Recovery Still Policy-Led, Political Risks on the Rise, EMs Under Pressure

Five years into the crisis, the global recovery remains supported by policies[1]. In 2014, monetary policy will remain accommodative, to facilitate the healing of the financial system and private sector deleveraging. While the Federal Reserve (Fed) will gradually reduce quantitative easing (QE), the European Central Bank (ECB) and the Bank of Japan (BoJ) are likely to provide additional stimulus via unconventional policies. A more limited fiscal consolidation in both the United States (US) and the European Union (EU), and fiscal expansion in Japan will further sustain economic activity.

In absence of shocks, the world economy is expected to grow at 3.5 percent in 2014, up from 3 in 2013 … Yet, growth is fragile and uneven. As developed markets (DM) and emerging markets (EM) are still coupled by trade and financial links, local crises can abruptly go global. The US will grow faster than a two-speed EU – where the Euro-periphery is still struggling – and Japan. As DM Central Banks will progressively decelerate liquidity supply, global financial conditions will tighten, leading to periphery-to-core flows (i.e. funds repatriation from EMs to DMs). While supported by faster DM growth, EM performance will remain subdued. Countries with fragile fiscal and current-account positions (i.e.: Brazil, India, Indonesia, South Africa and Turkey) may suffer currency depreciation and rising inflation.

… but it is likely to remain below-potential for a few years to come. The 2008 financial crisis brought about a prolonged stagnation. According to the IMF, for the global economy to regain its pre-crisis 4 percent potential-trend, DMs need to pay down sovereign and corporate dues, and EMs implement structural reforms. Reducing debt levels is essential to achieve job-generating growth and recoup pre-2008 levels of per-capita income. However, as excess leverage led to overstretched public and private balance sheets, it is taking years for banks to rebuild their capital and for consumers to deleverage. Unfortunately, in almost any country the room created by expansionary monetary and fiscal policies was/is not used to spur growth and create jobs. In other words, while policy-driven stimuli have decreased financial uncertainty, most economies still face below-potential growth prospects.

Deflation risks still outweigh inflationary pressures. Despite massive monetary easing, inflation is still below target across the globe; going forward, disinflationary pressures are likely to outweigh inflationary ones. In other words, the ongoing economic stagnation – a combination of below-trend GDP growth and unused capacity in good and labor markets – will keep inflation subdued. Downward pressures will be reinforced by private sector deleveraging, reduced bank lending, cost-containment, productivity increases, and demographics, as older people have lower spending propensity. Euro-zone (EZ) disinflation might turn into deflation, hampering the recovery. Indeed, deflation would bring about higher real interest rates, higher public and private debt burdens, lower demand, lower growth, and further deflation pressures.

In 2014, DMs will grow at about 2 percent, up from 1.3 in 2013. Most DMs are in recovery, but growth is below-potential, constrained by weak fundamentals, high debt and unemployment.

  • In the Unites States (US), the economy is set to grow at 1.9 percent in 2014 and 2.2 in 2015. In 2013, fiscal consolidation hampered public sector demand. In 2014, both public and private demand are likely to support the economy. Yet, to sustain the recovery incomes need to improve, but long-term unemployment is structurally high and a quarter of mortgages are still above house value. The unemployment rate is declining – at 6.6 percent in January 2014, down from 7.9 in January 2013 – but employment is yet to reach pre-recession levels. Income inequality is widening. Conflicts around debt-ceiling limits could lead to further destabilizing uncertainty and lower growth. Monetary policy remains expansionary, but a rise in the policy rate is expected in 2015. At $60 trillion, the net present value of future liabilities (social security, Medicare, Medicaid) erodes the dollar’s “reserve currency” status.
  • The European Union (EU), emerging from recession, is set to stagnate at 0.3 percent in 2014 and 0.5 in 2015, as political impasse, sovereign and banking linkages (over-indebted states and over-leveraged banks keep financing each other), and competitiveness divergence hamper growth prospects. Confidence is low, and inflation – expected at about 1 percent in 2014 – runs below ECB’s target of “below, but close to, 2%”. While core economies show signs of recovery, mostly led by foreign trade, peripheral countries are struggling, and need capital to finance budget and trade deficits. The EZ most vulnerable members still suffer from depressed internal demand, cautious firms, dry credit markets and, in the banking sector, risky balance-sheets and asset-quality. Structural reforms are needed to lift potential growth, enhance competitiveness and achieve public debt sustainability. Posing a serious threat to social cohesion, EZ unemployment is at record levels, at 12 percent – with youth unemployment above 23 percent.  To sustainably create jobs, annualized growth needs to reach about 2 percent.
  • In Japan, between 2014 and 2015, growth is set to decelerate from 1.0 to 0.8 percent. The recent rebound was largely driven by fiscal stimulus, accommodative monetary policy, currency weakness and exports. In 2014, however, economic activity may decline as Abe’s policies are likely to tighten. The proposed consumption-tax increase will help fiscal consolidation but may hamper consumer spending. Timing will be of essence: an excessively slow fiscal consolidation could fail to reassure debt holders, but a rapid one could stall the recovery. To transform a cyclical rebound into sustained growth, structural reforms and deregulation are needed; in absence of these, long-term growth forecasts will keep hovering around 0.9 percent. For growth to be sustained, consumption and investment need to increase.

