Catalog

Global Outlook

Financial market turmoil

Adjustments in real economic activity are now in train. As new economic data are released, pundits have been revising down their estimates of growth. In January 2008, the International Monetary Fund (IMF) cropped its growth forecasts for the G3. Consensus forecasts of growth for the three main economic blocs have tracked steadily down through the March 2008 release (Figure 1.1.6). The baseline ADO 2008 assumptions in Table 1.1.1, anchored in IMF analysis, were last updated in mid-February and more recent news would possibly warrant cuts to these growth estimates.

The global economy's health has taken a turn for the worse. What initially appeared in mid-2007 as a domestic problem in the US housing market has now infected the broader financial system in the US and in Europe and is spilling over into the real economy worldwide. The discovery of substantial credit risks camouflaged by complex, collateralized securities has exposed highly leveraged investors to substantial losses and in some cases led to insolvency. Problems are no longer confined to the "subprime" mortgage market. Troubles are amplifying and spreading—and are yet to run their full course. Nobody cares to predict what may still turn up.

Initially, much of the pain centered on banks whose balance sheets were forced to shelter the damaged assets of their (unregulated) investment entities (so-called structured investment vehicles). This sapped bank liquidity and required fresh equity to replace depleted capital. Difficulties ensued in the short-term money markets and markets for commercial paper as potential lenders lost confidence in borrowers' ability to repay and in the true value of the collateral that they had pledged.

Now, troubles have overwhelmed non-deposit-taking (investment) banks. Balance sheets that had been puffed up on leverage and inflated asset values have been badly punctured. As investors have sold into a falling market to limit losses and to meet collateral requirements on their leveraged portfolios, they have succeeded only in tipping the market further down and raising broader market risks. The ability of all but the most creditworthy borrowers to refinance has been seriously impaired and, as investors dump assets whose values can no longer cover their debts, defaults are rising. Insurers that had acted as guarantors against default—"enhancing" credit quality and transferring risks—are now facing steeply rising claims and are scrambling to replenish their capital. As the New York Federal Reserve has warned, an unstable dynamic has been unleashed that threatens the functioning of the US and other funding markets.¹

Alarmed by clear risks to the financial system, and a rising probability of recession, the US Federal Reserve has slashed its target policy interest rate. Since its peak in September 2007, the Fed Funds rate has been gouged by 300 basis points (bps) in only 5 months (Figure 1.1.7). In the eurozone, where there had been an expectation that interest rates would track up in 2008, short-term policy rates are on hold despite inflation reaching a 14-year high of 3.3% in February. The prospects of rapid slowing mean that a cut in eurozone rates in 2008 cannot be ruled out. A cut in yen interest rates, inconceivable only a few months back, is also possible (Figure 1.1.8).

Yet despite aggressive US Fed Funds rate cuts, credit spreads have widened in the US and the flight to cash and high-quality securities has persisted (Figure 1.1.9). Even qualified borrowers are having difficulty in obtaining funding as banks buttress their liquidity against the possibility of losses. Confidence about the solvency of counterparties continues to ebb despite substantial liquidity support to markets.

Efforts to support the functioning of money and funding markets are now being closely coordinated among the central banks of the G10 economies. Efforts outside the US have focused largely on ensuring liquidity in the interbank market and in the eurozone dollar market. But most of the action has been in the US where the Federal Reserve has taken unprecedented steps to extend support to "primary dealers" (all of which are nondepository financial institutions) as well as to banks. On 16 March, the discount window was opened to primary dealers, providing unlimited credit in return for pledges of investment-grade collateral, with credit being extended up to 30 days. In some ways, the Federal Reserve is now acting as a lender of last resort to nondepository financial institutions that may be facing difficulties in the wholesale funding markets. At each step, the Federal Reserve has relaxed conditions on collateral and pricing and extended greater flexibility on maturity. Through a substantial guarantee to JP Morgan, the Federal Reserve has also in effect underwritten the acquisition of Bear Stearns, the US's fifthranking investment bank, after it became clear that Bear Stearns was in all likelihood insolvent.

In this complex and dynamic environment, there is considerable dissonance about the outlook and appropriate policy responses (Box 1.1.1).

United States

News coming out of the US economy points to a slowing of demand in the first months of 2008. There is no end in sight to the rout in the housing market. Foreclosures are rising, housing starts are in free fall, inventories of unsold units are piling up, and house prices continue to tumble (Figure 1.1.10). Difficulties have now spread beyond housing into the wider economy. Institute for Supply Management indexes (Figures 1.1.11 and 1.1.12) show that, despite an uptick in the nonmanufacturing index in February, both manufacturing and nonmanufacturing indexes signal contraction. A variety of other survey data paint much the same picture. The University of Michigan Consumer Sentiment index (Figure 1.1.13) was at a 5-year low in March. A contraction in February's retail saless has confirmed these early warning signals. To say the least, producers and consumers in the US are in a highly cautious mood.

