RBC economist: Inequality drives the economy and politics

2016 has been a tumultuous year. Democracy itself has faced a crisis, and the political establishment has been shaken. Voters in the U.S. and the U.K. expressed their desire for change, regardless of the form this change is going to take and at times fueled by xenophobic sentiment.

Worldwide economic and political freedom has declined.

The Global Freedom Report, published by Freedom House, which promotes democracy and human rights, noted a 10th consecutive year of decline of political rights and personal liberties in countries around the world.

Last year, freedom diminished in 72 countries, the largest number during that period. Over the past 10 years, 105 countries have seen a net decline, and only 61 have experienced a net improvement, Freedom House noted.

The numbers indicate that democracy is under threat. The outcome of the British referendum to leave the European Union and the election of Donald Trump to become U.S. president are seen by some as symptomatic.

Inequality

Political commentators have ascribed the current sentiment to xenophobia, automation causing job losses and the middle classes in developed countries being left behind amid the rapid change of a more globalized world.

“But I think underlying all those things is inequality,” Royal Bank of Canada group economist Marla Dukharan said during a Global News Matters webinar on the economic outlook for the  Caribbean region in December.

“If you look at how inequality has been trending since the financial crisis, the richest 1 percent of the world has more wealth than the rest of the world combined,” she said, citing a report by aid agency Oxfam.

The same report notes that 62 individuals have the same wealth as the bottom half of the population.

“That extensive inequality is unprecedented,” said Dukharan. “This rise in inequality has been exacerbated by the policy response to the financial crisis.”

The policy response of monetary fiscal stimulus to generate economic activity was somewhat successful, but it has been far more effective at driving up asset prices. “So the 1 percent have seen their wealth increase significantly as a direct result of the policy response to the financial crisis.”

The resulting rise in inequality is more than a political problem. It is an economic one.

A 2015 study by the International Monetary Fund determined that increasing the share of income of the top 20 percent results in lower economic growth, whereas rising incomes for the lower and middle classes increases growth.

In other words, “when the rich get richer, benefits do not trickle down,” the report concluded.

“Causes and Consequences of Income Inequality” thus recommended country-specific policies with a focus on raising the income share of the poor and preventing the hollowing out of the middle classes.

The answer in advanced economies, the authors said, has to be to raise human capital and skills and to make tax systems more progressive.

Inequality in the Caribbean, measured by the Gini coefficient, is even higher than in the U.S.

“We need to fix that inequality problem in the Caribbean and on a global scale,” Dukharan said.

But she concedes that although global growth is at 3.1 percent, only slightly above the level of 3 percent which the IMF considers to be a recession, “nobody sees a need for a coordinated response.”

Globalization

Just like democracy, globalization has faced a backlash in the current political climate. Not only have trade flows dropped significantly, the flow of capital between countries has dried up.

Cross-border capital flows, measured as a percentage of gross domestic product, are at the lowest level since 1989. Current levels of 2.6 percent are down from 20.7 percent just before the financial crisis.

Dukharan says this suggests that the Caribbean will see similar patterns, for example in the form of lower foreign direct investment.

“That is a challenge in two terms: with infrastructure and to help us with our productive capacity. In the Caribbean we have a current account deficit in most countries, we import more than we export. And we finance the deficit through inflows on the capital account. That means we borrow U.S. dollars or we get FDI inflows,” she explained.

“If they are declining, we are challenged to balance our current accounts. We will face diminishing reserves, which we have seen in some countries.”

China, she added, will reduce its outflow of U.S. dollars to hold on to its reserves. The Chinese government recently issued a directive that state-owned enterprises will not be allowed to invest more than $1 billion on any single overseas transaction.

“That is going to have implications for the Caribbean. We have relied very heavily on Chinese capital inflows and direct investments,” the RBC economist said. “It has implications for refineries in Curacao and the Baha Mar project in the Bahamas as far as that they need more capital to finish that project.”

Commodity prices, currencies

Meanwhile, most Caribbean economies must likely deal with the challenge of rising oil prices. RBC Capital Markets is expecting West Texas Intermediate crude oil to average US$56.40/bbl in 2017, reaching the US$60/bbl range by late 2017.

This is not even a positive for oil producers like Trinidad and Tobago, which generates 75,000 barrels a day but imports 100,000 barrels a day.

“So higher oil prices can put a strain on the raw materials for running the refineries,” Dukharan said.

Guyana, Suriname, and Dominican Republic will also be impacted by an anticipated decline in the price of gold. And due to a strong correlation between the one-month gold and three-month natural gas prices, natural gas should soften as well, she added.

The strengthening U.S. dollar, on the other hand, can affect the exports and tourism competitiveness of Caribbean countries whose currencies are pegged to the U.S. dollar and have appreciated against major currencies like the Canadian dollar, the euro and the sterling.

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