The Year That Was And The One Ahead
In this end-of-year newsletter, we look back at 2011 and forward to 2012.
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World Risk Developments - December 2011 (2Mb)
2011
The mounting eurozone crisis, the sovereign debt default by Greece, the debt ceiling drama in the United States, the Japanese earthquake and tsunami, the Arab uprisings – it has been an action-packed year.
All of these developments were, or continue to be, drags on the world economy, so it is unsurprising that both world economic growth and world trade have slowed this year. World GDP looks likely to expand by 4% or a touch under in 2011, down from 5% in 2010 (Chart 1).
Once again, world economic growth became more dependent upon emerging markets in general and China in particular. China will contribute more than a third to world growth this year. The advanced economies will contribute a fifth.
Despite their relative out-performance, emerging markets have also slowed through 2011, from tighter monetary policy to rein in inflation and slowing export demand.
World trade volumes have been broadly flat since March ― Asian exports have fallen (Chart 2).
The slowdown in world trade has flowed through to commodity prices. But prices remain well above recent cyclical troughs and historical averages (Chart 3).
In the world of credit ratings the gap between emerging markets and advanced economies narrowed. The US lost its AAA credit rating from Standard & Poor’s on concerns about mounting medium term fiscal problems. Sovereign credit ratings in the eurozone also came under the spotlight, even for countries with a record of fiscal prudence and triple A pedigrees such as Germany, Austria and Luxembourg. In contrast, several prominent emerging economies got upgrades – including Brazil, Indonesia, Sri Lanka, Colombia, Kazakhstan and Peru.
In Australia, resource exports were held back by the Queensland floods, but boosted by high prices, and consequently remained strong up to October (Chart 4). Manufactured and service exports, however, suffered from the strong Australian dollar and the slowdown in major trading partners. The level of exports for many manufactured and service exports remains below pre-global financial crisis levels.
Australian resource companies continued their push into frontier markets. In Mongolia and Guinea, Rio Tinto is developing copper, gold and iron ore deposits. Australian mining service companies are also expanding their Mongolian footprint ― Macmahon, a contract mining and civil works company, was awarded a contract to undertake large scale open cut mining operations at the Tavan Tolgoi coal mine. Australian suppliers and contractors are also in the running for contracts worth at least US$1.2 billion to develop an LNG project in Papua New Guinea, in which Santos and Oil Search are joint venture partners with ExxonMobil. In contrast, Australian construction companies continued to face subdued demand in Dubai, although prospects are still reasonably encouraging in Saudi Arabia, Qatar and Abu Dhabi.
There has been much media commentary on how the eurozone crisis threatens the Australian economy through confidence, trade, commodity price, and banking channels. Some effect is already being felt through European bank deleveraging. In an effort to manage liquidity and meet regulatory capital requirements, many European banks are shrinking their loan books – selling long term assets, while allowing short term trade credit lines to lapse (except those for core clients). This has meant that European banks have figured less prominently than before in both short-term trade finance and long-term project finance and syndicated lending deals. All else equal, this would have meant a credit squeeze on Australian exporters and investors and diminished capacity to fund the national savings-investment gap. But so far at least, less constrained Australian and Asian banks have been stepping into the breach.
2012
The most conspicuous international economic risk in 2012 will continue to be the eurozone. If worse comes to worst, there could be disorderly sovereign defaults that could trigger a banking crisis and lead to the exit of one or more countries from the eurozone. This would in turn knock confidence, credit availability and demand worldwide, and send the world back into recession.
So far, bond investors appear unconvinced by the agreement formalised at the December 9 EU summit ― yields fell in the lead up to the summit but Italian and Spanish yields have since widened, although they remain well below recent peaks (Chart 5).
The market’s tepid reaction partly reflects fears that the agreement could be difficult to implement and do little to narrow the eurozone’s underlying imbalances and restore healthy growth ― a process that needs to happen if the eurozone is to have an assured future. It is also unclear whether the agreement will catalyse more aggressive intervention by the European Central Bank. The outlook is instead for continued austerity and recession at the Periphery, and at best stagnation at the Core. In these circumstances, renewed financial crises could flare up, and the risk of eurozone exits won't disappear.
