Global Economic Scenario
The US economy continues to grow slowly. Growth has averaged slightly more than 2% over the past three years. At this pace, it is certainly less robust than other recoveries, but history does show that recoveries after a financial crisis are often slower. Importantly, despite a variety of headwinds during this four-year period, the economy continues to improve in several key aspects. First, the pace of job growth has gradually been putting people back to work. The unemployment rate has declined from its peak of 10% late in 2009 to its current level of 7.7%. Over the past six months, private sector payroll gains have averaged 200,000 per month. The rebound in housing has likely contributed to this improved sentiment. Home prices have risen 8% over the past year as a result of low inventory levels, boosting household wealth and supporting consumption.
Although the ECB kept policy unchanged. But economist across the world expects a 25bp rate cut in the next couple of months with the persistent weakness in cyclical indicators. However, such a move is unlikely to bring about a meaningful change in the euro area’s cyclical trajectory. Importantly, it’s also unlikely to make a change to the prospect for euro area inflation. Global Economists expect headline inflation to fall well below 2% through the rest of this year in line with the ECB’s low inflation forecast for next year. In large part that fall would be due to the contribution to inflation from erratic and special factors such as energy prices and indirect taxes becoming much smaller. Underlying inflation, excluding those factors such as food, energy and indirect taxes, is already close to 1% at the euro area level.
The ECB’s forecasts for inflation remain low – with a central expectation for inflation of 1.3% for 2014. The effects of past increases in energy prices and indirect taxes will gradually fall out of the inflation rate over the next 3-6 months, meaning that the headline inflation rate could fall to rates consistent with the ECB’s 2014 forecast.
The situation in Cyprus is still very fluid and very serious—perhaps more so than in Greece last year. While the country may be too small to have a meaningful direct impact on the rest of the euro area, the big issue for markets is the potential for contagion to more systemically important countries. Cyprus is a small economy, with nominal GDP last year of just €18 billion (USD23 billion) or 0.2% of the euro-area total. So while Cyprus’s bailout may seem small in euro terms, it is huge relative to the size of its economy.
The epicenter of the problem is the country’s outsized banking sector. Total banking assets currently stand at 736% of GDP. To make matters worse, the IMF estimated in 2011 that Cypriot banks’ exposure to Greece (government bonds and loans to Greek residents) was €29 billion, or 160% of GDP. Meanwhile, Cyprus’s public finances don’t look too bad. Latest estimates show that it had a budget deficit equal to 5.5% of GDP last year, slightly higher than the euro-area average of 3.2%. Government debt, at 87% of GDP, is actually below the regional average of 93%. The problem is that Cyprus’s banks took enormous losses on their exposure to Greece and now need to be recapitalized at an estimated cost of €10 billion, or 55% of GDP. Adding this to the sovereign balance sheet would quickly push the debt-to-GDP ratio above 150% of GDP, similar to the debt trajectory in the original Greek program which is now considered unsustainable. This is why the EU/IMF is unwilling to lend Cyprus the full €17 billion of funds required to recapitalize the banks and finance the government for the next four years.
Note: The above data has been generated from sources in public domain.