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4th Quarter 2012
Global Economic Outlook Q4 2012
Ira Kalish, Deloitte Research in the United States (Deloitte Services LP)
Will 2013 Be a Turning Point?
t has probably been said too many times, but it is worth repeating now. The world economy is at a crossroads. Every major region seems to be at a potential turning point. In Europe, the leaders of the Eurozone are moving slowly toward more integration, while periodically fighting back against new crises. In the United States, slow growth continues, but various forces seem destined to push the economy either toward recession or faster growth. In China, the economy has landed softly, but the next steps depend on the decisions of a new leadership. And in India, the government has attempted to kick-start the reform process just as the economy seems to have stalled. At the very least, the next year will be an interesting one. In this issue of the Global Economic Outlook, our economists from around the world offer their perspectives on these and other issues. First, Alexander Borsch discusses the Eurozone situation. He notes that, while the crisis appears to have ebbed in the wake of new policies by the European Central Bank, the underlying problems remain unresolved. He suggests that, other than collapse, the Eurozone has four options to move forward. These range from modest efforts to enforce existing constraints to full-scale integration in the form of a political union. Next, Carl Steidtmann looks at the US economy and notes that the situation is historically unique. That is, never before has growth “been so anemic for so long.” He demonstrates that, historically, such slow growth usually leads to a recession, or sometimes to accelerated growth, but never to simply more of the same. Thus, we appear to be in new territory. He suggests that the economy has been the beneficiary of “luck and resilience” that are likely to be severely tested in 2013. This will be due to a range of factors, including fiscal policy, headwinds from Europe, and risky monetary policy. Consequently, he sees a high risk of recession. In my examination of China’s economy, I point to evidence that a soft landing is underway. Moreover, I suggest that the current policy regime is likely to modestly boost economic output in the coming months. Yet many questions remain, not the least of which concern the policy choices to be made by the incoming leadership. As such, there is some degree of uncertainty about China’s outlook. In his article on the British economy, Ian Stewart says that the UK may be turning the corner but not perhaps in the way that many would like. He says that although growth should resume in 2013, the situation warrants concern, given all the remaining problems—both external and internal.
He says that “plenty of things could go wrong” and that the UK is headed for a “shaky and tepid recovery.” In my article on Japan, I indicate that Japan’s economy remains on shaky ground. With severe external headwinds, a highly valued currency, continued deflation, declining real wages, and stagnant consumer spending, Japan is not experiencing a significant recovery. Moreover, the central bank has chosen not to expand its policy of quantitative easing despite falling prices. Finally, a political dispute with China appears to be having a negative impact on the industrial economy. Thus, the outlook for Japan is not especially good. In his article on India, Pralhad Burli discusses the fact that India’s economy is Global Economic Outlook operating below potential. He says that the outlook for a return to high growth published quarterly by is not especially good. The country faces a number of downside risks, including Deloitte Research uncomfortably high inflation, which has restrained the central bank; external headwinds; and an uncertain policy environment. On the other hand, the governEditor-in-chief ment has proposed several new reforms that, if enacted, would likely lead to better Ira Kalish long-term growth. The problem is that severe political opposition remains. Thus, Managing editor uncertainty prevails. Ryan Alvanos Next, I discuss the outlook for Russia. Against the wind of much of the global economy, Russia’s central bank is tightening monetary policy in order to restrain Contributors inflation. In the midst of a global slowdown, this is likely to lead to a slowdown in Pralhad Burli growth. Indeed, there are signs that this is already happening. Alexander Börsch Brazil, on the other hand, is moving in a different direction. In my article on Carl Steidtmann Ian Stewart Brazil’s economy, I note that the central bank has cut its benchmark interest rate by over 500 basis points in the past year. It has clearly chosen to focus on growth Editorial address rather than inflation, which remains above the central bank’s target. The outlook, 350 South Grand Street therefore, is for stronger growth next year. The most notable short-term issue is Los Angeles, CA 90013 the potential impact of US monetary policy on Brazil’s exchange rate. Tel: +1 213 688 4765 Finally, Neha Jain and Satish Raghavendran offer a perspective on the email@example.com omy of South Korea. At a time when South Korea has achieved an enviable level of affluence, it now faces short-term obstacles to growth. With export demand weakening, the domestic economy is at risk due to excessive consumer debt, accumulated to fund an increasingly consumer-driven economy. Longer term, Neha and Satish point out that South Korea needs to shift the focus of its economy away from manufacturing in favor of services.
Dr. Ira Kalish Director of Global Economics Deloitte Research
Eurozone: Four Models for Future Governance | 6
The Eurozone’s crisis appears to have ebbed after the European Central Bank’s recent policy responses. However, many of the region’s underlying problems remain unresolved. Discounting a complete collapse, the Eurozone has four fundamental governance models to choose from.
India: Cautious Optimism
Uncomfortably high inflation, external headwinds, and an uncertain policy environment are adding downside risk to India’s economy, which is operating below its potential. The government has proposed several reforms that could improve long-term growth, but political opposition is adding a dose of uncertainty to India’s economic outlook.
Russia: Slowing Down
United States: Uncharted Waters
The US economy has benefitted from a combination of luck and resilience, and ongoing anemic growth in the United States is historically unprecedented. A wide range of factors, including fiscal policy, headwinds from Europe, and risky monetary policy may loom over the US economic outlook into 2013.
Despite a global economic slowdown, Russia’s central bank decided to tighten monetary policy in an attempt to curtail inflation. This may lead to a slowdown in growth.
Brazil: Chasing Growth | 38
Brazil’s central bank decided to focus on growth rather than inflation, which will likely result in stronger growth next year. The US monetary policy could have a significant impact on Brazil’s exchange rate.
China: When Exports Decline
The current policy regime may continue to boost economic output in the coming months, paving the way for a soft landing. Uncertainty pertaining to China’s economic outlook stems from the policy choices that will be made by the country’s incoming leadership.
Korea: S(e)oul Searching |
United Kingdom: Turning the Corner, Slowly
The United Kingdom’s current downturn is likely coming to an end, but myriad internal and external problems remain, which could result in a shaky and tepid recovery.
South Korea has achieved an enviable level of affluence, but weakening export demand and excessive consumer debt may put the brakes on economic growth. In the longer term, South Korea may need to consider a move away from manufacturing in favor of developing a service-based economy.
Japan: An Elusive Recovery |
Charts and Tables | 46
GDP growth rates, inflation rates, major currencies vs. the US dollar, yield curves, composite median GDP forecasts, composite median currency forecasts, OECD composite leading indicators
External headwinds, a highly valued currency, continued deflation, stagnant consumer spending, and declining real wages are hindering Japan’s economic recovery. Furthermore, despite falling prices, the government has decided against expanding its policy of quantitative easing, and a political dispute with China is having a negative impact on Japan’s industrial economy.
Dr. Alexander Börsch is head of Research, Deloitte Germany
Eurozone: Four Models for Future Governance
by Dr. Alexander BÖrsch
he euro crisis is now officially in its fourth year. It started in October 2009 when the Greek government admitted that its budget deficit was much higher than it previously stated. In the years that followed, the crisis not only deepened in Greece and spread to other countries, it also exposed serious flaws in the governance of the euro and the Eurozone. There are basically four options to reform the Eurozone’s governance. The two main dimensions that will determine the future shape of the Eurozone are the possible combinations of extended political integration and fiscal transfers. The options range from
a renewal of the Eurozone’s original guiding principles with a focus on member state responsibility to a political union with nationstate-like features. In early October, the euro looks as if it is on a slow road to recovery, at least measured against recent expectations. Many experts considered September to be the decisive month for the fate of the euro, and expectations tended to be pessimistic. From that perspective, things developed fairly well. The decision of the European Central Bank to renew its bond purchase program has reassured the financial markets and bought important time. The decision
of the German constitutional court that the euro rescue strategy is in principle consistent with the German constitution, given certain limitations, removed doubts about the future of the rescue mechanism. The Dutch elections resulted in a stable pro-euro coalition. Taken together, and contrary to more apocalyptic predictions made during the summer months, early autumn has been a comparatively quiet time for the Eurozone. However, this situation is not a reliable predictor of future events. Part of the difficulty in solving the euro crisis is due to the
fact that there is no clear vision about where the Eurozone is heading in terms of governance structures and architecture. The euro crisis includes a debt crisis, a banking crisis, a growth crisis, and a competitiveness crisis. That is why it is unrealistic to hope for grand bargains and comprehensive solutions to cut the Gordian knot. However, a clear vision for the future of the Eurozone’s governance structures is a precondition for political action and for kicking the can in the right direction.
