What happened while you were on holidays?
In our last newsletter in December 2011, we described a grim outlook for the eurozone and the threat of knock-on effects to the rest of the world.
What has changed while you were on holidays? Quite a lot. In a word, the outlook has improved – the US economy has strengthened, major central banks have eased monetary policy, the eurozone crisis has subsided, and all three factors have rallied financial markets – the MSCI world share price index, for instance, has risen 18% since its trough in October 2011; commodity prices have also jumped (Chart 1). But we still see several risks, and even if none eventuate, the world economy is still likely to grow relatively slowly this year.
One item to galvanise markets has been a strengthening US labour market. The US economy has been adding 150,000– 200,000 jobs a month for three months now, which has pushed unemployment down toward 8% of the workforce (Chart 2). Moreover, a purchasing managers index suggests world growth has rebounded, after slowing sharply through 2011. This number prompted the chief economist for the index compiler, Markit, to hazard, ‘The global economy is faring much better than many had feared at the start of 2012’.
The rally has also been helped by the Federal Reserve’s promise of a near-zero interest rate policy till ‘late 2014’. Other major central banks have also eased monetary policy, including the European Central Bank, which lowered rates by 25 basis points in late 2011, and the Bank of England, which is pushing ahead with further quantitative easing. Central banks in emerging markets, including Indonesia, Brazil and Thailand, have also eased policy.
In the eurozone, there has been some progress towards a second Greek financial rescue package, involving further austerity from Greece, further bailout funds from the EU and IMF, and a further haircut for bondholders. If clinched, as seems likely, the package should head off a disorderly default.
Even more importantly, the European Central Bank (ECB), under its new leader ‘Super’ Mario Draghi, has expanded ‘LTROs’, or long-term refinancing operations – in effect lending unlimited sums of 3-year, 1% money to eurozone banks. This has been instrumental in driving down GIPSI sovereign bond yields – those for Greece, Ireland, Portugal, Spain and Italy – from the dangerous levels they had reached in December (Chart 3).
The growing confidence that the ECB is both willing and able to prevent contagion taking hold among the GIPSIs has encouraged the Bank of Canada Governor Mark Carney to pronounce, ‘There is
not going to be a Lehman-style event in Europe’. How justified is all this optimism? We still have six concerns.
First, the US, Japan, UK and eurozone are all travelling at ‘stall speed’. The IMF expects annual growth in the first three to stay below 2% over 2012-13; and the eurozone to slip back into recession (Chart 4). All these economies therefore remain prone to shocks, of which there are plenty still to worry about.
Second, monetary policy is still not gaining much traction. Central banks are pumping out ‘base money’, but banks are reluctant to lend and households and business to borrow (Chart 5).
Third, the eurozone crisis could still go acute. We think it more likely than not that a deal will be clinched between Athens, ‘the troika’ (of the EU, ECB and IMF) and bondholders that will avert a default on €14.4 billion in debt redemptions coming due on March 20. But many things could still go wrong. For one, the bailout funds come with strings attached in the form of austerity measures that Athens must carry out. If it fails – or baulks – the troika could withhold future instalments of those funds.
There is also the issue of ‘contagion’ because of inadequate ‘firewalls’. The bailout funds amassed by the EU fall well short of the financing needs of governments under suspicion by the markets. And the ECB remains unwilling to make up the shortfall by acting as a lender of last resort to these governments. So the markets rightly perceive a risk of default, and if they act on this perception by deserting bond auctions, perception will become reality. Judging by risk premiums, the markets think Portugal is the next Greece (Chart 3).
Finally, there is the question of longer run adjustment. As we have argued in previous bulletins, the eurozone’s rescue blueprint lays too much stress on avoiding inflation, not promoting financial stability; on adjustment, not financing; and on austerity at the Periphery, not reflation at the Core. As a result, it risks consigning the Periphery to a lost decade or more of stagnation, which in turn prompts its members to consider leaving the eurozone.
Fourth, emerging markets may struggle to decouple from a North Atlantic downturn as successfully as after the Lehman bankruptcy. They spent much of their monetary and fiscal ammunition combating that earlier downturn, and now have less scope to carry out further stimulus. Indeed, growth has already slowed noticeably in parts of Asia in 2011 (Chart 6).
Fifth, China could suffer a home-grown crisis as its own unbalanced growth model becomes unsustainable. The authorities are trying to bring about a soft landing in the overheated property market, tackle stubbornly high food prices, but also maintain growth in the face of softening overseas markets. We don’t see a hard landing as a major risk in 2012, but in any event, growth is likely to come off from its 2011 level.
Sixth, risk of conflict with Iran has increased. In an effort to spike Iran’s alleged nuclear weapons program, both the EU and the US have been tightening sanctions. The EU announced in January a ban on Iranian oil imports; the US has meanwhile been imposing sanctions on financial institutions dealing with Iran’s central bank – designed to hamper Iran’s oil sales. In response, Tehran has threatened to pre-emptively cut oil exports to Europe, to block the Straits of Hormuz through which 35% of the world’s oil supplies are transported, and to retaliate against Saudi Arabia if it increases oil production. To complicate matters, there is mounting speculation that Israel may attack Iran’s nuclear facilities. For all these reasons, we must ponder the risk of an oil price shock, or worse, military conflict. Probably neither Iran, nor its opponents, at this stage see their interests served by conflict. Still, the heightened tension has raised the risk of a misstep that could trigger conflict.
So for all the recent good news, 2012 still looks as if it will be a year of weak world growth. And we will need to remain alert to downside and tail risks.
Roger Donnelly, Chief Economist
The views expressed in World Risk Developments are Export Finance Australia’s. They do not represent the views of the Australian Government. The information in this report is published for general information only and does not comprise advice or a recommendation of any kind. While Export Finance Australia endeavours to ensure this information is accurate and current at the time of publication, Export Finance Australia makes no representation or warranty as to its reliability, accuracy or completeness. To the maximum extent permitted by law, Export Finance Australia will not be liable to you or any other person for any loss or damage suffered or incurred by any person arising from any act, or failure to act, on the basis of any information or opinions contained in this report.