Global economy watch - April 2013

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The unraveling of the Cyprus debt crisis and political stalemate in Italy is a reminder of how fragile and fast-changing the situation in the Eurozone is.

In fact, our analysis shows that investor’s attitude to some peripheral countries has changed; Ireland for example can now borrow at a cheaper rate in international debt markets than Spain or Italy. Businesses should continue to monitor the situation and avoid a blanket approach in assessing the environment in the Eurozone economies.

Closer to home, the Chancellor’s prudent Budget had a raft of promising announcements for businesses. These ranged from a gradual decrease in the headline corporate tax rate and lower National Insurance contributions to a “Help to Buy” scheme intended to spur activity in the construction industry.

But the low-growth, high debt environment most advanced economies including the UK face, means the main burden of policymaking falls on central banks.

This month we also review the current debate on monetary policy, where governments are asking their central banks what more they can do to promote economic growth. For example in Japan the government has concluded that its central bank can do a lot more and has reset the Bank’s inflation target to 2% from 1%.

But Japan’s persistent low inflation environment means that lessons may not be transferrable to other struggling economies where higher inflation continues to exert pressure on businesses.

At a glance

Key messages:

  1. The Cyprus bailout and Italian political stalemate are reminders of how fragile and fast-changing events can be in the Eurozone
  2. The Chancellor’s latest Budget offered modest support to the economy in 2014-15, but rising public debt levels are a concern
  3. Japan has signalled a bolder, more radical monetary policy to boost growth, but this may not be appropriate for countries with higher inflation rates.
  • After a quiet start to 2013, the latest episode in the Eurozone crisis in Cyprus provided a reminder of how fast events can unfold there.
  • The Cyprus bailout negotiations revived fears of a disorderly bankruptcy and Eurozone exit, because of the events leading to the bail-out (extended bank holidays), the unprecedented content of the agreed package (deposit-holders taking a hit) and the post-bailout side-effects (capital controls).
  • Italy also remains in a fragile state and appears to face a political stalemate after the elections in February, casting doubt on the pace of economic reforms that need to take place.
  • More positively, the Irish government successfully tapped into international bond markets in March. This was just over two years after Ireland was bailed out and shows the merits of implementing a credible economic reform programme.
  • In the UK, the Chancellor used the Budget announcement to try to bolster confidence by announcing a number of business-friendly measures. These included a lower corporation tax rate, reduced National Insurance Contributions particularly for small businesses and increased infrastructure spending from 2015.
  • We expect the measures announced in the Budget to provide some modest support for the economy in 2014 and 2015, although they are not large enough to have a major impact on the growth outlook.
  • Also, even though the Chancellor said this was a fiscally neutral budget, figures from the Office for Budget Responsibility (OBR) show that UK public debt is now set to rise to over 85% of GDP in 2016-17 before peaking, which is getting uncomfortably high.
  • The Chancellor also announced changes to the remit of the Monetary Policy Committee (MPC). In this spirit, we have reviewed the global debate on monetary policy, where governments are asking their central banks what more they can do to promote economic growth.
  • In Japan, for example, the government has raised the Bank of Japan’s inflation target to 2% from 1% and encouraged them to do more to boost growth.
  • However, Japan’s case should be put in the context of its persistent deflationary environment  (see Figure 2). This approach may be less appropriate for other struggling economies with higher inflation rates.

Charts of the month

Figure 2 – Japan is uniquely placed to use its monetary policy to stimulate the economy as inflation has been consistently lower than in other major economies