Simply put, Standard & Poor's Ratings Services thinks the current US slowdown is much less critical than it would have been a decade ago. The rise of Asia and an improving picture elsewhere have reduced overall dependence on the US as the leader for global growth. Even if the US slips into a recession (as we think it has), industrialised and emerging countries will likely keep growing in 2008, though most will do so more slowly. Still, a protracted slowdown in the US will have an effect.
The best news continues to come from emerging markets, which are still expanding at a solid pace regardless of the significant weakness in the US and the financial market turmoil. Overall, domestic demand and regional strength will be large factors in determining how other economies fare during the US slump. In particular, the industrialised countries that are more closely tied to US fortunes will need to rely more heavily on spending at home.
Where the US appears to be heading
The US economy has clearly hit a rough patch. Real GDP increased just 0.6% in the fourth quarter 2007 after a strong 4.9% in the third quarter. S&P expects GDP to drop in the first half of 2008 and then rise through the second half as monetary and fiscal stimulus kicks in. We expect GDP to rise 1.2% this year, 1 percentage point less than in 2007. The odds of an actual recession have risen to 70%. But even if there is no downturn officially, it will feel like one to most Americans. Housing will likely keep depressing the expansion through 2008. However, the longer term outlook remains upbeat, with growth probably returning to close to 3% by the second half of 2009.
The US reliance on foreign capital is a major danger point. While improving from the record current account deficit reached in 2006, the current gap is a still-high 5.4% of GDP. Private money was almost entirely financing it ù at very low interest rates. Now foreign investors have lost confidence in US securities and the US dollar, and money is not so easy to come by. If investors outside the US continue to worry about the risk of a dollar decline, the result could be both a sharp drop in the dollar and a sharp rise in US interest rates, extending the recession.
It is, however, unlikely that foreign central banks would allow this. They have intervened to slow the dollar's fall in 2007, though not as much as they did in 2003 and early 2004. They aren't doing this to help the US financial markets but rather to protect their own countries' trade surpluses, which depend on bilateral surpluses with the US. More important, since August 2007 foreign and US investors have panicked about credit risk, which has sharply increased borrowing costs. Because of the US subprime mortgage problems and related instabilities in the international capital and financial markets, central banks have taken dramatic action to stabilise global markets.
However, business conditions could continue to erode and bring about a much harder landing in the US than we currently expect. That would increase recession risk abroad.
The following is a quick summary of the outlooks for the major regions.
In Canada, growth is poised to slow in 2008 to 2.0%, less than the 2.6% rate seen last year. Shrinking exports are likely to weaken overall growth, as a strong Canadian dollar and soft growth for Canada's major trading partners stymie demand. Continued weak business conditions will also hamper growth. However, consumer strength will remain a support, though less than before since a more tentative mood among homebuyers will cut into purchases, particularly big-ticket items.
We expect that European economies will escape a recession, though growth will slip to 1.7% in 2008, 1 percentage point less than last year's strong performance. Consumers across Europe will play a large part in determining how big the slowdown will be.
Japan's growth should be just 1.6% in 2008, after seven years of expansion. Two main engines of Japanese growth in recent years ù corporate investments and net exports ù will continue in that role. However, a stronger yen and a soft US economy add downside risk to export revenues.
Although Europe and Japan face hurdles, for the first time since 2001 economic growth in both will outpace that of the US in 2008. However, Europe and Japan, which together constitute about one-quarter of the world's GDP, contributed just 12% to worldwide GDP growth in 2006, the same contribution as the US alone.
Developing Asia is still the growth leader
The fastest growth continues to come from the developing Asian economies, especially China and India. In 2007, China's GDP rose 11.5% and it has averaged 10.6% in the past five years. For the past 10 years, India has averaged about 7%, and near 9% in the past five years. S&P expects China to expand at a 9.3% pace and India to grow at 8.5% in 2008.
One beneficiary of outsize growth in China and India is Australia, where demand for resources from its Asian neighbours will help counter weakness in the US. Latin American economies are also benefiting from Asian resource demand. Although Latin America will feel the effects of a recession in the US and a slowdown in Europe, the region is more prepared to withstand less favourable global conditions. For the Asia-Pacific region as a whole, the recovery from the 1997 Asian currency crisis has been stronger than we expected, though not all countries have rebounded equally. Key risks this year are whether the slowdown in US growth will deepen, become protracted, and lead to a broader slump in Asia, Latin America and elsewhere.
Inflation risks are increasing in most regions
On the price front, inflation has climbed from its 2006 levels in most regions. Core inflation (CPI excluding food and energy) in the US decelerated to a 2.3% pace in 2007 compared with 2.5% in 2006, but has climbed back to 2.5% in January. We expect it to moderate to 2.3% in 2008 as slowing growth eases price pressures. The inflation outlook in Europe and the UK generally appears disappointing. In China, food is pushing inflation higher, but core prices are more favourable. However, since Chinese households spend more on food as a share of total expenditure than those in advanced economies, higher prices will be a greater burden. The Japanese data continue to indicate a firming in prices as the country continues its very slow escape from deflation.
