Waiting for a US-China explosion

Pimco

This is part two of PIMCO's look at the growth prospects for the global economy. Part one can be found here.

The year ahead will likely be very challenging for the global economy. Growth faces several hurdles that PIMCO believes collectively will impose a sense of greater uncertainty and increased volatility on financial markets. These hurdles include the need for accelerated balance sheet deleveraging, slowly creeping but surely rising risks of financial and economic de-globalisation, and the constant drumbeat of re-regulation, particularly in developed country banking systems.

China has now joined the US, the eurozone, Japan and the UK in some form of balance sheet deleveraging. However, PIMCO expects Chinese deleveraging to be rather benign as long as policymakers use their substantial financial resources to manage the process over time.

China, for the last two years, has engaged in an accelerated program of domestic investment via rapid credit creation in its domestic banking system. This has provided the global economy with a substantial and much-needed boost to aggregate demand at a time when developed economies were all undergoing private sector deleveraging. But this source of global aggregate demand is slowing significantly now.

Due to a combination of issues ranging from excess capacity, rising income inequality and bank capital stresses that will require a slowdown in the rate of credit creation, China is likely to slow future domestic investment in favour of a more balanced and stability-focused growth model. China is likely to use its substantial public financial resources to address imbalances between domestic investment and consumption, between capital and labour shares of national income, and to slowly re-capitalise its banking system as non-performing loans crystallise to losses.

The major implication for the global economy is that the process of Chinese deleveraging and rebalancing could mean much slower Chinese growth and a smaller impact of Chinese aggregate demand on the global economy. PIMCO expects the Chinese economy to grow by just 7 per cent in 2012, significantly below consensus expectations of 8-8.5 per cent real growth.

And what of America? The US economy continues to make steady progress in private sector deleveraging, but little to no progress when public sector balance sheets are included. US households and banks have generally reduced debt either via defaults or orderly recapitalisations, and many companies have benefitted tremendously from a weaker dollar and strong growth in global trade via the emerging market economies.

Despite the progress made to date, the process of US deleveraging is not nearly complete. This is especially the case given that the US government continues to run large structural deficits to support private sector aggregate demand, and that demographically driven unfunded liabilities are starting to crystallise onto public balance sheets at a faster rate.

Were it not for the brewing crisis in the eurozone, and the expected slowdown in aggregate demand in China (and other emerging economies), the outlook for the US economy might have been relatively sanguine for the year ahead. In 2011, US GDP grew by a modest but decent 1.5-1.75 per cent. But with global headwinds gathering – and US expansionary fiscal policy becoming much more difficult to maintain – we think the US economy will only manage 0-1 per cent growth in 2012. This is substantially below the industry consensus expectation of 2-2.5 per cent growth.

Turning from deleveraging to de-globalisation, we believe the most important component of this creeping process is occurring in global finance. Global imbalances between savings and investment have long been sustained via cross-border intermediation across an integrated global banking system. European banks have played the major role in this process, with American and Asian banks being perhaps a degree less important. We have discussed the potential impact of European bank deleveraging on the eurozone economy, but have not spent much time on how they might impact the global economy in a direct way (An ECB leap too late?, December 23).

The eurozone banking system is 2.5 times as large as the US banking system, in part because it plays an important role in intermediating global savings. At $41 trillion in total balance sheet assets, the impact of a eurozone banking system deleveraging would dwarf the effect of any successful re-leveraging of the U.S. banking system, which is only about $16 trillion in size. The race to higher capital ratios combined with sovereign stresses means that the global banking system will likely turn inward and the process of cross-border savings intermediation could slow substantially in the year ahead. This is yet another hurdle for global growth.

A second component of de-globalisation is the glacial but observable increase in trade skirmishes between the US and China. There have been a series of tit-for-tat tariff increases lately, and the US political machine has begun to increase calls for a more transparent and open Chinese economy only to be summarily rebuffed by Chinese officials. This glacial trend is an important one to watch, as trade between the US and China has been a very important source of strength for large portions of the global economy.

Finally, the cyclical outlook would not be complete without a mention of MF Global and the implications on financial re-regulation. We have long suggested that the developed world financial system has begun a gradual process of returning to 'utility banking,' a boring destination where the financial system largely separates deposit taking and loan making from the riskier endeavours of leveraged finance and asset price speculation. MF Global is likely to spark an acceleration in this process, only because it has shown that the regulatory changes planned (and yet to be fully implemented) after the collapse of Lehman Brothers in 2008 have done little to protect investors from concentrated financial system risks.

We expect to see changes in the regulatory architecture of capital markets that may reduce system-wide liquidity, increase financial transaction costs and de-risk balance sheets even further. Think of this as an incremental source of friction to global growth in the year ahead.

In sum, we expect the global economy to grow by 1 per cent to 1.5 per cent in 2012. This is significantly slower than the 2.5 per cent growth rate achieved in 2011 and the 4.1 per cent rate achieved in 2010. The risks to this forecast lay to the downside, which speaks to the question of inflation expectations. We expect global inflation to slow to 2 per cent in 2012 from 3.1 per cent in 2011.

© Pacific Investment Management Company LLC. Reprinted with permission. All rights reserved.