Read this speech in Portuguese
The world economy has been on a hot streak for four successive years. And like every pot on the boil, the world economy has generated bubbles pockets of excessive and speculative activity that have little fundamental support. Central banks hate bubbles, because they distort decision-making and because they can be dangerous if they become too big.
The trouble with bubbles is that you cant let the air out of them gradually they burst. Perhaps the biggest and most widely recognized bubble that has emerged during this expansion is the U.S. housing market bubble. We are presently witnessing its collapse, fully cognizant that if it has knock-on effects on the U.S. economy, then all other countries will share in the pain.
The long global expansion has produced bubble-like activity in other sectors. Of key concern to emerging markets is that some of these bubbles have supported their own expansion over the last three years, just as the U.S. housing bubble has fueled consumer spending there. Certainly, some commodity markets are exhibiting these characteristics, and, arguably some equity markets as well.
In our latest forecast, we analyze the implications of the collapsing U.S. housing bubble for U.S. growth, and then work through the implications for the rest of the world. Brazils economy has taken advantage of the good times to make some fundamental improvements. But those have not paid immediate dividends and, with some bubbles already bursting and others poised to burst, Brazilians are wondering if an opportunity was squandered. Of greater concern is the fallout from bursting bubbles: is the country better prepared this time around?
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We have experienced these bubbles before excessive real estate market activity was apparent in both the US and Canadian economies both at the beginning and end of the 1980s. Concurrently, tight labour conditions in these markets brought excessive, bubble-like wage gains. A huge bubble was created in Japanese property markets in the late 1980s. And we all remember the growth of the high-tech bubble in the latter half of the 1990s.
Fallout from bursting bubbles can be dramatic. In Japan, the burst property bubble left an enormous crater, ushering in a period of economic stagnation that lasted well over a decade. Although the Japanese experience is an extreme example, other burst bubbles have had serious consequences. North American excesses presaged serious recessions in the early 1980s and early 1990s. However, not all burst bubbles leave huge craters. The high-technology implosion in 2001 had a relatively mild effect on the broader world economy. While a slowdown did ensue, recovery was swifter than most were expecting. Past experience suggests that the magnitude of burst-bubble fallout is generally related to the size of the bubble and the economic fundamentals extant at the time.
For the longest time, we argued that there was no clear evidence of a bubble in U.S. housing. A shift in consumer preferences in the wake of the terrorist attacks in 2001, together with low interest rates, ignited a new-millennium US homebuying spree. That was fundamental people purposefully chose to live for today and to buy homes earlier in their life cycle in response to the insertion of terrorism into their awareness. But significant price gains boosted residential investment and eventually led to speculative activity, probably in mid-2005. This in turn encouraged a pace of new home construction that could not be sustained. Higher interest rates and slower economic growth helped to burst the bubble, and housing statistics have descended rapidly since early-2006, and are still in free-fall.
If contained within the sector, the descent of the housing market might well be among the milder burst bubbles of recent times. Would that it were that simple. US consumers are highly leveraged at present, and over the years have become heavily dependent on rising home equity to supplement their income. Dipping into this home equity has added roughly $250 billion to income annually in recent years, a hefty 2.5 per cent of US consumer spending weighty, considering that US consumer spending accounts for over 70 per cent of US GDP, or about 15 per cent of global GDP. Given the leading role of the US economy in the recent global boom, and the contribution of US consumer spending, outright loss of this income supplement alone could tip the world into recession.
While possible, the full effect of this scenario is unlikely. First, US consumers still have a lot of scope to draw down home equity, and prevailing trends suggest that even in the worst conditions, there would at least be a modest income supplement. Second, tight US labour markets have pushed wage growth up in recent months. This alone could add about $200 billion to income, roughly equivalent to the home equity supplement. Third, lower gasoline prices have already created over $80 billion of additional spending room, and this could well increase through 2007.
Bursting bubbles and the accompanying news stories have an additional effect. They make average people a bit more careful. Consumer confidence is currently riding above average, and has been remarkably stable in recent years. More recently, lower gas prices have helped consumers feel better, offsetting the effects of slowing overall growth. But like economic conditions, confidence can ebb quickly, and when confidence ebbs, consumers spend less and save more. How much more? A 2 per cent rise in the saving rate not uncommon when nervousness increases could pull almost $200 billion annually away from consumption. Given current US economic conditions and past circumstances, lower consumer confidence presents a downside threat to the US outlook.
On balance, the response of the US consumer to the burst housing bubble will slow the worlds economic growth engine next year. The US economy is forecast to expand by a moderate 2.2 per cent, largely a result of weaker residential investment, a partial consumer retrenchment and softer auto production. Weakness began colouring performance in the second half of 2006, with some Asian economies already reporting weaker export growth, but the slowest period will likely be the first half of 2007. However, given the global economys underlying fundamentals, activity is expected to improve in the latter half of next year.