Global Economic Outlook: 4th Quarter 2012
Is there a light at the end of the recession tunnel?
At first glance, no. The latest data on the economic sentiment in the Eurozone reinforce the trend of the last months. The European Economic Sentiment Indicator, which measures the outlook on the part of business, consumers, industry, and services, continues to decline for the Eurozone as a whole as well as for the crisis countries, with the exception of Spain. Also, the outlook for Germany is
Figure 1: Unit labor costs [2000 = 100]
deteriorating. The ifo Business Climate Index continued to fall in October, the sixth consecutive monthly decline. Nevertheless, there are some cautious signs that reforms in the crisis countries are beginning to gain traction and yield positive results. Among these are the reduction in the current account deficit and the improvement in price competitiveness. Unit labor costs in Greece, Spain, and Ireland have fallen quite substantially and are forecasted to continue to do so (see figure 1).
Figure 2: Current account [% of GDP]
10 5 0 -5 -10 -15 -20 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Source: OECD France Germany Greece Ireland Italy Spain Eurozone (17 countries)
140 130 120 110 100 90 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Germany Eurozone Greece Spain France Italy Ireland
Equally remarkable is the development of the current account deficits of the crisis countries. Greece managed to reduce its current account deficit from an extremely high level. Spain achieved the same, and Ireland managed to turn its deficit into a surplus (see figure 2). In other words, fundamentals are beginning to improve. While this is not yet reflected in business expectations, the conditions for an improvement are being built. While reforms in the crisis countries are crucial for a recovery in the Eurozone, the
other main pillar is the governance of the euro itself.
resort to devaluations. Second, rules to prevent excessive budget deficits in the form of the Maastricht criteria are enough to guarantee the stability of the euro. Third, specific provisions for crisis management are not needed. Crises will not happen if members stick to their obligations and follow the Maastricht rules. The euro crisis has made it blatantly obvious that these assumptions do not hold any longer. Crisis management has become the almost-exclusive focus of European political leaders. The rules of the Maastricht treaty have prevented neither excessive budget deficits nor the resulting threats to the euro. The euro did not initiate a broad dynamic toward reforms and higher competitiveness. The burning question, therefore, is how to redesign and amend the euro’s governance structure to prevent
future crisis and support the way out of the current crisis. Conceptually, there are two main dimensions of Eurozone reform. The first is political integration. The question is whether the Eurozone needs deeper political integration and a transfer of decision making to the European level or whether the primacy of the member states needs to be preserved and strengthened. The second dimension concerns fiscal transfers between member states. Fiscal transfers can, in principle, be used for emergency measures or in an institutionalized form.
Options for the Eurozone
Combining these two dimensions in a matrix illustrates the main options for European policy makers.
Governing the Eurozone
The institutional architecture of the Eurozone was built on three main assumptions. First, mechanisms compensating for the loss of the exchange rate as an adjustment tool are not needed. Countries will adjust to the new currency regime by internal reforms and will modernize their economies once they cannot
Fiscal transfers between member states
Low High Emergency union Political union
Degree of further political integration
Maastricht 2.0 Coordinated association
Global Economic Outlook: 4th Quarter 2012
The original Maastricht treaty from 1992 includes three main elements: • Member states must not run a budget deficit of more than 3 percent of GDP. • They must have a debt level of no more than 60 percent of GDP. • Eurozone members should not be liable for, nor assume, the commitments or debts of any other member state. In this original Maastricht framework, it is the member states that are exclusively accountable and responsible for healthy public finances. As long as the rules work, the stability of the euro is not threatened as overindebtedness and resulting instability cannot be an issue. However, the rules obviously failed, and the main elements of the original Maastricht provisions, such as the debt ceilings, are under pressure. Others, such as the no-bailout clause, have been totally pushed aside. The option of a Maastricht 2.0 scenario would need to include strengthening the original provisions, ensuring compliance, and providing a framework that puts national responsibility for public finances first. This implies that future crises of the euro are to be prevented by an improved version of the original framework. Some of the recent reforms in the EU—above all, the debt brake— go arguably in the direction of Maastricht 2.0.
While it is obvious that the European Union cannot become a nation-state overnight, it could assume the functions of a nation-state in key areas to guarantee the survival of the euro. These key functions would include a banking union, common deposit insurance, at least some mutualization of debt, and larger redistribution through fiscal transfers between the Eurozone’s member states. These moves would imply a centralization of fiscal policies and therefore a much stronger role of the EU in fiscal policy, if not a European finance ministry with corresponding competencies. As this would touch upon the core functions of national parliaments, a political union might need to follow to ensure democratic control. In other words, in economic and financial matters, the EU would become the main actor and decision maker. While there are many proposals and plans on how and in which areas European integration should move forward, concrete steps have not been taken, and workable plans have not been developed.
sanction mechanisms; the method works mainly through peer pressure. A greater coordination of the economic policies of member states would require enlarging the scope and the depth of coordination, as well as palpable sanctions. Areas that offer themselves to greater coordination in order to support a smooth functioning of the euro include wage policy, pension policy, and fiscal policy. For example, a coordinated association could aim at preventing the emergence of large imbalances in the Eurozone by mutually adjusting national economic policies.
similar intention, and so has the European Stability Mechanism, the main instrument to guarantee the liquidity of governments that lose access to financial markets. Whether this approach can work and bring the euro into shallow waters depends on whether the crisis is due to a temporary exceptional situation or to deeper institutional flaws in the governance of the Eurozone. If the latter is true, the caseby-case approach is unlikely to work, and bridge financing is not enough to let the storm pass.
The model of an emergency union comes quite close to the current working of the Eurozone in the face of the crisis. It is a series of rather unsystematic emergency measures that try to prevent the worst on a caseby-case basis. The worst, of course, is a fragmentation of the Eurozone. This process does not have a well-formulated goal, but is highly event-driven. While it is true that the European Union has been built in times of crisis and that a step-bystep process is not a bad thing in itself, the question is whether the measures add up to something that prevents future crises. So far, the bailouts—especially in the case of Greece— bought time, tried to keep states liquid, and forced them to introduce reforms. The ECB’s announced bond purchase program has a
The most consistent options of the four are the Maastricht 2.0 scenario and the political union as they define clear responsibilities for decision making, either on the level of the nation-state or on the European level. Both are ambitious. The Maastricht 2.0 would need to address and overcome obvious weaknesses in the old institutional architecture. The formation of a political union would imply a transfer of authority unseen in the history of the nation-state with many foreseeable and unforeseeable challenges. The main issue, however, is what the preferred option for the future of the Eurozone actually is.
Currently, the European Union is a complex combination of national, supranational, and intergovernmental decision making. While the big political decisions regarding the Eurozone are taken in the Council of the European Union by the national government leaders, the day-to-day business in the EU’s areas of competence is carried out by the European Commission. National economic policies remain firmly in the hands of national governments. To be sure, there have been some attempts to achieve a higher coordination of national economic policies. The last decade saw the introduction of the “open method of coordination.” This method aims at directing national policies toward common and agreed goals. It rests on instruments such as evaluation and benchmarking of policies. There are no hard
A future political union is being widely discussed. It builds on the idea that the fundamental reason for the euro crisis is the fact that there is no nation-state standing behind the euro that defends it unconditionally. So, saving the euro may require the establishment of a European nation-state—or at least something that resembles a nation-state.
