Despite the recent market optimism, the global economy remains on edge. It is not that the risks in Europe, China and elsewhere have disappeared: Markets are rising on the hope that policymakers will miraculously resolve the formidable challenges. In this context, Singapore cannot remain complacent.

As a small, highly open economy, its vulnerability places an inordinate burden on policy to be proactive. As we approach two key policy milestones — the budget at end-February and the monetary policy statement in April — it is worth thinking through how investors and businesses might be affected by policy changes in Singapore.

Global economy: Headwinds dominate

Markets have rebounded because the US economy appears to be improving. Moreover, investors believe that a decelerating economy in China will persuade policymakers there to ease monetary policies and that European leaders will do just enough to prevent further bad news out of the eurozone. But a cold, hard look at the facts suggests that developments in Singapore’s environment are not likely to be all that positive:

•     The US economy remains at risk: It has certainly improved: The labour market has unambiguously strengthened while the housing market, where the crisis started, is finally finding a bottom. The question is whether this can be sustained, and the answer is no. The bottom line is really what the forward-looking indicators tell us. The ECRI (Economic Cycle Research Institute) lead indicator, which has an excellent track record of forecasting slowdowns in the US, is indicating a slowdown from current levels soon. And this is not surprising as the stimulus effect of previous budget measures are giving way to a contractionary fiscal stance and the uncertainty and gridlock in US politics is likely to make US businesses hesitant to hire or expand capacity. In addition, US growth in 1H2011 was flattered by two factors that cannot be sustained — a fall in the savings rate of households and businesses rushing to take advantage of tax incentives for capital spending, which have now expired.

•     Eurozone stresses continue to build: Yields on sovereign bonds of key eurozone countries such as Italy and Spain continue to rise while Greece is struggling to meet the conditions needed to secure donor funds — failure to do so will mean a default in March when a large debt repayment is due. Economic activity continues to lose momentum and popular anger against austerity measures is rising.

•     Japan’s recovery from triple disasters is losing momentum: Latest data shows business confidence ebbing, capital spending weakening and consumer spending faltering. While spending on post-earthquake reconstruction will keep Japan’s economy growing this year, it is also clear that the strong yen and weaker demand in Europe are hurting its recovery.

•     China’s economy decelerating rapidly: Import growth weakened sharply in December, suggesting domestic demand is at risk. Although the purchasing managers’ index shows the economy rebounding in December from weakness in October and November, weaker export demand, a fall in real-estate prices, failures of land auctions that deprive local governments of desperately needed revenues to repay debts and rising wage costs following sharp rises in minimum wages this month are all taking a toll. It is too complacent to say that policymakers will be able to prevent a further slowdown and the financial stresses that will inevitably follow. They have the resources to soften the blow of a slowdown but they cannot prevent this slowdown. For the next one to two quarters, we are likely to see weaker demand out of China.

So, external demand and global financial dynamics will probably hurt Singapore’s economy in the coming quarters. Unlike in 2008/09, Singapore will not face a short, sharp financial shock with the global downturn quickly reversed by massive policy response. This time, we will see a prolonged period of mediocre global demand interspersed with occasional financial stresses that fall just short of a full-blown crisis — and that is what policy should address.

Domestic economy: Some positives but not enough

But there are also domestic headwinds. Government measures to cool the property sector will certainly slow construction and real estate-related services. Tighter restrictions on foreign workers will also constrain businesses in the hospitality, construction and manufacturing sectors, in particular. At the same time, wage, rental and other business costs continue to rise.

Of course, there are also some domestic positives. Some large new manufacturing plants will start operations this year, adding to output growth. The Iskandar Region across the Straits of Johor is taking off with a flowering of opportunities for Singapore businesses as Singapore-Malaysia economic cooperation reaches the most amicable level in decades. Strong loan growth suggests that domestic banks are able to take market share in regional funding activities from the global banks that are under stress.

