Subdued, below-potential global growth forecast

The world economy is expected to pick up gradually from the second half of this year, but significant risks and uncertainties remain which could yet derail this recovery, according to a UN economic outlook report.

by Kanaga Raja

GENEVA: “After a marked downturn over the past two years, global economic activity is expected to slowly gain momentum in the second half of 2013,” the United Nations has said in a mid-year update of its economic projections.

In its report titled World Economic Situation and Prospects as of mid-2013, the UN has now projected world gross product growth at 2.3% in 2013, the same pace as in 2012, before gradually strengthening to 3.1% in 2014.

“Most world regions are likely to see a moderate strengthening, but growth will still remain below potential,” said the report, which cautioned that several key risks and uncertainties remain and, if not mitigated, could derail global growth again, as in the past few years.

The report is before this year’s substantive session of the UN Economic and Social Council (ECOSOC), taking place here from 1-26 July.

According to the report, since late 2012, several new policy initiatives in major developed economies have reduced systemic risks and helped stabilize consumer, business and investor confidence, but with very limited impacts on growth.

“In the euro area, sovereign bond risk premiums of debt-distressed countries have fallen notably, but the real economy is held back by austerity programmes, weak bank lending and continued uncertainty, and only a very gradual recovery is expected as these factors diminish,” said the report, adding that significant downside risks remain “if the vicious cycle of de-leveraging and banking sector fragility continues unabated”.

In the United States, the avoidance of the fiscal cliff and the expansion of monetary easing, along with a continued recovery in the housing sector, have improved growth prospects. While private sector demand is projected to gradually strengthen, the automatic spending cuts and uncertainties associated with budget issues will continue to weigh on aggregate demand.

In Japan, the bold expansionary policy actions adopted by the monetary and fiscal authorities are expected to provide some support for economic activity in the short run. They may, however, also create heightened medium-term uncertainties regarding the sustainability of public debt.

The report said that developing countries and economies in transition continue to register much stronger growth than developed economies. In response to the economic slowdown in 2012, many of them, including some large countries in East Asia, South Asia and Latin America, adopted more expansionary monetary and – to a lesser extent – fiscal policies to strengthen domestic demand.

“This, along with a slight upturn in external demand, should provide a lift to economic growth in 2013. The pickup in growth will, however, be slower than previously estimated as many large economies in this group, including Brazil, China, India and the Russian Federation, face significant structural challenges.”

Potential growth in many developing countries is likely to be lower than before the global financial crisis; China, for example, is expected to have shifted to a lower but more sustainable and balanced growth trajectory.

The least developed countries are projected to see faster growth in 2013 than in the past two years. However, with commodity demand moderating and official development assistance falling, the pace of expansion in least developed countries will still be notably slower than during the period from 2004 to 2008.

Unemployment challenge

Turning to labour markets, the report underlined that the employment situation remains a key policy challenge in a large number of countries, as the world economy continues to expand well below its potential.

Among developed countries, unemployment is most severe in parts of the euro area, which continue to see sharp contractions of economic activity amid stringent fiscal austerity programmes. In early 2013, the unemployment rate increased to 26.7% in Spain and 27.2% in Greece, with youth unemployment rates exceeding 59%. In addition, unemployment is still on the rise in other euro area countries such as Belgium, Finland, France and Italy. Average unemployment in the euro area reached a new all-time high of 12.1% in March 2013, and is forecast to average 12.8% in 2014.

In most developing regions, labour markets have not suffered as extensively from weak demand as in developed economies. In some emerging economies, unemployment rates have dropped below the levels seen before the financial crisis, particularly in South America and East Asia. In both regions, the employment outlook has remained robust in the face of the recent economic slowdown. By contrast, said the report, employment continues to be a key problem in many African countries, despite relatively high growth rates over the past few years. Developing countries face many structural labour market challenges, such as low participation rates, particularly among women, high youth unemployment, large informal sectors, high shares of low-quality jobs and slow productivity growth.

After slowing in 2012, growth in international trade is projected to pick up moderately in 2013 and 2014, in line with the expected mild recovery in global aggregate demand. Notably, the ratio between the growth of world trade and the growth of global output may be at a lower level than before the global financial crisis.

In 2013, growth in global trade volume is projected to recover slightly to 3.5%, before strengthening to 5% in 2014. This forecast reflects expectations of a moderate pickup in import demand in developed economies and most developing regions, in particular East Asia and Latin America and the Caribbean, said the report.

The report further said that global financial conditions have stabilized in recent months as new policy initiatives in developed economies, including a further expansion of unconventional monetary policies, reduced the near-term tail risks for the world economy.

“Increased global liquidity and higher risk appetite among investors have led to rising asset prices in developed countries, while also pushing up capital flows to emerging economies. These capital flows have been dominated by portfolio investments, especially in corporate debt.”

