This article first appeared in Capital, The Edge Malaysia Weekly, on November 16 - 22, 2015.
Global GDP growth will remain lacklustre in 2015-17 as the ongoing gradual slowdown in China continues and a sharp deterioration in terms of trade, together with less favourable financing conditions, weigh on economic growth in most other emerging markets. Global economic growth will not support significant reductions in government debt or increases in interest rates by major central banks. As a result, authorities lack the ample fiscal and monetary policy buffers usually created at the top of the business cycle, leaving growth and global financial stability particularly vulnerable to shocks for an extended period of time.
We forecast that G20 GDP growth will average 2.8% in 2015-17, only 0.3 percentage point higher than in 2012-14, compared with 3.8% in the five years prior to the global financial crisis. In particular, the contribution of emerging markets to G20 GDP growth in 2015-17 will fall to the lowest levels since the early 2000s. During this period, G20 GDP growth will rise very slowly to 3% in 2017, from 2.6% in 2015. Our forecast is broadly unchanged from our previous Global Macro Outlook.
The main downside risks to the economic outlook relate to larger negative global effects of a slowdown in China than we currently factor in our forecast, and a more significant impact of tightening external and domestic financing conditions in other emerging markets. In both cases, the direct effects on the global economy would likely be limited. However, in neither case would advanced economies be in a position to shore up global growth given the high leverage in a number of sectors and countries and limited space for fiscal and conventional monetary policy easing.
The main features of our baseline Global Macro Economic Outlook for 2015-17 are:
• The most likely scenario for China’s economy is a gradual slowdown. This reflects significant policy support and the relative resilience of the consumer and services sectors. While the adjustment in the industry sector will continue, policy stimulus will be provided to sustain employment growth and social stability;
• But the slowdown in Chinese demand faced by the rest of the world is more abrupt. The companies that have supplied the raw materials and equipment goods necessary to sustain investment growth at 20-30% in recent years now face very weak or negative growth in demand from China;
• No significant rise in commodity prices in the next few years. A large inventory build-up, a slow supply response and muted demand for commodities from China and other key importers will continue to put pressure on commodity prices in 2015-17;
• Low nominal revenue growth will impede deleveraging, in both advanced economies and emerging markets. Combined with persistently low commodity prices, subdued global economic growth will maintain disinflationary pressures, weighing on revenues and hampering the deleveraging of household, corporate, and government balance sheets;
• Multi-year adjustment by commodity producers. Cuts in investment in commodity sectors, and in some cases in public spending, will continue. As a result, income growth and consumption will be weaker in commodity-producing economies, weighing on GDP growth throughout 2015-17. Unfavourable terms of trade dampen otherwise relatively robust growth for Australia, Canada and Indonesia, and they exacerbate other negative factors in Brazil, Russia and (to a lesser extent) South Africa;
• Political and policy uncertainty contribute to persistently weaker growth. Uncertainty is suppressing business investment and consumer spending in many countries, in Brazil, in particular;
• External and domestic financing conditions will be less favourable for some emerging markets than in recent years, weighing on GDP growth. Unfavourable terms of trade and policy uncertainty will continue to fuel a reassessment by financial and real investors about the risk-reward trade-off in emerging market investment, as already reflected in lower portfolio and foreign direct investment inflows. Turkey is the most vulnerable economy in the G20 given its dependence on credit, including external debt;
• In the medium-term, emerging markets’ GDP growth will rise, although falling short of pre-crisis averages. Weaker currencies, lower asset prices, slower increases in unit labour costs than in the past and, in some cases, reforms to address structural deficiencies will eventually raise the relative attractiveness of these economies as a place to invest. In most cases, medium-term growth prospects are higher than in advanced economies due to a combination of more favourable demographics and productivity catch-up. However, we do not think that emerging market growth will return to pre-global financial crisis averages as international financing conditions and global trade will remain less favourable; and
• By comparison, the economic outlook for advanced economies is relatively stable. Growth will be supported by accommodative monetary policies, even after the US Federal Reserve starts raising interest rates. Fiscal policy will be broadly neutral. Lower commodity prices will support real incomes although much of the gains may be saved rather than spent in a context of general uncertainty about the global growth outlook and, in particular in Europe and Korea, pressure or willingness for corporates or households to deleverage further.
Our Global Macro Outlook underpins our universe of ratings, providing a consistent benchmark for analysts and investors. This report is an update to our August 2015 Global Macro report. It reviews key recent developments, provides an update on our central forecasts for 2015-16, and discusses the main risks around our forecasts.
