Exploring the labyrinth: Twists and turns for the global economy in 2012

But the main picture for 2012 is clear: A significant slowdown with much greater risk of double-dip recession. 

This is largely caused by market fluctuations as a result of the unresolved European fiscal crisis. Emerging markets, especially those with heavy trade ties with the US and Europe, will also be affected by the slowdown in major economies. However, the scale of contraction – which may range from minor recessions in some countries (eg, the euro zone) to full-blown global financial crisis – will depend on three main factors.

The first is European governments’ reaction to the fiscal crisis. It is becoming clear that solving the problems in the euro area will be a long and painful process. However, to forecast what will unfold, we must understand how the EU got into this mess in the first place. 

The answer, of course, is the fiscal indiscipline of its peripheral countries. So, it is tempting to say that the way out of this mess is to tighten these countries’ belts. That would be correct in normal circumstances, but in today’s fragile economic environment, austerity measures imposed by creditors on wayward countries are not unlike war reparations exacted by the victors from the defeated, worsening an already bad situation. The correct way is in fact to relax belt-tightening and give countries time to rebalance their economies in order to have means to generate income to pay their debts.

Not until the northern European countries relax the tight conditions attached to loans to their peripheral partners will we see light at the end of euro-zone tunnel. The EU leaders’ latest grand plan – a 50-per-cent “haircut” for Greek debt, the recapitalising of the European banking system, and increasing the firepower of the EU bail-out fund in exchange for austerity measures – is not only worsening the situation in the medium term, but will lead to more turmoil as the plan’s lack of detail becomes apparent (see the recent turbulence in the Italy-bond market). 

The second factor governing the depth of 2012’s slowdown will be the fiscal tightening rhetoric of developed economies. As with peripheral European countries, fiscal tightening is needed all around the developed world – but not right now. A premature tightening, or even an announcement of tightening, will not only hurt the fragile recovery through “fiscal drag”, but will also give a false signal to consumers and investors that governments will hike taxes to cover their earlier stimulus measures. Hence, people will tend to save more money so as to be able to pay those taxes when they arrive. 

The third and final factor governing 2012’s outlook is the monetary decisions taken by central banks. At the beginning of this year, it was clear that central banks in emerging markets had a different viewpoint from their mature-market counterparts. Faced with rising commodity prices and the threat of inflation, emerging-market countries have hiked their policy interest rates briskly, in contrast to rates in developed countries, which have been cut historically low to accommodate their weak economies. 

Things are about to change. The worsening situation in Europe means that the European Central Bank (ECB) needs to pre-emptively relax its monetary stance further. At the beginning of November, the ECB surprisingly cut its policy rate and also aggressively bought its peripheral countries’ bonds in order to stabilise the market. Although beneficial to the economy in the short term, this act is not sustainable, since it helps create excessive liquidity in the capital market which will eventually flow into the commodity market, and lead to inflation.

Concurrently, it is increasingly evident that the hike cycle in emerging markets will be halted, at least momentarily, due to the rising threat of a European crisis. It remains to be seen, however, whether this halt will be permanent and herald a reversing trend. This depends on three factors: the severity of the European crisis, the state of each domestic economy and the threat of inflation. 

If Europe cannot come up with a sustainable solution for the current fiscal crisis, the ECB will have no other alternative but to buy peripheral-country bonds, especially those of Italy which is expected to have a huge redemption (about 120 billion euros) next spring. This bond buying, coupled with the halt in emerging economies’ policy rates, will undoubtedly lead to an inflation spiral, and an increased risk of “stagflation” – simultaneous inflation and recession. 

If you asked any economist for a forecast this time last year, the answer would have been much brighter than the picture we see now. It is to be hoped that with today’s dim view of the economy, the fortunes will be reversed next year. It is the duty of policymaker, businessman and investor alike, however, to prepare for the worst – but hope for the best. 

 

Piyasak Manason is vice president for research & planning at Kiatnakin Bank.