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Special Topic: Rebalancing of growth in the global economy

Emerging market (EM) economies have been the main drivers of world growth in the period since the global financial crisis (GFC), as developed market (DM) economies recovered only slowly.  Now the tables are turning, with EM economies’ growth and outlook weakening recently and DM economies recovering more strongly.  This topic explores the reasons for this development and its implications for the New Zealand economy.

EM economies recovered quickly from GFC...

The GFC, while partly caused by global imbalances, originated in the DM economies but spread to EM economies through trade, financial and confidence channels.  A slump in demand in DM economies, combined with a fall in the provision of trade finance and a run-down in inventories, led to a sharp fall in growth in EM economies (Figure 1).

However, EM economies recovered quickly from the effects of the GFC as they benefitted from the various fiscal and monetary stimulus measures introduced in DM economies, enabling them to resume their position of leading growth in the world economy which they held prior to the GFC.  EM growth rates were similar to DM rates until the 2000s when they diverged and lifted world growth (Figure 1).  EM growth remained positive in 2009, while DM growth was negative during the GFC.

Figure 7 – EM and DM growth rates
Figure 7 – EM  and DM growth rates   .
Source:  International Monetary Fund, WEO April 2013

The recovery from the GFC was boosted by a large fiscal stimulus and credit expansion in China.  In late 2008 China announced a fiscal stimulus package estimated to be equivalent to 6% of GDP, spread over 2 years; much of the stimulus was delivered via infrastructure investment and credit growth in 2009 and 2010 reached 30% per annum, far in excess of growth in nominal GDP.  Growth fell from 9.6% in 2008 only to 9.2% in 2009, supporting demand for commodities and boosting output in other EM economies and in Australia and New Zealand.

...but DMs struggled to recover until recently...

Meanwhile, the major DM economies recorded falls in output in 2009, before growth recovered in 2010 (Figure 1).  However, since that rebound and until recently, growth has languished in those economies, with the euro area and the United Kingdom (UK) falling back into recession in late 2011, growth remaining sluggish in Japan, and the United States (US) economy struggling to achieve self-sustaining growth.  Continuing high household, corporate and government debt constrained demand in these economies.

Recently, however, DM economies have started to show more sustainable growth.  The housing and labour markets in the US are beginning to recover, leading to increased household demand and business investment; the euro area recorded positive growth in the June quarter after six quarters of contraction; Japan’s economy grew by 1.9% in the first half of 2013, boosted by monetary and fiscal stimulus, and output grew 1.0% in the UK in the first half of 2013.

This pick-up in growth in the major DM economies is chiefly owing to the large fiscal and monetary stimulus delivered in each of them and steps taken to stabilise financial markets and banking systems.  For example, the US increased general government gross debt from 66% prior to the GFC to more than 100% in 2012 as a result of fiscal stimulus; at the same time, the Federal Reserve (Fed) expanded its balance sheet from 6% to 22% of GDP currently as a result of quantitative easing, and it has held its policy rate at 0-0.25%.

...but their stimulus benefited EM economies

The large stimulus in the DM economies also benefited EM economies through increased demand for their goods and services, and by holding down long-term interest rates and redirecting funds from DM bonds into riskier assets such as EM equities and commodities.  While some EM leaders voiced concern about the potentially destabilising impact of financial inflows, these conditions supported EM economic growth and brought a marked shift in the shares of output in the global economy.  EM economies will have nearly doubled their share of global output from 20% in 2002 to 38% in 2012.  Adjusting for differences in the cost of living, EM economies will account for more than half of world output this year, according to the IMF, giving them a greater impact on the world economy than before.

Pick-up in DM growth prompts tapering...

The pick-up in activity in DM economies in the first half of 2013 led to the first steps towards reducing monetary stimulus.  (Governments had generally started to reverse fiscal stimulus earlier.)  The Fed announced in May that it would begin to reduce its asset purchases later in the year and complete its purchases by mid-2014.  Although the Fed was widely expected to begin tapering its purchases in September, it has decided not to start yet.
The announcement in May brought a fall in US bond prices (and increase in rates) as markets anticipated reduced demand for bonds from the central bank, increases in equities as funds flowed into riskier assets in anticipation of more self-sustaining growth, and a rise in the US dollar as USD assets will offer better returns and growth in the supply of US dollars will be reduced.  These changes had an impact on financial markets around the world:  long-term interest rates moved up and the US dollar strengthened against most other currencies, including the NZ dollar which fell from 85 to 80 US cents over the course of May.

...leading to reversals in EM financial markets

The Fed’s announcement in May also led to a reversal in EM financial markets, as the signalled tapering indicated reduced availability of global liquidity at low interest rates which had contributed to robust investment growth in EM economies since the GFC.  Bond rates increased and equity prices fell as money flowed out of these economies and their currencies weakened.

EM economies’ growth had already started to slow in the second half of 2012 as their own stimulus and the indirect stimulus from the DM economies led to resource pressures and rapidly rising asset prices (eg, property values).  Tighter monetary conditions were evident in the appreciation of EM currencies and – in some cases – higher short-term interest rates.  EM economies continued to slow in early 2013 as slower growth in DM economies in 2012 had a lagged impact on them.

