appropriate level of the federal funds rate implied four more rate hikes in 2016, four more in 2017, and three more in 2017. While these forecasts were only marginally different from those given in September, the December decision meant that the four rate hikes signaled to be on the way in 2016, for investors, suddenly became "live" prospects rather than hypothetical ones. To many market participants, it appears that four rate hikes by the Fed in 2016 feels like too much monetary tightening, and therefore the makings of a policy error, and this seems to be weighing on market sentiment. Added to that were decisions by the European Central Bank (ECB) and the Bank of Japan (BOJ) that appeared to disappoint or unnerve the market. At its Dec. 3-4 meeting, the ECB announced a number of incremental easing measures: lowering the interest rate on the deposit facility by 10 bps to -0.30%; extending the interim horizon for the monthly purchases of €60 billion under the asset purchase program (APP) to the end of March 2017 (from the end of September 2016); and beginning to reinvest the principal payments on the securities purchased under the APP as they matured, for as long as necessary; including, in the public sector purchase program part of the APP, in the list of assets that are eligible for regular purchases by the respective national central banks, euro-denominated marketable debt instruments issued by regional and local governments located in the euro area; and continuing to conduct the main refinancing operations and three-month longer-term refinancing operations as fixed-rate tender procedures with full allotment for as long as necessary, and at least until the end of the last reserve maintenance period of 2017. The content of this further easing by the ECB, particularly the failure to increase the amount of monthly purchases,

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appeared to disappoint markets, given the prior communications by ECB officials. The BOJ surprised financial markets at its Dec. 17-18 Monetary Policy Meeting by announcing the introduction of "Supplementary Measures for Quantitative and Qualitative Monetary Easing," including establishing a new program for purchasing equity exchange-traded funds (ETFs) at an annual pace of about ¥300 billion, in addition to its existing program of purchasing ¥3 trillion of ETFs a year, and extending the average remaining maturity of its JGB purchases to about seven to 12 years (from about seven to 10 years), and adding banks' foreign-currency denominated and housing loans as eligible collateral for the BOJ's credit-providing operations. But the Christmas surprise by the BOJ seemed to unnerve or flummox the market more than to please it. This was because BOJ Governor Haruhiko Kuroda, in his press conference, played down the significance of the moves, characterizing them as measures that would facilitate further monetary easing should such an "adjustment" become necessary, rather than as further monetary easing itself. Indeed, the ETF plot thickened. The BOJ has a portfolio of stocks separate from those held for monetary policy purchases, purchased from banks, that it started to accumulate from November 2002 as a measure to strengthen bank balance sheets during "banking crisis" days. The BOJ started releasing these stocks back into the market in October 2007 but stopped doing so during the financial crisis. It is due to resume those sales in April this year, and announced after the Dec. 17-18 policy board meeting that it had decided to increase the length of time over which it would sell these stocks from five to 10 years. Japan's additional annual ETF purchases, announced outside of the main asset purchase program, exactly matched the estimate of the amount of stocks the BOJ would be selling per year. In other words, although they were ostensibly separate decisions, the ETF decision seemed intended to offset or neutralize any negative impact from the forthcoming share sales. The December moves may also have damaged the "Kuroda brand" a little, and, in light of the increased number of dissents (from one to three on some decisions), raised concerns in the minds of investors about Governor Kuroda's ability to keep firing his "bazooka." Up until December, for the almost three years of monetary policymaking under Governor Kuroda's leadership, the BOJ had eschewed its previous predilection for announcing policy measures in dribs and drabs in favor of front-loaded bold moves (such as the April 4, 2013, launch of quantitative and qualitative easing, or QQE, and its Oct. 31, 2014, surprise ramping up of QQE). The December decision and the rather clumsy communication accompanying it created the impression that the BOJ may have been "reverting to type." Either the December decisions did not constitute further monetary easing or they were easing measures cut from a Shirakawa-looking (4) rather than Kuroda-looking cloth. Either was disappointing to investors. But let's not get carried away here. Monetary policy remains a key support and tailwind for economic expansion in the U.S., the eurozone, and Japan (among other countries). There is a tendency for market participants to regard the Fed's (and other central banks') monetary policy as an exogenous factor acting on the economy, but monetary policy is thoroughly endogenous. If the Fed is signaling its expectation of hiking rates four times, by a cumulative 100 bps, this year (and again next year), but investors doubt that economic activity will be strong enough to withstand that amount of monetary policy tightening, that starts to spell trouble in the minds of those investors. But the Fed is not hell-bent on tightening monetary policy--its monetary policy decisions are an instrument it uses to achieve its goals, which for the time being are to spur above-potential growth in order to get the economy back to full employment and inflation up to its target, and then keep them both

