Economic prospects are highly uncertain and likely to disappoint
World Risk Developments December 2022
The global economic outlook is complex and precarious. Unfortunately, while economic prospects are unpredictable, downside risks are unusually large. If realised, the six major risks described in this section could tip the global economy into recession and keep inflation higher for longer.
Monetary policy could miscalculate the right stance to moderate inflation
The risk of a policy mistake is high given seismic monetary and fiscal policy shifts and mixed economic signals. In particular, decelerating growth and subdued consumer and investor sentiment sit somewhat awkwardly alongside still tight labour markets. Central banks must chart a difficult course. Not tightening enough would entrench inflation, dent central bank credibility, and de-anchor inflation expectations. But tightening too much, or for longer than necessary, risks unnecessary economic harm. Already, US Federal Reserve staff estimate the possibility of a US recession next year as almost as likely as their baseline of weak growth. Given the uncertain outlook, 2023 is likely to test central banks’ mettle in rooting out inflation, particularly if further shocks to energy and food prices emerge, either from the war in Ukraine and the potential flaring of other geopolitical conflicts, or from more extreme weather events.
Monetary policy tightening could provoke turmoil in vulnerable financial markets
Fast rising interest rates, tighter global financial conditions and significant asset repricing could expose longstanding financial vulnerabilities for governments, households and corporates. Emerging markets recorded US$96 trillion of debt in September 2022, up 26% from pre-pandemic levels. While there have been only five major defaults to date in 2022, more debt distress in vulnerable emerging markets could arise amid higher borrowing costs, US dollar appreciation and the slowdown in global trade. The OECD cautions that risk premia have increased, capital outflows have accelerated, and foreign reserves have declined in many countries. Of the world’s poorest 69 countries, the IMF estimates that 9 are currently in debt distress while 28 are at high risk of debt distress. At greatest risk are emerging markets with large external financing needs, higher energy and food input bills, and strained public balance sheets. As debt repayments take a greater share of budget revenues, tighter fiscal policy against a backdrop of increasing economic hardship will raise the risk of social unrest and political instability.
Similarly, higher interest rates and tighter bank lending standards may hinder the ability of households to service their debts, potentially leading to bankruptcies and house price corrections. While prices have already started to decline in some countries, house price-to-income ratios remain at record highs across most OECD countries. Meanwhile, the share of corporates unable to service debt payments could increase sharply as monetary policy tightens; default volumes on leveraged US loans and high-yield bonds are already three times higher than in mid-2021. While tighter regulatory measures have helped improve the resilience of the banking sector following the GFC, more loan defaults raise the risk of large losses at financial institutions, especially in emerging markets. Last, turmoil in the gilt market following the UK’s announcement of large debt-financed fiscal loosening amid economic stagnation revealed obscure fault lines (in this case, illiquid pension fund holdings) that can trigger instability if investor sentiment deteriorates.
The forecast steady economic recovery in China could fail to materialise
The IMF forecasts China’s real GDP growth to accelerate to 4.4% next year. But two downside risks to China’s growth recovery dominate the outlook.
First, disruptions from strict COVID-19 restrictions. Following a wave of protests this month, the Chinese government has loosened COVID restrictions. Relaxation of COVID measures is likely to be uneven given that only 40% of people in China aged 80+ have had three COVID vaccines and a fourth dose is yet to be rolled out. Domestically produced vaccines have shown lesser efficacy and recent COVID subvariants are increasingly infectious. Modelling from The Economist suggests that if the virus spread unencumbered, infections would peak at 45 million a day, with the need for intensive care beds reaching 410,000, almost seven times China’s capacity. As such, there is a risk that some COVID-19 restrictions could be reinstated in 2023, despite the economic impacts and business uncertainty they would cause. For instance, new loans declined 25% year on year in October, while road freight is 33% lower year on year and urban youth unemployment is 18%, nearly double the 2018 level.
Second, financial fragilities in the highly indebted property sector. Weak housing demand and market oversupply is preventing developers from accessing much-needed liquidity to finish projects, raising the possibility of further debt defaults. Meanwhile, thousands of buyers are calling for a moratorium on mortgage payments that would exacerbate the risk of nonperforming loans for banks. The weak property sector will weigh on consumption and local government finances. But a more protracted real estate adjustment would be a large blow, given the sector constitutes about one-fifth of China’s GDP. Broader macro-financial spill overs from potential banking sector losses would weigh heavily on medium term growth.
The energy crisis could worsen
The largest energy crisis since the 1970s is expected to exact a high economic toll over the next several years. But current and planned embargos on Russian coal and oil imports and the dwindling supply of gas from Russia to Europe could prove more disruptive and persistent than assumed. EU gas storage levels were 92% on average in EU member states and full in many, as of October. Still there is uncertainty about whether demand for the forthcoming winter can be met without storage levels falling below effective operational levels. Even if supplies prove adequate, significant challenges are likely to persist through 2023. If Europe fails to secure enough non-Russian supply to rebuild storage capacity ahead of next winter, or if demand is higher than expected, European energy shortages could result. OECD modelling suggests this would push up global gas, fertiliser and oil prices (as European countries bid for additional gas supply in world markets), hit confidence and financial conditions and require a temporary period of energy rationing by businesses in early 2023 and early 2024. Taken together, the shocks could reduce growth in Europe by 1½ percentage points and raise inflation by over 1¼ percentage points in 2023. This would push many countries into a full year recession. For the world, inflation would increase by 0.6 percentage points and growth would fall by 0.5 percentage points in 2023.
Further geopolitical fragmentation could impede trade and international cooperation on climate change
Russia’s invasion of Ukraine ruined relations between Russia and the West. Meanwhile, geopolitical tensions in Asia and elsewhere are increasing. Heightening tensions could see the world fragment into different spheres of geopolitical influence, with adverse impacts on global trade and capital flows. Indeed, the spike in global inflation has recently prompted a wave of short term protectionism, mostly pertaining to food. Fragmentation of the world economy could also hamper international cooperation, increasing climate change risks. As physical climate change disruptions rise and mitigation is underfunded, the weather increasingly risks undermining economic performance and living standards.
Increased economic hardship and inequality could drive further social unrest
Inflation hits the lowest earners hardest, increasing income inequality and poverty. The UN food price index fell for an eighth consecutive month in November but remains 34% higher than at end-2019. Any further supply disruption would reverse the expected continued easing of food prices. For instance, Russia and Ukraine account for around three quarters of wheat and wheat flour imports for many countries in the Middle East and North Africa. Modelling by the OECD indicates that the number of undernourished people could double to over 200,000 in Egypt in 2023 amid moderate declines in exports from Russia and Ukraine. More frequent extreme weather events, along with continued droughts in Europe and China, could also cause further food price spikes. As could high energy and fertiliser prices and supply shortages, which may weaken next year’s harvests. Food price increases have traditionally led to more social unrest. Moreover, as discussed earlier, increasingly austere public budgets could also fuel social unrest in emerging markets next year.