gems belwether report: turbulence revisited: 2012 global economic outlook jan12

In this Report:- US Recovery- Euro Zone Crisis- Emerging Markets in Asia- Conclusions

Turbulence Revisited: 2012 Global Economic Outlook By Dr Yuwa Hedrick-Wong

Bellwether ReportJanuary 2012

GEMSSMTHE GLOBAL EMERGING MARKETS SERVICE

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GEMS | Bellwether Report | January 2012

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In the GEMS January 2011 inaugural report, we described the global economy as being in a state

of turbulence created by cross currents, which included an anemic recovery in the US, the deepening crisis in the Euro Zone and emerg-ing markets struggling to shift gear from exports to domestic demand to sustain their high paced growth. At the risk of sounding like a broken record, GEMS’s outlook of the global economy for 2012 again features turbulence as the main theme. However, the primary cross currents creating the turbulence in 2012 have changed since those of 2011. In this report, GEMS argues that:

(i) the US recovery is actually showing signs of growing strength, and more importantly, could be in the early stage of a new phase of economic rejuvenation under-pinned by robust productivity gains and business innovations;

(ii) the Euro Zone crisis, in contrast, is not only deepening but is facing the rapidly rising risk of a banking sector crisis and fragmentation;

(iii) although the emerging markets will not escape unscathed

from the fallouts from the Euro Zone, they are actually better anchored against the global storm, with China again playing a key role in Asia. Turbulence, however, fundamentally implies that power-ful chaotic dynamics are at work. There will inevitably be unforeseen and unintended consequences, as well as unanticipated shocks. As we will describe below, a number of developments could easily trigger a disorderly fragmentation of the Euro Zone, throwing the entire global economy into a period of heightened uncertainty, putting growth in the rest of the world at risk. The possibility of such an out-come simply cannot be discounted.

US Recovery There is no question that the US faces big problems: tril-lions of dollars in national debts, stubbornly high unemployment, and to make things worse, 2012 is an election year, which means more policy uncertainty. The US is not, however, unique in having such problems today. Every major economy in the world faces serious and complex challenges. The US stands out from the rest because it is better in terms of taking advantage

of opportunities and in adapting to challenges. There is something in the DNA of the American society that allows it to cope better with change. There has been a great deal of commentary on the USA’s persistently high unemployment rate. Relative to a similar stage in a normal recovery cycle, un-employment today appears to be at least 3% - 4% higher than we saw in previous recoveries. This is considered to be one of the weakest links in the US economy. High unemployment, however, masks a productivity boom which is cur-rently underway in the US. Real GDP per employed person has been rising steadily throughout the entire business cycle, suggesting that the non-financial corporate sector has been growing through productivity gains. As Chart 1 (left hand side) shows, real GDP per employee is estimated at US$95,360 in September 2011, about 5.6% higher than the pre-crisis 2007 average. The US non-financial corporate sector has simply found ways and means to produce more with fewer workers. And it is no surprise that they are sitting on a pile of cash estimated at around US$2 trillion. US exports



have correspondingly boomed, as seen in the right hand side of Chart 2, in spite of periods of surging exchange rate. These are not cycli-cal phenomena, but are reflective of changing structural conditions in the US economy in response to the 2008/09 global crisis. Productivity boom and rising exports are a potent mix that will facilitate accelerated business innovations and the re-industrialisation of the US economy in high value-added

manufacturing in the coming years. While high unemployment is undeniably the weakest link in the US economy today, the unique American DNA in its society is allowing them to cope in ways that

few other societies can. For ex-ample, in the New York Times/CBS News poll of jobless Americans in October, 2011, more than half of the respondents said they were either very confident or somewhat confident that they would find long term employment next year. Even more astonishing is that nearly two-thirds said that when they did find long term employment, it would be at salaries similar to or higher than the level they had received

in the past. US sceptics would no doubt write this off as Americans’ unique capacity for self delusion. Self delusion or not, this resilient optimism is what will make all the difference in coping with severe

stress in times like today. When people are collectively optimistic and forward-looking, the society as whole is better positioned to recover from setbacks and shocks. And that is why American households have been rebuilding their savings for tomorrow. Total household debt as a percentage of annual disposable income has dropped from 135% in 2007 to 115% in 3Q 2011.1 In fact, in the aftermath of the 2008/09 crisis, US

households have out-performed themselves versus previous reces-sions in debt reduction, as Table 1 shows.

