RaboResearch - Economic Research

Light in the middle of the tunnel

Economic Quarterly Report


The world has entered calmer waters since the beginning of this year. As such, some are already claiming that they are ‘seeing the light at the end of the tunnel’. We caution that there may still be some tunnel ahead.

The light and the tunnel

The eurozone crisis has exited its acute phase since mid-2012. The US fiscal cliff was partly avoided at the turn of the year. Japan’s growth is set to pick up in the near-term. China’s economy seems to have bottomed out. And the pace of activity in the emerging markets will rise this year.

Others, however, remain unconvinced and instead argue that the light at the end of the tunnel is in fact the light of an oncoming train. There may be some truth in this assertion. The eurozone economy remains in a fragile state and a number of triggers can still push it back to the depth of the crisis. The US’s fiscal soap opera may have a tragic ending if the debt ceiling is not raised in the Summer. Japan’s fiscal time-bomb has not been defused yet. China’s much-needed economic rebalancing is also being postponed. And many emerging countries continue to rely on an unsustainable export-growth model.

Below, we shall take a look at each positive development in turn and discuss the downside risks to our economic outlook.

Figure 1: Financial conditions loosening in EMU

Figure 1: Financial conditions loosening in EMU

Source: Reuters EcoWin, Rabobank

Super Mario saves the day …

Arguably, the most important reason for the recent market optimism in the eurozone is that Mario Draghi, the president of the European Central Bank (ECB), expressed in mid-2012 that he would do “whatever it takes” to preserve the euro. He later backed this claim by introducing the Outright Monetary Transactions (OMT) programme [1]. The clear willingness of the ECB to safeguard the monetary union together with its ability to do so (through liquidity provisions and OMT) made it clear to the financial markets that Mr. Draghi not only has a big bazooka but that he shall use it in desperate times. The eurozone financial conditions loosened strongly as a result of this bold move (figure 1). Of course, the periphery countries must also take credit for the enormous austerity/reform drive they have had so far. The commitment to stick to tough adjustment programmes amid severe economic headwinds made it clearer that the eurozone breakup scenario is not very likely.


[1] The OMT allows the central bank to purchase unlimited amount of government bonds (with maturities up to 3 years) if countries sign up to certain conditionalities. 

… but the eurozone economy is not out of the woods, yet

Although the euro breakup scenario is no longer imminent, we cannot claim that the eurozone is out of the woods. This is evident from figure 2, where we see that the VSTOXX index (stock market volat­ility), a commonly used barometer of market fear, has fallen considerably while economic policy uncertainty [2] remains at elevated levels. This is because a number of potential triggers can still reignite the euro crisis.

Figure 2: Uncertainty and stock market volatility

Figure 2: Uncertainty and stock market volatility

Source: Policyuncertainty.org, Reuters EcoWin, Rabobank

First, Italy’s inconclusive election has plunged the country back into a period of political uncertainty. By gaining the biggest share of the national vote, the centre-left gained control of the Lower House. But in it did not win enough seats in the Upper House to form an absolute majority. What happens next remains unclear. New elections may have to be called. In all, Italy looks set for a potentially long period of political instability, which may prompt government bond yields to climb higher, with likely contagion effects for the rest of the region (see our Special Report 13/05).

Second, the recent corruption allegations in Spain have put the Prime Minister, Mariano Rajoy, and his People’s Party (PP) under pressure. The worst-case scenario would be if the allegations prove accurate and the PP completely loses the confidence of the electorate and, therefore, be forced to call for new elections. Not only will this usher in a renewed period of uncertainty, but it may also bring a less reform-minded political party to power. Spooked investors may then rush for the exit far in advance and, in so doing, push Spain into the arms of the ‘troika’ (the ECB, the European Commission and the IMF).