In many emerging economies, large corporations have taken advantage of low borrowing costs. Bond markets in East Asian countries as well as Mexico and Turkey saw particularly large inflows in late 2012 and early 2013. Foreign direct investment flows to emerging economies have also strengthened since mid-2012.

The report said that the upward trend of private capital flows to emerging economies is likely to continue as significant growth and interest rate differentials will persist in the near term.

However, it warned, “the current environment of low global interest rates, moderate volatility and rising risk appetite among investors poses considerable risks for emerging economies. A further surge in capital inflows could lead to an appreciation of domestic currencies, excessive credit growth and a build-up of significant leverage and asset price bubbles.”

Corporate leverage and foreign exchange-denominated debt have indeed been on the rise in parts of East Asia and Latin America, a trend which, if continued, could lead to an increase in balance sheet risks and heightened vulnerability.

In contrast to private capital flows, net official development assistance declined by 6% in nominal terms in 2012. In real terms, this is the first time since 1997 that official development assistance has fallen in two consecutive years. Most of the fall was due to lower contributions from European countries, many of which were facing severe fiscal constraints.

According to the report, the past three quarters have seen two major trends in international currency markets, resulting from the expansion of unconventional monetary policies in developed economies and lower risk aversion among investors.

First, the Japanese yen has depreciated sharply against all major currencies following the fundamental changes in the country’s monetary policy strategy. Against the dollar, the yen depreciated by 22% between September 2012 and April 2013.

Second, the currencies of many large emerging economies have appreciated gradually since late 2012, mainly as a result of rising capital inflows. Upward pressures on the national currencies have been particularly significant in Brazil, Mexico, the Philippines and Thailand. The Chinese renminbi also strengthened gradually, reaching a 19-year high against the dollar in the second quarter of 2013.

“In several emerging economies, policymakers have expressed concerns over the shifts in competitiveness associated with the recent swings in exchange rates and the resulting negative impact on local export sectors. The sharp weakening of the yen puts particular pressure on the export industries of some East Asian countries (notably the Republic of Korea), but the magnitude of this effect is uncertain.”

Since capital flows to emerging economies are expected to increase in the quarters ahead, upward pressures on national currencies are likely to persist, especially in countries where economic prospects become more favourable, the report warned.

Downside risks

According to the UN, the world economy continues to face significant uncertainty, with risks still tilted to the downside. It said that the World Economic Situation and Prospects 2013 report released in January examined three major global risks and analyzed their potential impact on global growth: a substantial worsening of the euro area crisis; the United States falling off the fiscal cliff; and a hard landing for some large developing economies.

“Since then, there has been improvement in some of these areas, with short-term risks diminishing but not disappearing.”

Meanwhile, new risks and uncertainties have emerged, particularly for the medium run. First, the ever-expanding monetary measures adopted in developed economies could have significant adverse effects on financial stability in the future. The bold new policy actions adopted by Japan, for example, could help reverse the country’s economic weakness, but they also entail certain risks and uncertainties as already evidenced by the sharp devaluation of the yen.

Second, a prolonged period of subdued growth in many economies, with high unemployment and inadequate investment, may have led to noticeably lower potential output in the world in the medium term.

“These factors and other risks, including those beyond the economic domain (such as geopolitical risks and natural disasters), have the potential to derail the still feeble global recovery. This could lead to much lower growth in the world economy than what is projected in the baseline outlook.”

The report said that the crisis in the euro area remains a major risk factor for the world economy, although recent policy actions have lowered some of the short-term risks. In particular, the European Central Bank’s Outright Monetary Transactions programme and other policy initiatives since late 2012 have significantly reduced sovereign risks and the risk of a euro area break-up. This explains why the political impasse in Italy and the Cypriot bank bailout have caused only limited disturbances.

Despite the progress, it added, considerable banking and fiscal risks remain. A large number of banks still have weak balance sheets, remain fragile and could face insolvency. The recent Cypriot bailout actually raised risks in the banking sector by increasing the possibility of bank runs. This has heightened the urgency to create a region-wide banking union, but significant uncertainties over the timeframe and the final form remain.

In addition, despite improved bank liquidity, there continues to be considerable fragmentation in financial conditions across the region. Lending conditions are very tight in the southern countries, particularly for small and medium-sized businesses, but markedly easier in other parts of the region.

“The ongoing lack of adequate access to funding in the crisis countries hinders economic activity, exacerbates unemployment and could threaten the recovery.”

Lower sovereign yields, meanwhile, have not yet broken the downward spiral formed between fiscal consolidation and the economic downturn. Risks on the fiscal front are primarily related to countries missing their fiscal targets and having to undertake additional austerity measures.

The countries already under assistance programmes will have to follow agreed-upon consolidation and restructuring measures. These measures may become more onerous, particularly in light of the harsh resolution to the recent Cypriot crisis, which demonstrated that support for assistance has dwindled.

