Global economy to improve slightly, but risks abound

The UN has projected higher but still moderate growth for the world economy this year, cautioning, however, that this outlook is subject to several downside risks.

by Kanaga Raja

GENEVA: The global economy is expected to expand at a slightly faster but still only moderate pace over the next two years, with world gross product (WGP) projected to grow by 3.1% and 3.3% in 2015 and 2016 respectively, a United Nations report has said.

In its World Economic Situation and Prospects 2015 (WESP) report released on 19 January, the UN said that this compares with an estimated moderate pace of growth of 2.6% in 2014.

The report cautioned that its global economic outlook is subject to a number of risks and uncertainties, including the fragility of economic recovery in the euro area, the forthcoming further normalization of the US Federal Reserve’s monetary policy, domestic and external vulnerabilities faced by emerging economies, and current geopolitical tensions, in particular the crises in Iraq, Libya, Syria and Ukraine.

According to the UN, in preparing its global outlook, it had received inputs from the national centres of Project LINK and from the participants at the annual LINK meeting held in New York from 22 to 24 October 2014.

[The report appears to have been prepared before the latest news of the economic situation and outlook for the eurozone, falling consumer prices in the euro area, the European Central Bank (ECB) hesitating on its Outright Monetary Transactions facility in the face of German opposition despite the EU court clearing the way for supporting the euro by buying bonds, the Greek elections and prospects of a new government under Syriza, the Swiss National Bank abandoning its Swiss franc/euro peg, throwing currency markets into turmoil and possible deflation in Switzerland, falling oil prices hitting most producers, and financial markets with proliferating speculative trading in derivatives etc. – SUNS]

According to the report, six years after the global financial crisis, gross domestic product (GDP) growth for a majority of the world economies has shifted to a noticeably lower path compared to pre-crisis levels.

Excluding the three years from 2008-10 which featured, respectively, the eruption of the financial crisis, the Great Recession and the policy-driven rebound, four-fifths of the world economies have seen lower average growth in 2011-14 than in 2004-07.

At issue is whether such a shift to a lower path of growth in most countries will become entrenched for a long period. According to some pessimistic views, major developed economies are highly likely to be entrapped in secular stagnation, while policymakers in China have indeed taken growth of 7.0-7.5% as the new normal for the Chinese economy, compared with the average growth of 10% that China achieved in the previous three decades.

The report said that a salient feature for major developed countries during 2014 has been the erratic movements in their quarterly GDP growth rates. For example, the United States economy oscillated from a decline of 2.1% in the first quarter of 2014 to an increase of 4.6% in the second quarter, while at the same time the economy of Japan swung from growth of 6.7% to a contraction by 7.3%.

In the baseline outlook, the UN said that a further improvement is expected for developed countries, with growth projected to be 2.1% and 2.3% for 2015 and 2016 respectively, compared with the 1.6% estimated for 2014. However, downside risks remain significant, especially in the euro area and Japan, which have seen renewed weakness in 2014.

Growth rates in developing countries and economies in transition have become more divergent during 2014, as a sharp deceleration occurred in a number of large emerging economies, particularly in Latin America and the Commonwealth of Independent States (CIS). According to the report, a number of these economies have encountered various country-specific challenges, including structural imbalances, infrastructural bottlenecks, increased financial risks and ineffective macroeconomic management, as well as geopolitical and political tensions. In contrast, East Asia, including China, managed to register relatively robust growth, while India led South Asia to a moderate strengthening.

In the baseline outlook, developing countries as a group are expected to grow at 4.8% and 5.1% in 2015 and 2016 respectively, up from the 4.3% estimated for 2014. Growth in the least developed countries (LDCs) is expected to continue exceeding the global average, at 5.7% in 2015 and 5.9% in 2016. The economies in transition as a group are expected to grow at 1.1% and 2.1% in 2015 and 2016 respectively, up from the 0.8% estimated for 2014.

The report cautioned that as in the case of developed economies, the risks to this baseline outlook are mainly on the downside. Many developing countries and economies in transition appear vulnerable to a tightening of global financial conditions and to the risk of a sharper-than-expected slowdown in major emerging economies, as well as a further aggravation of geopolitical tensions and an escalation of the Ebola epidemic.

Regional outlooks

Among the developed economies, the economy of the United States, after some erratic fluctuation in 2014, is expected to improve in 2015 and 2016, with GDP projected to expand by 2.8% and 3.1% respectively, compared with an estimate of 2.3% for 2014.