We present our central scenario in Exhibit 1 and highlight the following factors:
• We express our forecasts for annual GDP growth and unemployment as a range of one percentage point (ppt) to avoid undue precision and to focus on significant changes that could potentially influence rating decisions; and
• We indicate the level of uncertainty for our central forecasts, presenting ranges from the forecasts that we survey and comparing them to the historical standard deviation of real GDP growth. The blue shading in Exhibit 1 denotes countries with greater forecast uncertainty relative to historical GDP volatility.
China: Economic slowdown underway with widening divergence between industry and services
We maintain our forecast of a gradual slowdown in China, with GDP growth at 6.3% and 6.1% in 2016 and 2017 respectively, after just under 7% in 2015. China’s direct contribution to annual G20 GDP growth will average 1 percentage point in 2015-17, from 1.1 percentage point in 2012-14. China’s slowdown is offset by its larger share in the G20.
The gradual economic slowdown reflects a trade-off between further reforms — aimed at lessening the economy’s dependence on investment and credit and increasing the influence of market mechanisms — and the risk of jeopardising employment and social stability.
In the next few years, China’s economic rebalancing will be mainly visible in the form of weak growth or outright declines in fixed asset investment and manufacturing and construction activity. The general reform objective includes addressing overcapacity in a number of sectors, which will result in further cuts in investment outside government-funded infrastructure projects. In particular, downside price pressure in these sectors is likely to persist. Accounting for both quantity and price changes, the slowdown in the industry sector has been sharper than in 2009 and sharper than at any time on record (since the early 1990s) (see Exhibit 2).
In turn, price pressures are dampening profits. In the year to September 2015, China’s National Bureau of Statistics reported a 11.7% increase in the number of loss-making industrial enterprises compared with one year earlier. Stagnating or falling revenues will continue to weigh on highly leveraged corporates in these sectors, hampering their ability to respond to easier monetary policy with increases in spending.
Meanwhile, in the next few years, growth in consumer spending and services activity is likely to be sustained, reflecting robust real income growth and a large catch-up potential by a growing middle class. This will prevent a sharper slowdown in GDP. Essential to this will be ongoing growth in employment. While it has slowed this year, employment growth remains ahead of the official target of creating 10 million new jobs this year. Evidence of a further deceleration in employment would likely prompt significant further policy stimulus.
An acceleration in consumption and services from the current growth rates will only be achieved once reforms of the financial sector unlock a greater proportion of households’ savings and enable more efficient allocation of these savings, prospects which are beyond the three-year forecast horizon of this report.
The main risk is that policy stimulus is, or is perceived to be, less efficient in supporting growth while adhering to the overall reform objectives than we currently assume. This is discussed further below.
Reassessment of medium-term growth prospects is underway for commodity exporters
The contribution of emerging markets excluding China to annual G20 GDP growth will also fall, to 0.4 percentage point in 2015-17, the lowest since the 2000s.
First, muted demand for commodities from China, by far the largest consumer in some of these markets, implies that excess supply and inventories will only be absorbed slowly, weighing on prices. Taking into account the G20 economies’ share of global commodity consumption, the slowdown in demand for commodities is markedly sharper than if simply assessed by GDP growth.
Net exports of commodities account for a significant share of the economy in Saudi Arabia, Russia and Canada for energy, and Australia, Argentina, South Africa, Brazil and Indonesia for mining, metals and agricultural commodities.
Together these economies account for 15% of the G20. We do not forecast any material change in commodity prices in the next few years. For energy, metal and mining commodities, we assume that by 2017, price levels will still be significantly below 2014 levels.
The immediate economic effects of persistently low commodity prices are investment cuts in the commodity sectors, which are typically large enough to dent overall investment growth. In Indonesia and Australia for instance, non-housing investment growth was negative in 2Q2015, in line with the deterioration in these economies’ terms of trade. Investment cuts may continue over the next few quarters and our assumption that commodity prices will not recover quickly implies no prospect of a rapid turnaround in investment. Where fiscal room is limited, slower government spending also contributes to lower economic growth.
Over the next two years, the economic effects of lower commodity prices will spill over into other sectors via supply chains and weaker growth in households’ income. The overall impact of persistently lower commodity prices on these economies will be marked throughout 2015-17.