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there. Now, the Fed is capable of making mistakes; monetary policymaking is decision-making under uncertainty on steroids (that's why central banks are such richly and expertly resourced institutions). But investors would be foolish to bank on its systematically doing so (assuming they share the standard economic and policy model). If it turns out the economy is not strong enough to withstand the presumed pace of rate hikes, the Fed will likely notice pretty quickly: It is the pace of rate hikes, not the economic trajectory, that will likely end up adjusting the most. That's what "data-dependent" means. Both the ECB and the BOJ may have disappointed investors a bit with their December decisions, but let's not lose sight of the fact that those two central banks are latter-day converts to quantitative easing (5) and are currently in full-fledged QE mode, in the manner of the Fed's open-ended QE3 (put in place at the September and December 2012 meetings). QE is not a powerful monetary policy tool in the circumstances in which its use is likely to be observed; but that is an argument for using it aggressively, not for avoiding it or using it half-heartedly. QE is likely to be most effective when the central bank signals its intent to keep exchanging electronically created ("printed") central bank money for government debt securities and other assets held by the private sector until it achieves its objectives; confident and decisive communication, backed up by commensurate QE action, is the lever that a central bank can use to ensure that the public's inflation expectations are "well behaved" (that is, aligned with its inflation target). The BOJ is committed to expanding its balance sheet by the equivalent of about 16% of nominal GDP per year, and the ECB by about 6%. Such policy action is not to be sneezed at, and is a key factor in our view that both the eurozone and Japan should be able to register above-potential growth this year.

China's Steadily Evolving Monetary Architecture The People's Bank of China (PBoC) also capped off an important and busy year in December when, in tandem with its China Foreign Exchange Trade System (CFETS), it announced that henceforth it would be managing the renminbi against a basket of 13 currencies, or an "effective exchange rate index," the largest weights being the U.S. dollar (26.4% of the basket), the euro (21.4%), the Japanese yen (14.7%), and the Hong Kong dollar (itself pegged to the U.S. dollar) (6.6%). China's exchange rate reforms in 2015, and increasing exchange rate volatility against the U.S. dollar, became a major focus and source of considerable angst in global financial markets. A little theory may go a long way here. Mundell's "impossible trinity" holds that a country can have only two of the following three: a fixed exchange rate, an open capital account, and domestic monetary control. Most developed economies operate with an open capital account (investors can freely buy and sell domestic securities using foreign currencies), a floating exchange rate, and a central bank that targets domestic price stability; it is the flexible (freely floating) exchange rate (relative price of domestic and foreign currencies) that gives the domestic monetary authorities the leeway to control an absolute price (the domestic inflation rate or rate of change of a representative basket of domestic goods) when people can switch freely in and out of domestic currency. When the capital account is open, the central bank can either control the domestic price level and lose control of the foreign exchange rate, or control the

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Economic Research: Why The Global Economy Is Set To Perform Better Than Its "Angst Meter" Implies

exchange rate and lose control of domestic inflation. It is usually an easy choice. Many emerging economies make a different choice, or have tended to in the past: operating a fixed exchange rate and maintaining domestic monetary control by keeping the capital account closed. That was the system China operated under until July 2005. But after China entered the World Trade Organization in December 2001, it experienced a rapid increase in trade with the rest of the world, and grew rapidly. It made sense for China to start to integrate with the rest of the world financially, as well as via trade--that is, to start to open up its capital account (the current account and the capital account essentially being mirrors of one another, since net trade flows between countries involve net financing flows). But the only way to open up the capital account and maintain domestic monetary control is to move to a floating exchange rate. China has been moving down this path since July 2005, when the PBoC announced that the yuan would no longer be pegged to the U.S. dollar and that "China will reform the exchange rate regime by moving into a managed floating exchange rate regime based on market supply and demand with reference to a basket of currencies." Things accelerated last year as Chinese authorities used the International Monetary Fund's (IMF's) five-year review of the composition of its Special Drawing Rights (SDR) basket to push for inclusion of the renminbi alongside the U.S. dollar, the euro, the British pound sterling, and the Japanese yen. To China's gratification, the IMF announced on Dec. 1, 2015, that it would include the renminbi in the SDR basket from Oct. 1 of this year (6). Getting the renminbi included in the SDR basket had both symbolic and incentive value to the Chinese authorities. For the renminbi to be included, the IMF had to judge not only that China was among the largest exporters in the world (an easy tick), but that the renminbi was a "freely usable" currency. While a currency's being deemed "freely usable" by the IMF is not the same thing as the respective country's having an open capital account and a flexible exchange rate, there is a fairly close correspondence between the two. In order to satisfy the IMF on various counts relating to the "freely usable" criterion (as the IMF laid out in a report titled "Review of the method of valuation of the SDR – Initial considerations," released Aug. 3, 2015), the PBoC had to improve the method and transparency by which it implemented the daily fix of the renminbi. On Aug. 11, 2015, the PBoC announced that it was taking steps to improve the quotation of the "central parity" of the renminbi against the U.S. dollar, specifically by linking the daily fix to the closing rate of the interbank foreign exchange market on the previous day, "in conjunction with demand and supply conditions in the foreign exchange market and exchange rate movement of the major currencies." In implementing this change "for the purpose of enhancing the market-orientation and benchmark status of [the] central parity," the PBoC devalued the renminbi by 1.9%. This sent shock waves through global financial markets. It should not have. Many investors, spooked by recent events in the Chinese equity market, seem to have inferred from the move that the Chinese authorities were panicking and were about to launch a big competitive devaluation. An equity market bubble had formed on the Shanghai and Shenzhen bourses in the fourth quarter of 2014 and started to collapse unceremoniously from mid-June; the ensuing policy responses by the authorities were widely viewed by investors and commentators as ill-advised and ham-fisted. Things must be really bad, investors figured, if the authorities were now engineering a competitive devaluation. This may have been a misreading of the situation, however. It is not surprising that, when the exchange rate mechanism is made more flexible, it moves more, and in both directions. That's what exchange rate flexibility means.