Inflation is a key concern in other regions as well. Australia's strong economic performance and uncomfortably high inflation pressures led the Reserve Bank of Australia to hike the official cash rate 25bp to 7.00% in February. The central bank indicated more is necessary. Inflation risk has also put pressure on the Reserve Bank of India to maintain a tight monetary stance even as signs of slowing growth intensify.
How long can global growth buck pricier oil?
For all the world's economies, oil remains a wild card. The major risk is that supply disruptions in the Middle East spark a further surge in prices and slow the global expansion prematurely. Crude oil hit a record $102/barrel in February. We expect the price at year-end to be about $73/barrel. However, our confidence in the forecast is weak.
A few years ago, many economists believed that a global recession would occur if oil held at more than $70/barrel. However, the world economy has survived far higher prices, not without a scratch, but certainly with more limited damage than feared. This is largely because wealthier countries have become less dependent on oil than in the past. For example, during the last big spike in 1981, energy was 14% of US GDP; today, it's only 8%. Per capita energy use in the US, Europe, and Japan has been essentially flat over the past 35 years, while incomes have more than doubled. Still, even though the world is more efficient, higher energy prices remain a risk to global growth.
In addition, energy demand in China and - to a lesser extent ù India, continues to rise sharply. That's only natural because industrialising countries need more and more energy, unlike postindustrial economies where demand drops relative to GDP. Beyond industrialisation's needs for more energy than the service or agricultural sectors, it also reflects popular demand for transportation services. Expansion in the Chinese and Indian economies could keep energy prices elevated for a protracted period, despite the slowdown in the US.Central banks are becoming more active
After climbing from 45-year lows, US interest rates have reversed course. Between June 30, 2004, and June 29, 2006, the US Federal Reserve raised the benchmark federal funds rate 17 times, to 5.25% from 1%. However, the liquidity squeeze (in the international financial and capital markets) brought about by the US subprime mortgage problems has forced central banks to quickly change direction.
The European Central Bank (ECB), the Bank of England (BoE), the Fed and the Bank of Canada (BoC) injected liquidity into the global financial system after BNP Paribas in August suspended three funds with exposure to US credit markets. Since then, the Fed has cut rates by 225bp, including a record 125bp reduction during the last two weeks of January. The Fed is not ignoring inflation, which has accelerated in recent months, but will deal with it after it's sure this isn't a major recession.
The BoE and the BoC are also trimming rates. The latter left the door open for additional cuts as it reduced forecasts for growth and inflation amid deteriorating financial conditions and a weak US outlook. The BoE said in February that growth was beginning to slow and that conditions in the financial market had deteriorated. However, it also acknowledged higher risk of inflation, which makes further cuts uncertain.
The ECB held at 4.0% in February but said "risks surrounding the outlook for economic activity lie on the downside". We expect two ECB rate cuts this year, with the first in May or June.
The Bank of Japan (BoJ) held its target overnight call rate at 0.5% at its February 14-15 meeting, similar to the past year. Though the BoJ is aware of both unstable financial markets and the possible impact of the US recession on domestic growth, it's also concerned about longer-term risks to price stability from overly accommodative monetary policy.
The People's Bank of China announced its sixth consecutive rate increase on December 21 and cooling measures are likely to continue in 2008. But given global uncertainty and its impact on their region, Chinese policymakers may be more cautious about tightening this year.
The US dollar is likely to keep falling
The dollar weakened against major currencies in early August and is down 12.0% since last February. Concerns about the US subprime mortgage situation are weighing on the dollar. We expect depreciation to continue because of the enormous $752 billion US current account deficit, albeit down from a record $811 billion in 2006. A weaker dollar will help real growth in the US by encouraging exports and slowing import demand. However, it will dampen expansion in countries that now have trade surpluses with the US. The dollar is likely to stabilise after mid-year, when the Fed stops cutting rates and the ECB starts.
World growth is expected to slow in response to the slowdown in the US and higher energy prices. Overall, 2008 promises to have plenty of tough challenges for the world's economies. Even though the US doesn't dominate the world economy as it once did, the US slowdown will still ripple through the world economy. With some luck, the global economy can avoid falling in response to the US stumble, but it will have to slow down to regain its balance.
By Beth Ann Bovino, senior economist at Standard & PoorÆs
The article is extracted from RatingsDirect, Standard & Poor's Ratings' Web-based credit research and analysis source (www.ratingsdirect.com). To learn more, please contact our representative Cherrie Chui in Hong Kong at +852 2533 3516 or [email protected], or Dowson Chan in Singapore at +65 6530 6438, or [email protected].
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