World economic prospects improve, but risks persist
In our last newsletter in December, we described two scenarios for the world economy in 2013.
‘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.’
What has happened since then? Mostly positive things. America did indeed avoid the year-end fiscal cliff and lift the federal government debt ceiling. The Irish government gained relief on debt it had raised to fund its bank bailout. Signs came in that China is achieving a soft economic landing. More broadly, it became clear that growth in emerging economies was starting to turn up even as developed economies were still slowing. Finally, Japan announced additional monetary and fiscal stimulus. All of these developments followed the pledge of the European Central Bank in July to ‘do whatever it takes to preserve the euro'.
In their totality, they have boosted confidence and rallied risk markets. In particular, sovereign bond yields on the euro area periphery have fallen and funds have flowed back into peripheral banks (Chart 1). This is a big improvement from even last October, when the IMF remarked, ‘Tail risks, such as those relating to the viability of the euro area or major US fiscal policy mistakes, continue to preoccupy investors’.
But will the positive scenario continue to unfold? Not necessarily. At least three concerns linger.
- US fiscal event risk. Congress has only deferred important decisions on public spending, taxing and borrowing. They will surface again shortly. In March, a ‘sequester’ could lop US$110b a year, or 0.8% of GDP, from spending. Such a cut would come on top of tax increases equivalent to 1½% of GDP enacted in January. Then in April, a ‘continuing resolution’ to fund federal spending lapses. Finally, in May, the government is projected to again hit its debt ceiling, preventing it from borrowing any more. If Congress allows the sequester to bite and the continuing resolution to lapse, the resultant fiscal drag could send the American economy back into recession. And if it doesn't lift the debt ceiling, the US Treasury could be forced into a partial debt default. Needless to say, all of these mishaps would be unnecessary and self-inflicted.
- North Atlantic liquidity trap. The economies of the US, the euro area and the UK remain stuck in a 'liquidity trap' in which private demand is inadequate to absorb idle labour and capacity even at the near-zero interest rates engineered by ultra-loose monetary policy. In the December quarter, GDP shrank in the US, Germany, France, Italy, Spain, the euro area as a whole, and the UK.
- Peripheral euro area debt trap. Governments on the periphery are still struggling to restore debt sustainability and regain capital market access despite carrying out draconian budget cuts. The problem is interest rates on public debt remain well above nominal GDP growth, so even with primary (non-interest) fiscal surpluses, debt continues to rise as a percentage of GDP (Chart 2)
Emerging market buoyancy
Still, for all the problems in the North Atlantic, the world economy continues to record growth near its historical average (Chart 3). Such a set of circumstances was unheard of a decade ago. Yet with the weight of the more dynamic emerging economies in world GDP now so large, they can buoy global growth to a respectable level even with rich countries stuck in the doldrums. Emerging economies accounted for 80% of world growth in 2012 and are expected to contribute a similar amount in 2013.
Australian growth downshift
How is the Australian economy placed among these developments? Well, might be one answer. Asia now buys 75% of Australian goods exports, Asia ex-Japan 55%, and the latter number is growing. The export share of the US and the EU is correspondingly low at 4% and 7% respectively. So Australia is firmly tied to the faster bloc in the two-speed world economy.
Even so, growth could slip to ‘a little below trend over 2013’ (2½%), according to the Reserve Bank. The reason – the resource investment boom is peaking, and other industries may struggle to pick up the slack, for reasons that include the strong A$, fiscal consolidation and further commodity price correction.
Downside and upside risks
Confidence is growing about world economic prospects, partly because the worst didn't happen last year.
But some caution is warranted: the worst may not be over in the euro area or even in the US.
World GDP could expand more slowly than expected in 2013 if North Atlantic economies succumb to the still considerable risks they face.
Then again, it could perform better if emerging markets grow more quickly than expected.
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.