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Economic Research: Why The Global Economy Is Set To Perform Better Than Its "Angst Meter" Implies

Since the PBoC's Aug. 11 announcement, including the initial near-2% move, the renminbi has depreciated by 6.7% against the U.S. dollar, a significant but hardly huge move in the grand scheme of things. Movements in flexible exchange rates tend to reflect differences in respective monetary policy stances and in economic fundamentals, the latter also tending to influence the former. The Chinese economy has been slowing and is continuing to slow (7), and the monetary authorities have been easing policy to cushion the slowdown; at the same time, the Fed has started to unwind its extremely accommodative monetary policy stance, given that economic conditions and the outlook have improved. In that context, a renminbi that is gradually weakening should not be a big surprise or source of concern. Meanwhile, and to add to the China-directed angst, as China has been opening its capital account or de facto it has been becoming more open (porous), residents have been taking the opportunity to convert part of their renminbi assets into U.S. dollar and other foreign assets--and they've done so on a large scale. The best indicator of this is the steady decline in China's foreign exchange (FX) reserves, notwithstanding China's continued significant (albeit much smaller than pre-crisis) current account surplus, of about 2.5% of GDP. FX reserves peaked at $3.993 trillion in June 2014, but had fallen by $663 billion by the end of 2015. The pace of decline quickened in the second half of 2015, with reserves falling by $363 billion in those six months. For sure, what happens to China's FX reserves bears close watching. But again, one should not be too surprised that as China evolves its monetary architecture in line with its long-telegraphed reform intentions, and consistent with other things it is doing to further internationalize the renminbi, there is a rebalancing of the ownership of its claims on foreign assets. The foreign assets that China's State Administration of Foreign Exchange (SAFE) is releasing are going into the hands of Chinese citizens, and this, in principle, is a good thing.

China: The Epicenter Of Global Market Angst Last year was a watershed year for China and for the global economy. For the first time, global shocks emanated from China, and China truly became the center of attention for global financial markets. For many investors, what the Chinese equity market and foreign exchange market did overnight became the first thing, or among the first things, they looked at when they woke up in the morning. This is for good reason. China's annual real GDP growth since 1980 has averaged 9.8%, and its economy, by virtue mainly of the country's huge population, is now the second-largest in the world and edges out the U.S. on a purchasing power parity (PPP) basis. Since the global financial crisis erupted in September 2008, China's quarterly real GDP growth has averaged 8.4% year-on-year. But China's growth rate has been steadily falling, and the precipitate drop in oil and other commodity prices since mid-2015 has led many investors to suspect that the growth rate may be much lower than official figures report. Chinese policymakers are dealing with three challenges simultaneously, the collective content of which are weighing heavily on markets. The first is coping with a slowing economy, specifically to ensure that growth does not fall too far too fast. Chinese leaders have lowered their target for growth over the next five years to "at least six and a half percent," at the same time signaling that the days of more than 7% growth are gone. The new growth target of 6.5%-7% is fairly arbitrary, representing the implied growth rate that the Chinese leadership needs to achieve to meet