Labor market indicators, which often lag other developments, are now weakening as well. March 2008's data release from the Bureau of Labor Statistics shows a reduction in nonfarm seasonally adjusted payrolls between January and February of 63,000. This is the largest drop since March 2003. Most sectors in the US economy, other than public services, are shedding jobs. Private sector job losses in February exceeded 100,000. Earlier payroll numbers for January and December were also revised down, confirming the downward trend in employment. The US unemployment rate has so far held firm but only because workers who have become discouraged in their search for work are leaving the labor force.

Rising headline inflation, stoked by increases in gasoline and to a lesser extent food prices, is taking cash out of households' wallets. Real disposable income is probably falling and data also show a decline in household financial and real estate wealth (Figure 1.1.14). These trends cast a pall over prospects for consumption in the first half of 2008. Fiscal measures will put about 1% of GDP into taxpayers' pockets from the second quarter and easier credit conditions—if in fact interest rate cuts work (Box 1.1.1 above)—are expected to provide a fillip later in 2008. Growth of net exports could also provide important near-term support for aggregate demand.

Hunches about the depth and duration of the slowdown for the rest of 2008 (and possibly through 2009) diverge widely. The most recent labor market data and weaknesses in consumer sentiment both signal a distinct possibility of a contraction in output. The key to the near term is likely to be determined by how credit markets function. If they seize up and therapies work slowly, the expected recovery later in 2008 and in 2009 may not even materialize. Core as well as headline inflation is now showing a rising trend and yields on inflation-protected securities suggest that underlying inflation expectations are rising (Figure 1.1.15). A conjunction of rising inflation expectations and further deterioration in the real economy would undoubtedly make the Federal Reserve's job even tougher, and could limit scope for interest rate cuts.

Eurozone

Financial troubles have reverberated across the Atlantic. Though Europe has not experienced a subprime mortgage crisis, its banks have taken losses as subprime securities prices have fallen. In Germany, three small local banks have failed. Lending has tightened and market rates have risen.

Recent signals from the real eurozone economy are mixed. GDP growth slowed in the fourth quarter of 2007 but then, following 2 months of weak data, industrial production jumped in January (Figure 1.1.16). Germany's export performance has held up well and the business mood is buoyant.

Business confidence in other European countries is not quite so perky, and the eurozone-wide confidence index dipped in February. Other signals are mixed. Although labor market conditions have improved, as unemployment rates continue to inch down, consumer confidence has plummeted (Figure 1.1.17). Indicators of the outlook for the services sector are distinctly gloomy. Inflation is now running at its highest level in 14 years, reaching 3.3% in February. Rising fuel and food prices are adding to inflation and there are concerns that rising wage costs may aggravate inflation pressures.

Growth in the eurozone in 2008 is likely to fall significantly below the outcome in 2007 (2.6%). In March, the European Central Bank (ECB) cut its own projection for 2008 to 1.7% from its earlier forecast of 2.0%. The European Commission's estimate and a range of private sector forecasts are also drifting down. A variety of troubling developments, including the real appreciation of the euro, is likely to restrain output growth. That said, the probability of a recession in the eurozone seems more distant than in the US.

The dependence of Europe's exports on demand in the US is hotly debated. One line of thought is that declining dependence on the US market—only 7% of Germany's exports now go there—and diversification toward Asia and oil exporters mean that, as Germany's exports uncouple from the US, so too will Europe's (Figure 1.1.18). It is for this reason, so the argument runs, that robust export growth has continued despite the appreciation of the euro against the dollar.

Recent research by Deutsche Bank,² however, pours cold water on this thesis. Over a protracted period, Germany's exports have closely tracked broader measures of price competitiveness and there is no reason to think that this relationship is about to break down. Moreover, exports from other eurozone economies, including Italy and Spain, appear to be much more sensitive to the value of the euro than Germany's. In real effective terms, the euro appreciated by 5% in 2007 (Figure 1.1.19). As the impact of the euro's appreciation on exports and industrial output passes through to prices, the support that exports have provided to growth is likely to dissipate. Also, if the US slowdown percolates through to moderation of growth in other regions, this impact will be transmitted indirectly to the eurozone.

Other factors—including high oil prices; housing market troubles in countries such as Ireland, Spain, and the United Kingdom; and rising wage cost pressures in Germany—may also weigh on demand and growth in Europe. There is a risk, too, that credit market conditions will tighten further. Continental European businesses are highly dependent on bank finance and through this channel are exposed to credit market troubles. The full extent of European bank exposure to the credit market crisis is not yet known.

