Global Economic Outlook: sand in the engine of growth?
Economic Quarterly Report
In most of the industrialised economies, it looks as though the recovery will continue for this year and the next. However global economic growth is picking up very gradually, mainly because the key engines of global growth - the emerging markets - are facing a mild headwind. While only a limited number of emerging markets are directly vulnerable to tapering by the US Fed, credit growth may have been excessive in a broader group of emerging markets, which could pose a risk to future growth.
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Global growth picks up gradually
Both actual data on economic activity and sentiment indicators show that the global economic recovery is gradually gaining momentum. Figure 1 shows that global industrial production rose steadily in the latter months of last year. Industry had a relatively strong last quarter, not only in emerging Asia, but in the US and Japan as well. The eurozone has moreover finally emerged from recession, even though its growth figures are lagging those of the other large economies. Sentiment indicators up to the end of February also suggest that the global recovery has continued in early 2014. It is particularly notable that sentiment is improving mainly in the industrialised countries. Figure 2 for instance shows that sentiment among purchasing managers (as shown by the purchasing managers’ indices, or PMIs) was strong in February, and especially so in the industrialised countries, both within and outside the eurozone. Sentiment in the BRICS countries (Brazil, Russia, India, China and South Africa) is lagging, with the PMIs in these countries still around the neutral level of 50.
This picture chimes with our expectation for 2014 of an acceleration of growth in the US and the UK and a return to growth in the eurozone. In the US and the UK, the recovery is supported by rising house prices and a strengthening labour market. In the US, the political agreement on the debt ceiling will ease policy uncertainty, which is good news for the investment climate. The economic recovery in the eurozone is clearly lagging the US and the UK, mainly due to the continuing and slower process of public and private debt reduction. The downside effects of this on domestic demand will gradually ease in the coming years, which will allow the eurozone to return to moderate growth. Japan is an exception within the industrialised world. While the long-awaited structural reforms have still failed to materialise, a sharp increase in VAT will restrict Japanese growth this year.
We expect emerging markets to produce a varied performance in 2014. For most countries, we see only a very limited increase in growth compared to 2013. There are various reasons for this. Firstly, lower growth in China affects the neighbouring Asian countries and exporters of raw materials. Other countries are facing domestic structural challenges that are undermining growth (Russia, Brazil). It is currently difficult to estimate the extent to which the recent tensions between Russia and Ukraine could affect the regional and global economy. The potential impact of rising geopolitical tensions is serious, but this depends very much on how the conflict develops. The major potential for contagion of other regions is in the form of higher energy prices, trade restrictions and contagion on financial markets.
On balance, we expect global economic growth to rise to 3.75% in 2014 from just over 3% in 2013, with a similar growth figure in 2015. The rate of growth will be modest, certainly in comparison to the years preceding the financial crisis. It is notable that most of the expected acceleration of growth compared to last year is occurring in the industrialised countries. This does not change the fact that it is still the emerging markets that will deliver by far the greatest contribution to global economic growth. In 2014 they are expected to account collectively for nearly three-quarters of global growth (last year, this was four-fifths), with the emerging Asian economies taking a major role (figure 3).
Figure 3: Global economic growth
Source: IMF, Rabobank
Impact of tapering of monetary stimulus
The currencies of emerging markets came under pressure at the end of January when the US Federal Reserve (Fed) for the second time reduced its monthly purchases under the QE3 programme by USD 10 billion and disappointing industrial production figures were published in China (figure 4). Looking ahead, global liquidity will probably only be reduced gradually, since the tapering in the US is expected to be very gradual, while the end of monetary stimulus in Europe and Japan would still appear to be a long way off (see also Interest Rates & Currencies). In the base scenario of a World Bank study of the impact of normalisation of US monetary policy, total private capital flows into emerging markets and developing countries would fall by only 10% in 2016. However it is still very possible that the process of adjustment will be accompanied by serious shocks, certainly if the Fed decides to up the tempo. This was also shown in 2013 when yields on US bonds rose by 100 basis points over a couple of months.
Figure 4: Emerging market currencies
Source: Reuters Ecowin
In the past, a tightening of US monetary policy has often been followed by crises in emerging markets, for example the Latin American crisis in the 1980s or the Asian crisis in the 1990s. Since the Asian crisis, foreign currency reserves have become much larger, countries are lending more in their own currency and there is more exchange rate flexibility. Countries have thus become more resilient. There are however exceptions. For instance, Turkey’s foreign exchange reserves cover only a small proportion of its financing requirement, which makes the country vulnerable in case foreign financing dries up (see also the focus on Turkey in this EQR). There are also still some countries where the debt denominated in foreign currency is larger than the total foreign holdings, meaning that the external position would deteriorate in case of a depreciation. Hungary, Poland, Romania and Turkey are the main examples of countries that could be affected by this. We should point out though that the first three of these countries have so far been less affected by tapering, as their financial systems are more interlinked with the rest of the EU than with the US.
Excessive lending is the major risk in emerging markets
The immediate vulnerability to tapering in most countries would therefore appear to be not too serious in most emerging markets. There is however a risk in a wider group of countries that the combination of increasing integration of the capital markets and accommodative monetary policy in the West has contributed to excessive lending. Much private capital has flowed into the emerging markets in recent years. Total private capital inflow into emerging markets in 2011 was equivalent to 8.5% of GDP, which is a high percentage by historical standards. The huge monetary stimulus in the West has depressed interest rates in emerging markets. A recent study by the World Bank suggests that since 2004, official interest rates in emerging markets and developing countries have been much lower than one might have expected on the basis of the so-called Taylor rule. The Taylor rule is used to determine the desired level of the official interest rate on the basis of inflation and the output gap. First of all, these findings imply that monetary policy has been more accommodative than was probably desirable in many emerging markets over the last decade, but also that a tighter monetary policy in the West could lead to monetary tightening in emerging markets, which would negatively affect growth in these countries.
In this context, the rapid credit growth that has occurred in many emerging markets (figure 5) is a potential cause for concern, since past financial crises have often been preceded by strong credit growth and an inflow of foreign capital. Fortunately, there are factors which reduce the risk of unsustainable levels of debt. Most banking systems are relatively sound, as capital ratios are high and non-performing loans are low, and as a percentage of GDP the financial sector is mostly much smaller than in the West.
Figure 5: Credit growth in emerging markets
China is a country that deserves special mention. Although China is still more or less closed in financial terms and monetary easing in the West accordingly has had less of a direct effect, this country has featured the highest credit growth in recent years and total debt is now at a very high level in comparison to GDP. The growth of credit in China is largely politically driven, and the government has ample resources to take action if things go wrong. A rapid adjustment of the Chinese growth model could however significantly depress economic growth, something the government wishes to avoid (see also the section on China in this EQR). In view of China’s importance in today’s global economy, the combination of a difficult economic reform challenge and a debt mountain constitutes a significant potential risk.
Our forecast of a gradual recovery of the global economy is based mainly on an acceleration of growth in the industrialised countries in 2014. However the major risks to our base scenario lie in the emerging world. While only a limited number of emerging markets are very vulnerable to the tapering of monetary stimulus in the US, we see the rapid credit growth of recent years as a risk to future growth in a broader group of emerging markets, especially in China. Another downside risk lies in a potential escalation of tensions between Russia and Ukraine.
This is a translation of a part of the Dutch version of the Economic Quarterly.