Bill Jamieson: Recovery at risk of ending up in relapse

The biggest question mark is over Europe and its Club Med debt

FOR the Group of 20 major industrial countries, the economic story has reached a critical turning point. After an initial recovery from the sharpest recession in living memory, opposing forces of advance and relapse are locked in struggle.

G20 finance ministers and central bank governors have been meeting in the South Korean city of Busan pondering how to restore confidence in financial markets badly dented over the past six weeks and to assess prospects for recovery.

Many believe government fiscal stimulus by governments has reached a limit and that no more should be given. Others would like to see greater co-ordination of deficit reduction and austerity programmes. The risk here, however, is that if many G20 countries follow the example of the southern eurozone and go on austerity programmes at once, the risks of a relapse into a double dip recession are magnified – "coordinated relapse".

If global economic recovery wins out, those massive sovereign debt problems become more manageable and we could be in a virtuous cycle of falling deficits, falling debt, cuts in business taxes, rising business investment, falling unemployment and a gathering return to something approaching stability. A relapse threatens a dark-side vicious cycle of slumping business confidence, falling profits, higher unemployment, persistent high deficits, more severe market turmoil, higher taxes and a world slump would be in prospect.

Here in the UK this stand-off between recovery and relapse is particularly acute. A new and untried coalition government unveils a budget in less than three weeks that will set the tone for this year and beyond. Its programme for deficit reduction needs to be convincing after a disturbing period of turbulence across Europe triggered by concerns of sovereign risk default – not companies but whole countries falling down on their debt repayments. Were such a default to occur, it would spark a chain reaction of bank crises and failures across Europe.

At the same time the government needs to take care that its deficit reduction programme of spending cuts and tax increases – more severe and sustained than anything we have seen outside war time – will not crush the recovery altogether.

As if all this was not enough, there are continuing problems with the supply of bank finance to businesses and to small and medium sized companies in particular. And a good supply of loan finance is vital to drive the economy forward.

So, relapse or recovery: which is it to be? At the global level, the recovery story appears to be intact, due the continuing boom in China, the resilience of Asia/Pacific and the strength of developing country economies. Global GDP dipped by just 0.8 per cent last year and looks on course for a return to 4.6 per cent growth in 2010 and 4.3 per cent in 2011.

But China may be in for an asset price tumble. And despite all the hype over efforts at global co-operation, is there sufficiently common ground for the G20 to agree a policy or recommend action? In the last three years there has been a change in the relative strength of emerging and developing country economies on a scale beyond anything previously experienced. The economic world, if not being turned upside down, is seeing power shift from West to East. But even within the BRIC nations (Brazil, Russia, India and China) there is considerable disparity.

Stephen Lewis, economist at Monument Securities, says: "The lesson to be drawn is that the chances of G20 co-operation being effective are remote. Those taking part in the G20 process, noting its very limited progress so far, have been inclined to attribute this to the number of participants involved, but the absence of a common purpose more likely lies at the root of the failure."

For the UK, the "good" news is that most are still forecasting a continuing if very weak recovery this year and a strengthening of recovery momentum next.

Another conundrum is Bank of England policy on interest rates. So far governor Mervyn King has indicated that interest rates will be kept at their ultra low level of 0.5 per cent for the foreseeable future. But how long can rates be kept there when the Retail Price Index is now rising at an annual rate of more than five per cent and even the official CPI measure is well above the two per cent target level? Insolvency trade body R3 calculates that seven per cent of UK businesses would be likely to become insolvent were base rates to rise to between two and 3.5 per cent and 12 per cent would go under on a rise to 3.5 to 4 per cent.

The US has been enjoying the fastest rate of recovery so far, with the economy set for GDP growth of 3.5 per cent this year and 3.2 per cent next. Recent figures showed that new orders of durable goods rose $5.6 billion or 2.9 per cent month on month in April – the fourth rise over the past five months.

The biggest question mark is over Europe where growing worries over Club Med debt and accompanying austerity programmes have raised major doubts over the ability of the European single currency to survive long term. Barclays Capital is forecasting growth of just one per cent this year and 2.1 per cent next, with Germany in the van of the advance. It may be a surprise to many, given reports of export-driven growth, that Germany has been one of the weakest G7 performers. But, says Stephen Lewis, "we should be careful to note that, even after the past year's rebound, German industrial orders are still running at only 80% of their pre-crisis level."

Overall, this confirms warnings that this is going to be a long, slow haul at best, with the possibility of another severe financial crisis and economic relapse not to be lightly dismissed. For the UK the pace of recovery is set to be markedly slower than from the recessions of 1980-81 and 1991-92. Should the Budget tell us better news, throw a party.