Hong Kong, January 5, 2017 - The global policy remedies to the Great Recession of 2008-09 in the developed and emerging markets have seen a divergence of economic cycles since. Developed economies are still on the mend for balance sheet repair, implementing quantitative easing (QE) in different ways. By contrast, emerging economies introduced stimulus measures between 2008 and 2010. The successful measures prompted economies such as China, Brazil and Russia to reverse course in the subsequent years until 2013 which brought on a wave of recessions and currency weakness.
“For both developed and emerging economies, the outlook for 2017 will be closely related to how these differing problems are addressed,” says Dr. John Greenwood, Chief Economist at Invesco. “In spite of the current short to medium setbacks in the recovery process, my longstanding view has been that the current global business cycle expansion will be an extended one. The main reason is that sub-par growth and low inflation in developed economies would avoid the kind of tightening policies that would bring an early end of the expansion. It is also the case that recessions or growth weakness in the emerging market (EM) economies are unlikely to disrupt the modest-paced recovery in the developed economies.”
China and emerging markets
In the emerging economies, the strong stimulus programs comprising excess credit creation and over-leveraging between 2008 and 2010 were implemented so successfully that remedial measures were required since 2013 until last year, when a modest upswing in commodity prices and renewed capital inflows into EM economies were seen except for China, which rolled out more credit expansion from the start of 2014.
“Since China is by far the largest EM, and the biggest buyer of commodities on world markets, the renewed surge in credit growth could yet cause another episode of inflation for China, as well as affect commodity prices globally,” Greenwood points out. “This would not only derail China’s adjustment to a more consumption-led growth model, but it would also have serious knock-on effects on other emerging markets, especially commodity producers and China’s neighboring East Asian economies.”
So far, the excess credit growth in China appears to have been largely contained within the financial and government sectors, “but there are worrying signs that the credit explosion is starting to leak out into the broader economy,” he adds. First, there has been a series of mini-bubbles in equities (2014 and 2015), housing and commodities. Second, the large, industrial, state-owned enterprises have seen a notable uptick in growth and profits. Finally, producer prices, which had been falling, started rising again in October.
How China handles these issues in 2017 is one of the biggest questions for the year ahead. Greenwood forecasts China real gross domestic product (GDP) growth to be 6.4% and CPI inflation to be 2.3% for 2017.
For Japan, the economic policies of Japanese Prime Minister Shinzo Abe, known as “Abenomics,” have not lived up to their promise, leaving Japan’s prospects for 2017 little better than for 2016, says Greenwood.
“One fundamental issue is that the BoJ buys most of its securities from banks instead of from non-banks, and the result is that while the monetary base has more than trebled since the start of QQE in March 2013, there has been almost no change in the rate of growth of broad money. Since total spending is related to the quantity of money held by firms and households, and not the monetary base, it is no surprise that growth has been weak,” Greenwood explains. He expects the real GDP growth to remain at 1.0% and consumer price inflation to be 0.5% for 2017.
The US under a Trump administration
Moving to the US, president-elect Donald Trump’s program is aimed at rebuilding the core strengths of the American economy by giving a strong boost to the health of US businesses and households, notes Greenwood, who expects real GDP growth to improve to 2.4% and CPI inflation to reach 2.1% in 2017.
However, “most of the incremental growth in 2017 would come not from fiscal stimulus, tax cuts or infrastructure spending, but from the strengthening business cycle upswing,” adds Greenwood. He expects the US Federal Reserve to raise interest rates two or three times in the year, taking the target range to 1-1.25% by the year-end.
“The recovery in the US, although already seven and a half years old, is only now starting to take on the typical characteristics of a normal recovery: banks have been providing credit instead of the Fed, businesses and households are in good financial shape and can resume normal spending momentum,” he says.
Outlook on the European Union
In Europe, the outlook is much less favorable. “The slow progress of bank balance sheet resolution, the weakness of the ECB’s QE program and the consequent descent into negative interest rates are among the headwinds holding back economic recovery,” says Greenwood.
Unemployment across the continent has only fallen below double-digit levels since September and income growth remains anemic. This is fuelling populist political sentiment, notes Greenwood, who forecasts Eurozone real GDP growth of 1.2% in 2017, and CPI inflation of 1.1% (due largely to the weaker value of the euro) which falls well short of the ECB’s target (“close to but below 2%.”) The Italian referendum result shows that political pressures for fundamental changes to the European Union (EU) are gaining ground.
“Compared with the Eurozone the British economy has been doing relatively well, thanks to the gradual balance sheet repair in the household and banking sectors, assisted by two series of injections money (QE) by the BoE in 2009-10 and 2011-12,” Greenwood says. However, he points out that the continued Brexit fallout will slow Britain’s real GDP growth, particularly foreign direct investment in the UK, and he forecasts UK real GDP growth to be 1.5% and consumer price inflation to rise gradually towards 3% during 2017.
Greenwood points to a widespread misunderstanding in the financial markets about the stance of monetary policy - most economists and analysts tend to judge monetary policy by the level or direction of interest rate changes. According to Greenwood, interest rates are not a good measure of the stance of monetary policy. Taking the Eurozone and Japan as examples, if monetary policy is tightened, interest rates will rise initially, but after the economy has slowed and inflation subdued, interest rates will fall. The longer term and more important effect of tightening monetary policy is lower rates not higher rates.
The low interest rates in Japan and the Eurozone economies are the result of the second phase of a prolonged period of tightened monetary policy. “It is hardly surprising that in these circumstances Japan and the Euro-area have been confronted with deflation and negative bond yields,” he adds.
On the other hand, with the Fed in the US having moved to raise interest rates (to normalize but not tighten monetary policy) in December 2015 and December 2016, the critical issue will be whether money and credit growth can be sustained at 6-8% p.a. If the commercial banks are able to maintain these money and credit growth rates, then even if bond and equity markets are temporarily jolted by further rate hikes, Greenwood believes the economy will be able to shrug off the interest rate normalization. The US economy could be expanding for several more years before the business cycle hits a peak.
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