World economy stumbles in 2015, major headwinds persist

Coming off a year in which it grew less than expected, the world economy continues to face “major headwinds” that will affect both its near-term outlook and long-run prospects, says a UN economic report.

by Kanaga Raja

GENEVA: The world economy stumbled in 2015, with world gross product projected to grow by a mere 2.4%, a significant downward revision from the 2.8% that was forecast as of mid-2015, according to a United Nations report.

The World Economic Situation and Prospects 2016 report (WESP), released on 20 January, said more than seven years after the global financial crisis, policymakers around the world still face enormous challenges in stimulating investment and reviving global growth.

The world economy has been held back by several major headwinds: persistent macroeconomic uncertainties and volatility; low commodity prices and declining trade flows; rising volatility in exchange rates and capital flows; stagnant investment and diminishing productivity growth; and a continued disconnect between finance and real sector activities.

In its chapter on the global economic outlook, the report said the world economy is projected to grow by 2.9% in 2016 and 3.2% in 2017, supported by generally less restrictive fiscal and still accommodative monetary stances worldwide.

The anticipated timing and pace of normalization of the United States monetary policy stance is expected to reduce policy uncertainties, while preventing excessive volatility in exchange rates and asset prices.

“While the normalization will eventually lead to higher borrowing costs, rising interest rates should encourage firms to front-load investments in the short run. The improvement in global growth is also predicated on easing of downward pressures on commodity prices, which should encourage new investments and lift growth, particularly in commodity-dependent economies.”

WESP noted that since the onset of the global financial crisis, developing countries generated much of the global output growth. China, in particular, became the locomotive of global growth, contributing nearly one-third of world output growth during 2011-12. As the largest trading nation, China sustained the global growth momentum during the post-crisis period, maintaining strong demand for commodities and boosting export growth in the rest of the world.

With a much-anticipated slowdown in China and persistently weak economic performances in other large developing and transition economies – notably Brazil and the Russian Federation – the developed economies are expected to contribute more to global growth in the near term, provided they manage to mitigate deflationary risks and stimulate investment and aggregate demand.

On the other hand, bottoming-out of the commodity price decline, which will contribute to reducing volatility in capital flows and exchange rates, will help reduce macroeconomic uncertainties and stimulate growth in a number of developing and emerging economies, including in the least developed countries (LDCs).

The report projected the developing countries to grow by 4.3% and 4.8% in 2016 and 2017, respectively.

Average global inflation continues to decline amid persistently subdued economic activity, modest wage growth and lower commodity prices. In 2015, global consumer price inflation is projected to fall to 2.6%, the lowest level since 2009, owing to reduced oil and commodity prices. Inflation in developing countries is expected to rise moderately in 2016, mainly driven by higher levels of inflation in transition economies.

“Risks of deflation, however, still persist in developed countries, mainly in Japan and the euro area, and to a lesser degree in the United States, where average inflation hovered at about 0.2% during the past four quarters,” the report cautioned.

Five major headwinds

According to WESP, global growth prospects face considerable headwinds in the near term, amid a macroeconomic environment of falling inflation and weak employment generation.

Five major headwinds – both cyclical and structural – will continue to shape the near-term outlook of the global economy as well as its long-term prospects: persistent macroeconomic uncertainties and volatility; low commodity prices and declining trade flows; rising volatility in exchange rates and capital flows; stagnant investment and diminishing productivity growth; and continued disconnect between finance and real sector activities.

The report noted that persistent uncertainty has been a legacy of the global financial crisis that began in the third quarter of 2008. The policy deliberations in the United States Federal Reserve (Fed), for example, have repeatedly identified macroeconomic uncertainty as a key factor affecting the subdued economic performance during the post-crisis period.

While lax regulations that allowed the financial sector to take excessive risks precipitated the financial crisis, persistence of macroeconomic uncertainty continues to adversely affect aggregate demand and investment in the post-crisis period.

Both output growth and inflation have shifted downward since the global financial crisis, representing the level effects of the crisis. At the same time, volatility of output growth has increased in developed economies in the aftermath of the crisis.

WESP emphasized that effective fiscal, monetary or exchange-rate policies can help reduce uncertainties and influence the behaviour of firms and households. “Macroeconomic policies, as such, need to be designed and implemented more effectively to reduce uncertainties and stimulate aggregate demand and growth of the global economy.”