________________________________

1 Federal Reserve estimates.



In a period of eight quarters from the beginning of recession, US households have reduced their total debt by 3% in the current recession, whereas they increased their debts by 24% in the 1982 recession, 10%

in the 1992 recession and 25% in the 2001 recession. This is in spite of the extraordinarily high unem-ployment today.

The housing sector, which was the epicentre of the 2008/09 crisis, has been the single most serious drag weighing down the economy over the past three years. Contraction in residential

investment and construction has subtracted an average of 1% of GDP growth per year since 2007. In 3Q 2011, its impact became

neutral and it is likely to be posi-tive in 4Q 2011. In other words, housing has started to show signs of bottoming. As Chart 2 shows, the US housing market in 3Q 2011 is estimated to be 22% under value

relative to household income and 8% under value relative to rent. New home permits started to show a more convincing growth trend in



3Q, 2011, reaching 653,000, the highest since 2007. Consumer spending will revive in 2012 in spite of high unemployment. However, growth in consumer spending will be moderate, unlike the halcyon pre-crisis days when American households treated their home like an ATM machine. GEMS believes that a generational change in consumer behaviour is underway

in the US. An entire generation of American households which lived through the 2008/09 crisis will now be much more frugal than before, and they will watch their pennies when they spend. But spend they will. This is because, apart from

their home value stabilising, their debt servicing burden has also been dropping, as seen in Chart 3. As a percentage of disposable income, debt payment dropped from 13.8% in 2007 to 12.5% in 2010, then to an estimated 11% for 2011. While US households will save more in the future, but within their means, they will also spend more as debts are being paid down. There has been a great deal

of talk of the “decline of America”, and in this narrative the 2008/09 crisis is seen as the tipping point. There is no question that America’s number one position is increasingly being challenged by China and the size of the Chinese economy could

well surpass the US economy by as early as the end of this decade. Nevertheless, GEMS sees the US’s global leadership position remains paramount in the foreseeable future. Asia is actually a geopolitical tinderbox and the rise of China is making things worse, not better. In one of the great ironies of history, Vietnam is seeking support from the US in its confrontation with China in the South China Sea. The

presence of the US in Asia today is far more welcome than any time in the past half century, as a much needed counter balance to the rise of China. From a longer term perspective, the US remains the



magnet of global talents, endow-ing its economy with unmatched capacity for self-renewal. The current productivity boom is just part of the ongoing process of the US economy adapting to new challenges and reinventing itself. The primary task of every society is to manage, survive and master change. The US is simply better at doing this than any other country. Change is in the DNA of the American society -- it is who Americans are and what Americans do. It is this ability to adapt and adjust that will see the US remain-ing the global fountainhead of innovations and creativity. The biggest risk in 2012, the election year, is a return to iso-lationism in the US. Isolationism is America’s biggest threat to the world, not imperialism. With weak economic growth and high unem-ployment, an anti-immigration, xenophobic streak is emerging in US politics and the risk in 2012 is that elements of this isolationism may come to the forth. Having been the world’s leader in globalisa-tion, the greatest calamity for the US, and for the rest of the world, would be if the US leads the world into de-globalisation in 2012.