“While an increase in business investment will be the major driver, household consumption is also expected to strengthen, along with continued improvement in employment. The fiscal drag on growth is expected to remain, but with much milder intensity than in previous years. The policy interest rates are set to rise gradually after mid-2015, but the monetary policy stance will continue to be accommodative.”

According to the UN, the risks for the economy are mainly associated with the possibility of sizeable volatility in financial markets in response to the normalization of monetary policy, leading to adverse effects on the real economy.

Western Europe continues to struggle, the report said, pointing out that in the EU-15, GDP growth is estimated to be only 1.2% in 2014, with a slight pickup to 1.5% and 1.9% in 2015 and 2016 respectively.

“The region is held back by the travails of the euro area, where the level of GDP has yet to regain its pre-recession peak. Unemployment remains extremely high in many countries in the region and headline inflation is at alarmingly low levels.”

There is a ray of hope in that some of the crisis countries have resumed growth. Spain resumed positive growth in mid-2013 and has been strengthening since; Ireland and Portugal have also returned to positive growth, but all three recoveries remain extremely fragile. The only example of more robust growth is outside the euro area in the United Kingdom.

Among the developing countries, said the report, Africa’s overall growth momentum is set to continue, with GDP growth expected to accelerate from 3.5% in 2014 to 4.6% in 2015 and 4.9% in 2016. Growth in private consumption and investment are expected to remain the key drivers of GDP growth across all five sub-regions and all economic groupings.

“A number of internal and external risks remain, such as a continued slow recovery in the developed countries, a slowdown in China, tighter global financial conditions, the Ebola outbreak, political instability, terrorism and weather-related shocks.”

East Asia remains the world’s fastest-growing region, with GDP growth estimated at 6.1% in 2014. In the outlook period, the region is projected to see stable growth of 6.1% in 2015 and 6.0% in 2016, said the report. China’s transition to more moderate growth is expected to be partly offset by higher growth in other economies, where investment and exports will likely strengthen as activity in developed countries improves.

The key downside risks for East Asia are related to the upcoming tightening of global liquidity conditions, which could result in weaker growth of domestic consumption and investment, and to a sharper-than-expected slowdown of the Chinese economy.

Economic growth in South Asia is set to gradually pick up from an estimated 4.9% in 2014 to 5.4% in 2015 and 5.7% in 2016. While the recovery will be led by India, which accounts for about 70% of regional output, other economies such as Bangladesh and Iran are also projected to see stronger growth in the forecast period.

There are, however, significant downside risks for the region due to the continuing fragility of the global economy and considerable country-specific weaknesses, including political instability and the agricultural dependency on the monsoon.

Economic growth in Latin America and the Caribbean is projected to moderately improve from a meagre 1.3% in 2014 to 2.4% in 2015 and 3.1% in 2016, albeit to varying degrees across countries and with significant risks to the downside. Investment demand is estimated to recover from the current sharp slowdown, as large public investment projects are expected to be implemented in countries such as Brazil, Chile and Mexico. Accommodative monetary policy is also expected to support economic activity in some countries.

The downside risks are related to a larger-than-expected growth decline in China, further reductions in commodity prices and the potential financial spillovers from the normalization of the monetary policy stance in the United States.

The employment challenge

The report underlined that the global employment situation remains a key policy challenge, as GDP growth continued to be modest and below potential in many parts of the world. Globally, employment is estimated to have grown by 1.4% in 2014, similar to the pace in 2013 but still lower than the 1.7% rate in pre-crisis years. As a result, unemployment figures remain historically high in some regions, even though they appear to have stopped rising.

The overall labour market situation is, however, more complex and challenging if a wider range of indicators are taken into consideration, such as labour force participation, long-term unemployment, wage levels, involuntary part-time work and informality.

[Meanwhile, the International Labour Organization (ILO) has warned that the global employment outlook will deteriorate in the coming five years. In its World Employment and Social Outlook – Trends 2015 report, released on 20 January, the ILO said that by 2019, more than 212 million people will be out of work.

[Global unemployment stood at over 201 million in 2014, over 31 million more than before the start of the global crisis, and is expected to increase by 3 million in 2015 and a further 8 million in the following four years.