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Economic Research: Why The Global Economy Is Set To Perform Better Than Its "Angst Meter" Implies

its commitment to double Chinese real GDP in the current decade. In mature developed economies, governments do not usually have a target for the real growth rate (8). The government and the central bank share responsibility for macroeconomic policy management, and with Keynesian-style fiscal policy falling out of favor in recent decades, most of the responsibility has devolved to the central bank. The main macroeconomic policy targets are price stability and full employment, with attaining the latter often being seen as following naturally from attaining the former. Price stability and full employment, almost by definition, prevail at the potential growth rate of the economy, whatever that may happen to be, but a real growth target per se is nowhere in sight (9). On the other hand, the government is responsible for supply-side policies (and fiscal policy and redistributive policies, as well as a host of other functions) and implicitly may be thought of as trying to implement policies to improve the potential growth rate, although usually without putting any particular numbers on it. Viewed in this light, the growth target so beloved of Chinese policymakers is a bit of an odd construct. It is simultaneously three things: (i) a commitment to achieve a certain rate of potential growth over time and, at any point in time, both (ii) an estimate of what the potential growth rate is and (iii) a commitment to manage aggregate demand (actual growth) to be in line with it. This bundling of three objectives into one number invites a certain amount of conceptual and operational fuzziness. That China persists with its growth targets is somewhat understandable given its stage of economic development, but it is also a sign of the immaturity of its policy framework. No wonder markets get nervous. The second major policy challenge that China faces is how to cope with and digest the aftermath of the credit and investment binge that policymakers engineered to try to insulate the country from the Great Recession's adverse impact on growth. In the three years from 2009 to 2011, China's real growth averaged 9.8% year-on-year. That was a remarkable growth performance for the world's second-largest economy in the wake of the worst global financial crisis and recession since the Great Depression. But this growth did not "just happen." It was the result of a concerted effort by the authorities to provide credit through the state-controlled banking system to finance a massive program of infrastructure and housing investment across the whole country, but focused on the central and western provinces. It worked, but it left a big credit, debt, and investment overhang. The investment share of GDP rose by six percentage points in just two years between 2007 and 2009, from an already high level (10). A simple proxy measure of "excess credit" can be obtained by extrapolating the pre-crisis trend of financial institution loans outstanding, which exhibits a startling kink upwards in fourth-quarter 2008, to the present and comparing it with the actual amount outstanding; this comes to about 60% of China's current nominal GDP. A similar back-of-the-envelope calculation for the M2 stock of money (which includes currency in circulation and other easily converted equivalents, notably demand and time deposits in banks), the balance sheet counterpart of the credit created, yields a figure of about 80% of GDP. History shows that credit-fueled investment booms are usually followed by severe slumps and often financial crises. To paraphrase Carmen Reinhart and Ken Rogoff (11), it is the concern that "this time is unlikely to be any different" that weighs heavily on many investors, and the more so the more China's growth appears to be weakening and signs emerge that policymakers may not be able to counter that.

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Economic Research: Why The Global Economy Is Set To Perform Better Than Its "Angst Meter" Implies

The third challenge facing Chinese policymakers is to rebalance and reform the economy. When it comes to per capita income levels, China is still a developing economy; when it comes to its markets and institutions, it is still a transitional economy. China may be the second-largest economy in the world, but per capita nominal GDP is still only about $8,280 (compared with about $55,900 in the U.S.; the respective figures for per capita GDP in PPP terms in 2014 were $13,224 and $54,370). China, taken as a whole, is still relatively early in its economic development, and Chinese leaders are focused on undertaking the necessary reforms to lay the foundation for the next stage, one that is seen as requiring a change in the economic model and a rebalancing of growth from exports and investment toward household consumption and services. As most recently articulated in the Decision on Deepening Reforms of the Third Plenum in November 2013, China is embarking on a long-range, ambitious, and sweeping program of reforms (12). A stated pivotal point in that reform program is to "make the market play a decisive role in allocating resources." However, unleashing market forces, particularly financial market forces, into a slowing economy with a large legacy credit and debt overhang can be a precarious undertaking. This fact too has not escaped investors. So, Chinese policymakers certainly have their hands full. They need to reform the economy and refashion its institutional fabric and rules of the game, but do so without triggering a financial crisis or too sudden a slowdown in growth. For that, it is necessary that claimants on the financial system maintain confidence in the asset backing of their claims (which could be government guarantees) and that the necessary rebalancing of GDP from investment to consumption take place. Reforms are a double-edged sword: They are needed to facilitate rebalancing, but they can increase stresses in the financial system and markets. Chinese policymakers may thus face a dilemma. If they push ahead with reforms, they may trigger financial instability; but if they put too much weight on maintaining financial stability, they may retard the rebalancing process, storing up even bigger adjustment challenges and making a prolonged growth slowdown more likely later on. To avoid this kind of outcome, Chinese policymakers may need to heed the lessons of both Japan's and the United States' policy responses to their most recent financial crises. Japan (in the 1990s) was a lesson in what not to do: quell financial instability by guaranteeing bank deposits but not adequately disclose latent losses and not quickly mobilize public funds to recapitalize banks (13). The U.S. (in 2008-2009) was a lesson in what to do: force banks to disclose the state of their balance sheets and adequately capitalize themselves, and be prepared to quickly inject public funds to restore capital and investor confidence if necessary. When financial balance sheets are impaired to the point that serious systemic risk arises, the government needs to be prepared to put its own fiscal resources to work to help to mark assets to market (and restructure those assets) while ensuring that the financial system is adequately capitalized. As far as China is concerned, the implied pessimism about 2016 outcomes in recent market movements seems excessive. We expect China's real GDP growth to continue to slow, to 6.3% for the full year, but that level of growth is the equivalent of about 14% growth in 2009, in terms of the size of the increment to global GDP. So let's keep things in perspective. While facing serious risks and challenges, China has a number of things going for it, among them a long track record of policymakers successfully managing the economy; significant institutional capacity; the ability to learn from the experiences and policy errors of other countries, and a penchant for studying and acting on these lessons; still-huge untapped economic development potential; plentiful macroeconomic policy ammunition;

