Daily Themes
28 May 2010

Europe’s fiscal tightening to have a negligible impact on global growth

Our 2010 Investment Outlook “Sailing into the wind” was thus named because of our confidence that the global recovery would continue, but with significant headwinds as the year progressed. Fiscal tightening was one of the three key risks we identified, and the Greek debt crisis has triggered a wider ‘involuntary’ fiscal consolidation process across the euro-zone. Our analysis of this process suggests it will push most of the peripheral euro-zone countries back into recession, but will not be enough to derail the global recovery. Outside of the eurozone, countries such as the UK and Switzerland will take the biggest hit from the slowdown in the euro-zone, while the US and Japan should be relatively unaffected.

We estimate the fiscal consolidation plans announced by European countries will cut around 1.7% from GDP growth over the next 12 months, causing the euro-zone to almost stagnate this year. One of the transition mechanisms through which the euro-zone crisis could have an impact on global growth is trade. Lower European growth translates into lower demand for imports from their major trading partners. In addition, the depreciation of the euro makes foreign products less competitive, especially for products priced in such “safe heaven” currencies as the dollar, yen and Swiss franc.

Switzerland and the UK are the most dependent on trade with the European Union (EU), with between 50% and 60% of their exports going to that area in the past 5 years. This is equivalent to more than 20% of Swiss GDP and a little bit less than 10% of UK GDP. On the contrary, 14% of Japan’s exports go to the EU, making up only 2% of GDP. About a fifth of US exports are directed to the EU, but this equates to just 1.7% of GDP, which is mainly driven by domestic consumption.

China also sends about a fifth of its exports to the EU, but this translates to a little bit more than 5% of GDP given the greater importance of exports to China’s economy. For all of Asia ex-Japan, 16% of exports are to the EU, making up 6% of GDP.
 

 
Cleary the fiscal tightening process that has started in the EU will take a toll on global demand. However, we believe this will not be enough on its own to derail global recovery. The euro-zone represents 22% of world GDP at current exchange rates and about 15% based on a measure of equilibrium exchanges rates. So a reduction in euro-zone growth of 1.7 percentage points relative to its trend rate would reduce world GDP growth by 0.3 to 0.4 of a percentage point in the next 12 months. This leaves plenty of room for the global recovery to continue, with the most recent Consensus Economics forecast for world growth to be 3.4% in 2010.

Fiscal tightening is not necessarily bad news for financial assets. A smaller public sector will allow the private sector to take a higher share of the domestic economy and grow faster (‘crowd-in’ effect). Tighter fiscal policy from the governments in advanced countries would enable central banks to keep interest rates low. Rates are likely to remain lower for a longer period than previously expected, which may lead to a re-rating of global equities. In our view, the transition from a loose monetary/loose fiscal policy mix to one of loose monetary/tight fiscal policy will prove favourable for risky assets in the medium term.

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