Dr. Carl Steidtmann is Chief economist at Deloitte Research
United States: Uncharted Waters
by Dr. Carl Steidtmann
Rom the performance of the US economy to the unprecedented policy mix being employed to address the current malaise, the United States is in uncharted economic waters. The US economy’s performance over the past 18 months has been unprecedented. There has never been a time when growth has been so anemic for so long. There have been 14 instances since the end of the Second World War when real economic growth fell to less than 2 percent. In 11 of those cases, a recession followed within two quarters of hitting the 2 percent stall level. In three cases, expansion reaccelerated. This is the first case where
growth has neither accelerated nor fallen into recession. What is also unprecedented about the weakness of the current recovery is that it is following a deep recession. Historically, deep recessions create pent-up demand. During a recession, businesses put off investments, and inventories are drawn down. Consumers put off purchases of cars and homes. Young people stay at home with their parents, putting off marriages and delaying the process of household formation to save money. When a recovery comes, much of this pent-up demand gets released, producing a strong recovery. In
Global Economic Outlook: 4th Quarter 2012
the three years following the end of the Great Depression in 1933, real GDP rose a sizzling 38.9 percent. That has not been the case this time; growth is up a modest 5.8 percent in the two and a half years since the end of the recession, which is the slowest pace of growth for any recovery since 1948 (see figure 1).
The performance of the labor force has also been uncharacteristic. Throughout the past 50 years, labor force participation has risen as women and baby boomers moved into the work force. With the baby boomers approaching their retirement years, one would expect labor force participation to begin to fall.
Figure 1: Real GDP change—recession and recovery % change
25 20 15 10 5 0 -5 1948 1953 1957 1960
10 quarters of recovery
However, the mix of the decline in overall labor force participation does not fit the narrative of retiring baby boomers. Over the past five years, even as participation rates for other age cohorts have fallen, boomers have lingered in the labor force. Since the beginning of the last recession in December 2007, labor force participation among the 55–64-year-old cohort has actually risen slightly from 69.2 to 69.6 (see figure 2). Over the same period of time, participation among 16–24-year-olds has plummeted from 61 to 55.6. Of the 4.3 million jobs created since 2010, nearly 3 million of them went to workers over the age of 55. The inability of young people to gain a footing in the labor market will stunt their career development and earning power for years to come. It will also make it more difficult for them to service their student loans. The default rate for the first three years on student loans has jumped $120 billion or roughly 13.4 percent of all outstanding student debt.
Figure 3: Real per capita disposable income Five-year growth Percentage change over the past ﬁve years
25 20 15 10 5 0 -5 1964 1970 1976 1982 1988 1994 2000 2006 2012
Source: US Bureau of Economic Analysis Household net worth In trillions of dollars
80.0 70.0 60.0 50.0 40.0 30.0 20.0 10.0 0.0 1964 1970 1976 1982 1988 1994 2000 2006 2012
Source: Federal Reserve Board of Governors
A falling standard of living
Weakness in the labor market has translated into an unprecedented decline in the standard of living (see figure 3). Real per capita income has dropped over a five-year period for the first time in the post-World War II era not once but twice in the past five years. Slow job growth coupled with declining labor market participation has made for a toxic combination for income growth. In addition, record low interest rates have cut deeply into interest income,
Source: Bureau of Economic Analysis
Figure 2: Labor force participation Percentage of the cohort population 75.0
60.0 Over 16 55.0 55 to 64 16 to 24 50.0 1997 2000 2003 2006 2009 2012
Source: US Department of Labor
Global Economic Outlook: 4th Quarter 2012
sending it down from $1.4 trillion in May 2008 to $986 billion in August 2012. In addition to the decline in per capita income, the household sector has also experienced an unprecedented decline in net worth. After peaking at $67.3 trillion in the third quarter of 2007, household net worth fell to
Figure 4: Federal Reserve’s balance sheet Trillions of assets
The Fed’s response
Faced with a weak labor market and a declining standard of living, the Federal Reserve’s response to the current business conditions has also been unprecedented. Founded in 1913, it took the Federal Reserve 95 years to grow its balance sheet to just under $1 trillion. In the fall of 2008, in response to the collapse of Lehman Brothers, the Fed pursued its first round of quantitative easing (QE), purchasing a wide variety of financial assets in the process of doubling its balance sheet to just over $2 trillion (see figure 4). The purpose of the first round of QE was to provide liquidity to the banking system that was reeling from the shock of the Lehman bankruptcy. In the fall of 2012, the Fed initiated a second round of quantitative easing, adding another $1 trillion to its balance sheet through the purchase of mortgage backed secu2012 rities and US Treasury bonds. While the banking system no longer needed liquidity, the Fed’s objective was to lift asset prices in an attempt to encourage investment from banks and businesses and spending from consumers. Two years later, with unemployment still above 8 percent and the economy still growing at a subpar rate of growth, the Fed has initiated a third round of quantitative easing. Unlike
the previous efforts at QE, this one has no end date and no set amount. The Fed will buy $40 billion in Treasuries and mortgage-backed securities every month until unemployment falls below a level that is deemed acceptable by the Fed. Most Fed watchers expect QE3 to go on through 2013 at the very least, resulting in a $600 billion expansion of the Fed’s balance sheet at the very least. Quantitative easing is not a risk-free policy. Printing money for the purpose of buying government debt risks higher inflation and a weaker dollar. While a weaker dollar would
give a boost to exporters, it will result in higher import prices, particularly for energy. The case for quantitative easing is that by suppressing interest rates, the Federal Reserve will force investors to take more risk in both the bond market and the stock market. The reduction in interest rates and the increase in investor risk taking will give a boost to asset prices in the housing market, the stock market, and the bond market. The corresponding rise in wealth from these three developments will bring about a recovery in the housing market and induce consumers to spend more and businesses to invest more.
0.00 2007 2008 2009 2010 2011
Source: Federal Reserve Board
$51.2 trillion in the first quarter of 2009, a stunning $16.1 trillion destruction of wealth. Since then, wealth has climbed due entirely to the rise in the value of financial assets. Even with the rebound, net worth is still down $4.7 trillion from its peak, and it actually fell by $300 million in the second quarter of this year.
Global Economic Outlook: 4th Quarter 2012
Taken together, the tax increases and spending cuts that make up this year’s fiscal cliff come to roughly $600 billion. While there is no guarantee, there does seem to be some agreement on at least some of the elements of the fiscal cliff. Both sides are on record as favoring a phase out of the payroll tax cuts. The 2 percent payroll tax holiday that went into effect in 2010 represents roughly $95 billion in The fiscal cliff additional taxes. The automatic minimum tax gets bigger every The debate in year. The fix for the United States the automatic over fiscal policy minimum tax revolves around plus the “Doc fix” the pending for Medicare are fiscal cliff (see also likely to gain figure 5). What bipartisan supis remarkport as they have able about this in the past. debate is how The big stickunremarkable ing point will be it really is. Over extending the the past decade, Bush tax cuts more and more for high-earning of the tax code households. This has become a was the point of part of a yearcontention back end dance in August 2011 between political — Ben S. Bernanke, Federal Reserve chairman that led to the parties, making downgrade of longer-term tax US debt by the and investment credit rating agencies. A second impasse over planning for businesses and individuals more this issue could result in another downgrade. challenging. In most years, indexing of the While the outcome of the fiscal cliff debate automatic minimum tax and various investremains uncertain, at the very least, it seems ment and R&D tax credits were among these certain that the United States will face much items. Medicare’s “Doc fix” also seemed to tighter fiscal policy in 2013 than it has in require a yearly vote. recent years. With an economy growing near 2 Three factors make this year’s fiscal cliff percent, tighter fiscal policy will slow growth debate different: one is size, the second is timin the short term. A failure to resolve any of ing, and the final issue is the reaction of the the issues of the fiscal cliff could result in a bond rating agencies. The downside argument against more quantitative easing is that it results in a mispricing of risk. It reduces the income of retirees who depend on low-risk, interest-bearing assets. It also gives a boost to the price of food and energy, reducing the purchasing power of all consumers.