Still, it is quite clear that the headwinds will dominate over the tailwinds for Singapore. The contraction in economic activity in 4Q2011 shows this clearly. There is, therefore, a greater burden of responsibility on economic policy than usual.

What can we expect from policy?

The immediate issue is the forthcoming budget. Finance Minister Tharman Shanmugaratnam has cautioned that trying to offset every decline in demand would not be the most efficient way of using fiscal resources. It is certainly true that conventional demand management policies will probably not work in Singapore, where domestic demand is a small component of total demand and where both consumer and investment spending contain a large import element.

And, it is also true that fiscal policies should not impede necessary structural adjustments, such as raising productivity.
Nevertheless, there is still room for proactive measures that can be announced with the budget. The key to resilience in a crisis is to ensure that shocks are absorbed and not amplified. Fiscal policy should thus be geared to help the economy absorb likely shocks.

•     Financial measures: In a downturn, banks usually cut or slow credit extension to small and medium-size enterprises, which are considered more risky. Since they cannot tell the truly risky SMEs from the majority that can survive, all SMEs tend to suffer from credit tightening, hurting a sector that is the largest source of jobs. The government can step in with risk-sharing schemes where it assures financial institutions such as banks or factoring companies that the government will take, say, 50% of the risk of a bad loan to SMEs. Such measures will help keep credit flowing in an economy and so maintain demand.

•     Labour market: When businesses retrench workers in a downturn, domestic demand falls and hurts local businesses, forcing even more cuts. To prevent this sort of downward spiral, the government can offer incentives for employers to avoid retrenchment. The Jobs Credit Scheme (JCS) employed in 2009/10 is one example that could be used, although the JCS should probably be refined so that it does not impede restructuring where it is needed.

•     Confidence-building measures: Falls in business confidence can be self-fulfilling in a crisis. One way fiscal policy can mitigate this is through a strong signal that government will boost demand — even if the impact of such spending is weakened through import leakages, the boost to confidence makes the policy still worthwhile. Accelerating infrastructure spending that would have been undertaken anyway could be one way of doing this. A large tax rebate would also help the cash flow of businesses in a difficult year.

What about monetary and exchange-rate policies? Singapore’s monetary policy faces a number of challenges that make it difficult to ease aggressively. Inflation has remained relatively high in recent months, with 5.5% reported for November. Tighter restrictions on foreign workers are raising wage costs while cuts to vehicle quotas are raising transport costs. Input costs such as rentals continue to rise despite the slowdown, suggesting that our factor markets are not flexibly adjusting to economic changes as they should.

Moreover, recent surveys by Sim Kee Boon Institute put inflationary expectations at a very high level of around 5.2% for the long term. With such high expected inflation, It is no wonder that Singaporeans are desperately trying to find investments that protect their wealth better than the insultingly low deposit rates that banks offer them.

High expected inflation also spurs workers to demand high wage adjustments even as the economy slows.
This suggests that monetary policy needs to be communicated to consumers and businesses more actively.

There is no reason people should expect long-term inflation in Singapore to be as high as above 5%. Perhaps it is time for the Monetary Authority of Singapore to consider an explicit inflation target and educate people as to how inflation has been kept low for so long in Singapore.

Beyond communication, MAS probably also needs to ease policy — the coming slowdown will certainly reduce the currently high rate of inflation, and the risk that MAS has to focus on is that as the slowdown grinds down on Singapore businesses, there will be a deflationary adjustment as excessively high rentals and wages are pressured down.

Finally, the government should consider issuing inflation-indexed bonds as the US and several other developed economies do — this will give savers a safe inflation-protected instrument and avoid this unhealthy situation where many savers are forced to speculate in real estate and other assets in order to get a decent return on their savings.

In short, Singapore faces severe economic challenges in the next two years. Both fiscal and monetary policy should be eased proactively.

Manu Bhaskaran is a partner and head of economic research at Centennial Group Inc, an economics consultancy. This article appeared in the Forum page of The Edge Malaysia, Issue 893, Jan 16-23, 2012