In Australia, Canada and Indonesia, unfavourable terms of trade are a significant factor accounting for relatively subdued GDP growth in 2016, below these countries’ potential. We forecast 2016 GDP growth at 2%, 1.6% and 4.7% in these three countries respectively (see Exhibit 3). While there are downside risks to our forecasts for these economies related to a possible underestimation of the adjustment in investment and its spillovers, we expect consumption growth to remain robust, underpinned by ongoing increases in real incomes.
By contrast, in Brazil, Russia and to a lesser extent South Africa, low commodity prices compound other negative economic factors. We expect the current recessions in Brazil and Russia to continue in 2016, followed by very slow growth in 2017, at around 1%. In South Africa, we forecast GDP growth below 2% this year and next, rising to just above 2% in 2017.
Idiosyncratic factors combine to result in durably lower growth in emerging markets
Other factors will account for lacklustre growth in emerging markets in 2015-17 compared with recent years. In particular, political and policy uncertainty will be a negative factor for economic growth in Brazil and Russia and to a much lesser extent Indonesia, although the issues have very different root causes and economic consequences. The negative economic effects are currently most acute in Brazil.
Furthermore, tighter fiscal and monetary policy will be a drag on growth in Brazil, Russia and, to a lesser degree, in South Africa, in 2015-17. In addition, in Turkey, credit-fuelled investment and consumption spending in recent years is unlikely to be sustained at the same pace as inflation erodes incomes and profits and domestic credit conditions may become less accommodative. We forecast GDP growth at 2.3% in 2016, after around 3% in 2015. The risks to this forecast are on the downside if investor confidence and capital flows weaken further. In South Africa, persistent infrastructure shortages that are gradually being addressed will continue to hamper investment in non-commodity sectors. Finally, Russia is adjusting to the new reality of persistently lower oil prices, a weaker and volatile exchange rate and very limited access to external finance.
The country-specific combinations of unfavourable terms-of-trade, policy or political uncertainty and less accommodative domestic credit conditions are leading investors to reassess growth and return prospects in these countries. This is already reflected in lower portfolio and in some cases foreign direct investment inflows, although the Institute of International Finance reported positive net portfolio inflows in emerging markets in October 2015, following three months of net outflows. Financial and physical capital flows are likely to remain subdued in the next few years, further contributing to lower growth in emerging markets.
Adjustment will create conditions for growth rebound, below pre-crisis averages
In general, G20 emerging markets’ exposure to a shift in external financing conditions is moderate, given limited reliance on external debt and sizeable foreign exchange reserve buffers. This suggests that rather than triggering a balance of payment crisis, the less favourable external financing environment will dent economic growth over the next few years.
As emerging market economies and financial markets adjust to the less favourable environment than in the last few years through weaker currencies, lower asset prices, slower increases in unit labour costs and in some cases structural reforms, the relative attractiveness of these economies to financial and real investors will stabilise and eventually increase. In most cases, medium-term growth prospects are higher than in advanced economies due to a combination of more favourable demographics and productivity catch-up. GDP growth will rise, although it will fall short of pre-crisis averages as financing conditions and the international trade environment remain less favourable than in recent years.
Slower trade with EMs will dampen, not derail, growth in advanced economies
Growth will be broadly stable in the US, Europe, Japan and South Korea in 2015-17. We forecast GDP growth at around 2.5% in the US, the UK and South Korea and 1.5% in the euro area. In Japan, it will rise slowly to 1.3% in 2017 from 0.5% this year.
Muted exports to China and other emerging markets (EM) will weigh on economic growth in advanced economies. South Korea is most exposed, with nearly 60% of its exports of goods shipped to emerging markets and exports accounting for around 50% of GDP.
Exports to emerging markets have increased by 10% a year on average in the last five years. If growth in exports to EMs were to fall to 5% per year on average (it was at -5% in the first five months of 2015), that would directly reduce South Korea’s GDP growth by 0.4 percentage point every year. Lower trade volumes together with persistent price competition from Japan mainly account for our below-consensus growth forecast for South Korea.
The US and the UK are least exposed directly, with either low dependence on exports (US: exports account for 13.5% of GDP) or a limited share of emerging markets in total exports (UK: EMs accounted for 20% of exports of goods in 2014). For these two economies, the direct growth shortfall from weaker demand from EMs amounts to a few decimal points off GDP growth.
More generally, uncertainty about the outlook for emerging markets, which have significantly contributed to global growth in recent years, will dampen propensity to consume and invest globally.
