The world economy enters this year at a fork in the road. One track leads to the self-sustaining vigorous recovery that policymakers have sought in vain ever since the financial crisis erupted in 2007. Lower oil prices get consumers spending and businesses investing. Memories of the biggest recession since the 1930s are finally banished. The rest of the world starts to look like a revitalized US.
The other track leads back toward recession. Problems that have been stored up since 2008 can be contained no longer. A financial crisis erupts in emerging markets. China has a hard landing. Greece sparks off a fresh phase of the eurozone’s struggle for survival. Deflation sets in. The rest of the world starts to look like Japan. So, what are the five issues that will define a make-or-break year?
RUSSI AND UKRAINE
Illustration: Mountain People
The Russian economy is set to go into deep freeze this year. Even before the dramatic plunge in the ruble in the weeks leading up to Christmas, the central bank was predicting a fall in output of 4.5 percent. Pushing up interest rates from 10.5 percent to 17 percent in one move might well help to stabilize the ruble and prevent further capital flight — but at a cost.
Capital Economics emerging markets economist Neil Shearing said history is about to repeat itself; just as after the debt default of 1998, Russia is “staring down the barrel of a deep recession.”
The depth of that slump is likely to depend on what happens to the price of oil and whether the West lifts the economic sanctions that it has gradually been intensifying since last spring, Shearing said.
Two other things are also unclear. Firstly, how Russian President Vladimir Putin is set to respond. Putin offered the people a bargain: Accept a hard man in the Kremlin in return for rising living standards. That deal is set to be broken this year and there is no guarantee that it will encourage the Kremlin to take a softer line over Ukraine.
On the contrary, a failing economy could spur Putin into acts of nationalist defiance. That would not just intensify the recession; it would also have knock-on effects for Russia’s neighbors and for the eurozone.
The second unknown is whether Russia is a special case. The fear is that it will set off a chain reaction across other emerging markets that have attracted the copious amounts of footloose capital generated by the quantitative-easing programs of the world’s central banks. Turkey and Indonesia and are two big nations to look out for.
OIL
In the summer last year, a barrel of Brent crude was changing hands at US$115 a barrel. By Christmas, it could be obtained for barely half that price. The big drop in the oil price is positive for global growth: it puts more spending power in the hands of consumers and it cuts costs for businesses. The link between the cost of crude and the world economy is well established: The long booms of 1948 to 1973 and the 15-year period that preceded the great recession of 2008 and 2009 were both built on cheap oil. The four recessions of the postwar era (1974 to 1975, 1981 to 1982, 1990 to 1991 and 2008 to 2009) have all been associated with rising oil prices.
Fidelity Solutions asset allocation director Trevor Greetham said: “A low oil price is a stimulus for consumers. Global growth should pick up over this year and there are as yet few signs of the kind of inflation that would necessitate meaningful monetary tightening.”
However, there is a caveat. The plunging oil price could prompt “credit stress,” Greetham said.
This would affect governments such as Russia, Venezuela and Iran, that can only balance their books if the oil price is at US$100 a barrel or more. In addition, it would affect the shale gas sector in the US, where much of the investment has been financed by high-yielding, but risky junk bonds.
As the Bank of England said in its recent Financial Stability Review: “As US oil and gas exploration firms account for 13 percent of outstanding debt in US high-yield bond markets, an increase in the perceived or realized credit risk in this sector could lead to sales by investors and potentially illiquidity in the broader high-yield market.”
In other words, shale could be the next sub-prime.
CHINA
China is going to be crucial to the performance of the global economy this year. Depending on the yardstick used, it is now the world’s biggest economy. It is also a net exporter of foreign direct investment, according to the Economist magazine’s data editor, Kenneth Culkier. China could soon join the select club of nations with a reserve currency.
However, last year was an uneasy year, as Beijing tried to mop up the credit excesses left behind after the growth-at-all-costs approach adopted during the deep downturn of late 2008.
