Global Outlook: Shifting Sources of Growth

View the Moody's Economy.com Global Forecast.

• In the post-recession global economy, sources of growth are shifting noticeably to the East.
• Patterns of global trade are also changing.
• Shifting international trade and capital flows should help reduce global imbalances and make for more stable growth.
• Vastly different rates of recovery are putting national policymakers at odds over the timing of the stimulus withdrawal.

The global economic recovery is gaining steam, powered by strong policy-driven domestic demand in the emerging economies of Asia and Latin America. For the first time in modern history, the developing world—particularly China, India and Brazil—has supplanted the U.S. in leading the world out of recession.

Emerging economies with high saving rates and large domestic markets continue to outperform. China has been the main locomotive pulling the world economy into recovery. China retained its position as the world's fastest-growing economy in 2009 by deploying vast state resources—including a massive fiscal stimulus equal to 13% of GDP—to generate broad, domestic demand-led growth. This in turn fueled demand for imports from China's trading partners in East Asia and elsewhere and revived industrial production among its neighbors. Commodity exporters in the Southern Hemisphere have also benefited from China's large appetite for copper and other base metals.

Strengthening domestic demand, aided by an aggressive policy stimulus, brought Latin America out of recession in the second half of 2009, led by Southern Cone countries that benefited from rising commodity prices. Brazil's recovery has strengthened on the back of government infrastructure spending and housing construction for low- and middle-income families. Meanwhile, lower interest rates and capital controls to curb hot-money inflows have helped shield the Brazilian economy from harmful exchange rate volatility.

Contours of global trade

Among emerging markets, trade with each other has rebounded much faster than trade with the developed West. This, in part, has enabled China to overtake Germany as the world's leading goods exporter. Whilst the U.S. remains the largest goods importer by a substantial margin, China is rapidly closing the gap. China's import mix is also changing to reflect the shift to domestic demand-led growth. The country is moving from primarily importing in order to produce goods for export to importing in order to build domestic infrastructure. This has lifted global demand for raw materials and capital goods. In the process, China is contributing to the recovery of its trading partners.

Through greater "south-south" trade, other emerging economies are also increasing their share of world trade. As their share of global output grows as well, the developing world will account for the lion's share of global growth. Structural efforts to boost domestic spending in emerging economies and reduce reliance on the external sector will also help trim massive external imbalances built up following the 1997-1998 Asian financial crisis. In 2010, countries with large current account surpluses are expected to boost domestic spending, whilst countries with large current account deficits will ratchet up savings.

Because of its size and increasing economic heft, China will play a large role in determining the extent of global rebalancing in coming years. Its domestic economy is already emerging as a major growth engine, and planned reforms of pensions, healthcare and education are expected to support private consumption in the longer run. These reforms will provide a wider income safety net, helping to reduce the need for high precautionary saving. China's household saving rate is amongst the world's highest at over 25% of income. Yet attempts to shift the sources of growth from exports to domestic consumption will take time and need to be accompanied by substantial changes in exchange rate policy. China’s continued currency peg to the dollar is keeping the yuan artificially low, hampering its own transition as well as adjustments in global trade and investment flows. A stronger yuan would benefit China's trading partners by boosting their price competitiveness and potentially accelerate the global recovery. Yet Beijing seems prepared to thwart any substantial currency appreciation, despite growing international political pressure.

China's great wall of liquidity

Beijing's massive economic stimulus last year provided a major source of liquidity for the global economy, contributing to the dramatic sea change in investor sentiment and the surge in a wide range of asset prices, including commodities and financial assets. New loans surged by 9.6 trillion yuan ($1.4 trillion) in 2009, equal to well over a quarter of China's total GDP. Furthermore, new lending continued to surge into 2010; preliminary reports suggest new lending skyrocketed by a further 1.5 trillion yuan in the first two weeks of January, around 20% of the 7.5 trillion yuan target for new lending for 2010.

Runaway bank lending has prompted Beijing to try to curb the rapid pace of credit growth and drain excess liquidity from its financial system. Recent measures have included guiding money market rates higher through gradual adjustments to yields on its bills and bonds and raising large commercial banks' deposit ratio by 50 basis points to 16%. This will force banks to hold more capital and hence lower the amount of funds available for lending. The higher deposit ratio will also serve as a capital buffer for nonperforming loans.

The surge in domestic liquidity has fuelled fears of destabilizing asset price appreciation and a resurgence in loan losses. A large amount of new bank lending last year likely flowed into the stock market and real estate ventures. In 2009, Shanghai's benchmark stock market index surged 80% whilst residential real estate prices, particularly at the luxury end of the market, gained upward momentum. Beijing appears keen to rein in all forms of speculative lending, particularly amongst highly leveraged real estate developers, as the surge in domestic liquidity has fuelled a big increase in housing transactions and construction.

More monetary tightening is expected during 2010 in response to rising inflation expectations and growing asset price speculation; bank deposit and lending rates are expected to be raised later in the year. Currency appreciation, also expected later this year, will also draw liquidity from the domestic economy and ease imported inflation pressures. This will help domestic demand become a more prominent driver of growth, by boosting household purchasing power and consumption, helping the Chinese economy move from its overreliance on low value-added exports. However, dialing back the monetary stimulus is expected to be a gradual process, as policymakers remain careful not to scupper employment growth.