On a brighter note, if unemployment continues to fall and consumption sentiment turns around this may provide some favorable economic ballast. But labor market conditions cannot swim against broader economic currents indefinitely.

Policy support for eurozone growth in 2008 is likely to be limited. Fiscal options are theoretically constrained by agreements under the Stability and Growth Pact, and the ECB seems unlikely to cut interest rates until it sees hard evidence of economic slowing and retreating inflation expectations. Though the ECB has now softened its hawkish rhetoric on the inflation outlook, monetary policy adjustments, when made, are very unlikely to emulate the aggressive and anticipatory movements of the Federal Reserve.

Japan

Despite unexpectedly strong fourth quarter GDP growth in 2007 (3.5% measured on an annualized basis), trouble is brewing in Japan too.

Several factors are weighing on Japanese prospects. Most immediately, export demand, which has been the mainstay of growth, is likely to be constricted by a slowdown in global economic growth. The US is still a large market for Japan, accounting for over 30% of its exports when indirect demands are taken into account, and the slowdown there as well as in Europe will curtail demand. Robust growth in developing Asia may help, but it too is expected to moderate.

A cheap yen has been one of the major factors supporting Japanese export growth in the past, but its recent sharp appreciation will likely dent exports (Figure 1.1.20). In trade-weighted terms, the yen appreciated by 10% in the 6 months to January 2008. Early indications of export slowing are already appearing. As measured in the Purchasing Managers Index, export orders fell below 50 in February, their lowest level in 3 years, indicating probable future contraction. However, the slowdown is not yet apparent in actual exports, with growth of 8.7% in February.

Domestic demand is unlikely to replace exports' contribution to growth. Residential construction growth is still in negative territory following regulatory changes in 2007, though this one-time reduction in the level of demand should begin to fade from growth statistics in the second quarter. There may even be catch-up of residential investment, deferred in 2007, if the mood among households holds up, but the corrosive effects of a rising yen and raw material prices on industrial profits are likely to subdue nonresidential investment. Nevertheless, if there is a bounce after the housing-induced contraction in 2007, fixed investment may grow in 2008.

Japanese consumers continue to have little appetite for spending. Consumer confidence is at a 3-year low (Figure 1.1.21). Real wages are barely growing, if at all, and hours worked are now beginning to dip. In a context of considerable fiscal uncertainty and an aging population, Japanese households are saving industriously for retirement. Equity prices, often a good barometer of the Japanese consumer's mood, are tumbling (Figure 1.1.22). With the prospect of stagnant disposable incomes and declining wealth, it seems that consumption growth will decelerate in 2008.

Japan is still struggling to reduce its public debt, limiting the scope for fiscal measures in support of growth in 2008. Likewise, there is little wiggle room for monetary policy with interest rates hovering close to the nominal floor of zero. In these circumstances, Japan's growth too is likely to slow in 2008. The Japanese Government has itself recently downgraded its growth forecast and is now expecting growth of just 1.3% this year.³

Summary

These are highly uncertain times for the global economy. Forecasts vary widely for just how difficult the next 12–24 months could be. The variance of macroeconomic growth forecasts of GDP has widened (Figure 1.1.23). One concern is that the absence of a reliable economic compass may heighten the risk of policy mistakes. Another is that the complex nature of the problems in credit markets and the changes wrought by financial innovation may render orthodox monetary policy ineffective.

In this environment, it is particularly important to keep close to rapidly developing events and to revise judgments in light of new information. The most significant departure from earlier assessments is that ADO 2008 now expects a coincident slowdown in the US, Europe (including the UK and some other non-eurozone countries), and Japan in 2008, possibly extending into the early part of 2009. Whether these slowdowns eventually materialize in the data as technical recessions (two consecutive quarters of contraction) is still an open question—certainly in the eurozone and Japan—but their coincident nature will definitely limit opportunities for Asian producers to switch to new markets. If recessions of significant depth and duration were to occur, there is a strong risk of rising protectionist measures in industrial countries, squeezing exports by low-cost producers in Asia and elsewhere.

Robust growth in developing Asia will make a welcome and significant contribution to global growth in 2008. ADO 2008's baseline projections suggest that just over one fifth of global growth in 2008 will be attributable to developing Asia, though the region is yet to reach a point where it can provide a significant cushion against slower demand growth in the G3. Indeed, to replace just a 1 percentage point reduction in US consumption demand growth, developing Asia would have to add another 1.3 percentage points of GDP growth—but in fact, developing Asia is much more likely to decelerate in 2008.