Wall Street's Best Minds
Citigroup: ‘Rapidly Rising Risk’ of Global Recession
A global downturn fueled by China’s woes could very well soon be upon us, warns Citi’s top economist..
By Willem Buiter
Editor’s Note: This is excerpted from a much longer piece with charts by Buiter, chief global economist with Citigroup.
This paper develops the idea that a global recession – a period of global output below potential output – is a high and rapidly rising risk. We argue that recession may now be the most likely outcome over the next few years. This is indeed the view now held by Citi’s Global Economics team, although the debate across our broader economics team remains fervent.
It is to be expected that economists – even economists working for the same team – have different views about the likelihood of different future outcomes. Economics isn’t rocket science, and even rockets frequently land in the wrong place or explode in mid-air. We believe we provide a better service to our clients if we don’t pretend there is a consensus if there isn’t one. It is better to provide a range of alternative forecasts, and to explain the reasons for the differences between them, than to present a phony consensus.
Since 2010, Citi’s global growth forecasts for the next year, like the consensus global growth forecasts, have started each year at a consistently high level, only to be revised downwards systematically during that year. The forecast for the next year, made at the beginning of that year, was invariably higher than the final estimate of growth in the previous year.
Over the course of this year our downgrades have been mostly for emerging markets while our upgrades have been mostly for developed markets. That has also been the pattern for the earlier years. A notable exception is the US, where the pattern of starting high and ending low has also been evident. For instance, the January 2015 forecast for US real GDP growth for the year 2015 was 3.6%.
By August 2015 it had fallen to 2.5%.
This scenario of a global recession of moderate depth and duration, starting in the second half of 2016, is not yet reflected in Citi’s benchmark forecasts for China’s growth, emerging markets growth and global growth.
When Citi’s most recent forecasts for global economic growth and for economic growth in China were made, in the August 2015 issue of our Global Economic Outlook and Strategy (GEOS), a global recession was not the most likely scenario.
These forecasts are clearly too optimistic to be consistent with a modal recession scenario. Our best guess of potential output growth for the global economy is 3% per annum or just below it. According to Citi’s benchmark forecast, actual global growth is therefore likely to be at or just below potential growth for the current year, rising slightly above it for the four years following. In the Global Economics team, however, we believe that a moderate global recession scenario has become the most likely global macroeconomic scenario for the next two years or so. That does not mean that a moderate recession as described in this paper, starting in the second half of 2016, has a likelihood of more than 50%.
We do believe that a recession is the most likely outcome during the next few years, but it is important to distinguish between a moderate recession without a regional or global financial crisis and a deep or severe recession accompanied by a regional or global financial crisis.
To clarify further, the most likely scenario (40% probability), in our view, for the next few years is that global real GDP growth at market exchange rates will decline steadily from here on and reach or fall below 2% around the middle of 2016. Growth is likely to bottom out in 2017 and start recovering again from late 2017 or early 2018. The output gap could be closed (the world exits recession) late 2018 or 2019. The next most likely outcome (30%) is that the global economy will avoid recession during the next few years and grow at a rate roughly equal to that of potential.
There is also a probability of 15% that the global economy goes into severe recession and financial crisis, and a 15% likelihood that the global economy will enter a boom (a period of overheating), with output above potential and, for a while, growing faster than potential.
In our view, the probability of some kind of recession, moderate or severe, is therefore 55%. A global recession of some kind is our modal forecast. A moderate recession is our modal forecast if we decompose recession outcomes into moderate and severe ones and assign separate probabilities to them.
In this publication, we analyze how, starting from where we are now, the world economy could slide into recession, defined as an extended period of excess capacity: the level of potential output exceeds the level of actual output, or the actual unemployment rate is above the natural rate or Nairu. The recession scenario is that of a recession of moderate depth and duration, without a major regional or global financial crisis. We conclude that if the global economy slides into a recession of moderate depth and duration during 2016 and stays there for most of 2017 before staging a recovery, it will most likely be dragged down by slow growth in a number of key emerging markets (EMs), and especially in China. We see such a scenario as increasingly likely. Indeed, we consider China to be at high and rapidly rising risk of a cyclical hard landing.
