The bottom is Near but a Long, Hard Slog Lies Ahead

Published on 11th August 2009

The outlook depends on the economic fundamentals, the policy response and confidence. In recent months confidence has rebounded from its lows but remains fragile. Fear of a meltdown has been replaced by the reality of an eventual recovery. The rise in financial market sentiment is fully justified, particularly if, as I think, official interest rates have to remain low for some considerable time. The trouble, of course, is that sentiment can swing from too much pessimism to overoptimism. The world economy may soon stop shrinking, but recovery will not return us to the boom years that investors and people became used to. A long, hard slog lies ahead. 

The British economy looks set to hit bottom this autumn, growing modestly next year. However, unemployment will keep rising, probably not peaking until the end of 2010. Thus, for many people, it may not feel like a recovery. Furthermore, it will take some time for the economy to return to the level it was at only last summer. In the recessions of the early 1980s and early 1990s it took almost 3½ years to reach the pre-recession peak. This time it could take longer. The policy response has been bigger and more helpful than in the past, but the economic hit is harder and higher taxes threaten to knock recovery off course. 

The global policy response has been impressive. Last summer, when the United States was unveiling tax cuts, the saying was that policy required the three Ts: timely, targeted and temporary. A better way to think of global policy now is the three Ss: stimulative, synchronised and successful. When people and firms are not spending, governments need to. Yet the UK should learn a lesson from Chile, Singapore and China, which ran budget surpluses in the good times, allowing them to boost spending from a position of strength without unnerving the markets. 

Although this was a financial crisis made in the West, the outcome has been a global recession, driven by balance-sheet restructuring, deleveraging in the financial sector, a severe inventory correction and a collapse in world trade. These downward pressures are starting to wane. In recent weeks I have travelled extensively and the clear message from around the world is that the bottom is close. 

This will be a relief for exporting nations, which were hit hard. A year ago many firms were increasing inventories, fearing rising commodity prices. When the crisis hit, not only did global demand fall, but firms had to cut inventories aggressively. On top of this, there was a deterioration in credit risk and lower availability of trade finance, particularly for small firms. This explained the slump in exports in the fourth quarter of last year and first quarter of this. For instance, 30 per cent of China’s exports and 45 per cent of its imports required letters of credit, which became hard to get. For India, the figures were 20 per cent and 27 per cent, respectively. Likewise, many small firms, even in the UK, lost insurance cover necessary for trade. Now trade seems to be stabilising. 

It is important to keep this in perspective. The improvements in financial markets and in expectations follow big declines. This is highlighted by the performance of equities. The capitalisation of global stock markets has rebounded from a low of $29.8 trillion in March to $37.4 trillion. This is a big jump; however, it still leaves capitalisation way below its peak of $63 trillion in October 2007. Despite recent gains, the loss of wealth has been severe. 

Where is demand going to come from? This is the biggest global challenge. Measured in trillions of dollars, the US economy is 14.3, Japan 4.9, China 4.4, Germany 3.7, UK 2.7, Russia 1.7, Brazil 1.6 and India 1.2. Of these, only China and India are growing this year. The mood I encountered in India recently was very positive. There is a feeling that the election of a new Government with a working majority could usher in a reform agenda. If so, then India has the potential to open up in a way that boosts domestic growth and also helps South Asia, the Middle East and parts of East Africa, just as China’s growth increased intra-Asian trade in recent years. In China, the message was that the huge fiscal boost was having a big impact, but no one was ignoring the need for more private sector spending, particularly when stimulus measures wear off in a couple of years. 

The relentless rise of China continues to impact us all. This year it has been stockpiling commodities aggressively. If this continues, I believe that it will eventually be felt in the UK in squeezed profit margins — not in inflation — as companies absorb higher costs. China also continues to try to call the shots on the dollar, raising doubts about it as a store of value and as a medium of exchange. Yet the dollar was seen by many as a safe haven during the crisis and may even benefit as more countries decide to build their currency reserves in the future. 

With so many issues, perhaps we should heed one lesson from Japan: there can be many false dawns in a recovery. There could be further shocks. Central Europe and Eastern Europe are in trouble. Western Europe is fragile, with banks there accounting for two thirds of the reduction in international bank lending seen since last summer. 

UK policymakers need to ensure credible but not premature exit strategies. The US will be helped by policy measures over the next year but still needs to save more. The Middle East and Asia, given their surpluses and reserves, look best able to cope, but they still need to encourage more spending in the years ahead. There is clearly a need to differentiate as the fundamentals, policy and confidence play their part. 

By Dr Gerard Lyons

Chief Economist at Standard Chartered.

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