Parallels drawn with Asian financial crisis...

The Fed’s foreshadowing of its tapering of asset purchases in May was a symptom of the rebalancing in growth between DM and EM economies that was already under way and not a cause of it.  However, the Fed’s announcement brought considerable volatility in EM financial markets, particularly in Asia and some commentators compared the situation to the lead-up to the Asian financial crisis (AFC) in 1997/98.

The similarities with the AFC are that Asian EM economies have been experiencing high growth rates (driven largely by rapid investment growth), rising asset values (equities and property) and exchange rate appreciation.  In the late 1990s a tightening in DM monetary conditions and a resulting growth slowdown led to large capital outflows from Asian EM economies and falls in their exchange rates, the erosion of their foreign exchange reserves, lower growth and large fiscal deficits.  Many already had large current account deficits.

...but a repeat looks unlikely...

However, there are significant differences from the late 1990s.  The chief of these is that most Asian economies have floating exchange rates which have adjusted gradually to changing conditions; in addition, most of the those economies have larger foreign exchange reserves than previously, their current account positions are stronger, they have less foreign-currency external debt and what external debt they do have is financed by private capital flows rather than official borrowings.  In addition, investment currently accounts for a smaller share of GDP in these economies than it did prior to the AFC.

...although growth likely to slow

While a repeat of the AFC looks unlikely, growth in Asian EM economies is still expected to slow as they adjust to tighter monetary conditions in the form of higher long-term interest rates.  The low-income economies in New Zealand’s trading partner basket (India, Indonesia, Malaysia, Philippines and Thailand) are likely to be more affected than the newly industrialised economies (South Korea, Taiwan, Hong Kong and Singapore) because the latter group is in a stronger position on the macroeconomic indicators mentioned above and they are not as dependent on commodity exports to other DM economies, in particular China.

China less affected by these developments...

China is likely to be less affected by these developments than other low-income Asian EM economies for a couple of reasons.  Its financial markets are largely insulated from the rest of the world with a closed capital account (ie, capital cannot move freely in and out of China) and a managed-float exchange rate (although there are moves to open the capital account to some degree).  In addition, China has a current account surplus of 2.3% of GDP and foreign exchange reserves equivalent to nearly 40% of GDP.

Nevertheless, there was some volatility in China’s financial markets in late July when the central bank initially refrained from easing a liquidity crunch in the inter-bank market, causing overnight interest rates to spike up.  It subsequently injected liquidity but only after indicating that it wanted to curtail lending growth.  Growth is expected to slow in China chiefly for its own reasons, namely tighter domestic monetary conditions, a rebalancing of growth from investment and exports to private consumption, slowing productivity growth as returns to investment decline, slower population growth and eroded competitiveness as wage costs escalate.

...but New Zealand affected by slowdown...

The rebalancing of global growth from EM to DM economies will have an impact on New Zealand.  In the recovery from the GFC, New Zealand’s dependence on fast-growing Asian EM economies was an advantage with 36% of goods exports destined for Asia ex-Japan; the inclusion of Australia, which is even more dependent on Asia, increases the region’s share of NZ’s goods exports to 57%.  With the Australian economy slowing as the mining boom winds down (see the August 2013 special topic), our dependence on emerging Asia and Australia becomes a negative for the outlook.

...although there are some positives

However, not all the global developments are negative for New Zealand.  In the medium term, stronger growth in DM economies will be positive for Asian EM economies as their major export markets are the DM economies.  The transition in China from investment- and export-led growth to greater emphasis on private consumption can only be positive for our exports of food products.  In addition, as we suggested last month, the rebalancing of the Australian economy from mining investment to household consumption and residential investment will be positive for New Zealand exports to that market.

The rebalancing of global growth from EMs to DMs, as flagged by the Fed’s tapering, will have other impacts on the NZ economy as well.  The initial announcement from the Fed brought a fall in the NZ dollar, as noted above, which will assist the competitiveness of the export sector, particularly for manufactured products and services, and promote the rebalancing of the economy towards tradable activity.

Although the NZD has crept back up towards its pre-taper announcement level against the USD, the USD is expected to resume its appreciating trend once tapering commences.  However, an offset has been the appreciation of the NZD against the AUD which has fallen further against the USD than the NZD has.  This may be a brake on demand from our major export market.

The outlook is positive, but risks remain

Despite lower growth in EM economies, they will continue to drive growth in the global economy given their larger share of world output and higher growth rates.  In addition, stronger DM growth will be positive for EMs and the world economy in the long run. 

However, many risks remain for DMs, in particular the debt crisis, banking and fiscal union, and the lack of competiveness in peripheral economies in the euro area; the impact of Japan’s efforts to boost its economy through monetary and fiscal stimulus; and the longer-term issues facing the US of fiscal sustainability, reversing asset purchases and normalising monetary policy.

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