It is worse than that: the US, Japan and the UK also face weak economic outlooks. So all up, 50% of world GDP (at PPP exchange rates) may grow at no more than 1% in 2012.
A key issue will be whether Australia’s major trading partners in Asia will be able to withstand this North Atlantic-cum-Japanese torpor. We think they could struggle. While Non-Japan Asia is structurally decoupled from the North Atlantic – thanks to higher potential growth – it is still cyclically coupled through exports and financial flows. One factor that supported Asia’s rapid recovery from the global financial crisis was a surge in capital from the North Atlantic, some of which could now reverse.
Still, strong external buffers reduce the risk of financial crises. Asia’s exposure to a ‘sudden stop’ in capital flows is limited, because most countries have their external financing needs well-covered by current account surpluses and foreign exchange reserves. As in 2008-09, Emerging Europe seems the most exposed (Chart 6).
China will be critical to the level of Asia’s resilience. Will it be able to counter export and other external setbacks as it did so successfully in 2008-09? Or have growing domestic imbalances restricted its room to move ― and indeed left it prone to a home-grown downturn? China is heavily reliant on the availability of credit to fund investment for growth (Chart 7).
Most expect the People’s Bank again to loosen policy if things get really shaky. Indeed, in late November it took the first step down this path by cutting the bank reserve requirement ratio by 50bp in an effort to lift bank lending. Opening the credit taps may support growth in the near term, but it could also worsen China’s capacity glut and add to non-performing loans at banks. Because of these concerns, Beijing may instead focus on boosting consumption. If so, the impact on Chinese GDP will not be immediate, nor will it be as supportive to Australian commodity exports.
Another issue to watch will be the kaleidoscopic change set off by the Arab uprisings. There are three categories of countries to consider: those in political transition, those with social vulnerabilities, and those in civil war.
The first category of countries contains Tunisia, Egypt and Libya. In Tunisia, a new government dominated by the moderate Islamic party al-Nahda is proving to be economically pragmatic and liberal. In Egypt, the current parliamentary elections are likely to bring forth a coalition government that also includes Islamists, but what economic policies it will follow is unclear. In Libya, major investment decisions are on hold until elections take place.
The second category of countries contains Jordan, Morocco, Oman and Bahrain. Governments here are increasing social spending in an attempt to head off unrest and are receiving aid from Saudi Arabia, the UAE and Qatar.
In the third category, consisting of Syria and Yemen, political turmoil is severely damaging economies. In Syria there is also the threat of tighter international sanctions, while in Yemen a separatist uprising could emerge in the south.
Iran will remain a flashpoint. Tensions are rising in the wake of a resolution by the International Atomic Energy Agency expressing 'deep and increasing concern' over the country's nuclear program. In an attempt to ramp up the pressure on Iran, the United Kingdom has tightened financial sanctions and the European Union, which bought 450,000 barrels a day of Iranian crude last year ― about a fifth of its exports ― is discussing imposing an oil embargo. In addition, speculation about military options refuses to die down.
Conclusion
The eurozone looks as if, in the words of the Financial Times journalist Martin Wolf, it will do 'just enough, just in time' to avert a chain of disorderly sovereign debt defaults and eurozone exits – the sort of setback that could bring on another world financial crisis and recession. But it seems unlikely to do enough to promote growth-oriented adjustment. The outlook is instead one of prolonged stagnation-cum-recession – and possibly future sovereign debt restructurings and moves to exit the currency union.
The imponderable is whether Asia – or rather non-Japan Asia – can continue to grow regardless. Its growth is becoming more self-sustaining. But it is still reliant on the eurozone as a market for exports. And it has its own home-grown vulnerabilities.
Merry Christmas and Happy New Year.
Roger Donnelly, Chief Economist
rdonnelly@efic.gov.au
Dougal Crawford, Senior Economist
dcrawford@efic.gov.au
Ben Ford, Senior Economist
bford@efic.gov.au
The views expressed in World Risk Developments are EFIC's. They do not represent the views of the Australian Government.