But there are some important differences too. This time, the US and euro area economies are facing downside risks to growth just as normalising monetary policy is slowing EM economies down too. A year ago, EM monetary policy was still stimulative and domestic demand growth was encouraged as output gaps were still negative. The risks to global growth today are thus broader now than they were last year. At the same time, the thresholds for central banks to ease appear to be higher this year too. Rising core inflation in the US, elevated inflation in the euro area and a recent battle with inflation in the EM world all make it difficult for central banks to abruptly reverse the direction of policy. A look at the challenges facing DM and EM central banks has the Fed, the ECB and the RBA facing the biggest downside risks to growth in the DM world while the ECB (again), the BoE and the Riksbank face immediate inflation concerns. In the EM world, central bankers have no time to rest despite a recent victorious battle with that old enemy, inflation. European contagion and weaker global growth should keep policy-makers there on their toes for the next few months.
All Over the Cycle in the DM World
Just as it is difficult to summarise EM economies in one bloc, the DM world has also shown an idiosyncratic recovery cycle with at least three distinct blocs. Almost turning a full circle and all by itself, the Australian economy weathered the financial crisis and the Great Recession remarkably well. The RBA then stepped in with a series of rate hikes and now there are downside risks to growth from the non-mining part of the economy thanks to both monetary and fiscal tightening. In a second bloc, Sweden and commodity exporters Norway and Canada have seen robust growth and the central banks there see upside risks to inflation on their radar. Finally, in the bloc that has a mix of inflation and growth worries but where recoveries don't yet inspire confidence, we have the US, the euro area and the UK. Growth concerns are home-grown in the US, the euro area, the UK and Australia, which makes the external environment for the rest of the DM (and indeed the global economy) precarious.
But growth is rarely the only issue on the central bank radar. The BoE, the ECB, the Riksbank and, to a lesser extent, Norges Bank and the Fed all have concerns about high and/or rising inflation. In addition, concerns about credit growth and financial stability remain high for the Fed, the ECB and the BoE.
External Risks Rising for EM Economies
EM economic outperformance finally pushed EM central banks to tighten policy when export growth surged in late 2010. With domestic and external demand growing strongly, inflation started rising, aided by commodity prices. Since late 2010, a concerted drive by EM central banks to rein in inflation has yielded results.
Inflation is now only a moderate concern for most central banks, even including the high inflation economies of Russia and India. The uncertainty surrounding US and euro area growth shows up as a concern everywhere, but this has not yet become the primary concern for most EM central banks. The obvious links from global growth to the EM world work through (i) export growth for export-oriented AXJ economies, LatAm economies with close ties to the US and CEEMEA economies with close links to Europe, and (ii) the adverse impact of lower global growth on commodity prices for commodity-exporting LatAm, Russian, South African, Indonesian and Malaysian economies but a beneficial impact of lower commodity prices on commodity importers. There are also financial links between DM and EM growth via bank lending, capital flows and EM funding requirements. In this note, we restrict our attention to the former set of links since they feature more prominently on the central bank radar under normal circumstances. The latter take the spotlight during a crisis.
CEEMEA
CEEMEA central banks are feeling the heat from renewed European concerns faster than the rest of the EM world (see Macro Spills and Beyond: Thoughts on Contagion, July 15, 2011). This is perfectly understandable, given their proximity to Europe and the natural trade and financial links. The economic recovery in the CEEMEA region lagged the recoveries in the AXJ and LatAm regions. Monetary tightening, however, has been slow and is likely to get slower still. CEEMEA inflation prints have recently turned benign, prompting a pause in rate hikes from the central banks of Russia and South Africa, downside risks to our call for the National Bank of Poland to hike to 5% by year-end, and both delayed as well as fewer rate hikes from the Central Bank of Turkey.
Global and European growth is on the radar of CEEMEA central banks via oil prices for Russia, contagion risks for CEE economies, export potential for Turkey and commodity price downside risks for South Africa. Regardless of the diversity of the countries within these regions, the risks surrounding global growth are ubiquitous in their potential impact on CEEMEA growth.
AXJ
Notoriously export-oriented AXJ (ex-India) economies and capital inflow-dependent India are most obviously linked to US and European growth and sentiment. Inflation appears to have turned the corner in most economies there (even though core inflation remains elevated in many countries, and even continues to rise in Korea) and monetary policy hikes for 2011 have therefore run their course almost everywhere (see Asia-Pacific Economics: Nearing the End of Rate Hike Cycle, June 30, 2011).
