Tumultuous 2011 in retrospect

By Andrew Sheng, special to The China Post

Looking back, the gods of risk mocked investors. The fastest-growing economies, India and China, had the worst-performing stock markets. Both economies managed to achieve 7-9 percent growth last year, but the Sensex and the A-share markets were down 24.6 percent and 21.7 percent respectively. In contrast, the advanced economies were supposed to be in crisis, yet the U.S. Dow Jones Industrial Average was up 5.5 percent. True, the European index lost 25 percent and the Nikkei declined 17.3 percent, but many of the emerging markets did just as badly.

At first sight, the usual macro numbers did not suggest that 2011 was that serious a crisis year. U.S. annual GDP slowed down to 1.8 percent, whilst euro area annual GDP growth was 1.5 percent. But the eurozone had a sharp downturn in the fourth quarter of -2 percent. Japan did slip into -0.9 percent growth, due to the disruptive effects of the tsunami and nuclear disasters.

What caught everyone by surprise was the European debt crisis, which unfolded like a supertanker crash in slow motion. The delays in getting political consensus and leadership brought the financial markets to brink of panic, but by year-end, the combined leadership of German Chancellor Merkel and French President Sarkozy finally stitched together a package that brought some temporary relief to the Italian bond rates. With new austerity coalition governments in Greece and Italy, there is some hope that the political problems will temporarily not add to the panic.

Taking a more detached perspective, we should treat the period from 2007 to 2011 as a double-dip crisis. Recent data showed that the crisis really started when European banks expanded far too quickly in the 2002-07 period, particularly after the creation of the euro, relying excessively on inter-bank funding and in U.S. dollars. European banks invested heavily in U.S. AAA-rated yet toxic products and it was the July 2007 intervention in inter-bank markets by the Fed and European central banks that marked the true beginning of the global crisis. The quantitative easing restored liquidity in the system but did not address the core structural problems, which resurfaced in 2011.

The double-peak effect can be seen by the behavior of inflation. Inflation peaked in July 2008, before it was stopped by the Lehman crash. In the wake of quantitative easing, inflation returned, causing the emerging markets to begin raising interest rates again. Inflation fears have receded with declining oil and gold prices, which topped at US$1888.70 per ounce in August 2011, before closing the year at US$1,565.80. Almost all other commodity prices fell in the wake of fears that the Chinese economy was slowing down.

Economic forecasts are by nature biased on the optimistic side, with only lagged recognition that deflation has set in. For example, the Institute of International Finance (IIF) acknowledged that their forecasts in 2011 had to be adjusted downward. They predict the U.S. economy to strengthen somewhat from 1.7 percent growth in 2011 to 2 percent in 2012 and further to 3.5 percent in 2013. They are cautious on Europe with a decline of 0.6 percent in 2012 and a recovery of 1.7 percent in 2013. For Japan, they see a recovery of 2.1 percent growth in 2012, compared with a decline of 1 percent in 2011. For the emerging markets, they see slower growth, as exports and capital flows would also slow. The IIF thinks that India will grow only by 6.5 percent in 2012, rather than 7.8 percent projected earlier.