Retrospect and Prospect
In this, our last newsletter for the year, we look back at 2012 and forward to 2013.
Deleveraging continued to be a drag
Deleveraging continued to be a powerful drag on activity in the world economy in 2012 – five long years after the global financial crisis got underway in 2007.
As history shows, when leverage soars above long-run norms, as it did during the credit boom of 2000-07, economies become prone to sudden lending stops. And when those strike, financial crisis and deep slump follow. Over-leveraged households and firms are then faced with the need to deleverage. Even worse, crisis and slump can cause debts of governments to balloon, which prompts them to deleverage as well. Such all-round deleveraging caps spending and acts as a drag on recovery.
As a result, ‘recessions associated with crises ... are more severe in ... duration and amplitude than the usual business cycle ... for the post-World War II period ... Crises that are part of a global phenomenon may be worse still ...’ Thus spoke the economists Carmen Reinhart and Kenneth Rogoff in their seminal 2009 study of financial crises, This Time Is Different: Eight Centuries of Financial Folly.
Citibank economists add, ‘even with low central bank rates, countries with boom/bust credit cycles typically have deep recessions and sluggish recoveries, with GDP remaining 9-10% below the pre-crisis trend in the next 5-10 years’. (i).
The current global recovery certainly seems to be following this bleak script. The American and European economies again struggled in 2012 to restore the production they retrenched during the 2009 slump, and neither is yet back to a pre-crisis level of real per capita GDP (Chart 1). The EU hasn’t even managed to get back to its pre-crisis peak for overall GDP (Chart 2).
When will the deleveraging end – allowing the recovery to speed up? America has made more progress than Europe. Private debt as a percentage of GDP has declined considerably in America, yet hardly at all in the euro area (Chart 3). This is thanks to greater debt repayment and writeoff in America, and also faster growth.
Euro crisis failed to go acute
One risk we flagged at the start of the year failed to eventuate – disorderly sovereign defaults and exit from the monetary union on the euro-periphery.
Euro leaders did just enough, just in time to avert such a blow-up. First, the European Central Bank became more active as a lender of last resort to troubled banks (through so-called LTROs, or long-term refinancing operations) and to troubled governments (through so-called OMTs, or outright monetary transactions). Second, the governor of the European Central Bank vowed to do ‘whatever it takes to preserve the euro’. Third, Spain got a €100 billion bank bailout. And finally, Greece got further bailout loans and extension of its repayment terms.
Unfortunately, none of these initiatives, nor the fiscal austerity being implemented alongside them, has yet restored solvency (Charts 4 and 5).
Emerging economies' export engine sputtered
Advanced economies aren’t the only ones to have slowed over the past two years – emerging economies have too (Chart 6). The emerging economy slowdown has been export-led – it has become increasingly difficult to export to the troubled North Atlantic (Chart 7). The parallel slowdown of the Chinese economy hasn’t helped either now that China is such an important export market for so many other emerging economies. Because of the export slowdown, emerging economies have shifted over the past couple of years from overall trade surplus.
The Australian resource boom continued - despite reports of its death
In Australia, a prominent topic of debate was, Would the Chinese slowdown kill the resource boom? Many media commentators said ’Yes’.
We presented arguments that the boom remained intact despite the cancellation of some large projects such as the Olympic Dam mine expansion. After all, resource investment was still expanding; it would probably peak at around 8% of GDP next year, a scale nearly four times the historical average; no significant project with committed financiers and customers had been cancelled; and resource exports were ramping up strongly.
There is also indirect evidence of the scale of the boom in the lacklustre performance of the non-resource economy including its exports (Chart 8). Flat non-resource exports are exactly what one would expect in a fully employed economy such as Australia’s where an expanding resource sector has to compete away resources from other sectors.
If ‘what’s past is prologue’, then developments this year should provide some clue to what will happen in 2013.
America should continue to outgrow Europe
The greater deleveraging that has occurred in America provides some basis for believing that it will continue to outgrow Europe – supported by spending from its less financially constrained consumers and investors. We say ‘some’ basis because the evidence presented in Chart 3 is merely suggestive, not conclusive. There is no iron law saying how far the private debt/GDP ratio needs to fall before an economy gets back to normal spending.
But the fiscal cliff looms
More to the point, the American economy faces the fiscal cliff, and also a looming federal government debt ceiling – again. We are inclined to believe that, for all the bad temper in Washington, politicians will, as in Europe, do just enough, just in time to avoid the cliff and lift the ceiling. But even in the best case, there will probably be a fiscal drag on the economy of 1% of GDP in 2013. For an economy growing at just a little over 2% pa, this might actually constitute a ‘brake’ rather than a ‘drag’.
Hope for re balancing in emerging economies
The emerging economy slowdown is troubling because this economic bloc – especially China – has been the chief motor of world growth since the financial crisis erupted. Since 2008, China has accounted for close to half of world growth. Yet the emerging economies could have trouble reviving their exportled growth model given the difficulties in the North Atlantic. This means that to sustain growth they will have to encourage domestic demand instead.
We believe they will probably manage such a re balancing successfully. After all, they have massive infrastructure needs (even China), large domestic savings to finance those needs, increasingly sophisticated credit markets to channel funds from those with spare savings, and a rapidly growing middle class engaging in discretionary spending. Already, there are signs in many economies of healthy growth in consumer and investment spending.
Still, it is likely that the rebalancing could entail some slowdown. We argued earlier this year that supply-side constraints, particularly a growing scarcity of labour, would lower China’s potential growth rate.
The Euro crisis persists
Because the existing EU plan to provide liquidity support to governments and banks while they restore solvency is plainly failing, we see a significant risk of further sovereign debt restructuring on the euro-periphery.
Where? Greece has an obvious need for further restructuring. But Portugal, Ireland, Cyprus, Spain and Italy could follow suit.
Though the EU will no doubt take pains to hide net present value writedowns in any restructuring, writedowns there could well be.
If writedowns do eventuate, the ratings agencies will downgrade countries to ‘selective default’.
And the risk of euro area exit and disorderly default? Our base case assumes that the euro area holds together and that orderly debt restructurings, rather than disorderly defaults, take place. Still, Greece could well quit the euro area, and disorderly defaults can’t be ruled out either.
So in the positive scenario, America avoids the fiscal cliff, lifts the debt ceiling, and completes its deleveraging. The euro area agrees on a writedown of peripheral debt, setting the stage for renewed growth. And emerging economies manage a successful rebalancing towards greater reliance on domestic demand.
In the negative scenario, America’s fiscal risks materialise. Greece unilaterally defaults on its sovereign debt and ditches the euro. The Spanish and Italian governments lose access to the bond market and require bailout. And emerging economies fail to rebalance their economies and stagnate.
Roger Donnelly, Chief Economist
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