Beware of the rosier glow coming off paint-by-numbers economic analysis
Looking back, the gods of risk mocked investors. The fastest growing economies - India and China - had the worst performing stock markets. Both achieved 7-9per cent growth last year, but the Sensex was down 24.6per cent and the A-share markets lost 21.7per cent. In contrast, the advanced economies were supposed to be in crisis, but the US Dow Jones Industrial Average was up 5.5per cent. True, the European index lost 25per cent and the Nikkei declined 17.3per cent, but many emerging markets did just as badly.
At first sight, the usual macro numbers did not suggest 2011 was a crisis year. Annual US growth slowed to 1.8per cent, while euro-zone annual GDP growth was 1.5per cent. But the euro zone had a sharp downturn in the fourth quarter of minus 2per cent. Japan slipped to minus 0.9per cent growth, due to the disruptive effects of the tsunami and nuclear disasters.
What caught everyone by surprise was the European debt crisis, which unfolded like a supertanker crash in slow motion. But, by the end of the year, Germany and France had stitched together a package that brought temporary relief to the Italian bond rates. With new austerity governments in Greece and Italy, there is hope that the political problems will not add to the panic.
From a more detached view, we should treat 2007-11 as a double-dip crisis. Data show the crisis really started when European banks expanded far too fast in 2002-07, particularly after the creation of the euro, relying excessively on interbank funding and US dollars. European banks invested heavily in AAA-rated, but toxic, US products and it was the July 2007 intervention in interbank markets by the US Federal Reserve and European central banks that marked the true start of the global crisis. Quantitative easing restored liquidity to the system but did not address the core structural problems, which resurfaced last year.
The double-peak effect can be seen by the behaviour of inflation, which peaked in July 2008, before the Lehman crash. In the wake of quantitative easing, inflation returned, causing the emerging markets to begin raising interest rates again. Inflation fears have receded with declining oil and gold prices. Almost all other commodity prices fell amid fears the Chinese economy was slowing.
Economic forecasts are, by nature, biased on the optimistic side, with lagged recognition that deflation has set in. For example, the Institute of International Finance acknowledged that its forecasts in 2011 had to be adjusted downwards. It sees the US economy strengthening somewhat from 1.7per cent growth in 2011 to 2per cent in 2012 and to 3.5per cent in 2013. It is cautious on Europe with a decline of 0.6per cent in 2012 and a recovery of 1.7per cent in 2013. For Japan, it sees a recovery of 2.1per cent growth in 2012, compared with a decline of 1per cent in 2011. It sees slower growth in the emerging markets as exports and capital flows slow. The institute thinks India will grow by only 6.5per cent in 2012, rather than the 7.8per cent projected earlier.
The good news about 2011 is that global rebalancing is finally happening. The US current account deficit has been falling to the range of US$400 billion annually, roughly 2-3per cent of GDP. Similarly, China's current-account surplus has also moderated, to around 3 per cent of GDP. I believe this moderation will continue faster than most analysts predict, partly due to some deterioration in public-sector savings due to the need to deal with the domestic adjustments, and also shifting demand towards domestic consumption.
What can throw these forecasts completely out? The general consensus is the European crisis. The Institute of International Finance thinks 2012 will be a make-or-break year for the euro. The European governments confront ugly politics, with tough choices about whether a slimmer version of the euro zone is likely to survive. The problem is that the banking and fiscal crisis has not gone away. The European banks need to rebuild their capital and are already cutting back their international loan books.
To reduce risks, many are putting funds with the European Central Bank for fear of counterparty credit risks with each other. Ironically, central banks in the advanced countries have de facto replaced their banking systems as the primary engine of credit during a crisis. With only a mandate for price stability, the ECB has to deal with the liquidity of the banking system, as well as the borrowing rates of the key member countries such as Italy.
This situation cannot continue forever, as rising interest rates reflect a lack of confidence in the system, while higher rates will accelerate the pace of insolvency. Ultimately, the integrity of the euro zone hangs on the solvency of the whole. If the interest rate and debt burden is too heavy, it will break.
Euro-zone politicians basically face an unpalatable choice. They have to fix the fiscal union and bite the fiscal bullet, but will the electorate tolerate that pain?
My real concern is that the ECB is the only credible institution that can act fast enough to deal with the liquidity situation, but it does not have the fiscal powers to tax and pay its way out of the mess. That is ultimately in the hands of the politicians. The triggers for a crisis tend to happen when your eye is off the ball, and they come from areas you did not suspect; 2012 is likely to be full of such surprises.
Andrew Sheng is president of the Fung Global Institute