Figure 5: The ﬁscal cliff components In billions of dollars
$250 $200 $150 $100 $50 $0
$95 $65 $18 $65 $26 $11
If the fiscal cliff isn’t addressed, as I’ve said, I don’t think our tools are strong enough to offset the effects of a major fiscal shock, so we’d have to think about what to do in that contingency.”
s ro ay ll t
s Ot he
s ble ca r
s q Se ue
n Jo s ble sb
c Do Ot
ﬁx p rs en d
Source: Congressional Budget Ofﬁce
significant increase in the fiscal contraction and a sharp recession in early 2013.
Conclusions and observations
The US economy has shown a combination of luck and resilience in avoiding a recession while growing well below its potential for the past 18 months. That resilience and luck are going to be tested in 2013 as the economy sails
off into uncharted waters. Current monetary policy risks higher inflation and lower incomes for retirees and lower spending power for everyone else. The fiscal cliff impasse all but guarantees a more restrictive fiscal policy and potentially another credit downgrade. Sluggish employment growth, declining labor force participation, and shrinking real incomes are a dangerous combination that could push the economy into recession in 2013.
China: When Exports Decline
by Dr. Ira Kalish
hInA’S economy is slowing down, but a soft landing is still a possibility, thanks to various measures undertaken by the government that are helping to offset economic headwinds from Europe. Just the same, the country is experiencing an abundance of bad news. In September, for example, HSBC and Markit published a purchasing manager’s index that suggests that Chinese manufacturing was in negative territory for the 11th consecutive month. The PMI was 47.9 in September compared to 47.6 in August; a reading below 50.0 indicates a decline in activity. The weakness was largely related to poor export performance. The sub-index for export orders reached its lowest level in 42 months, and the sub-index for employment was also in negative territory. Exports are the primary culprit. China’s government reported that total exports were up a very modest 2.7 percent in August from a year earlier. Exports to the EU were down 12.7 percent from a year earlier, and Chinese imports fell 2.6 percent in August to their weakest performance since 2009. This was partly due to declining commodity prices, but it also reflected weakening demand in China.
Industrial production was up a relatively modest 8.9 percent in August. Automobile sales were up 8.3 percent in August, far slower than the pace of the last few years. All of this news suggests that China’s economy is weaker than expected, and the anticipated rebound is not yet here. It also boosts expectations that the Chinese authorities will engage in further measures to stimulate the economy. Meanwhile, weakness in the industrial sector is having a negative impact on investment into China. In August, China experienced a net outflow of capital for the third time in 2012. This means that investors are moving money out of China, perhaps as a result of the declining profitability of Chinese companies and pessimism about the Chinese economy. To facilitate the outflow and prevent a drop in the value of the currency, the central bank sold foreign currency. The central bank is boosting domestic credit in order to offset the negative impact on the money supply of sales of foreign currency. When a country experiences a net outflow of capital, it either leads to a decline in the value of the currency or a decline in the money supply if the central bank intervenes
to hold the currency steady. Evidently, China’s authorities are averse to allowing currency depreciation as it would likely draw criticism from foreign governments. Given this political climate, China’s central bank has been intervening to keep the currency steady by trying to mitigate rising inflation and declining currency that could kindle political unrest. Yet at the same time, it is assuring that money supply growth continues at a moderate and rising pace. One effect of the weakening industrial sector is a decline in Chinese company profitability. The profits of China’s industrial companies fell in August for the fifth consecutive month. Profits were down 6.2 percent from a year ago, the fastest rate of decline this year. Corporate revenue continues to increase, but export-oriented companies are struggling to maintain sales by cutting prices, resulting in weaker profitability. To deal with the slowdown in economic activity, the government has taken a variety of
actions. The central bank cut the benchmark interest rate and reduced banks’ required reserves, thereby boosting bank lending. In addition, the government has increased public investment in infrastructure. The result of these measures has been positive. China’s government announced that new local currency lending increased by $111 billion in August, the biggest August increase on record. This is very likely due to the recent cuts in interest rates and the reduction in banks’ required reserves. Indeed, the broad money supply increased 13.5 percent in August from a year ago. Increased lending is welcome, given that several indicators have lately been disappointing. The question now is whether the government will choose to take further actions aimed at stimulating the economy. With a change of leadership about to take place in Beijing, major decisions may be put on hold until the new leaders have time to assess the situation.
Ian Stewart is Chief economist at Deloitte Research in the United Kingdom
United Kingdom: Turning the Corner, Slowly
by Ian Stewart
he last five years have seen the worst growth performance by the UK economy since the 1920s. The UK economy saw a deep recession in 2008–2009 and entered a milder second recession in the last quarter of 2011. The current cycle’s GDP levels are comparable to those of the 1920s. However, this comparison overstates the degree of stress facing businesses and households today. Low interest rates and forbearance on the part of lenders have helped soften the damage to the economy in recent years. UK interest rates and government bond yields today are at the lowest level since the foundation of the Bank of England in 1694. Debtors have not faced an acute interest-rate squeeze, which
was the hallmark of most postwar boom bust cycles. The United Kingdom has also escaped Great Depression levels of unemployment. Indeed, employment has risen for the last three years as job growth in the private sector has outstripped public-sector job losses. Ben Broadbent, a member of the Bank of England’s Monetary Policy Committee, recently observed that, had the normal, pre-recession relationships held, the number of jobs in the United Kingdom would have fallen by 8 percent over the last five years. Instead employment has stayed roughly unchanged. The result is that the UK unemployment rate today is well below the peaks seen in the previous, milder UK recessions of the ’80s and ’90s.
Global Economic Outlook: 4th Quarter 2012
Relatively low unemployment has helped support consumers during a period of acute difficulties. Other factors are also becoming more positive for consumers. Most of the big tax rises are past. Sharply lower inflation—CPI
inflation has almost halved in the last year to 2.5 percent—should lend additional support to consumer spending power. The outlook for a battered consumer sector is starting to look up. Real disposable incomes have risen 1.7 percent over the last year, having declined through 2011. And consumer spending is rising once again. Given that consumer spending accounts for over 60 percent of the UK economy, an upturn in consumer activity should lend significant support to growth next year. The universal assumption among economists—at least for now—is that the worst has passed for the UK economy. All 37 independent forecasting groups that provide GDP forecasts to the Treasury expect UK growth to bounce back in 2013. Most believe that the current slowdown in the United Kingdom is drawing to an end, and that steady growth will resume in the first quarter of next year. ut a better test is what kind of growth is expected next year. The news here is not encouraging. Consensus forecasts for UK GDP growth for 2013 have dropped from 1.8 percent to 1.3 percent in the last four months—a pretty weak rate of growth for an economy used to growing at 2.5 percent a year. Our guess is that most economists would say that the risks to their UK growth forecasts lie on the downside. Many of the problems facing the United Kingdom exist elsewhere in the world. After a lull over the summer, worries about the euro area are growing. Hopes that a bond-buying program by the European Central Bank would crack the euro’s problems have dissipated. Meanwhile, the United States may be on course for sharp tax hikes and cuts in public spending in three months’ time. Unless politicians strike a postelection deal, the so-called fiscal cliff could derail America’s recovery. Such external uncertainties constitute a significant drag
on a UK recovery, which is widely expected to be powered by demand for British exports from abroad. While the UK consumer outlook has brightened marginally and corporates are continuing to hire, businesses remain cautious. The third-quarter Deloitte Survey of UK Chief Financial Officers suggests that big corporates increasingly subscribe to the notion that we are in a lowgrowth world. Perceptions of macro-uncertainty and of the risk of continued recession are widespread. Corporates are increasingly focusing on defensive balance-sheet strategies, including cash generation, cost control, and leverage reduction. In 2008, a combination of a shock to demand and a credit crunch caused a deep recession. The financial system is in far better
The universal assumption among economists—at least for now—is that the worst has passed for the UK economy.
shape today, and the larger corporates who responded to the CFO survey are not especially constrained by cash or capital shortages. The big problems seem to be the weakness of Europe’s economies and a climate of macroeconomic uncertainty. After successive waves of bad macro news followed by policy stimulus and equity rallies, UK corporate CFOs may need some convincing to turn significantly more positive on expansion. The United Kingdom’s current downturn seems to be drawing to an end. Growth should pick up next year. But, as the continued difficulties in the euro area highlight, plenty of things could go wrong. For now, the United Kingdom seems to be heading for a shaky and tepid recovery.
