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United States
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The United States: a weakness that will remain for some time yet
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The United States will grow by less than 3.0% in 2010 and this weakness will continue in 2011.
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The US economy is en route to a modest recovery. For 2010 as a whole we therefore expect 2.8% growth that's mostly due to the boost from the first quarter, when stocks made a record contribution to growth. However, the economy slowed down considerably in the second quarter, going from 0.9% to 0.4% growth quarter-on-quarter. The latest year-on-year figures might be deceptive in this case as they've been skewed by significant base effects. Low growth will continue to be the main concern throughout 2011, a year for which we expect tepid growth of 2.2%. Nevertheless, although strong growth will have to wait, the latest data point to little risk of a double-dip recession and deflationary period.
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Household debt, weak housing and the labour market hinder the recovery.
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The main cause of this lethargy in activity lies in the problems affecting private consumption, which represents approximately 70% of the US economy and for which we don't expect growth of above 2.0% before the end of 2011. Consumption is gripped by three key factors: household debt, the weak housing market and the labour market. Three factors that are interrelated like a dog chasing its own tail.
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Good performance from capital goods investment and fiscal stimuli reduce the risk of a double-dip recession.
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Household debt accounts for 118.4% of annual disposable income, a much higher level than befits the long-term trend. Although the current low interest rates assuage the cost of this debt, the low inflation rate also means that the principal isn't falling in real terms to any great extent. Households therefore have to save more to reduce their debt, 5.9% of gross disposable income in July, consequently limiting their spending budget.
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A second factor afflicting private consumption is the reduction of equity of real estate which, through the wealth effect, is also taking away consumers' appetites. But the surplus supply in the sector must be reduced before the housing market can recover. With construction at a record low, this surplus supply is mostly due to the large number of foreclosed mortgages as a result of non-payment, which continues to expand the inventories of empty homes.
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But mortgage delinquencies are a direct consequence of the anaemia in the job market, a third factor of weakness in economic activity that, in turn, affects private consumption due to lower incomes. Consequently, the dog is chasing its own tail because, with weak growth in private consumption, the economy's growth is necessarily modest and, without strong growth, we're unlikely to see any substantial recovery in a labour market with a high proportion of long-term unemployed and discouraged workers. The recovery in capital goods investment, government stimuli and a foreign sector that, helped by lower domestic demand and growth in exports, has a smaller deficit than in the years prior to the crisis, will help to avoid a double-dip recession but it won't be enough to push the economy onto a path of strong growth.
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Retail sales reflect consumer pessimism.
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This continued moderation in consumer appetite is reflected in the trends in retail sales. The slight increase in August, after four consecutive months of weakness, did not stop retail consumption, without cars or petrol, from being 2.3% below its figure for December 2007 in real terms, which is representative of pre-crisis levels.
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For their part, non-financial firms continue to provide the most solid part of the recovery, as shown by the trends in capital goods investment in the national accounts. This strength in capital goods investment should continue in the coming quarters due to the good performance of corporate profits and the fact that, in the last few years, there has been no excessive investment but quite the opposite, in fact. However, over the last three months, the trends in business sentiment for manufacturing and services have gone their separate ways. The ISM business sentiment index (Institute for Supply Management) for manufacturing rose surprisingly to 56.3 points, far from the record highs of April but in line with an economy enjoying strong growth. Although more modest, the recovery in industrial production and industrial capacity utilization also brought these indicators close to their long-term trend.
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Service entrepreneurs see a gradual recovery.
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But the US recovery cannot live on manufacturing alone, as services account for more than four fifths of private employment. And it's precisely in services where the deterioration in business sentiment is most severe, with the ISM index going from 60.3 points in April to 54.4 in August, in line with a modest recovery.
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The general consumer price index (CPI) for August confirms this moderation, with a 1.1% increase year-on-year, while the lethargy in consumption and the weakness of owners' equivalent rent of a primary residence meant that core inflation rose by 0.9% year-on-year for the fifth consecutive month. For 2010 as a whole, we predict that prices will rise 1.6%, a moderation that should also continue in 2011. In any case, we believe that the action taken by the Fed (including a new quantitative expansionary phase) will avoid any deflationary scenario.