Slowdown in trade

WESP noted that in the aftermath of the financial crisis, international trade, largely driven by demand from China, played a critical role in sustaining global output, particularly for developing economies.

During 2009-11, high commodity prices and early signs of recovery sustained the export income of large emerging and developing economies in Asia, Africa and Latin America. The downward trends in commodity prices since 2011 and sharp decline in oil prices since mid-2014 have altered the trade dynamics of many commodity-exporting countries.

The commodity price declines have generally deteriorated the terms of trade of commodity exporters, limiting their ability to demand goods and services from the rest of the world. This apparently has had second-order effects on non-commodity-exporting economies, unleashing a downward spiral in the value of global trade.

Global trade flows have slowed significantly in recent months, with total volumes of imports and exports projected to grow by only 2.6% in 2015, the lowest rate since the Great Recession. The source of the global slowdown in trade is primarily rooted in weaker demand from developing economies and a sharp decline in imports demanded by economies in transition.

Global exports to the Commonwealth of Independent States (CIS) countries started to decline in 2014 and dropped sharply in 2015, as geopolitical tensions, weaker oil prices and declining remittances led to large currency depreciations and erosion of real income in many of these economies.

On the other hand, import demand from the United States accelerated, supported by the strong appreciation of the dollar since mid-2014 and relatively solid economic growth, while imports by the European Union (EU) economies have also strengthened and the EU demand is now a key impetus to the growth in world trade.

(In a separate chapter on international trade flows, the report said for the second consecutive year, developed economies played the leading role in driving global trade. Among all regions, the developed economies in Europe contributed most significantly to global import growth in 2015, accounting for 70.3% of the growth.)

WESP noted that sluggish growth, a weak yen and the slowdown in Japan’s key trading partners in East Asia, particularly China, has had a dampening effect on global trade growth.

As growth in China moderates, import growth has slowed sharply from the double-digit rates recorded for most of the last two decades. Total East Asia imports grew by an estimated 0.9% in 2015, after just 3.3% growth in 2014.

“The anticipated slowdown of the Chinese economy will have significant adverse effects on the growth prospects of many economies. A larger-than-expected slowdown in China would have further adverse effects on global trade, reducing aggregate demand and slashing global growth,” said WESP.

It further noted that the oil price has plummeted by more than 55% since mid-2014, bringing down the price of oil to levels that prevailed a decade ago.

Non-oil commodity prices have continued on the downward trend initiated in 2011, with a particularly sharp drop in metals prices during 2015.

The UNCTAD nominal price index of minerals, ores and metals dropped 13.3% in the first nine months of 2015, and the food price index dropped by 12.2%. This has led to a substantial shift in the terms of trade and a sharp deterioration of GDP growth in commodity-dependent economies.

The low level of oil and non-oil primary commodity prices is projected to remain stable and extend into 2016 before seeing modest recovery for some commodities, as downward pressures recede in the later part of the forecast period.

The global oil market continues to remain oversupplied and demand growth is not expected to accelerate in 2016, in line with the overall weak global economic conditions, especially in China and other emerging economies that have been the main drivers of oil and metal demand for the past decade.

WESP said that in the outlook period, world trade is expected to grow by 4.0% and 4.7% in 2016 and 2017, respectively.

“Weak commodity prices, increased exchange-rate volatility and the slowdown in many emerging economies, including China, will continue to exert some downward pressures on trade flows, but stronger demand in the United States and Europe will offset the downward pressures and contribute to reviving global trade growth.”

Volatility in exchange rates and capital flows

Against the backdrop of falling commodity prices, increased capital outflows from developing countries and diverging monetary policies, exchange-rate volatilities have become more pronounced, said WESP.

Global exchange-rate volatility has risen considerably since mid-2014, while many emerging-market currencies have plunged amid significant capital outflows. The downward pressure on emerging-market currencies partly reflects deteriorating market expectations about these economies amid expectations of a rise in United States interest rates.

The Brazilian real and the Russian rouble have recorded the largest losses, and both countries remain mired in severe economic downturns, accompanied by elevated inflation. The sharp declines of emerging-market currencies against the dollar have contributed to concerns over the high level of dollar-denominated debt of many non-financial corporations in emerging markets.

In the case of a sudden currency depreciation or increase in interest rates, deleveraging pressures are likely to rise along with risks of corporate defaults in these economies. Sharp adjustments in commodity prices – and commensurate swing in exchanges rates – have led to reduced capital flows to developing countries, said WESP.

