A Happy End to a Challenging Year?


Neil MacKinnon
Global Macro Strategist
VTB Capital

The last year has been tremendously challenging for policy-makers everywhere. The financial crisis was so severe that it required prompt and decisive action as well as the implementation of unorthodox and unconventional policy measures. Few economies have been unaffected and there has been a downturn in the global economy. Germany and Japan, among the world’s leading exporters, experienced a collapse in trade with exports down 30 percent on a year ago.

For those economies at the epicenter of the financial crisis — the US and UK — it has required massive government bail-outs of the banking sector, sizeable fiscal stimulus, effectively zero short-term interest rates as well as significant quantitative easing. Economic recovery is slow, unemployment is rising sharply and there is deterioration in debt to GDP ratios.

So where is the global economy right now? Well, the financial markets have been the first to respond positively to the policy actions taken over the past year. There is greater confidence in the proper functioning of the money and credit markets, which is already helping to reduce corporate borrowing and funding costs. Equity markets have enjoyed a massive rally since the lows in March, which has been one of the biggest rallies in stock-market history.

Following a V-shaped recovery in global equity markets, there is growing evidence of V-shaped recoveries in global industrial production. Inflation is not yet a problem. Deflation, while less of a threat than it was, is still a potential problem. It is interesting to note that even with the oil price at $70 there is no indication that CPI inflation rates are being pushed higher. Indeed, some controllable asset price inflation alongside modest CPI inflation is a preferable outcome to deflation.

Many economists have been upgrading their GDP forecasts in response to better-than-expected data and, in the United States, the third quarter (which will be the recipient of the maximum impact of fiscal stimulus) is expected to post 3.5 percent annualized growth. Even the UK, which was one of the worst hit economies in the crisis, is now showing indications of an improvement in lending and a pick-up in retail confidence. In Japan, exports are being hit by a stronger yen and preventing an upturn in production. Unemployment remains a blackspot and labor market pressures will continue for a while yet. The Fed has already announced that it will reduce its credit easing programs as some have already done their job of bringing normalization back to the markets. The financial markets should not confuse recent announcements on this score as signaling a tightening of policy. Low interest rates will be needed to lift global consumer gloom.

However, consumers need solid real income growth, rising house prices and improved job prospects before feeling safe in increasing spending. One country that is leading the way on this front is China, where a policy of fiscal expansion is helping to sustain economic growth (and some commodity prices), and in particular, investment which is a necessary ingredient for longer term potential. Nevertheless, the outlook for 2010 is still uncertain and so policy-makers need to tread with caution and not tighten policy too early.

The outlook is more favorable for Asian economies as well as the so-called BRIC economies (Brazil, Russia, India and China). The fact is that the centre of gravity in the global economy is shifting from the West to the East. The setting-up of the G-20 rather than the G7/G8 is a belated recognition of this fact. Growth of consumer spending to GDP growth means that the US economy is starting to lose global leadership; growth in Asia and the BRICs could mean the difference between the global economy tipping back into recession or making a durable recovery.

In conclusion, there are some grounds for optimism regarding the outlook for the global economy. However, there is no room for complacency. There is no need for an early exit from current growth-supportive policies. The financial crisis has focused the debate onto the future of the existing international monetary system. The crisis has highlighted its weaknesses and deficiencies, the core of which is the dependency between the US and China. A rethink looks overdue and the debate about the longer-term role of the US dollar in the international monetary system will be key.