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Japan
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Japan: after the recovery in exports, the decline sets in
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Thanks to exports, Japan will grow by 2.8% in 2010 but will slow down notably in 2011.
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In the first half of 2010, the economy of the land of the rising sun benefited from the recovery in world trade and from fiscal stimuli for consumption. The unmet demand accumulated during the crisis and the very low starting point mean that exports have been pushed to higher growth rates in annual terms, namely 30% in the first quarter. This means that the growth forecast for the whole of 2010 for the Japanese economy is close to 2.8%, conditioned by the 1.2% rise quarter-on-quarter of the first quarter. However, weak domestic demand and the continuing deflationary situation that, according to the Bank of Japan, will go on until early 2012, mean that our forecast for 2011 as a whole is much more cautious, namely growth of around 1.4%.
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The growth in imports and fiscal stimuli will diminish.
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Thanks to fiscal stimuli, private consumption started 2010 with growth rates of more than 2.0%. However, once these stimuli ended, difficult to extend with a gross public debt in excess of 200% the gross domestic product (GDP), consumption stagnated in the second quarter. This is unlikely to pick up over the coming months, even though the latest indicators, such as consumer confidence, retail consumption and car sales are still benefiting from the strong first quarter. But the real estate market continues to be sluggish, with land prices still falling, and the labour market is weaker than statistics suggest, with unemployment at 5.2%, very close to the record high of June 2009.
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Deflation continues: the CPI fell by 0.9% and core inflation by 1.5%, while unemployment is at 5.3%.
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Deflationary trends continue in prices. August's CPI posted a drop of 0.9% year-on-year and core inflation, the general index without energy and food and therefore more representative of the general trends, dropped 1.5% year-on-year, accumulating 19 consecutive months of falls and leaving it at the same level as March 1992.
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Export growth is affected by the strong yen.
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In the foreign sector, exports have benefitted from China's recovery. In the first third of 2010, this stimulated capital goods investment and industry, whose production index, by July, had recovered 60% of what it had lost during the crisis. However, this recovery in exports and industry has been stuck for the last three months, partly due to the strong yen, which the monetary authorities want to sort out. According to customs data, exports fell by 4.6% in the three months from May to July while industrial production was down 1.3%. In 2010, the foreign sector might contribute 85% of the total growth in GDP. The difficulty in holding onto the growth rates seen at the start of the year and the trends in the last few months warrant caution.
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China
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China: far from a standstill
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China will grow around 10% in 2010.
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The Chinese economy continues to advance firmly, demonstrating its resistance to the crisis. With growth prospects of around 10% and 9% in 2010 and 2011, respectively, the Asian giant is far from any kind of standstill.
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This resistance does not mean that the country's structural weaknesses have disappeared, however. Growth still depends too much on the foreign sector and investment, largely in the export sector itself and infrastructures developed by public bodies. However, the Chinese authorities have already set up numerous measures this year aimed at resolving this investment-foreign sector bias. The following are particularly of note: relaxing exchange rate controls, leading to a slight appreciation in the renminbi compared with the dollar; and limitations on granting credit.
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Main policies during 2010: a more flexible exchange rate and credit limits.
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Although it's still too soon to talk of transforming its economy's growth pattern, slight changes have already been noted in some indicators. Specifically, from January to August investment in fixed assets was up 24.8%, compared with 33% in 2009, revealing a moderation in its growth that we expect to intensify given the slowdown in credit. In the same period, the trade balance surplus increased to 104 billion dollars, 15% below last year's figure. This moderation in the trade balance is due to solid growth in imports.
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Although certain signs of moderation might have started to affect the investment and foreign sector components, it's clear that they will still be an important driving force in the future. The alternative would be a rise in private consumption but this has yet to take on a leading role. In real terms, retail sales grew on average by 15% year-on-year during the first eight months of the year, merely equalling the average of the last five years. Nonetheless, it should be noted that the retail sales indicator does not include all the consumption of services, an increasingly important component in overall consumption.
