There has been a significant improvement in sentiment toward the global economy in the first few months of the year. Even though this improvement can be easily explained, it needs to be kept in context. There are still considerable challenges ahead.
When considering the economic outlook, we must not lose sight of two key influences. The first is the shift in the balance of economic and financial power, highlighted by the emergence of China, India and Brazil – not to mention a host of other economies across Asia, Africa and the Middle East. This shift is a strong, positive driving force.
The second factor is shorter-term in its influence, but is negative. This is the overhang of debt that continues to weigh on the recovery in Europe and the U.S. The need to deleverage – as people, firms and governments pay off debt – points to a steady but unspectacular recovery in the U.S., and signals further problems in the euro area. It is against this backdrop that one needs to view the recent improvement in financial-market sentiment across the globe.
At the end of last year, a number of factors were weighing on the world economy. Lest we forget, the markets feared a double-dip recession in the U.S., a hard landing in China and a collapse of the euro. None of these fears materialized. Thankfully, I did not share the markets’ views about the U.S. or China, but I was pessimistic about the euro, expecting a muddle-through. The fact that economic data from both the U.S. and China was better than expected helped sentiment, but the actions of the European Central Bank were key.
The ECB did a great job pulling the euro area back from the brink by providing cheap three-year money in both December and February. The ECB averted a bank collapse and a credit crunch, which in turn helped sentiment. As profound and necessary as the ECB’s actions were, the short-term relief it has provided should not be seen as a longer-term cure for Europe’s problems.
This year, the world economy still faces significant challenges. Let me highlight the main ones.
The first is the euro. The euro area is in recession. With the exception of France, most major European economies contracted in the last three months of 2011. This included the peripheral euro-area countries of Ireland, Italy, Spain, Portugal and Greece. There is every likelihood that this contraction will have continued in the first quarter, and perhaps even in the first half of this year. In short, the periphery is seeing a double-dip recession. The ECB’s actions may have averted a credit crunch, but they will not prevent a credit squeeze where funds are still hard to come by.
Moreover, the euro area is focusing on the wrong problem. Although debt levels are high, the biggest challenge is the lack of growth. Europe needs a growth strategy. It does not have one. Instead, it is cutting public spending and raising taxes to reduce debt. This is a long and painful process. Unless private spending picks up, economies will be weak. The trouble is, with demand sluggish, many firms are thinking twice about increasing their spending. The result is a continuation of the difficulties that have engulfed the euro area in recent years. This means further problems for Greece, and future worries for Spain, Portugal and Italy, as they will be in recession, probably this year and next.
Another challenge is the U.S. I am positive about America’s long-term prospects. If there were to be a pleasant surprise this year, with U.S. growth being much higher, it would be because big companies whose balance sheets are in good shape decided to go out and invest. Instead, they seem reluctant, either because they fear demand will be weak, or because they are worried about the regulatory outlook following this year’s presidential election in November.
Confidence, of course, is an impossible thing to predict. It would be pleasing if a rebound in confidence did allow corporate America to go on a spending spree. Yet, if it does not, then the backdrop for the average American will be one of only modest employment growth, a small rise in wages and a still-weak housing market. Americans still need to save more and spend less.
This leads to the issue of energy and food prices. A year ago, rising food and energy prices added to inflation pressures across the globe, justifying higher interest rates in many growing economies. Now, rising oil prices appear more like a tax on global growth, eating into spending power in the U.S. and Europe, and hitting many Asian economies at a time when they are slowing.
The impact of oil prices on the global economy can never be underestimated. Rising oil prices are usually the biggest threat to continued global growth.
There can often be a big difference between oil prices being driven higher by strong demand and by supply shocks. If strong demand is driving prices, then at least when oil prices rise, there is also increased spending and trade. In the past, demand-driven spikes in oil prices would come late in an economic cycle. Now, it is demand from Asia and the Middle East that is driving oil prices up, and thus Western economies may not be in a strong position to cope. The more oil prices rise this year, the weaker the economic outlook will be in the West.
This vulnerability is worse now, as supply-side worries surrounding Iran have led to a large risk premium, pushing oil prices up. Oil prices appear to have a firm floor because of strong demand, and a soft ceiling because of geopolitics.
It is not just the West that watches prices closely. So, too, does China. Over the past year, China’s authorities have tightened policy in order to squeeze inflation. Their main focus appears to have been on property prices, yet they have also been keen not to see a wage-price spiral develop.
As has so often been the case in recent years, the Chinese authorities have handled things well. But the challenges are not getting any easier. China’s economy is cooling, not collapsing, and it is having a soft, not a hard, landing. At this year’s National People’s Congress, Prime Minister Wen Jiabao sensibly cut the growth projection to 7.5 percent from 8 percent. Although I remain positive about China’s longer-term prospects, it is important to stress that, at some stage, China will have a setback. This should be seen as a feature of China’s likely development. As the economy grows bigger, it becomes harder to manage than in the past. Moreover, the need to switch from investment- to consumption-led growth poses many challenges.
Thankfully, China has enough room for policy maneuver to cope with any setback, although that setback seems unlikely to occur this year. As the Chinese economy cools, one should expect further, gradual policy easing that allows for a rebound later this year.
Overall, this should prove to be another challenging and interesting year for the world economy. In the immediate aftermath of the financial crisis, the world economy contracted in 2009, its first fall since World War II.
In 2010, there was a strong rebound, with the world economy growing 4.4 percent, led by policy stimulus in the West, and by the strength of China and the emerging economies. But in 2011, the pace of growth slowed as the policy stimulus in the West started to wear off and as more economies in Asia and Latin America raised interest rates to curb inflation. Last year, the world economy grew by 3 percent.
This year, the good news is that there will be growth, but the challenge is that it seems difficult for it to be any higher than it was in 2011. Europe faces further challenges. America still has a debt mountain to climb. And many emerging economies have been slowing in the early months of the year. The economic story is one of a fragile West and a resilient East.
Dr. Gerard Lyons is Chief Economist at Standard Chartered Bank.