Oil fears supplant Eurozone worries
- Sentiment about the world economy continues to improve. Aggressive liquidity injections by the European Central Bank plus a Greek debt exchange have eased fears that the eurozone crisis will escalate. And better US data are stemming concerns that the American economy will succumb to a double-dip recession.
- Yet fears of an oil shock are growing. Crude oil prices have jumped 17% over the year-to-date. Markets aren’t worried just about the drag on growth from expensive oil, but also the prospect of military conflict with Iran.
- Oil isn’t the only threat. In our view, the eurozone crisis has entered a lull, not ended. Troubled Peripheral governments still face enormous financing needs and the danger of self-fulfilling solvency crises as they struggle to recover and outgrow their debts.
- America continues to face drags from fiscal retrenchment, combined with threats from the oil market and eurozone.
ECB to the rescue
The European Central Bank has now injected more than €1 trillion of 1% p.a., 3-year loans into the eurozone banking system – €530 billion last month to 800 banks, on top of €490 billion in December to 523 banks (Chart 1). The banks have reportedly been using some of these funds to buy high-yielding sovereign debt, which has in turn been pushing down yields, and easing anxiety about sovereign liquidity and solvency.
Greek debt exchange
As well as easing the funding difficulties of eurozone banks and Peripheral governments, the eurozone has also managed to head off a much-feared disorderly default on Greek sovereign debt by organising a so-called voluntary debt exchange. Investors holding 86% of Greece’s private debt have agreed to take part in the €206 billion debt restructuring. A further 10% were persuaded to take part through the use of collective action clauses. The exchange will involve at least a 75% net present value writedown for bondholders. It is the largest ever sovereign debt restructuring and the first default by an advanced economy since West Germany in 1948.
Pleasant American surprises
Data on the US economy have been delivering pleasant surprises for several months now. Labour hiring has been sufficient to reduce the unemployment rate from 9.1% in August 2011 to 8.3% in February 2012 – even after accounting for the ‘discouraged worker effect’ unemployment has come down noticeably (Chart 2). Household spending and business investment have also been buoyant. According to the Federal Reserve, ‘the economy has been expanding moderately’ and will probably show ‘moderate economic growth over coming quarters’.
Still, there are three downside risks to this improved outlook.
1. Oil shock fears
Oil prices have been rising sharply (Chart 3). There seem to be three main reasons why. The first is brisk demand – regardless of stagnancy in the North Atlantic economies, fuel-thirsty countries like China and India continue to expand their oil purchases rapidly. The second is sanctions against Iran – importers are reportedly switching to other suppliers ahead of the start of EU sanctions in July; surprisingly, other buyers are not rushing in; and the result is a loss of Iranian oil from the market. The third factor is a growing fear of military conflict with Iran.
Recent comments by Israeli Prime Minister Benjamin Netanyahu in Washington have encouraged speculation that Israel could launch a military strike in coming months against nuclear installations in Iran. ‘Israel has waited patiently for the international community to resolve this issue. We’ve waited for diplomacy to work. We’ve waited for sanctions to work ... None of us can afford to wait much longer.’
Saudi Arabia has indicated that it will use its spare capacity to offset production shortfalls elsewhere. Advanced economies, under coordination from the International Energy Agency, will no doubt release some of their strategic oil reserves as well in the event of conflict. Still, importers remain intent upon precautionary stockbuilding.
If conflict were to occur, oil prices could spike sharply higher and exert a powerful drag on economic growth, probably sending the world economy back into recession.
2. Renewed eurozone turbulence
Even if the oil price subsides, we expect the eurozone crisis to flare up again, because of a host of unresolved issues like large fiscal financing needs among troubled Peripheral countries and the danger of self-fulfilling solvency crises as they struggle to recover and outgrow their debts.
As we have seen before, these risks have the potential to curtail international credit availability and import demand, and thereby dampen world growth.
3. Another US slowdown
There is also a risk of renewed US slowdown if oil market or eurozone tail risks surface. Even if they don’t, fiscal retrenchment through spending cuts, and even more importantly tax hikes, could act as strong drags on growth in 2013.
The good news is two-fold. First, the world economy seems to be accelerating swiftly from its December quarter soft patch. Second, emerging markets continue to act as powerful global growth engine. The bad news? Even in the best case, growth is likely to be slower in 2012 than 2011. And downside risks predominate.
Roger Donnelly, Chief Economist
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