The so-called US ‘fiscal cliff’ represents the single biggest near-term threat to a global economic recovery, according to Fitch Ratings.
The credit ratings agency (CRA) says that while it is not its base case, the dramatic fiscal tightening implied by the fiscal cliff could tip the US, and possibly the global economy, into recession. At the very least it would be likely to halve the rate of global growth in 2013.
Under current law, US tax increases and spending cuts worth US$600bn, equivalent to 4% of gross domestic product (GDP), will take effect in fiscal 2013. With most of the measures scheduled to take effect at the beginning of calendar 2013, the fiscal contraction would be equivalent to more than US$800bn (5% of GDP) on an annualised basis, according to the Congressional Budget Office. The scale and speed of this fiscal tightening would be likely to push the US economy into an unnecessary and avoidable recession, and Fitch therefore thinks the cuts will be pared back to a more manageable 1.5% of GDP.
However, if the fiscal cliff did involve US$600bn of permanent fiscal tightening, it would knock almost two percentage points of the CRA’s 2013 growth forecast of 2.3%, according to its alternative scenario analysis detailed in Fitch’s just-published Global Economic Outlook. The gap with our baseline GDP level would be almost three percentage points in 2014, before narrowing slowly.
This would have a global impact. According to the Oxford Economics model used in the CRA’s alternative scenario analysis, a US fiscal shock would be exported to the rest of the world via a sharply weaker US dollar and asset prices, lower US price and wage inflation and heightened risk of deflation, and the impact on commodity prices.
Model simulation results show the major consequences for the global economy. As domestic demand fell, US imports would drop faster than exports, and the resulting improving trade balance would need to be matched by deterioration in trading partners’ balances, causing growth to slow. While the world economy would still grow 1.3% in 2013, this is just half Fitch’s baseline forecast of 2.6%. The potential contagion effects from greater stress in the US financial sector and asset markets could further amplify the negative effects on the global economy.
The size and timing of the shock would be different for different countries. Export-orientated countries like China and Japan would experience the steepest falls in GDP in 2013. Growth would then resume at baseline rates, but at a lower level. Commodity exporters like Russia and Brazil would be less affected in 2013, but the effects would be felt into 2014.
Some policy response by US trade partner countries is assumed in the model. However, the size of the shock may mean that they respond on a scale outside the model’s parameters. In particular, it could amplify the risks of uncoordinated ‘beggar-thy-neighbour’ actions, as some countries would feel tempted to limit the appreciation of their currencies versus the US dollar.
Mounting Risks to Global Recovery Impact on China and India
Fitch has also cut its 2012 growth forecasts for China, to 7.8% from 8%, and India, to 6% from 6.5%. Both regional giants face a deteriorating global growth outlook with diminished willingness or capacity to respond with domestic policy loosening, compared with 2009.
Slower exports are weighing on China’s growth, but Fitch also views the slowdown as reflecting the authorities’ efforts to squeeze consumer and house-price inflation out of the system after the strong credit-led stimulus of 2009-2010. Fitch expects slowing construction activity to knock about 0.8 percentage points (pp) off China’s growth in 2012. The CRA expects only marginal policy loosening unless the labour market deteriorates sharply.
Fitch does not expect a ‘hard landing’ in China given the authorities’ scope for fiscal and monetary policy flexibility if they choose to use it. The resilience of the labour market seen in current data suggests growth of 7.5%-8% may be in line with the economy’s potential rate. Weak corporate profitability poses downside risk for China’s economy. This could eventually incline firms to shed labour, which would in turn affect consumption, currently a resilient part of the outlook. Real estate and construction have been a source of downside risk given the authorities’ restrictive policies in the sector following its rapid growth in 2009-2011. However, the residential real estate market has shown some signs of turning the corner in summer 2012, which leans against a negative outcome. A significant deterioration in financial stability and in the ability of the banks to transmit monetary loosening is another but more remote risk to the outlook.
India’s economic outlook remains challenging. Investment rose just 0.7% year-on-year in Q212, with higher-frequency indicators pointing to another weak outturn in Q3. Ongoing concerns over government economic and investment policy may be weighing on business confidence. The authorities’ ability to respond with looser policy is constrained by India’s high inflation, fiscal deficit and public debt.
Fitch projects India’s general government deficit at 8.5% of GDP in fiscal 2012, leaving little room for fiscal easing. A number of quarters of weak investment, in turn, may be starting to affect the economy’s supply capacity, pointing to a weaker growth outlook. The authorities announced a range of reforms earlier this month, 2012 including liberalisation of foreign direct investment (FDI) in multi-brand retail which may help to restore confidence and lift investment, although the volatile political environment points to implementation risk.
The growth outlook is holding up better elsewhere in emerging Asia in part because of the growing importance of domestic demand in many regional economies. The 0.3pp reduction in Korea’s forecast for 2012 to 2.5% is modest and underpins the open, trade-driven economy’s resilience, a key factor behind Fitch’s upgrade of the Korean sovereign to AA- in September. Growth in Malaysia and Thailand will benefit in the short run from public-sector-led investment. Indonesia’s growth forecast is unchanged at 6%, reflecting the increasing importance of domestic demand as a driver of that country’s growth, notwithstanding the importance of commodity exports.
Fitch has cut its forecast for growth in the major advanced economies by 0.2pp in 2012 (to 1%) and 0.3pp in 2013 (to 1.4%). The CRA has revised down its expectations in the euro area to a 0.5% contraction in 2012 and just 0.3% growth in 2013, while the US forecast remains unchanged at +2.2%/+2.3%.
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