Growth or stagnation? A world tour

Photo Eric Chaney / Chief Economist AXA Group & Head of Research AXA IM / November 14th, 2014

Is the global crisis behind us? The divergent development of major emerging countries, Europe and the United States reminds us that despite a strong tendency for unification during the past two decades, despite our growing interdependence, the world economy is still highly fragmented. Under the circumstance, it doesn't make sense to draw a general picture without taking a closer look at these differences: between emerging and advanced countries, between the United States and Europe, and even within Europe itself.

ParisTech Review – The impression spreads throughout the world, especially in Europe, that economic growth could remain sluggish for many years, a sort of “remake” of the Japanese stagnation of the 1990s. Is this a likely scenario or will growth take off again in 2015?

Eric Chaney – It is quite difficult to identify the factors that could cause an acceleration of global growth in 2015. Growth could vary depending on the country, but the global trend is around 3.25% if we consider GDP computed on the basis of  purchasing power parities. That’s very little, compared to the 4.4% average between 1993 and 2008. If Europe is waiting to be driven out of its stagnation by global growth, it is a serious delusion. Growth will meet the expectations only in the United States and China.

The Eurozone is exposed to the greatest risk of stagnation.

If we only consider advanced economies, the differences are growing not only between Europe and others, but also within Europe. Countries that are doing well are small, open economies such as Switzerland or Sweden. Both have by far exceeded their GDP level of 2008.

The UK appears to follow the same path, after collapsing dramatically in 2009. This is evidence that being open to world trade is rewarding and not only when times are good. It also shows that it is wise to make fiscal adjustments quickly, even when economists recommend the opposite. Fiscal adjustment can be made during a crisis. Afterwards, the political pressure drops and it is too late. The British strategy worked even better because the pound depreciated following the massive increase in the monetary base of the Bank of England as a result of its quantitative easing policy.

As for the Eurozone, there is every reason to be worried. With a near-zero nominal growth, interest rates are dragged down as markets begin to anticipate that this situation can last a long time. This is the beginning of “japanification,” which is very worrying. We often speak of Japan’s lost decade but the real GDP per capita continued to grow – albeit much slower than before – and the country never experienced such a serious situation that it would threaten its institutions: the Japanese political and social systems have proved resilient. However, if we transfer the Japanese scenario into the Eurozone, some countries will see their debt explode: Italy, Spain and possibly France. This would eventually create political tensions between countries and cause serious consequences which could lead – even though it is unlikely – to a breakup of the Eurozone or of the EU, with chilling effects on trade.

Is France, second largest economy in the Eurozone, as fragile as Italy or Spain?

France is a special, almost paradoxical, case. Its debt continues to be considered very safe because its economy, while in objectively poor condition, is gauged on the basis of criteria which are not purely economic. To start with the edges, the French debt is very well managed – probably the best managed debt in all Europe – in terms of liquidity and predictability of emissions. France imported the American system of primary dealers (specialists in government securities) and even improved the system. French debt management is very popular among institutional investors because the average maturity of the debt is very stable, the issuance program is known and respected, and the series of securities are very liquid.

The investors’ indulgence also relies on a political analysis: they observed that Germany is strongly opposed to the idea of ​a major political crisis in Europe. The importance of political stability in Europe was the argument put forth in 1995 by two prominent members of the German CDU, Karl Lamers and Wolfgang Schäuble (Mr. Schäuble is the current German Finance Minister) to take a position in favor of a single currency. But the basis of this stability is Germany’s relationship with France. Without France, there is no euro and probably no European Union. So for the investors, Germany provides France with an implicit guarantee. And with such a guarantee, it is only logical that French term bonds are so much coveted by the Japanese and Chinese central banks.

But in reality, the French economic fundamentals are bad. Since 1980, there had never been such a significant divergence between the French and German government debts compared with their respective GDP. And the gap has been widening since 2010. I am convinced that if the gap becomes too big, a political problem would be posed to Germany concerning the viability, even the necessity, of the Franco-German couple. The day institutional investors come to the conclusion that Germany no longer backs this couple, the French debt could be sold massively, all the more so that it is extremely liquid! Moreover, to get an idea of the raw reality, one only needs to watch the stock markets. The divergence between France and Germany is stunning. Since 2009, the two countries no longer belong to the same world. German companies are profitable, French companies are not.