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Economic Research: Why The Global Economy Is Set To Perform Better Than Its "Angst Meter" Implies

and an abundance of Chinese "animal spirits." A forecast for China, as for any economy, is a joint forecast of three things: the existing trajectory of the economy; how forcefully, and how quickly, policy authorities will respond if that trajectory does not accord with their desired one; and how the economy responds to that policy reaction. When markets start to discount a weakening economy, they tend to discount that fact heavily but fail to account for the ensuing policy response and subsequent improvement in economic outcomes. That is, market sentiment and market prices tend to overshoot. The current juncture feels like that, rather than like a true inflexion point (down). There is little doubt that the Chinese economy is slowing, and perhaps quite sharply. But Chinese policymakers will not idly stand by and allow the growth rate to fall tangibly below the floor of their target range, of 6.5%; they have plenty of monetary and fiscal ammunition to use, and the economy, still at an early stage of overall development and with plenty of scope for further urbanization, has plenty of leeway to respond.

China: Trusting The Numbers A question that always comes up when discussing China's growth is whether the official GDP numbers can be believed. This discussion is usually framed in terms of suspicions or assertions that the authorities know the "true" GDP number, but, because this is too low, are covering it up and publishing an inflated number instead. There may well be an element of fudging or massaging of the official numbers for political purposes (particularly with respect to GDP deflators, which are used to convert nominal into real amounts); it's impossible to know for sure. But it is probably better to think about this issue in terms of what needs to be done to improve the quality of China's GDP (and other economic) statistics. GDP is a measure of the value of final goods and services produced in an economy, where those goods and services are valued at market prices or a proxy for same. GDP is not an objective thing or a reality waiting to be revealed; it is first and foremost conceptual in nature. And it is subject to all kinds of measurement error. In any country, GDP "numbers" are statistical estimates of the size and composition of a highly complex entity: the economy (14). The GDP numbers that any statistical authority report are only as good as the quality of the data that are collected and fed into the calculation process, and only as good as the statistical and econometric techniques used to tease out the meaning from the "raw" data. Producing "good" national accounts--national accounts that are relatively accurate, informative, and trustworthy--takes a lot of resources and institutional capacity, and is a mark of a developed economy. It is no surprise that China, with its developing--and also huge, far-flung, and rapidly growing--economy, does not have "good" national accounts. That said, China is not just any old developing economy. Weighted by its importance in the global economy, its inherent risks, and a low level of visibility for the rest of the world into its economic, social, and political processes, China is now probably the most influential economy in the world from the viewpoint of market participants globally. Given this newfound status, it is imperative that China improve the quality, transparency, and integrity of its national accounts and other economic statistics. Doing so should be made a high priority in the ongoing reform process. Now that China is at the center of global market attention, it can no longer afford a situation in which many investors,

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Economic Research: Why The Global Economy Is Set To Perform Better Than Its "Angst Meter" Implies

rightly or wrongly, simply do not believe "the numbers" coming out of the country. There is a simple reason for this urgency. The effectiveness of policy in any country depends largely on the credibility of its policy authorities, and there is a virtuous circle between the two. Good communication is a tool of policy and underpins policy credibility. Policymakers accumulate credibility over time when they communicate their objectives, assessments, and commitments clearly and consistently and follow up with policy actions that accord with prior communication. The economic statistics a government reports are among the most basic elements of its communication to its own people and to the world at large. Allowing a big question mark to hang over those statistics impedes not only the operation of markets but the effectiveness of policy and thereby economic performance.