The prospect of an imminent increase in the United States policy rate has also affected the volume and direction of capital flows, particularly to large developing economies.

“Changes in the relative rates of return, heightened risk aversion, deteriorating economic prospects (especially in commodity-exporting economies), and associated sharp realignments of exchange rates leave many developing economies and economies in transition vulnerable to a sudden stop, and reversal, of capital inflows, which may adversely affect their balance of payment and put further downward pressures on their exchange rates.”

In 2015, net capital inflows to emerging economies are projected to be negative for the first time since 2008. The current retrenchment in net capital flows to emerging markets is far more severe than that experienced during the financial crisis, with net capital outflows expected to reach about $700 billion in 2015.

WESP noted that during the third quarter of 2015, portfolio outflows reached a record of $40 billion, the largest withdrawal since 2008. Corporate debt in emerging economies has increased more than four times faster than GDP growth over the last decade, with much of the new debt denominated in United States dollars. Given the appreciation of the dollar, this will increase the debt-servicing burden for many large firms, said WESP.

“The risks of more pronounced capital outflows from developing economies and economies in transition are substantial. In the short term, portfolio liquidity could dry up and financing costs might rise abruptly in response to the anticipated interest rate rises of the Fed, putting pressure on exchange rates, equity prices and international reserves.”

Such a scenario would exacerbate the difficulties that many economies face in reinvigorating investment, as volatile capital flows tend to amplify financial and real business cycles, it cautioned.

“In the medium term, the adjustment in emerging economies to the new global conditions, including lower financial market liquidity and commodity prices and higher levels of risk aversion, will pose new challenges for monetary, fiscal and exchange-rate policies.”

Investment and productivity

WESP also said that the global financial crisis has had the most pronounced negative effect on investment rates. Notwithstanding the debates as to whether the lack of aggregate demand or the absence of structural reforms and improved business environment inhibits new investments, it remains clear that global investment rates have sharply declined since the onset of the financial crisis.

The growth rates of fixed capital formation nearly collapsed since 2014, registering negative quarterly growth in as many as nine large developed and developing countries and economies in transition.

Fixed capital formation is, however, likely to witness a moderate increase during the forecast period, supported by less restrictive fiscal positions, an accommodative monetary policy stance and also by reduced macroeconomic uncertainty and stabilization of commodity prices. Low (but stable and predictable) commodity prices are likely to attract new investments in the sector.

WESP said that alongside declines in investment rates, productivity growth has also slowed down significantly in recent years across a large set of economies. Reversing the trends in productivity growth will be critical for putting the world economy on a trajectory of sustained, inclusive and sustainable growth, as envisaged in the 2030 Agenda for Sustainable Development.

“This will require extensive policy efforts and coordination among fiscal, monetary and development policies to increase investments in physical infrastructure and human capital, as well as alignment of policies and effective regulations to ensure that the financial sector facilitates and stimulates long-term and productive investment.”

WESP also highlighted that a growing disconnect between finance and real sector activities is evident in the data: fixed investment growth nearly collapsed, while debt securities (a financial instrument to raise capital) issued by non-financial corporations increased by more than 55% between 2008 and 2014, representing a nearly 8% increase per year.

The total stock of financial assets worldwide is estimated at $256 trillion at the end of 2014, increasing from $184 trillion at the end of 2008. Total financial assets in the world – measured in terms of all debt securities outstanding, equities and the stock of bank credit – exceeded the pre-crisis level as early as 2010.

“Given the rapid build-up of financial assets and the decoupling of finance and real sector activities, the world economy again faces the risk of rapid financial deleveraging, as observed at the onset of the financial crisis between the second and fourth quarters of 2008,” said WESP.

In G7 economies, the financial sector deleveraging of securities averaged 6.1% of GDP during those periods. In the United Kingdom, total deleveraging was as high as 18.3% of GDP in 2008.

WESP cautioned that a similar deleveraging pressure may rise – particularly in developing countries – with increases in the United States policy rates, which may increase the debt-servicing cost and the counter-party risks of borrowing firms.

“A sudden and disorderly adjustment in equity prices could increase the debt to equity ratio of highly leveraged firms and force them to reduce their debt level to avoid defaults. The deleveraging may increase financial market volatility and have significant negative wealth effects on households and corporations, reducing investment and aggregate demand and possibly pushing the world economy towards an even weaker growth trajectory than currently anticipated.”