In 2014, EMs will grow at about 5 percent, up from 4.7 in 2013. EMs are facing challenges: over-reliance on investment and high-leveraging in China, elections and slow reforms in India, low growth and protests in Brazil, low oil prices and middle income trap in Russia are just a few examples. In general, they suffer from a combination of:  a) structural issues – likely to bring about a decline in potential output, particularly in China, India and Russia; and b) cyclical factors, due to tighter financial conditions and liquidity outflows – particularly in Russia and Turkey.

  • In Brazil, growth is expected at 2.4 percent in 2014 and 3.0 in 2015. As international demand for commodities declines, the industrial sector is likely to underperform. To contain inflation pressures, the Central Bank tightened lending. In the short term, fiscal and monetary stimuli can sustain demand – but investment is needed to carry long-term growth. A free trade agreement with the European Union is likely to support exports.
  • Russia will grow at 3.0 percent in 2014 and 3.5 in 2015. Between 2008 and 2013, potential growth declined from an average of 7.5 to about 4.5 percent. In the past, oil-price increases and commodity exports drove economic performance. Today, weak external demand and reduced natural-resource revenues are coupled with a decline in the active population, slow and state-led reforms, over reliance on hydrocarbons, subdued investment, and an underperforming manufacturing sector. Macroeconomic and business challenges – such as twin deficits and dependence on foreign financing – call for reforms to spur private-sector development and productivity growth. Failure of some members of the Soviet bloc to cooperate on trade activity has also dented Russia’s ambitions to play a dominant role in the Eurasian economy. Going forward, investments are needed to support log-term growth.
  • In India, the economy will grow at 4.5 percent in 2014, to stabilize at 5.5 in 2015. Domestic challenges hamper economic activity: low government effectiveness, reliance on subsidy spending, growing fiscal and current-account deficits, major infrastructure bottlenecks, rapid inflation, rising interest rates, banking sector fragility, corruption claims, a difficult business environment and declining confidence. As growth is below-potential and inflation on the rise, fiscal consolidation and structural reforms are needed – but will be postponed after the elections, scheduled for May 2014. The five-year plan should remove barriers to investment and spur infrastructure expenditures.
  • In China, growth is expected at 7.2 percent in 2014 and 7.0 in 2015.  Over the past five years, growth has declined below-potential, hampered by a weak property-market, lower export to Europe, and capital outflows. Fixed-investment – led by infrastructure-spending and property-speculation – is high and inefficient at about 50 per cent of GDP. Eventually, over-investment will lead to overcapacity, declining productivity, low returns and bad debt, and reduce potential growth even further. Structural reforms need to facilitate a rebalancing towards domestic-consumption-led growth. Yet, the required conditions to unlock savings are politically unpalatable and time consuming: stronger social safety nets, improved financial liberalization, and a non-undervalued exchange-rate. Meanwhile, rising labor costs and Renminbi (RMB) appreciation pushed overseas investors out of China – but also pressured local low value-added manufacturers to venture into higher value-added production. As a result, China is gaining US market share in medium-to-higher-skills manufactures, such as electronics. Banking reforms are needed to curb the expansion of shadow banking, and to help deflate a property bubble due to the financial system’s failure to offer savers good investment opportunities.
  • In Turkey, growth will slow to 2.4 percent in 2014, to pick up to 3.9 in 2015. Over the past 10 years, economic performance relied on external financing and averaged 4.4 percent. In 2014, political uncertainty is likely to hamper the economy. The ruling party (AKP) is split between PM Erdogan and Mr. Gulen – an Islamic clerk living in self-imposed US exile.  This rift will continue at least until local elections in March and cause market jitters.  Capital outflows remain the biggest risk. As slower economic activities reduced tax revenues and the government increased stimulus-spending, the fiscal position is deteriorating. Domestic credit conditions – currently tight to preserve currency stability, reduce inflation, and gradually readjust the external balance – are restraining consumption and investment. Exports are decelerating, because of external demand weaknesses and stagnation in the EU, the major trading partner. In 2015, low global growth and a gradual withdrawal of liquidity will hamper prospects. As markets will price-in rate hikes across the globe, high leverage will result households struggling to pay credit cards dues and mortgages – while corporations will find it difficult to roll over their foreign borrowing. This could result in a rising number of non-performing loans (NPLs) and bankruptcies – and negatively impact consumption, investments and trade.
  • In the Middle East and North Africa (MENA), oil-led stimuli support prospects. In 2013, while government spending sustained consumption, declining oil prices and stable oil output brought about a decline in growth in oil exporting countries – Algeria, Gulf Cooperation Council (GCC), Iraq and Libya. Oil importing countries – Egypt, Jordan, Lebanon, Syria, and Tunisia – also grew below-potential. As North Africa (the Maghreb) suffered the EU recession, Algeria maintained its policy stimulus. In Tunisia manufacturing production was hurt by recession in the EU and strikes. Libya recovered, thanks to the resumption of oil production. Egypt stagnated during the political transition. In the Levant (the Mashrek), the Syrian civil war clouded the regional outlook. Lebanon suffered from dwindling tourism and capital inflows. Jordan faced weaker trade and rising commodity imports. In 2014, oil prices and output are expected to stabilize, supporting growth in oil exporting countries. In oil importing countries, growth is likely to pick up in North Africa and the Levant. In the GCC, growth will be propped up by oil revenues and fiscal expansion. Investment-led growth is sorely needed and job creation remains a key issue.