Downside risks focused on emerging markets but with limited policy space in advanced economies
The main downside risks to the economic outlook relate to larger negative global effects of a slowdown in China than we currently factor in our forecasts and a more significant impact of tightening external and domestic financing conditions in emerging markets, possibly related to a rise in interest rates in the US. In both cases, the direct effects on the global economy would likely be limited.
However, in neither case would advanced economies provide much of support to global growth given the high leverage in a number of sectors and countries and limited space for fiscal and monetary policy easing.
China risk: Relevant alternative is an even softer and longer landing rather than hard landing
The short-term negative growth impact of economic rebalancing on China’s economy could prove more severe than we estimate or, put differently, the stimulus measures aimed at preventing too sharp a slowdown could be less effective. In particular, very high leverage implies that corporates may not be able to respond to monetary policy stimulus. More generally, uncertainty about the economic outlook could encourage households to save a greater-than-usual proportion of any stimulus-related income and only respond very moderately to incentives to spend.
The economy’s reliance on offsetting stimulus measures to mitigate the slowdown also implies a risk that such measures either lose credibility with investors and consumers or that their announcement is perceived as a signal that the economy is decelerating further, which could prompt further retrenchment in spending.
Moreover, previous examples of corrections of credit and investment booms point to risks that China could experience a sharper slowdown than we currently forecast. To the extent that some of China’s fixed-asset investment in recent years was unproductive and misallocated, experience of corrections in other countries suggests that sharp and long-lasting falls in investment would be typical.
However, the influence of the government sector on the Chinese economy and a relatively closed capital account mitigate the risk of a very sharp correction. Overall, even a downside scenario for China’s economic outlook seems unlikely to involve a hard landing of the economy. Rather a further, more intense and prolonged, slowdown is the most likely alternative to our baseline forecast.
With China contributing a large share of global growth and trade in the last few years, a more pronounced slowdown than we currently envisage would have global implications. Direct trade linkages are most easily quantified and, with the exception of Australia, Brazil, South Korea and Japan, are relatively limited for G20 economies. However, China aims to reduce its reliance on imports and boost domestic production, as part of its Made in China 2025 programme. These efforts could accelerate in a more marked economic slowdown, which would exacerbate the negative spillovers to the rest of the world. Moreover, evidence that policy support to the economy is not as effective in maintaining robust growth as currently assumed would have a negative impact on risk appetite and asset prices globally, exacerbating the economic impact of weaker global trade.
Although a further slowdown in China would likely involve lower commodity prices for longer, the potential positive economic impact on consumer economies may not materialise immediately. The negative global demand shock that China’s sharper slowdown would represent would foster higher savings in general, and in particular, if it is accompanied by a general increase in risk aversion in the more highly leveraged economies including Europe (corporates or household sector depending on the countries) and South Korea (households).
Possible deeper and longer adjustment by other emerging markets
As regards risks posed by other emerging markets, the adjustment to less favourable global trade, terms of trade and financing conditions is underway and embedded in our baseline forecast. This adjustment could be more severe in the next two years than we currently assume, in particular for those economies that have limited buffers and room for policy easing and weaker institutions that can help define and implement credible policies.
In particular, for commodity producers, shifting resources towards other revenue-generating and employment-creating sectors is a multi-year process. In the transition, investment and employment cuts dominate; asset prices and labour costs fall across the board which facilitates a reallocation of resources. However, while commodity price corrections are typically specific to one or a few commodities, as explained above, the current episode is unusual in terms of the breadth of commodities affected. This could mean that we underestimate the extent and duration of the adjustment of production resources for multi-commodity producers. Limited policy and institutional capacity would make the adjustment slower and less effective.
Moreover, external and domestic financing conditions could tighten more significantly, via lower capital flows and currency depreciations which would lead to higher domestic policy interest rates, for instance, once interest rates rise in the US. Among the G20 emerging markets, moderate dependence on external financing in general implies a limited risk of balance of payment crises.
However, heightened risk aversion by international investors could spill over into domestic financing markets. As a result, investment could be markedly weaker than implied in our baseline forecast. Currencies would likely depreciate further, raising inflationary pressures that would lower real income growth and dampen consumer spending.
Economic developments in Brazil in the last two years and the very large deterioration in the economy’s growth outlook provide useful insights in this respect. Could other G20 emerging markets experience such a rapid and large reversal in growth prospects?
As mentioned in this report, a number of factors make the economic outlook for Turkey particularly uncertain.
For other emerging markets, while somewhat weaker growth than currently forecast is plausible, we do not foresee the possibility of a radical change in the economic outlook in the next few years.