In this issue ...

• Emerging economies recouple to advanced ones in synchronised downturn
• Emerging economies outslump OECD
• Japan's Q4 GDP drop sharpest in 35 years
• Eurozone / UK contract at same pace as US
• Western Europe's banking exposure to Eastern Europe becomes problematic ... for both sides
• Eastern European downturn could match Asia 1997-98
• Eastern Europe the next crisis epicentre?
• Are Greece and Ireland at risk of default?
• How low can oil prices go before oil exporters feel the pinch?
• Policymakers are pulling out all stops to revive economic growth
• Two long-term scenarios for the world economy 
  

Emerging economies recouple to advanced ones in synchronised downturn

The health of the world economy has continued to deteriorate since our last bulletin. Recent data point to sharp contractions in trade, industrial production and GDP in Q4 2008, even in East Asia, which was supposed to be able to defy the international downturn. A breakpoint in the world business cycle is discernible in September after the Lehman Brothers collapse. Pre-collapse, it made sense to speak of 'decoupling', with emerging economies outgrowing by a considerable margin advanced ones. But in Q4 2008, advanced and emerging economies alike seem to have contracted sharply. 'Recoupling' - and 'synchronicity' - have become the new watchwords.

Emerging economies outslump OECD

Surprisingly, leading emerging economies top the league table of GDP falls in Q4 2008, with Korea shrinking at an almost 21% annualised rate, Taiwan at 17% and Russia at 14%. No major region escaped; all experienced sharp downturns - Emerging Europe, Asia ex-Japan and Latin America. Chinese economic growth looked to be flat or slightly positive in Q4. But this is a sharp deceleration from the more than 5% annual growth pace achieved in Q3.

Japan's Q4 GDP drop sharpest in 35 years

Among advanced economies, the largest contractions in Q4 occurred in Singapore, which dropped at a 17% annualised pace, the biggest in its history, and Japan at a 13% rate. For Japan, this is the fastest pace since the recession of 1974, which was triggered by the first OPEC oil shock. The Japanese slump represents a big drag on world economic activity, because Japan, as the world's No 2 economy, constitutes 8% of world GDP.

Eurozone / UK contract at same pace as US

Japan and Singapore aren't the only advanced economies to turn in disappointing growth performances; the eurozone and the UK did likewise. In Q4 they both contracted at about a 6% annualised rate, similar to the contraction in the US at the epicentre of the global financial crisis.

Why? One contributing factor may be exposure of their banks to the rapidly slowing emerging economies. Calculations by investment bank Morgan Stanley suggest that European and British banks are about five times more exposed to emerging markets than US or Japanese banks. Eurozone and British bank exposures are about 24% of GDP - compared to 4% for the US and 5% for Japan.

Western European banks are particularly exposed to Eastern Europe, where many countries appear to be falling into crisis. Austrian banks are most exposed, with Eastern European exposure equivalent to 80% of Austrian GDP. Next comes Switzerland (50%) and Sweden (heavily exposed to the Baltic states; 25%). Non-performing loans in Eastern Europe are reportedly running at 8% of total loans, from 5% a year ago, and ratings agency Standard & Poor's has forecast that they will climb to 25% on average. Rival agency Moody's has warned that the Eastern European exposures of Western European banks put them at risk of rating downgrades.

Western Europe's banking exposure to Eastern Europe becomes problematic ... for both sides

The strong trade links and capital flows between West and East Europe are placing both at risk. The slump in the West is undermining Eastern European exports, while Western European banks' refusal to refinance foreign currency loans is triggering sharp currency depreciations. In the other direction, the exposure of Western European banks to the troubled East is intensifying the credit crunch in the West. Finally, there are concerns that some Western European banks will withdraw support from their Eastern European subsidiaries, further weakening Eastern European currencies and banking systems, thereby causing additional ricochet effects.

Eastern European downturn could match Asia 1997-98

The contractions underway in the weakest Eastern European economies are already beginning to rival those seen in Asia during the 1997-98 financial crisis. Investment bank JP Morgan estimates that growth in Eastern Europe (including Russia) did a turnaround from (an annualised) 4.9% in Q3 2008 to -8.3% in Q4. Danske Bank forecasts annual contractions in all Eastern European countries in 2009. Least affected, according to Danske, will be Poland, Czech Republic, Slovakia and Slovenia, which will contract by 2-5%. Worst affected: the Baltic states, Bulgaria, Romania, and the Ukraine, all facing double-digit declines.

Eastern Europe the next crisis epicentre?

Not only is Eastern Europe 2009 coming to resemble Asia 1997-98 in terms of production falls; the most vulnerable countries could also succumb to financial crisis in the way that Thailand, Korea, Indonesia and Malaysia did 12 years ago.

Already the IMF has provided rescue packages to Latvia, Hungary, Serbia and the Ukraine to try to head off outright crisis, while last week East European banks received a US$31 billion rescue package from the European Bank for Reconstruction and Development (EBRD), the European Investment Bank (EIB) and the World Bank. Unfortunately, the Ukrainian IMF package has hit snags, with Kiev struggling to meet the Fund's fiscal tightening conditions. Default worries are rising: the bond market is currently pricing into Ukrainian bonds a 35% country risk premium (Chart 1).

So far Turkish bonds and the lira haven't been as affected (Chart 1), but this could change rapidly, because Turkey has very large external financing needs, estimated by the World Bank in November to be US$130 billion in 2009, and is still umming and ahhing about going to the Fund.

South Africa isn't part of Emerging Europe, but has a large current account deficit in need of financing, so it too is prone to a sudden stop to capital inflow and a currency sell-off.

Are Greece and Ireland at risk of default?

