New storm clouds gather
- Recovery remains on track, but fragile
- Business cycle in tricky transitional phase
- Slowdown in prospect
- Downside risks predominate
- Global imbalances to rise again
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Roger Donnelly, Chief Economist
rdonnelly@efic.gov.au
The views expressed in World Risk Developments are EFIC's. They do not represent the views of the Australian Government.
In this month's bulletin we do a ‘mid-year stocktake’ of the world economy. Our last, ‘end-of-year’ stocktake was in December 2009. Since then, the global recovery has continued, but new risks are emerging that could blunt future growth.
Recent developments. Until a month ago, both real economies and financial markets were continuing to recover in tandem.
Indeed, the news from the real economy – GDP data for the March quarter and partial data for the June quarter – suggests that global growth will proceed at around a 4% annual rate through the first half of 2010 (Chart 1 below). GDP has now climbed above its previous pre-crisis peak in emerging markets, and has almost reached that peak in the US; only in the eurozone does it languish (Chart 2).
A wide range of financial markets have also been rallying strongly , including sharemarkets, interbank lending, emerging market bonds and emerging market currencies.
However, for a month now many markets have been retracing somewhat on nervousness about the eurozone debt crisis. The correction has spanned sharemarkets and the eurozone bank funding market (Chart 3). It has also forced an appreciation of the US dollar and renminbi against the euro and Australian dollar (Chart 4).
Outlook. The correction raises the question: Can the recovery continue? Or will it falter, validating the market’s fear that the eurozone crisis will be a big global growth shock?
There are five reasons to believe that at least a moderate slowdown is in prospect, and that downside risks have risen.
- Business cycle dynamics. As we have discussed in previous bulletins, the recovery from last year's deep slump largely owes its impetus to two transient factors – stockbuilding and fiscal and monetary stimulus. And sure enough, their influence is now fading. Meanwhile, private consumption and investment demand in many advanced economies remain subdued as households and businesses attempt to repay excess debt and struggle with spare production capacity. The result is likely to be some slowdown in coming quarters.
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- China slowdown. Concurrently, Beijing is moving to wind back the stimulus it administered to the Chinese economy last year. In May, it ordered banks for the third time this year to set aside more reserves against loans and in April tightened regulations governing purchase of investment properties. As a result, growth of bank lending and of fixed asset investment have both come down, if only moderately so far (Chart 5). Most forecasters foresee a soft landing for the economy, with GDP growth decreasing from its current 12% pa pace to around 9-10% in coming quarters, as rising consumption spending and exports compensate for the slowdown in investment. But there is the risk of a sharper slowdown if this rebalancing doesn't proceed smoothly; or if the tightening of credit causes a sharp correction of property prices.
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- Eurozone crisis. While the preceding two factors could act as a drag on global growth, the eurozone crisis has potential to act as a brake. It is already causing funding problems for European banks with large holdings of troubled sovereign debt, which can hardly be good for the availability of bank credit. Even worse, it could force some of the directly affected economies into double-dip recessions, as their governments move to decisively tighten fiscal policy in order to reassure bond markets. If worse comes to worst, and bond market confidence isn’t restored, some governments may be forced to default on and restructure their debt, which would reverberate back to the banks holding that debt. Many are highly geared and the World Bank has warned that a default or restructuring among the 'EU-5' (Greece, Ireland, Italy, Portugal, Spain) could threaten the solvency of several banks outside the EU-5, ‘with potentially far-reaching consequences for the global financial system’.
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- Disinflation/deflation. One of the legacies of the 2008-09 recession is a lot of idle capacity and labour. This has created a situation of 'too much supply chasing too little demand', which has in turn caused core inflation in the US and eurozone to plummet below 1% (Chart 6). At such a low rate, both economies have become extremely vulnerable to outright deflation and the harmful process of debt deflation that follows, in which indebted households, firms and governments see their wages and prices fall, their nominal incomes and revenues shrink, their debt/income ratios rise, and their debts become unmanageable. This is a predicatment in which Japan has been stuck for years. The threat – and reality – of deflation is one reason why G3 central banks will remain ‘low for long’ with interest rates, and won't hesitate to flood economies with liquidity through quantitative easing if they encounter further shocks.
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- Global imbalances. All of these drags could be kept at bay if the surplus nations of the world – those with large financial and external current account surpluses, predominantly in Asia and OPEC, but also Germany – showed a greater preparedness to import more from the deficit countries – including the US, UK and EU-5 – and thereby allowed the latter to ‘grow out of’ their financial difficulties. Unfortunately most surplus economies want just as much as the deficit countries to follow such an export-led growth strategy. But since the surpluses of some must be matched by the deficits of others, some economy must be willing to run a deficit. As Professor Fred Bergsten has argued recently, this means that the eurozone can increase its surplus, and Asia and OPEC can maintain theirs, only if America allows its fiscal and external deficits to rise again.
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Unresolved tensions. In other words, the US must be prepared to go back to its pre-crisis role of ‘consumer and borrower of last resort’. Such an outcome would have the advantage of sustaining the global recovery in the short term. But there would be a price to pay: global imbalances would rise again, paving the way for future instability, either in the form of a protectionist US reaction against a rising tide of imports, or an eventual run on US assets and the dollar by investors concerned that ‘this can’t go on’.
As Bergsten notes, one way to secure more balanced and sustainable growth would be through some multilateral agreement resembling the Louvre and Plaza agreements of the 1980s. Such an agreement would involve four things: deficit nations pledging to cut their fiscal deficits and encourage private saving; surplus nations promising to encourage domestic demand; Beijing letting the renminbi appreciate; and countries intervening in currency markets to prevent further euro depreciation.
This will be something to watch – and hope – for at forthcoming G20 meetings.
