2011 Outlook: Rebalancing, Reflation and Reconciliation

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This post is a guest contribution by Joachim Fels of Morgan Stanley.

Another year, same themes: Looking into 2011, the five key themes we postulated for the 2010 global economic outlook a year ago should remain very much intact. Our ‘tale of two worlds’ continues to unfold, with robust growth in EM economies trumping the creditless, jobless and joyless ‘BBB recovery’ (bumpy, below-par, brittle) in the mature economies.  Within the latter, US economic growth should again top European growth, especially if the fresh tax deal between President Obama and Republican Congressional leaders gets enacted. Moreover, central banks around the world look set to keep policy super-expansionary, thus continuing to provide ‘AAA liquidity’ (ample, abundant, augmenting).  And finally, but importantly, the sovereign debt concerns in the mature economies, which we highlighted as our fifth major theme a year ago, should remain front and centre in 2011.  We continue to think that the European sovereign debt crisis will eat its way through the periphery and start to affect the core, and we wouldn’t rule out (though it is not our base case) that concerns about debt and deficits will also start to adversely affect the US in 2011.

The three ‘Rs’: Against this backdrop, we think that the global macro debate in 2011 will revolve around three ‘Rs’ – rebalancing, reflation and reconciliation – which encapsulate our key themes above. Further progress from the pre-crisis unbalanced global economy to a more balanced one is a pre-requisite for making this recovery sustainable over the next several years. During the rebalancing process, central banks will likely keep policy very expansionary, which should support the ongoing reflation of the global economy and financial markets. However, debt-laden governments are facing the huge challenge of reconciling conflicting claims by their creditors (private and public bondholders) and stakeholders (pensioners and other recipients of public transfers, users of the public infrastructure, taxpayers and public servants) on their limited resources. Which choices governments will be making between the various options – default, engineer strong growth, fiscal austerity, monetisation and/or force lenders to fund them at low interest rates – will likely be key for economic and market outcomes in 2011 and beyond.

Rebalancing: Our country economists forecast some good progress on the road to rebalancing in the upcoming year. In China, consumer spending will become the biggest contributor to GDP growth, contributing more than half of the 9% GDP growth we forecast for 2011, and the current account surplus should shrink by a full point to 3.6% of GDP.  In the US, conversely, net exports are expected to make a positive contribution to GDP growth, reversing this year’s drag on growth. More broadly, external imbalances are likely to shrink in most countries, largely reflecting the rebalancing from consumption to exports in the countries with current account deficits and vice versa in surplus countries.

This ongoing process of rebalancing from export-led to domestic demand-led growth and vice versa has two important implications. First, it requires a shift of resources (capital and labour) from the external to the domestic goods-producing sectors or vice versa, which takes time and thus weighs on growth in the meantime.  This is especially true in high-income economies where workers’ skills and the capital stock are often sector-specific. Hence, the ongoing rebalancing is contributing to the ‘BBB’ nature of the recovery in mature economies.  Second, as capital is often sector-specific, the sectoral shift in the drivers of growth requires new investment in the expanding sectors and should thus support capex globally, despite the fact that there is still considerable spare capacity in the (relatively) shrinking sectors.

Reflation: The combination of undesirably low inflation in the US, deflation in Japan, the ongoing sovereign debt crisis in Europe and a BBB recovery in virtually all of the mature economies implies that G10 central banks will keep their foot on the monetary accelerator for much or all of 2011.  With official interest rates near zero in major economies and quantitative easing in various disguises continuing at least in the G3, monetary policy looks set to remain super-expansionary and will support the ongoing reflation of the global economy, in our view.  True, we see many EM central banks, including the People’s Bank of China, raising interest rates in the upcoming year. However, in most cases we think the tightening will be moderate in order to prevent a sharp deceleration of economic growth and/or excessive exchange rate appreciation.

Given these constraints on EM monetary policies, the AAA global liquidity cycle should remain intact.  Yet, these constraints also imply that the risks to our relatively benign inflation outlook for EM economies are tilted to the upside.

Reconciliation: While rebalancing and reflation should provide support for the global economy and markets in 2011, the reconciliation of the many claims on debt-laden governments remains a gargantuan task for governments and a major source of downside risk to the outlook. In principle, governments have five options to deal with unsustainable debt trajectories: they can default, engineer strong growth, tighten fiscal policy, monetise and/or force lenders to finance them at low interest rates.  Of these, default or restructuring is likely to be avoided at all costs in 2011, given the severe systemic consequences – but that doesn’t mean markets won’t be nervous about potential defaults in the future, especially in euro area member states that are not true sovereigns any more. Engineering strong growth is virtually impossible for any length of time, given the BBB recovery. And a massive tightening of fiscal policy also looks unlikely in most countries outside of the European periphery, as many governments lack the public support to implement draconian measures à la Greece or Ireland.

This leaves most governments with only two options – monetise (if your central bank agrees) and/or take measures to ensure continued access to cheap funding from other sources. As our colleague Arnaud Marès has argued, the latter is inherent in financial regulation that requires banks, insurance companies and pension funds, explicitly or implicitly, to increase their holdings of government bonds for financial stability purposes. Alternatively, cheap funding could come from the IMF and/or other governments as in the recent cases of Greece or (less cheaply) Ireland.  And the former option – monetisation – is inherent in quantitative easing, which raises longer-term inflation risks if the banks’ excess reserves that are created in the process are not withdrawn in a timely fashion once banks start to use them to lend and create deposits.

Source: Joachim Fels, Morgan Stanley, December 10, 2010.

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