World Risk Developments December 2015

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In our final edition for the year, we look back at 2015 and forward to 2016

A year ago, we made four sanguine predictions for 2015. That the world economy would accelerate but at a rate insufficient to counter chronic demand dExport Finance Australiaiency, emerging markets would withstand periodic selloffs, commodity prices would trough and the AUD depreciate. In the event, improved economic fundamentals did allow emerging markets to withstand greater volatility, and AUD depreciation offered continued relief to exporters. But world economic growth failed to accelerate and commodity prices failed to bottom. To this extent, 2015 was a disappointing year.

View a summary of this month's edition.

World economic acceleration — albeit with continued chronic demand dExport Finance Australiaiency

We expected that better growth in both advanced and emerging markets would expand the world economy by 3½% this year. But the latest set of IMF numbers suggests that world economic growth will come in lower, at 3.1%. Advanced economies continued their muted recovery — driven by the US, eurozone and Japan. But activity in emerging and developing economies is set to slow for the fifth consecutive year. This largely reflects slowdowns in China and commodity-exporting countries, and severe recessions in Russia and Brazil. World economic underperformance made our forecast for continued chronic demand dExport Finance Australiaiency even worse. Despite the Fed’s imminent expected rate hike, inflation and interest rates remained low over the year.

Emerging markets withstand periodic selloffs

As we predicted, better economic fundamentals — including lower debt and current account dExport Finance Australiaits, large international reserves and flexible exchange rates — enabled most emerging economies to cope with market volatility and avoid systemic crises. But some vulnerable economies did experience selloffs. For instance, Brazil’s investment grade was downgraded, South Africa’s languishing economy fuelled nationalism and violence, Russia fell into severe recession due to low oil prices and sanctions, and Turkey’s political vicissitudes caused investor alarm. Bright spots were India’s continued economic resilience, Myanmar’s first steps into democracy, and Cuba and Iran’s thawing relations with the West.     

Commodity prices bottom

We expected commodity prices to trough as demand slowly picked up and supply adjusted to lower prices. This was not to be. Instead the RBA’s Commodity Price Index has fallen 27% over 2015 to date (Chart 2) — driven by lacklustre Chinese demand and rapidly expanding supply. For Australia, robust resource export volumes were inadequate to offset soft prices, so resource exports fell 14% over 2015. They nonetheless remain triple their pre-boom (2000-02) average.

AUD depreciation

We suggested the overvalued AUD had further to fall. And indeed it did. The AUD fell 18% against the greenback and 11% against major trading partner currencies over 2015 (Chart 2).  Increased competitiveness will boost exports and non-mining business investment.

We also flagged several possible ’tail risks’ which thankfully did not eventuate — including another euro area debt crisis (although Greece provided prolonged excitement) and a China hard landing. At the other end of the probability spectrum, we said that the global economy could receive a boost from lower oil prices, and a strong US recovery. We were partly right. Low oil prices were a boost, if not for many oil producers. And the US economy did accelerate, but from rising consumer spending, not business investment as we surmised.

Another subpar year ahead

We expect global growth to grind higher in 2016 supported by ongoing improvements in the US and a mild improvement in emerging economies. Global trade flows will mirror the sluggish growth outlook and will remain well below the 7% p.a. experienced in the decades before the global financial crisis. Growth in Australia’s trading partners is forecast to strengthen, with the exception of China, which will continue to record slower growth as authorities rebalance the economy away from exports and investment, towards services and consumption. 

Global commodity prices will remain at record low levels as markets continue to digest the supply glut and underperforming global economy. We expect the Fed will lift rates later this week for the first time in nine years; markets have priced in 50 basis points of rate hikes in 2016. Most other major central banks are likely to remain on the sidelines or ease monetary policy further through 2016. Higher US rates and ongoing weakness in iron ore, coal and LNG prices will keep the AUD below US$0.80, with markets expecting US$0.72 through 2016.

What does this mean for Australian exporters?

Softening Chinese demand for hard commodities and the stubborn weakness of prices will remain a drag on the value of Australia’s mining exports. But the lower AUD and rising export volumes will offer some relief. The lower Aussie will also support the competiveness of non-resource exports, which has grown close to 10% p.a. through 2015. The raft of free trade agreements will improve market access for Australian exporters, particularly agriculture producers.

