East resilient but West faces oil-slicked slope to recovery

The second factor is the overhang of debt that continues to weigh on the recovery in Europe and the US. The need to deleverage – as people, firms and governments pay off debt – points to a steady but unspectacular recovery in the US, and signals further problems in the euro zone. It is against this backdrop that one needs to view the recent improvement in financial-market sentiment across the globe.

At the end of last year, a number of factors were weighing on the world economy. The markets feared a double-dip recession in the US, a hard landing in China and a collapse of the euro. None of these fears materialised. Thankfully, I did not share the markets’ views about the US or China, but I was pessimistic about the euro, expecting a muddle-through. The fact that economic data from both the US and China was better than expected helped sentiment, but the actions of the European Central Bank (ECB) were key.

The ECB did a great job pulling the euro zone back from the brink by providing cheap three-year money in both December and February. The ECB averted a bank collapse and a credit crunch, which in turn helped sentiment. As profound and necessary as the ECB’s actions were, the short-term relief it has provided should not be seen as a longer-term cure for Europe’s problems.

This year, the world economy still faces significant challenges. Let me highlight the main ones.

The first is the euro. The euro zone is in recession. With the exception of France, most major European economies contracted in the last three months of 2011. This included the peripheral euro-zone countries of Ireland, Italy, Spain, Portugal and Greece. In short, the periphery is seeing a double-dip recession. The ECB’s actions may have averted a credit crunch, but they will not prevent a credit squeeze where funds are still hard to come by.  

Moreover, the euro zone is focusing on the wrong problem. Although debt levels are high, the biggest challenge is the lack of growth as it is cutting public spending and raising taxes to reduce debt. This is a long and painful process. Unless private spending picks up, economies will be weak. The trouble is, with demand sluggish, many firms are thinking twice about increasing their spending. 

Another challenge is the US. I am positive about America’s long-term prospects. However, American big companies seem reluctant to go out and invest, either because they fear demand will be weak, or because they are worried about the regulatory outlook following this year’s presidential election in November. In this case, the backdrop for the average American will be one of only modest employment growth, a small rise in wages and a still-weak housing market. Americans still need to save more and spend less.

This leads to the issue of energy and food prices. A year ago, rising food and energy prices added to inflation pressures across the globe, justifying higher interest rates in many growing economies. Now, rising oil prices appear more like a tax on global growth, eating into spending power in the US and Europe, and hitting many Asian economies at a time when they are slowing.

There can often be a big difference between oil prices being driven higher by strong demand, and by supply shocks. If strong demand is driving prices, then at least when oil prices rise, there is also increased spending and trade. Now, it is demand from Asia and the Middle East that is driving oil prices up, and thus Western economies may not be in a strong position to cope. The more oil prices rise this year, the weaker the economic outlook will be in the West.

This vulnerability is worse now, as supply-side worries surrounding Iran have led to a large risk premium, pushing oil prices up. Oil prices appear to have a firm floor because of strong demand, and a soft ceiling because of geopolitics.

China’s economy is cooling, not collapsing, and it is having a soft, not a hard, landing. At the National People’s Congress, Premier Wen Jiabao sensibly cut the growth projection to 7.5 per cent from 8 per cent. Although I remain positive about China’s longer-term prospects, it is important to stress that, at some stage, China will have a setback. This should be seen as a feature of China’s likely development. As the economy grows bigger, it becomes harder to manage than in the past. Moreover, the need to switch from investment- to consumption-led growth poses many challenges.  

In 2010, there was a strong rebound, with the world economy growing 4.4 per cent, led by policy stimulus in the West and by the strength of China and the emerging economies. But in 2011, the growth pace slowed as the policy stimulus in the West started to wear off and as more countries in Asia and Latin America raised interest rates to curb inflation. Last year, the world economy grew by 3 per cent.

This year, the good news is that there will be growth, but the challenge is that it seems difficult for it to be any higher than it was in 2011. Europe faces further challenges. America still has a debt mountain to climb. And many emerging economies have been slowing in the early months of the year. The economic story is one of a fragile West and a resilient East.

 

Gerard Lyons is chief economist at Standard Chartered Bank.