In this context, policy withdrawal may trigger political risks. Central banks and governments cannot indefinitely sustain growth. With international trade and private sector activity still below pre-crisis levels and global unemployment at record levels, the upcoming normalization of monetary and fiscal policy is likely to drive political risks – as it will inevitably lead to lower growth, higher volatility and rising income inequality.

  • Global unemployment is at record levels. Corporations are on hold, puzzled by the outlook. Large companies, even when cash-rich, are reluctant to hire workers. Small and medium-sized firms, a major source of job creation, lost access to capital. As a result, according to the International Labor Organization (ILO), unemployment affects 202 million people worldwide (up 29 million since the start of the crisis, with under-29 joblessness at almost 100 million in 2013). In 2014, world unemployment will rise to 6.1 – from 6 percent in 2013 – and for several years will remain well above its pre-crisis rate of 5.5. Youth unemployment is at 13.1 percent, a record level. As deleveraging constrains the recovery, DMs high unemployment is likely to depress an already frail consumer confidence and, with young people hit the hardest, spark unrest.
  • Inequality is rising and the middle class is increasingly strained … In both DMs and EMs political uncertainty and anti-establishment sentiments are on the rise. Since 2011, the economic pressures faced by the middle class have fuelled the Occupy Movement. Its main slogan, “we are the 99%”, condemns wealth-concentration among the top 1 percent of income-earners and denounces how a disproportionately-benefitting minority undermines democracy. Enhanced by social media, large-scale social protests keep drawing attention to inequality and corruption. Examples are the Arab Spring, Occupy Wall Street in the US, calls for social justice in Israel, the Indignados in Spain and Portugal, anti-corruption rallies in India, mass demonstrations in Brazil, the Gezi Park movement in Turkey, Egypt‘s riots and marches, public dissent in  Bulgaria, mass protests in Thailand, violence in Ukraine, unrest in Venezuela.
  • … turning politicians to more populist responses. In the US, where the average family earns less – in real terms – than in 1989, the Tea Party is strengthening. The same is true in France for the National Front (FN), in the United Kingdom (UK) for the Independence Party, in the Netherlands for the Freedom Party and in Italy for a plethora of discontent-driven parties. In China, President Xi Jinping launched an anti-corruption initiative, aimed at restricting government consumption. In India, the Aam Aadmi Party (AAP – its symbol is a broom) is a rising political force and launched a nationwide anti-corruption drive, via a string of rallies. In MENA and GCC, where possible rulers buy peace by increasing entitlements. Political risks to be monitored include tensions in North Africa – due to the upcoming elections in Algeia, Tunisia and Egypt, succession issues in Saudi Arabia, and a possible spillover of the Syrian civil war into the Levant.

DM liquidity withdrawal will also hurt EMs. In the second half of 2013, Fed tapering expectations resulted in a sharp fall in EM currencies and capital markets. In early 2014, quite a few EMs – Argentina, Brazil, China, India, Russia, Thailand, Turkey, and Ukraine – suffered further instability, due to structural weakness or political instability. While expectations about DM policy-normalization are getting priced in bond rates and exchange rates, capital movements across countries will remain volatile. EMs with weak macro frameworks will be most affected, and policy makers will face a tough choice: either to a) rise interest rates and face lower growth (a likely move in current-account deficit countries); or b) keep rates low and face outflows.

Currency volatility as a base case. Since the onset of the 2008-crisis, periodic uncertainty about the global economy resulted in increased currency volatility, which in turn brought about additional uncertainty into the currency and commodity markets and the real economy. With lower growth ahead, competitive devaluation is becoming an attractive alternative to cutting public spending. Depreciating the exchange rate is an easy way to spur exports, limit imports, attract investment and tourism, and create jobs. Over the next few years, currency volatility is likely to remain high, hampering capital transfers and commercial activity. The US dollar (USD), the Euro (EUR) and the Japanese yen (JPY) are likely to witness policy-induced exchange-rate moves. EM currencies will suffer risk aversion. Search for safety will privilege the USD, and the USD is likely to strengthen versus EUR, JPY, and EM currencies.

[1] Over the past five years, policymaking avoided a depression. Fiscal and monetary stimuli transferred debt from private to public agents via bank bailouts and central banks’ balance sheet expansion. Most governments’ debt-to-GDP ratios rose above 90 percent. The world’s main central banks kept global interest rates low and supported the financial system by tripling – from $5 to $15 trillion – their combined balance sheets.