Globalization & Monetary Policy Institute
International Economic Update
Euro-Area Uncertainty Hurts Global Growth
January 26, 2012 | Update in PDF
The global economy is expected to slow. The Organization for Economic Cooperation and Development estimates in its January Economic Outlook that world gross domestic product (GDP) will grow 3.4 percent in 2012, following growth of 3.8 percent in 2011. This is down from 5 percent growth in 2010. The expected contraction of the euro-area economy is creating negative spillover effects for both advanced and emerging economies in international trade. Currency appreciation is hurting the export sectors of the advanced economies. Decreased demand is threatening the export sectors of the emerging economies. However, the U.S. outlook has become more optimistic, and recent negotiations in Europe provide hope for a solution to investor uncertainty in the euro area.
Investors Wary of Euro-Area Instability
The expected economic contraction in the euro area is a major contributor to the worsening global outlook. The euro-area economy suffers from a buildup of sovereign debt and a vulnerable banking system. The December Consensus Forecast predicts the economy will contract in the first quarter of 2012; real GDP is expected to decline 0.1 percent in quarter one, 0.3 percent in quarter two and 0.3 percent in quarter three, year over year. These forecasts are consistent with the euro area entering a recession in 2012.
Contributing to this drab outlook is the immediate concern of a Greek default and the potential for Italy to default. Comparing the 10-year government bond yields of highly indebted euro-area economies with the German equivalent highlights the negative investor sentiment (Chart 1). Because Germany is perceived as a safe investment, the German bond becomes more attractive as investors believe other euro-area countries will be unable to repay their debt obligations. Consequently, bond yields fall for Germany but rise for high-risk countries. Bond yields for Greece rose rapidly in the latter half of 2011 and remain at escalated rates.
Among the measures implemented to avoid a Greek default was a reduction in the market value of Greek government bonds held by the private sector. This reduces Greece’s debt obligations but also devalues the assets of banks that hold the bonds as collateral. Interbank lending has decreased as a result. When banks stop lending, credit becomes restricted. This stifles investment in the euro area, hindering future growth.
To increase credit availability, the European Central Bank (ECB) injected liquidity into the economy. On Dec. 21, the ECB conducted the first of two planned auctions offering banks three-year loans at very low rates—the average of the ECB policy rate over that term. The policy rate was reduced to 1 percent on Dec. 14.
The ECB added 489 billion euros to the economy at the first auction, with the hope that increased bank lending would encourage investments in risky government debt and drive down high bond yields. However, following the liquidity injection, deposits at the ECB surged (Chart 2). This suggests that reduced bank lending was a result of market uncertainty rather than insufficient funds. Banks doubted the ability of borrowers to make loan repayments.
Investors Seek Safety in Advanced Economies
The declining confidence within the euro-area financial system has caused investments to surge in countries with less-risky sovereign debt levels. Increasing capital inflows to Japan and Switzerland have caused their currencies to rapidly appreciate against the euro (Chart 3). This can be detrimental to the export sector by making traded goods more expensive to international buyers.
Both countries chose to actively control their appreciating currency. Japan intervened by swapping large quantities of yen for U.S. dollars. Switzerland also swapped francs for U.S. dollars, but in an unprecedented move, pegged the franc to the euro. Switzerland’s peg has been successful in preventing future appreciation, though the effectiveness of Japan’s interventions remains uncertain.
Falling Demand Hurts Emerging Economies
Previous downgrades to global growth have been mostly based on the underperformance of the advanced economies. Though emerging economies continue to expand at high rates, recent downgrades have been influenced by the deceleration of these economies. Monetary policy rates have started to ease across the emerging economies, suggesting concerns have switched from an overheating economy to a stalling economy. One drag is the decrease in demand from the advanced economies, which is affecting the largely export-driven emerging economies.
China is the world’s largest single-country exporter, contributing 11 percent of total world exports in August 2011. A large portion of China’s exports go to advanced economies (Chart 4). In 2010, 42 percent of its total nominal exports went to the G-10 aggregate.
A contraction in China’s manufacturing sector suggests the sluggish performance of the euro area has translated into decreased economic activity in China. The purchasing managers index (PMI) from the China Federation of Logistics and Purchasing fell to 49 in November (Chart 5). The index rebounded in December to 50.3 but is still close to the contractionary threshold of 50. A closer look at PMI components for the overall manufacturing sector shows that employment fell along with new orders. Rising wages could also be contributing to the slowdown of China’s manufacturing sector, given that rising labor costs lead to higher export prices.
Optimistic Outlook Emerges with Negotiations in Europe
On Dec. 9, the European Council proposed a resolution for the euro-area sovereign debt crisis. Dubbed the “fiscal compact,” it imposes stricter regulations governing sovereign debt levels and includes plans to convert the temporary European Financial Stability Facility into the permanent European Financial Stability Mechanism (EFSM).
The EFSM differs from its predecessor in that the funds available to aid countries on the verge of default would be extended and backed by physical capital instead of guarantees. As investors grow more confident in the euro area’s ability to rein in sovereign debt and prevent a default, government bond yields should decline. This will lower the cost of borrowing and make debt payments more manageable. With increased assurance that debt obligations can be met, banks will begin to lend, further stimulating investment in the euro area. This should reverse the direction of the depreciating euro, offering relief to Japan and Switzerland. As advanced economies improve, increased demand will stimulate the emerging economies.
About the Author
Mack is a research analyst in the Research Department of the Federal Reserve Bank of Dallas.