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Retail sales do not show the expected upswing.
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Lastly, although the inability to boost domestic consumption and private investment is the main risk facing the Asian economy in the medium term, inflationary pressure and the risk of real estate bubbles continue to arouse the greatest misgivings in the short term.
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The Chinese real estate market is showing signs of moderating.
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While base effects and especially food explain the behaviour of the price index, the excessive liquidity during the last year is behind the overheating of the housing sector. However, the limitations to new bank lending and the various measures aimed at cooling off this sector have already started to have an effect: sales have slowed up, as well as the rise in house prices over the last three months, from 12.4% year-on-year in May to 9.3% in August.
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Brasil
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Brazil: a turning point?
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Once again Brazil has exceeded all expectations with a year-on-year growth of 8.7% in the second quarter of 2010 and 1.2% growth compared with the previous quarter. Domestic expenditure again confirmed its role as the engine along with investment, which grew by 26.6% year-on-year and was the main driving force. For its part, consumption dropped off compared with the first quarter but still continued to grow in year-on-year terms (by 6.6%). Public expenditure continued to add, both in year-on-year and quarter-on-quarter terms, as much as foreign demand continued to subtract, fundamentally due to the effect of imports, up 51.5% compared with the same quarter a year ago.
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Brazil continues to offer pleasant surprises with 8.7% growth in the second quarter.
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Given these results, and in spite of the fact that activity will tend to ease off during the second half of the year, we have slightly raised our growth forecast for 2010, from 7.0% to 7.2%. With a view to 2011, we have kept to our scenario of a gradual adjustment in the pace of growth for the Brazilian economy to more sustainable levels, around 5%. Nonetheless, this scenario is not without its risks.
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To begin with, this month's presidential elections will lead to a change in administration and a new president (female, if the polls are right). Although the bulk of the evidence available on this matter suggests that the government's approach will not change and most believe that the main macroeconomic policies will continue, any transfer of power is accompanied by uncertainty and this, in itself, is a risk.
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On the other hand, if the new government delays the withdrawal of fiscal and quasi-fiscal stimuli set up to tackle the crisis, this will complicate the fight being waged by its monetary policy to keep manifest inflationary pressures at bay. Pressures that set off a series of rises in the reference rate (200 basis points for the year so far) that Brazil's central bank interrupted in August, when prices took a break. In any case, the pressures are still latent and the basic causes haven't abated: the labour market continues to adjust itself, credit is still fully expansionary, the confidence of Brazilian consumers in their economy is at a record high and industrial capacity utilization reached 85.4% in August. Because of this, we expect interest rates to start to rise again in 2011.
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The Brazilian economy is starting the second half of 2010 with a more moderate tone but will continue to grow above its potential.
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Another of the occurrences facing the Brazilian economy is the rapid deterioration in the current account balance. Although exports are rising, imports are soaring and the Brazilian authorities are intervening more and more in an attempt to slow up the real's growth. The expected growth differential between Brazil and the more mature economies does not point to a change in trend in the exchange rate in the short term, so that reserves will continue to rise over the coming months.
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In the medium term, the main risk will come from the fiscal flank. The high investment in infrastructures required by the football World Cup in 2014 and the Olympics in 2016 might end up pushing the public accounts into excessive debt. So, although the new government will not be forced, under normal circumstances, to take extraordinary measures to combat inflation or high fiscal imbalances, it will have to continue with the necessary adjustments and avoid excessive leveraging.
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In any case, the current situation places the government's party in a very happy position: growth is spectacular, domestic confidence is at record levels, employment is rising and even inflation took a break in August. Consequently, both Brazil and Dilma Roussef are facing the future with good prospects. All that needs to be done is to keep on course without letting down their guard regarding the risks.
