Better Global Growth Prospects, But Mind the Policy Uncertainties

Citi GPS Opinion Article

28 January 2013 – With improving financial conditions and giving some credit for ongoing plus future policy stimulus, we are raising our forecasts for advanced economy growth by 0.1% in 2013 and 2014, to 1.0% and 1.6%, respectively (measured at current exchange rates). The main upward revisions are for the US and Japan, whereas we continue to expect GDP in the euro area to fall in both 2013 and 2014 and have cut our forecasts for various smaller economies (UK, Sweden, Australia, New Zealand). For 2013, the advanced economy upgrade is offset by a slight downgrade to our emerging market forecasts to leave our global growth forecast at 2.6%, while we are edging up our 2014 global growth forecast from 3.1% to 3.2% (at current exchange rates). Our forecasts imply that, despite modest advanced economic growth, global growth in 2013-14 will be close to the average of the last 30 years (2.9% YoY at current FX rates).

We revise up our US growth forecast by 0.3% for 2013 and 0.1% for 2014 (to 1.9% and 3.1%, respectively) reflecting the continued improvement in domestic demand in the fourth quarter of 2012, supportive financial conditions and the reduced fiscal-cliff risks of heavy early fiscal tightening. With the drag from private deleveraging easing and a clear recovery seen in housing, we continue to expect that US growth will rise to a seasonally adjusted annual rate of about 3% QoQ in the second half of 2013 and again in 2014. At the same time, we lift our Japan growth forecast by 0.6% for 2013 and by 0.5% for 2014 (to 1.3% and 1.2% respectively), reflecting the recent yen depreciation and the large economic stimulus package, centered on public works spending, announced earlier this month. This is the biggest upward revision to our Japan growth forecast for the current and next year from one month to the next since 2004.

With some easing of financial strains, we also edge up our 2013 euro area growth forecast by 0.1%, although we continue to expect that the euro area will remain in recession this year and in 2014, with GDP falling by 0.6% this year and by 0.4% in 2014. Our forecast implies that the gap between US and euro area growth this year will remain similar to 2012 (2.7%), which was the widest gap since the early 1990s. Against this background, we have notable forecast downgrades to a range of smaller economies, including the UK, Australia, New Zealand and Sweden. Our emerging market growth forecasts also are a bit weaker for 2013, with downgrades to our forecasts for Brazil, the Czech Republic, Hungary, Russia and Venezuela offsetting slight upgrades for Nigeria and South Africa.

A Leveling Off in China Driven by Industrialization

After last year’s slowdown, China’s economy appears to have picked up slightly in recent months, and we continue to expect growth to level off at 7-8% this year and each year to 2017. Both monetary policy and credit supply have been loosened, and — while the working age population is now falling — productivity growth continues to benefit from catch-up industrialization and modernization. China’s labour productivity growth (GDP per person employed) has averaged 8.9% YoY over the last five years — the highest of any country — and even though it slowed to 7.4% YoY in 2012, it remains extraordinarily high compared to other countries (exceeded in 2012 only by Nigeria) (1) . We expect China’s productivity growth will remain high by global standards for many more years to come. In addition, real GDP per person employed has risen to 17% of the US level in 2012, from 6% in 2000 and 9% in 2005. But, China’s relative GDP per person (i.e., real GDP per person in work as a percentage of the US level) is about the same as that of Japan in 1950 (19%), or Taiwan in 1965 (18%) or Korea in 1970 (18%) — and the industrialization booms of those countries continued to produce rapid productivity gains for several decades. For comparison, among the Western Europe an economies, the least productive economy is Portugal, with real GDP per person in work at 47% of the US level.

While we have doubts about the long-run viability of China’s investment-intensive growth mix, we aren’t convinced that this mix has yet hit its limits. Total factor productivity growth, a measure of an economy’s long-term technological change, remains quite strong at about 2% YoY, whereas this growth number in the US and euro area during the pre-crisis boom was close to zero or negative, reflecting over-investment and the poor allocation of resources. It is unclear whether China’s GDP per person will ever fully catch up with Korea (61% of the US level) or Taiwan (78% of the US level) — let alone the US — but we suspect that the industrialization and modernization boom will continue for many more years. In turn, China’s rapid growth is likely to sustain demand for commodities, and spill over into relatively high growth in countries and companies with strong export exposure in China.

Saving the Euro is only Part of the Euro Crisis

The “Draghi put”, a term used to describe the accommodative monetary policy enacted by Mario Draghi, President of the European Central Bank (ECB), continues to help ease euro area financial strains, and in turn has helped improve some recent economic surveys. However, saving the euro is not the same as ending the euro crisis and achieving a return to normal growth. The underlying economic problem is that overall euro area nominal growth is weak and periphery economies face additional powerful headwinds from private deleveraging, poor credit availability and a heavy fiscal drag. Export gains are unlikely to be large enough to achieve sustained economic recovery in periphery economies. Hence, we continue to expect that economic weakness will cause fiscal deficits and public debt ratios in periphery economies to stay high and generally to overshoot official forecasts. Even in Ireland, which has the advantages of extreme openness (exports above 100% of GDP) and supply-side flexibility, the economy is capped by the “patent cliff” in the pharmaceutical sector (pharma accounts for 33% of Ireland’s total industrial production and 36% of manufacturing output) and sharp patent-related declines in industrial production probably caused GDP to fall in the fourth quarter of 2012.

