ARE THE RICH FALLING BEHIND?

The economy has dominated international concerns amidst inflationary pressures and the recent financial sector turmoil. In the initial months of 2023, indications that the global economy might experience a smooth transition—with decreasing inflation and stable growth—have diminished due to recent turbulence in the financial sector. Despite central banks raising interest rates and declining food and energy prices, inflation has remained stubbornly high. This could be attributed to enduring price pressures and tight labour markets in several economies.

Global Snapshot

The global economy is expected to experience a significant slowdown this year, reaching its third weakest growth rate in nearly thirty years, surpassed only by the global recessions of 2009 and 2020. This downturn, as per experts, is due to coordinated policy tightening measures aimed at curbing elevated inflation, worsening financial conditions, and persistent disruptions caused by the Russian Federation’s invasion of Ukraine.

The banking sector has demonstrated signs of vulnerability, which has sparked fears of possible wider unrest across the financial sector, including nonbank financial institutions. Furthermore, elevated levels of debt continue to impede fiscal policymakers’ capacity to address emerging issues. Although commodity prices, which surged after Russia invaded Ukraine, have shown signs of moderation, the conflict persists, and geopolitical tensions remain elevated.

Global growth is expected to decelerate sharply to 1.7 per cent in 2023—the third weakest pace of growth in nearly three decades, overshadowed only by the global recessions caused by the pandemic and the global financial crisis. This is 1.3 percentage points below previous forecasts, reflecting synchronous policy tightening aimed at containing very high inflation, worsening financial conditions, and continued disruptions from Russia’s invasion of Ukraine.

The emergence of infectious COVID-19 variants resulted in widespread outbreaks last year, but economies that were severely impacted, notably China, seem to be rebounding and alleviating disruptions in global supply chains.

Nevertheless, despite the positive effects of decreased food and energy prices and improved supply chain operations, risks are predominantly tilted towards the downside due to heightened uncertainty in the financial sector.

The baseline forecast, which assumes that the recent financial sector stresses are contained, is for growth to fall from 3.4 per cent in 2022 to 2.8 per cent in 2023 before rising slowly and settling at 3.0 per cent five years out––the lowest medium-term forecast in decades. Advanced economies are expected to see an especially pronounced growth slowdown, from 2.7 per cent in 2022 to 1.3 per cent in 2023.

In a plausible alternative scenario with further financial sector stress, global growth declines to about 2.5 per cent in 2023––the weakest growth since the global downturn of 2001, barring the initial COVID-19 crisis in 2020 and during the global financial crisis in 2009––with advanced economy growth falling below 1 per cent.

The subdued forecast reflects the necessity of strict policy measures to curb inflation, the repercussions of the recent worsening of financial conditions, the ongoing conflict in Ukraine, and the increasing fragmentation of the global economy. Global headline infla tion is projected to decrease from 8.7 per cent in 2022 to 7.0 per cent in 2023, primarily due to lower commodity prices. However, under lying (core) inflation is expected to decline at a slower pace. It is unlikely that inflation will return to target levels before 2025 in most sce narios. Once inflation rates align with the desired targets, long-term structural factors will likely drive in terest rates towards their pre-pandemic levels.

The outlook is significantly biased towards downside risks, with a substantial increase in the likelihood of a severe economic downturn. The strain on the financial sector may escalate, potentially triggering contagion effects that weaken the real economy by severely deteriorating financing conditions. This situation may force central banks to reassess their policy trajectories. There is a possibility of isolated instances of sovereign debt distress, which could spread and become more systemic in the context of higher borrowing costs and slower economic growth.

This has already been seen in many countries in the Global South, like Sri Lanka and Pakistan. The ongoing conflict in Ukraine can potentially escalate (with tactical nukes not being entirely ruled out), leading to further spikes in food and energy prices, thereby increasing inflationary pressures. Core inflation might prove more persistent than expected, necessitating even more aggressive monetary tightening measures to bring it under control.

Global growth is expected to decelerate sharply to 1.7 per cent in 2023—the third weakest pace of growth in nearly three decades, overshadowed only by the global recessions caused by the pandemic and the global financial crisis. This is 1.3 percentage points below previous forecasts, reflecting synchronous policy tightening aimed at containing very high inflation, worsening financial conditions, and continued disruptions from Russia’s invasion of Ukraine. The combination of slow growth, tightening financial conditions, and heavy indebtedness will likely weaken investment and trigger corporate defaults. Further negative shocks—such as higher inflation, even tighter policy, financial stress, deeper weakness in major economies, or rising geopolitical tensions and catastrophic climate events—could push the global economy into recession.

Sliding Western Fortunes

Both the United States and the euro area are currently experiencing a phase of economic fragility. This condition amplifies the challenges emerging markets and developing economies (EMDEs) face. The increasing debt burden of the United States exacerbates the challenges confronted by a decelerating global economy. As interest rates surge and debt levels soar, the vital investments necessary to drive enhanced productivity are being stifled. Clearly, distress in the world’s biggest economy has impacts on everyone.

On May 31st, subsequent to a consensus reached between US President Joe Biden and House Speaker Kevin McCarthy, a bill was successfully passed by the US House of Representatives, which aimed to temporarily suspend the $31.4 trillion debt ceiling. The agreement has temporarily halted the debt ceiling, which is the Congress-imposed restriction on the government’s borrowing capacity, until 1 January 2025.