Third, the way Cyprus’s bailout will be handled can still have important implications for markets’ risk appetite even though the country accounts for merely 0.2% of eurozone GDP. Should the troika fail to reach an agreement, then Cyprus can head for a banking crisis and a messy sovereign default. Investors may take this as a sign that Greece was not a ‘special case’ and that the European leaders will be less forthcoming in bailout agreements. As such, sovereign risk premia of the other periphery countries may be pushed upwards.

Fourth, the risk of rising social unrest and political instability should not be underestimated. We must realise that the rebalancing process of the Southern European countries has come at a great economic cost. Unemployment rates have risen to uncomfortably high levels amid a strong contraction in domestic demand. Since this is placing enormous strains on the social fabrics of these countries, the public might at some point refuse austerity/reform measures. Needless to say that talks of ‘euro breakup’ will then return in full swing.


[2] This is a weighted average of two indicators: the frequency with which terms like ‘economic policy’ and ‘uncertainty’ appear together in the media and the dispersion of forecasts of future government spending and inflation.

The fiscal cliff was (partly) avoided ...

A highly significant event that resulted in the ‘risk-on’ tone in the financial markets was the agreement between the Democrats and the Republicans to partly avoid the fiscal cliff, which could potentially have pushed the economy into a recession in 2013. On January 1, the US congress approved a bill to make the Bush tax cuts permanent for individuals with an income below USD 400K, and households below USD 450K. The expiry of the payroll tax break and the termination of the Bush tax cuts for higher incomes went into effect immediately (figure 3). 

Figure 3: The growth impact of fiscal cliff

Figure 3: The growth impact of fiscal cliff

Source: Congressional Budget Office

The postponed automatic spending cuts (USD 85bn in 2013) also took effect on March 1. The so-called sequestration calls for a cut to the level of funding of USD 109bn in each of the next nine fiscal years. The cuts are not that large in the context of the USD 3.5trn federal budget, but the Congressional Budget Office estimates that the sequester will shave around 0.6%-points off growth in 2013 and reduce employment by 750k. At this point, we expect the spending cuts to be modified later on to minimise the damage inflicted on the economy.

The political gridlock and contractionary fiscal policy will hold back the US recovery in 2013. But the good news is that the underlying pace of activity is picking up in speed. Once the fiscal uncertainties have cleared, there is a lot of pent-up investment demand waiting to be unleashed and that should also be accompanied by stronger employment growth. Consumers may also spend more given the bottoming out of the US housing market. The fact that private sector deleveraging in the US is at an advanced stage allows households to slightly loosen their purse strings as soon as they regain confidence. Meanwhile, the Fed will continue to support the recovery with extremely loose monetary policy.

… but the US fiscal soap opera is still carrying on

Mind you that our GDP growth forecast for this year (1¾%) rests on the assumption of the two parties finding common ground. In the coming weeks, the budget battles on Capitol Hill will flare up again. Without doubt, the most significant budget battle will commence once the debt ceiling is hit on May 19. The US Treasury is likely to announce ‘extraordinary measures’ to avert a default on the government’s obligations on that date. This could delay a default by around two months. Even though we believe the debt ceiling will eventually be raised given the enormous economic and political costs of sovereign default, the brinkmanship in Washington may weigh on private sector confidence and hold back the US recovery until mid-2013. 

There is a new Sensei in town …

Since Shinzo Abe took over as the new Prime Minister in late 2012, the near-term prospects of Japan have improved. This is based on Mr. Abe’s three-pronged approach to reflate the economy through fiscal, monetary and structu­ral measures, informally referred to as Abenomics. On the fiscal front, the government has swiftly put together a JPY 10trn stimulus package (around 2.2% of GDP) to buoy growth. On the monetary policy front, Mr. Abe has forced the Bank of Japan (BoJ) to raise its inflation target to 2% and increase the asset purchase programme by JPY 10trn in 2014. And the nomination of the highly dovish Haruhiko Kuroda as BoJ governor is probably meant to lead to more aggressive QE measures in the future. Recall, the BoJ already has one of the largest balance sheets, as a share of GDP, in the industrialised world (figure 4). Sadly, the administration has been very vague regarding the structural reforms they wish to take to increase the growth potential. 

