International Economic Update
The Recovery, Growth and New Signs of Financial Market Strain
June 23, 2010
The current international situation can best be described as strong economic growth in emerging markets, a continued economic recovery in advanced economies and financial market strains in Europe. European sovereign debt problems persist, and the potential for contagion beyond the euro area remains. Inflationary pressures are still subdued and are expected to stay at modest levels. In addition, the number of countries beginning to tighten monetary policy has increased, with the Bank of Canada the first G-7 central bank to raise rates.
Growth in Emerging Economies
Rapid growth in manufacturing has pushed industrial production levels close to or beyond the 2008 peak for the emerging market economies, namely China, India and Brazil (Chart 1). In the same way, GDP growth has returned to precrisis levels, with China's growth at 12 percent year over year and Brazil's growth at 9 percent year over year in first quarter 2010. Employment growth has also been faring better in emerging economies than advanced, with Brazil and China showing positive growth in the first quarter.
Recovery in Advanced Markets
Industrial production has also shown positive growth for many advanced economies. Japan's industrial production soared in 2009 and grew by approximately 30 percent year over year in March 2010, possibly due to its proximity to its rapidly growing Asian neighbors. The euro area's industrial production grew 9.4 percent year over year in April—the highest pace in 10 years (Chart 2). Despite the jump in industrial production, the euro area's annualized first-quarter GDP growth was only 0.8 percent, compared with Japan's and Canada's growth of 5 percent and 6 percent, respectively. One reason for the weak performance may be Greece's 4 percent contraction, bringing down the euro area's overall economic growth. GDP growth in the other member countries was also weak: France's GDP rose 0.53 percent, Germany's by 0.64 percent, Spain's by 0.33 percent and Italy's by 1.7 percent. In spite of Europe's weak pace, the latest edition of "Economic Outlook," released by the Organization for Economic Cooperation and Development (OECD) in May 2010, revised its forecasts from its previous edition, dated November 2009. World GDP growth was raised from 3.4 percent to 4.6 percent for 2010 and from 3.7 percent to 4.5 percent for 2011.
Signs of Financial Strain in Europe
Recent international developments have increased concern over the high debt in Ireland, Portugal, Spain, Italy and Greece, with projections rising for 2010 and 2011 (Chart 3). Similarly, Hungary's sovereign debt has come under scrutiny after Hungarian officials likened their budget deficit to that of Greece. At the end of 2009, Hungary's debt was 78 percent of GDP. The country's current budget deficit is only 3.8 percent of GDP, but debt obligations in 2010 are over 70 percent of projected government revenue. Although the budget deficits of the five countries named above are high, forecasts seem to stabilize in the next two years (Chart 4). As fears of government default have risen, interest rate spreads on the governments' bonds relative to the comparably safe German bonds have soared, increasing the cost of borrowing. A common characteristic of emerging markets' debt crises is when interest rate spreads on short-term bonds become higher than interest rate spreads on long-term bonds. This tends to be a sign of a relatively high probability of default. This inversion of the spread curve happened for Greece and Portugal in January, for Ireland in March, and for Spain and Italy in May (Chart 5).
Banking Sector in Europe and U.S.
Banks in Europe hold a large amount of debt from troubled euro-area countries, particularly France with about $911 billion (25 percent of total foreign claims) and Germany with about $704 billion (20 percent of total foreign claims). Increased concern over potential losses has raised bank credit default swap (CDS) rates in Greece, Italy, Portugal, Spain, Ireland, France and Germany (Chart 6). Additionally, the increased uncertainty over individual banks' exposure to bad sovereign debt could hinder bank funding in Europe, which would tighten the amount of cash banks lend out.
By comparison, U.S. banks' direct exposure to the troubled debt of these five countries totaled $151 billion (approximately 6 percent of total foreign claims) at the end of 2009. This is not to say the U.S. is insulated from all risks. U.S. banks are indirectly exposed to sovereign risks through their claims on euro-area banks, which may hold troubled sovereign debt or face funding difficulties. Consequently, the risk of reintroducing strains on credit and interbank funding may increase.
Inflation and Monetary Policy
Headline inflation for major economies in the OECD has started edging upward in recent months, while core inflation (inflation excluding volatile items such as food and energy) has hovered between 1.5 percent and 2 percent. Commodity prices have increased since late last year, while prices of energy and industrial commodities have declined over the past couple of months. Consumer price inflation in the U.K. reached 3.7 percent year over year in April, while the euro-area inflation was 1.5 percent in April and 1.6 percent in May. The European Central Bank inflation forecasts remain modest.
Despite relatively subdued inflation rates in the OECD countries, some monetary authorities have begun tightening monetary policy. Canada raised its policy rate by one-quarter percentage point to 0.5 percent, citing strong growth and stable inflation projections. Meanwhile, Brazil raised interest rates in its April meeting and again in its June meeting. China has not yet tightened monetary policy. However, inflation rose to 3.1 percent in May, above the government's 3 percent target for the year, raising concerns over the pace of growth.
In short, there is strong economic growth in emerging market economies, while the advanced countries are sustaining a modest recovery. Sovereign debt problems are plaguing Europe, and signs of some financial concerns are apparent in the European banking sector. Inflationary pressures are relatively subdued in the advanced economies, and some central banks are tightening monetary policy. Finally, the future looks hopeful, with upward revisions in world GDP growth forecasts.
About the Author
Mendoza is a research analyst in the Research Department at the Federal Reserve Bank of Dallas.