Policy challenges

WESP noted that more than seven years after the global financial crisis, policymakers around the world still face enormous difficulties in restoring robust and balanced global growth.

In developed countries, most of the burden of promoting growth has fallen on central banks, which have used a wide range of conventional and unconventional policy tools, including various large-scale quantitative easing (QE) programmes, forward guidance and negative nominal interest rates. These measures have led to an unprecedented degree of monetary accommodation in recent years, with monetary bases soaring and short- and long-term interest rates falling to historically low levels.

Accommodative monetary conditions and abundant supply of global liquidity have also given rise to wide swings in capital flows to emerging markets. Financial stability risks have increased amid concerns over the excessive build-up of financial assets, commensurate asset price bubbles and balance-sheet vulnerabilities, especially in emerging markets.

Volatility in commodity, currency, bond and stock markets has moved up since mid-2014, partly as a result of monetary policy adjustments and uncertainties over future policy moves.

Against this backdrop, said WESP, the monetary authorities in developed countries face the task of balancing the need for continued monetary accommodation with the goal of limiting real and nominal volatilities and minimizing the risks to global financial stability.

“Macro-prudential policies, when designed and applied effectively, can help mitigate financial sector volatility and redirect financial resources to more productive sectors of the economy.”

For developed-country central banks, the main challenge over the coming years is how to normalize monetary policy without crushing asset prices, causing major financial volatility and potentially threatening the expected recovery.

At present, the international focus is on the US Fed, which is the first major central bank to start the monetary tightening cycle. Going forward, the challenge for the Fed is not only to get the timing of interest-rate hikes right, but also to adequately prepare financial markets for the moves via effective communication of its plans.

Referring to the expected normalization of United States interest rates, WESP said some uncertainties remain regarding both the anticipated path of interest rates and the reaction of global financial markets and the real economy to the shift in policy rates.

A rise in debt-servicing costs will necessarily be associated with the United States interest-rate normalization, both domestically and in the many developing economies and economies in transition that hold debt denominated in US dollars.

In addition, as the rates of return on United States assets normalize, a sudden change in risk appetite could trigger a collapse of capital flows to developing economies and economies in transition, or sharp exchange-rate realignments as experienced following the Fed’s announcement in 2013 that it would soon begin tapering its QE programme.

Significant levels of net capital outflows have already occurred in many developing economies in anticipation of the normalization of United States policy rates, and there is a risk that these withdrawals could increase further, drying up liquidity in many developing economies. This may lead to a depreciation of many developing-country exchange rates, or pressure them to raise interest rates to prevent capital outflows.

Countries that hold a large stock of net external debt are particularly exposed to the associated rising costs of debt servicing. As a downside risk to the outlook, financial markets could overreact and overshoot the adjustment, or exhibit a sudden change in risk appetite, leading to heightened financial market volatility, an even sharper withdrawal of capital from developing markets, and a more significant slowdown in global growth.

In developing countries and economies in transition, the current global economic and financial environment poses major challenges for monetary and exchange-rate policies. Economic growth in most countries has slowed significantly over the past few years amid declining commodity prices and domestic weaknesses.

Given that monetary policies have done most of the heavy lifting for supporting growth during the post-crisis period, both developed and developing countries will need to rely more on fiscal policy instruments to stimulate growth in the near term.

Fiscal policies will need to primarily focus on boosting investment and productivity growth, said WESP.

It stressed that stimulating inclusive growth in the near term and fostering long-term sustainable development will require more effective policy coordination – between monetary, exchange-rate and fiscal policies – to break the vicious cycle of weak aggregate demand, under-investment, low productivity and low growth performance in the global economy.

The Addis Ababa Action Agenda, agreed at the Third International Conference on Financing for Development in July 2015, provides the framework for policies and actions to align all financing flows and international and domestic policies with economic, social and environmental priorities, said WESP.

The successful conclusion of the 2015 United Nations Climate Change Conference in Paris, leading to binding commitments to reduce emission levels, is expected to pave the way for more effective international policy coordination for sustainable development in all three dimensions: economic, social and environmental, it added. (SUNS8164)        

Third World Economics, Issue No. 607, 16-31 December 2015, pp2-5