A Washington, D.C. Footnote Sometimes historic things happen with a pop, not a bang. On Dec. 18 of last year, the Consolidated Appropriations Act of 2016, also known as the 2016 omnibus spending bill, was passed by the U.S. Congress and signed into law by the president. The last-minute budget deal funds the U.S. federal government through Sept. 30, 2016 (on Oct. 30 of last year, the Congress had suspended the debt ceiling until March 2017). Tucked into this bill, and passed into law, was the approval by the U.S. Congress of the IMF's 2010 Quota and Governance Reforms. These reforms, which themselves had been a long time coming, doubled the IMF's quota resources, to about SDR477 billion (about US$659.67 billion) from about SDR238.5 billion (about US$329.83 billion), and shifted about 6% of quota shares to emerging-market and developing countries from "over-represented" countries, European ones in particular. As a result, four emerging-market countries (Brazil, China, India, and Russia) will now be among the 10 largest members of the IMF. Notably, China's quota will increase to 6.39% from 3.99%. Even though the 2010 IMF reforms did not result in the U.S. losing its veto power over IMF decisions (15), the reforms went nowhere in Congress for five years, ostensibly because of Republican Party opposition. The failure of the U.S. Congress to pass the IMF reforms, among them giving China a bigger voice in the institution and therefore a bigger stake in the international monetary system, was widely seen as a U.S. "slap in the face" to China and as a major impetus for China to launch two new international development banks: the New Development Bank BRICS (16) and the Asia Infrastructure Investment Bank (AIIB) (17), in which the U.S., along with Japan and Canada, conspicuously refrained from becoming founding members (the other G-7 member countries all did). China also became the 67th member of the European Bank for Reconstruction and Development on Jan. 15, 2016. The quiet slipping in of the IMF reforms into the budget deal may have represented a belated recognition among former opponents that "the rise of China" is a fact that needs to be accepted and managed, not something that can be ignored or wished away.

European Union: More Flaws Revealed The 28-member EU, and within it the 19-member eurozone, represent a distinctive and hybrid form of statehood: a political and economic union in which some but not all aspects of national sovereignty have been pooled.

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Economic Research: Why The Global Economy Is Set To Perform Better Than Its "Angst Meter" Implies

Notwithstanding that some countries in the world allow dual or multiple nationalities, sovereignty at its core exists in a single body: The people of a sovereign nation or state share a common identity and allegiance. True, sovereignty has many dimensions, corresponding to the respective functions of the state: economic, political, monetary, fiscal, redistributive, military, electoral, educational, and so on. But normally these dimensions are unified in the system of government of the nation-state, whether it be a unitary or federal state, or spread in a connected and logical fashion across the various levels of government. The gravitational forces are such that the different dimensions of sovereignty tend to stay together and remain connected: That's what having a sovereign identity means. It's different for EU member states in that some of these dimensions of sovereignty are pooled at the level of the EU or the Economic and Monetary Union (EMU) and others are not, in a way that appears somewhat arbitrary or unnatural. This selective pooling of sovereignty came to light most noticeably in the eurozone sovereign debt crisis, which started with the Greek debt crisis that erupted in late 2009. It became clear that there were big problems associated with countries pooling monetary sovereignty (being in a monetary union) but not pooling fiscal sovereignty (not being in a fiscal union). Fiscal and monetary policy being two sides of the same sovereign money-regulating coin, so to speak, they go together in the normal state of affairs. European, particularly eurozone, leaders gradually noticed this conundrum and took various steps to deal with it, including a whole host of fire-fighting measures and some other ad hoc efforts involving new institutions, as well as visionary planning exercises aimed at building a "genuine" Economic and Monetary Union (the Four Presidents' reports of June, October, and December 2012) or "completing" the Economic and Monetary Union (the Five Presidents' report of June 2015). These plans have centered on introducing a banking union and, more recently, a capital markets union, bolstering the fiscal framework, and moving in the direction of embracing some forms of fiscal union, as well as increasing the economic union and contemplating more sharing of political sovereignty. The Five Presidents' report was slated for discussion at the Dec. 17-18 meeting of the European Council (comprising the heads of state and government of the 28 members of the EU), but appears to have been superseded by talks on the more urgent refugee crisis and terrorism threat (as indeed appeared to have happened at the June and October European Council meetings as well, with respect to the refugee issue). The European Council decided to come back to "the legal, economic and political aspects of the more long-measures contained in the report" by the end of 2017 at the latest, notably a deadline that falls after the French and German elections. The refugee crisis has highlighted yet another problematic aspect of the selective pooling of sovereignty in the EU. Despite the EU's having some common foreign policy in the form of the position of High Representative of the Union for Foreign Affairs and Security Policy (established under the Amsterdam Treaty, which came into force in 1999), sovereignty as it relates to national security, foreign affairs, and defense lies very much at the member-state level. Yet freedom of movement of people within the EU is a fundamental tenet of the union (enshrined in Article 45 of the Treaty on the Functioning of the European Union), and the Schengen Agreement abolished all internal borders in lieu of a single external border. Is it really possible for a nation-state to be the unit of sovereignty for national security and defense but not to have complete control over its borders? With the emergence of this contradiction, the operation of the Schengen Agreement now appears to be under stress. While the influx of refugees and migrants is likely to remain front and center in European economic and political affairs

