Shooting the rapids: What happens if financial turmoil capsizes the global economy?

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A new Economist Intelligence Unit risk report looks at how the credit crunch could play out as it spreads beyond finance into the real economy

When the US Federal Reserve rescued Bear Stearns, an investment bank, in March it elevated the subprime mortgage meltdown to historic levels, alongside the 1987 Black Monday stock-market crash, the 1992 attack on the British pound, Mexico’s 1994 “tequila” crisis and 1997-8’s triple whammy-Thailand’s currency devaluation, Russia’s debt default and the collapse of an iconic US hedge fund.

Today’s crisis could be much worse. Financial losses from the US mortgage rout and the spreading credit crunch are likely to approach US$1trn, according to the International Monetary Fund. If the contagion infects an ever-widening group of assets, the US could plummet into the kind of recession that saw Japan enter its “lost decade” in the 1990s.
This would contribute, in turn, to sharp slowdowns globally, including a decline in China’s growth rate which, in that rapidly-growing economy, would feel very much like a recession.

This report updates the Economist Intelligence Unit’s August 2007 analysis of the early stages of the credit crisis, Heading for the
rocks: Will financial turmoil sink the world economy? In that report, we saw a 30% likelihood that the US would fall into a recession, with serious consequences for the rest of the world. That scenario has now come to pass. The US will endure a recession this year, and growth is already slowing in most other countries. In this report we discuss the possibility of a more dire outcome: a massive, worldwide flight from risk that causes asset values to plunge, banks to collapse, credit to contract and the world economy to stall. This is now our 30% scenario.

Three scenarios

The report outlines three alternative views of the future:

Scenario 1: Our central forecast (60%)

The US economy dips into recession in 2008, but responds to monetary and fiscal stimulus, rallying in 2009. Other developed economies slow sharply, but avoid outright recession. World trade growth and commodities prices stay high, and major emerging markets suffer only a modest (and in some cases desirable) slowdown in activity.

Scenario 2: The main risk scenario (30%)

The US economy fails to respond to policy stimulus and suffers a deep recession and a long period of sub-par growth comparable to Japan’s “lost decade”. This induces a stall in other developed economies, and, through a halt in world trade growth and a sharp correction in commodities prices, a severe slowdown in developing countries, including China and India.

Scenario 3: The alternative risk scenario (10%)

Successful policy stimulus results in overheating, requiring, in turn, a sharp tightening in policy stance to relieve rising inflationary pressures. The need to rebuild anti-inflation credentials limits the capacity for subsequent policy stimulus, prolonging the downturn.
With a special focus on the low-probability, high-impact second scenario, the report looks at how events play out in a number of areas, with articles on the leading developed and developing markets, the financial sector and commodities.

The report concludes with an examination of the implications for government policy and market regulation over the coming years.
Governments and regulators are left with the task of re-establishing credibility and re-drafting the principles guiding their role in national and international markets, perhaps involving a paradigm shift away from light-touch oversight towards a more interventionist stance.

Key conclusions:

? The US economy is vulnerable to some of the conditions that
afflicted Japan in the late 1990s, including the failure of conventional monetary and fiscal policy to stimulate economic recovery. As happened in Japan’s downturn, the combination of a prolonged correction in the housing market, and the rebuilding of regulatory capital by banks, risks choking off both demand and supply for loans.

? The US endures a recession every 8-10 years, but the slump that
is now under way could become the worst in more than half a century, with virtually no growth this year, a sharp contraction in 2009 and another year of falling output in 2010. The US could lose as many as 5m jobs by the end of that period, with the unemployment rate jumping to well over 8%.

? Japan’s lack of room for policy manoeuvre makes it uniquely
vulnerable. Not only are interest rates still ultra-low, but, with the sickliest public finances in the developed world, Japan has no scope for fiscal loosening. A sharp fall in commodity prices, coupled with a strengthening yen and economic stagnation, leave Japan vulnerable to a renewed deflationary shock.

? The breakneck expansion of recent years in China and India could
come to an abrupt halt, with their economies facing pressure from both the global slowdown and a build-up of domestic problems. Under our 30% risk scenario, growth in both countries falls sharply in 2009 and rebounds only modestly in 2010, and the rest of emerging Asia is also severely hit.

? On the balance of probability a systemic banking crisis is likely
to be averted, but there is a substantial risk that the financial crisis will spread far beyond its epicentre in US sub-prime mortgages to encompass a broad range of asset classes, threatening banks’ solvency as they are forced to sell even healthy assets to strengthen capital adequacy. This could trigger a self-reinforcing cycle whereby declines in asset prices trigger margin calls and further sales by leveraged investors.

? A shallow and short slowdown in the developed world would remove
little of the buoyancy in commodities markets, but a more marked and prolonged decline that included the major emerging markets would bring a much sharper adjustment. Under this scenario, the oil price could drop towards US$50/b in 2009-10, creating problems for oil producing countries with vulnerable fiscal positions, such as Nigeria, Venezuela, Syria and Iran.

? In the face of a deep and prolonged slowdown in global growth, it
is likely that policymakers-in the face of continued balance-sheet stresses and the threat of further financial failures-would adopt a more interventionist regulatory stance that would limit the ability of the financial sector to innovate.

Shooting the rapids: What happens if financial turmoil capsizes the global economy?
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Economist Intelligence Unit
Joanne McKenna, Press Liaison: +44 (0)20 7576 8188, [email protected] Alasdair Ross, Editor, Risk Briefing: +44 (0)20 7576 8230, [email protected]

About the Economist Intelligence Unit
The Economist Intelligence Unit is the business information arm of The Economist Group, publisher of The Economist. Through our global network of about 700 analysts, we continuously assess and forecast political, economic and business conditions in 200 countries. As the world’s leading provider of country intelligence, we help executives make better business decisions by providing timely, reliable and impartial analysis on worldwide market trends and business strategies.

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