Europe's age of austerity

Europe's recovery remains fragile and tentative. The European Monetary Union's reputation has been dealt a blow by recent revelations about Greece's public financial picture. Misreporting of budget and deficit data hid the stark fact that the Greek fiscal deficit had climbed to about 12.7% of GDP last year, while its public debt-to-GDP ratio stands at 115%. Athens must raise €54 billion this year to avoid default. The debt and deficit drama unfolding in Greece has caused credit default swap spreads and the gap between Greek government bonds and safer German bunds to reach record-high levels. Heightened investor concern has also caused credit spreads to widen sharply in Ireland, Portugal and Spain. Credibility concerns and fears of a possible debt default in Greece are expected to keep the euro on the back foot in coming months.

Asymmetric recoveries across the euro area and large divergences in competitiveness, growth and inflation prospects also present policy challenges. The euro zone's common monetary policy will be sorely tested, as inflationary pressures in Germany and France push the ECB to begin normalizing rates later in the year despite the risks to recovery in weaker currency union members. While the recovery in the region’s largest economies grows more robust, smaller nations such as Greece, Ireland and Spain are expected to continue to contract in 2010.

Unhappiness with such monetary tightening will increase tensions within the euro zone and, as a distant possibility, could propel some of the weaker members to seek a way out of the monetary union to regain control over their own interest and exchange rates. More likely is a compromise involving significant help from stronger members of the monetary union—despite much hand-wringing over moral hazard—and painful internal adjustments among the periphery countries to limit public expenditures and wage growth. For this reason, the European recovery is expected to be tepid, with risks weighted to the downside.

Fiscal fog has spread

Economic and political uncertainty extends well beyond the European continent. Governments and central banks around the world have spent more than $11 trillion to support the financial sector and about $6 trillion on fiscal stimulus programs. Without these extraordinary policy measures, private demand would have collapsed, and the resulting social and economic costs would have been even greater. However, costly fiscal stimulus measures and bank bailouts, combined with lower revenues, have rapidly eroded public finances, threatening longer-term fiscal sustainability in some countries.

Policymakers face a difficult balancing act. If they withdraw support too early, they risk depressing demand, hindering job creation, and scuppering the recovery. But delaying fiscal correction measures too long could harm medium- to long-term growth, as public finances would take longer and be much harder to repair. Whilst fiscal policy will remain supportive in most countries in 2010, as the year rolls out, some fiscal tightening will occur, especially in countries where there is evidence of self-sustaining private sector growth.

Fiscal deterioration has also increased pressure on central banks to protect the recovery. Monetary policymakers must guard against further contraction of credit markets, as it would trigger a fresh downward lurch in economic activity. So far, they have done a good job stabilizing the financial system. Credit markets in 2009 rallied in response to extraordinary monetary support from central banks, via emergency-level interest rates and record injections of cash into banks and money markets. The resurgence in credit markets enabled companies to refinance debt, helping to limit defaults. Whilst monetary policy will remain accommodative in the medium term, central banks will gradually drain liquidity and raise key policy rates over the coming year.

An opportunity for change

Emerging market economies with large domestic markets and ample savings will continue to be the main driver of the global recovery in 2010. Investment in infrastructure will remain important in emerging market countries that are using fiscal stimulus spending to lay the foundations for future growth. Many governments around the world see the global downturn as an opportunity to employ underutilized resources, transition to a low-carbon economy, or develop other energy-efficient technologies to strengthen their countries' long-term competitiveness.

Compared with emerging economies, the developed world will not contribute much to growth in 2010. Private sector demand will remain weak, especially in countries still reeling from popped real estate bubbles. Higher saving rates in the U.S. and a number of European countries will temper Western demand for imported goods. At the same time, rising disposable incomes in the East will feed growing appetites for Western goods. The resulting shifts in international trade and capital flows should help reduce imbalances in current and capital accounts and contribute to more stable growth over time.

Global growth will remain well below trend this year as most developed economies will grapple with heavy debt burdens and endure a slow and fitful recovery. Indeed, recoveries in the U.S., Europe and Japan may run out of steam if concern over growing public debt and long-term fiscal sustainability forces a premature withdrawal of policy support.

Downside risks predominate

Most countries face common risks on the road to recovery, principally stemming from actions taken by policymakers as they dial back support and prepare to implement exit strategies. A fresh downward lurch in activity is possible in some countries as stimulus measures fade or are withdrawn. Whilst policymakers need to nurture the fragile recovery in the near term, credible exit strategies and fiscal discipline will be needed to ease investors' concerns regarding fiscal sustainability over the long term, especially in countries with excessive borrowing. Considerable uncertainty continues to cloud the outlook for some heavily indebted countries with large borrowing requirements.

Several clear risks regarding the stability of the international financial and banking system also shadow the medium-term outlook. Commercial banks' ability to finance the recovery in some countries remains uncertain. Banks, especially in the U.S. and Europe, face further loan losses and a protracted period of repairing and shrinking their balance sheets. As lenders remain vulnerable to further shocks they are unlikely to substantially ease credit before a sustained recovery takes hold. This implies that credit growth in the West will remain weak over the medium term and that the full impact of the financial crisis will take several years to unfold.

Furthermore, harsher regulatory and tax environments and restrictions on financial operations in the West could deter the rebound of finance. Whilst the West will remain the centre of finance in the foreseeable future, the fate of some segments of the financial services industry is uncertain as policymakers debate regulatory changes. Tighter financial regulation, including higher liquidity and capital requirements, threaten to place financial centers in the U.S. and Europe at a competitive disadvantage to emerging financial centers in Asia, Latin America, and the Middle East.