Japan: An Elusive Recovery
by Dr. Ira Kalish
APAn’S economy has been mostly sluggish for some time, despite the increased government spending on reconstruction following last year’s earthquake and tsunami. Although there have been periodic bursts of economic activity, such as the 5.5 percent growth rate in the first quarter of this year, growth has mostly been disappointing. For example, the Japanese government reported that the economy grew at an annual rate of only 0.7 percent in the second quarter. This was revised down from the original growth estimate of 1.4 percent in the second quarter. The slow growth was largely due to weak private investment as well as weaker-than-expected public spending on reconstruction.
The government also reported that the compensation of workers continues to decline, with total wages to workers in Japan in the second quarter only marginally higher than in 1991—21 years ago. This means, of course, that unit labor costs are declining, thereby improving the competitiveness of Japanese products. Yet that improvement is largely offset by the negative impact of a highly valued Japanese yen. On the other hand, declining wages contribute to declining purchasing power and stagnant consumer spending. This wage decline also contributes to deflation, which remains a serious problem in Japan. This begs the question of whether the central bank will act according to its goals. The Bank of Japan has set a formal inflation target
Global Economic Outlook: 4th Quarter 2012
of 1.0 percent, yet prices continue to decline despite a more aggressive monetary policy. For the past year, the Bank of Japan has engaged in quantitative easing: the bank purchases assets such as government bonds in order to inject liquidity into the economy. The idea is to boost the money supply, thereby creating some inflation. Other goals include keeping market interest rates low and putting downward pressure on the value of the yen. Yet the policy, which involved purchases of 45 trillion yen worth of assets (roughly US$570 billion), has yet to result in any inflation. Perhaps that is because it is not very aggressive compared to what has been done by the US Federal Reserve or the Bank of England. Consequently, on September 18, 2012, the Bank of Japan boosted its program of quantitative easing by 10 trillion yen, demonstrating that the bank is concerned about continued deflation and a high-valued yen. It also means that the bank recognizes that the Federal Reserve’s new third round of quantitative easing is likely to put downward pressure on the US dollar and, therefore, upward pressure on the yen. Yet again, the question of whether this will be sufficient must be asked. By October, with Japanese government officials urging a more accommodative policy,
Japan’s major automotive companies report that, in September, sales of Japanese brand vehicles in China dropped sharply.
the Bank of Japan chose to leave its asset purchasing program unchanged at 55 trillion yen (US$700 billion). In addition, the Bank of Japan downgraded its assessment of the outlook for growth and inflation, saying, “Economic activity is leveling off.” Unusually, the economy minister attended the latest meeting of the bank’s policymaking committee. He said that he wanted to express his “sense of crisis” to the bank. Clearly he failed to move the bank toward a more aggressive stance. Still, some observers now believe that the bank will boost the quantitative-easing policy at its next meeting, especially if it continues to downgrade its assessment of inflation. Meanwhile, some indicators suggest that the health of the Japanese economy is not improving. The wellknown Tankan survey, which measures confidence among manufacturers, declined in September. This was the fourth consecutive decline in this quarterly measure. In addition, exports fell in August for the third consecutive month, declining by 5.8 percent year over year, and imports fell 5.4 percent due to a recent slide in oil prices, marking the sharpest decline in nearly three years. Industrial production fell in July, and purchasing managers’ indices for both manufacturing and services were down in August. On the other hand, new orders for machinery rose 4.6 percent from June to July.
This unexpected increase could bode well for capital spending in the months ahead. Just at a time when the Japanese economy hardly needs bad news, the political dispute between Japan and China over a group of islands is starting to have a real impact on the economy. Japan’s major automotive companies report that, in September, sales of Japanese
brand vehicles in China dropped sharply. While the vehicles are mostly assembled in China, many of their parts are made in Japan. Consequently, if this dispute results in a sustained decline in Chinese demand for Japanese products, it could have real consequences for Japan’s already troubled industrial sector.
Pralhad Burli is Senior Analyst at Deloitte Research, India
India: Cautious Optimism
by Pralhad Burli
LL of a sudden, the cogs of government policy have been set in motion. While the government’s reform agenda momentarily raised hopes, the implementation of the reforms remains uncertain. The economy, however, is not out of the woods yet. Weak industrial production, an erratic and delayed monsoon, muted global demand, and policy uncertainty cloud India’s economic outlook. Meanwhile, inflation remains elevated, and the government’s woes arising from a high fiscal and current account deficits continue to constrain the economy. Growth projections have been lowered several times, and analysts predict that India will grow at less than 6 percent during the 2012–2013 fiscal year.
A step forward, but will the government retract?
The government decided to allow foreign players to invest up to 51 percent in multibrand retail. This announcement opens up India’s retail sector for multinational retail giants, but there are some restrictions. Retail stores can be set up only in cities with a population of more than 1 million. The minimum investment must be $100 million, and at least 50 percent of the investment must be in back-end infrastructure within three years. Moreover, state governments will have the right to decide whether or not they will allow
Global Economic Outlook: 4th Quarter 2012
foreign direct investment (FDI) in the retail sector in their respective states. The decision to allow FDI in retail can potentially eliminate several inefficiencies that mar India’s retail sector. However, the political consequences of the decision have already cropped up. The government faced significant political backlash from the opposition parties as well as its allies. One of the government’s allies has already withdrawn its support from the ruling coalition. While the government is unlikely to collapse on the back of this decision, the implementation of the FDI policy is unlikely to be smooth. The central government is unlikely to backtrack on its policy stance because state governments make the final decisions about whether or not to allow retailers into the country. But, as of this writing, only 10 states have decided to allow FDI in multi-brand retail. The success of multinational organizations that enter India’s retail space may depend on how they and the government are able to assuage the fears of those who are likely to be affected by their presence. Given India’s huge consumer base and a rising middle class, global retail companies are excited about their growth prospects. However, retail outlets have faced the ire of angry mobs in the past, and multinational retailers will likely tread cautiously amid uncertainty. Another policy decision that met stiff political opposition was the reduction of subsidies on diesel and cooking gas. The government decided to restrict supply of subsidized cooking gas to six cylinders per household in a year and increase the price of diesel by 5 rupees per liter, which led to political resistance. All major political parties also participated in a day-long
Given India’s huge consumer base and a rising middle class, global retail companies are excited about their growth prospects.
strike soon after the reforms were announced. Furthermore, the National Federation of LPG Distributors of India has threatened to go on a strike against the government’s multiple-rate policy on cooking gas cylinders. Some state governments have intervened by increasing the limit on subsidized cylinders to nine, while others have waived state taxes on the sale of diesel. The backlash against the subsidy reform is just beginning, and political parties and trader unions are demanding a rollback of these reforms. The ensuing outcome is difficult to predict. The government’s subsidy bill rose substantially, owing to a decline in the value of the rupee and elevated prices of petroleum products. While the subsidy drawdown is unlikely to solve India’s fiscal woes, it is considered to be a step in the right direction. India’s high-deficit problem raises the interest rates for domestic borrowing, which impacts private investment; it also restricts the monetary policy options of the central bank because deficits are usually financed by borrowing funds from the central bank. Meanwhile, the finance ministry approved 49 percent FDI in the insurance and pension sector, up from the current ceiling of 26 percent. However, the bill is yet to be approved by the parliament. In addition, the government has proposed allowing foreign minority stakes in the aviation, electricity trading, and broadcasting industries. Finally, the government will also divest its equity ownership in some state-owned corporations. It may be relatively easier to implement these reforms as they are unlikely to face significant political roadblocks.
