Unabated trade tensions heighten recession risks

The World Bank in its latest Global Economic Prospects report, titled “Heightened Tensions, Subdued Investment”, established the nexus between the worsening US-China trade spat and the spectre of an imminent global economic recession. It stated that “downside risks to growth predominate, including rising trade barriers, a build-up of government debt, and deeper than expected slowdowns in several major economies.”

Earlier in the year, it had surmised that “financial market pressures and trade tensions could escalate, denting confidence and further setting back growth prospects in emerging market and developing countries”. That caution went largely unheeded and instead of taking positives measure to abate frictions, the two trading giants have not only sent mixed signals about coming to a negotiated resolution but have in fact entrenched their respective positions, raised the ante in escalating tariffs while continuing to rattle global financial markets.

As a result, The World Bank downgraded global growth in 2019 to 2.6% from 2.9% in its previous forecasts to reflect weaker-than expected international trade and  investment.

While major European and Asian economies such as the Eurozone, China and Japan are showing clear signs of slowdown, the US economy which is on its longest run of sustained economic expansion is also showing early indication of deceleration. It witnessed a sharp fall in 10-year US Treasuries, mirroring concerns about a slowdown and growing uncertainty over the direction of trade negotiation. This has led to an inversion of the yield curve from late May. This spooked markets as an inverted yield curve has preceded every post-war US recession. The World Bank reported some models predicting the probability of a US recession in the next 12 months at 33%.

Of particular concern is the lacklustre investment growth prospects for emerging market and developing economies (EMDEs). Investment growth is subdued and falls below historical averages, exacerbated by weak global economic growth. This in turn has the potential of trapping these economies in a vicious low-growth cycle as investment growth is fundamental to sustained economic growth

Consequently, EMDEs are expected to face the continuing risk of destabilising exchange rate movements. It observed that such stress periods tend to force central banks to leverage monetary policy to lower currency and inflationary pressures amid slowing growth. For authorities to implement the appropriate policy response it is critical to ascertain the exchange rate pass-through impact on inflation given the country’s specific fiscal, macroprudential and monetary governance structures. The impact on inflation is more acute when currency movements are initiated and/or increased by monetary policy imperatives.

On the other hand, the impact on inflation is substantially lowered when “central banks pursue a credible inflation target, operate in a flexible exchange rate regime, and are independent from fiscal authorities”. The World Bank highlighted the criticality of central bank independence and credibility, given the self-reinforcing feedback loop between credibility, the exchange rate and price stability. It reminded policy makers that the risks posed by excessive levels of foreign currency debt, and EMDEs may enhance resilience to episodes of financial stress by issuing debt of longer maturities, at fixed interest rates, and denominated in local currencies.