According to the nonpartisan Congressional Budget Office, the legislation will generate savings of $1.5 trillion over a span of ten years.

As per the agreement reached between Biden and McCarthy, the debt ceiling of $31.4 trillion will be temporarily suspended until January 2025, extending beyond Biden’s current term.

During this period, the government will have the ability to continue borrowing to meet its financial needs. In exchange, the White House has committed to limiting non-defense discretionary spending at 2023 levels in 2024, with a subsequent 1% increase in the following year. The agreement maintains non-defense spending at the same level next year, with a 1% increment anticipated in 2025.

The debt ceiling deal includes caps on spending, but not on defense, measures for returning unspent covid funds, realigning welfare benefits for the able bodied, funds to enforce tax rules on wealthy Americans, and easier licensing for renewable energy projects.

The U.S. Federal Reserve looks set to temporarily pause its aggressive interest rate hikes in response to the alarming situation. Central bankers, both in the U.S. and internationally, are grappling with an additional apprehension regarding the continuous wage increase. This upward trend in wages has the potential to trigger a wage-price spiral, where higher wages propel prices upward, leading to the entrenchment of inflation.

When the Fed stops raising interest rates in response to stable inflation levels, there could be a corresponding slowing effect on the U.S. economy and possibly beyond.

The Dollar Effect

The United States played a pivotal role in instigating a worldwide surge in the cost of living. As signs of abating price inflation become apparent within the country, does it indicate the trajectory that the rest of the world might follow?

The United States was the first major economy to experience inflation, primarily due to a surge in activity and spending driven by government-issued pandemic relief funds. Subsequently, these price escalations extended beyond U.S. borders. Strong demand from American consumers elevated the prices of essential commodities like oil, while global shipping firms increased their fees, and companies coping with shortages raised prices.

However, when the U.S. central bank initiated interest rate hikes to combat this issue, it spurred a flood of capital into the country. As a result, the U.S. dollar strengthened significantly, reaching its highest level in two decades. This, in turn, further elevated costs in other countries.

While the United States was not solely responsible for the abrupt surge in the cost of living, the war in Ukraine also significantly impacted energy markets and food supplies, particularly in Europe. Nonetheless, analysts suggest that if the inflation situation in the United States shows signs of improvement, it could bring positive implications for the rest of the world. This is especially true if it allows the central bank to ease its efforts in combating inflation, potentially leading to stabilization in exchange rates.

There has been a reflection of global price moderation attributed to the recovery of oil markets following the impact of the Ukraine war. Additionally, investors are speculating that energy demand will decline as economies slow down due to the ongoing efforts to combat inflation.

Experts warn that relief from lower inflation in the U.S. may prove a “double-edged sword” since it is likely to reflect a recession in the world’s largest economy. This could prove to be negative for employment and output growth in the rest of the world.

The UK economy is another leading Western economy that has been in the spotlight for the wrong reasons. According to the International Monetary Fund (IMF), the UK economy is projected to have the weakest performance among the G20 countries, including Russia, which sanctions have impacted. The latest projections indicate that the IMF expects the UK economy to contract by 0.3 per cent in 2023, followed by a modest growth of 1 per cent in the subsequent year.The weak economic performance of Britain can be attributed to several factors, including its vulnerability to high gas prices, the impact of rising interest rates, and sluggish trade performance. Additionally, central banks in the UK, the U.S., Europe, and other countries have been implementing interest rate hikes as a measure to tackle inflationary pressures or the rate of price increases.

The Asia Story

China’s post-COVID recovery has thus far been patchy. While in 2008/09, China’s stimulus helped the global economy recover, these, in turn, have left China mired in a mountain of debt. The IMF points out that the local government debt in China has surged to an unprecedented level, reaching a record of 66 trillion yuan, approximately half of the country’s GDP.

The Indian economy is a key contributor to Asian economic growth, and thus far, the broad-based recovery in demand runs counter to the weakness seen outside Asia. India is currently experiencing the advantages of both cyclical and structural factors propelling its growth. As a result, India is projected to contribute 16 per cent to the global gross domestic product (GDP) growth during 2023-24.

Morgan Stanley experts estimate that “Meanwhile, the key macro stability indicators of inflation and current account deficit have moved back into policy makers’ comfort zones, and we expect it will remain there for some time. This suggests that policymakers will not have to bring monetary policy into restrictive territory, allowing economic expansion further room to run. “

“India’s strong growth outlook stands out as the best among large economies, and we forecast it will contribute 16 per cent to global GDP growth over 2023-24.”

Morgan Stanley

India’s economy is anticipated to grow 6.7 per cent in the calendar year 2024, primarily driven by robust domestic demand. While the economic prospects of other South Asian nations face more challenging circumstances, India’s growth outlook is expected to remain strong.

Assessment

Amidst the overall gloom in the global economy, advanced economies of the U.S. and EU are experiencing the worst turmoil. The current situation underscores the need for stringent policy measures to address inflation, the adverse consequences resulting from the recent deterioration of financial conditions, and the persisting conflict in Ukraine.

In this pervading scene of economic gloom, India’s performance has been reassuring through its broad-based recovery in demand. India stands out in terms of growth outlook among large economies propelled by domestic demand.