Sunday, 30 December 2007

2008: Difficult but not depressing

2008: Difficult but not depressing
28 Dec, 2007, 0312 hrs IST,Saumitra Chaudhuri,

Managing high oil and food prices will be the challenge, even as modest growth in the developed world eliminates concerns that would have arisen had the slowdown resembled recessionary conditions.

There are two opinions about what may be happening in the US economy, and by extension to the rest of the developed world and then to the emerging economies of the world. There is widespread consensus that the US economy will slow in 2008.

The difference is about by how much? In both 2004 and 2005, the world’s largest economy had been running a bit ahead of the long-term trend value of 3%, though it had scaled back to 2.9% in 2006. In any case, this was nowhere as far out as in the closing years of the last decade when it had exceeded 4%. The idea that growth would be slower still in 2007 had preceded (or had quietly subsumed) the outbreak of the subprime crisis in August 2007.

Since August 2007, the world’s financial markets and US and European lenders have taken a beating as the subprime mortgage asset and the Collateralised Debt Obligations (CDO) structures imprudently built on weak ground started to give way.

This compounded the uncertainty about the extent of the adverse economic implications for the US economy and the rest of the world in 2008. First, the difficulties of banks and other intermediaries, as also the increase in risk pricing, suggested that credit delivery would slow and in any case happen be at higher interest rates, suggesting that US consumer spending would slow more than expected.

Second, the decline in home prices (through the wealth effect) was set to further compress consumer expenditure. Why Europe should follow suit was much unclear, except the premise that given the surprisingly large exposures to US subprime assets by many European banks, a generalised outbreak of credit flu would sweep the Euro-zone.
There is no home-grown problem in either the mortgage or consumer lending markets in Europe. The only place in Europe that there is a problem is in the United Kingdom. Where aggressive lending and ill-advised means adopted to fund balance sheets, have worked in tandem with a very long house price boom, to land many deposit and non-deposit taking financial companies into rather hot water, as both regulators and government have seemingly been caught flat on both feet.

The extreme view is that the US is headed for a recession in 2008, defined as two successive quarters of negative growth. This is however something of an undercurrent, whispered but not quite said out aloud in polite company: A product of the general sense of gloom that has pervaded the world’s financial capital, as not only has a nice big business gone out of the window, but the pride of the market have taken big losses and seen the top men leave — albeit in gilded parachutes.

Thus the gloomy end of the spectrum is the argument of a strong likelihood of “near recessionary” conditions emerging in the US economy in 2008. That is, conditions where growth would be close to, or even below 1%, rather than the recent 3% growth trend. It must be noted that most big banks maintain growth forecasts of 1.5%. Those, with a penchant for seeing code and subliminal images in public communications, may not be wrong in this case, to read it as 1% plus a readiness to take it further down on the receipt of the bad news, widely believed to be on the way.

That the particulars of our immediate circumstance distorts our view of the rest of the world, is a common human failing — no stranger even to the cerebrally over-endowed and chronic over-achievers who populate the world of high finance.

The other viewpoint is that while US growth will slip, it will not do so by much. This conclusion derives from the fact that the US economy has recorded strong growth even as late as the third quarter of 2007, and anecdotal information on the December shopping season do not suggest a squealing of the brakes. In fact, except for the home-building sector, all other sectors are doing well, with GDP growth excluding the problem-stricken sector at 2% in the third quarter of 2007.

In fact, this economy grew more strongly in the third quarter of 2007, than it had in the first and second. This conclusion is also supported by the employment figures. Unemployment in November 2007 was 4.7%, broadly unchanged from earlier in the year and low by historical standards. The data on non-farm employment creation has also continued to be healthy through 2007 including in October and November.

The Euro-zone has had a revival of strong growth since 2006. In the third quarter of 2007 the region grew by 2.8%, with none of the major economies of the region showing signs of weakness. From all of this the only conclusion that emerges is that while 2008 will be a slower year, it will not be depressing. That has implications for inflation and on the extent of monetary accommodation possible in the US and elsewhere.

Recessionary conditions in the developed world would have compressed export demand of emerging economies, creating possible slumps in the prices of some manufactured commodities, which price signals passed through to home markets, would have squeezed operating margins and acted as potential disincentives for investment. That these things will not come to pass in 2008 is good news. However, the flip side is that the demand for crude oil, industrial raw materials and grain will not fall.

The main lesson of the past months is that the world can live with $80 to $90 per barrel oil. Between November 2005 and 2007, wheat prices doubled and though more acreage is coming under the crop, it is unlikely that augmented output will soften wheat prices by much in 2008-09 — though over the medium-term it is a possibility. India is both an importer of oil and of wheat.

Managing the inflationary burden of high oil and food pries will be the big challenge through 2008-09, even as modest economic growth in the developed world eliminates concerns that would have arisen had the slowdown resembled recessionary conditions.
(The author is economic advisor, ICRA)

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