Risk of world recession begins to fade

THE CHANCELLOR took some flak last week for publishing a forecast for the UK economy which many observers saw as over-optimistic. At present levels of interest rates, even after last week's welcome half-point cut,the official forecast does indeed look challenging.

But as the Chancellor has argued, there is nothing in the underlying behaviour of the economy which makes a recession inevitable. None of the usual precipitating causes of recession - inflation pressures, problems with private-sector balance sheets, a trade deficit or red ink in the public accounts - is present in the economy today. This means that both fiscal and monetary policy can be eased rapidly if needed to boost demand.

Serious risks, however, stem from troubling events overseas. After a truly torrid patch, the recent rebound in global equity prices, taken together with the more moderate recovery in spread markets (such as swaps, asset-backed securities and corporate bonds) has clearly come as a response to the encouraging changes in Group of Seven economic policy over the past few weeks. The Chancellor himself has worked energetically to shift the G7 into a more activist mood, and he deserves much credit for this.

But will the policy changes announced so far prove sufficient? Since July, there have been new financial shocks in three separate areas which,taken together, threatened to be more powerful than the first Asian shock. These three new developments were: first, the negative wealth effects associated with declining equity prices; second, the risk of a credit crunch as the process of deleveraging was unleashed in the "credit spread" markets; and third, the risk of new trade drags from other parts of the emerging world, notably Latin America.

At the low point in early October, the collapse in world equity prices was threatening to exert a significant negative wealth effect on the world economy over the coming year. Relative to the peak reached in July, the wipeout in global financial wealth reached about $2,300bn (pounds 1,400bn) in early October, an amount equivalent to 19 per cent of the annual consumers' expenditure of the OECD economies. The recent rebound in share prices has, however, substantially mitigated this effect. The loss of world wealth has been reduced to just under $1,000bn, which is only 7 per cent of OECD consumers' expenditure. Although this remains a significant figure, it no longer looks sufficient to do much damage to world growth prospects in 1999.

The return of confidence in the financial markets has also impacted the "credit spread" markets, although to a smaller degree than has occurred in equities. Spreads have narrowed to varying extents and, more important, there has been a faltering return of new issuing activity in the corporate bond markets. This should reduce the threat of a credit crunch.

It remains possible that we may see some renewed accidents in these markets in coming weeks, as excess leverage usually takes quite a long while to unwind, and there will be intensified downward pressure on balance sheets as leveraged entities approach the end of their financial years. Nevertheless, now that the central banks have shown urgency in preventing a significant credit crunch from developing, this seems unlikely to act as a significant drag on world activity in 1999.

Next, the emerging markets. The first Asian shock in 1997-98 directly affected growth in the Western economies mainly via the impact on trade. In the five Asian crisis economies, a current account deficit of 5 per cent of GDP in 1997 was transformed into a surplus of 9 per cent of GDP in 1998 - one of the most dramatic transformations of all time in trade imbalances. However, because these economies accounted for only 7 per cent of world GDP, this swing in trade positions did not have a dramatic impact on output in the US and the European Union. In fact, the direct depressing effect on GDP growth in the Western economies was only of the order of 0.5 to 0.75 per cent in the year ending in the second quarter of 1998. Since the current account positions of the Asian economies are now expected to stabilise, the extent of this trade drag on the western economies may diminish in 1999.

The problem is that this drag may be replaced by new shocks in other areas. The provision of bank finance for emerging economies is likely to be curtailed further as western banks attempt to reduce the size of exposure in these areas. At present, total emerging market loan exposures account for high proportions of bank capital in the developed economies - 34 per cent of bank capital in the US, 79 per cent in the EU and 118 per cent in Japan.

As banks seek to reduce the extent of these exposures, emerging economies may be forced to adjust their current account surpluses upwards in order to raise the money needed to pay down bank debt. This could lead to a further, possibly large, drag on Western GDP growth in 1999, though it is dubious whether the extent of this drag will be larger than it has been this year.

Despite these continuing worries about emerging markets, the downside risk to growth in the world economy stemming from the three financial shocks listed above has clearly declined markedly in recent weeks. Although far from perfect, the response of the G7 authorities to the sudden worsening in the crisis since August has not been negligible, either. Fortunately, a series of un- coordinated - indeed piecemeal - policy changes have gradually accumulated into something quite significant.

Nevertheless, an early return to healthy GDP growth is unlikely in the OECD area. In contrast to 1987, business conditions had been weakening sharply around the world for several months before the onset of the most recent financial shocks. Even if these shocks turn out to have little or no effect on growth in 1999, the background condition for the world economy is much weaker than it was around the time of the 1987 stock market crash. (This is clearly demonstrated in the accompanying graph on business confidence, which compares current conditions with those existing in 1987- 88.)

The combination of business survey indicators and other leading indicators recently published in the major economies suggest that a further slowdown in GDP growth during 1999 is highly likely, even without incorporating any large effects from recent financial shocks. Goldman Sachs therefore continues to expect that OECD GDP growth will slow markedly to only 1.6 per cent next year - and this could get much worse if the central banks lose their new-found enthusiasm for easing global monetary policy.

As this column has frequently argued in recent months, one of the core problems for the world economy this year has been that global monetary policy has been around a full percentage point (or 100 basis points) tighter than "neutral". Since midsummer we have seen reductions in rates of 25 basis points in Japan, 40 basis points in Europe, 50 basis points in the US and 75 basis points in the UK. Taken together, the world has therefore reduced interest rates by less than 50 basis points, not even half the amount needed to shift policy back to neutral. More is needed, and soon.

The Bank of England, responding to the drop in business and consumer confidence in this country, has shifted its stance more rapidly than any other major central bank. It is mapping out an activist path which other nations should follow.