BY OTAVIANO CANUTO.
8th January 2014
The global economy looks poised to display better growth performance in 2014. Leading indicators are pointing upward – or at least to stability – in major growth poles. However, for this to translate into reality policymakers will need to be nimble enough to calibrate responses to idiosyncratic challenges.
Consider the United States. Job creation has accelerated since last August. Household debt is now US$800 billion less than at the end of 2008, due to liquidation or refinance at lower interest rates. The current housing recovery does not seem exhausted as demand is expected to outstrip the pipeline of housing starts this year. Non-financial corporations have plenty of cash, empowering them to respond to improved prospects. Finally, the agreement in Congress on the federal budget for 2014-15, together with the political weakening of the opposition to adjustments of the public debt ceiling, point to an easing of the fiscal drag that harmed the US recovery last year.
But even with these positive factors there is a challenge as the Federal Reserve starts unwinding its “quantitative easing” (QE), beginning this month with a reduction of US$10 billion in its monthly asset purchases (currently at US$85 billion). Notwithstanding the limited size of this change – when matched with the US$2 trillion of assets currently held by the Fed – as well as Fed’s “forward guidance” signaling that basic interest rates will remain low for an extended period, the initially muted reaction in bond markets was followed by 10-year Treasury yields crossing the 3% mark at the end of 2013. As 2-year yields also climbed, markets seem to believe that the Fed will be obliged to speed up the unwinding. The Fed thus must be sure to strike the right balance of actions and communication so as to avoid precocious interest rate hikes which could harm the recovery.
In the Euro-area, perceived risks of a currency breakdown and a financial and economic collapse have receded substantially. Despite sticky high levels of unemployment in crisis-ridden countries, the European Central Bank (ECB) forecast of 1.1% (GDP growth) plus 1.1% (inflation) for 2014 has been taken as a signal that the bottom of the crisis has been left behind.
The crisis still casts some shadows, however. The implementation of structural reforms in several member countries has fallen short. The public and private debt legacy in those countries still remains tall. Furthermore, the Euro-area institutional framework, which has now been fully recognized as essential, has not yet been refurbished enough. While the time horizon for tackling these issues will necessarily be long, there is a major immediate task to be faced by policymakers: the health check and prescriptions to which their banks will be submitted this year.
The vicious circle between fiscal fragility and national banks’ balance-sheet deterioration that plagued crisis-ridden member countries has been broken, thanks to fiscal adjustment programs and, especially, the ECB’s promise “to do what it takes” to impede a collapse. Nevertheless, the resurgence of bank credit to the private sector – particularly to small and medium enterprises – will be fundamental to consolidate the recovery. Such resurgence will only take place when banks are once again able to be funded and create credit at interest rates much lower than currently available. Therefore the Euro-area major policy challenge will be to calibrate the “asset quality review”, stress tests, and new capital requirements making them tough enough to ensure that the exercise is credible, while simultaneously avoiding spooking markets.
China will also face the challenge of appropriately calibrating the implementation of its structformural re package. Higher penetration of non-state firms in several sectors, including the banking system, will require some slackening of regulation and phasing out interest-rate controls. Prior to that, however, the central government will need to rein in subnational finance and the “shadow banking” through which local governments have splurged on infrastructure and real estate spending in the last few years. Results from a public debt audit were released last month, showing that the debt of localities had risen 67% from the end of 2010 to June 2013. In that context, another important consideration when looking ahead is to remember the interbank market turmoil of December, which only ended when the Central Bank of China conceded to providing liquidity. This illustrated that authorities will have to step cautiously— a stone at a time— to cross the transition river, if an economic growth collapse is to be avoided.
Meanwhile, tax policy will be a key policy challenge in the case of Japan. Aggressive fiscal and monetary stimuli implemented during Prime Minister Abe’s government have jolted Japan’s economy out of its deflationary lethargy. However, Japan’s public debt has climbed to levels around 250% of GDP. As part of the solution, the consumption tax will be hiked to 8% from 5% in April. There is also a scheduled decision in next November on whether to additionally increase it to 10% as of October 2015. It will be crucial that such a higher tax burden does not countervail the overall anti-deflationary direction of macroeconomic policy.
Finally, there is the case of emerging economies coping with the actual unwinding of QE. Last summer – in between Ben Bernanke’s testimony to the US Congress in May, when he alluded to the eventual unwinding of the currently third round of QE, and the Fed meeting in September postponing its beginning – the so-called “fragile 5” (Brazil, India, Turkey, Indonesia, and South Africa) underwent massive capital outflows and large currency depreciation. Some analysts referred to that turmoil as a potential revival of the emerging-market crises of the 1990s. Those countries shared in common the presence of large, liquid, and integrated financial systems, as well as current-account deficits associated with substantial capital inflows and currency appreciation since the beginning of the US “unconventional monetary policies.”
Now that the unwinding is really starting, the baseline scenario is not one of a repetition of the turbulence, since changes in asset values, exchange rates, and investors’ positions have not reverted. The unwinding is to some degree already priced in. On the other hand, four of the “fragile 5” (Brazil, India, Turkey, and Indonesia) will have major elections in 2014. As they still remain vulnerable to sudden stops in capital flows, their macroeconomic performance will depend on the calibration of their macroeconomic policies and on political risks.
The bottom line is this: there is room for optimism about the global economy in 2014. The key is to temper this with caution given that the success of the global economy will hinge on policymakers’ ability to strike the right balance in several key parts of the world.