[According to the ILO, the global employment gap, which measures the number of jobs lost since the start of the crisis, currently stands at 61 million. If new labour market entrants over the next five years are taken into account, an additional 280 million jobs need to be created by 2019 to close the global employment gap caused by the crisis, it said.]

According to the WESP report, in developed economies, the job recovery has been insufficient to recuperate the losses from the financial crisis. The employment rate (employment-to-population ratio) declined significantly after the financial crisis in developed economies and remains below the pre-crisis level, with the exception of Japan.

The overall decline in employment rates since the beginning of the financial crisis is explained by weak labour demand, but also by structural factors and lower labour force participation, said the report. A case in point is the United States, where the labour force participation rate is near its lowest level in the past 10 years due to an ageing population, an increase in skills upgrading and a higher number of discouraged workers.

Employment has been improving slowly in developed economies, although significant challenges remain. While the unemployment rate in the United States has decreased to below 6%, the unemployment rate in the euro area remains elevated, with several economies in the euro area featuring extremely high unemployment. In addition, youth unemployment rates remain high in several European countries, at 53% in Spain, 44% in Italy and 35% in Portugal, for example.

In developing countries and economies in transition, the employment situation has not improved considerably either, with economic expansion decelerating in many economies.

However, said the report, there have been noticeable improvements in some countries since the beginning of the financial crisis, including in some larger emerging economies. For example, Argentina, Brazil, Indonesia, Russia, Saudi Arabia and Turkey have recorded higher employment rates in 2014 than in 2007.

Slow and uneven recovery in major developed countries and moderated growth in developing countries have led to sluggish trade growth in the past few years. World trade is estimated to have expanded by 3.4% in 2014, still well below pre-crisis trends.

In the forecast period, said the report, trade growth is expected to pick up moderately along with improvement in global output, rising to 4.5% in 2015 and 4.9% in 2016.

Developed countries are expected to see some improvement in trade growth, with export growth rising from 3.5% in 2014 to 4.4% in 2015. Import growth will also progress at a similar rate. Further improvement is expected in 2016, said the WESP report.

Growth of exports in developing countries is expected to increase from 3.9% in 2014 to 4.6% in 2015 and 5.5% in 2016, while growth of imports will expand even more rapidly from 3.8% in 2014 to 5.3% in 2015 and 6.0% in 2016.

Risks and uncertainties

The report highlighted three different scenarios with respect to the uncertainties associated with normalization of monetary policy by the US Federal Reserve.

It said that while the assumption for the baseline outlook is a smooth process of interest-rate normalization, any unexpected changes in GDP growth, employment creation, inflation or other circumstances can trigger a deviation from the assumed interest-rate path. This, in turn, would lead to the sudden repricing of financial assets, higher volatility and possibly global spillovers.

In one scenario, higher inflation or financial bubble concerns would lead to a more rapid increase in the policy interest rate. Together with a rise in term premia, this would drive up credit spreads, accompanied by an increase in volatility and significant repercussions for global financial markets.

By contrast, in another scenario, a renewed slowdown in growth would prompt a delay in interest-rate hikes. This would set off higher volatility and possibly lead to additional financial instability risks in the light of asset pricing that is based for an even longer time on abundant liquidity rather than on economic fundamentals.

The report cautioned that any deviation from the policy interest-rate path expected by financial markets could have major ramifications in financial markets.

One reason for this is the decrease in market liquidity for corporate bonds due to a retrenchment of market-making banks. As a result, any sell-off in bond markets caused by an upward revision of interest-rate expectations would lead to a more pronounced fall in bond prices, higher yields and higher borrowing costs.

A further reason lies in the increased role of financial actors that feature a higher redemption risk, such as mutual funds and exchange-traded funds. These actors, together with households, have seen a continuous increase in their share as holders of corporate bonds, while the share of insurance and pension funds has decreased.

“A faster-than-expected normalization of interest rates in the United States can also create significant international spillover effects, especially a drying up of liquidity in emerging economies and an increase in bond yields,” said the WESP report.

Many emerging economies also remain vulnerable to the fallout from rising global interest rates. While certain economic fundamentals such as currency reserve ratios are overall in better condition than in the past, various factors have increased emerging markets’ vulnerability, particularly to higher global interest rates. These include, for example, rising levels of foreign-currency-denominated debt, particularly short-term debt in a number of cases.