Markets have also started to ask whether highly-indebted investment grade countries with large fiscal and current account deficits can meet their financing needs in the current difficult conditions. The answer will depend on the willingness of markets to continue funding. Iceland proves that mere investment grade status is no proof against default.

The countries most under the microscope are Greece and Ireland (and to a lesser extent Spain). Each has large macroeconomic imbalances (Chart 2), to which ratings agency Standard & Poor's has responded with downgrades and watchlisting, and the markets by pricing in a larger risk premium on government bonds.

• Standard & Poor's has put Ireland's AAA rating on negative watch, and has downgraded Greece to A- from A and Spain from AAA to AA+.
• Yields on Irish government bonds have increased to 240 basis points over German bunds. The spread on Greek government debt has risen to 300 basis points. Credit default swap spreads have shown a similar rise.

Simon Johnson, the former chief economist of the IMF, has weighed in with a comment that the time has come for G7 finance ministers to put Ireland's troubles 'at the top of the agenda'.

Still, speculation about Greece and Ireland going the way of Iceland is probably exaggerated. While their governments now have to pay much higher yield spreads on new bond issues, the absolute yield they have to pay has actually fallen, thanks to falling German bund yields. In addition, Ireland and Spain have only recently moved into fiscal deficit; during their recent booms they were running fiscal surpluses; so they are not carrying excessive foreign debt burdens. If worse came to worst, and a country was forced to the brink of default because of a bondholder revolt, the eurozone would probably bail it out. As German Finance Minister Peer Steinbruck noted recently in an interview, 'The euro region treaties don't foresee any help for insolvent countries, but in reality the other states would have to rescue those running into difficulty'.

How low can oil prices go before oil exporters feel the pinch?

The collapse in oil prices from the July 2008 peak of $147/b to $40/b now is proving to be a big setback for the export and budget revenues of oil-exporting countries. How tolerant of oil price falls are major oil exporters? Recent work by the IMF gives a clue. The IMF estimates 'break-even prices' for the export price of crude oil that would balance different countries' budgets for 2008 (Chart 3).

Most vulnerable are Iran, which needs US$90/b for fiscal balance, and Russia at US$75. Least vulnerable is the UAE at US$23/b. By implication, Iran and Russia are now under severe financial strain. Iran's President Ahmadinejad has come under heavy domestic criticism for his economic management, including for squandering windfall revenue when prices were high and allowing unemployment and inflation to rise. He was forced in December to backtrack from a statement that the economy could function with a US5/b price and recently presented a contractionary 2009 budget to parliament based on a $37.50 oil price. It remains to be seen whether he can push these changes through parliament.

In the UAE, Dubai in particular is suffering from the bursting of a property bubble that is hammering many of its highly indebted, state-controlled companies. The UAE central bank, backed by the oil-rich, less-indebted Abu Dhabi emirate, recently lent US$10 billion to Dubai to help its companies meet foreign debt repayments. The UAE's break-even price of $23/b suggests that it will be able to afford a bailout without undermining national fiscal solvency. 

Policymakers pull out all stops to revive economic growth

Official interest rates have been slashed to very low levels (Chart 4). The exceptions are Eastern Europe and Latin America where monetary policy has lagged, due to concerns over currency depreciations and external financing. There is also large fiscal spending in the pipeline. Discretionary fiscal policy will probably add about 2-3% to world GDP in both 2009 and 2010. On this front, the most significant recent news is the US fiscal package, which is expected to add over 2% to US GDP in 2009.

Governments have also taken unprecedented action to support their financial sectors. This has been in several forms, including increasing liquidity, taking equity stakes in financial institutions and providing government guarantees. While more needs to be done, the functioning of financial markets appears to have improved. Cuts in official interest rates are beginning to flow through to mortgage and corporate rates. Sovereign bond spreads for most emerging economies have also narrowed, which has encouraged the Philippines, Turkey, Brazil, Colombia and Indonesia to issue bonds to help finance their budgets. There has also been a recovery in bank bond issuance.

Two long-term scenarios for the world economy

Two views of the longer-term growth path of the world economy are starting to emerge among economic forecasters.

The more conventional one acknowledges that because of over-borrowing and irrational exuberance (encouraged by a glut of savings and petrodollars in East Asia and the Gulf plus inadequate regulation) the previous worldwide boom has culminated in a crash. But it notes that just as all booms end, so too do the subsequent crashes and slumps. Market forces in the form of inventory and asset price adjustment will do a lot to revive economic activity. And government intervention can help Adam Smith's Invisible Hand. Government liquidity and capital injections into banks plus purchases of 'toxic' assets will make banks willing and able to lend again. Interest rate cuts will make companies and households willing and able to borrow again. And fiscal stimulus will fill the hole left by private spending cuts, ensuring that production soon recovers to its potential. On this view, the world economy should be climbing back to its trend growth path by at latest end-2010.

The less conventional - and more pessimistic - view, espoused by the likes of the Financial Times journalist Martin Wolf and the economist Wynne Godley of the Levy Institute, is that the spending cuts and debt repayment needed to restore solvency to many private sector balance sheets are so large and will be so drawn-out that no amount of government intervention can feasibly compensate for the resultant demand shortfall. For instance, Godley calculates that for private debt in the US to fall back to 130% of GDP by 2013 - its pre-2000 level - the private sector would have to swing round from running an annual financial deficit of 4% of GDP, as it did pre-crisis, to a surplus of 8% of GDP. He argues that it is difficult to conceive any fiscal or net export expansion that would compensate for this demand decline - even in a world of coordinated policy intervention. Therefore, the US economy, and by extension the world economy, is in for a prolonged bout of stagnation.

As the extent of the financial imbalances that accumulated during the boom years become more and more apparent - not just sub-prime American mortgages as many initially thought - it seems appropriate to prepare for the second scenario - even while hoping for the first! 
 

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