“In countries not under assistance programmes, the key question is whether they will be forced to adopt new measures given that they are likely to miss their current deficit reduction targets,” said the report.

In the United States, the report noted, the full impact of the fiscal cliff was averted when an agreement was reached in March over the Bush-era tax cuts, extending most but not all of the cuts. But Congress failed to agree on a new deficit reduction plan, triggering automatic, across-the-board spending cuts (sequestration) worth $1.2 trillion over the next nine years. For the remainder of fiscal 2013, this is estimated to result in a cut of $85 billion.

According to the report, in the baseline outlook, it is assumed that the sequestration will be replaced at the end of the current fiscal year (September 2013) by a new agreement with a combination of some tax increases and lower spending cuts than in the sequestration. It is also assumed that Congress will increase the debt ceiling in May 2013.

Significant uncertainties and risks remain, however, said the report, adding that political gridlock may result in a failure to raise the debt ceiling and the sequestration may continue into 2014 and beyond. An additional risk is that the private sector proves to be less resilient than expected to the sequestration.

“If any of these transpire, economic growth in 2013-2014 would be much lower than projected in the baseline. Policy impasse and more fiscal tightening could erode consumer and business confidence, leading to weaker consumer spending, business investment and hiring. This, in turn, could undermine the recovery in the housing sector.”

Many large developing countries, including Brazil, China, India and the Russian Federation, saw a significant deceleration in GDP growth in the past two years, owing to a combination of weak external conditions and domestic impediments. In the baseline outlook for 2013-14, growth in these economies is expected to strengthen in some cases, such as Brazil and India, and to stabilize in others, such as China.

For some economies, however, the risk of a further considerable slowdown in growth remains, the report said, noting, for example, that in China, “economic activity moderated again in the first quarter of 2013, with growth slowing to 7.7% year on year and 1.6% quarter on quarter. While the baseline forecast projects growth to stabilize between 7 and 8% in the coming years, the possibility of a slowdown to about 5% cannot be ruled out.”

Macroeconomic policy stances

The report further notes that the fiscal stance in most developed economies, with the salient exception of Japan, is expected to continue tightening in 2013, although the degree of tightening is expected to ease in some countries in 2014.

The fiscal challenge for policymakers in most developed countries is to support a solid recovery in output and employment in the short run, while at the same time ensuring the sustainability of public finances in the long run. According to recent studies, the negative effects of fiscal tightening on output and employment in the current economic environment are much larger than originally estimated, particularly when a group of countries tighten their fiscal policies simultaneously.

“Therefore, for those countries facing low financing costs and high unemployment, it would be desirable to postpone fiscal tightening until the economy has recovered. At the same time, policymakers should lay out a credible plan for fiscal sustainability.”

By contrast, most developing countries and economies in transition are expected to adopt a relatively neutral fiscal stance, with mild tightening in some countries, such as Brazil and the Russian Federation, and a moderate expansion in others, such as China and the Republic of Korea.

The report noted that major developed economies have recently strengthened their monetary policy measures, both quantitatively and qualitatively, in an attempt to offset the negative effects of tighter fiscal policies on output and employment. Policy interest rates in these countries are expected to remain at or close to zero in 2013-14.

The central banks will continue to implement large-scale asset purchasing programmes, the report said, further noting that a new key feature of these policy measures is the open-ended strategy, which sets neither the total amount nor the duration for asset purchases. This strategy seems to have worked better than earlier intermittent approaches in providing a more stable anchor to financial market expectations.

“Major challenges for monetary policy in the developed economies lie ahead. One of them concerns when and how to unwind the large-scale asset purchasing programmes with a view to keeping inflation in check and avoiding risks of financial instability.”

For instance, said the report, the purchases may support delays in balance sheet cleanups in some banks, lead to excessive increases in asset prices and boost leverage- and risk-taking. The unwinding of securities held by the central banks could then trigger an abrupt increase in long-term interest rates resulting in losses for bond holders and a reversal of asset price rises.

“The central banks should therefore have a forward-looking mechanism to mitigate possible financial instability when those unconventional measures end. They should also develop a sound exit plan for the medium term and provide effective forward-guidance to anchor inflation expectations.”

According to the report, the monetary stance varies across developing countries and economies in transition. Most recently, several of these economies, for example, India, have reduced interest rates to counter the growth deceleration, while others, such as China, have mainly relied on liquidity operations without reducing policy interest rates.

“A common challenge for monetary authorities in developing countries and economies in transition is to deal with the spillover effects of unconventional monetary easing by developed countries, such as increased volatility in capital inflows and international commodity prices and appreciation pressures on local currencies.”

In some cases, the report concludes, the policy authorities may have to resort to controls on short-term capital inflows and macroprudential measures. (SUNS7621)   

Third World Economics, Issue No. 549, 16-31 Jul 2013, pp7-9