RaboResearch - Economic Research

Has the world turned upside down?

Economic Quarterly Report

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The emerging markets are facing some headwinds. Slower growth in China together with the ‘taper’ talk in the US is weighing on economic activity. Meanwhile, the advanced economies are finally experiencing some tailwinds, although the recovery is still fragile. Overall, global growth is likely to remain relatively weak because the current account surplus countries remain reluctant to stimulate domestic demand.

Growth slowdown in the emerging markets

In recent years, the emerging markets have been the growth engines of the world economy (figure 1). While the advanced economies faced a sluggish recovery following the global financial crisis, many emerging markets were booming. However, growth in the emerging world has been falling after it peaked in 2010 and it seems that the slowdown has intensified this year. Russia and Thailand were even in a recession in 13H1. Weak manufacturing PMIs in almost all emerging markets in July suggest that momentum remains weak.

The Chinese ‘tapering’…

The developments in the world’s second largest economy, China, are very impor­tant. There, growth also continued to ease and reached 7.5% y-o-y in 13Q2. This slowdown is in itself welcome. China’s high growth rate in recent years was unsustainable, as it was driven by rapid credit and investment growth. As a result, the credit-to-GDP ratio increased to very high levels, which elsewhere often preluded a financial crisis (figure 2). Furthermore, in a number of sectors there is overcapacity as a result of overinvestment. China’s new leadership want to make the growth model more sustainable and have been pusing ahead with reforms, although they are facing a delicate balancing act. The authorities have indicated that they will not allow growth to fall below an undisclosed floor. They already announced a mini-stimulus programme and the latest data suggest that the economy is once again gaining momentum. 

Figure 1: Global growth
Figure 1: Global growthSource: IMF
Figure 2: China’s worrying credit boom
Figure 2: China’s worrying credit boomSource: BIS, Laeven and Valencia (2012), Rabobank

As far as rebalancing goes, investment continues to be the main growth driver, and changing the model takes time, especially because China will employ a gradualist approach. Nonetheless, it looks likely the world should prepare for a ‘new normal’ where China will remain a growth engine for the world economy, but less so than in recent years. Commodity producers will be particularly affected by the gradual slowdown of China’s investment growth. 

…and the US tapering

Besides lower Chinese growth, a second development that is having wide repercussions for the emerging markets is the anticipation that the US Federal Reserve starts to dial down the rate of asset purchases. This resu­lted in a fall of stock prices and currencies and an increase of borrowing costs in the emerging markets (figure 3).

Figure 3: Emerging markets financial conditions

Figure 3: Emerging markets financial conditions
Source: Reuters EcoWin, IMF, Rabobank

Countries with large and/or widening current account (CA) deficits (i.e. those relying on foreign capital inflows) such as Brazil, India, Indonesia, South Africa and Turkey, have been particularly hit. If history is any guide, we must be wary of monetary tightening in the US, as it has preluded crises in emerging markets in the past, such as the 1980s Latin American debt crisis and the 1990s Asian crisis. The good news is that even though capital inflows are larger than in the past, the emerging markets are nowadays much more resilient thanks to large stocks of foreign exchange reserves (though Turkey is a bit of an outlier), floating currencies and larger amounts of borrowing in domestic currencies. Furthermore, tapering is intended to be triggered by a stronger US economy, which implies a strengthening of external demand. On balance, however, the tightening of financial conditions because of US tapering is likely to have a negative impact on growth in the emerging markets. First, tighter financial conditions are likely to have an impact on investment and consumption. Second, the countries most affected also tend to be the those with the highest inflation rates. These countries are likely to tighten monetary policy or have already done so (in the case of Brazil, India, Indonesia and Turkey), which will further depress domestic demand. Third, tighter financial conditions are likely to affect confidence, especially in countries that were already struggling with domestic problems (e.g. India). Besides the effects on growth, the currency depreciations in countries with large CA deficits may lead to a shift from a consumption-driven growth model towards an exports-driven one. Given that the CA deficit of Brazil, India, Indonesia, South Africa and Turkey was USD 241bn, on aggregate, in 2012, which is roughly half the US CA deficit (USD 475bn), the impact of a strong rebalancing of these economies on global demand will be non-negligible in the short-term. 

Advanced economies decouple

While the emerging markets are sailing through some choppy waters, the major advanced economies are finally experiencing much-needed tailwinds. The world’s largest economy grew by 2.5% q-o-q (annualised) in 13Q2 and GDP is now 5% above the level reached in 08Q1 (figure 4).