The reasons behind China’s downturn and likely recession are familiar from the long history of business cycles everywhere: rising excess capacity in a growing number of sectors, excessive leverage in the private sector and episodes of irrational exuberance in asset markets – in China there were two thus far, for residential real estate and equity – resulting in booms, bubbles and busts. This is the classical recipe for a recession in capitalist market economies. This time is unlikely to be different for China. Policy options to prevent a recession exist but are, in our view, unlikely to be exercised in time.
Should China enter a recession – and with Russia and Brazil already in recession – we believe that many other EMs, already weakened, will follow, driven in part by the effects of China’s downturn on the demand for their exports and, for the commodity exporters, on commodity prices.
We also consider it likely that, should the EMs enter recession territory, the advanced economies or developed markets (DMs) will not have enough resilience, either spontaneous or policy-driven, to prevent a global slowdown and recession, even though many large developed markets will not experience recessions themselves but will merely grow more slowly, and possibly more slowly than potential, and more slowly than expected.
When forecasting the outlook for growth in China we have the further problem that the official GDP data are ‘manipulated’ to such an extent that ‘true’ real GDP growth is likely to be at most weakly positively correlated with real GDP growth according to the official data. There has been a long history in China of the official GDP data understating true GDP during a boom and overstating it during a slowdown, but the degree of overstatement of ‘true’ growth by the official data since about 2010 goes well beyond such ‘smoothing’. Incorporated in our August forecast in Figure 3 is our best forecast of what the official data will report as real GDP growth for 2015 (6.8%) and for the next four years between 6.2% and 6.5%.
Conclusion
There are two risks that could worsen the outlook:
1) The first is that we get another systemic debt crisis, in developed markets, in emerging markets, or both. The emerging and developed markets remain very highly leveraged. In many advanced countries, the public debt burden is higher than it has ever been except during and in the aftermath of major wars, when the political economy of spending cuts and tax increases was very different.
Combined public and private non-financial gross debt burdens are at a record high. In many EMs, private leverage has soared.
We simply don’t know much about how to engage in effective macroeconomic stabilization in highly leveraged environments, or how to manage a financial crisis and limit the immediate damage it does without increasing the likelihood and the magnitude of the next crisis, and bringing it forward. The track record of the supervisory and regulatory authorities, central banks and finance ministries in most DMs (and in all large DMs) before, during and since the Great Financial Crisis has been poor.
For some of these actors, this may have been because of political constraints, beyond their control, on their ability to act. Many of the supervisory, regulatory, monetary and fiscal authorities in the EMs are untested in a severe financial crisis.
The last time we faced a situation like this there were, outside Japan, policy interest rates that could be cut, and most countries had more fiscal space. Today, the interest rate is out of commission as a policy instrument in most DMs and fiscal space is more severely constrained than in 2008 almost everywhere.
2) The second risk is that the world lapses into protectionism. Competitive devaluations (currency wars) by themselves would not damage the global recovery. When every nation tries to devalue its currency against every other currency, all will fail. Even then, however, the uncoordinated attempts to depreciate each currency against all others will produce a globally expansionary set of national monetary and credit policies.
If, however, protectionist measures other than competitive devaluations are resorted to support and boost national economic activity, things could get much worse and stay that way for much longer.
If the right combined monetary and fiscal stimuli are implemented immediately, a recession in 2016 can be avoided. Even the belated application of helicopter money drops in the cyclically afflicted countries can ensure that the coming bout of cyclical stagnation does not worsen the problem of secular stagnation. If, during and following the global recession, significant debt restructuring takes place in both EMs and DMs, and in both public and private sectors, we can look forward to a more durable and robust recovery after the next recession than we had following the last one. If in addition the necessary structural reforms of labor markets, professions, product markets and financial markets are initiated in a serious manner, if we can move from rule by law to rule of law in some key countries and from rule by lawyers to rule of law in others, if structures, institutions and policies are adapted to rapidly changing conditions, then future potential output growth will be enhanced and secular stagnation avoided. We are not holding our breath.
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