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After a year of financial shock and sharp economic loss, 2009 is likely to be extremely difficult for the global economy, with investors, business leaders and policymakers struggling to find signs of recovery, according to Wharton faculty and academic partners around the world.
“It’s all pretty negative,” says Wharton finance professor Franklin Allen. “The economy is going into a recession and my own view is that it will be deep and quite long-lasting. There doesn’t seem to be anything on the horizon that is a bright spot.”
In the wake of crumbling stock markets, mounting bad debt and rising unemployment, policymakers are scrambling to devise strategies to restore stability and lay the groundwork for new growth. “There’s no country in the world that’s doing well,” Allen continues. “Everybody is doing badly, with large amounts of debt and heading toward deflation,” plus “unemployment and a rush by companies to fire people.”
The collapse in the United States is different than in other industrialized countries around the world because the problems began in the financial sector and spread out into the broader economy, says Wharton management professor Mauro Guillén. In the rest of the world, problems in the real economy — created largely by trouble in the United States — led to weakness in financial markets. “In the United States, the key in 2009 is, ‘Can we clear up the mess in the financial sector?’ Unfortunately, I’m not very optimistic,” says Guillén.
Wharton finance professor Richard Marston says he is shocked by the impact of the crisis on U.S. financial firms and markets. “To see Wachovia, Wash Mutual, Citi all gravely wounded. It’s extraordinary.” Marston contends that while the banks have been shored up, they are unlikely to lend for a long time. On top of that, he adds, the inability to securitize will constrain credit more than if banks alone had cut back on lending.
Looking ahead, other shocks — bankruptcies, bond defaults and additional job losses — will buffet the economy, according to Marston. While markets have probably priced these events in, people will be shaken up when they actually occur, adding further jolts to confidence. He notes that during the 2001 recession — which was not as serious as today’s — the economy turned upward in November, but large job losses continued through 2002. Worse, he says, demand remains depressed around the world. “This is our first world-wide recession in a long time. And the engine of past recoveries — the American consumer — is in the repair shop for an overhaul.”
Businesses will hold back from investing until there is a revival of demand, he continues. “Where will demand come from?” asks Marston, who sees no obvious answer. “So I think the consensus in the press that recovery will start ‘sometime in 2009′ may be wishful thinking. We shall see.”
John Percival, Wharton adjunct professor of finance, says the nation is still facing a mortgage crisis that will hamper recovery. He points out that while foreclosure rates are already high, many mortgages are due to reset in the coming years. Those mortgages may not be as shaky as subprime debt, but many are still likely to become problem loans. Further, he says, the commercial mortgage market is likely to start falling into default, and financial institutions will face problems with consumer credit.
“It’s easy to say that this, too, shall pass. People are talking about 2009 being tough and things will turn around in 2010,” says Percival. “I’m not so sure. It could be longer than that.”
Allen predicts that unemployment will continue to rise and the economy will remain weak as consumers and businesses refrain from new spending until they are confident asset prices are no longer falling. “We need things to stabilize,” says Allen. “The problem at the moment is that people don’t know what their wealth is.” Americans have no idea what their investment portfolios or real estate holdings are really worth and, as a result, are afraid to spend or make additional investments. “I think everybody is frozen with fear of losing their jobs and the rest of their wealth. There’s huge uncertainty. Until that starts going away, until things stop getting worse, we’ll keep going down.”
Percival says the rate of consumption in recent years, fueled by easy credit and excess borrowing, was too much of a good thing for the U.S. economy. Ultimately, though, consumers will return to the malls, auto showrooms and the real estate market. “The consumer will be chastened for a while, but I can’t see any dramatic change in the long run.”
He notes that the emergence of bargain prices for stock in world-class companies is one positive note in the gloomy economic picture. “The prices you can buy these companies for are ludicrous. If you have some liquidity and a little bit of patience and a little bit of courage, there certainly are some wonderful buying opportunities out there.”
