Global economy on the eve of 2019 and impact of main development trends on Russia

By Stanislav Skakun, Head of Finance


Станислав Скакун, финансовый директор Интеркомп
Stanislav Skakun
Head of Finance

This year, while going through the budgeting period, we decided to analyze in detail macroeconomic factors that affect us in Russia. It is important to understand what is happening in the world because Russia is an export-oriented economy so whatever happens in the world will somehow affect Russia. It is therefore important to understand what the sources of growth and the sources of challenges will be.

Let’s start with the global economy which, approaching 2019, is as described below.

The world’s major economies are the European Union (still considered in this review with the UK) which accounts for 22% of world GDP (all figures are provided here and below at purchasing power parity), China which is the second largest economy and the United States which is the third with 15.3% of world GDP. Together these 3 economies account for more than half of world GDP.

World:

  • Growth of 3.9% — highest rate in the past 4 years
  • Debt — USD 247.6 trillion or over 300% of GDP

European Union (22% of world GDP at PPP):

  • Growth — 2.1%
  • Unemployment — 7.1%
  • External debt — 101% of GDP

China (18.2% of world GDP at PPP):

  • Growth — 6.7% lowest rate in the past 26 years
  • Unemployment ~3.9% — lowest rate since 2002
  • External debt — 14% of GDP

USA (15.3% of world GDP at PPP):

  • Growth 4.2% in Q2 — highest rate over the past 4 years
  • Unemployment — lowest rate over the past 40 years
  • External debt — USD 21.6 trillion or 105% of GDP

The growth rate of world GDP is 4%. This is the fastest rate in the last five years. It is true that this growth is achieved thanks to record high debt: the total world debt has reached 300% of world GDP. The growth of the world economy is indeed financed by huge infusions of borrowed funds, and the cost of these borrowings is now growing as discussed below.

The situation in the EU and in the States is fairly similar. The rates of economic growth are gathering pace and are at their fastest since the protracted crisis of 2007 – 2013. These economies are gradually emerging out of the crisis – or as it were – have bust out of the slump.

There is, however, reason to believe that the growth rate is approaching its upper limit and topping it might be rather difficult. Unemployment in the USA and the EU is at its lowest level. In the US, for example, unemployment is now at its lowest level in decades. This means that economic growth can no longer be achieved by increasing employment, and debt also cannot be used as a reliable source of growth as both public debt and total debt (inclusive of debt from the corporate sector) are already very high in relation to GDP.

Meanwhile, in China the situation is reversed. At 6.7% the growth rate is at its lowest over the past decade. This is alarming as 5% growth is deemed to be critical, and if the Chinese economy slows down to that rate, this will affect the whole world.

Is the growth we are observing now sustainable? Let’s have a look at factors that suggest that problems are more likely.

First, this growth is the aftermath of the crisis of 2007-2008 that was resolved by introducing a “money machine” and printing a large amount of money. Here is how it went:

Нормализация баланса ФРС США. Прогноз..PNG
Graph No.1: Normalization of balance of US Federal Reserve System. Forecast

The balance of the US Federal Reserve System amounted to less than USD 1 trillion in 2008. The crisis in the mortgage sector resulted in crash of trillions of dollars in value and in a decline in money velocity in the economy. To compensate for this slowdown in the economy, huge funds were allocated through so-called “quantitative easing” mechanisms, i.e. the allocation of loans from the Federal Reserve System to the US Treasury (i.e. the Ministry of Finance). USD 4 trillion were printed this way through a few rounds of quantitative easing. Dollars were issued to the US Treasury in the form of debt.

Large bankrupt companies were bought with those funds, and so-called “junk assets” were bought by the US government. Then the end of the quantitative easing program was announced in 2014, but the “money machine” was not switched off as the money withdrawn from circulation for repayment of bonds was printed and issued again by the US Treasury as new borrowing tranches. The money machine continued operating and maintaining the level of monetization in the economy. This period during which the US Federal Reserve System issued every month as many loans as the US Treasury was supposed to repay lasted until the end of 2017.

The tightening of this monetary flow began only a year ago. At the moment, when issued bonds expire every month, USD 50 billion less than is withdrawn from the market is printed so this money “canopy” will be curtailed but slowly. As we can see on the graph, normalization will not be achieved even in 2021. In other words, the balance of the US Federal Reserve System will not be back to its pre-crisis level even by 2021.

Rates of tightening of quantitative easing in the US and the EU.PNG
Picture No.2: Rates of tightening of quantitative easing in the US and the EU

At the same time, the Federal Reserve System began gradually increasing rates several years ago. Increase increments were very cautious, i.e. 0.25% each time, but the rate already reached 2.25% by the end of October. Another increase is scheduled before the end of 2018.

The same process is taking place in Europe, but only more slowly. The European Central Bank printed in total EUR 2.5 trillion, approximately USD 3 trillion. The tightening is due to start in December 2018 with about EUR 30 billion to be withdrawn each year. As in the United States, the process will go hand in hand with a rise in the European Central Bank rates.

What’s happening in such case? Higher and higher interest payments need to be made for loans issued at zero rate. The dollar and the euro are becoming scarce currencies. For example, in the United States, USD 50 billion are withdrawn per month if only due to the tightening of quantitative easing (approximately USD 600 billion per year). At the same time, rates are increased at least twice by 0.25% so that all dollar loans in the world increase by approximately USD 400 billion. In other words, an additional burden of up to USD 1 trillion will be borne by borrowers of dollar loans. Borrowers will somehow need to find this money to pay off their debts, and repayment price will set the pace for economic growth.