Limited options, limited action
In April 2012, the Reserve Bank of India (RBI) aggressively cut its policy rate by 50 basis points. In its mid-quarter review in June, it did not opt for further policy easing. While the domestic economy remained fairly sluggish between June and September, global macroeconomic weaknesses did not subside either. Industry participants anticipated that the RBI would cut interest rates and prop up India’s negative investment climate. However, in its policy meeting in September, the RBI maintained its monetary stance and kept the policy
Through its current policy stance, the RBI has reiterated that containment of inflation remains its primary focus. Driven by a rise in food prices, consumer price inflation came in at 10.3 percent in August 2012. Food prices for consumers accelerated to 12.0 percent in August from 11.5 percent in July. Meanwhile, revised CPI data for July remained at 9.9 percent. Vegetable prices witnessed the highest increase at over 20 percent during August. Currently, inflation is well beyond the central bank’s comfort level. In addition, a weak monsoon is expected to have a significant
repo rate unchanged at 8 percent. However, the cash reserve ratio (CRR) was lowered by 25 basis points to 4.5 percent. The CRR cut is likely to inject primary liquidity in the banking system to the tune of $3.1 billion and would likely have a larger cumulative impact on the economy through the money multiplier.
impact on grain production, and farm output may experience a contraction this year. As such, food price inflation is likely to persist. However, abundant rainfall in the latter half of the monsoon season will likely ensure adequate irrigation for the winter crop.
Global Economic Outlook: 4th Quarter 2012
Finally, the government’s recent policy announcements regarding an upward revision in diesel prices and a partial curtailment in subsidy on cooking gas are likely to put upward pressure on inflation in the short term. However, over the medium term, these initiatives are expected to help the central bank to manage inflation and strengthen India’s macroeconomic fundamentals. The central bank may adopt an easier monetary policy if inflation declines to manageable levels.
Twin deficit, twin challenge
Some of India’s macroeconomic challenges stem from its twin deficit problem. Government expenditures exceed revenues, resulting in a fiscal deficit, and the country imports more than it exports, leading to a current-account deficit. Persistent current account deficits put pressure on the exchange rate, and additional government borrowing increases the borrowing cost for other
market participants, thus crowding out private investment. In the 2012–2013 fiscal year, the government expects the fiscal deficit to be restricted to 5.1 percent of GDP. However, that target seems ambitions and is likely to be missed. Subsidies on oil and other petroleum products, fertilizers, and expenses on social welfare programs will make it extremely difficult to contain the fiscal deficit. Furthermore, any decision to deregulate diesel prices further or cut subsidies is likely to face political hurdles. In the absence of additional fiscal reforms, the central government’s deficit will likely range between 5.6 and 5.9 percent of GDP. Combined with the deficit of the state governments, the overall deficit could be as high as 9 percent of GDP. Moreover, ambiguity pertaining to the government’s policy around taxation of foreign capital flows led to a huge exodus of foreign funds from India. This put additional pressure on the exchange rate and exposed importers
to currency risk. The Reserve Bank of India’s timely intervention stemmed the decline and bolstered investor confidence. As a result, the rupee has appreciated in recent months, after witnessing a steep drop between February and June this year. However, if India’s economic prospects do not improve or investors flee to safer assets as the European crisis deepens, the rupee could experience some volatility. India’s economy is operating below its potential, and a return to pre-crisis levels of growth is unlikely in the near future. Given the global economic uncertainty and India’s domestic macroeconomic challenges, the downside risks to the economy outweigh the upside. In an already-inflationary environment, a weak monsoon is likely to push food prices even higher, which may dampen domestic consumption. Furthermore, a weak performance in the agricultural sector does not bode well for the economy. Finally, India will remain vulnerable to the geopolitical tensions in the Middle East, which may lead to a spike in global oil prices. While the government’s reform plan is a welcome sign, it may be too early to celebrate.
While the government’s reform plan is a welcome sign, it may be too early to celebrate.
Russia: Slowing Down
by Dr. Ira Kalish
t is unfortunate that, at a time when the global economy is decelerating and major central banks are taking more aggressive action to boost growth, Russia’s central bank finds it necessary to tighten monetary policy. In mid-September, the Central Bank of Russia boosted its benchmark interest rate by 25 basis points, citing the risk of rising inflation and, importantly, rising expectations of inflation in the marketplace. The inflation problem stems largely from rising food prices, as well as from the freeing of administered prices, but the central bank has noted that this can create expectations of inflation that lead to more inflationary behavior among businesses and workers. The bank sees this as a greater problem than slowing output growth. There could be a silver lining to this otherwise cloudy situation: Increasing interest rates will boost capital inflows into Russia, causing a rise in asset prices and a boost to wealth. Moreover, such capital flows would have the effect of boosting the value of the Russian ruble, thus reducing import prices and relieving some of the inflationary pressure. On the other hand, rising interest rates could stifle already weak private sector
investment. In addition, a rising currency would hurt the competitiveness of noncommodity exports and, by boosting imports, would damage the trade balance. The question, of course, is whether the central bank’s rate increase is a one-off action or the start of a new round of monetary policy tightening. Some analysts believe that the central bank has only just begun, and that more rate increases are in the cards. That is because core inflation has lately accelerated from 3.6 percent in April to 5.9 percent in August— above the central bank’s target of 5–6 percent. Moreover, although economic growth recently has slowed largely because of export weakness, domestic demand has remained strong. As a result, there have been considerable wage pressures in a tight labor market. The unemployment rate has fallen from 6.1 percent a year ago to 5.2 percent in August. This was the lowest rate of unemployment recorded since the end of the Soviet Union. Wages, consequently, have risen about 15 percent in the past year. Why has domestic demand been so strong? First, consumer spending has grown rapidly, in part due to rising real wages and in part due to a rapid increase in consumer leveraging.
Second, business investment accelerated due to strong cash flow, especially in the energy sector when energy prices were rising. Third, government spending rose early this year in anticipation of the election in March. The lingering effects of fiscal stimulus remain. Many of the factors that contributed to strong growth of domestic demand have already begun to reverse, even before the central bank raised interest rates in September. First, the acceleration of inflation has eroded the gain in real income for consumers. In addition, banks have already begun to tighten lending standards for household borrowing. Second, fiscal policy was tightened once the election ended. Stimulus from the government has begun to diminish. Third, investment has begun to decelerate owing to weakening corporate profits. The latter have been hurt by the rapid rise in wages as well as by the weakness of demand in Western Europe. The end result is that the domestic side of the economy is showing signs of weakness, which will only be exacerbated by the tightening of monetary policy. Thus, Russia appears headed for a slowdown.