According to Allen, the early weeks of 2009 will be marked by a wave of bad economic news as the incoming administration attempts to lay the political groundwork for a massive stimulus package. “They need to get everything out as soon as possible,” he says. “It will be a very negative January and February and then hopefully things will start to stabilize. I think we have some painful months in front of us.”
While the Obama administration will be pressed to take action to address the financial problems, adds Percival, it runs the risk of creating additional problems, primarily rising government debt and inflation. Meanwhile, he says, the global economy continues to remain vulnerable to oil price shocks. Finally, given the severity of the current economic crisis, politicians will find it next to impossible to stand up and take decisive action on the funding gaps in Medicare and Medicaid. “This will be put on the back burner, but the longer we wait to solve these problems, the bigger they are going to be,” warns Percival.
Marston says the Obama administration’s fiscal stimulus plan could result in an economic “spring thaw” that may only be temporary. “The fiscal stimulus is desperately needed to make sure things don’t get worse. But I am pessimistic about the long-term impact of all of the spending. The pump priming may not really get things flowing. We need another source of demand — consumers, exports, investment?”
Meanwhile, an auto industry bailout may only postpone for a time major restructuring that will erode the financial security of workers and retirees, particularly in Michigan, suggests Allen. “I don’t think they can avoid it being like a Great Depression.”
U.S interest rates are hitting historic lows and a flood of liquidity is coming into financial markets through Treasury bonds, he adds, noting that low interest rates did not do much to speed recovery in Japan in the 1990s and he does not expect them to help much in the United States now.
Europe: Hit Hard — and Early
The new year will also be difficult in Europe, in part because the recession started there about six months later than in the United States, says Guillén, who is also director of Wharton’s Joseph H. Lauder Institute of Management & International Studies. He adds that European economies are less flexible than the U.S. system and will take longer to adjust to the changing economic climate, prolonging the downturn. “The outlook for 2009 in Europe is not great. It’s going to be a difficult year.”
The global economic slump threatens to stall Eastern Europe’s promising economic growth. “For the last 10 years, all these countries have been trying to make the transition to a market economy, and the financial systems are kind of shaky,” he says. “I think they’re going to have some hard times.”
While the transition will slow growth, Guillén does not believe governments in these emerging markets will backslide into protectionism or reject other free-market characteristics of their economies, although they may postpone additional reforms. “The countries that have become members of the European Union realize how important that is for them and they don’t want to do anything that will jeopardize their standing,” Guillén notes.
Meanwhile, Russia is suffering from a sharp decline in oil prices, and is a key factor in what will happen in the European economy in 2009.
According to Guillén, Russia’s manufacturing sector is not competitive globally and the country has essentially become dependent on commodities which fluctuate wildly in value. Despite a well-educated population with strong capabilities in engineering and science, Russia’s commodity booms have crowded out investment in other parts of the economy, undermining global competitiveness.
Allen points out that Europe is experiencing a deep recession, especially in the United Kingdom. Germany, Spain and Ireland have also been hit hard, although France is holding up a little better because greater state involvement in the economy is somewhat cushioning citizens from the downturn. Italy, despite long-term structural problems in the economy, is also faring relatively well at the moment because of low levels of debt.
Europe, he adds, is likely to experience deflation, but will keep interest rates at 1.5% or 2%, while the United Kingdom will be more aggressive and may let rates fall to zero percent or 0.25%. Low rates have advantages and disadvantages, he says: While they help soften the impact of recession, they can delay recovery.
Around the world, emerging markets in Latin America, India and China are still growing, but at lower rates — exposing some underlying problems in their economies.
Latin America: Economic Highs and Lows
Latin America, which is typically a casualty in global financial crises, has managed to keep itself afloat this time. According to Juan Carlos Martínez Lázaro, professor at the IE Business School, Latin America finished 2008 with a growth rate of more than 4%. The first part of the year was very strong as a result of record-high prices for raw materials, making up for the sharp declines during the second half of the year.
However, 2009 is going to be hard for Latin America, which will not be able to totally escape the global economic problems, says Martínez Lázaro. He predicts that the region will suffer the impact of the global downturn in several areas: manufacturing exports, remittances from workers living abroad, investments and financing. Some countries will suffer more than others.