The first challenge that will arise from this for all developing economies stems from dollar scarcity. If the dollar becomes scarce, then all currencies of developing countries will begin to fall against the dollar. This will result in the erosion of national wealth: people will become poorer, and companies with assets denominated in assets of developing countries will also become poorer. Investors will also leave developing countries once their national currency weakens as they will fear that their return on investment will not cover currency risks.

This process began this year in Turkey, Brazil, Russia, China and South Africa. All major emerging markets and all currencies of developing countries have weakened this year, and many have reached historic record low.

On the other hand, commodity and stock markets have not yet felt the bleeding of dollar liquidity. The US stock market is still at a historic high, and oil prices are reaching very high levels, but this cannot go on forever.

The second factor that will affect the global economy is the UK exit from the EU.

Brexit and related consequences.PNG
Graph No.3: Brexit and related consequences

Negotiations are currently being held between the UK and the European Union, and the deadline for their completion is March 29, 2019. No agreements have been reached so far. Some will most likely be made in the first quarter of 2019, perhaps even only at the very end of this quarter.

There are 3 exit scenarios.

Тарифная нагрузка в разных сценариях.png
Picture No.4. Tariff burden in various scenarios (according to an expert report submitted to the UK House of Commons in January 2019)

In the first scenario, the United Kingdom would have the same status as Norway, i.e. that of an associate membership with the EU, keeping all trade preferences which entail zero tariff duties on all goods. In other words, free trade with the EU is preserved.

The second scenario entails the conclusion of a bilateral UK-EU trade agreement as done with Canada. In such case, many commodity items will be subject to zero tariff duties, while agricultural goods and foodstuff will be subject to very high protective tariffs.

If no agreement is reached on any of the two scenarios outlined above, then cooperation will remain only on WTO terms, and tariffs will increase for all segments.

Замедление темпов роста экономики Великобритании в разных сценариях (согласно докладу экспертов в Палате Общин Великобритании в январе 2019).png
Graph No.5. Slowdown in growth of the UK economy in various scenarios (according to an expert report submitted to the UK House of Commons in January 2019)

Brexit could significantly affect the UK economy over the next 15 years. The first scenario – associate membership – would result over the next 15 years in a GDP loss of 1.6% which will be almost unnoticeable. However, in the worst case scenario, growth is expected to shrink by 8%. The UK is the fifth economy in the world with a GDP at PPP of USD 3 trillion. Reaching an agreement on any of the first two scenarios would be less onerous for the UK so it would make sense to reach such agreement from an economic standpoint.

Brexit will affect both the world economy and Russia. First, Brexit will result in a slowdown in economic growth in Europe which is the largest buyer of Russian export products.

Percentage of EU countries in export from Russia.PNG
Graph No.6. EU share (including the UK) in Russian export turnover

On the other hand, the UK is one of the largest financial centers in the world. A considerable proportion of stock exchange deals, mergers and acquisitions, and other financial transactions are completed in the UK and, if the legal procedure for movement of capital changes, then this market will become less attractive. This will result in a redistribution of financial flows, and we cannot figure out now what the final consequences will be.

The third trend that is disrupting economic growth is the restructuring of world trade system, and Brexit is part of it. For example, it is clear that global trade will suffer greatly from Brexit which will give rise to new barriers undermining the economic growth and competitiveness of various countries.

Main agenda items of the President of the United States on world trade and their effect:

Withdrawal from Trans-Pacific Trading Partnership

  • Ratification deadlines have expired
  • Possible revision on US terms​

Trade war with China

  • Trade turnover of USD 630 billion
  • Import into China — USD 130 billion and export — USD 500 billion

Cancelation of nuclear deal with Iran

  • EU investments in joint projects with Iran — USD 20 billion
  • New payment system (UK, Germany, France, Russia, China)
  • 50% (2 million barrels per day) of oil supply from Iran under threat of market withdrawal

USMCA (United States-Mexico-Canada Agreement) = NAFTA 2.0 — on US terms

  • Retention of duties on import of steel (25%) and aluminum (10%)
  • Growth in localization required for auto industry from 62.5% to 75% (+250,000 jobs)

The US President Donald Trump is an active world trade newsmaker, proclaiming a protectionist policy for all the sectors in the American market. This is an important part of Trump’s program, and Trump seems to consistently fulfill his promises. For example, three days after his election, he abolished the Trans-Pacific Trading Partnership which was one of the greatest victories of Barak Obama and his administration. Barak Obama gathered the entire Pacific community around the United States, but Trump withdrew from this partnership with one stroke of the pen.

It also makes sense to monitor the trade war with China, putting at risk USD 500 billion of export from China to the United States. This could seriously slow down both the Chinese and global economy if more restrictions are imposed.

And finally a new trade agreement between Mexico, Canada and the US was concluded mostly on US terms last month to replace the North American Free Trade Agreement.

All these and many other measures erect barriers, diminish competition and undermine economic growth. The record economic growth rates resulting from these measures in the US have already exhausted themselves.

Conclusion

  • The world economy continues experiencing the deferred effects of the crisis of 2007-2013 in the form of trade wars and disruption of the world trade system;
  • The cost of borrowing will inevitably increase, and this will jeopardize economic growth rates.

Even non-manufacturing companies, which do not need to buy raw materials, equipment, metal and oil, will still need to monitor the abovementioned indicators (basic interest rates, stock markets of developing countries, etc.) These indicators, indeed, need to be monitored to make the right investment, borrowing, recruitment and any other decisions.