The European Parliament adopted in April 2014 a banking union, which establishes a European system to supervise all banks in the Eurozone and deal with possible bankruptcies. Can this measure contribute to the recovery of the Eurozone?

The banking union is the most important change brought by the crisis of 2008-2009. If there hasn’t been a recovery in the Eurozone, it is partly because the liquidity provided by the ECB to the banks doesn’t reach economies such as Italy, Spain or Portugal. Those  countries have undergone a real credit crunch. Banks suffer because of the poor quality of their assets: when companies go bankrupt, bank assets are weakened. Giving to the ECB the responsibility of monitoring the Eurozone was a crucial decision because the ECB could do what Sweden achieved in 1990: separate “bad banks,” those whose assets are losses for the others. Thanks to this banking union, we will be able to restructure our banking systems. This is crucial to allow for a resumption of credit.

But with the banking union, the ECB goes one step further. It wants to revive the securitization of bank loans: if banks lend in good condition, they can sell their loans to the ECB. The ECB, in turn, is ready its balance sheet by around 1,000 billion euros, a considerable amount. The securitization of corporate loans is relatively limited, but that of real estate loans, for instance in the Netherlands, is quite important. With its repurchase program of ABS (Asset Backed Securities) and of covered bonds, the ECB created a weapon with several shots.

First, it helps unfreeze bank lending by offering a way out to banks, through securitization. Second, the ECB increases its balance sheet, which is the very definition of quantitative easing. Foreign exchange markets quickly got the point and the weakening of the euro against the US dollar is supporting the theory according to which the country whose money supply is growing fastest is also the one whose currency depreciates most. The UK, the US and Japan have already used this balance-sheet policy. The Eurozone hadn’t done so as massively and irreversibly but is willing to, now.


Is the credit union enough to protect banks?

For securitization to show its full potential, capital charges applied to the safest ABS need to be reduced, i.e. constraints on investors (Basel 3 for banks, Solvency 2 for insurers) need to be relaxed. The EU is in talks about this with the Basel Committee, which also includes non-Europeans. Europe’s word will certainly be heard because prolonged stagnation in Europe is a risk to the world, a risk that Americans take very seriously.

Obstacles could come from populist reactions denouncing finance as the mother of all evils and identifying securitization to toxicity. But finance, when well-designed and well-controlled, is simply a very effective tool to improve market liquidity. In a distant future, it is possible that the financing of European economies will be achieved mainly by capital markets, just as in the United States. But for the moment, in Europe, banks are the ones doing the job and it is therefore crucial to make things easier for them.

Are the United States still a safe bet for global growth?

In the United States, the aberration of the first quarter of 2014 (-2.1% of GDP at annualized rates) was corrected by the second quarter (+4.6%) and, in my opinion, it will eventually be offset by the revisions of national accounts. Growth is back at a rate of approximately 3%. That being said, we’re talking of a country whose recovery is much lower than if the 2008-2009 crisis had been a normal recession. Generally, US recovery rates are around 4% to 6% per annum.

So far, the recovery has been driven by corporate investments. Since they are profitable and demand is strong, US companies see good reasons to invest, especially because, as everywhere in the world, the 2009 recession has dug a huge investment gap. Consumption is not as strong but will grow faster than income because the increase in household wealth allows a drop in the savings rate. As for exports, they are no better than world trade, which grows slowly.

Looking at the real estate market, there has been a real upturn in investment but, during late 2014, it has slowed, which could be testimony of  persistent weaknesses in household balance sheets. Macroeconomic vision, i.e. the aggregate picture, is not enough. US households have indeed reduced their debt largely thanks to the Fed that allowed them to renegotiate their loans, but the lowest incomes are still fragile. In general, income distribution is altered by the impact of the IT revolution, artificial intelligence in particular, in favor of the highly skilled or unskilled workforce, but at the expense of the median workforce i.e. people who have a short university education. High-impact technologies are no longer ICTs as before but algorithms related to Big Data and machine learning. An increasing number of trades are being automated, at the expense of the middle class.

The economic event of the decade is the slowdown in Chinese growth. Will the landing be soft or brutal?

China pulled the global economy out of the crisis into which it had sunk in 2009 thanks to a fiscal stimulus of unparalleled magnitude. This stimulus, worth nearly $600 billion, will be studied for a long time. China, whose growth model was based on exports, suffered from a decline in world trade of about one third in a few months. In a way, it was like an experience of sudden death. The IMF called on all countries to support the recovery, but developed countries responded to the call cautiously – Italy did nothing at all for example.