There are however upside and downside risks to our central view for 2016. The table below summarises alternative paths the global economy could take in the year ahead and what this means for Australian exporters.

Key scenarios in 2016

Risks

Chinese hard landing

Global growth improves, AUD trends lower

Increasing uncertainty and divergence of monetary policy

Scenario  

The rebalancing of the economy causes a sharper than expected fall in investment. This creates a banking crisis and drags on heavy industry which employs a third of the population. Both harm the broader economy, causing growth to fall below 4% in 2016.

The US economy outperforms through 2016 prompting the Fed to lift rates more than the 50 basis points currently expected. Structural reforms in Japan and Europe gather momentum reducing the need for additional monetary stimuli. Higher US interest rates cause the AUD to fall below US$0.65. Furthermore  commodity prices stay at 2015 levels as the supply glut more than offsets the pickup in demand.

Central banks fail to effectively communicate the path for monetary policy, which is becoming increasingly divergent; the US and UK raise interest rates sharply, while Europe and Japan step up their use of unconventional monetary easing to stimulate growth in their economies. The lack of effective communication to the market raises volatility in global financial markets and undermines financial stability.

Impact on global financial markets

A Chinese hard landing weighs on the global growth outlook, clouds US monetary policy and creates volatility in global financial markets. There are similarities to earlier this year when the US delayed lifting rates following signs of softer Chinese growth, which led to uncertainty over the path of US monetary policy.

An outperforming US economy is accompanied by higher US interest rates. Markets look favourably upon structural reforms in Europe and Japan.  Overall financial market volatility is kept to a minimum and capital flight from emerging economies is limited as investors remain sanguine on EM long term growth prospects.  

Heightened volatility in global financial markets causes investors to reposition their portfolios to safer assets in the US and UK. Higher US interest rates reduce liquidity in financial markets. The USD and pound strengthen, while the yen and euro weaken. These factors lift capital outflows from emerging markets and raise borrowing costs for EM governments and companies.

Impact on global economy

China has been the single largest driver of global growth over the last five years.  A Chinese hard landing would crimp global trade flows. Countries with strong trade links to China—particularly in Asia—and commodity exporters are amongst the hardest hit. Softer Chinese demand puts further downward pressure on commodity and oil prices, increasing the risk of deflation.

The robust US economy and calm financial markets provide the catalyst for a revival in global growth. Structural reforms in Europe and Japan add further upside to the outlook. The recovery in global demand stabilises commodity prices, but the supply glut keeps prices at 2015 levels. An export-led recovery takes hold in embattled emerging markets, including Brazil and Russia.

EMs bear the brunt of the weakness, especially highly leveraged  companies that borrowed heavily in foreign currency.  Capital outflows and weakening currencies prompt some EM central banks to raise interest rates—even as their economies slow—to maintain financial stability and avoid crisis. The economies most crisis-prone include Ukraine, Russia, Turkey, Argentina, Brazil, South Africa and Indonesia.

Impact on Australian exporters

Export volumes suffer significantly under a Chinese hard landing. China takes 30% of our exports and is a major driver of commodity demand. Softer growth across our other major trading partners, many of whom are also reliant on China, further drag on export earnings. But higher financial market volatility and lower commodity prices cause the AUD to weaken, adding some upside to Australian export receipts.

This is a positive setting for Australian exporters. Strong global growth lifts export volumes, while a weaker AUD further improves the competiveness of Australian agricultural and services exporters.  Softer commodity prices drag on mining revenues, but softer AUD will provide some upside.

Australia’s direct trade linkages with vulnerable EMs are moderate, with the exception of Indonesia our 12th largest export partner and a major consumer of Australian agricultural products. But most of the region’s other EMs appear well positioned to handle a selloff. Furthermore, the volatility in financial markets pushes the Aussie lower. 

Cassandra Winzenried, Senior Economist
cwinzenried@exportfinance.gov.au

Fred Gibson, Economist
fgibson@exportfinance.gov.au

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.