International Economic Update

The Global Economic Recovery and Its Threats
March 25, 2010

Economic recovery is expected to continue at a slow pace, with developing countries growing faster than developed economies. Consensus Economics' latest report indicates that the euro zone and North America are expected to grow by 1.3 percent and 3.1 percent, respectively. The general outlook in the emerging economies is positive, and according to the International Monetary Fund, 6 percent growth is expected this year due to a pickup in trade and manufacturing. Capacity utilization rates remain at low levels and inflation is likely to remain subdued in developed economies. Developing countries, particularly India and China, are experiencing some inflationary pressures. The recovery seems to be under way but is threatened by the high levels of public debt in developed countries, especially in Europe.

High Public Debt
Greece has run sizeable fiscal deficits over the past decade, leading to €300 billion ($419 billion) in government debt, 113.4 percent of its GDP. Prime Minister George Papandreou has already cut spending and increased taxes to reduce the deficit from 12.7 percent of GDP to 8.7 percent this year. He also plans to freeze pay in the public sector, reform pensions, increase petrol prices and implement other severe austerity measures to bring public finances under control. Although Greece managed to sell €5 billion in bonds earlier this month, it still needs more than €20 billion to meet debt redemptions in April and May (Chart 1).

The crisis in Greece is putting downward pressure on Europe's growth prospects. From January to February, the growth expectations for 2010 decreased for Belgium, Germany and Italy and remained negative for Spain. The prospect of contagion is growing as the recent developments in Greece have exposed Portugal, Ireland, Italy and Spain's fiscal situations to scrutiny (Table 1). Additionally, rating agencies have warned these countries or downgraded their sovereign debts or both. As seen in Chart 2, the cost of insuring these countries' sovereign debt against default has also risen in tandem with Greece. Even if the Greek government is able to successfully address the fiscal deficit, these countries could remain in recession for the rest of 2010.

Table 1
Financial Situation in Euro Zone Periphery
 
Greece
Ireland
Italy
Portugal
Spain
Current account deficit (2009)
(avg. of 4 quarters; % of GDP)
–11.1
–2.8
–2.7
–9.7
–5.3
 
Budget deficit (2009)
(% of GDP)
–12.7
–11.7
–5.3
–8.1
–11.5
 
Public debt (2009)
(% of GDP)
111.5
61.3
114.8
74.9
51.9
 
Public debt 2010 OECD Forecast
(% of GDP)
119.9
76.7
118.3
81.9
60.1
 
SOURCES: Haver Analytics; Bloomberg; national statistical offices.

Foreign Exchange Markets
Although some agree the worst of Greece's financial crisis is over, there is still enormous pressure on the euro. Since Greece's creditworthiness came into question, speculation over the future of the euro has caused it to drop 6.6 percent against the dollar (Chart 3). Further appreciation in the dollar came shortly after the Federal Reserve increased the discount rate in February. In the currency futures market, three-month dollar exchange rate contracts project a continued strengthening of the dollar versus the euro and British pound.

Similar to the dollar, higher risk aversion has increased demand for the yen as a safe haven, raising the value of the currency. However, the appreciation of the yen could bring unwelcome news to Japan's frail recovery. A higher yen may cause a decrease in external demand and further downward pressure on prices. Japan already suffers from serious issues with deflation and largely depends on exports and its expansionary fiscal and monetary policies to spur economic growth.

Emerging Markets
In January, Japan's industrial output increased by 2.5 percent month-over-month due to rising demand from China, the country's biggest export market; China's exports and imports grew by 21 percent and 86 percent year over year, respectively. Much of China's growth, which is expected to stay in the range of 9 percent this year, can be attributed to its response to the financial crisis in 2009, which involved aggressive monetary and fiscal policies. China's consumer price inflation increased to 2.3 percent in February 2010 (Chart 4), largely driven by a 6 percent jump in food costs. Premier Wen Jiabao aims to hold full-year inflation around 3 percent, and with some speculation that inflation may top this target in April, focus could be split between boosting growth and preventing the economy from overheating.

Much of the positive outlook for emerging economies can be attributed to rebounding commodity prices and the overall increase in manufacturing, which is promoted by the improvement of trade. The February Consensus Economics' report estimates that Asia–Pacific countries will lead the recovery with an estimated growth of 5.3 percent; Latin America follows with an anticipated 3.8 percent growth. Although there is some speculation that China and India will seek to restrict economic growth to curb inflation, emerging economies are still expected to grow by approximately 6 percent this year.

Summary
The global economic recovery is expected to continue at a sluggish pace. The crisis in Greece has opened the door for contagion to other highly indebted countries and caused another wave of uncertainty and volatility in the fragile recovery. As Europe is considered a risky zone for investors, the dollar and yen have appreciated. For advanced economies, recovery is expected to be weak by historical standards, while the general outlook for emerging economies is rather positive.

—Hector Mendoza

About the Author

Mendoza is a research analyst in the Research Department at the Federal Reserve Bank of Dallas.

 

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