Sunday, February 3, 2008

Risk Of A Global Recession?

Nouriel Roubini's Global Economonitor Risk Of A Global Recession Following The U.S. Hard Landing?

By Nouriel Roubini | 30 January 2008

It is now clear that the US economy is already into a recession that started in December 2007: the data on December employment, retail sales, manufacturing ISM, housing and other macro variables confirm it. And the 0.6% growth for Q4 GDP confirmed that sharp slowdown of the economy in Q4 and its tipping over into a recession by December. It may take— as usual— almost a year for the NBER to formally declare that a recession started; but when that decision is made it will be clear that the great US recession of 2008 started in December 2007 or— at best— Q1 of 2008.

At this point it is clear that the debate has shifted to how deep this recession will be, a mild one lasting two quarters as the new consensus claims or a deeper, longer recession—
lasting at least four quarters— as I have been arguing for a while.

It is also clear now that this US recession will lead to at least a global economic slowdown— short of
a global recession that would occur if global growth were to be below 2.5%— and to actual recession in a number of individual economies.

The economies most at risk of an outright recession are the following ones:

The United Kingdom that looks— in many dimensions— like the US, a housing bubble now going bust, excessive consumer credit creation, unsustainable boom in consumption, large current account deficit, overvalued currency. A recession in the UK is now highly likely.

Spain is an even worse example of an unsustainable housing bubble than the US or the UK: in the US, residential investment peaked at 6% of GDP; in Spain at a whopping 19% of GDP. For many years, the housing bubble masked— via high GDP growth— the fact that Spain had experienced a real appreciation of its currency and a loss of competitiveness as large as that of the other Club Med countries (Portugal, Italy, Greece). Now that the Spanish housing bubble is busting, it is clear that the emperor has no clothes, i.e. Spanish growth was driven by the housing bubble.

Ireland— like the UK and Spain— had a massive housing bubble that is now deflating. The medium term fundamentals of the Irish economy are sounder than those of Spain or the Club Med, but in the short run the Irish economic slowdown will be severe and an outright recession cannot be ruled out.

Among the other Eurozone countries Italy and Portugal are at risk. In Italy even official forecasts put 2008 growth below 1% and an outright recession cannot be ruled out; and the political instability (61 governments since World War II with the latest one falling this past week) will not help the economic outlook. Portugal— like the other Club Med economies— has structural problems of competitiveness given the large increase in unit labor costs, the real appreciation of the currency and the loss of market share in international trade given the rise of China and Asia.

In the new EU accession countries and the other economies in south Europe there are also serious vulnerabilities and outright risk of financial crisis. These 18 economies— from the Baltics all the way to Turkey— all share a large current account deficit; some also have a large fiscal deficit, an overvalued currency and fixed exchange rates; also, currency and maturity mismatches prevail throughout the region; and housing booms if not bubbles financed with excessive credit growth in foreign currency are also common. The Baltic nations— especially Latvia— are at risk of currency and financial crisis; Hungary, Romania and Bulgaria look fragile (especially the former); and even Turkey, which has better fundamentals, has an unsustainable external deficit.

The risk is that a sudden stop of foreign capital and a global credit crunch in these countries could lead to a currency crisis that will, in turn, lead to a private sector (household) crisis. Differently from Western Europe where mortgages are financed in local currency, in these countries most of the mortgages are in foreign currency (Swiss francs and Euros). Thus, a currency crisis would have a devastating balance sheet effect on the household sector and lead to a household mortgage debt crisis and a banking crisis, as happened in Mexico in 1995 and in Argentina in 2001 - 2002 when their currency pegs collapsed. And given the exposure of Italian, Austrian and Swedish banks to these East European economies, a financial crisis in these economies will lead to a credit crunch in these 'other' European financial systems, in the same way as the East Asian crisis of 1997 - 98 worsened the condition of Japanese banks exposed to East Asia.

Japan also looks like a candidate for a likely recession in 2008. The economy is anemic— always on the borderline between growth and recession, between inflation and deflation. Most of the growth of Japan in the last few years has been driven by external demand, net exports with a weak yen. Domestic demand has been weak, especially private consumption, as real income and real wage growth has been anemic. But now a US recession and a strengthening of the Yen are likely to tip Japan back into a recession.

The biggest victim of a severe US hard landing will be China. For China, having growth falling from 11% to 6 - 7% is the equivalent of a hard landing, as every year China needs growth above 10% to transfer about 20 million rural workers to the modern, manufacturing and urban sectors. Officially Chinese economists expect Chinese growth to slow down only to 9% following a US recession; but this is conditional on such a US recession being mild— i.e. lasting two quarters. If the US recession is severe— lasting over four quarters— and centered on a faltering US consumer that cuts back on his imports of cheap Chinese goods, then the consequent Chinese growth slowdown will be severe and at least close to a 'hard' landing (e.g., of growth less than 7%). Of course China could use fiscal policy to counter the effects of this slowdown, but there is a question on how fast the Chinese fiscal lever can be put into action.

In Australia the housing boom has already started to go bust. But until recently high commodity prices kept the growth rate sustained, especially in the commodity producing regions of the countries. But a US recession and global slowdown will lead to a sharp fall in commodity prices; thus a recession in Australia cannot be ruled out.

Most emerging market economies have much better fundamentals than they did a few years ago: current account surpluses, flexible exchange rates, large stock of forex reserves, lower fiscal deficits and actual primary surpluses, lower stocks of foreign and public debt, lower balance sheet vulnerabilities. They have done well because of reforms and better polices. But they have also done well because of good luck and the best external global conditions in a generation: the high global growth; high and rising commodity prices; low risk aversion and a search for yield among investors, especially international investors. In a world with a US recession and global slowdown, commodity prices and global growth will be significantly lower, and investors' risk aversion will rise.

No wonder that stock markets in emerging markets have already started to correct sharply in the last few weeks. One cannot lump all emerging market economies together; there are those with better macro, policy and financial fundamentals; and those with weaker ones. Countries with large current account deficits or large external financing needs (rollover of foreign currency liabilities), with fiscal deficits, overvalued and semi-fixed currencies, credit booms, asset bubbles in real estate and equity markets are most at risk of financial pressures— sudden stop of capital inflows and credit crunch— if not outright financial crisis. Current account deficit countries include— on top of the 18 in East/Central/South Europe— India, South Africa, Mexico and a few other emerging market economies.

In conclusion, while a global recession will likely be avoided as global growth is unlikely to fall below 2.5%, the global economy will sharply slow down in 2008 and it will feel like a global recession even if one is formally avoided, with several countries being in an outright recession.



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