Exports of raw materials will be affected by dropping prices amid declining global demand. Exporters of petroleum, including Venezuela, Mexico, Peru and Ecuador, will suffer the most. Chile, one of the world’s largest exporters of copper and molybdenum, will see a drop in its export revenues and lower investment in new projects because of declining tax revenues, says Juan Carlos Guajardo, executive director of CESCO, Chile’s center for research on copper and mining. Central American and Caribbean countries will be net importers of raw materials.
Latin American manufacturing exports are also expected to decline, following lower demand from U.S. consumers. Remittances to Latin America will also drop, which will have a strong impact on Latin American countries that have a lot of immigrants working abroad, such as Mexico and Ecuador. In addition, Martínez Lázaro forecasts a drop in foreign direct investment in 2008 and 2009. “Fewer and fewer companies are committing themselves to new projects, and this will be felt in such countries as Brazil and Mexico, which attract the most investment in the region. However, it will also be felt in such countries as Peru and Chile,” he notes.
Financing throughout the region is increasingly difficult and expensive. In Brazil, for example, Anita Kon, a professor at the Pontifical Catholic University in S?o Paulo, notes that “credit is increasingly scarce, interest rates continue to be very high and inflation will accelerate, given global conditions in which the supply of certain food products and other commodities doesn’t meet demand. Brazil does not have enough savings of its own to finance the development and modernization of its infrastructure and manufacturing structure. It depends a great deal on externally financed loans and foreign direct investment.”
Large-scale public sector investments in infrastructure have already slowed and will do so even more in 2009, especially since tax rates are already very high and are in no condition to increase, Kon explains. Although Brazil has foreign exchange reserves that exceed $200 billion, she says financing currently depends on short-term capital speculating against Brazil’s currency, the real, which will lead to a dramatic rise in the price of the dollar. “Brazil continues to be vulnerable, because it strongly depends on short-term speculative capital to balance its external accounts.”
Meanwhile, Chile’s financial system is relatively strong and its fiscal accounts are in good shape, according to CESCO’s Guajardo. “Chile took advantage of the period of high prices [in raw materials] to reduce its debt to low levels, and to accumulate [foreign exchange] reserves of more than $20 billion, which will enable it to sustain an expansionary budget in the coming year.”
As for the populist sentiment stirring in the region, Martínez Lázaro quotes Ricardo Lagos, former president of Chile, “who once said, ‘It is easy to be a populist when your wallet is full.’ We’ll find out if it is so easy now to be a populist or become a demagogue.” In his view, leaders such as Hugo Chávez in Venezuela and Evo Morales, in Bolivia are going to feel the impact of the crisis a great deal. Any possible deterioration in social conditions in other countries could also lead to more populism.
Generally, Latin America was well prepared for this crisis. “During boom times, they did their [macroeconomic] homework, so 2009 is not going to be dramatic,” states Martínez Lázaro, adding that the entire region is going to grow more slowly, at about 2.5%. While growth will slow, he says, the region should not drop its guard. Latin America “can pursue a very stable macroeconomic policy and [also] reduce [social and economic] inequality. It would be a shame if [Latin America] loses its way moving down that road.”
India’s Diminished Expectations
In India, the official line is “cautious optimism.” In December, the government reported that economic growth in the first half of the current fiscal year (April-September 2008) was 7.8%, a strong showing in a global economic slump. The government projects full-year growth at 7%, but expects to fall short of fiscal and revenue deficit targets this year mainly because of stimulus measures that could total up to 2% of the nation’s $1.2 trillion GDP. The fiscal deficit may jump to 5% of GDP compared to the targeted 3%, according to the government. Overall, however, officials say the economy should not be hard hit because services and agriculture account for 55% and 18.5% of GDP respectively, and these sectors are less affected by cyclical downturns.