Euro Zone Crisis Three key ingredients for a deep recession in 2012 are all in place in the Euro Zone. The first is austerity. Austerity means fiscal contraction. For most of Euro Zone countries, government spending accounts for over 50% of GDP (compared with 23% in the US). So when government spending contracts, the impact on aggregate demand is severe. And austerity is now no longer limited to the original crisis countries of Greece, Spain, Ireland and Portugal. Today, Italy and France are also under pressure to cut government spending. The second recessionary ingredient is a severe credit crunch due to deepening troubles in Europe’s banking sector in Europe (more on this below). Banks have scaled back their lending, and when they do lend, they charge much higher lending rates. As a result, businesses and consumers are adversely impacted across continental Europe, not just in the Euro Zone. Rising uncertainty is the third recessionary ingredient as the Euro Zone crisis goes from bad to worse, as governments in the Euro Zone demonstrably failed again and again to ring-fence the

crisis in order to stop the contagion. Business sentiment and consumer confidence have accordingly taken a nose dive, which has in turn deterred investment and spending. These three ingredients for recession will converge in the Euro Zone in 2012 to create havoc. The situation is not helped by a change in the focus of how the market now views the Euro Zone crisis. Previously the market was primarily concerned with the level of sovereign debts in the crisis countries. Today the market is focusing on the deeper structural difficulties within in the Euro Zone. Take Italy for example. In November 2011 the borrowing costs to the Italian government soared from 3.5% to 6.5% for debts maturing in six months, and from 4.6% to 7.8% for debts maturing in two years. Why the sudden change? Italy’s government debt, at 118% of GDP, is certainly high, but it has been so for a long time. It did not suddenly increase (it has a debt to GDP ratio of over 100% since 1991), thereby prompting the market’s sudden change in its perception of lending risk to Italy. Instead, the change came when the market started to focus on Italy’s



economy, which is seen as structur-ally weak and uncompetitive (wages rose too fast relative to productivity after joining the Euro Zone), and under the straitjacket of the single currency, the option of depreciating its currency to regain its interna-tional competitiveness simply does not exist. Italy’s real GDP growth averaged an anemic 0.75% a year in the past 15 years, which is lower than the rate of interest it pays on its debts. Panic set in when the penny dropped; under the single currency Italy is locked onto a path leading to defaults. It is a similar situation for Spain. When Spain joined the euro, interest rates fell to the level in Germany. Government debts in Spain are actually rather modest by European standard, but the private

sector in Spain feasted on the cheap loans that came with being a mem-ber of the Euro Zone. A massive

housing bubble grew on the back of cheap mortgages, with house prices rising by 44% in the four year period to 2008 when the bubble burst. Over the decade of 1999 to 2008, average wage rose by 36% in Spain with virtually no growth in productivity, rendering the Spanish economy highly uncompetitive (over the same time period German wages rose by only 3%, but with much higher productivity gains). But strong economic growth in Spain is needed to enable Spanish borrowers to repay their debts. Again, when the market started to focus on Spain’s weak economy, panic set in. In spite of Italy now being the line of defense in containing the contagion, Greece remains the most dangerous salient in the Euro Zone.

The reality today is that Greece is simply not sustainable without continual injections of subsidised

capital. The Greek financial system as it currently stands will crash merely from the weight of its sovereign debt. As Table 2 shows, the Greek government has consis-tently failed to meet the govern-ment budget deficit reduction targets set by the Troika (European Commission, the European Central Bank, and the IMF). The Troika’s target for the Greek government deficit for 2010 was 8% of GDP (-8.0%), but by the end of that year the actual deficit was 10.2% of GDP (-10.2%). Similarly the estimate for this year is that the Greek government deficit will come in at 8.3% of GDP, short of the Troika’s target of 7.6%. Based on the Greek government’s own projection (considered optimistic), government deficit will end 2012

at 6.5% of GDP, which will still be slightly short of the Troika’s target of 6.2% of GDP.



This is in spite of the fact that the Greek economy has been shrinking continuously for four years. If the forecast of a 2.5% GDP contraction is realised in 2012 (considered to be conserva-tive), then the Greek economy would have shrunk by a disastrous 14% between the 2008 to 2012 period. Unemployment rate will also breach the 20% mark by end of

