View the Moody's Analytics' Global Forecast.
- Despite Europe's slow recovery and changing capital flows, the global recovery is not in jeopardy.
- Capital outflows have hit emerging market currencies, but should not cause a new financial crisis.
- Emerging markets are in better shape than in the past, with more reserves and flexible exchange rates.
- The euro zone, with its struggling southern members, is still the main drag on global growth.
The global economy remains on the mend, with Europe as a whole out of recession, though still recovering slowly. The latest tremor is a sharp decline in the value of many emerging market currencies, but this is less ominous than it looks. With North America improving slowly but steadily, the main risks emanate from the debt-ridden European economies and some larger emerging markets—but not because of the sudden drop in currency values. The adjustment was expected as global interest rates rebalanced, and by itself should not halt the global recovery. The shock to emerging market economies may indeed be temporary; currency markets tend to overshoot. The Federal Reserve and other major central banks will be careful to avoid a repeat of 1981-1982, when drastically higher U.S. interest rates triggered a Latin American debt crisis.
The long-awaited increase in U.S. interest rates, heralded by the slowdown in long-term bond purchases by the Fed, nevertheless seemed to catch many governments by surprise, and belied financial markets' supposed ability to anticipate policy changes. Currency values for emerging markets other than China fell gradually through the second half of 2013, and the decline accelerated in January.
Argentina's central bank was forced to stop supporting its currency as its own foreign-currency reserves dwindled, causing a 20% drop in the peso's value late in the month. Despite avoiding similar mistakes, other emerging economies have also seen their currency values decline. The main exception is China, whose capital controls shield the yuan from currency fluctuations.
A drop in many currency values was inevitable, however, as a natural consequence of economic recovery in the U.S. The Fed's decision to withdraw its aggressive monetary stimulus could have easily been predicted, along with the resulting shift in short-term capital flows from the U.S. and Europe to Brazil, Mexico, Turkey, India, and other large emerging markets.
Since most emerging market economies no longer maintain fixed exchange rates and have accumulated substantial foreign-exchange reserves, speculative attacks on their currencies are less likely than in the past. Steady currency depreciation is still in view, however, for much of the coming year as U.S. interest rates climb back up. With less capital flowing in to pay for imports, emerging markets will also be increasing their current account surpluses. The important question is whether there will be any generalized financial crisis as a result of this adjustment.
So far, that looks unlikely: Besides China, no large emerging economy has seen a massive buildup of private sector debt nor seen asset or property price bubbles similar to those in the U.S. before 2008. It was unavoidable that increased capital inflows would increase foreign debt and make balance sheets more fragile, but the lack of unsustainably large capital inflows to any single emerging economy in the last three years is helping maintain stability at a difficult moment.
China is the exception to trends in emerging markets, primarily because its capital controls prevented large inflows of short-term external debt, but also because its financial system is closely linked to the government and it has a huge stash of foreign-currency reserves. Yet China, too, is in transition, and a buildup in domestic credit over the past years could yet produce a hard landing. So far, the data point to slower growth but not a crisis. Industrial production growth has moderated but is still rising 19% per year, while fixed capital formation is growing 10% year over year, compared with twice that at the start of 2010.
So far, neither the slowdown in investment nor the climb in interest rates, especially for the benchmark Shibor, has led to financial repercussions. Financial firms in China seem reassured by the Peoples Bank of China's willingness to intervene to make sure banks meet counterparty obligations. Despite the temporary spike in rates, there has been no extended freeze in credit that could seriously damage the economy.
Aided by large trade surpluses, China seems to be managing the shift from fixed investment-led growth to a consumption-led model with minimal fallout. This is not necessarily reassuring to other emerging economies, as slowing growth in China also puts downward pressure on global commodity prices. Mineral exporters such as Chile and Peru will have to adjust, if not in the coming year then over the longer term, as China slows to more sustainable growth rates.
Tethered to the euro
Although the euro zone recorded weak growth in 2013 after contracting in 2012, Europe's core economies continue to lag and drag on global growth. The output gap is still large: Euro zone unemployment is at 12% but is twice that rate among the currency union's southern member states such as Greece and Spain. Not surprisingly, business confidence and coincident economic indicators have barely started to nudge upward. The U.K., the largest non-euro zone economy, is still convalescing, recording better growth than the euro zone, but this is not an especially high bar.
The main worry is whether such slow growth will be sufficient to hold the euro zone, or even individual countries, together if high unemployment and excess capacity persist. Separatism has flared up in both Scotland, which plans a September referendum on leaving the U.K., and Catalonia, which is threatening to do the same regarding independence from Spain. Even if those efforts fail, high unemployment, slow growth and possible deflation increase political risks. High unemployment in Greece, Spain and Italy will eventually raise pressures that threaten the euro zone, bringing parties into power that are less committed to austerity and debt service.
Southern Europe's malaise also puts downward drag on the northern European economies. France shows little sign of accelerating its growth, and even Germany, for all its export prowess, has slowed since 2011.
Cautious optimism, but big risks
A careful assessment of the situation finds no imminent danger, either in emerging market economies or in Europe, despite less than optimal conditions in both cases. North America and China will drive global growth. Latin America is performing unevenly, with stable if slowing growth in Brazil and a slightly improved recovery in Mexico, despite the traditional post-election slowdown. But Venezuela and Argentina still have supply-side constraints, high inflation and unstable politics. Emerging Asian countries outside of China also face a period of adjustment to reduced capital inflows and slower demand growth from China, but this should not lead to recession and may not even cause a slowdown, thanks to improved outlooks in industrialized countries. Japan, in particular, looks set for steadier if slow growth thanks to the government's determination to pull the economy out of deflation.
The downward pressure on currencies will lead neither to recession nor to financial crisis, even though it has eroded business confidence in India, Mexico and Argentina. Countries such as Brazil will see slower growth due to tighter external constraints, while India will not accelerate as rapidly as it might have if short-term capital had continued to pour in. Since many emerging markets were showing signs of overheating, the change in global capital flows is a step in the right direction.
The outlook thus calls for moderate global recovery, but with downside risks, led by adverse political instability in Europe and financial instability in China. Other risks are receding: A new confrontation over the U.S. debt ceiling is less likely, and the largest economies in Latin America and developing Asia no longer suffer from external debt overhangs. Despite many policy mistakes, the world economy is in better shape than three years ago, and is likely to improve further this year.
Andres Carbacho-Burgos is an Economist at Moody's Analytics.
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