LOOKING back, the gods of risk mocked investors. The fastest growing economies, India and China, had the worst performing stock markets. Both economies managed to achieve 7%-9% growth last year, but the Sensex and the A share markets were down 24.6% and 21.7% respectively.
In contrast, the advanced economies were supposed to be in crisis, but the US Dow Jones Industrial Average was up 5.5%. True, the European index lost 25% and the Nikkei declined 17.3%, but many of the emerging markets did just as badly.
At first sight, the usual macro numbers did not suggest that 2011 was that serious a crisis year. United States annual GDP had a slowdown to 1.8%, while euro area annual GDP growth was 1.5%. But the eurozone has a sharp downturn in the fourth quarter of -2%. Japan did slip into -0.9% growth, due to the disruptive effects of the tsunami and nuclear disasters.
What caught everyone by surprise was the European debt crisis, which unfolded like a supertanker crash in slow motion.
The delays in getting political consensus and leadership brought the financial markets to brink of panic, but by year end, the combined leadership of German Chancellor Merkel and French President Sarkozy finally stitched together a package that brought some temporary relief to the Italian bond rates.
With new austerity coalition governments in Greece and Italy, there is some hope that the political problems will temporarily not add to the panic.
Taking a more detached perspective, we should treat the period 2007 to 2011 as a double dip crisis. Recent data showed that the crisis really started when European banks expanded far too fast in the period 2002-2007, particularly after the creation of the Euro, relying excessively on inter-bank funding and in US dollars. European banks invested heavily in US AAA-rated but toxic products and it was the July 2007 intervention in inter-bank markets by the Fed and European central banks that marked the true beginning of the global crisis.
The quantitative easing restored liquidity in the system but did not address the core structural problems, which resurfaced in 2011. The double peak effect can be seen by the behaviour of inflation. Inflation peaked in July 2008, before it was stopped by the Lehman crash.
In the wake of quantitative easing, inflation returned, causing the emerging markets to begin raising interest rates again. Inflation fears have receded with declining oil and gold prices, which topped at US$1888.70 per ounce in August 2011, before closing the year at US$1,565.80. Almost all other commodity prices fell in the wake of fears that the Chinese economy was slowing down.
Economic forecasts are by nature biased on the optimistic side, with only lagged recognition that deflation has set in. For example, the Institute of International Finance (IIF) acknowledged that their forecasts in 2011 had to be adjusted downwards.
They see the US economy to strengthen somewhat from 1.7% growth in 2011 to 2% in 2012 and further to 3.5% in 2013. They are cautious on Europe with a decline of 0.6% in 2012 and a recovery of 1.7% in 2013. For Japan, they see a recovery of 2.1% growth in 2012, compared with a decline of 1% in 2011. For the emerging markets, they see slower growth, as exports and capital flows would also slow. The IIF thinks that India would grow only by 6.5% in 2012, rather than 7.8% projected earlier.
The good news for 2011 is that global re-balancing is finally happening. The United States current account deficit has been falling to the range of US$400bil annually, roughly 2%-3% of GDP. Similarly, the Chinese current account surplus has also moderated to around 3% of GDP.
My personal assessment is that the moderation in the Chinese current account surplus will continue faster than most analysts predict, partly due to some deterioration in public sector savings because of the need to deal with the domestic adjustments, and also shifting demand towards domestic consumption.
The general consensus is on the European crisis. The IIF thinks that 2012 will be a make or break year for the Euro. The European governments confront ugly politics, with tough choices whether or not a slimmer version of the eurozone is likely to survive. The stark problem is that the twin banking and fiscal crisis has not gone away. The European banks need to rebuild their capital and they are already cutting back their international loan books.
To reduce risks, many of the European banks are putting funds with the European Central Bank (ECB) for fear of counter-party credit risks with each other. Ironically, central banks in the advanced countries have de facto replace their banking systems as the primary engine of credit during crisis. Mandated only with the target of price stability, the ECB has to deal with the liquidity of both the banking system, as well as the borrowing rates of the key member countries such as Italy.
This is a situation that cannot continue forever, as rising interest rates reflect a lack of confidence in the system, while higher rates will accelerate the pace of insolvency. Ultimately, the integrity of the eurozone hangs on the solvency of the whole. If the interest rate and debt burden is too heavy, it will break.
Hence, the eurozone politicians basically face an unpalatable choice. They have to solve the fiscal union and bite the fiscal pain, but the question is whether their electorate will tolerate that pain.
My real concern is that the ECB is the only credible institution that can act fast enough to deal with the liquidity situation, but it does not have the fiscal powers to tax and pay its way out of the mess. That is ultimately in the hands of the politicians. The triggers for crisis tend to happen when your eyes are off the ball and they come from areas you did not suspect.
2012 is likely to be full of such surprises.
Andrew Sheng is president of Fung Global Institute.
Think Asian
By ANDREW SHENG, http://biz.thestar.com.my/news
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