2012. The Greek government has accepted the austerity programme mandated by the Troika as a condi-tion for providing the cash bailouts, and has actually implemented some of the austerity measures such as an across-the-board salary cut of

government employees of 20% and the introduction of a “solidarity tax” of 2-5% in 2010. The govern-ment has also agreed to cut another 120,000 public sector jobs by 2014, and senior government officials will lose another 15-20% of their salary. But the fact remains that the Greek government has not done enough to shrink the deficit to meet the Troika’s targets, but has done more

than enough to shrink its GDP. The shift in focus from debt to the economy in the Euro Zone in 2011 has set the stage for a po-tentially catastrophic banking sector crisis in 2012. Just as the penny dropped for the market when it

started to focus on the structurally weak economies in the Euro Zone, the penny also dropped for the banks when they started to focus on the asset side of their balance sheets. As the Euro Zone economies become increasingly feeble, the asset quality of Euro Zone’s bank-ing sector rapidly deteriorates as well. As shown in Chart 4, in the nine month period from January

to September 2011, European commercial banks’ deposits with the ECB increased by as astonishing 289%. Over the very same period, inter-banking lending literally froze, leading to dramatically higher inter-bank lending rates. In other



words, banks now realise how bad their own asset quality is, and they assume (reasonably) that it is the same or worse for other banks. The prudent thing to do for a bank, therefore, is not to lend to another bank. They much prefer to deposit their extra cash with the ECB instead. Adding to the woes of European banks is their very high exposure to Eastern Europe. As seen in the right hand side of Chart 4, Austrian banks’ total exposure to Hungary alone is estimated at US$41 billion in 2Q 2011. As many Eastern European countries are facing mounting difficulties in refinancing their debts, European banks’ exposure to these countries means further deterioration in their asset quality. Thus there is a danger-ous dynamics at work. The more Europe’s banks are in difficulty, the more they are unwilling to lend to each other, thereby making their situation worse. What makes sense for individual bank is collectively pushing the entire banking sector deeper into a crisis. In 2012, the Euro Zone crisis could quickly spin out of control, leading to its disorderly fragmentation. There are three main “triggers” that could ignite

an implosion. The first is an unexpected failure of a government bond auction. All eyes today are focusing on Italy, where it will have to refinance some US$40 billion of debts by the end of January 2012. The fact that this is a “big” one could very well mean that it would succeed because the Italian govern-ment , the ECB, the IMF, and the EC will be well prepared. The real risk, as usually the case, is with the small debt auctions (and there will be many), where a failure may trigger a stampede of panic.The second trigger is a failure of a small bank that was not on anyone’s radar up to that point. But its failure then shows up dramatically the cracks within the bigger banks, which then leads to doubts about the viability of the entire bank-ing sector in Europe. Again, it is the unexpected that is going to cause the worst panic. Everyone today knows how weak the Greek, Portuguese and Spanish banks are, and many analysts have factored into their forecasts some form of nationalisation of some of the banks there at some time. But the sudden failure of a German or Dutch bank, however small, could create such a shock that a wholesale collapse of

confidence in the banking sector could follow. The third trigger is some kind of political backlash against the ever-deepening bites of auster-ity, leading a change of political leadership in one of the crisis countries, with the radical fringe taking centre stage, which then proceeds to abrogate all debt obliga-tions unilaterally. This may sound far-fetched today. But we need to look no further than the youth unemployment rates in the crisis countries to see the dangerous po-tential of such a political backlash. In Spain, for instance, the overall unemployment rate is 22%. As high as it is, youth unemployment (defined as those under 24 who are unemployed but are actively seeking work) is estimated at a shocking 40%. 2 A similar picture is seen in Greece, Portugal, and increasingly in Italy as well. When close to half of a country’s young people are unemployed, political risks rise accordingly.

_________________

2 Eurostat



2012 will be fraught with risks in the Euro Zone. There is still a chance that strong German lead-ership may come to the rescue. But there will be challenging obstacles to overcome, both within and outside of Germany, before such a German leadership can materialise. Before then, the Euro Zone’s way forward in 2012 will be a perilous one across a minefield where many things could go wrong.

