View the Moody's Analytics Global Forecast.
- Growth is slowing across the globe, with few exceptions.
- Investors are holding back due to uncertainty about the euro crisis and U.S. fiscal policy.
- European policymakers will do whatever is necessary to keep the euro zone from collapsing, even if Greece exits.
- Slowing growth in China and India further clouds global prospects.
The global economy faces enormous challenges. The euro zone’s political and policy paralysis casts a dark shadow. The U.S. election season and the possibility that the world’s largest economy will stall as fiscal policy slams on the brakes early next year is paralyzing business and household decisions. Worse, emerging economies such as Brazil, China and India are at more risk than they were during the 2008-2009 recession. Room to expand fiscal spending is limited and inflationary fear has constrained monetary policy. In tandem, the high level of uncertainty created by the euro zone crisis and the U.S. "fiscal cliff" is suppressing private investment across the globe.
Weather and politics
Global growth has been tepid and uneven and is expected to remain so through the rest of 2012. A large part of Europe is either in recession or sliding toward it. The recovery in the U.S. is slow but relatively solid. In Asia, performance is uneven, with China and India decelerating while other small East Asian economies experience unexpectedly strong growth. Australia, where the economy is tied closely to China, is slowing in tandem with its largest trading partner. South America’s agricultural commodity exporters are experiencing a boom as agricultural regions in North America and elsewhere experience drought conditions. Metal and nonmetal commodity exporters are seeing prices fall as growth slows in India and China. Oil exporters are enjoying a temporary bump in fortune due to the West's embargo of Iran.
Europe's problems will weigh on global growth into 2013. While the emerging economies and North America will continue to recover, recessions in a number of euro zone members will drag output lower, with subpar growth over much of the rest of Europe. Global GDP will grow 2.3% this year, prolonging the weak spell that began in 2011. Growth will pick up to 2.9% in 2013, when most of Europe will emerge from its slump. Emerging economies, including China, will power the global economy in the medium term, while fiscal drag will keep most European economies on a slower path.
Euro zone breakup remains a possibility
Life in the euro zone is returning to normal as people return from traditional August vacations. European Central Bank President Mario Draghi’s stated determination to do whatever is necessary to preserve the euro zone calmed markets after a wild July. Spanish sovereign bond yields have returned to reasonable levels but remain sufficiently above those on benchmark German bunds, showing the currency zone's potential collapse remains a major concern.
September may be a key month for the euro zone. On September 12, Germany’s highest court is expected to rule on the constitutionality of the permanent European Stability Mechanism, which replaced the temporary European Financial Stability Facility created in May 2010. A negative ruling would set back the European Union's efforts to resolve the crisis and would cause unpredictable market turmoil. A favorable verdict will clear the way for future rescue operations in Spain and Italy, if needed.
Progress report due on Greece
Also due in September is a report on Greece's progress toward fiscal health from the troika—the European Commission, ECB, and International Monetary Fund. Early signals indicate the report will criticize Greece's implementation of its austerity program, which was negotiated with the troika in exchange for financial assistance. Greek Prime Minister Antonis Samaras wants to delay some of the agreement's target dates, citing a much deeper recession in Greece than was assumed when the pact was negotiated. Germany, a key player in the talks, shows no inclination to alter the current deadlines.
The refusal to give Greece more room to address its economic woes could set the stage for Greece's exit from the euro. Such a scenario could play out if Greece fails to meet a target and the EU withdraws its financial support from the government. Without funds from the EU, Greece would default on its loans and be unable to pay state workers in euros, forcing it to leave the union and resume printing its own currency. Moody’s Analytics estimates a 45% chance of this occurring within the next two years.
Greece can go but not Spain
While northern European leaders say the euro zone could survive without Greece, the cost could be quite significant, undermining market perceptions about the currency union's permanence. Spain would most likely suffer first from this change in market psychology, seeing its bond yields rise sharply. If the contagion from Greece's exit is severe enough, it could spell the end of the single currency.
However, odds are that Europe's leadership will do what it takes to keep the euro zone together, showing measured but temporary flexibility with Greece while it works through its fiscal problems. At some point, Greece still may have no option other than leaving the euro zone but only after the ECB is certain that the exit will not set off a calamitous chain reaction—meaning not for two years, at least.
Planning for a post-euro world
For European policymakers, a collapse of the currency union is almost unthinkable; litigation over existing euro contracts alone would create a nightmare. The cost of a Greek exit is manageable by comparison. It appears from the drama being played out in Berlin and Brussels that this is the outcome European leaders are anticipating. Nonetheless, legal departments in international corporations and trading companies and even some member nations of the euro zone are quietly making plans in case the currency union falls apart. Negative bond yields in Denmark and Switzerland are the result of investors parking money in safer currencies to hedge against a euro collapse.
For better or worse, punishing Greece for its fiscal profligacy is a popular idea in northern Europe. Doing so will send the message to other peripheral euro zone member countries that membership is not guaranteed and bad behavior will be punished. It also creates a strong foundation for a closer fiscal, political and monetary union in Europe.
Even Asia's giants feel the pain
Asia so far has weathered the euro storm but not as well as it did during the Great Recession, which was of considerably shorter duration than Europe's debt crisis. The financial market turmoil of 2008 was brought under control within a year by central banks and governments. The euro crisis, by contrast, started in 2010 and has no end in sight.
Data from China show growth steadily weakening this year. Chinese exports to Europe have declined, while shipments to the U.S. have been flat. Fixed asset investment, a major driver of China's domestic demand, was unchanged at 20.4% y/y in July, and industrial production decelerated to 9.2% y/y from 9.5% in June. Most of the decline is due to manufacturing: Growth rates fell in the output of cars and other transportation, ferrous metals, and electrical machinery. On the upside was energy output: Growth accelerated for electricity and crude oil production.
India's economy slowed through mid-2012 as turbulent global conditions and domestic policy missteps weighed on confidence and demand. The cycle is proceeding as expected, with GDP growth bottoming midway through the year. The slowdown has been most pronounced in India’s corporate sector. Confidence among Indian firms has been knocked by weak demand, elevated interest rates, high inflation, and instability created by a weak central government that has badly lost its way.
Power failure in India
The recent electrical blackout that affected more than 600 million residents was the most graphic illustration of the infrastructure woes and regulatory headaches that Indian firms contend with daily. The direct economic impact should be small, as Indian firms and households use generators to cope with power outages. It is generally reckoned that India’s electricity limitations knock 1 percentage point off annual GDP growth anyway. But the indirect effects could be larger, as the blackout highlights India’s inadequate public infrastructure and the business challenges faced by firms there.
Meanwhile, major developing countries such as Brazil, Russia, India and China, along with the oil-exporting nations, are preparing for a worst-case scenario in the euro zone. Currency-swap agreements among major developing countries are aimed at preventing the kind of trade-credit squeeze seen after Lehman Brothers collapsed in 2008. These agreements allow central banks to buy and sell each others' currencies to promote bilateral trade. Exchange values are still measured in U.S. dollars, but uncertainty about the ability to convert currencies for trade is removed from the equation.
Germany to the rescue?
The predominant risk to our outlook is to the downside. While the U.S. government is expected to negotiate a moderate path around the 2013 fiscal cliff, uncertainty will continue to color investor perceptions until Washington's fiscal course is clear. On the upside, quick definitive action by the ECB to resolve the euro crisis could provide a considerable boost to the global economy. Such a decision will be made mainly on political grounds, and a change in the ruling party in Berlin next year could tip the balance in favor of an activist central bank.
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