Even though country-specific issues (e.g., concerns about the quality of debt in China, weak IP and slowing government spending and consumption in India, concerns about household debt in Korea and political transition in Thailand) continue to feature prominently on the central bank radar, it is quite clear that the impact of global growth is already making waves as far as implications for monetary policy are concerned. With inflation abating, it is probably natural that external demand concerns, over which AXJ central banks have little control, become the next risk to grapple with. Exports in Taiwan and Korea have already fallen on a sequential and seasonally adjusted basis. If this is a leading indicator for exports for the region, downside risks to AXJ economies may materialise soon.
LatAm
The focus in Latin America still remains on slowing down growth and reducing the risks of overheating. Thanks to the ‘growth mismatch' (a surge in spending and stagnating production as a result of the massive terms of trade shock and currency appreciation thanks to high commodity prices), economic growth has been very strong and capacity constraints are raising inflation pressures. There are signs that growth is slowing in Brazil and Chile but remains buoyant in Peru, Colombia and Argentina. With the exception of Mexico, where the output gap is still negative and credit growth has been weak, overheating concerns are still present in this region to a greater extent than elsewhere in the EM world. Monetary policy has tightened quite sharply from the extremely accommodative monetary policy of the Great Recession. The impact of this sharp tightening is likely to assert itself in 2011 and should help to lower inflation everywhere in the region. As a result, monetary policy in the LatAm region too is probably close to the end of the normalisation process (see This Week in Latin America, July 18, 2011 and This Week in Latin America, July 11, 2011).
However, LatAm economies, with their strong commodity export orientation, are also in the line of fire if global growth falls sharply. A small slowdown in growth with slightly lower commodity prices might actually help Brazil with its ‘growth mismatch'. To boot, this will likely be disinflationary. However, a more pronounced global slowdown would create a negative terms of trade shock that could push growth down sharply.
Our Base Case
While the discussion has centred on the materially higher risks and the scope for policy mistakes, we maintain our base case (see The Global Monetary Analyst: How Uncertainty Begets Uncertainty, July 13, 2011) of a better 2H performance in the US and a policy-led containment of euro area problems (though not a comprehensive solution to these problems). The EM giants, China and India, were expected even before the onset of these higher risks to return policy from their slightly restrictive stance towards a more neutral one as confidence about inflation receding grows. Other EM economies are either close to the end of their normalising cycle or are likely to postpone it to early next year. Should our base case work out without the need for outright policy easing from the major EM and DM central banks, the direction of the next rate move from not just DM but also EM central banks could well be higher.
Higher Thresholds for Policy Easing
Further easing from the Fed, a reversal of the ECB's hiking cycle and a move by EM central banks from neutral back into accommodative territory all have higher thresholds now. The Fed faces rising core inflation along with its own and our base case of a better 2H performance. Despite normalising monetary policy, EM economies continue to have very little slack in their economies. A move to an accommodative stance would have to be justified by downside risks large enough to overcome a renewal of the overheating and inflation concerns that they have just battled against for the better part of a year. Having recently embarked on a tightening campaign and kept its asset purchase programme dormant for the last four months, a pause in hikes and renewed use of asset purchases would mark a dramatic change for the ECB.
The Risks Surrounding Our Base Case
However, the risks surrounding our base case may prompt one or more of these to occur, probably starting with renewed purchases of assets by the ECB to augment the stop-gap measures we expect euro area policy-makers to administer - though things would have to deteriorate dramatically for the ECB to carry out renewed purchases. These risks are already raising the risk of contagion outside the euro area to CEEMEA economies. Should the downside risks to US growth materialise, further easing from the Fed and another round of policy accommodation from EM central banks would be reasonable to expect.
The Global Central Bank Is Not Out of Ammunition
Finally, it is worth emphasising that the ‘global central bank' still has ammunition left, if needed. The Fed and the Bank of England could do another round of QE, the ECB could lower rates and purchase (more) bonds, and EM monetary authorities have room to cut policy rates: hardly an empty arsenal.
Summary
Rising risks in the US and euro area are already beginning to make themselves felt elsewhere in the DM as well as the EM world, just like in mid-2010. Unlike 2010, however, the threshold for monetary easing is now higher. In other words, some of the downside risks we see would actually have to be realised for the global central bank to employ the arsenal of tools at its disposal. However, if it is our base case that plays out, better US growth, a stop-gap resolution of the euro area problems and outperforming EM growth all mean that the direction of the next move in policy rates in the DM as well as the EM world could be higher.
Debt Sustainability Revisited
What Would it Take for the Debt Trajectory to Go Up?