Emerging Markets in Asia What is the potential impact of the Euro Zone on the emerging markets, especially those in Asia? Chart 5 shows the weight

of the Euro Zone as a market for Asian exports as well as estimates of how much Asian exports could decrease from a 1% contraction of Euro Zone GDP. Four key markets in Asia are used as a representative sample: one developed market, Singapore, and three emerging markets, Indonesia, China and India. Singapore, being a small city-state with a highly open economy, is the most exposed. It is estimated that in 2010 exports to the Euro Zone accounted for 11% of Singapore’s GDP. For emerging markets in Asia, the exposure is smaller (though still significant); and it is 2% of Indonesia’s GDP, 3.5% of China’s GDP, and 2% of

India’s GDP. From the perspective of potential impacts, however, India is the most vulnerable. A 1% contraction of the Euro Zone GDP could induce a 15.6% decline in India’s exports to the Euro Zone. For Singapore, exports to the Euro Zone could decline by 4.9% from a similar 1% contraction of Euro Zone GDP, for Indonesia it is 5.3% and for China 6.1%. But the Euro Zone average hides important variation within the Euro Zone. For Asian exports, the key market is actually Germany. In 2007, German imports from Asia accounted for about 28% of total Euro Zone imports from Asia. In 2010, Germany’s share of



Euro Zone imports from Asia has risen to over 30%. 3 Thus, as long as Germany can avoid an outright recession in 2012, Asia’s exports to the Euro Zone may also be able to avoid a serious collapse.

For emerging markets in general, their credit conditions have actually improved over the period of 3Q 2010 and 3Q 2011; a period when inter-bank lending froze in Europe and when crisis contagion ensnared Italy. As Chart 6 shows, cross-border lending to emerging markets rose between 3Q 2010 and 3Q 2011. The year-on-year growth is the highest in Asia at 33%, followed by Latin America at 28%, Turkey at 18% and Middle

East and Africa at 16%. One of the key reasons for the sudden collapse of exports in the emerging markets during the 2008/09 crisis was the drying up of trade financing, apart from a drop in demand. It

is unlikely to see a repeat of this in 2012. Domestically, the banking sector in most emerging markets is also better positioned. In Asia, for instance, loan to deposit ratio (adjusted for reserve and statutory liquidity requirements) is estimated at 92% (excluding Japan). In China it is 82%. So the banks in Asia could lend a lot more with their current capital base. 4 This is in sharp contrast with banks in

the Euro Zone, where the loan to deposit ratio is estimated at 145%.5 In other words, European banks on average today cannot lend one additional euro without raising new capital, whereas banks in Asia still

have a lot of dry powder should they need to lend more. Fundamentally for emerg-ing markets the challenge in 2012 will be the extent to which they can mobilise domestic demand (invest-ment and consumption) to sustain high-paced growth, even as their exports are affected by a slowdown in the developed markets (and

___________________________

3 Eurostat

4 The exceptions in Asia/Pacific are: Australia with a loan to

deposit ratio of 120%, Korea 108% amd India 107%.

5 Eurostat



especially those in the Euro Zone). The proportion of total economic output that results from domestic activities is technically defined as “real effective domestic demand”. The higher the real effective domes-tic demand, the less dependent the economy is on external demand. Estimating real effective domestic demand is, however, a tricky busi-

ness -- the readily available trade data do not provide an accurate picture. In a region like Asia, trade data are especially skewed by high levels of trade in components for assembly manufacturing. The only

accurate way to estimate the real effective domestic demand of an economy is to conduct an input-output analysis to estimate the total value-add accrued domestically, which is a complicated and labori-ous undertaking. Fortunately just such an exercise was conducted by researchers in the ECB in 2009 on Asia. Chart 7 shows the top

line results. India is the least dependent on external demand as its real effective domestic demand is estimated at 80% of GDP. Surprisingly, China’s real effective domestic demand is also relatively

high, estimated at 69%. For rest of Asia, it is estimated at around 60% of GDP. With its real effective domestic demand close to 70% of GDP 6, it is relatively easy for China to expand domestic economic activities to maintain real GDP growth in the range of 7-8% in 2012. To the extent that

China is successful in so doing, the rest of Asia will benefit accord-ingly. This is because China has

________________________________

6 The 69% of GDP estimate is made for 2009. Updating the

analysis suggests that it is close to 72% today.



become either the number one or number two market for most of the region’s exporters. 7 As Chart 8 shows, China’s contribution to growth in exports from rest of Asia out-weighs those from the US and EU in 2010. For example, growth in demand from China contributed 29% of total growth in exports in

Korea, versus 12% from the US and 17% from the EU. For Thailand, the contrast is equally stark. China accounted for 13% of Thai export growth, against 7% from the US and 6% from the EU. What could China do in 2012 in the event of a serious de-cline in demand in the Euro Zone?