China did much more than what it was asked. A by-product, of course, was a sharp increase in domestic debt, that will need to be cleared. The other consequence of the crisis is that Chinese leaders understood that their growth pattern was too vulnerable to global randomness and could even threaten their power. Hence the efforts to move to a more balanced growth model.

China is in the frontline of two fights. It must clear the debts accumulated by the shadow banking system through real estate speculation. Indeed, local authorities cannot be funded by taxes – that’s slowly changing – and therefore they use land speculation by selling lands (for a limited time). Therefore, they need prices to rise. It is interesting to note that in the US, in China or in Europe, the relationship between the central government and local authorities is always problematic. But in the case of China, Beijing has been struggling for 5,000 years to assert its authority. So there is a link between institutional reforms – the financing of local authorities – and the reform of the financial system, so as to make it capable to withstand market fluctuations.

At the same time, China is willing to change its growth model to refocus it on domestic demand. To revive the economy in 2009, the Chinese government granted strong tax incentives for car purchases, which resulted in doubling the size of the market in a year, raising it above the US market. But the most surprising fact is that when these incentives ended, the market didn’t collapse: there has been a plateau and then it increased again. This change of model is happening before our eyes.

It is difficult to imagine that this real Chinese economic revolution will unfold seamlessly.

Every bad piece of news from China creates a stir in the markets. There have been accidents and there will be more.Some savings products will go bankrupt, probably some banks too. Not major banks, controlled by the government and proteced by the central bank, of course. But the trend is positive. The emerging model is based on consumption and services rather than on exports and manufacturing. This will inevitably lead to a slower growth. In the old model, China imported the knowledge of foreign countries and racked up incredible productivity gains because it was starting from the scratch. In services, there will be less productivity gains. This choice of slowing down is perfectly accepted, although Chinese leaders know that if growth slows too much, unemployment will increase, and without unemployment insurance, this might create political risks. The implicit tolerance threshold is around 7% today, but growth will tend to gradually slow down in the years to come down to 5% within ten years. For the rest of the world, what matters is the evolution of the Chinese trade balance. While it was in a very large surplus before 2009, it has declined significantly since then, which means that China began to export growth to the rest of the world rather than the opposite. So even if China’s growth slows down, its growth will benefit more to its partners.

India, which according to some forecasters will be in the Top 3 of world GDP in 2050, is a huge paradox that makes us really wonder where its economy is heading.

India has a quite considerable growth but faces major structural obstacles. It is a very fragmented economy, plagued with trade barriers between states. We see India as one sole entity where in reality it is a decentralized aggregation of different economies, some of which are highly protected. What the Indian government decides is one thing, what Kerala does is another! Overall, India is much less open to the world that China and its integration into the world trade is still low. The evolution of its economy has an impact on the life of the Indians themselves, not much on the rest of the world. Doing business in India, where bureaucratic hurdles are even higher than in China, is difficult. The infrastructure is also an obstacle to development: a power line can sometimes not even cross the border between two states. India’s situation reminds of the United States, where federated states are very powerful in terms of regulation; or that of Japan, where the frequency of the electrical network is not the same in the south and the north. Note, however, that the new government is decided to implement in-depth structural reforms to free up the huge potential of the Indian economy.

Will other emerging countries become drivers of global demand?

Emerging countries have experienced difficult times because of capital flight following the statements of the President of the US Federal Reserve, Ben Bernanke, who announced in May 2013 the end of the quantitative policy. The anticipation of reduced liquidity made the capital that had benefited from the liquidity injected by the Fed leave the country. The situation is likely to recur because the Fed will eventually raise interest rates before the end of 2015. Emerging markets are therefore subject to US financial cycles.

But if their fundamentals are strong, they can limit this dependence. Turkey and Brazil have provided two outstanding examples during the last twenty years: less budget deficit, lower inflation, a monetary policy relatively independent from political constraints, and open capital markets. These economies have become more resilient and are able to withstand large outflows of capital. In the long term, the growth of emerging countries does not depend on Western liquidity, it is generated by reducing their productivity gap. This is what makes it sustainable, even if it cannot last indefinitely.

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