Global recovery will continue despite euro crisis

FROM THE ECONOMIST INTELLIGENCE UNIT

Despite the crisis unfolding in the euro zone, the world economy continues to recover. Recent indicators for the US and some emerging markets (particularly in Asia) have been strong, and the Economist Intelligence Unit sees no clear evidence that the turmoil in Europe has undermined this otherwise improving picture. We think world GDP in purchasing power parity (PPP) terms will grow by 4.1% in 2010, up from 3.9% in last month’s forecast. We have also substantially revised our currency forecasts, and now expect a much weaker euro.

It is impossible, nonetheless, to ignore the fiscal crisis in the euro zone. The situation carries major risks for financial stability and even the future of the single currency. But our projections still indicate that the crisis will have little worse than a neutral impact on GDP growth. In essence, while austerity measures in some countries will depress domestic demand, a weaker euro will boost exports. With emerging markets still powering ahead and the US economy also getting back on its feet, the recovery in the rest of the world should be largely unaffected.

There remain other major challenges to the sustainability of the global recovery, however. For some time, we have held the view that temporary factors such as fiscal stimulus and inventory adjustments have been driving growth, and that the global economy is too weak to expand at the same speed once these forces wear off. This view is reflected in our forecast for next year, when we think global GDP growth in PPP terms will slow to 3.5%. Yet the “upside risks” to global growth are also increasing. Private-sector balance sheets in a number of major economies have improved, as companies have returned to profit and as households have reduced debt. This will allow private-sector demand to generate a degree of self-sustaining momentum in the coming months, though we remain sceptical that this will be sufficient to offset the fading of fiscal stimulus and inventory effects.

Developed world

We have raised our forecast for US growth, and expect the world’s largest economy to grow by 3.3% in 2010 and by 1.8% next year. Yet our forecast for 2011, in particular, remains much more pessimistic than consensus. We still think that fundamentals will hold back the economy once short-term effects recede. There is also a high risk that a stronger US dollar resulting from the problems in the euro area could undermine export prospects.

The sustainability of Japan’s recovery remains uncertain. On the plus side, the improvement in the global economy, particularly rapid growth in China, will boost Japan’s exports in 2010 despite the strength of the yen. But the negatives, including sluggish domestic demand, deflation and political indecision, will weigh heavily. Real GDP will grow by just 1.7% this year.

In Europe, in contrast, the economic situation has not lacked for drama—though sadly for the wrong reasons. The euro area is in the worst crisis since its inception, as investor fears of sovereign default in Greece have become contagious. The EU and IMF have launched a massive joint stabilisation programme. This has lowered financing costs, but underlying concerns about governments’ solvency remain unresolved. We think that Greece will eventually restructure its debt, probably in 2012.

The need for other countries in the euro zone to accelerate budgetary repairs as a precautionary measure, to prevent bond markets from losing faith, will further undermine demand. The only consolation is that the weakening of the euro will benefit export-oriented economies such as Germany and the Netherlands. For the euro zone as a whole, this will come close to offsetting the negative impact of fiscal retrenchment. As a consequence, our euro area GDP forecast remains little changed, with projected growth of 0.7% this year and 0.8% in 2011. However, this export-driven growth will be uneven, with some of the fiscally weakest countries benefiting the least. They will pay the price for years of focusing on domestic markets, at the expense of cultivating strong export bases.

Emerging markets

With some exceptions, emerging markets have weathered the global financial and economic crisis of the past two years much better than rich countries. Indeed, financial conditions are now too expansionary in a number of countries, and policymakers are turning their thoughts to the containment of inflationary pressures. Policy has already started to tighten, and we expect interest-rate hikes and other tightening measures in many more countries in the rest of 2010.

Asia, unsurprisingly, is at the forefront of the emerging-market upturn. China’s economy, which grew by a heady 11.9% in the first quarter of this year, is grabbing the attention, but indicators for other markets such as Singapore, Taiwan and South Korea have also been very strong. We think Asia and Australasia as a whole, excluding Japan, will post GDP growth of 7.2% in 2010. On the negative side, concerns about asset bubbles are rising.

Eastern Europe has fared less well, having been hit hard by the global recession, but the outlook is improving. Exports and industrial output are recovering in most countries. However, recent financial-market volatility underlines the threat of contagion from the crisis in the euro area.

