The Global Recovery Gathers Steam

by: Carnegie Endowment

As world trade and industrial production continue their impressive acceleration, the global economic recovery is gaining traction. Generally strong reports in the United States, China, Japan, and emerging markets, however, are contrasted by weak fourth quarter numbers in Europe. Nevertheless, European activity is picking up and last weekend’s announcement of a Greek rescue package has provided markets with a badly needed dose of reassurance.

Despite these improvements, demand in the advanced countries is still dependent on expansionary monetary and fiscal policy, which will likely remain supportive into 2011. The possibility of a contagious spread of Greece’s debt problems to other vulnerable countries in Europe implies that fiscal policy will tighten in those countries, but also that European policy interest rates will stay low for longer. Asset bubbles and rising inflation in emerging markets are shaping up as significant risks going forward, especially if oil and other commodity prices surge with the global expansion.

Recovery Gaining Strength in Much of the World

The recovery is gaining momentum in the major economies. Coincident and leading indicators—those that typically move simultaneously with economic growth or in advance of it—have been improving throughout the United States, Japan, and major emerging markets, suggesting that GDP growth will be strong at least into the first half of 2010.

Global industrial production continues to pick up. The annualized three month moving average (3m/3m, saar) rose by 11.7 percent in January, led by increases of 22.9 percent in Japan and 15.6 percent in emerging markets. In the United States, industrial production has increased for eight consecutive months through February.

Surveys also point to strength ahead. In the United States, the Services Purchasing Manager’s Index (PMI), which covers approximately 90 percent of the economy, rose from 53 to 55.4 in March (readings over 50 imply expansion) and the Manufacturing PMI rose from 56.5 to 59.6. China’s manufacturing and service sectors continued to expand in March, while manufacturing rose in the UK.

Retail sales in the United States and Japan are up 3.9 percent (y/y) in February. Japan's increase was its largest in over ten years. Though U.S. consumer credit declined more than anticipated in February, suggesting consumers’ reluctance to take on more debt, they can be reassured by the addition of 162,000 jobs in March, the largest monthly increase in two years.

Global trade has continued its advance, rising 22.5 percent (3m/3m, saar) in January while global demand is becoming more balanced. For the first time in nearly six years, China reported a monthly trade deficit of $7.1 billion in March, after averaging surpluses of $25 billion in 2008. Though most of the deficit came from trade with Asian economies and large surpluses are expected to return, the report may help ease tensions over the value of the renminbi. Demand in other major emerging markets has also surged as merchandise imports are up 50 percent (y/y) in Brazil in March and 57 percent (y/y) in India in February.

A Two-Track European Recovery?

Concerns about a potential Greek default, which has been a major risk to the global recovery in recent months, eased as European leaders provided a more detailed financial rescue plan. According to the plan, Greece would receive $40 billion in loans at around 5 percent interest—significantly lower than the 7.4 percent that the markets demanded before the announcement—with another $20 billion widely expected from the IMF. Greece’s borrowing costs eased as Greek spreads over ten-year German bonds narrowed to 367 basis points as of April 13 from an 11-year high of 430 basis points (1 basis point is one hundredth of a percent).

Unfortunately, the Greek crisis is still in its infancy: it will take years for the country to return to a sustainable fiscal path and claw back some of its lost competitiveness through wage controls and structural adjustment measures. Similar—though less acute—problems affect Italy, Spain, Portugal, Ireland, and several smaller countries that recently acceded to the EU and pegged their currencies to the euro. These countries, which together accounted for 35 percent of Euro area GDP in 2009, will see slow domestic demand growth and will be a drag on an already sluggish long-term growth trend in the continent.

Latest indicators in the Euro area are mixed. Retail sales fell by 0.6 percent (m/m) in February, and were down 1.1 percent compared to last year. The labor market has yet to improve, as unemployment reached 10 percent in February and has not declined in any month since early 2008. After expanding by 10 percent (3m/3m, saar) in October, Euro area industrial production grew by only to 2 percent in the January. Import growth fell from 17 percent (3m/3m, saar) in October to just 0.8 percent in January; export growth fell from 9.5 percent to 2.4 percent.

Nevertheless, some green shoots are clearly emerging. The services PMI rose from 51.8 to 54.1 in March, while the manufacturing index rose from 54.2 to 56.6. Net exports could rebound following the euro’s 11 percent drop against the dollar since December 2009.

Rising Inflation and Asset Bubbles May Pose a Risk

Inflationary pressures and asset price bubbles are a modest but growing risk in emerging economies. Rising confidence in the global economic recovery and increasing oil demand in emerging economies—oil demand in China grew by 17 percent (y/y) in the fourth quarter of 2009—have pushed oil prices to about $85 per barrel last week after averaging between $70 and $80 for more than five months. The price rise prompted the International Energy Agency to warn that the global economic recovery could be threatened if the price of oil stays over $80 per barrel. Already, gas prices are about a dollar per gallon higher than a year ago, crowding out $12 billion in U.S. consumer spending each month.

Asset prices in emerging economies, mainly driven by better economic fundamentals, have been rallying spectacularly since last year and present another source of risk. Debt issued by emerging-market borrowers returned 11.3 percent this year, outpacing the 2.8 percent gains of U.S. company bonds. As demand for riskier assets has increased, the extra yield investors demand to own emerging markets bonds over U.S. Treasuries has narrowed to 250 basis points, from 600 basis points a year ago. Additionally, the MSCI emerging market equity index has risen 60 percent since last year, compared to a 40 percent gain by S&P index.

To contain the rise of inflationary pressures caused by rising commodity and asset prices, monetary policies have been tightened in several emerging countries. India, Malaysia and Australia have all increased interest rates by 25 basis points, and more increases in Australia are expected. The Chinese government restricted bank lending to prevent the economy from overheating, causing lending to fall 43 percent in the first quarter (y/y).

Meanwhile, the Fed and European Central Bank (ECB) noted that inflationary pressures remain subdued and, along with the Bank of England, continued to signal that their expansionary stance will persist. The Japanese central bank continues to fight deflation. While this reduces the risk of premature stimulus withdrawal in the advanced countries, low interest rates combined with rapid growth in the emerging economies increases the likelihood of inflation and asset bubbles there.