Turning to the euro area, the report said that the sovereign debt crisis has subsided dramatically since the ECB announced its Outright Monetary Transactions facility in August 2012. “It has yet to be activated, but its mere existence has broken the negative feedback loop between weak banks and weak government fiscal positions. Sovereign-bond spreads have narrowed significantly and some of the crisis countries have seen an improvement in their debt ratings.”

However, while the sense of crisis has dissipated, significant risks remain, the report warned, noting that the banking sector remains under stress. Lending conditions remain fragmented across the region, with firms in periphery countries, particularly small and medium-sized enterprises, starved of credit.

The most significant risk, however, is the precarious nature of the euro area recovery. The underlying growth momentum in the region has decelerated to the point where an exogenous event could lead to a return to recession. The current tensions in Ukraine and resulting sanctions have already had a serious negative impact on activity and confidence.

The weak state of the recovery is characterized by continued low levels of private investment, extremely high unemployment in many countries – which becomes more entrenched as the ranks of the long-term unemployed increase – and dangerously low inflation, which could turn to Japan-style deflation. “Aside from being exceptionally difficult to exit, deflation would also increase real government debt burdens and perhaps reignite the debt crisis as fiscal targets become increasingly difficult to achieve.”

Vulnerable emerging economies

The report underlined that many large emerging economies continue to face a challenging macroeconomic environment, as weaknesses in their domestic economies interact with external financial vulnerabilities.

Although the baseline forecast projects a moderate growth recovery in 2015 and 2016 for almost all emerging economies – including Brazil, India, Indonesia, Mexico, Russia, South Africa and Turkey – and only a slight moderation in China, there are significant risks of a further slowdown or a prolonged period of weak growth.

“A broad-based downturn in emerging economies, particularly a sharp slowdown in China, would not only weigh on growth in smaller developing countries and economies in transition, but could also derail the fragile recovery in developed countries, particularly in the struggling euro area.”

At present, said the report, the main risk for many emerging economies arises from the potential for negative feedback loops between weak activity in the real sector, reversals of capital inflows and a tightening of domestic financial conditions amid an expected rise in the interest rates in the United States.

Given the expected normalization of monetary policy in the United States, it is likely that emerging markets will see a tightening of financial conditions in the forecast period. In the absence of a new reform push, this may further weaken real investment growth, particularly in the private sector. “A key question in this regard is the degree to which the upcoming increase in United States interest rates will affect borrowing costs in emerging economies,” said the WESP report.

It also pointed to geopolitical tensions as being another major downside risk for the economic outlook. In addition to the severe human toll, the crises in Iraq, Libya, Syria and Ukraine have already had pronounced economic impacts at the national and sub-regional levels, although the global economic effect has so far been relatively limited.

A major reason for the limited global impact thus far is that global oil markets remained on an even footing, with any actual or feared conflict-related decline in oil supplies being offset by oil production increases, notably in the United States.

Nevertheless, the world economy remains at risk to experience a more pronounced slowdown that could be caused by sub-regional economic weakness due to conflict and sanctions feeding into a broader global impact.

“A further risk lies in a drastic fall in oil output and exports by any of the major oil-exporting countries, which may set off a sharp adjustment in financial markets’ risk perception, leading to higher risk premia and an increase in market volatility across different asset classes,” said the report.

It further underlined that the Brent oil price is projected to decline in 2015-16 from the average price in 2014, as the gap between demand growth and supply growth is expected to continue. In 2015, the average crude oil price is expected to decline by about 10% to $92 per barrel from $102 per barrel in 2014.

This forecast is based on the assumption that OPEC countries will not cut production to support oil prices and that global oil demand growth will continue to be weak. In 2016, the Brent oil price is expected to recover moderately to $96 per barrel, provided that global demand growth accelerates gradually while oil output remains stable.

Nevertheless, said the report, there are important risks to this forecast. On the downside, growth in oil demand could be weaker, particularly from China, Japan and Western Europe, which would drive prices lower than forecast. On the upside, if OPEC members decide to cut oil production, oil prices could rebound faster than anticipated.

At the same time, it added, if the conflict in Iraq escalates, supply disruptions could be a major concern, which would lift the Brent price above the projected price. In addition, current reciprocal sanctions between Russia and leading OECD countries are raising more concerns about possible consequences for Russia’s oil production and exports. (SUNS7944) 

Third World Economics, Issue No. 584, 1-15 Jan 2015, pp2-5