Moody's "Global Outlook 2009: A Bleak Year" Print E-mail

Korea Newswire - 2 January 2009

The coming year will be a bleak one for the world economy. Recessions in recent years have tended to be brief and mild. This time, the unparalleled magnitude and systemic cast of the financial crisis increases the likelihood of a longer, more severe and broader downturn, not just in the U.S., but in other major developed countries. Compared with previous downturns, this one is more tightly synchronized because of the global spread and depth of the financial shock. As a result, recession's tentacles are now gripping Japan and most major European economies, including Germany, the U.K., France, Italy, Spain and Ireland.

Recognizing the threat to the world economy and financial markets, policymakers in the major economic powers have taken extraordinary measures that will eventually cost trillions of dollars to try to contain the crisis. These measures include taking an internationally coordinated, system-wide approach, providing liquidity and lending guarantees, recapitalizing banks, and nationalizing institutions whose insolvency threatened the integrity of the global financial system. The International Monetary Fund and other multilateral institutions have cooperated to put together multibillion dollar lending packages to help countries hit by sudden reversals in capital flows. Monetary easing is now more aggressive, and country after country has announced increasingly ambitious fiscal stimulus measures.

Financial shock, systemic risks

Deeper and more extensive and complex financial linkages worldwide in recent decades have speeded the integration of the world economy. The rapid diffusion of new financial products helped to cement interdependence among markets around the world. For example, institutions in Europe and elsewhere piled up billions in risky U.S. subprime debt, then thought they were immunizing themselves by also buying financial contracts such as credit derivatives to insure against debt default. In actuality, these transactions simply increased counterparty risk to an extreme level. That, along with weak regulation and excessive use of leverage by important financial market players, greatly increased the fragility of the financial system by unleashing forces that turbocharged credit booms and busts.

Sea changes in investor sentiment also contributed to this dangerous brew. As uncertainty grew, sentiment became more manic, giving rise to exaggerated and destabilizing market swings. Thus, sovereign credit default swap spreads became much more volatile, amplifying the more modest changes in macrofinancial data that measure sovereign creditworthiness. These and related factors caused lending standards to tighten excessively and contributed to the credit bust. In contrast, during the preceding credit boom, investor appetite for risk was excessive to the point of imprudence. This was seen in the muted response of the CDS spreads to fundamental changes in creditworthiness and in lending rates that suggested a very low price for risk. As a result, too much foreign capital poured into countries whose risks were downplayed, increasing their debt burden and vulnerability to sudden stops in capital flows.

The events following the bursting of the asset price bubble that peaked in 2007 show how problems in the financial industry got transmitted to the real economy. Rising defaults in the U.S. mortgage market, plunging asset prices made worse by forced deleveraging, and subsequent huge losses in the financial industry made banks increasingly wary of lending to one another. Indeed, growing uncertainty about counterparty risk gave rise to an unprecedented global credit freeze that squeezed private sector spending and aggregate demand, setting in motion a self-feeding downward spiral. At the same time, strong and intricate linkages between countries and regions through both trade and finance ensured that their economic downturns would be closely synchronized.

Consider the consequences of the sharp drop in house and equity prices, which slashed household net worth. The large negative wealth effect depressed consumption spending. At the same time, rising debt defaults weakened the balance sheets of major financial institutions, forcing them to tighten lending standards. This dampened consumer credit flows, further squeezing private sector spending. With lower demand came declining output, rising unemployment, and rising bankruptcies and foreclosures.

U.S. recession deepens

The recession in the U.S. has spread to nearly every industry, occupation, demographic group and region, with the latest indicators pointing to an estimated 4.5% decline in real GDP during the final quarter of 2008. Job losses continue to mount. Employment in November fell by 533,000, the largest one-month drop since December 1974, hurting both service- and goods-producing industries and boosting the unemployment rate to 6.7%. The most recent report on jobless benefit claims suggest that the decline in December nonfarm payrolls may exceed November's decline, for a cumulative loss of 1.9 million jobs since the beginning of 2008.

Falling asset prices from the third quarter of 2007 to the third quarter of 2008 slashed U.S. household net worth by over $7 trillion. That, combined with weak income growth and rising unemployment, will keep consumption spending sluggish in 2009. At the same time, recent data on new orders for manufactured durable goods indicate that capital spending is still weak and likely to contract further. With private consumption and investment spending in an absolute swoon, massive public sector spending is the last hope to stimulate demand.

