By Cees Bruggemans, Chief Economist FNB Cees@fnb.co.za

26 April 2011


One does not want to overstate either the growth hiccup underway or the storm warnings being sounded.

Yet it is precisely the shrillness of the warnings that can lead to overstatement while the growth vigour is easily understated.

So how robust is global growth (and our own), how temporary is the interruption (in our case drag anchors) and how severe are the warnings (to our advantage or disadvantage)?
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With the world economy having fully absorbed building contraction, bank deleveraging and household saving boosts that followed the 2008 financial crisis (none of these apparently any longer getting worse, having bottomed/topped out), global expansion is back on track.

Growth is accommodated by monetary support (if partially neutralized by fiscal austerity), and growth's main engine is business innovation, creative destruction and expansion, driven by record earnings.

There is nothing soft or tentative about the global expansion, the IMF putting a 4.5% growth number on it, admittedly only 2% in rich developed countries but 6.5% in still poor emerging ones.

Household income and consumption spending worldwide is on a recovery track, business animal spirits are lively (if modest), financial markets have mostly 'risk on' days, and even business outlays and trade are growth positive.

So the world remains on a growth recovery track, if not quite on a tear.

Even so, there are major distinctions. Rich developed countries have huge resource slack (high unemployment) and maintain maximum policy support (especially the US).

Many emerging countries have good growth and have closed their output gaps, with inflation potential rising. Though we hear daily about emerging central banks raising interest rates in response thereto, most are doing so only modestly, keeping a wary eye on the Fed from fear of moving too soon and too far, wanting to prevent undue overvaluation of already overvalued currencies.
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So the world is on track, but not without qualifications.

One important headwind is higher oil and food prices, eroding real purchasing power of households, and holding back consumption growth. Oil at $120 is already a growth retardant and should be acknowledged as such.

Japanese quake consequences offer major short-term growth distortions, lowering Japanese GDP growth but also interfering with global industrial growth (especially in the motor industry and IT).

The 2Q2011 will see quite a global dip on this score, overlaying a slowing inventory addition. Yet its effects should only be short-term. Japanese reconstruction efforts are fully underway and will start to outweigh contraction effects in 2H2011.

So as 2011 spills over in 2012 one would expect global manufacturing to regain the lift that lost production in 1H2011 withheld.

In this respect, Japanese effects will hopefully be short-term and fleeting (and generally net positive in subsequent years), though one takes note of the 7% loss of electricity supply, affecting especially industrial output in the Tokyo region, with talk of this potentially lasting for the rest of the year, if not longer.

Oil and food effects on the other hand are income corrosive and to be taken seriously as growth dampeners.

Which brings us to the dangers. How serious are they?
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There are three immediate dangers. Libya (and others) for oil, Greece for Europe, and S&P debt warnings for US financial disruption.

Everybody keeps emphasizing that nobody full understands how present the Arab Awakening will ultimately unfold, but when in doubt order some more precautionary oil supply, and speculate some more on dire outcomes.

That combination gives higher oil prices and yet more headwind to global growth.

But is this warranted?

The stories are not good, whatever lines the young want to feed you.

Tunisia may find that it will not quite become a fully fledged democracy, given the (conservative) make-up of the majority of its population. The next election will show up its true contours. The hope is certainly for a breakthrough, but when you read what a majority of people really believe you stand back.

Same applies in Egypt. It is all very nice to have the progressive young dominate the television images, but 40% of the population is illiterate and a similar percentage has to get by on less than $2/day.

Their political affiliations are yet to be fully tested. Some 77% of the Egyptian population voted for an early election, without insisting on early checks and balances, something that is taken by many middle class liberal-minded Egyptians as a bad sign.

Libya is even more complex. As is Syria.

Shaking off real dictators isn't that easy. With the world (West) apparently only taking half measures (otherwise the whole thing starts costing too much) and local opposition weak and/or poorly trained/organised, Mexican standoffs are in the making.

There is a real chance that some dictators will make their regimes stick. Still, there is potential for open-ended disturbances, spillovers to oil-rich countries, and a high political premium discounted in oil prices.

When combining this with many precariously-placed oil producers wanting to buy off discontent, they favour higher priced oil. And many of them do not reduce their local oil subsidies, causing internal demand to keep rising rapidly, reducing supply available for export, further worsening the longer term demand/supply imbalance favouring higher oil prices.

That is the direct cost levied on the world economy.

Indirectly the region's 300 million population footprint is deeply unsettled, with too many winners/losers situations. Potentially this sets in motion huge refugee migration waves. We have already seen this in Tunisia, Egypt and Libya (between them so far over a million people dislocated in a matter of three months) but far larger movements are still possible in the months and years ahead if "the wrong people" were to gain power and suppression or worse were to prevail (thinking Iran).

Even a couple of million people could become dislodged over the next 2-5 years, and most of them would try to head north-west (Europe). Few would want to go South or East (and West is no proposition).

If the growing xenophobia against Islamic immigrants in Western Europe of recent years is anything to go by, another major wave of such refugees, together with the troubles in peripheral countries, could push European politics to intolerant excesses.

And thus we wait to see whether the EU political centre holds or caves in under pressure from its rightwing fringes. The consequences for the shape of Europe, but also for risk appetite and growth potential could be major indeed.
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It has by now sunk in that European peripheral sovereigns are being kept afloat to prevent costly European bank bailouts from confronting increasingly unwilling Germanic electorates.

But how long can this be kept up?

