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The World Economy: Road to Recovery

By Jim O'Neill, Goldman Sachs

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Signs of economic indicators improving provide much-needed encouragement and reassurance in uncertain times

As the leaders of the G20 countries gather in Pittsburgh, they can take some measured comfort from developments since they last met, in London, in April.

Stock markets have recovered throughout the developed and developing worlds. Many economic indicators have improved. The strong, worrying consensus that the world was heading inevitably into a 1930s abyss has abated. Today, the most popular debate about the immediate economic future is whether it will resemble an L, a V or a W, with very little focus on the ‘D word’ – depression.

For the developed world, the forecast issued by Goldman Sachs does not resemble any of those letters. For the large developing countries, many of which are now G20 members, led by China, it forecasts a V. For the world as a whole for 2010, it forecasts positive growth in gross domestic product (GDP) of around 3.5 per cent. This is above the average of the past 25 years of global GDP growth. But it does follow 2009 and a year of global GDP contraction.

Many of the proprietary indicators identified by Goldman Sachs suggest better times ahead, with a number of them distinctly V-like and, as of early August, suggesting upside risks to the coming forecasts.

After the collapse of Lehman Brothers in September 2008, Goldman Sachs developed its Financial Stress Index. It consists of four equally weighted variables: the spread between the London interbank offered rate (LIBOR) and the overnight index swap (that is, the spread between the bank funding rate and the market’s perception of future official rates); the spread between the United States government’s repo rate (the discounted rate at which a central bank repurchases government securities from commercial banks to manage the level of money supply) and the mortgage repo rate; the amount of commercial paper issuance; and the ratio of money market funds to the value of equity market capitalisation in the US, a measure of risk aversion.

This index deteriorated through much of 2008, especially after Lehman. It is now back to more normal levels, at those last seen in the late spring of 2007. This suggests that policymakers have stabilised the systematic risk from the financial system. Moreover, if such exploding systematic risk was largely responsible for the collapse of the world economy last autumn, this return is a highly welcome sign.

Such an index offers no clues to what might happen if many governments decide to exit from their aggressively stimulative monetary and fiscal policies. While policymakers will need some time to consider, they should be pleased with current developments.

Goldman Sachs’s financial conditions indices (FCIs), for more than 20 countries, have been used for many years as a guide to the effectiveness of monetary policy. Ordinarily, FCIs can be used as leading economic indicators. For the US, the FCI has shown a reasonably consistent and useful early warning of how policy might influence the economy 12 months hence. A 100 basis point easing, all else equal, means a 1 per cent strengthening economy within 12 months. Because of the importance of US financial conditions, such an easing results in a

0.6 per cent improvement in the world economy. In contrast, a 100 basis point tightening of US financial conditions, all else being equal, leads to a 1 per cent weakening of the US economy, and a 0.6 per cent weakening of the world’s.

The US index consists of three-month short-term US interest rates, triple-B equivalent bond yields (these two constituting 90 per cent of the index), the trade-weighted dollar and the Wilshire stock market index.

In 2008, the US FCI tightened dramatically, by nearly 500 basis points, especially after the failure of Lehman. Soon after, the US and world economies began to sink. Fortunately, by early August 2009 the FCI had recovered around 65 per cent of what it lost, reflecting the very aggressive easing undertaken by the Federal Reserve Board. This suggests that the US and world economy should recover around 65 per cent of what they lost.

China’s FCI consists of four variables, slightly different from the US due to its different financial system. China uses M2 money supply instead of corporate bonds, as its corporate bond market is still a fledgling. Since November 2008, China’s index has eased by 630 basis points, an unprecedented amount for any country with such an index. This reflects the huge steps undertaken by China to stimulate its economy and shift from export dependency to more domestic demand-orientated growth.

By March 2009, due to easing financial conditions and related improvements in financial conditions, sensitive parts of the economy produced a significantly higher forecast for Chinese GDP growth in 2009 and 2010. Real growth GDP of 8.4 per cent is forecast for 2009 and 10.9 per cent forecast for 2010. This development is highly welcome not just for China, but also for the world. Many argue that the build-up to the crisis resulted from excessive global dependence on an over-levered US consumer, the China’s success is welcomed by the G20 countries, given the economic slowdown sparked by global reliance on over-stretched US consumers resulting global imbalances and vulnerability in the event of a slowdown. China’s success in boosting domestic demand is thus an extremely welcome development for the G20.

An encouraging message also comes from the proprietary global leading indicator (GLI), devised to be as accurate for predicting future movements as the well-known leading indicator produced by the Organisation for Economic Co-operation and Development (OECD), as measured by industrial production. By having only a single global indicator of 14 reliable, high-frequency variables from around the world, the GLI tends to be about two months quicker than the OECD’s indicator. Moreover, as it uses neither the stock market nor slope of the yield curve, it benefits asset allocation decisions.

The GLI fell sharply late in 2008 and continued to decline into spring 2009. It started to improve in March, about the same time as equity markets did. Its improvement accelerated in June and July. The year-on-year change in the monthly momentum of the index forms a V-shaped graph, suggesting some upside risks in the second-half 2009 global forecasts.

These factors should all encourage G20 leaders as they prepare to meet in Pittsburgh. The actions they took in April 2009, and in November 2008, appear to have helped arrest the decline of the world economy. But many challenges remain, not least the challenge of ensuring that the better tone of economic data and markets continue. Citizens want reassurance that financial systems will be more effectively regulated, that unemployment will stop rising, that the future will be more certain and, perhaps, fairer.

Many seem eager for a better natural environment and progress on climate change. The G20 leaders should persist with their soothing words – and keep the support that they have been nurturing. They will continue to be rewarded for keeping a steady hand on the tiller.

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