Article / 02 October 2015 at 11:30 GMT

IMF worried about wobbling world

Managing Partner / Spotlight Group
United Kingdom
  • IMF head Christine Lagarde expects EM slowdown
  • China remains uncomfortable with truly free markets
  • US corporate debt issuance an arguably bullish sign

Chongqing
The economic slowdown in China and its effect on world markets will doubtlessly 
be on the table at the IMF summit in Lima. Photo: iStock

By Stephen Pope

Christine Lagarde, the Managing Director of the International Monetary Fund, has suggested that global economic growth is probably going to come in on the softer side of expectations for 2015 given the multitude of problems that currently confront the world. These include…

• The slowdowns in Brazil and China
• Falling commodity prices
• An addiction to accommodative monetary policy
• An emerging market crisis once the Federal Reserve raises rates
• Turmoil in the Middle East leading to a refugee crisis in Europe

While she has looked for a moderate rebound in growth in advanced economies such as the US, Europe and Japan, she said this would be tempered by emerging economies who would endure a fifth consecutive year of slowing activity.

What fetters growth?

It is Mme. Lagarde’s opinion that the global economy will operate at a sub-optimal point inside its production possibility frontier as the growth potential was being restrained by low productivity, ageing populations and an overhang from the financial crisis (i.e. high consumer and sovereign debt levels).

Whereas it was once seen that the emergence of China and perhaps India and Brazil as global economic powerhouses would act as a great counterbalance to any slowdown in the mature developed economies, what became clear is that it would be critical to properly manage the transition in China to consumer-led growth. India is still held back by the caste system that effectively cuts many people out of society.

Brazil has not exploited the abundant economic opportunities that were afforded it with the staging of the 2014 FIFA World Cup and the 2016 Summer Olympics. Brazil’s central bank is now forecasting a much deeper recession as the country is hit by weak commodity prices, rising borrowing costs, political turmoil, and capital outflows as investors pull out of Latin American markets.

Such points are going to repeated next week at the annual gatherings of the IMF and World Bank, this year in Lima, Peru. One can expect that such a forum will see many of the smaller developing/emerging economies express their dismay at the collapse of almost every agricultural, metallic and mineral commodity. 

Brazil
A collapse in commodity prices, a stumbling currency and political turmoil have combined 
to produce something of a perfect storm for Brazil of late. Photo: iStock 

Although emerging markets did accumulate bigger emergency currency reserves and that has allowed their currencies to help absorb economic hits, Lagarde has said she is concerned that many emerging markets may have expanded their capacity to buffer against shocks in the wake of the financial crisis.

To coincide with the meeting, the IMF will release the latest economic forecasts and in her preview comments Lagarde suggested that global GDP growth was expected to be weaker this year (last forecast 3.3%) than last year (growth was 3.4%). 

There will be just a modest improvement in 2016.

Global GDP
Source: IMF, World Bank

One nation that will get a mention is Russia. Its economic fortune is closely tied to the fate of the commodities market and one can see that over the past three years, the correlation of the USDRUB rate and WTI crude has been 93%. Russia's economy is forecast to contract by 4% this year; once again forecasts are revised lower as evidence mounts of a protracted slump. 

The outlook has grown progressively gloomier for several months as signs of a China slowdown add to problems for Russia caused by low oil prices and Western sanctions imposed because of the Ukraine conflict.

As the economy struggles it is something of a concern to see the nation getting involved in a war front as bombing in Syria commenced this week.

China syndrome 

Lagarde also said China’s transition from export-led growth to a focus on domestic consumption-led growth presented a series of challenges for Chinese officials. Beijing is facing the problem of matching a centrally controlled fetish with the untidiness of the free market. 

I have said before that Beijing has shown how naive it is when comes to the market mechanism as it is clearly uncomfortable when asset prices decline. Free markets do not behave like a trained animal, they are wild and capricious. Often they can be ugly.

Many nations want to be China’s “best friend in the West” and that desire blunts the ability of Europe and US to call China out for the crude manner in which it is dumping steel onto the world market. 

As its own consumption needs for steel have declined, the steel mills have held their production levels despite the market already being crushed by oversupply. On this issue, the Chinese need to taken to task by the World Trade Organisation.

Ending the zero rate policy

Another tricky transition the world will have to manage is a change in interest rate policies in the US as the Federal Reserve prepares to raise rates away from the record low of 0.00% to 0.25% that was set in December 2008.

Once the market is convinced the Fed will move Fed Funds higher by 25 basis points one will see the US dollar make swift gains. That could create difficulties in the emerging markets and lead to a number of currency mismatches, leading to corporate defaults or wider credit events.

According to credit rating agency Standard & Poor’s, 52 companies defaulted on their debt in the first six months of this year. That’s more than double the number of companies that missed interest payments in the first half of 2014, and is worryingly close to the 60 companies that defaulted in all of 2014. It is also the highest pace of defaults since 2009.

If the USD rises the effect of other nations' import elasticies will impact US corporate export earnings. The Duke University/CFO Magazine Global Business Outlook Survey polled 1,000 business executives, mostly CFOs, around the world. 

Two out of three big US exporters – i.e. those with at least 25% of their total sales derived from overseas – said an appreciation of the dollar would have a negative impact on their businesses. And nearly a quarter of big exporters said they would have to reduce their capital spending plans as a result. A fall in earnings would imply future debt servicing would become more difficult.

The rise in defaults is partially because of mounting difficulties in the energy sector. Oil companies significantly increased their borrowing in the past few years so as to ramp up drilling and capitalise on high oil prices. 

Oil
The era of $100-plus/barrel crude saw oil companies invest in infrastructure. Photo: iStock 

Instead, oil prices have plunged and in May, a Fed study revealed that commercial banks were reducing or calling in oil companies' credit lines. They were demanding more collateral on new borrowings. Of the companies that have defaulted this year, 13 have been in the oil related industry.

There have been several notable bankruptcies so far this year including RadioShack and Doral Financial, one of Puerto Rico’s largest banks. Another notable corporate defaulter is coal mining company Walter Energy, which missed interest payments for a third time in June.

However, it is not all gloom as corporate America in general has taken advantage of low interest rates to not simply borrow more, but to refinance their borrowing by exploiting record low capital costs and buying back more expensive debt issues or shares.

Still, we must heed the IMF's warning as it is easy to understand why when interest rates rise, many companies will not be able to either repay or be able to afford to refinance their debts at higher rates. If corporate default rates rise across the world it will be a severe knock back to global growth.

If wants to end this note with a dose of optimism, one can argue that the fact that US corporate debt issuance is rising at its fastest pace ever in 2015 is a sure sign that corporations are more confident about the economy.

It all depends on whether one sees the glass as half full or half empty.

— Edited by Michael McKenna

Stephen Pope is managing partner at Spotlight Ideas

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