Overall, the good news is that Abenomics aims to increase Japan’s growth in the near-term. This is further supported by the recent depreciation of the currency, which is raising the export sector’s competitiveness. The yen has fallen drama­tically since Mr. Abe declared war on the country’s deflation. Figure 5 shows that, compared to currencies of the G20 countries, the yen has experienced the strongest depreciation, on a trade-weighted basis, between January 2012 and January 2013. Indeed, this sudden weakening of the Japanese currency has sparked the global debate about ‘currency wars’. 

Figure 4: Unorthodox monetary policy measures
Figure 4: Unorthodox monetary policy measuresSource: Reuters EcoWin, IMF
Figure 5: Who is waging a ‘currency war’?
Figure 5: Who is waging a ‘currency war’?Source: BIS, Rabobank

… and his policies are raising fiscal risks

Against the backdrop of a sizeable gross debt stock, and an ongoing budget deficit that will likely exceed 10% of GDP once recent stimulus measures are accounted for, the government faces a clear risk that investors will lose their appetite to buy the added debt issuance. Needless to say the stimulus would be self-defeating if it results in higher yields for Japanese government bonds. Until now, the stable domestic domestic investor base has shielded the government from the whims of the market (figure 6). But this situation cannot last forever given Japan’s quickly ageing population. As more workers retire and liquidate their holdings of government bonds (e.g. through their pension funds), the share of non-resident holdings of public debt will need to increase if the total stock of debt is not reduced. This might push long-term interest rates higher if foreign investors expect the exchange rate to depreciate or that the government will eventually default explicitly or implicitly (i.e. raising the inflation rate). All in all, we do not expect Japan to face a fiscal crisis in the short-term, but the government cannot postpone the day of reckoning forever. Restoring order to the public finances is essential for the country’s financial stability and the broader global economy.

Figure 6: Japan is highly indebted to itself

Figure 6: Japan is highly indebted to itself

Source: IMF, Rabobank

Growth has stabilised in the Middle Kingdom …

The Chinese economy, that had shown declining annual growth figures for seven consecutive quarters, dug itself out of that hole to end the year on a higher note, posting 7.8% GDP growth for 2012 as a whole. Although this number might seem disappointing based on passed results, it is nonetheless impressive given the fact that the Chinese government did not do all it could, as it did in the depth of the Great Recession, to keep growth rates near the 10% level. The benefit is that inflationary pressures will be more limited while the adverse impact on banks is smaller as well. 

… but the game of shadows is still ongoing

Although the short-term growth outlook remains relatively strong, the medium-term risks in China are still non-negligible. Six years ago, Premier Wen Jiabao cautioned that the economy is "unstable, unbalanced, uncoordinated and unsustainable." Those four ‘uns’ comforted us that there is a broad recognition that the current credit-driven investment growth model is bound to drive the economy off the track (figure 7).

Figure 7: China's investment addiction

Figure 7: China’s investment addiction

Source: IMF

Much to our regret, the government has not taken enough measures to rebalance the economy towards more private consumption. As a result, the medium-term risks to China’s growth outlook have increased substantially. The banking sector is sitting on a large amount of still unrecognised bad debt stemming from the investment stimulus effort in 2008/09, as these investments were carried out by local governments, but financed by commercial bank debt. Although official figures state that non-performing loans are still at a low level, the real situation is direr, in our view. The amount of credit in China is likely to be much larger than official figures lead us to believe. Since the credit boom has become a vital source of GDP growth after 2008 crisis, any problems in the banking sector will have a strong and negative impact on the performance of China’s economy. Even if the government acts to support the financial sector, which is highly likely, China won’t be able to escape a sharp economic downturn in such a scenario.

