World Risk Developments October 2016

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The view from Washington: weak and precarious growth fuels political risk

Our senior economist, Cassandra Winzenried was in Washington DC this month for a meeting of the Institute of International Finance (IIF). Her impressions are contained within.

The mood was pessimistic. The IIF—an association representing almost 500 international banks and asset managers—downgraded its global growth forecast to 2.4% this year—the lowest estimate since 2009. Despite the improving performance of emerging markets, the Brookings Institution warned the world economy is ‘sliding back into the low growth morass’. The IMF blames a cocktail of legacies from the 2008 crisis, and warns that weak growth could become self-perpetuating—if investment falls, productivity growth declines, and the labour market becomes less dynamic. The political fallout is rising protectionism and populism which could depress global growth further. Fortunately, Australia’s largest trading partners in emerging Asia look relatively resilient.

Advanced economy malaise puts emerging markets centre stage

Downgrades to the global economic outlook by the IMF since April were driven by advanced economies. This primarily reflects Brexit and a prolonged soft spot in the US.

  • The initial impact of the Brexit vote was less than feared thanks to quick action by the Bank of England and a smooth political transition. Though when Theresa May removed the last vestiges of hope for a ‘soft Brexit' earlier this month, sterling slumped to near-record lows. The UK expects to trigger Article 50 of the Lisbon Treaty by March 2017, starting the clock on two years of exit negotiations. But IIF members fret that new trade agreements, regulations, and procedures won’t be ready within that timeframe. Given the heightened uncertainty, the IMF expects the UK to eke out growth of 1.1% next year—half the 2.2% predicted before the referendum. IIF members are convinced Brexit will cause an erosion of confidence, investment, competitiveness and productive capacity.
  • US dichotomy. The relative strength of US households owes to solid gains in employment, incomes and house prices. But the historically strong correlation between employment and business investment has weakened. Despite strong jobs growth, US companies remain uninterested in investment—instead they have hoarded almost US$2 trillion of capital. Corporate investment is curtailed by declining profitability, high inventories and low oil prices. Conflicting signals will challenge the Federal Reserve—but a gradual approach to monetary tightening is thought by the majority of conference attendees to be both likely and appropriate.

Happily, the IMF expects emerging markets to gain momentum—owing to the stabilisation of commodity prices, a return of capital flows, and near term Chinese resilience. And while progress is uneven, Australia’s largest emerging market trade partners are leading the way.

  • China stable. Concerns about the risk of a sharp Chinese slowdown and even financial crisis have eased—public spending has boosted activity and more consistent and transparent exchange rate management has helped quell fears about a precipitous depreciation of the RMB. Barring shocks, this policy approach is likely to continue in the run-up to leadership changes at the 19th Communist Party Congress next October. But while credit expansion has been an effective anaesthetic to short term volatility, the unsustainable accumulation of debt, the declining effectiveness of credit and misallocation of resources continue to fuel medium term downside risk. And China’s growing integration in global trade and finance raises the potential for contagion.
  • India still No. 1. The IMF expects Australia’s fifth largest export market to remain the fastest growing major economy, expanding 7.6% next year. It is benefiting from low oil prices and interest rates, improved rainfall, robust public investment and gradual reform.
  • Rest of emerging Asia improving. The region is generally benefiting from more stable conditions in China, robust domestic demand, and an upturn in the tech cycle. But risks remain in some markets—for instance, the Philippines’ new president Duterte has raised investor nervousness, and Thailand lags regional growth, in part due to political uncertainty.

 1. IMF GDP growth forecasts

 

Figure

Outlook increasingly delicate

Risks to the global outlook abound. In particular, a prevailing lack of confidence and investment owes to a debt overhang, falling productivity growth, and an increasingly ineffectual monetary policy response.

  • Wedge of worry—increasing debt and declining productivity. The IIF estimates global corporate and household debt reached 330% of GDP last year (up from 230% on the eve of the financial crisis). Though debt service has not yet increased commensurately, when record low interest rates eventually normalise, over-indebtedness will likely become apparent. Rising debt loads are particularly worrying when set against declining productivity and returns on investment.
  • The exhaustion of monetary policy. At best, extraordinary central bank policies are increasingly ineffective. At worst, they are counterproductive. Consternation about negative interest rates owes to two possible outcomes. The first is banking weakness—owing to declining bank profitability and capital raising capacity. The second, the erosion of economic growth, owes to the potential encouragement of higher savings, the repression of ‘animal spirits’, and lower bank lending. JPMorgan Asset Management CEO Mary Erdoes thought ‘You can’t have capitalism without a cost of capital’.
  • Fiscal policy and structural reform MIA. Former Treasury Secretary Larry Summers said ‘secular stagnation’—where excessive saving acts as a drag on demand, reducing growth and inflation—is no excuse for fatalism. Policymakers must be more ambitious. While monetary policy is ‘currently the only game in town’, the need for fiscal policy and public investment that yields productivity gains has become pressing. The plea is clear—even where fiscal space is limited, there is scope to change the composition of spending and revenues in order to stimulate demand and raise potential growth.

Lacklustre world economy fuels political risk

Growth has been too low for too long and the benefits spread among too few. Disproportionate gains from globalisation in advanced economies has caused the gap between rich and poor to rise to its highest level in decades. The economic cost of this failure is high and the political repercussions—in particular, a surge of populism and protectionism—are a major source of uncertainty. Four of the IIF’s top five risks are political—with next month’s US election and Europe’s electoral marathon topping the list.

  • Opposition to globalisation and trade. Global trade remains weak. McKinsey suggests that the next era of trade digitalisation offers new potential, especially for SMEs. But rising opposition to globalisation is an increasing hindrance. Across the world, protectionist trade measures are rising. Stanley Fischer, Vice Chairman of the Federal Reserve warns that very few countries have grown rapidly over prolonged periods without global integration.
  • Opposition to immigration. Theresa May has signalled that UK concessions on immigration will not be made in return for access to the Single Market. EU leaders have in turn hardened their rhetoric—the usually diplomatic French President Hollande warning ‘there must be a threat, there must be a risk, there must be a price’. Other recent proposals, such as those to make companies declare their foreign workers are fuelling uncertainty about the UK’s broader vision on immigration and business. But despite limited buyer’s remorsehard Brexit is reluctantly becoming an accepted outcome.
  • Threats to EU unity. According to Jamie Dimon, CEO of JPMorgan Chase, while Brexit will be disruptive for Britons, the more serious risk is political contagion. Eurosceptic political parties are gaining traction and 14 elections are scheduled in the EU over the next 12 months. Italy’s referendum on senate reform and proxy vote on Prime Minister Renzi is due in December. While established parties are expected to prevail across the board, political infighting and uneasy coalitions could sap capacity to undertake necessary reforms—both to boost growth and buttress the foundations of the common market.

The political risks and potential for misguided policies are daunting. And the repeated failure of economic models to provide forecasts that accurately reflect the extent of the slowdown—and therefore the pressing need for policy support—have not helped. But political risks must be put in context. Those at the IIF conference console themselves with the view that virtually all major historical global geopolitical shifts have yielded no lasting effects on global capital markets. And within the US at least, considerable checks and balances within government insulate against major policy changes.

The consensus at the IIF conference is that economic malaise will be reinforced by the prevailing political mood—ensuring the new mediocre of global growth endures. And unless a broader reform effort ensues, the medium term risk of a disruptive adjustment will continue to rise.

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

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