Latin America, with exceptions like Venezuela, is in increasingly good shape. The policy improvements of recent years have made the region more resistant to economic and financial shocks. Chinese demand for commodities has been beneficial. We have raised our forecast for Brazil, the region’s largest economy, and now expect real GDP growth of 6.3% in 2010. This has pushed up our forecast for Latin America as a whole, which will grow by 4.2% this year.

Growth in the Middle East and Africa will also pick up robustly in 2010, thanks to higher oil prices, a stronger global economy and, in many cases, loose domestic policy. However, within this region North Africa will grow relatively modestly because of its dependence on exports to, and remittances from, the weak EU economy. Sub-Saharan Africa is benefiting from Chinese demand for commodities and will enjoy GDP growth of 4.5% in 2010.

Exchange rates

The European fiscal crisis has led the euro to fall sharply against most major currencies, and our new forecast assumes a much weaker euro over the next few years. The €750bn (US$930bn) European rescue package, announced on May 10th, briefly boosted the euro, but the single currency has subsequently continued its slide. On May 14th it was trading at less than US$1.25:€1, compared with US$1.33:€1 at the end of April.

Concerns over government solvency also pose risks to the dollar, yen and sterling, given the fiscal problems facing the US, Japan and the UK. However, on balance the fact that the situation is most acute in the euro area is likely to boost these currencies relative to the euro. The crisis in Europe also means that the European Central Bank is likely to delay raising interest rates for longer, making other currencies relatively more attractive to investors.

The US dollar, in particular, will remain the main safe-haven currency. We expect it to trade at an average of US$1.30:€1 in 2010, strengthening further to US$1.22:€1 in 2011.

Commodities

We expect oil to cost an average of US$80 a barrel in 2010, up from US$62 last year. Global demand for oil will start to recover in 2010, following two consecutive years of falling consumption. However, the impact of economic stimulus packages will fade in 2011, leading to a renewed downturn in OECD demand. This suggests that prices will ease to an average of US$78.5 a barrel in 2011.

Average prices of industrial raw materials will be much higher this year than in 2009. Base-metal prices, which have been supported by Chinese buying, will also benefit from a recovery in OECD consumption in 2010. However, Chinese demand growth will ease later this year. As a result, we believe that much of the good news has already been factored into base-metal prices and that, at best, they will sustain their earlier gains this year.

World economy: Forecast summary
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Real GDP growth (%)
World (PPP exchange rates) a 4.4 5.0 5.1 2.8 -0.8 4.1 3.5 3.9 4.1 4.1
World (market exchange rates) 3.6 4.0 3.9 1.7 -2.2 3.1 2.5 2.8 3.0 3.0
US 3.1 2.7 2.1 0.4 -2.4 3.3 1.8 2.0 2.2 2.3
Japan 1.9 2.0 2.3 -1.2 -5.2 1.7 1.1 1.2 1.0 0.9
Euro area 3.7 3.0 2.6 0.5 -4.1 0.7 0.8 1.4 1.7 1.9
China 10.4 11.7 13.0 9.6 8.7 9.9 8.1 8.0 8.3 8.0
Eastern Europe 5.6 7.3 7.3 4.6 -5.6 3.2 3.7 4.2 4.2 4.3
Asia & Australasia (excl Japan) 7.3 7.9 8.9 5.6 4.6 7.2 6.3 6.5 6.6 6.5
Latin America 4.9 5.5 5.6 4.0 -2.3 4.2 3.4 4.2 4.0 4.2
Middle East & North Africa 6.1 5.9 5.6 6.1 1.9 4.3 4.4 4.6 4.6 4.8
Sub-Saharan Africa 6.8 6.7 7.0 4.8 0.5 4.5 4.6 5.4 5.0 5.0
World trade growth (%) 7.5 9.1 7.6 3.7 -11.2 6.8 5.3 6.3 6.4 6.3
World inflation (%; av) 3.0 3.3 3.4 4.9 1.6 2.9 2.7 3.0 3.2 3.3
Commodity prices
Oil (US$/barrel; Brent) 54.4 65.4 72.7 97.7 61.9 80.2 78.5 82.3 78.3 75.5
Industrial raw materials (US$; % change) 10.2 49.6 11.2 -5.1 -25.6 35.6 2.7 4.4 0.9 -0.9
Exchange rates (annual av)
¥:US$ 110 116 118 103 94 93 93 93 92 92
US$:€ 1.25 1.26 1.37 1.47 1.39 1.30 1.22 1.18 1.18 1.21
a PPP = purchasing power parity
Source: Economist Intelligence Unit.