Brazil: Chasing Growth
by Dr. Ira Kalish
he Central Bank of Brazil has been easing monetary policy in order to boost growth, having decided that the slowdown in economic activity is more worrisome than the level of inflation. Yet going forward, the central bank will have to find the right balance between the goals of higher growth and lower inflation, lest one of the goals becomes unattainable. Moreover, with the US Federal Reserve having initiated a third round of asset purchases (quantitative easing), Brazil is one of many emerging countries to be concerned that the US policy will cause a boost in the value of the local currency. Brazil’s policy will thus aim to also keep the currency competitive. The central bank has cut the benchmark SELIC rate 11 times in the past year. The rate has declined by 525 basis points, reaching a record low of 7.3 percent in September of this year. Although economic growth remained feeble during the first half of 2012 (real GDP was up only 0.5 percent in the second quarter,
lower than a year ago), there are signs of economic renewal. Unemployment has fallen to a record low of 5.5 percent. Moreover, while second-quarter GDP was hardly up from a year ago, it did grow at an annual rate of 1.6 percent from the first quarter, a significant improvement from earlier quarters and the fastest rate of growth since early 2011. Thus, the easing of monetary policy is evidently working despite negative global headwinds. Indeed, secondquarter growth improved despite severe export weakness. Not only has monetary policy been eased, fiscal policy also has contributed to growth. The government has cut the interest rate charged by its development bank. It has also boosted spending on public investment, provided tax incentives for consumer spending on durable goods, and sold concessions for private sector development of public infrastructure. Meanwhile, inflation remains slightly higher than the central bank target of 4.5
Global Economic Outlook: 4th Quarter 2012
percent. In September, consumer prices were up 5.3 percent from a year ago. Moreover, this was the third straight quarter in which inflation accelerated. All these indicate a developing problem. The other big issue is the currency. During the past year, as interest rates were cut, the Brazilian real declined by 22 percent against the US dollar. While a cheaper currency tends to be inflationary, it also leads to more competitive pricing of noncommodity exports. This has been seen as a good offset to the weakness in global demand for Brazilian exports. Yet, the recent decision by the US Federal Reserve to engage in a third round of quantitative easing will, it is feared, cause the Brazilian real to increase in value. This was the fear two years ago during the last round of asset purchases by the US Federal Reserve. At that time, Brazil imposed a tax on inbound portfolio investment to discourage a rise in the currency. This time
With stimulation from both the Central Bank of Brazil and the government, domestic demand, including both consumer spending and public investment, is picking up.
around, the government has chosen to impose a new round of capital controls on portfolio investment that aim to discourage hot money from flowing into Brazil. One effect of these controls has been to shift inbound money from portfolio to direct foreign investment. Despite weakness in the global economy, foreign direct investment has remained strong. What can be expected going forward? It seems likely that Brazilian growth will recover in 2013, barring a deeper crisis in Europe or a recession in the United States. With stimulation from both the Central Bank of Brazil and the government, domestic demand, including both consumer spending and public investment, is picking up. With lower interest rates and increasing foreign direct investment, private sector investment should pick up in 2013. Moreover, Brazil is now seen as a favorable location for investment in energy, manufacturing, and offshored services.
On the other hand, there are a few things that worry observers: rising inflation, increased protectionism on the part of the government, a rising fiscal deficit, and the continued weak state of the global economy. Protectionism has involved a variety of government regulations aimed at boosting the domestic content of manufactured goods. Historically, such rules have tended to encourage inefficiency, reduce
productivity growth, and often contribute to inflationary pressures. The fiscal deficit could become worrisome if it is financed through monetary creation (which causes inflation) or if it leads to higher market interest rates (which would discourage private sector investment). If, however, growth accelerates sufficiently, that in itself could relieve the fiscal deficit by driving an increase in tax revenue.
Dr. Satish Raghavendran neha Jain is an Analyst is Vice President, Com- at Deloitte Research, munications excellence, India Deloitte Consulting Services India Pvt. Limited
Korea: S(e)oul Searching
by Dr. Satish Raghavendran and Neha Jain
he world today knows Korea not only for its smartphones but also for “Gangnam Style,” the recent pop single by rapper Psy that holds a Guinness World Record for being the “most liked video in YouTube history.” The music video is shot in the affluent Gangnam district of Seoul, which benefited from Seoul’s rapid economic development and planned expansion of in the 1970s. The video’s humorous compilation of unusual dance moves can be perceived as a social satire of the materialistic lifestyle of Gangnam’s elite residents. It also depicts two fundamental characteristics of the Korean economy: conspicuous consumption and rising income inequality. Consumption has long been the main driver of the Korean economy. Historically,
rapid industrialization from the 1960s to 1980s resulted in double-digit growth rates, which set the trend for robust private consumption in future decades. Today, private consumption accounts for almost half of Korea’s GDP. However, similar to many developed economies, rising levels of affluence have led to a consistent increase in conspicuous consumption as Korean households strive to achieve a higher social status. One of the immediate consequences has been the rise in household indebtedness; Korean household debt stands as high as 160 percent of disposable income, which is even higher than the rate in the United States right before the subprime crisis.
Global Economic Outlook: 4th Quarter 2012
Rising household debt
Korean consumer debt is equivalent to over 80 percent of Korea’s GDP and has expanded by an average of almost 9 percent per year since 2005. Data from the Central Bank of Korea shows that at the end of the first quarter of 2012, outstanding loans by the depository and other financial corporations stood as high as $757 billion—the highest level in the seven years for which data is available. What is worrisome is the fact that household indebtedness is rising in a sluggish economy with stagnant income growth and declining property prices. Rising real estate mortgages, especially at a time when external headwinds are having an adverse impact on the domestic economy, present a growing risk to the banking sector. Recent statistics from the central bank show that around 70 percent of outstanding loans in the banking sector are in the form of real estate mortgages, exposing the sector to fluctuations in property prices. Real estate prices in Seoul have already begun to contract; after negligible growth in 2011, property prices have already dropped 1.2 percent since the beginning of this year. Further softening of the housing market could lower the value of household borrowers’ collateral and further amplify indebtedness. Another concern stems from the growing involvement of the nonbanking sector (credit card companies and mutual savings banks) in household debt. With looser regulations than those imposed on the regular banking sector, these institutions typically enforce less stringent qualifying conditions on loan applicants but charge a higher rate of interest. Moreover, around 90 percent of household loans are subject to floating interest rates, leaving borrowers vulnerable to a rise in interest rates. While the central bank has kept interest rates low, expected economic recovery in the next few years could tighten policy rates and push up variable mortgage rates.
Record-high household debt levels have prompted policy action from the government. So far, the government has adopted a loose monetary policy stance to relieve pressure on borrowers; on the other hand, it has tightened measures for lending institutions to keep a check on household debt. The government faces an additional task of reviving private consumption, which has been declining as overstretched households are tightening their purse strings. Growth in private consumption, which is the main driver of growth after exports, is slowing down as well. After registering a growth rate of 4.4 percent in 2010, private consumption growth almost halved to 2.3 percent in 2011 and is forecasted to slow down to 1.9 percent this year. Underlining weaker consumer sentiment, retail sales have also experienced steady declines over the past few months. Policy makers are thus faced with the dilemma of reviving consumption while ensuring the stability of household debt.
The eggs and the export basket
Korea’s growth engine is losing steam primarily due to decelerating domestic consumption, declining investment, and weaker export growth. The export sector contributes to about half of Korea’s GDP, leaving the economy vulnerable to external headwinds. Korea’s exports, which mainly consist of electronics and semiconductors, suffered a quarter-over-quarter contraction of 1.4 percent during the second quarter of 2012. In the month of August alone, exports declined by 6.2 percent year-over-year, the sixth month this year in which exports have fallen. Exports to its main markets— China, Japan, the United States and the EU— all contracted. The outcome of the Eurozone debt crisis is uncertain, but depressed demand conditions are likely to persist for a few years and are expected to weigh down Korean manufactured exports.