Our analysis suggests that, given our forecast of a primary budget balance of 1% this year - to rise to 2% next year and 3.7% in 2015 - along with GDP growth of around 1% and inflation at 1.8%, an immediate and permanent increase in the cost of funding across the yield curve would result in a slightly upward-trending trajectory only for rate rises above 300bp from where we are at the moment.
Given current interest rates of around 4%, an increase of 100bp today would add about €0.6 billion of interest expenses this year, €4 billion next year and €6.9 billion in 2013. In terms of GDP, these amounts correspond to approximately 0.04pp, 0.2pp and 0.4pp, respectively.
How Does the Cost of Funding Evolve Over Time?
While non-negligible, these extra interest costs are hardly a heavy burden - although the debt/GDP is of course quite high already. Will an increase in interest rates of, say, 100bp be immediately reflected in the cost of servicing the debt? The answer is no. It all depends on the average maturity of the debt, which is roughly seven years in Italy. This means that it will take seven years for the cost of servicing the debt to fully reflect a 100bp increase in interest rates.
Put differently, the sensitivity of Italy's debt servicing costs to rising yields is quite gradual, given its relatively high average maturity of marketable debt securities. So, a rise in market yields only translates into higher interest costs when the debt is rolled over, or new debt is issued in the market. Italy's gross issuance is approximately 17% of its total debt, which implies that - given a parallel upward shift in the yield curve - only 17% of the rate increase feeds through and translates into higher debt servicing costs every year.
In particular, using our forecasts for Italy's issuance over the next 10 years, we assess the full impact of an immediate and permanent upward shift in the Italian yield curve. For example, a 100bp rise in the yield curve would fully translate into higher debt servicing costs by 2017, when Italy's interest rate paid on its debt increases from around 4% currently to 5%.
The Psychology of Contagion
Fiscal Slippage Avoided
Past investor concerns over a key austerity package, along with some uncertainty on the political front, are one reason for the recent spread widening in the Italian government bond market. But with the budget now approved, and a bill on tax reform likely to reinforce its public finances, market participants might refocus on Italy's generally better fundamentals than those of the smaller peripherals, and reassure the European policy-makers that Italy is taking further steps.
All Good Then?
With the smaller peripherals removed from the market, contagion now affects Italy disproportionately, given that it is one of the few countries under the market spotlight that is still able to fund in the market. Put differently, when the European policy-makers remove one country from the market through some kind of bailout - in the sense that the country in question does not need to issue for a few years - then investors focus on the next weak link.
On the Political Risk Premium
While no political risk premium seems to be reflected into asset prices so far, past evidence suggests that Italian financial markets have tended to react to political events - though the effect has been more muted after EMU membership. However, the EMU period is not necessarily a good comparison, as it was relatively more stable than most other periods in Italy from a political standpoint, and markets did not focus much on governments' ability to keep the public finances in check.
How Do Italian Markets Respond to Political Events?
For example, government collapses and other political shocks have exerted a substantial influence on Italian financial markets over the past 40 years, as suggested by various econometric analyses. These analyses suggest that, in the two weeks before and after a government collapse, the cumulative rise in interest rates is about 24bp. Similarly, equity markets fall by around 5% over the same period (see On the Return of the Political Risk Premium, September 20, 2010).
Fundamentals Better than in the Smaller Peripherals
Still Inching into the Core
Although market perception over rising political/budget uncertainty, prior to the approval of the austerity package, might have added to market concerns, Italy has stronger fundamentals than Greece, Portugal, Ireland, Spain, etc. Our research suggests that Italy compares favourably to these countries - and to some semi-core countries as well. While not yet regarded as a core European country, Italy has increasingly behaved like one (see Inching into the Core, March 15, 2010).
What Makes Italy Different from the Periphery
According to the conventional view, all the countries generally associated with the periphery of the euro area (Italy, Spain, Portugal, Greece and Ireland) are characterised by a degree of fiscal profligacy, a poor record of implementing structural reforms, a lack of cost competitiveness and sizeable current account deficits - unlike core EMU countries. Yet Italy differs from this description in a number of ways:
• Primary budget surplus: Italy has been running primary budget surpluses for almost two decades excluding the crisis period. Virtually alone in the euro area, we expect a 1% primary budget surplus this year and 2% in 2012.
• Low private sector indebtedness: The sum of household and corporate debt amounts to around 137% of GDP, below the euro area average of 169%. Accounting for government debt too, Italy is less leveraged than the ‘typical' European country.
• Housing/banking crisis avoided: Unlike in the housing hotspots in Europe, e.g., Spain and Ireland, no major credit-fuelled housing and consumer boom-turned-bust happened in Italy. And bank recapitalisation is continuing.
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