Strategy

Comment: After A Lull, Global Uncertainty Returns To The Fore

Gerard Lyons, Standard Chartered Bank, Chief Economist, 25 April 2012

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The optimism seen in global financial
markets during the first three months of the year is already giving way to
renewed uncertainty about the outlook for the world economy. Here, Dr
Gerard Lyons, chief economist atStandard Chartered Bank, gives his views on the fault lines that are becoming increasingly apparent in the West, while Asia and other parts of the emerging world continue to outperform, albeit at a slower pace.

Last autumn, financial markets feared a
double-dip recession in the US, a hard landing in China's economy and a
collapse in the euro area. None of these happened, as economic data in both the
US and China proved stronger than the markets feared, and as the actions of the
European Central Bank pulled the euro area back from the brink.

I did not share the fears about the US and
China, but it was interesting to observe how market sentiment moved from one
extreme of too much pessimism last autumn to the other of over-optimism. This
helps to explain the rallies seen in the first quarter. Now, market sentiment
is adjusting to somewhere in between.

This makes sense. The world economy
continues to recover after the crisis, but the picture varies greatly. A
fragile West contrasts with a resilient East.

Decoupling continents

Across Asia and many parts of the emerging
world, economies are in much better shape. But even there, the picture varies.
In China, for instance, the economy is cooling after the authorities tightened
policy last year in order to squeeze inflation. Now, the focus in China is both
on political change and on moving the economy to its next stage of development.

In the US, meanwhile, the good news is that
the economy is continuing to grow, but the bad news is that the recovery is not
particularly strong. It is steady, not spectacular. In the US, like the UK, the
biggest firms appear in good shape, with healthy balance sheets, but for now,
they appear reluctant to invest. There is still an overhang of debt, and it
will take time for people and firms to deleverage. In addition, whereas the UK
government has already taken big strides to try and reduce its deficit, in the
US, many of these problems are being left until after the presidential
election.

Although the outcome for the world economy
will be heavily influenced by the US and China, it is developments in the euro
area that continue to drive sentiment. The biggest threat facing the world
economy is a collapse of one or more euro area economy.

That is why markets were so relieved by the
actions of the European Central Bank (ECB). In December, the ECB provided cheap
three-year money to banks that wanted to borrow. The success of that led the
ECB to repeat the exercise in February. Its actions removed the immediate fear
of a funding crisis for banks across continental Europe, and provided valuable
time for the euro area to address its problems.

Changes afoot

Recent months have highlighted three types
of adjustment, none of which is particularly popular. First, if the economies
on the periphery were not in the euro area, they would now be seeing major
currency devaluations. But because they are in the euro, they are having to
endure ‘internal devaluations’ instead, which are squeezing their economies
very hard. The result is recession and rising unemployment.

It is difficult for the markets to know
which of these economies is the most important to focus on. Is it Greece, which
may need further external help as its recession deepens? Is it Ireland, which
has done all that has been asked of it but has slipped back into recession? Or
is it Portugal, which some fear may be the next in trouble after Greece? Or is
it Italy, the biggest peripheral economy, where an unelected government is now
pushing through cuts demanded by Germany (among others)? Or is it Spain, where
the government was elected only last autumn on a mandate of austerity but is
already running into trouble as youth unemployment rises? To these one could
add worries about France, where the presidential election adds to political, as
well as economic uncertainty in Europe.

Yet, it is not just the periphery that is
adjusting. In good economic times, the euro area worked, with money flowing
from the centre to the periphery creating the booms that have since become
busts. Indeed, before the crisis started, both Ireland and Spain had stronger
fiscal positions than Germany. It was only during the bust that their budgets deteriorated.
Now, in the bad times, the money that previously went to the periphery is
attracted back to the core of the euro area. This is adding to inflation in
Germany. The Germans do not like this, but there is little they can immediately
do. After all, if the ECB raises interest rates to curb inflation in Germany,
this will make the economic situation on the periphery worse.

The third area of adjustment is equally
worrying for Germany. Because of imbalances between the economies across
Europe, adjustments also have to take place via the central banks. This is not
a worry if you think the euro will survive. But it starts to become a concern
if there is a risk of any country leaving the system, as there is now.  Germany's central bank, the Bundesbank, has
the biggest exposure to others, currently at around €550 billion and rising. No
wonder there is concern in Frankfurt and Berlin.

Future uncertainty

There are several ways this could play out.
The euro system has to change to survive, and this includes moving faster to a
single political union, where the core provides more help to the periphery.
Taxpayers in Germany and elsewhere fear this. Yet there is little doubt that
Germany is one of the biggest beneficiaries of the euro, as its manufacturing
base does not have to contend with an overvalued currency, as does
Switzerland’s. But in return for ‘More Europe’, countries like Germany will
demand greater say over the policies being implemented in Spain, Portugal and
other countries. They may tolerate this to begin with, but if growth does not
follow, and there is instead austerity and recession, anti-euro sentiment is
likely to rise, as it has in Greece. So the remainder of this year is likely to
see renewed uncertainty over the euro area, as was the case in 2011.

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