Major European economies in recession

The British economy shrank by an annualized rate of 2.4% during the third quarter of 2008, the biggest quarterly contraction in 18 years, amid rapidly deterioriating labor market conditions. The unemployment rate has been climbing steeply, from 5.2% in May to 6% in October, while industrial output fell 1.8% m/m. In recent months, industrial output in Germany, France and Spain also has been falling much more rapidly than European monetary authorities expected. Indeed, policymakers' slow and overly cautious response to rapidly deteriorating conditions will delay Europe's economic recovery, and a protracted downturn is expected.

East Asia hit hard

The much-weakened world economy is worsening the recession in Japan more rapidly than expected. As a result of falling external demand, especially the steep plunge in auto demand worldwide, the November seasonally adjusted index of industrial production fell by 8.1% from the prior month for a 16.2% y/y drop. Based on survey findings, a further monthly drop of 8% is officially projected for December. Japanese motor vehicle and automotive equipment production has taken the biggest hit.

The other East Asian countries also have been badly hurt by falling external demand. Moreover, the reduction in trade flows is compounded by the credit crunch, which disrupted trade finance in China and other Asian countries. Credit to private exporters dried up, banks refused to honor letters of credit, and shipments were held up. China, South Korea, Taiwan, Hong Kong and Singapore have suffered sharply decelerating or contracting export growth, falling industrial output, and widespread layoffs. In China alone, an estimated 670,000 firms shut down in 2008, putting over 10 million people out of work.

Reverberations from slump in Chinese trade

China is the world's second-largest exporter after the EU, and slowing exports from China are hurting shipping companies and ports. The Baltic Dry Index, a measure of shipping costs of commodities, is down 93% from its peak in May, suggesting that export volumes will stay depressed. Given the high import content of China's exports, the sharp contraction in China's exports in November goes hand-in-hand with an 18% year-on-year drop in imports. Both export and import growth on a three-month moving average basis has been trending downward since mid-2008. The sharp decline in imports of machinery and materials points to falling exports in the future.

For many countries, China is now a major trading partner, and its declining import demand is being felt acutely across the region as well as around the globe. Exporters of commodities as well as capital goods are being hurt by China's demand slump. Korea, Japan, Australia and all of Southeast Asia are reeling from the impact of falling Chinese demand for their exports. As noted, most of these economies are already contracting or face much slower growth.

Commodity exporters face a double whammy: Demand from China is falling, and commodity prices have tumbled. Countries with diversified exports, such as many in the Americas, will ride out this storm with relatively little damage. Others, highly dependent on a few commodities?like most of Sub-Saharan Africa and oil producers in the Middle East?face a grimmer outlook.

Capital goods account for one-half of Chinese imports from the U.S. and euro zone, so China's demand swoon is hurting capital good exporters in the U.S. and Europe. The aerospace industry will feel the pain because the Chinese government is encouraging airlines?many are losing money?to cancel orders or postpone plane deliveries.

Latin America is less vulnerable

Thus far, the economies of Latin America have shown extraordinary resilience in the face of the financial shock. Latin American markets have suffered from contagion effects, but the region's financial institutions have remained strong for two reasons: They have low exposure to risky assets, and they benefit from higher standards of regulation by governments well-schooled by the financial crises of the 1980s and 1990s. The region is estimated to have grown by 4.6% in 2008, but the slump in global demand will cause it to slow to around 2.8% in 2009. Countries more exposed to international trade and external financing will be hurt more, while those that rely more on domestic markets and have the fiscal room to manuever will perform better.


Next year will be a bleak one, marked by rising unemployment and stressed financial markets. Global real GDP is estimated to grow on a market-value basis by about 2% in 2008 and may slow to 0.2% in 2009 because of sharply decelerating trade flows, plummeting private fixed investment spending, and near-dormant consumption spending. The weak state of the world economy gives rise to numerous downside risks, among them escalating protectionism and greater social unrest as the global slowdown consumes millions of jobs.

Given the huge drop in private demand, strong and coordinated policy action is urgently needed to prevent the world economy from sliding into a deep and protracted recession. With absolutely no risk that private investment will be crowded out, there is no better time for massive public spending on programs with high social returns that can increase the world economy's growth potential. Strong fiscal stimulus programs and accomodative monetary policies should help the global economy gain traction in the second half of 2009, though a self-sustaining expansion is not expected to take hold until well into 2010.
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