For a while, it all seemed so easy. A combination of addictive monetary stimulus from the US Federal Reserve and a Chinese economy seemingly able to expand at will led to substantial asset price gains in anticipation of a sustained global economic recovery. Yet many parts of the global economy are still in intensive care, the Fed is threatening to taper quantitative easing and Beijing is now much more focused on the quality than the quantity of growth. Suddenly, the world is a much more complicated place.
If there’s any good news, it is oddly packaged. The Federal Reserve’s plans to taper QE before halting it in 2014 will be fulfilled only if the US economy offers a combination of lower unemployment, faster growth and stable inflation.
The Fed’s own forecasts suggest this holy trinity may now be within reach, but our forecasts suggest otherwise. It may be that tapering is delayed and perhaps the Fed will not be able to withdraw easily from its unconventional monetary creation: like other policymakers, it has demonstrated a persistent ‘optimism bias’ in recent years.
Monetary uncertainty in the US is bad enough but, thanks to a slowing Chinese economy, the overall picture is even worse
More worrying is the idea – entertained by some central bankers – that QE is having unwanted side-effects and should thus be curtailed, whether or not a decent recovery is underway. The evidence increasingly supports the view that QE is affecting more the distribution of income and wealth than the overall pace of recovery.
Monetary uncertainty in the US is bad enough but, thanks to a slowing Chinese economy, the overall picture is even worse. Before the global financial crisis, China’s rapid economic growth was supported by export gains of 20 per cent to 30 per cent a year. Those gains are now a distant memory.
At first, Beijing responded with copious pump-priming measures but it has become increasingly clear that these offered only modest benefits: the marginal return on capital has declined while rapid credit growth has become a source of mounting concern.
With Beijing’s new leadership now much more focused on the quality of growth, there is more focus on supply side reforms than demand-side pump-priming. But while this new focus should prepare the foundations for a period of solid economic expansion over the medium term, it has a short-term cost: supply side reforms are disruptive and thus likely to be associated with lower near-term growth. We now expect Chinese GDP to increase by just 7.4 per cent this year and next.
So what does this mean for the rest of the world? Many emerging nations became unusually dependent on the combination of cheap American money and strong Chinese growth – so much so that domestic reforms were often delayed. Balance of payments positions deteriorated and, in some cases, the split between growth and inflation worsened.
For a while, none of this mattered. The hunt for yield engendered by QE allowed countries to carry on as if nothing had changed. However, with the removal of US and Chinese support, some of these countries are vulnerable, with some of the world’s major commodity producers among the most exposed, thanks to falling prices.
Meanwhile, higher US Treasury yields may trigger an unwarranted tightening of financial conditions in the eurozone and the UK, threatening a further outbreak of economic and financial distress.
While the Fed is thinking of monetary tapering, for us, the only tapering is of our growth forecasts. For the world economy, we now expect growth of just 2 per cent this year and a modest 2.6 per cent in 2014. Our latest revisions are all centred on the emerging world: we have shaved 0.8 percentage points off our 2013 projection and 0.5 points off our 2014 numbers.
Although dominated by the reduction in our forecasts for China, the new numbers also reflect further sizeable reductions in our projections for countries including Brazil and India. We now expect 2.4 per cent growth in Brazil this year and 3 per cent in 2014, while our projection for India has been cut to 5.1 per cent, followed by 6.5 per cent.
Even allowing for the emerging nations’ obvious long-term growth advantages, there is no easy escape from deteriorating near-term economic fundamentals.
This research was first published on 28 June 2013.