Precarious prosperity

Last year, the global economy forged ahead despite apparently teetering on a tightrope where one wrong step would bring disaster. The Sunday Times’ PETER KOENIG looks back at the contradictions of 2005 and assesses the economic balancing act governments need to conduct over the coming 12 months.

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By  Peter Koenig Published  January 8, 2006

The chief executive of Barclays spent New Year with his family in the country. John Varley may have had a low-key New Year’s Eve but there were plenty of reasons for his company to celebrate. “It wasn’t all plain sailing, of course,” said Varley, even though the global economy did well. “The British economy had a tough year as consumers grew cautious.” Still, 2005 was a test for globalisation, as Varley saw it. At the beginning of the year the bears were saying that deregulated markets — with companies, banks and investors blipping money around the world on the internet — were generating unsustainable imbalances, creating a growing risk of financial panic and recession. But the doom-mongers were wrong. The global economy grew 3.1% in 2005, not far off the pace set in 2004, the best year for economic growth in 30 years. World inflation stayed tame at 2.7%, despite high energy prices and American trade and budget deficits. Profits at big European companies grew by an average of 22%. “Natural disasters, oil-price shocks, the credit-rating downgrades of Ford and General Motors ... the capital markets handled it all with magisterial calm,” said Varley. But he is no Pollyanna. For Varley, as for most business leaders, prosperity in 2005 came at the expense of some sleepless nights. This year looks like more of the same — good performance darkened by anxieties about its sustainability. Dislocations and wealth transfers continue to shake things up. Toyota looks set to overtake General Motors as the world’s top-selling car manufacturer in 2006. Delphi, America’s largest auto-components maker, is closing many of its 44 plants in America’s rust belt, after filing for bankruptcy in October. In contrast, the Shanghai boom story gave way to the Dubai boom story, encapsulating the petro-boom story. As oil companies reported record profits, Saudi Arabia reported the highest oil revenues in 22 years. The whiplash of such dislocations, spawning market optimism one day, jitters the next, gives the art of economic forecasting a seat-of-the-pants quality heading into 2006. There is a sense that the good times will roll — until they don’t. The favourable economic climate could last throughout 2007 or stop tomorrow. Still, the most respected and carefully worked-out forecasts are persuasively bullish. The International Monetary Fund (IMF) predicts the global economy will grow 2.25% in 2006 and 2.75% in 2007. As people get used to a world in which Chinese factory workers and Soviet-trained engineers compete against their western counterparts in a global labour market, the bears are reconsidering their scepticism. UBS economist George Magnus compares today with the 1870-1914 period of globalisation. “There were massive dislocations then and they didn’t derail the world economy,” he said. “It may be that the imbalances we all talk about are a product of the accelerating pace of globalisation.” Magnus hasn’t entirely abandoned his bearish instincts. “It’s not a stable state of affairs, and the longer the imbalances go on, the greater the danger of some sort of financial event,” he said. However, he and other sceptics seem increasingly inclined to disregard the dangers of a collapse of the dollar or a confidence-destroying terrorist strike. These are beyond the scope of conventional economic analysis. “Perhaps it’s like the Tokyo earthquake,” said Magnus. “We all know it’s going to happen, but there’s no way of predicting when. It’s simply something we will suffer when we suffer it.” Man Group chief executive Stanley Fink spent the holidays in the French ski resort of Courchevel. But he took his Blackberry with him. Every 30 or 40 minutes he checked his emails. At a restaurant his wife threatened to throw it out of the window. On the slopes he skied fast enough to check it before his wife caught up with him. As the boss of the world’s largest quoted hedge-fund manager, Fink looks to exploit opportunities whatever direction the markets are heading in. He did it in the autumn, when American rival Refco collapsed after accounting irregularities. London-based Man snapped up Refco’s futures brokerage business. Fink said 2005 produced two other surprises: the resilience of the dollar - it went up when everyone said it would go down - and the strength of commodities prices, metals as well as energy. Fink’s outlook is consistent with the smart-money view around the world. High oil prices are now a given. The question is less what their effect will be in 2006, and more whether — as the so-called “peak oil theorists” have it — the world is at the peak of oil production and on course to run out of the fossil fuel. China’s rise is another given. The world’s most populous country is now the fourth-largest economy, after America, Japan and Germany. In November Alan Greenspan, chairman of America’s Federal Reserve, testified in Washington that China’s 750 million workforce, along with workers from India and the former Soviet sphere, will “approximately double the overall supply of labour once all these workers become fully engaged in competitive world markets”. America’s spendthrift ways are a third given. Its savings rate is close to zero. The current-account deficit — its balance of