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A recovery, but risks remain

2009 appears to have been a remarkable year by most benchmarks. Global financial markets bounced back with clear indications of economic stability and perhaps even those of a hesitant recovery. Trade flows have picked up and the Baltic Dry Index, an indicator of shipping demand, has begun to edge upwards after falling by more than 90% of its peak value. The massive fiscal and monetary stimulus provided by governments, in careful coordination, across the world, paid off and an extended recession that might so easily have crept in was averted. Emerging economies understandably recovered quicker with stock markets leading the upturn. These were sustained by large capital inflows. Chinese and Indian stocks literally doubled in a short period of time making good their earlier losses. Even optimists would agree that things simply could not have turned out better. However, the power of printing money does come with a fall side.

The underlying systemic problems that created failures in the first place, remain. An easy-money policy and abundant liquidity have recreated bubbles in asset prices, specifically in stock markets and in some areas within the real-estate sector. The fiscal situation of most governments has worsened. America which was never really prudent with its finances in the first place – allowing the creation of twin deficits, trade and fiscal – has now slipped into a further muddle. Other nations are on the verge of a sovereign default. Some countries have large fiscal deficits; others have high levels of short term debt, a lot of which is owned by foreigners. With Dubai leading the way, Greece, Ireland, Portugal and Spain are in trouble and what makes matters worse is that they are a part of the Euro-zone. A default by one of them may undermine confidence in the Euro as a currency unit, disrupting world financial markets a second time around. Italy, Japan and the United Kingdom are financially fragile and vulnerable. Global imbalances linger on with Chinese surpluses and US deficits. Many banks are yet unwilling to recognise loan losses and more so in those countries where mark to market regulation is not enforced. The process of de-leveraging in the US and European household sectors has only just begun with a long way to go.

The fiscal deficit in the US economy will exceed 10% of GDP and public debt will touch 100% within two years. Moody's has warned that the administration should not take its AAA rating for granted adding to the problems of financing the deficit. The Federal Reserve plans to unwind the USD 1.5 trillion quantitative easing this year and China has little appetite for US treasury paper as data points to a drastic reduction in its purchases. From 47% of new issuances in 2006, China purchased 20% in 2008 and 5% in 2009. This leaves the US public and other foreigners as the only buyers and interest rates on 10 year bonds are expected to rise from 3.3% to about 5.5% in the period of this year. This will limit capex spending as money becomes expensive. Public sector demand at the state level will also contract. Adding to these risks is the matter of trade disputes between the US and China which may take a sinister turn.

This leads us to suspect that there may be trouble ahead and now the 'W' shape recovery, suspected by some analysts, could actually become a reality, as interest rates harden to fund treasury paper and the fiscal stimulus is unwound to maintain sovereign rating. Somehow we don't see how Asia will escape. The inter-linkages extend beyond trade – which obviously impact China, despite the notions of domestic demand sustaining growth – but equally impact others through the financial markets. India is prone to the flow – in both directions – of risk capital. We have had it good over the past 6 months with large inflows but we suspect this may slow down when US rates become expensive and the dollar carry trade begins to unwind. If this were to happen, the shortage of risk capital will affect domestic industry. The better companies will raise money through local markets adding to pressures on limited resource and consequently, the second tier will face liquidity problems.

The World Economic Outlook released by the IMF, forecasts global growth of 3.1% in 2010 and a relatively strong 4.2% in the following year. This however masks the more important realignments in the world economy because growth in advanced countries will remain subdued. The driving force behind the recovery is expected to be emerging Asia, specifically China and to a lesser extent India. The result will be a dramatic shift in global market shares with advanced nations dropping from 72% in 2007; to 67% in 2011; and 63% in 2014. This rebalancing will inevitably play out, but in the near term it is consequent on the explicit assumption that global stability will remain and the hesitant recovery stay in place.

Some of the downside risks described in this piece may not play out after all. However, if they did the central forecasts for growth put forth by agencies (including IMA’s own Sydney based forecasting team) may need to be revisited. In the next few months economic trends will provide a clearer indication. But for now we can draw comfort from the fact that things did not turn out to be so bad after all.


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