The official optimism is not fully echoed in other circles. Japan-based Nomura Securities puts India’s current growth at 6.8% and predicts a decline to 5.3% for 2009-2010. Rajiv Kumar, director and chief executive of Delhi-based think tank Indian Council for Research on International Economic Relations (ICRIER), sees it going as low as 3.9% — or even lower — in the first half of the fiscal year.
Other indicators also point to hard times for India, where in recent years the economy was soaring. Industrial output fell 0.4% in October, marking the first decline in 15 years, and exports were down 12%, the first decline since 2003. Excise duty collections plunged 15% in November.
The bright spot in the Indian economy is inflation, which dropped to nine-month lows of about 6.6% in December. HDFC Bank chief economist Abheek Barua expects inflation to drop sharply to below 2% by March due to the declines in prices for manufactured goods and commodities. A. Vinay Kumar, a professor of finance at the Indian Institute of Management in Lucknow (IIML), says the easing of inflation is “the most heartening story of all.”
Hari Rajagopalachari, executive director at PricewaterhouseCoopers, has a different view. “Inflation is going to be high because of the injection of huge amounts of cash into the economy through monetary policies,” he says. “India is largely a supply-constrained economy. Putting more demand into the economy does not necessarily mean that there will be an equal supply of products or services.”
Rajesh Chakrabarti, a professor of finance at the Hyderabad-based Indian School of Business (ISB), expects Indian corporate performance to suffer. “The government stimulus will help the situation a bit, but it is unavoidable that profits will fall and margins will decline. At the same time we should not expect large losses for most of the major companies. They will maintain profitability though it will not be as good as in the past.”
Exports — where much damage has already taken place — will continue to suffer. “Nothing is going to improve before 2010-11 because the whole global situation is going to remain depressed all through 2009,” says Chakrabarti. Adds Kumar: “The export sector is not in good shape because of the volatility in the exchange rate. The rupee depreciation is a respite, but greater volatility is a matter of concern.”
The rupee depreciation is unlikely to be India’s saving grace much longer; experts expect its value to return to around 40 to the dollar, down from more than 50 in recent months. Kumar predicts the rupee will be around 40 or 42 to the dollar in 2009.
Chakrabarti says the dollar has appreciated against almost every currency in the world as worried investors seek safety in U.S. Treasury bonds. “Once people think that the crisis is over, there will be a reversal. This may bring down the dollar a little bit and the rupee may appreciate to around 45 or so. I don’t see the rupee falling much further than where it is now.”
The Sensex — the Bombay Stock Exchange Sensitive Index — may increase slightly in the coming year. “The market is expected to be flat, between 9,500 and 10,500, and could even come down below the 9,000 mark before the general elections” due in the next few months, says Kumar. Chakrabarti predicts the market will move sideways. “While the Sensex may go up slightly, I don’t see any sustained rise. If we manage to reach 12,000 by December 2009, it means we are doing wonderfully well.”
China: How to Support Future Growth
China, another once-hot emerging market, is also likely to face setbacks this year. Just a year ago, China’s central government cited inflation as its biggest economic concern and announced it would shift monetary policy to prevent the economy from overheating. Now, the hope that China would continue to be a rising economic star is fading and the resilience of China’s economy will be tested.
A December report released by People’s University of China in Beijing found that the current downward cycle signals the collapse of the nation’s growth model based on U.S. consumption along with Chinese savings and other exports. While China is widely expected to grow at 8% next year, the People’s University report predicted the economy will suffer from declining global demand and less ability to drive the economy forward with investment. Meanwhile, China’s inelastic demand and supply structure will make it hard for the nation to react to economic change.
Even before the Wall Street financial crisis hit, China’s export-oriented economy was under pressure. The international community was pressing China to raise the value of its currency. In addition, thousands of factories in south China were shutting down due to tighter regulation of product quality and labor and environmental standards, signaling that deep change in the economy is coming.
Andy Xie, an independent economist, says the government’s massive stimulus package of RMB 4 trillion ($586 billion) announced in November will bring some improvement to the economy in the second half of 2009. However, the plan does not address a key issue: The Chinese people cannot afford to buy the goods they produce. Xie suggests an effective approach to improve the economy would be to subsidize consumption and home purchases.