Policymakers have been running a tight ship and the constraints on credit have started to bite. Growth is likely to be lower this year. The question is: How much lower?
A marked slowdown would affect the rest of the world in two big ways.
First, exports to China would weaken. This would affect nations such as Germany, which sells the machine tools needed for China’s industrial expansion, and those such as Australia that provide China with its raw materials. A sluggish Chinese economy this year would compound a low oil price.
Second, China will export deflation to the rest of the world. The prices of goods leaving China are already falling and that trend will continue. The US and Europe will be flooded with cheap Chinese goods, driving down inflation. In the case of the eurozone, it may result in deflation. Central banks, faced with inflation being well below target, will be cautious about raising interest rates even if their economies are growing at a healthy rate, risking the recreation of the conditions that led to the pre-2007 asset bubbles.
The US
This year is going to be hugely significant for US Federal Reserve Chair Janet Yellen and her colleagues, and for global markets. A focus for investors is likely to be the timing of the first rise in interest rates. Rates have been in a record low range of between zero and 0.25 percent since December 2008, but the economy has been gaining momentum in recent months. The Fed has already called time on its US$4.5 trillion bond-buying program, completing its final purchases in October. Winding the clock back to May 2013, then-US Federal Reserve chairman Ben Bernanke triggered a so-called “taper tantrum” when he suggested the Fed might start slowing the rate of its bond-buying sooner than markets were expecting. Investors — hooked on ultra-loose monetary policy since the crisis fully erupted in 2008 — took fright and triggered a fresh wave of volatility.
Given that it is the world’s largest economy, speculation on the first rate rise is set to have repercussions around the world. Investors are going to scrutinize Fed statements for any change in tone that might indicate when the first increase is likely to occur. Until it does come, uncertainty — despised by markets — will reign.
At its latest policy meeting last month, the Fed dropped its insistence that rates would be kept on hold for a “considerable period,” replacing it with the message that it could be “patient” about policy changes. Within minutes of the statement, New York’s Dow Jones Industrial Average shot up 1.5 percent, as investors interpreted it as a signal that there would be no mad rush to raise rates.
However, if the economic data in the coming weeks and months continues to reflect a strengthening US economy, the Fed’s patience might wear thin.
Expect market volatility when the central bank drops its cautious tone as it paves the way for the first rate rise since the Great Recession.
EUROZONE
The eurozone is the crisis that keeps on giving, and there is every reason to believe this is going to remain the case this year. European Central Bank (ECB) President Mario Draghi lifted the single currency bloc out of the worst phase of the crisis in the summer of 2012 simply by saying that he would do “whatever it takes” to save the euro. However, he now faces one of his biggest challenges yet.
Last year, the story in the eurozone was one of a recovery that failed to get off the ground and of the mounting threat of deflation. Neither of those problems has gone away, with growth of just 0.2 percent in the third quarter of last year and an annual inflation rate of 0.3 percent at last count in November.
Greece and Spain are already stuck in a deflationary rut and there is concern that a dangerous deflationary spiral is set to spread to the rest of the region.
The fear is that as prices continue to fall, businesses and consumers will delay spending plans as they expect prices to fall further. With a backdrop of weak growth, low oil prices and general lack of inflationary pressures, the ECB’s battle against deflation is going to continue well into this year.
Measures announced last year — including charging banks to park cash with the central bank in a bid to encourage more lending — have failed to provide a silver bullet. The bank has one weapon left up its sleeve: full-blown quantitative easing (QE).
So far the eurozone’s policymakers have failed to take the plunge with QE, largely as a result of forceful opposition from Germany. However, this year could be the year to abandon the hints and throw the kitchen sink at the problem. More weak data from the eurozone would make investors nervy. Failure to press the QE button in the face of weakness could trigger outright panic.
The relevance for the UK is huge: policymakers at the Bank of England and within government have repeatedly warned that fragility in the eurozone is one of the biggest threats to recovery, not least because it is Britain’s biggest trading partner.
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