Global growth will follow suit. Aggregate growth will ease to 4 per cent in 2007, the slowest pace in 4 years. However, following the 4.8 per cent expansion in 2006, growth is much closer to the long-term trend, suggesting little further tightening in capacity pressures.
Commodity prices particularly those currently in bubble territory are expected to fall in the coming months. Oil prices have come down significantly from recent peaks, but remain at a relatively high level, given the support prices are receiving from recent changes in market structure. We expect the risk premium in oil prices to continue to decline, even as OPEC cuts production in the face of slowing demand, because each cut results in an even bigger cushion of reserve capacity to deal with any unforeseen event. Nevertheless, oil prices are likely to find a floor in the $50 range for the next 12-18 months.
Meanwhile, base metal prices are in for a more dramatic correction. As economic slowing and increased production capacity begins to put downward pressure on prices for such commodities as copper and nickel, speculators and pension funds are expected to head for the exits. Price declines could be sizable.
The combination of slower growth, weaker commodity prices, and greater financial uncertainty will hit Latin America in different ways. The question for Brazil is whether the economy can weather the coming storm.
Certainly, record current account surpluses and prudent debt management have helped improve the composition and size of the countrys external debt burden. Domestic market financing and enhanced global liquidity have allowed the government to buy back and retire costly obligations, smoothing out its amortization schedule, improving its currency matches, and effectively canceling all IMF obligations. Brazilian corporates too have been financing their operations using retained earnings, domestic issuances and real-denominated external debt. The countrys net stock of reserves is now enough to cover nearly three times annual debt payments.
Brazils enhanced external position has helped reduce currency volatility, putting an end to the reals sharp and frequent devaluations that, in the past, required the government to hike interest rates and squeezed industrial output growth. Since the market turmoil that accompanied the 2002 elections, the real has appreciated by an impressive 45 per cent against the dollar. With a stable currency and inflation in check, an effective and credible monetary environment has allowed for Brazils strongest expansion in a decade. Meanwhile, bond spreads have come down below 230bps, from a peak of close to 2,500bps, over that same period. Aside from macroeconomic stability, some success on microeconomic reforms and broad social improvements underpin the achievements of the first Lula administration.
Heading into a second Lula term, Brazil will reap the stability sowed by the painful adjustments of the last four years. Reduced external vulnerability has paved the way for an extended cycle of lower real interest rates, expected to stimulate growth of 3.5 per cent in 2007. Further, Brazils economy appears well-insulated from a slowdown in the US, with that market accounting for only 20 per cent of its exports. Deeper and more mature domestic financial markets have better positioned the country to withstand tighter global liquidity conditions and the anticipated recalibration of risks by international investors. Still, Brazils characterization as an emerging market means that it remains more exposed relative to its industrialized counterparts.
One such exposure is Brazils continued reliance on certain key commodities. Consider that in 1990 total trade accounted for only 11.2 per cent of GDP, versus 24.1 per cent today. Primary products account for close to 30 per cent of total exports with iron ore, oil derivatives, soy, coffee, and meat products comprising a relatively important share of the former. In addition to robust global trade activity, much of Brazils success in 2006 came from higher-than-expected growth in the average price of Brazilian exports. In 2007, global export growth will slow, and average prices of Brazilian exports will drop, albeit to still elevated levels. The 2007 outlook for iron ore is fairly bullish, with strong growth in Chinese demand and tight supply conditions expected to hold benchmark prices close to current levels.
While prices are expected to pull back by 10-15 per cent in 2008, as additional global capacity comes on line, lower cost centers like Australia and Brazil will be in a much better position to compete with high cost operations in Eastern Europe.
Sugar demand rose to a 25-year high at the beginning of 2006 driven by bioenergy, especially ethanol prices but prices have been on the decline as of late. Nevertheless, prices are expected to remain at historically high levels and come down by only about 5 per cent next year. Coffee prices also surged in 2006, as a result of lower production from key players. Greater production is anticipated in 2007, which is expected to result in a 7-10 per cent price decline. Soybean prices, meanwhile, are likely to rise by a further 4 per cent in the US market next year. The price increase is driven by strong global demand for vegetable oil, the growing demand for biofuels and lower production of corn and wheat, which have resulted in low feed supplies and inventories.
With Brazils economy set to grow by 3 per cent this year, average growth during President Lulas first term will be 2.7 per cent, about the average of the past 15 years and a far cry from the Brazilian miracle of the 1960s (6.2 per cent) and 1970s (8.6 per cent). Given the elevated expectations generated by three years of favorable external conditions, President Lula will now be under pressure to boost growth beyond this middling pace. This will be a very steep challenge in the context of a global slowdown like the one we are forecasting , but by this time next year we should be seeing signs of a recovery in global growth that Brazil will be able to ride.
The bottom line? Over the last three years, Brazil has taken great strides toward reducing its traditional vulnerabilities. Its lumbering public and external debt burdens are being tamed, perceptions of financial stability have helped secure more stable sources of capital flows, and it has succeeded in opening and broadening its trade profile. All these developments will make the country much more resilient in the face of the coming downturn.
