Increasingly the global economy finds itself at risk. Factors such as the threat of a US recession and wayward inflation has forced central bankers, both from the developed countries and the emerging markets to spend time in the “war room” in an effort to draw up strategies to tackle the potentially catastrophic outcome.

A recent survey by BNP Paribas concluded that the spill over effects of a US recession “will only partly develop via trade”. The survey said that, “rising funding costs and banks restricting funding is the real issue.” It also warned that those countries with currencies that required high funding and exposed to real estate were at risk the most. According to the survey, the current circumstances would lead to a slow down in the growth of currency reserves.
 
BNP Paribas’ conclusions are based on the conviction that once the spill over effects are out in the open, the US currency will rally, which in turn would force G10 central bankers to adjust monetary strategy.

The real cause of concern for policy-makers was the impact of all this on emerging market trends. It cited the fact that undervalued and fixed foreign exchanged rates, coupled with competitive production costs, had allowed Asia to grow rapidly.

BNP Paribas was of the view that a “glut of Asian savings, combined with greed” had led to the current financial sector crisis.

According to BNP Paribas current banking policies which allowed credit was a setting off a chain reaction where local credit increased money supply, causing an implosion of the bank’s balance sheet while at the same time reducing the assets’ value.

Consequently, the study suggested that a tightening of monetary policy was required along with countries facing deficits trying to maintain their currency levels. As for those countries in surplus, the fight against inflation has to be an ongoing one.

Meanwhile the International Monetary Fund was critical of the Gulf Co-operation Council member states’ handling of inflation weights, describing the measures taken as “outdated and inherently skewed”.

It said that, “Expatriates enjoy different benefits than locals but have different spending patterns and their housing cost tends to be underestimated by current measures.” Besides, in the region as a whole, services like education are very expensive in private schools, but free for public schools.

BNP Paribas was also quick to point out that fiscal surplus did not necessarily entail tighter policy.

It cited a number of studies which found that fiscal surplus had a positive relation with money growth through the increase in net foreign asset. Understanding expenditures according to the study is the key to comprehending the dynamics of fiscal policy. The study also added that “fiscal policy can help remove bottlenecks… if used appropriately”, for example, by increasing housing.

Of the regional countries, currently, the UAE (US$ 600 bn) has the largest net foreign assets, followed by Saudi Arabia (US$ 450bn), Kuwait (US$ 400bn), Qatar (US$70bn), Bahrain (US$ 20bn) and Oman (US$ 10bn).
 
BNP Paribas added that because regional currencies are pegged to the dollar, local monetary authorities have to follow US monetary policy and do whatever the US Federal Reserve Board does. The only exception to the case is Kuwait which severed its ties over record high inflation in the country.

According to BNP Paribas, the currency peg regime is effective in a stable synchronised economy “but in the case of large surplus economies, it contributes to create global liquidity through the surge in foreign currency reserves”.

But changes are on the cards, according to BNP Paribas, which noted that due to recent developments a divergence could be seen between the US and other pegged economies. This was testing the logic behind the peg, and forcing policy-makers to make hard choices.

BNP Paribas said there were basically three choices to choose from: Keep the ties and accept inflation, de-peg to restore control over monetary policy, or abandon capital account openness but then risk isolation. The study also forecast acceleration in the money supply which has been growing since 2004.

Other predications included the dollars continued bearish mood despite the softening of the huge current account deficit and the global de-leveraging which had suggested that the greenback’s weakness would be directed to where its is required to correct global imbalances.

The Euro, on the other hand, is forecast to be under pressure in the second half of this year and in 2009.

For Europe, the study indicated that “the global slowdown is now spreading in Europe as weak economic data suggest – the Spanish housing market slide, the German retail sales collapse, the drop in French consumer confidence – the European Central Bank was seen to relax its firm hold on interest rates. A change in ECB tone is expected in the fourth quarter as inflation peaks.

Based on the Eurozone inflation data, the study concluded that ECB’s task of “applying a one-size-fits-all monetary policy is becoming increasingly difficult and potentially negative for the euro over the medium term.”

Even the British economic outlook is not that promising primarily because of a negative turn to its house price data early this year. Under duress from consumers the Bank of England might succumb by cutting rates earlier than expected.

In summation, the report painted a continuation of the credit market tension as demand in emerging markets continues to accelerate.