payments with the rest of the world —stands at a modern record of 6.1% of gross domestic product, up from 5.7% in 2004. The fourth big theme that dominated 2005 - the “global savings glut” prompting the “search for yield” - remains less well understood. Five years ago, central bankers cut interest rates to keep the global economy ticking over in the face of the 2000 dotcom and stock-market busts. Cheap credit encouraged consumers to keep on spending. This kept the global economy from deflating despite weak business confidence. But low interest rates had a second effect. They depressed investment returns. Pension funds and traditional asset managers suffered. Hedge funds and private-equity firms prospered on the back of their demonstrated ability to “generate yield”, or good returns, despite low interest rates. Eighteen months ago central bankers led by the Fed set out to mop up the liquidity injected into the system. In 13 consecutive quarter-point increases the Fed raised its benchmark overnight-lending-rate target from 1% in June 2004 to 4.25% in December. This experiment in managing the deregulated, internet-driven world economy has produced contradictory results. On the one hand, it appears to have worked. There was no global recession in the wake of the dotcom and stock-market busts. There has been no bout of unmanageable inflation in the wake of the easy-money policy adopted to head off recession. Most indicators of economic performance are good. On the other hand, the Greenspan-led experiment in piloting a globalised economy through the shoals of recession and inflation appears to have thrown the relationships between economic indicators out of whack. Oil prices have risen from US$20 a barrel to US$60 a barrel in the past three years, and few understand why this has had so little effect on the world economy. High American deficits threaten the dollar, but China and other countries with trade surpluses seem content to keep buying the American currency. Junk bonds are riskier than triple-A-rated bonds by definition, but the difference in yields between the two classes has all but vanished. The prosperity enjoyed in 2005 - and the same again forecast for 2006 - is based on solid growth and adroit management of the world economy. But it comes with a health warning. The economic future has rarely seemed more bewildering. Planners working for BP chief executive Lord Browne began preparing for 2006 in April. Labouring throughout the summer and autumn, they moved from blue-sky thinking to Excel spread sheets. The fruits of their labour will be revealed in February, when BP publishes its annual strategic review along with its 2005 results. “The idea is to put strategy into plans and plans into action,” stated the company. “The exercise is dynamic. The plan moves as the world moves.” How the world will move in 2006 will be on most businessmen’s minds as they return to work. There is no shortage of predictions to guide people’s thinking. UK chancellor Gordon Brown said in December that the British economy would grow 2% to 2.25% in 2006, compared with 1.75% last year, the lowest since 1992. His authority is dented, however, after he forecast in March that the economy would grow 3.5% in 2005. Barclays predicted in December that sterling would be weak. “We think the pound is vulnerable to depreciation,” wrote Larry Kantor, a strategist. Barclays boss Varley said that in 2006 the pace of mergers and acquisitions would speed up further. Nationwide Building Society said that house prices in Britain would remain flat or fall slightly in real terms in 2006. Oil prices will remain high, according to Merrill Lynch. The City office of the American investment bank also predicted in December that Kingfisher and Rentokil could be leveraged-buyout targets in 2006. Analysts, including JP Morgan Chase’s Abhijit Chakrabortti, have forecast that Japan will be a hot stock market in 2006, even after a 43 jump in the Nikkei 225 index in 2005, its biggest gain since 1986. But forecasters are also in the business of spotting the early signs of trouble. Warning signs range from the broadly historical, such as social unrest in China, to the highly technical, including a widening in interest-rate differentials between junk and triple-A bonds signalling heightened fears over credit risk. In between these two extremes, the pundits are advising businessmen and investors to monitor consumer spending in the United States. American shoppers have been the engine of the world economy in recent years. The fear is that rising interest rates could hit housing sales, stop consumers from spending and set off a ripple effect around the world. The pundits are also advising people to stay alert in February, when the curtain falls on the 1987-2006 Greenspan era. Ben Bernanke, the Great Depression specialist who will take over from Greenspan, must earn the trust of markets. He must also make some tough calls on interest rates. It was a no-brainer to cut rates between 2000 and 2003, and it was a no-brainer to raise them in 2004-5. What to do now, though, is less clear. Some fear that if Bernanke continues to raise rates, he will spook the markets. The nightmare is that Bernanke will lose the confidence of markets and the result will be a panic that makes the nervous days in 1998 after the collapse of Long-Term Capital Management, the American hedge fund, look like a picnic. That is unlikely to happen. But it is what interrupts the sleep of men such as Varley, Man’s Fink and BP’s forecasters even as they celebrate and plan for continued prosperity in 2006.

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