Figure 4: Economic conditions are improving

Figure 4: Economic conditions are improving
Source: Reuters EcoWin

America’s economic recovery is truly in a league of its own due to a more aggressive economic policy response, a quicker pace of private sector deleveraging and a genuine housing market recovery. Across the pond, we see the UK recovery gathering further traction too. The 0.7% quarterly rise of Q2 GDP was more than double Q1’s 0.3% increase and the leading indicators point to a further pick-up of activity going forward. Meanwhile, Japan’s economy has surprised on the upside since ‘Abenomcs’ was launched. The three-pronged approach (fiscal stimulus, quantitative easing and structural reforms) to end chronic deflation has unleashed animal spirits and resulted in the strongest growth in 13H1 (1.9%) in the industrialised world. For now, timely indicators point to a sustained pace of economic expansion. The eurozone economy is also slowly coming out of the doldrums. In Q2, growth turned positive (0.3% q-o-q) after six quarterly contractions amid the improve­ment in private sector sentiment and the strengthening of demand from major trading partners. Looking ahead, we expect growth to be sustained unless external demand weakens abruptly and/or financial conditions begin to tighten. 

It’s too soon for policymakers to let down their guard

Even though the recent pick-up in economic activity is welcome news, there is a risk that it creates complacency amongst policymakers. To be clear, we believe the recovery in the advanced economies is still fragile and, therefore, needs to be nurtured. In the US, the Republicans may take the economy hostage in Q4 (i.e. by refusing to raise the debt ceiling) in order to push through for more public sector retrenchment amid higher growth. The return of heated rhetoric in Washington and flirting with sovereign default can raise economic uncertainty among households and businesses and, therefore, weaken domestic demand. Meanwhile, in the UK, the government is likely to be even more reluctant to opt for a fiscal plan ‘B’ – a slower pace of consolidation – in light of better-than-expected economic data. Although the recovery has gathered momentum, we must remind ourselves that output in the UK is still 3.3% below the pre-crisis level and so needs to be stimulated further to close the output gap. In Japan, higher growth bears two risks. First, the government might start to water down the reform proposals. Second, politicians might hope to grow their way out of debt instead of introducing concrete consolidation plans to ensure fiscal sustainability. Another risk in Japan is if the yen depreciation predominantly creates ‘cost-push’ inflation that serves to weaken domestic demand. Stronger economic performance in the eurozone may also make politicians postpone reforms at the country/ eurozone level. This will make the region more vulnerable to adverse economic shocks. Against the stronger economic back­drop, there is a risk that the European Commission becomes more stringent on Member States to meet their austerity targets, which could derail the recovery.

The big picture

Even though we see some bright spots in the advanced economies, world GDP growth is still expected to stay weak this year (3¼%). The reason is that the global economic adjustment is not taking place in a desirable way. To ap­pre­ciate this, we can look at the relationship between private and public sector balance in a number (or groups) of advanced and emerging economies (figure 5). If an economy is in quadrant I, it has a surplus on both the public and private sector balances, and is thus by definition running a CA surplus. Quadrant III is the opposite situation. Economies in quadrants II and IV have a CA surplus if net lending in one sector offsets net borrowing in the other.

Figure 5: Wrong type of economic adjustment

Figure 5: Wrong type of economic adjustment 
Source: IMF, Rabobank

It is clear that most economies have moved towards the upper left corner during 2007-13, meaning that households and firms in most countries have saved more of their incomes compared to the pre-crisis situation; partially accommodated by a deterioration of public finances. Indeed, this adjustment has been unwelcome even though economies are now closer to the diagonal line. The more appro­priate global rebalancing would be if the CA surplus countries stimulated their domestic demand, which makes them less vulnerable to external shocks. This would allow the CA deficit economies to benefit from stronger external demand while repairing their balance sheets. Sadly, we do not see any sign that CA surplus countries are opting for domestic demand stimulation. The Chinese leadership remain reluctant to shift gears completely owing to fears of economic ‘hard-landing’. The other surplus countries, both in the emerging and the industrialised world (e.g. Germany), have not taken material steps to stimulate domestic demand either. As a result, global demand is staying unnecessarily weak for a prolonged period and this will make the rebalancing and deleveraging process more painful in the CA deficit countries. 

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

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