Market Comment: Sovereign bubbles bring new threat to growth

A year ago the main aim was to counter threats of economic collapse and depression.

Today, the worst is probably behind us. But sustained recovery is not guaranteed, with a double-dip recession a serious danger and new sovereign debt bubbles heightening the risk of more instability.

While most economies recorded big GDP falls in 2009, there will be a return to positive growth sometime in 2010. But the recovery can easily be derailed after a brief initial bounceback. Even if we avert the threat of a double-dip, the world economy faces major obstacles that could limit expansion.

Huge cutbacks of stocks, which accentuated the deep recession, are now easing. This, together with huge injections of monetary and fiscal stimulus, will boost global activity in the next few quarters. But these factors are temporary. Sustained recovery requires steady growth in consumer spending, investment and world trade. Unfortunately, a strong medium-term recovery seems unlikely to be achieved.

Employment
High unemployment and pressure to cut excessive personal debt will dampen consumer spending. Banks are weak and risk-averse, while inadequate access to bank lending will limit capital investment. Most seriously, the need to slash budget deficits will dampen growth as most governments will be forced to raise taxes and cut public spending.

As house prices recover in many countries, helping to alleviate one area of toxic lending, new sovereign debt tremors show that excesses can unleash dangerous bubbles in the most unexpected corners. The debt moratorium announced by state-owned Dubai World in December was the most dramatic development. But the downgrading of Greece’s sovereign rating is, in fact, more serious.

The markets are unsettled by uncertainties over the timing of “exit strategies”. Official interest rates cannot stay at their current low levels indefinitely. Huge quantitative easing programmes will have to be scaled back. But if central banks withdraw the stimulus too abruptly, both equities and bond markets would suffer and the fragile recovery would falter.

JANUARY 2009
Desperate measures are a licence to print money
The pace of economic decline has intensified and policymakers are rapidly running out of ammunition. With UK interest rates falling towards zero, there is talk of ‘quantitative easing’, a polite way of describing printing money. In normal times, we associate this practice with countries such as Zimbabwe. But fears of slump and deflation are forcing extraordinary measures.

Rates
The European Central Bank has cut its policy rate to 2.50%. Though the cut was the biggest in the euro’s 10-year history, it still disappointed the markets as being inadequate in the face of mounting recession threats. Further eurozone rate cuts are expected early in 2009, at least to 2.0% and possibly to 1.5%.

The UK has intensified its policy easing; it is now the most aggressive European rate-cutter, with Bank rate down to 2% in December 2008, the lowest for 50 years. In spite of sterling’s sharp fall, and the risks it signals, the UK will probably cut rates to 1% early next year.

Borrowing
By pledging to buy up to $600bn mortgage-backed assets and offering to lend $200bn to support other loans (cars, credit cards), the Fed has expanded hugely its balance sheet and is already engaged in quantitative easing. Congress has also agreed bailouts to the ailing car industry. President-elect Obama’s newly appointed national economy team is set to introduce a massive fiscal package immediately after the 20 January 2009 inauguration.

Few doubt the US’s determination to avoid a slump, but the risks to US creditworthiness are real.

Chinese developments have been ominous and the leadership is very worried. As well as slashing interest rates, China has started to reverse the yuan’s appreciation. If China, with its massive trade surplus, devalues on a big scale, risks of a destructive trade war with the US would escalate.

DECEMBER 2007
Central banks act, but the signs are inauspicious
Third-quarter 2007 growth was better than expected in the US, Japan, the eurozone and the UK. Early fourth quarter figures show US growth in jobs, exports and retail sales. The economy is still relatively strong in areas other than housing. With inflation rising, there is a case for waiting before easing policy. But the banking system is not functioning properly.

Money market rates have risen to seven-year highs as investors and lenders become more risk averse. In response, the Fed, ECB and Bank of England all announced measures to pump liquidity and facilitate the supply of central bank funds.

Rates
The markets are unimpressed. The US Fed cut its policy rate to 4.25% on 11 December. The markets wanted a bigger cut and an additional cut to 4% is now expected early in 2008. But US consumer prices recorded in November their largest rise since 2005. The Fed will have to be cautious. Moving below 4% could be too risky. The Bank of England has cut Bank Rate to 5.50% and at least two additional UK cuts, to 5%, are now widely predicted for 2008. But if sterling weakens sharply, as many analysts fear, UK inflation could accelerate.

In contrast, the European Central Bank left its policy rate unchanged in December, at 4%. With eurozone inflation surging to 3.1% in November, the ECB is still adopting a hard line. But growth is set to weaken. The ECB will have to cut rates to at least 3.75%, to counter the threat of excessive euro strength.

Laurence Summers, former US Treasury secretary, summarised the pessimism dominating the 2007 festive season: “The odds now favour a US recession that slows growth significantly on a global basis.” Acute US housing sector weakness is a major concern.

But the pervasive gloom is mainly driven by growing fears that the credit crunch may unleash a vicious circle of liquidity shortages, falling asset values, damaged bank capital, reduced credit supply and a major economic downturn. The deep pessimism is exaggerated, given the recent global strength. But the dangers are very real.

David Kern of Kern Consulting is chief economist at the British Chambers of Commerce. He was formerly NatWest Group chief economist