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Mexico
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Mexico: not a very encouraging bicentenary
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The recovery progresses in Mexico, dependent on the United States and on domestic expenditure picking up.
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The recovery in Mexico continues to advance, boosted by the good performance of foreign demand and dependent on the United States' economic progress. Given its notable rate of growth in the first two quarters, we have slightly upgraded our growth forecast for 2010, from 4.2% to 4.6%. The gradual reaction of investment and domestic consumption will help the recovery to continue over the coming months, although we still expect a slowdown in activity in line with the moderation in the growth rate of the global economy and particularly of the United States. With a view to 2011, this slowdown will become a little more marked when the base effects start to play against the figures.
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Although the Mexican economy's growth was higher than expected in the second quarter, domestic demand is still considerably browbeaten. Consumer confidence is recovering but very slowly and both credit and retail sales have yet to take off. Within this context, the uncertainty regarding the global economy's growth prospects merely muddy Mexico's economic waters a little more.
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Inflationary pressures have still not appeared, so we don't expect any changes in the reference rate until 2011.
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The risks to growth have therefore eased, these being a greater than expected slowdown in the US economy or domestic expenditure failing to react, a victim of the prolonged effects of the crisis. In the medium term, additional risks will emerge on the fiscal flank if a reform doesn't succeed that aims to correct the excessive dependency on oil of the country's public coffers.
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In the area of prices, the risks are low at present and neither the restraint shown by domestic demand nor the gradual narrowing of the output gap suggest any great changes in this trend. Consequently, we do not expect any movement in the reference rate until 2011 or a strong peso in the coming months, although the recent inclusion of Mexican debt in the World Government Bond Index may have awoken an additional appetite for local debt, as well as for its currency.
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Commodities
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Commodities: on the up but in no rush
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Oil picks up and comes close to 80 dollars per barrel.
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Oil prices are still steady, albeit rising slightly and fluctuating within a range of 70 to 85 dollars. Between 20 August and 20 September, the price of crude rose 7.3% to reach 79.52 dollars per barrel (Brent quality, for one-month deliveries), a minimum rise of 2.2% this year so far and 12.3% higher than last year.
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The outlook for demand suggests stability in oil prices.
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The latest indicators for the US economy, not as bad as expected, helped oil to offset losses. However, the expected slowdown in growth makes it unlikely that oil will go over 80 dollars per barrel, the highest limit of the 70-80 dollars range considered as convenient by OPEC. In 2011, oil prices should rise only moderately in the wake of world growth.
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Commodities will rise, more because of problems with supply than higher demand.
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The story is somewhat different for the other commodities as, in general, last month's increases have been maintained and they still look like rising, but more because of problems with supply than because of any increase in demand. In the case of metals, China's need to make its production industry more ecological has resulted in a drop in supply, with numerous factories closing down or undergoing reforms. In the case of food, a succession of bad harvests has pushed prices up. Consequently, the Economist index was up 3.7% between 20 August and 20 September, accumulating a 12.3% rise in two months. For its part, gold once again hit record highs this month and will continue to benefit from the uncertainty reigning in bonds and foreign reserves.
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Fiscal adjustment and recovery: reconcilable differences?
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Practically all governments, albeit some more than others, are facing the need to reduce their fiscal deficit in the coming years. Moreover, adjustment has had to be started already in some countries due to the crisis in sovereign debt markets, as is the case of those countries on the periphery of the euro area, at a time when economic recovery has still not been consolidated (see the table below). Within this context, the fear that such adjustments will lead to a relapse in economic activity is uppermost in many people's minds. This fear is reasonable but the relationship between fiscal consolidation and economic growth is full of nuances.
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The most basic Keynesian intuition indicates that, just as fiscal expansion stimulates economic activity, a reduction in the public deficit reduces aggregate demand and therefore hinders growth. The extent of this impact continues to be debated (reducing the fiscal deficit by 1% of GDP might reduce the GDP by more or less than 1 percentage point, depending on whether the fiscal multiplier is more or less than 1) but few question the direction the effect takes (the multiplier is positive). This view is usually valid for small changes in the fiscal balance resulting from a normal countercyclical policy implemented within a situation of low risk premia. In other cases, however, it can be wrong.