Emerging economies’ are finding the path to higher growth…

Economic activity seems to have picked up in many emerging economies. Recent monetary policy loosening (figure 8) and a general increase in global trade should provide a boost to growth in 2013. Figure 9 shows that manufacturing PMIs in most major emerging countries are now above 50, indicating an expansion of output. Economic growth in 2013 is therefore expected to be slightly higher than in 2012. What’s more, statistically, domestic consumption is appearing as an increasing growth anchor in the emerging world, at a time where the positive growth impulse of exports is declining. This would imply that in spite of sluggish growth in the industrialised world, there are signs that the emerging economies are partly decoupling from their bigger brothers. If power were in the numbers, the emerging market consumer would definitely be capable of keeping the global economy afloat.

…but long-term challenges remain unaddressed

With the industrialised countries unable to find the throttle, and governments being less willing and able to go on another spending spree, private sector consumption in the emerging countries will now have to prove itself as a sustainable source of domestic growth. And this will be difficult. We can take Brazil as a successful example of a country in which domestic consumption has supported growth. Not only were the poverty alleviation programmes of the government hugely successful in generating new consumers, these efforts were backed by booming commodity prices, leading to windfall gains for the public sector. Also, Brazilian banks have been very willing to lend to consumers. While the latter is a typical Brazilian phenomenon, the former (windfall gains leading to increased consumer demand) is not.

The emerging markets have benefitted from high commodity prices due to rising demand in the western world in the 2000s. This is simply not a sustainable growth model, and a rebalancing act, towards a more consumption-driven model will have to take place. However, in the mean time there are far too many restrictions for consumers that will need to be addressed such as insufficient healthcare systems, a lack of social safety nets and financial illiteracy. And lest we forget, the emerging market consumer is vastly poorer than his western counterpart. As the world is anticipating a rise in the Asian consumer, the two most populous countries in the world have 13.3% (China, 2008) and 32.7% (India) of the population living on less than USD 1.25 per day. All these are structural impediments to consumers around the world to support the global economy. Currently, the emerging market consumer will still need demand from western economies to spur growth, and boost domestic consumption.

Figure 8: Central banks cutting rates in the EMs…
Figure 8: Central banks cutting rates in the EMs…Source: Reuters EcoWin
Figure 9: …leading to higher producer sentiment
Figure 9: …leading to higher producer sentimentSource: Reuters EcoWin

Concluding remarks

Given the mixed signals emanating from the global economy, it is difficult to identify the type of light we are seeing at the end of the tunnel. On a positive note, the eurozone crisis has not completely returned even after the disappointing election results in Italy. This gives us a feeling that, although the region is still in a fragile state, it has become more resilient to adverse shocks. The US’s recovery is also proving to be more shockproof than some pessimists feared. The country is expected to grow, albeit modestly, amid a sizable fiscal tightening. Japan has started experimenting with a more aggressive macro policy response. If the government finally manages to end the deflationary era, that would be great news for the world’s third largest economy. China’s growth is likely to pick up and this would be supportive of global demand. The commodity producing countries would be particularly benefiting. The rest of the emerging countries are also witnessing a rise in economic activity thanks, in part, to loosening monetary policies. For that matter, the non-industrialised countries should be able to put a floor under the global economy going forward given that they together account for roughly 40% of world GDP (figure 10).

Figure 10: Geographical breakdown of world GDP

Figure 10: Geographical breakdown of world GDP

Source: IMF

But we must be under no illusion that considerable challenges are ahead of us. The global recovery continues to be slow and policy complacency can make matters worse. European policymakers must make haste with the advancement of the European integration process. The US authorities must realise that reckless policymaking and playing a ‘game of chicken’ will have long-term repercussions for their country. Japan still very much needs a medium term fiscal consolidation plan. The emerging markets, especially China, must place economic rebalancing at the top of their policy agenda instead of resorting to measures (e.g. currency manipulation) that raises the risk of de-globalisation. If progress is made on all these fronts, cautious optimism may indeed be justified.

This is a translation of a part of the Dutch version of the Economic Quarterly.

Shahin Kamalodin
Rabobank KEO
+31 30 21 62666
Jeroen van IJzerloo
Rabobank KEO

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