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Economic Research: Why The Global Economy Is Set To Perform Better Than Its "Angst Meter" Implies

in the coming year and beyond, it is by no means negative for the economic growth outlook--it represents both a substantial addition to the workforce and to aggregate demand, particularly at a time when the ECB has its foot on the monetary accelerator. But whether the process of coping with the challenges ends up bringing more cohesion to the European body politic, or acts as a force rendering it apart, remains to be seen.

Davos And "Mastering The Fourth Industrial Revolution" This week the good and the great of the world are gathering in Davos, Switzerland, for the 2016 World Economic Forum Annual Meeting. This year's theme is "Mastering the Fourth Industrial Revolution," the fourth revolution referring to changes in society arising from new and emergent technologies: decoding of the human genome meets machine learning meets Artificial Intelligence meets nanotechnology meets the Internet of Things meets quantum computing, and so on. You get the picture. The (Robert) Gordon thesis (which is pessimistic about productivity) is probably wrong and misses the point--that successive productivity improvements over many decades accumulate to very significant increases in people's absolute living standards and, even if the pace of new productivity-enhancing technological advances slows, the scope for productivity dividends to be garnered from thoroughly exploiting and diffusing the existing stock of technological knowledge is enormous (18). Go back a century and look ahead to the technological innovation and application of even the existing stock of science and technology that drove rising living standards in the ensuing century. Could someone living in 1916 have imagined what life would be like 50 or 100 years later? For various reasons (too numerous and complex to go into here), GDP statistics can't adequately capture all of these changes and the value they generate. Then assume that the equivalent of only half or even a quarter of analogous life-changing technological developments are going to happen in the next century. Unless technological innovation and the application of existing human knowledge is about to grind to a halt, the world is set to be continuously and dramatically transformed--and in ways that are either unimaginable or in the realm of science fiction today. The most compelling economic policy challenge is to ensure that economic growth is "inclusive" (both within and between nations) and that economic and social institutions (relating to education, pensions, social security, income redistribution, etc.) are adapted and kept "fit for purpose" in the face of dramatically changing economic and technological conditions. Technological innovation and application have the capacity to dramatically expand society's "production possibilities frontier," but they can also render human capital obsolete and create and exacerbate "winners take all" effects. Creating the mechanisms for society as a whole to share in the associated affluence will be no mean feat. More on all of this after Davos.

Related Research • The Risk Of A More Disjointed EU: What It Might Mean For Sovereign Ratings, Dec. 14, 2015 • Stress-Testing Global Growth, Sept. 30, 2015 • Global Economic Outlook: Gaining Traction, Gaining Balance, April 16, 2015

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Economic Research: Why The Global Economy Is Set To Perform Better Than Its "Angst Meter" Implies • • • • •

A Parting Of The Ways In The Global Economy, Oct. 1, 2014 Global Economic Outlook: Unfinished Business, April 29, 2014 Taking Stock Five Years On From The Great Financial Crisis, Oct. 2, 2013 Global Economic Outlook: An Expansion With Complex Cross-Currents, May 15, 2013 Global Economic Outlook: Navigating Historic Times…With No Room For Error, Oct. 9, 2012