Korea’s export reliance is a result of an outward-looking strategy adopted in the 1960s. The strategy envisaged economic growth through labor-intensive manufactured exports, giving Korea a competitive advantage over countries with limited human resources. The government greatly encouraged foreign direct investment (FDI) in the manufacturing sector, which made up for the shortage of domestic savings. This strategy served Korea well for the next few decades, leading to rampant industrialization and a rapidly expanding export sector. However, in recent years, this outwardlooking strategy and the openness of the economy have exposed it to external economic conditions including trade demand, currency fluctuation, and volatile capital inflows. While macro prudential measures taken by authorities and the resilience of the economy itself has cushioned the landing so far, manufacturing—Korea’s export-oriented growth engine— has lost its magic in the wake of major global economic and geopolitical events.
Soul searching in Seoul
This is perhaps a wake-up call for the South Korean policy makers to identify a new growth engine that will catapult the economy back to a growth trajectory. Korea’s historic success as a manufacturing champion came at the expense of the country’s service sector, which was starved of capital and innovation that was directed toward manufacturing. However, the recent export slowdown and its negative impact on the manufacturing industry have highlighted the need to diversify away from both exports and manufacturing while striving for a more balanced and sustainable growth model. Although the government has taken some steps to expand its service sector, it has become imperative to design more focused policies to improve
the service sector’s efficiency and productivity. The service sector has traditionally been protected by several regulations that should be loosened in order to attract more competition and encourage investment in vocational training for employees. This strategy would also empower highly skilled professionals to drive innovation and reduce income disparities and migration of highly skilled professionals to foreign countries. Moreover, a healthy and vibrant service sector can exert positive externalities on the manufacturing sector. In short, there is a room for the services sector to increase its share to the GDP and provide immunity to external shocks. Indeed Korea’s large conglomerates, chaebols, can also play an important role in the development of the service sector; currently only about 4 out of Korea’s large enterprises are operating in the service sector as compared with 12 out of 30 large enterprises in the United States. There is also a need to alter the export-led strategy in order to move up the value chain. There are opportunities in newer technology areas; nanotechnology, pharmaceuticals, and energy offer employment to its skilled workforce and encouraging entrepreneurship. Diversification to high-value exports will provide some immunity to strong competition from its neighbors that produce low-cost manufactured goods. Perhaps geographical diversification to emerging trading hubs in the Middle East and Africa could also reduce dependence on its current trade partners. The South Korean economy is at a tipping point to explore new growth engines instead of trying to stoke engines that are beset with fatigue. South Korean policy makers need to design forward-looking policies that include expansion of the service sector, export diversification, and regional development while also being mindful of the trade-offs. It is indeed time for soul searching in Seoul.
Global Economic Outlook: 4th Quarter 2012
Yield curves (as of October 10, 2012)*
US Treasury bonds & notes 3 months 1 Year 0.10 0.16 0.68 1.74 UK gilts 0.33 0.24 0.75 1.78 Eurozone govt. benchmark 0.02 0.03 0.55 1.51 Japan sovereign 0.10 0.10 0.18 0.77 Brazil govt. benchmark 7.75 7.41 8.97 9.82 China sovereign 2.78 2.23 2.74 3.26 India govt. actives 8.18 8.03 8.03 8.12 Russia‡ 5.80 6.38 7.94 8.56
GDP growth rates (YoY %)*
8 6 4 2 0 -2 -4 -6 -8 -10 -12 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 07 07 07 07 08 08 08 08 09 09 09 09 10 10 10 10 11 11 11 11 12 12 -10 -15 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 07 07 07 07 08 08 08 08 09 09 09 09 10 10 10 10 11 11 11 11 12 12 0 -5
GDP growth rates (YoY %)*
(Note: India's ﬁscal year is April-March)
5 Years 10 Years
20 15 10 5
Composite median GDP forecasts (as of October 10, 2012)*
US 2012 2013 2014 2.2 2.05 2.6 UK -0.4 1.15 2.15 Eurozone -0.5 0.4 1.3 Japan 2.3 1.2 1.2 Brazil 1.6 4.1 4.1 China 7.7 8 7.5 Russia 3.75 3.6 3.85
Composite median currency forecasts (as of October 10, 2012)*
Q4 12 GBP-USD euro-USD USD-Yen USD-Brazilian Real USD-Chinese Yuan USD-Indian Rupee USD-Russian Ruble 1.6 1.28 78 2 6.31 54.33 31.05 Q1 13 1.6 1,27 80 1.98 6.29 53.59 30.94 Q2 13 1.6 1.26 81 1.96 6.27 53 31.2 Q3 13 1.6 1.25 83 1.95 6.23 52 31.29 2012 1.6 1.28 78 2 6.31 54.33 31.5 2013 1.6 1.25 83 1.95 6.21 51.75 31.46 2014 1.6 1.28 85 1.99 6.18 51 32.51
Inﬂation rates (YoY %)*
6 5 4 3 2 1 0 -1 -2 -3 Jan 09
Inﬂation rates (YoY %)*
(Note: Inﬂation data for India is based on the WPI) 16 14 12 10 8 6 4 2 0 -2 -4
OECD composite leading indicators (amplitude adjusted)†
US oct 10 nov 10 Dec 10 Jan 11 Feb 11 mar 11
Jan 09 May 09 Sep 09 Jan 10 May 10 Sep 10 Jan 11 May 11 Sep 11 Jan 12 Mar 12 Jun 12
UK 101.57 101.58 101.61 101.62 101.60 101.54 101.40 101.19 100.89 100.51 100.11 99.75 99.48 99.34 99.32 99.40 99.50 99.60 99.69 99.76 99.86 99.99 100.12
Eurozone 101.30 101.44 101.57 101.66 101.69 101.65 101.54 101.37 101.14 100.86 100.58 100.31 100.11 99.97 99.89 99.85 99.83 99.80 99.75 99.67 99.58 99.48 99.38
Japan 100.21 100.36 100.52 100.64 100.69 100.67 100.60 100.50 100.43 100.38 100.35 100.34 100.41 100.51 100.64 100.76 100.83 100.85 100.80 100.69 100.55 100.40 100.26
Brazil 101.22 101.30 101.34 101.27 101.10 100.89 100.61 100.24 99.79 99.31 98.87 98.51 98.25 98.08 98.07 98.18 98.41 98.63 98.80 98.94 99.09 99.26 99.45
China 101.27 101.49 101.60 101.58 101.47 101.33 101.18 101.03 100.90 100.77 100.64 100.53 100.41 100.28 100.13 100.00 99.89 99.74 99.56 99.45 99.39 99.39 99.40
India 101.41 101.31 101.18 100.97 100.68 100.31 99.91 99.53 99.25 99.07 98.95 98.89 98.91 98.98 99.00 98.94 98.79 98.56 98.31 98.06 97.83 97.62 97.47
Russia 101.99 102.41 102.72 102.88 102.91 102.77 102.55 102.31 102.13 101.98 101.91 101.91 101.96 102.05 102.12 102.13 102.02 101.66 101.06 100.32 99.63 99.11 98.82
100.07 100.26 100.47 100.66 100.78 100.81 100.73 100.58 100.37 100.14 99.96 99.91 99.99 100.20 100.45 100.68 100.85 100.92 100.90 100.82 100.71 100.61 100.55
Mar May Jul 12 12 12
Apr 11 may 11 Jun 11 Jul 11 Aug 11 Sep 11
Major currencies vs. the US dollar*
1.8 1.7 1.6 1.5 1.4 1.3 1.2 1.1 1 Jan 09
oct 11 nov 11
Dec 11 Jan 12
Feb 12 mar 12
Apr 12 may 12 Jun 12 Jul 12 Aug 12
75 May 09 Sep 09 Jan 10 May 10 Sep 10 Jan 11 May 11 Sep 11 Jan 12 May 12 Sep 12
note: A rising CLI reading points to an economic expansion if the index is above 100 and a recovery if it is below 100. A CLI which is declining points to an economic downturn if it is above 100 and a slowdown if it is below 100.
Global Economic Outlook: 4th Quarter 2012
Asia Pacific Economic Outlook
Global Economics Team
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