The time bought through the “Draghi put” will not, we expect, diminish the challenge faced by the periphery economies. Rather, as the period of economic underperformance extends, potential growth in periphery economies is likely to stay low and leaving these countries with shrunken tax bases on which to finance their elevated debt ratios. Foreign investment and — increasingly — people continue to exit periphery countries. Eurostat reports that, in the third quarter of 2012, the population of working age fell by 0.7% YoY in Ireland and Spain, by 0.9% YoY in Portugal, by 0.2% YoY in Italy, and by 0.1% YoY in Greece. At the same time, date from the Bank of International Statistics (BIS) show that the exposure of foreign banks to periphery economies continues to fall rapidly, with exposure to each of Italy, Spain, Portugal, Ireland and Greece down by more than 10% YoY and by more than 50% from the recent peaks. In turn, even though financial market strains have eased and bank lending rates to non-financial companies (taking loans up to €1million) in Germany hit a record low in November, bank lending spreads over Germany are still higher than a year ago in Ireland, Portugal, Spain and Italy.

For now, we continue to assume that Spain and Italy will probably enter some form of European Stability Mechanism (ESM) programme (most likely a conditionality-light enhanced condition credit line (ECCL) programme) during this year, although the timing is uncertain. Ireland probably will get a second programme (again, most likely an ECCL), which (along with evidence of market access) would be enough to activate the ECB’s Outright Monetary Transaction (OMT) facility (i.e. purchases in secondary and sovereign bond markets of bonds issued by eurozone member-states). Portugal probably will get a full second programme, and some form of rescue package probably will be agreed for Cyprus this year. But, longer term, we expect that European Monetary Union (EMU) financial strains will recur, perhaps late this year. Our base case remains for eventual Grexit and, further down the road, sovereign debt restructuring across a wider range of euro area countries, including Italy, Spain, Portugal and Ireland. It is possible that Ireland could achieve sufficient debt relief through restructuring its Promissory Notes and official loans alone, but recent proposals to merely limit the coupon and slightly extend the maturity of these debts may not be enough to achieve fiscal sustainability.

Expect Monetary Policy to Loosen Futher in Advanced Economies

Against this backdrop, we expect monetary policy to loosen further near-term in the main advanced economies and to stay loose for an extended period. But, as well as the usual economic uncertainties, there also are big uncertainties over the policy outlook in main advanced economies.

* In Japan, the Bank of Japan (BoJ) has committed to a new 2% inflation target, and announced a larger asset purchase program. However, at present we do not expect that the BoJ’s actions will be enough to achieve 2% inflation on a sustained basis in coming years. And yet, it is always possible to lift inflation if policymakers are prepared to do “whatever it takes” (which, in Japan’s case, would probably include a weaker yen). A key risk to our forecasts is that the BoJ and Ministry of Finance (MoF) might actually genuinely set policy to achieve sustained 2% inflation, hence most likely including more monetary easing (including yen weakness) and fiscal loosening than our base case — and also lifting growth further.

* In the US, the Federal Reserve has clearly signaled its intention to keep policy loose for an extended period, but there are major fiscal uncertainties. So far, it seems likely that the three-part challenge of the debt ceiling, the sequester and spending authority for the balance of fiscal 2013 will be hurdled in a minimalist way with a minor deal or deals. As of this writing, the House is set to vote imminently on legislation that would suspend the debt ceiling, allowing the Treasury room to borrow what it needs through mid-May with conditions. The measure would serve the dual purpose of defusing the most pressing default issue and focus the debate on spending discipline. Our forecast assumes that the static fiscal drag from policy changes this year will amount to about 1% of GDP. But, risks remain that political disagreements could yet prompt heavy early fiscal restraint that scuppers what is otherwise likely to be a steadily strengthening recovery.

* In the euro area, we assume that the ECB will do whatever it takes to save the euro, and that Germany will try to avoid creating financial market strains before the late-2013 general election. Eventually, however, the creditor nations will probably have to choose between lasting fiscal burden-sharing with the periphery, or sovereign debt restructuring. Over time, we expect the creditor nations will become increasingly unwilling to continue to support periphery countries, and hence expect greater eventual acceptance of sovereign debt restructuring. We do not believe that debt restructuring will cause the euro to split: indeed, we believe risks of EMU disintegration would eventually be greater if debt restructuring does not occur. Clearly, though, the timeline of debt restructuring is very uncertain and probably distant. Indeed, if euro policymakers believe that debt restructuring would irrevocably fracture the euro, then they may continue to do “whatever it takes” to avoid it — which eventually would have to mean a greater move towards debt mutualisation.

* In the UK, the Monetary Policy Committee’s (MPC’s) target and tools might both change once Mark Carney takes over as Bank of England Governor from mid-13. We believe there is a decent chance that the Chancellor will alter the 2% CPI inflation target to a 1-3% band, with the MPC tasked to usually aim for the centre of the band. Most inflation targeting central banks have a target range and central tendency. It has the advantage (like nominal GDP targets) of helping the central bank downplay modest but persistent inflation undershoots/overshoots if economic conditions justify, without the downsides of nominal GDP targets (lags in data publication, data revisions, need to change the nominal growth target as potential growth estimates change). We also expect that, under Carney, the MPC will start to give Fed-style guidance that rates are likely to stay low for a long time given the economic outlook. A cut in the Bank Rate may also be back on the agenda. Quantitative easing which is likely to resume, probably will continue to be focused on gilts rather than private sector assets.

For more information, please refer to the report Global Economic Outlook and Strategy: January 2013 dated 23 January 2013 on Citi Velocity.

(1) Source “2013 Productivity Brief ”, US Conference Board, January 2013, and associated global database.