EconSouth (Fourth Quarter 2008)

Global Economies Anticipate a Tepid 2009

photo of hands holding deflated globe

The slowing economic growth that countries around the world encountered in 2008 should persist into 2009. Hopes for a swift recovery are dim and hinge on several fragile developments.

Worldwide economic growth slowed significantly in 2008, buffeted by the deep financial crisis, sharp run-ups in energy and food prices, and declines in many developed economies' housing markets. As a result, the near-term outlook for developed and emerging economies alike deteriorated rapidly toward the end of 2008. While most major developed economies are in recession or close to it, economic growth in emerging economies has also decelerated substantially. The world economy is expected to stagnate for most of 2009, with a slow recovery beginning toward year-end.

A drama with roots in 2007
For four years through the summer of 2007, the global economy expanded rapidly, and emerging economies supplied three-fourths of this growth. Accommodative monetary policies supported strong growth, and the world's central banks maintained these policies for an extended period. Rapid economic expansion, along with low inflation and interest rates, encouraged investors to take considerable risks. Stock markets soared, and credit spreads fell to very low levels. Significantly, low mortgage interest rates led to a housing construction boom in many developed and emerging economies and a considerable run-up in house prices.

But just as the Federal Reserve began tightening monetary policy in mid-2004, the housing market in the United States began to weaken. House prices declined, mortgage defaults began to rise, and the value of mortgage-related assets sank. U.S. financial conditions began to deteriorate in August 2007, and the turmoil quickly spread to Western Europe, where banks had invested heavily in U.S. mortgage securities. At the time, China and other emerging economies remained relatively insulated from the financial turmoil because their holdings of troubled U.S. assets were comparatively low.

Related Links
On this site:
Economías mundiales anticipan un tibio 2009
As Economias Globais Preveem um 2009 Morno
On the Web:
International Monetary Fund
World Bank

Inflation creeps onto the global stage
Emerging economies continued to grow rapidly, and economic growth remained solid in most developed economies through the opening months of 2008. But this sustained expansion fueled a rapid increase in commodity prices. Crude oil soared above $140 per barrel, boosting energy prices around the globe as well as the price of some petroleum-based products. Prices of agricultural commodities such as wheat, corn, and soybeans also climbed sharply.

As energy and food prices rose to record highs, annual inflation shot up, reaching an estimated 5 percent worldwide—the highest pace since 1991. The resurgence in inflation was particularly pronounced in emerging economies, where food and energy account for a larger share of consumer spending. The food price spike led to riots in some 30 countries in late 2007 and early 2008. Some governments responded by increasing subsidies, freezing prices, and banning exports of key commodities—measures that exacerbated price increases in world markets.

As inflation quickly rose above their comfort zones, central banks in many countries tightened monetary policy. Among developed countries, central banks in Europe were particularly worried because many European countries index workers' wages to consumer price inflation. The European Central Bank continued to raise interest rates until July 2008, and Sweden increased rates through September 2008. In emerging economies, Latin American countries quickly followed suit by also raising interest rates, while most Asian countries took longer to adjust.

The crisis spreads
Financial market stress intensified significantly in mid-September 2008 after a series of developments including the bankruptcy of Lehman Brothers, which caused considerable losses to creditors. Investors' confidence in their counterparties evaporated, and interbank credit markets effectively seized up. The crisis quickly spread around the globe, and five European banks were nationalized or received public funding in the last week of September. Major central banks injected an unprecedented amount of liquidity into the banking system. Governments around the world tried to stem the panic by guaranteeing deposits and loans, recapitalizing banks, and passing legislation to use public funds to purchase troubled assets from banks.

Global GDP Growth Estimates
Chart of Commercial Paper Outstanding, Weekly
Note: Developing Asia excludes China and India.
Sources: International Monetary Fund and the Economic Intelligence Unit

Although the financial crisis originated in major developed economies, emerging countries were increasingly swept into the turbulence. Investors began to flee emerging markets as risk aversion intensified and many investors needed to sell assets to raise cash to cover debts. Along with the financial markets in developed countries, stock markets in emerging economies plunged, and currencies depreciated. Access to dollar funding tightened dramatically around the world. In response, the Federal Reserve opened or increased currency swap lines with major developed and emerging economies to provide them with dollars. Often called reciprocal currency arrangements, these swap lines are designed to help improve liquidity in global financial markets.

Meanwhile, the economic outlook for developed economies continued to deteriorate rapidly. Bank lending to businesses and households contracted, and elevated inflation put the brakes on consumer spending. Major developed economies fell into a recession, and economic growth in emerging economies decelerated substantially. In expectation of a global economic slowdown, commodity prices plunged, in many cases losing half their value in a matter of weeks. The price of copper, for example, fell 45 percent from September to November.

Economic activity slowed considerably in most of Western Europe. The United Kingdom has been hit especially hard largely because of a sharp housing market downturn. In recent years U.K. house prices rose faster than those in the United States, and British consumers became more indebted, making the U.K. economy extremely vulnerable to financial shocks.

No country immune to slowdown
Germany, the world's third-largest economy, is in a sounder financial position than most advanced economies. But the country's growth depends heavily on exports and has been hit hard by the global slowdown. Weakening foreign demand is also hurting Japan's export-oriented economy. Thus, despite Japanese banks' lower exposure to U.S. mortgage-backed assets, Japan has slipped into a recession as international trade has diminished.

The sharp slowdown in developed countries significantly dampened demand for emerging economies' exports, restraining their economic growth as well. In addition, decreased global demand for commodities has negatively affected countries that depend heavily on commodity exports, many of them in Latin America.

Among major emerging economies, China appears to be best positioned to weather the global slowdown. Although export growth has weakened substantially, China has a budget surplus that gives the government considerable flexibility to boost consumer and business spending. China's financial system has little connection to foreign banks, and the country's foreign exchange reserves are approaching $2 trillion.

India's banking system is also relatively insulated from the financial turmoil, and the country's economic growth has generally relied more on domestic demand than on exports. Although Brazil is a major commodity exporter, its economy is relatively well diversified and therefore more immune to the global economic and financial woes. Of the largest emerging economies, Russia appears to be the most vulnerable, with a heavy dependence on exports of oil and natural gas and on foreign lending.

Looking ahead to 2009
Sustained deleveraging and tight credit availability are likely to continue to weigh heavily on the world economy in 2009 (see the chart). Economic growth in developed countries will likely stagnate, but mild recovery could begin by the end of the year. The pace of growth in emerging economies should also moderate further but is likely to remain higher than during the 2001–02 recession.

The magnitude of the global slowdown in 2009 will depend to a large degree on the severity of the financial crisis and the effectiveness of government policy initiatives around the world. Considerable time could pass before financial institutions' losses are fully recognized, leverage is reduced, and market confidence recovers. A decisive commitment to multilateral concerted and coordinated efforts is crucial to a global recovery. Overall, the global economic situation going into 2009 remains extremely uncertain and faces significant risks.

This article was written by Galina Alexeenko, a senior economic analyst in the regional section of the Atlanta Fed's research department. The international estimates and forecasts represent a consensus of private-sector or multilateral outlooks and are not those of the Federal Reserve Bank of Atlanta or the Federal Reserve System.