China responded to the 2008/09 crisis by increasing bank lending massively, mostly to investment entities set up by local governments and to state-owned enterprises, in 2009. The banks are in no position today to repeat a similar feat. The government has actually been tightening money supply in order

to bring down inflation, and part of the tightening has been a series of increases in the reserve requirement ratio of the banks. And banks are also bracing themselves for a sub-stantial increase in non-performing loans as it is expected that a lot of the lending made in 2009 will turn into bad loans in the next few years.

It appears that China does have a “Plan B” in the event that the global economy takes a turn for the worse in 2012. As illustrated in Chart 9, the central government is able and willing to increase fiscal spending, focusing on infrastructure investment which can support growth in employment and income

immediately, while improving economic efficiency over the longer term. The central government’s debt burden is relatively low; its net liability in 2010 is estimated at only 22.3% of GDP. More importantly,

_________________________________________

7 Even though India’s real effective domestic demands is

estimated at 80% of GDP, India is not a significant market for

exports from the rest of Asia.



its tax revenue has been increasing by an average of 33% a year in the past five years. So the central government is certainly in a strong position to spend more in 2012 if necessary.

The right hand side of Chart 9 shows why local govern-ments are in no position to spend more, however. Not only are their net liability higher at 26.8% of GDP, more significantly around 80% of their bank borrowing in the last few years has been securitised

by cash flows generated from their investment projects. While this helps banks to lower the risk of loans turning bad, it also reduces local governments’ fiscal power. Thus, in 2012, it will be entirely up

to the central government in China to sustain strong economic growth.

Conclusions The three cross currents of the US, Euro Zone and emerging markets will determine what the global economy will look like in

2012. While interconnected, they are also moving in different direc-tions, driven by divergent factors. Under these conditions, we will see that high volatility in equities and commodities is a certainty and a

catastrophic implosion in the Euro Zone a distinct possibility. Yet emerging markets are likely to be able to stay resilient while economic resurgence in the US cannot be entirely ruled out in spite of the heightened political risk in its election year.



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REAL GDP GROWTH IN ASIA

ABOUT US

The Global Emerging Markets Service of The Insight Bureau

GEMS is an exclusive subscription service for clients of The Insight Bureau provided in partnership with Dr Yuwa Hedrick-Wong. It is designed to provide senior inter-national executives and boards with timely, actionable business intelligence about the world’s most dynamic growth markets. Consistent with The Insight Bureau’s mission to help senior executives make better business decisions, GEMS has been launched to explain the crucial linkages between the world’s developed economies and the developing world, to identify the main drivers of growth, to highlight signif-icant changes, to assess the threats and opportunities facing international businesses, to provide a reality-check about popularly-held assumptions and to alert executives about the likely implications of recent events or developments.

The Insight Bureau provides speaker placements and briefings as a service that helps achieve a better understanding of the world in which we do business and to ultimately help senior executives to make better business decisions. The Insight Bureau represents Dr Yuwa Hedrick-Wong for speeches and briefings. www.insightbureau.com

Dr Yuwa Hedrick-WongYuwa Hedrick-Wong is a global economist and business strategist, based in Singapore. He is the HSBC Distinguished Visiting Professor of International Business at the University of British Columbia in Canada, as well as being the global economic advisor to MasterCard, ICICI and Southern Capital Group. Along with other leading economists, journalists and business commentators, Dr Hedrick-Wong belongs to The Insight Bureau’s resource network, providing speeches and presentations at business conferences and also delivering confidential, in-house briefings to senior executives and boards. www.insightbureau.com/YuwaHedrickWong.html


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