Global Outlook: Ugly New Risks Emerge in the Aegean

Author: Uri Dadush
Originally published by the Carnegie Endowment for International Peace

The global recovery is strengthening, with GDP growth estimates being revised upward, emerging markets returning to long-term trend output levels, and world trade, industrial production, and services expanding. Though still relatively mild by historical recovery standards, growth in 2010 is likely to be modestly higher than consensus estimates, as pointed out in the January Bulletin. A rebalancing of demand in favor of emerging markets, especially China, and confirmation that policy makers are resisting an early exit from stimulus policies have buttressed prospects for the recovery to continue into next year. However, the Greek crisis and its possible spread to other uncompetitive and fiscally vulnerable Euro area countries that together account for 7.5 percent of world GDP has emerged as a significant risk.

Global recovery strengthening

Upward revisions of GDP growth estimates for the fourth quarter of 2009 in the United States and the UK are signs of strength in the global recovery. The Asian Development Bank is revising its 2010 economic growth forecast for developing Asia to around 7 percent, up from 6.6 percent last December.

Several emerging markets are returning to trend growth, including China, India, Indonesia, and Argentina.

World trade remains below its pre-crisis peak but is expanding very rapidly. World trade rose at a record monthly pace of 4.8 percent in December, following a 1.1 percent increase in November. Imports in emerging economies grew 7.8 percent (m/m) in December while import growth in advanced economies rose 2.7 percent that month.

The manufacturing sector has continued to expand as well. The United States, Japan, and Germany all exhibited strong industrial production (IP) growth in January. Surveys point to continued expansion: the Euro area’s manufacturing PMI rose to 54.2 in February, up from 52.4 in January (a reading above 50 represents expansion).

Importantly, growth also appears to be extending into services. The U.S. Institute for Supply Management (ISM) Non-Manufacturing Index rose from 50.5 in January to 53.0 in February. While the UK’s corresponding index grew at a faster pace, the Euro area’s expansion slowed.

Despite these improvements, however, private sector demand growth in the advanced countries remains fragile and overly dependent on government stimulus amid high unemployment, weak housing markets, and hesitant consumers.

Rebalancing is happening

Declining external deficits and surpluses represent another encouraging development that enhances the sustainability of the recovery. Total current account imbalances, the sum of current account balances across deficit and surplus countries in absolute value terms, narrowed to 3.6 percent of world GDP in 2009, down from 5.7 percent in 2008. Imbalances are expected to expand only marginally in 2010.

The U.S. current account deficit, the world’s largest, declined from 5.2 percent of GDP in 2007 to 3 percent in 2009. Given the relative strength of the recovery, however, the U.S. deficit is projected to widen to 3.4 percent in 2010. The euro’s weakness will also delay rebalancing in the United States by bolstering the dollar. The U.S. Dollar Index, which tracks the dollar against a trade-weighted basket of currencies, has risen by about 8 percent since November. On the other hand, China’s current account surplus declined from 9.6 percent of GDP in 2008 to about 6 percent in 2009 and, helped by strong domestic demand and import growth, is projected to fall further to 4.7 percent in 2010.

Emerging market growth sustained-so far

Capital flows to emerging markets have regained strength, with the IIF predicting that net private inflows will rise to over $700 billion in 2010, up two-thirds from 2009, but still down 45 percent from their peak in 2007. Returns in equity and bond markets there have also been spectacular, with the MSCI Emerging Markets Index doubling over the last year, though there has been little change since December 2009. Strong growth and balance sheet fundamentals appear to justify these advances.

At the same time, according to JP Morgan, the MSCI Emerging Market Index’s price-to-book-value ratio was 2.45 in February, above its average of 2.1 since 2000, and there are other indications that some markets may be overreaching. The Brazilian Bovespa and Mexican Bolsa, for example, are only 6.3 percent and 1.2 percent below 2008 and 2007 peaks, respectively. In China, property prices in 70 cities rose 10.5 percent (y/y) in February, the fastest pace in 23 months, while consumer prices rose a higher than expected 2.7 percent (y/y), the most in sixteen months.

Though it is too early to speak of a speculative bubble in emerging markets, prospects for very low interest rates in the advanced countries continuing well into 2011 and the wide growth gap favoring emerging markets suggest that the classic conditions for a bubble may be starting to build.

Greek crisis, a major source of risk

Greece is a small economy, but its problems—a massive secular loss of competitiveness and rapidly rising public debt—are shared to different degrees by at least four other Euro area members (Portugal, Ireland, Italy, and Spain), whose combined GDP is 30 percent larger than Germany’s. A sovereign debt crisis affecting all or a subset of these countries will slow European growth, depress the euro, and could eventually spill over into a global confidence crisis that would affect some vulnerable emerging markets (Turkey is one example) and other advanced countries. Japan, whose public debt/GDP burden—though held domestically—is on track to be almost twice that of Greece, could also come into the markets’ crosshairs.

Europe Under Stress

Greece is likely to be rescued by the IMF or its European partners, or at least supported in an orderly restructuring of its debt, but its competitiveness problem will persist for years to come. Even if its structural adjustment measures succeed, they will take years to complete and Greek growth will remain depressed. The same will apply—though to a lesser degree—in the other vulnerable European countries. These problems will severely test the political support for the European project in the vulnerable countries as well as in Germany and the other countries that will have to come to the rescue. One or more countries leaving the Euro area, though still a low probability scenario, can no longer be ruled out.

Exit strategies will remain cautious

Though countries are already paving the path to exit from stimulus, and some, like Australia, have taken steps along it, the larger advanced economies are maintaining expansionary monetary and fiscal policies and are likely to continue to do so at least into 2011, reflecting the weakness of private sector demand. Although the Fed may raise U.S. interest rates later this year from their record low levels, the still-low rate will continue to powerfully stimulate activity. Given the serious risk of prolonged stagnation in the European periphery, there are worthy arguments for Germany, and other countries that can afford it, to increase fiscal stimulus in the coming years, and for the European Central Bank to maintain its expansionary stance for the foreseeable future. Monetary policy will remain expansionary in Japan as well.

In emerging Asia, where the recovery began, policy makers have already begun to wind down stimulus efforts. Over the past two months, China has increased reserve requirements several times and repeatedly urged banks to curb lending. India has also outlined plans to unwind its $162 trillion fiscal stimulus package.

As economies continue to recover at different speeds and international interest rates remain low, the coming years will be marked by increased carry trades and exchange rate fluctuations, implying a heightened risk of bubbles and speculative attacks. Sovereign debt problems, which had disappeared from sight in the pre-crisis years, have again become a central source of risk—underscoring the need for policy makers to develop credible, long-term fiscal consolidation frameworks and to build the political consensus necessary to execute them once the global recovery is on firmer footing.