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Modern economic theory, even Keynesian-oriented versions, suggests that, under certain circumstances, fiscal adjustment does not necessarily harm economic growth. In particular, adjustments that aim to correct very big deficits might encourage economic activity, provided they are credible, for several reasons. Firstly, because they can generate confidence if they avoid an even greater and certainly sharper adjustment in the future. In questions of confidence and growth, it's always better to confront the reality rather than put off the inevitable. On the other hand, if the deficit correction manages to bring down the country's risk premium, economic activity will benefit from an upswing in those components of demand that are most sensitive to interest rates, such as investment. Lastly, an adjustment that includes moderating public employee wages can help to create jobs once this moderation is passed on to the private sector (experience tells us that public wages are used as a reference for wage negotiations in the private sector).
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Empirical evidence confirms that fiscal adjustment processes tend to result in modest contraction in the short term and suggests that, in some cases, their impact might even be expansionary.(1) In its latest World Economic Outlook, the IMF estimates that fiscal consolidation equalling 1% of GDP reduces GDP growth by 0.5 percentage points on average. This institution also warns that the effect might be more negative if a lot of countries adjust their accounts at the same time, as will happen in 2011. In another recent study, Alesina and Ardagna conclude that a quarter of all episodes of fiscal adjustment in the OECD countries since 1980 have had an expansionary effect on growth in the short term.(2) They also point out that most successful adjustments largely reduced the deficit by cutting current public spending. On the other hand, adjustments that led to a contraction in economic activity tended to rely on higher taxes. Other studies stress the importance of how the fiscal adjustment is carried out. In general, the conclusions suggest that cuts in spending on production infrastructures and tax hikes on work or savings particularly harm growth; however, cuts in wages or transfers and tax hikes on consumption are seen to be less harmful to the economy's performance.
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Fiscal adjustment was also more likely to be expansionary, or less contractive, if it was accompanied by structural reforms. For example, experience tells us that reforms to the health system, pensions or unemployment benefits are not only useful for moderating public spending but can also raise the level of activity as they boost incentives for employment. These reforms are usually politically difficult but, precisely because of this, they bestow credibility on a government that carries them out. And credibility is a sine qua non for a fiscal adjustment policy to be successful and encourage growth.
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Coordination between fiscal and monetary policies is also decisive in the kind of impact fiscal adjustment will have on growth. Low interest rates, encouraged by a lax monetary policy, help fiscal adjustment to succeed and be compatible with economic expansion. On the one hand, because they reduce the government's interest payments, which helps to reduce the deficit and public debt. On the other hand, because low interest rates release resources in the private sector for consumption or investment, thereby promoting growth.
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The adjustment programmes started in the countries on the periphery of Europe (Spain, Ireland, Greece and Portugal) contain several ingredients that help to make adjustment and growth compatible: cuts in spending, structural reforms and a lax monetary policy. However, in spite of this, risk premia have so far refused to fall significantly. This is normal, up to a point: credibility can be lost overnight but it takes time to win it back again. In this respect, the data on budget implementation over the coming months, the budgets for next year and the new structural measures adopted will be crucial to underpinning confidence and promoting growth. Consolidating the recovery won't be easy but nobody's fooling themselves: growth wouldn't be any greater without a fiscal adjustment plan; in fact, we'd be more than likely stuck in recession for longer.
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(1) FMI (2010). «Will it hurt? Macroeconomic effects of fiscal consolidation», in: World Economic Outlook, October 2010, Washington DC.
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(2)??Alesina, A. and S. Ardagna (2009). «Large changes in fiscal policy: taxes versus spending», in: NBER Book Series Tax Policy and the Economy, vol. 24, J. Brown (ed.), The University of Chicago Press, Chicago.
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This box was prepared by Enric Fernández
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International Unit, Research Department, "la Caixa"
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