“It’s very possible that China will expand policies in this regard and the economy will be better in the second half of 2009,” he says. “The stock market might have a rebound by then, but it will only be a rebound, not a real bull market. The key issue is, what shall we rely on to support our future growth?”
At a December central government meeting on the economy in Beijing, China’s top leaders placed a priority on changing the nation’s growth engine. Wu Jing Lian, a prominent economist and member of the State Council’s Research Center, told journalists after the meeting that China’s existing growth model leads it to suffer when the U.S. economy runs into trouble. “It makes us believe that … we have to focus on the structural adjustment and growth model reform, which will be the only way for us to survive.”
In his column in Cai Jing magazine, Huang Yi Ping, chief economist for Citigroup Asia Pacific, writes that “the sky will not fall even if growth is lower than 8%.” He assured readers that China’s government is determined to keep growth above that level and is capable of making that goal.
However, he questions why the government’s stimulus package does not focus on consumption. “We can’t expect to solve trouble by investing in infrastructure every time. Ten years ago, China needed a lot of infrastructure, but today our infrastructure is even better than many developed countries. The focus should be on people’s lives, the quality of growth and [ways] to make ordinary people richer.”
Some scholars have offered detailed suggestions on how to boost the Chinese people’s disposable income. Chen Zhiwu, a finance professor at the Yale School of Management and a visiting scholar at Chang Kong Business School in Beijing, said the government should give tax drawbacks to subsidize the low- and middle-income households, individuals and farmers; increase China’s investment on healthcare, education and social security with the goal of making people more secure and willing to release savings; facilitate a trading market of rural land use rights; and take bold actions to cut taxes on enterprises and individuals.
Toyota Underscores Japan’s Woes
As the rest of the world comes to grips with the global financial crisis, Japan, the world’s second-largest national economy, is suffering too. Wharton’s Allen says Toyota’s first money-losing quarter underscores the severity of Japan’s economic problems. Not only are Toyota and other Japanese companies facing a slowdown in demand from China and the U.S., but investors are seeking safe haven in the yen. As the yen rises in value, Japanese exporters suffer even more in the global economy.
In addition, Japan faces political uncertainty. Its third prime minister in three years is already facing a lack of confidence in the polls. “The last three prime ministers have been disasters,” says Percival. “The few actions they took have been strange and bizarre. And it looks like the prime minister will change again, which makes Japan’s ability to deal with the situation more complicated.”
Allen says Japan’s economic future is troubled. “But on the positive side they have been dealing with these problems for 20 years and they have come through it without huge damage. So this society is resilient and the economy is resilient. It will be difficult for them, but not terrible.”
In a way, Japan is especially relevant in today’s global economic crisis because of its experience with a sharp economic decline and struggle to revive in the 1990s — often referred to Japan’s “lost decade.” Its policy makers tried a variety of fiscal and monetary stimuli that may provide clues to how today’s global economic leaders should approach the current problems.
Wharton management lecturer Adrian Tschoegl worked for six years as a macroeconomist at a Tokyo investment bank during that country’s economic rise and fall. “That’s when I realized that most forecasts of complex political and economic events are valueless,” says Tschoegl. He says he made some good calls and some bad calls when he was working in Japan, but came to believe that in today’s complex, interrelated global economic system, it is nearly impossible to predict the true impact of one policy action or another.
“We can come up with some ideas and a range of forecasts and some information about the risk of what is out there,” he says, “but the reality is that all sorts of things can come out of nowhere and suddenly hit you.”
When governments attempt to enact policies to respond to economic problems, it is hard to tell what will happen one or two steps forward as policies and market forces begin to interact, he adds.
“The problem is that very often the best thing to do is to simply not do anything,” says Tschoegl. “But no politicians can bring themselves to stand up here and say, ‘We don’t have the faintest idea of what to do, and right now we’re not going to do a damn thing.’”