Notes (1) See George Soros, 2003: The Alchemy of Finance, Hoboken, NJ: John Wiley & Sons (paperback edition). (2) See my article "Some Thoughts On Monetary Policy And Central Banking," Sept. 18, 2015. (3) See the speech by Jeremy Stein, "Challenges for Monetary Policy Communication," May 4, 2014. (4) I am referring here of course to Mr. Kuroda's predecessor, Masaaki Shirakawa, who was governor of the Bank of Japan from to April 9, 2008, to March 19, 2013. (5) Here is a compelling statistic: start the clock ticking when the global financial system suffered its cardiac arrest in September 2008 and ask how long it took for each of the major central banks to embrace QE as a monetary policy operating regime. The answer (taking the start date as the announcement, not the beginning of asset purchases) for the Fed is three months and for the Bank of England is six months; for the BOJ it is 42 months and for the ECB it is 60 months. While there is by no means a strong or automatic link between QE and real growth, there is nonetheless a link; after all, that is why central banks use the policy. Note that (as of third-quarter 2015) the level of real GDP in the U.S. was 9.5% above its pre-crisis peak, and in the U.K. it was 4.1% above, while in the eurozone it was 0.6% below and in Japan it was just back to its pre-crisis peak level. (6) The new weights in the SDR basket will be (old weights in brackets): U.S. dollar 41.73% (41.9%); euro 30.93% (37.4%); Chinese renminbi 10.92%; Japanese yen 8.33% (9.4%); British pound sterling 8.09% (11.3%). (7) Real GDP growth for the fourth quarter in China was reported to be 6.8% year-on-year, making full-year growth 6.9%. Our forecast for 2016 implies a significant deceleration of growth (about half a percentage point) from here. (8) An exception is Japan, where a real growth target of 2% over the financial year 2011 to 2020 decade was written into the August 2012 legislation authorizing the raising of the consumption tax from 5% to 10% (in two stages) and which Prime Minister Shinzo Abe incorporated into his "Abenomics" policy agenda. (9) Governments will of course make assumptions about future growth rates for fiscal policy planning purposes, but these are usually projections, not targets. (10) The investment share of GDP (including both public and private investment) was 38.1% in 2007, but had increased to 44.1% by 2009. As of 2014, it was 44.0%, after peaking at 44.6% in 2013. (11) See Carmen M. Reinhart and Kenneth S. Rogoff, 2009: This Time Is Different: Eight Centuries of Financial Folly, Princeton: Princeton University Press.

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(12) There are said to be 336 "reform tasks" underway. (13) The Japanese Minister of Finance in June 1995 announced that all bank deposits, including those not guaranteed by the Deposit Insurance Corporation (amounting to about half of total bank deposits), would be fully guaranteed until a "five year financial stabilization plan" (kin'yu anteika gokanen keikaku) had been completed; this plan was legislated in 1996, with an initial plan to run until the end of March 2001. Subsequently, the blanket guarantee on time deposits was extended until the end of March 2002 and that on demand deposits until the end of March 2005. A bank recapitalization program using public funds was not implemented until 1998, and then only on a very small scale; a large-scale program was implemented in 1999. For more details, see Paul Sheard, 2007: "The Japanese economy: Where is it leading in the Asia Pacific? Anatomy of an abnormal economy and policy failure," in Mari Pangestu and Ligang Song (eds), Japan's Future in East Asia and the Pacific, Canberra: Asia Pacific Press, pp.1-30 (available on request from the author). (14) See Diane Coyle, 2014: GDP: A Brief But Affectionate History, Princeton and Oxford: Princeton University Press. (15) A 15% voting share gives a country a veto over IMF Executive Board decisions. Under the quota reforms, the U.S. quota goes from 17.661% to 17.398%, and the U.S. voting share goes from 16.718% to 16.471%. (16) According to its website, "The New Development Bank BRICS (NDB BRICS), formerly referred to as the BRICS Development Bank, is [a] multilateral development bank operated by the BRICS states (Brazil, Russia, India, China and South Africa) as an alternative to the existing US-dominated World Bank and International Monetary Fund. The Bank is set up to foster greater financial and development cooperation among the five emerging markets. Together, the four original BRIC countries comprise in 2014 more than 3 billion people or 41.4 percent of the world's population, cover more than a quarter of the world's land area over three continents, and account for more than 25 percent of global GDP. It will be headquartered in Shanghai, China. Unlike the World Bank, which assigns votes based on capital share, in the New Development Bank each participant country will be assigned one vote, and none of the countries will have veto power." (17) Headquartered in Beijing, the AIIB opened for business on Jan. 16, 2016. The inaugural meeting of the Board of Governors was held on Jan. 16-17. (18) Northwestern University economics professor Robert Gordon is well known for his somewhat pessimistic view on the outlook for future productivity growth in the U.S. and his view that the Internet and other 21st century technologies are not in the same productivity-game-changing league as earlier inventions, such as the steam engine, electricity, and the telephone. See his most recent book, The Rise and Fall of American Growth: The U.S. Standard of Living since the Civil War (Princeton: Princeton University Press, 2016).

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