In this issue ...

• The year that was and the one ahead

The year that was and the one ahead

In this last bulletin for the year we review developments in 2008 and prospects for 2009.  

2008 …

Unpleasant surprises. Like many others we misjudged the severity of the global credit crunch and economic slowdown. When we did our end-of-year stocktake a year ago we wrote of a credit squeeze , not crunch - and of a moderate global slowdown cushioned by emerging market resilience.

We did flag the downside risk of the squeeze morphing into a crunch and acting as a brake, rather than drag, on the real economy. But we didn't give it great credence.

Since then, of course, we've witnessed astonishing events.

Without doubt, the pivotal month was September, when investment bank Lehman Bros collapsed. Since then the crisis of confidence and international outlook has deteriorated dramatically.

Resilient v vulnerable economies. Did we get anything right last year? Yes, two things.

• We talked about East Asian resilience and we stand by that call. East Asia is being hit by trade shocks that are dragging down growth rates. But thanks to buffers like current account surpluses, large foreign exchange reserves, comfortable fiscal positions and well-capitalised banks, economies have proven largely immune to financial contagion.
• The other thing we got right was the list of countries now succumbing to trouble, or on the edge of trouble. Countries like the Baltic states, Turkey, Sri Lanka, Hungary and Ukraine. It's always easier to say who will be hit hardest in a storm than to predict the timing and severity of the storm.

2009 ...

Synchronised downturn. The world economy is now in a sharp synchronised downturn that looks as if it will be one of the most severe in the post-war period.

There is a significant risk that world trade could fall below GDP growth - a far cry from the typical post-war situation where trade growth has outstripped GDP growth. The IMF is forecasting a contraction in annual GDP of advanced economies - the first since the Second World War.

Capex crunch. The investment cycle has done a dramatic turnaround in the past three months, especially in resources, construction and infrastructure - sectors where Australian companies are particularly competitive internationally.

Inflation or deflation? Beyond these comparative certainties, however, the range of possible outcomes seems wide-open. We really do seem to be on a knife-edge between various dramatically different possibilities.

The 2008 Nobel economic laureate Paul Krugman said the other day

The scenario I fear is that we'll see the whole world in the equivalent of Japan's lost decade in the 1990s, that we'll see a world of zero interest rates and inflation and no sign of recovery, and it will just go on for a very extended period. (i)

The eventual outcome will depend largely on whether governments' financial rescue plans and expansionary policies gain traction. This will happen only if they revive the willingness of the private sector to lend and borrow.

Interventionism. The financial crisis has brought with it a strong swing round to government interventionism.

This is justified. The world needs macroeconomic stimulus at the moment because of the crisis of confidence in the private sector. Otherwise production could collapse, leading to further rounds of bankruptcies, defaults and forced asset sales. 'We are all Keynesians now', as Richard Nixon put it.

The idea that the previous boom and bubble were all the fault of central banks providing too easy money for too long, and market forces will now sort out the mess, looks misguided. It overlooks the large savings surpluses that Gulf economies and East Asian economies led by China have built up over the past decade - surpluses that could be earned only because the rest of the world was willing to accept corresponding deficits. These imbalances have proved unsustainable and are now being unwound. The unwinding and rebalancing will proceed more smoothly if governments in all economies, but especially surplus ones, support domestic demand, and surplus economies allow their currencies to appreciate.

Anti-business policies. As welcome as macroeconomic stimulus may be, there is a raft of other anti-business (and anti-market) policies that governments may now dust off to shield themselves from contagion and recession that are more worrying. These include

• competitive currency depreciations
• raising of tariff and quota barriers on imports
• capital controls to stem capital flight
• expropriation of central bank reserves by national treasuries for public spending
• expropriation of other private sector assets, eg. Argentina's nationalisation of pension funds
• price controls.

A descent into wholesale protectionism is unlikely. The G20, for instance, have recently said they want to press on to a conclusion of the Doha Round. But concern is being expressed that some emerging economies will resort to piecemeal and hidden export subsidies and competitive currency depreciations.

Declining resource nationalism. On a more positive note, resource nationalism is in decline. During the commodity boom, governments in several countries like Zambia, Guinea and the Democratic Republic of Congo (all countries that matter to Australian companies) tried to gain a greater share of resource revenues by renegotiating tax and royalty rates and equity shares. But now with commodity prices and associated windfall revenues both down, that risk is ebbing. Governments will be content just to retain investment.

Some charts ...

Squeeze becomes crunch. After bubbling away all year, the financial turmoil took a turn for the worse in September and October as a sequence of financial insolvencies threatened the entire international financial system. During this period, capital markets largely froze, the cost of credit skyrocketed, and yields on US Treasuries dropped close to zero.

Plunging sharemarkets. The decline in stockmarkets since late 2007 rapidly turned into a rout in the second half of 2008. Markets in the United States and Western Europe are now back around 1997 levels, while in Japan, shares are hovering around early 1980s levels. Emerging stockmarkets have also plummeted, as capital inflows have reversed. The MSCI Emerging Market Index has dropped by almost 50% since the start of the year.

Commodity prices stronger no longer? The demand for commodities has dried up, causing prices to nosedive. After reaching almost US$150 a barrel in mid-2008, oil is currently trading around US$45. Spot prices of coal, iron ore and base metals have fallen by at least 40% since mid-year and in some cases are below the marginal cost of extraction. Meanwhile, the Baltic Dry Index, which measures the cost of moving major raw materials by sea, has dropped 90% to near-record lows. In response to the commodity price slump, producers are cutting production and putting new developments on hold. Have prices slumped excessively? Perhaps. There is some anecdotal evidence to suggest that Chinese enterprises in particular are running down commodity stockpiles, but when the destocking is complete will have to resume commodity purchases. In addition, since mining projects have long start-up times, supply constraints may resurface when economic activity recovers.

More crises? Emerging markets running large current account deficits (> 5% of GDP) and therefore dependent upon the kindness of strangers in world capital markets for external financing are in an uncomfortable position right now. Some of these countries have already succumbed to crisis. Others remain vulnerable.

Season's Greetings.

(i) 'Nobel prize winner Krugman warns global economy to be depressed until 2011', news.xinhuanet.com, 9 December 2008

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