The year 2012 was difficult for the global economy in general, and India in particular. The US economy remained the ‘best of the West’, with real GDP growth running at close to 2% and mounting evidence that its housing market is finally emerging from its worst downturn since the Great Depression. But the unemployment rate stayed stubbornly high at around 8% as uncertainty over the politicians’ ability to put its public finances on a sustainable course and navigate the so-called ‘fiscal cliff’ curbed animal spirits and crimped business spending.
The US also suffered from weak export demand, especially from the troubled euro area, which remained mired in recession. At least the worst fears of a collapse of the euro that were so prevalent a year ago were averted with the European Central Bank (ECB) twice stepping in to save the day. Under the new leadership of Mario Draghi, the ECB first bailed out the European banking system with huge injections of liquidity early in 2013. ‘Super Mario’ then effectively backstopped the bond markets of Spain and Italy with his promise to buy their debt if necessary. So far, Mr Draghi’s ‘Jedi mind-trick’ has worked perfectly. The promise of buying debt if necessary has calmed financial markets to the point that the ECB’s firepower has so far not been required. Greece has needed two huge bailouts over the last year but remains in the eurozone and the fears for a Grexit have similarly retreated for the time being.
Perhaps the biggest surprise was the weakness of the BRICs, which began to buckle under the strain of carrying the world economy since the collapse of Lehman Brothers. China saw its economic growth slow to sub-8%, the slowest since the Asian crisis as it continues to suffer indigestion from its credit splurge of 2009 to 2011. India too saw its growth slide to a near decade-low of around 5.5%. Brazil fared even worse with GDP growth tumbling to less than 1%! Completing the dismal picture, Japan, the perennial underperformer, slipped back into recession with a combination of weak global and trade tensions with China denting its export performance.
2012’s disappointing macro-outcomes however have likely sowed the seeds for better performance in 2013. Policymakers globally appear to be responding to disappointing macro-economic out-turns with increased urgency as central banks in the developed world open the monetary spigot ever wider. The US Federal Reserve is in the vanguard of this process. Under Chairman Bernanke’s increasingly radical stewardship, the Fed has not only launched a third round of asset purchases—QE3—but also expanded the scale of money printing at its December policy meeting to $85 billion per month for the foreseeable future. From a little less than $3 trillion, the Fed’s balance sheet should expand close to $1 trillion over the next year, flooding the world with liquidity. This should not only cap the downside risks facing the US economy but the global economy in general. Global stock markets and other risk markets should advance steadily as the tide of US dollar liquidity rises.
At its recent December policy meeting, the US Federal Reserve not only increased the scale of QE3 but it also took the revolutionary step of linking its zero interest rate policy to labour market conditions, signalling it is unlikely to start raising interest rates until the unemployment rate has fallen to 6.5%. With most estimates of the US’s sustainable rate at around 6%, the Federal Reserve is attempting to convince the private sector of its commitment to create an economic boom. Assuming politicians are able to cobble together some kind of deal that ensures the economy does not plunge over the ‘fiscal cliff’, the Fed’s radicalism should be rewarded by quickening economic growth with housing and the shale gas boom key drivers. This time next year expect the US to be growing at a brisker 3% pace.
Other central banks look set to follow the US Federal Reserve into increasingly uncharted waters in an all-out push for faster economic growth. 2013 could be the most revolutionary year in central banking for some time. As already discussed, the ECB has already crossed the intellectual Rubicon. Expect its bond-buying programme to be launched next year with a request from Spain, the most likely recipient. While less acute, the European crisis will inevitably rumble on with the parliamentary elections in Italy early next year and then in Germany in the autumn, the most obvious political flash points. Buoyant global liquidity and improving demand outside Europe however should ensure that the euro area moves out of recession by the second half of next year. Assuming Chancellor Merkel is successfully re-elected next autumn, the pace of euro area fiscal and political integration—key to the long-run resolution of the crisis—should quicken towards the end of the year.
Elsewhere, the recent landslide victory of the LDP in Japan on a platform of aggressive economic stimulus is already triggering radical change at the Bank of Japan. The new PM Shinzo Abe has already requested that the central bank replaces its current 1% inflation target with a new, more expansionary 2% target. This could be adopted as soon as the Bank of Japan’s next policy meeting in early January. And with current Governor Shirakawa stepping down in March, his (as yet unknown) replacement is likely to further accelerate the central bank’s money printing, deepening concerns about its independence.
The Bank of England will also see a change of leadership with the Canadian Mark Carney replacing Mervyn King as Governor of the ‘Old Lady’ in June. Mr Carney has already signalled his radical intentions by floating the idea of a nominal GDP target whereby the central bank targets the growth rate for overall economic growth including both output and prices. The People’s Bank of China is also set for a change of leadership and its new Governor is similarly expected to pursue growth-orientated policies.
All told, the central banks of the world’s developed economies are becoming more desperate in their attempts to out-run the wreckage of the global financial crisis using the printing press. Should we be worried about inflation? Yes, but given the degree of spare capacity in the world economy and the long lags always involved with monetary policy, inflation is probably more a story for 2014 or even further out. Ditto the global bond market crash that accelerating inflation will inevitably trigger. In the here and now, currency markets will be driven by this unfolding battle of the central bank’s balance sheets. The US dollar should be soft in the first half of the year reflecting the Federal Reserve’s faster money printing but other central banks are likely to fight back later in the year.
The rising liquidity should to some extent lift all boats next year with emerging markets big beneficiaries. Hot money inflows will generate appreciation pressures on many currencies which are likely to be resisted via a mix of temporary capital controls and central bank intervention. India’s sizeable current account deficit of around $75 billion should be easily financed for the time being given abundant global liquidity. If the government’s reform push continues with measures such as the Land Acquisition Bill, GST, further cuts to subsidies and more FDI liberalisation pushed through Parliament, the Indian rupee, which has been volatile over the last year against the US dollar, could even appreciate despite its challenging external financing requirements.
RBI, which looks set to trim policy rates early next year given fading inflation pressures, has also indicated it will reward greater fiscal discipline with rate cuts. Tighter fiscal policy and looser monetary policy could then reinvigorate corporate animal spirits and push economic growth back up towards 8% that India should be able to achieve with the right policy mix. If the looming general election of 2014 however induces populism rather than prudence in New Delhi, macro-outcomes next year may continue to disappoint with GDP growth only picking up a little from current rates of around 5.5%. The money printing policies of the West should provide Indian policymakers with undeserved time and space next year to repair macro-fundamentals and recast the policy mix. Let’s hope that it is used!
The author is BNP Paribas Chief Asia Economist