There has been increasingly vigorous speculation about imminent Greek debt restructuring (because the present trajectory may be non-sustainable), yet it would not suit the Greeks or the larger European footprint to start re-scheduling early. Greek banks couldn't handle the losses and Europe couldn't afford to confront its electorates with its own bank bailouts.

Over the Easter weekend, ECB chief economist Jurgen Stark reportedly said that any Eurozone debt restructuring could cause a crisis far worse than the 2008 Lehman collapse and for that reason is to be avoided, giving new meaning to ECB, EU and IMF officials keeping a close watch over peripheral countries such as Greece maintaining their fiscal austerity efforts.

Much better to buy yet more time, give European banking systems the opportunity to provide against losses and restore capital buffers while keeping peripherals afloat and electorates and markets at bay.

Still, financial markets show growing trepidation about suddenly being caught out by debt restructurings and forced haircuts, in the process discounting risk yet deeper (Greek 10-year paper now only worth 65% of face value and falling).

If this dyke can't be held, and debt restructuring were to commence, speculation is that other peripherals would probably get drawn in, too.

Reading Germanic electoral sentiments, there could be an endgame here which potentially could end spectacularly in the demise of carefully crafted Euro plans of two generations.

Another Muslim immigration wave for unrelated reasons would be the cherry on top to inflame European politics.

Thus two great movements could potentially come together, as much Europe's own reinvention as the Arab Spring igniting deeper fault lines, with all kinds of implications for financial risk appetite, currency volatility and growth.
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The S&P decision to put US government debt on negative outlook was at best a warning shot across the bow, giving warning of what could come a few years down the road.

It may well be that warring Washington factions need such an external warning to cut the necessary deals. Without it little may happen.

If so, not all is lost (yet). Only a warning has been sounded so far, with the US bond market reacting in the apparent belief that politicians will take note and act, especially once politics is out of the way (and the next President and Congress safely elected), making it possible to correct US financial shortcomings.

Watching the ongoing Debate of the Deaf, however, one wonders where the compromises will come from.

On a ten-year view, the US debt dynamics are as much a game changer for global markets and economic prospects as Syria (and Libya) may prove to be politically in the Middle East, proving to be the hinge fundamentally unsettling the contest between Iranian theocracy and Saudi monarchy (and oily prospects).
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That's a lot of severe storm warning out of the Middle East, Europe and the US potentially disrupting deeply the medium-term global outlook.

Meanwhile in the short-term Japanese output disruption will hopefully prove fleeting, ere long overtaken by reconstruction stimulus. More damaging may be high commodity prices at a time when many countries are fiscally consolidating (pulling back), between them eroding growth momentum.

Higher inflation in outperforming emerging countries is inviting monetary tightening, but that is a corrective and not to be feared unduly. The underperforming West, especially the US, is likely to retain a supportive monetary stance, keeping things afloat.

All is therefore far from lost, even if a casual read of daily news could easily trigger such sentiments.
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South Africa benefits from the anxieties triggered by Middle Eastern, European and American problems in the way it boosts our export prices (gold, coal and others).

It creates old-fashioned commodity price windfalls boosting our incomes and domestic spending.

These same forces also firm the Rand, which still has further potential to gain towards 6:$, suppressing rising inflation and preventing too much of an interest rate boost further worsening the currency overvaluation.

Our exports are at risk, but Europe may not lose the plot prematurely, while our trade emphasis is in any case shifting in favour of Asia. Thus our risks are lessening while our potential gains from such global fallout could be improving.

One watershed ahead is the Fed finally changing policy direction. It starts with ending QE2 in June, thereafter likely starting to run down its bloated balance sheet and eventually starting to lift its interest rates.

Somewhere in that policy reversal (2012?) may eventually reside a precious metal peak, arresting our terms of trade gains, but also ultimately seeing a tempering of global inflation revival.

Such a period may eventually see renewed Rand subsidence and support for our external trade.

If this plays benignly, two years into economic recovery, we may well find that our interest rate normalization remains modest and tempered, keeping the business cycle expansion and equity market ascent alive (and preventing another property relapse).

That would open up the way for a long cyclical expansion to continue uninterrupted, for the American and European output gaps will take many years closing, Japan is engaged in a long reconstruction, Asia still has much catch-up growth potential, and we would remain long-term beneficiaries of such processes.
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Locally, the income engine looks robust, with double-digit wage increases being demanded in the public sector, robust business recovery in substantial parts of the private sector, fiscal policy mostly supportive and our export prices yet to peak out.

It is a combination capable of good support for ongoing consumption spending. Parts of the fixed investment space (machinery and equipment) should eventually respond positively even if residential, non-residential building activity and construction lag, even severely.

And thus our growth should also keep going along, even when facing so many external risks and local drag anchors. The main beneficiaries should be consumption, labour and business incomes, even with an overvalued currency and increased interest rates.

References (select)

David Pilling, "Tepco makes Lehman seem a mere bagatelle", Financial Times 14 April 2011

Ed Morse, "Expect more oil price rises in world of new geopolitics", Financial Times 7 April 2011

John Sfakianakis, "The Arab spring risks economic malaise", Financial Times 6 April 2011

Gerbert van der Aa, "De Islamisten roeren zich", Elsevier 2 April 2011

Gideon Rachman, "Egypt's liberals are losing the battle", Financial Times 26 April 2011

Cees Bruggemans
Chief Economist FNB
Cees@fnb.co.za