Taking a Walk on the Downside:

Alternative Global Downside Risk Scenarios

for the World Economy
By Daniel Solomon, Economist at Euromonitor International
www.euromonitor.com
2013 Euromonitor International
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Introduction
Macroeconomic forecasts for the next few years are all over the news. But
these baseline forecasts only provide a single number, the best guess of
the analyst about what is likely to happen to the economy. Giving a single
number does not capture the signicant level of uncertainty surrounding the
future, uncertainty that should be taken into account in any major business
decision especially on the downside. In addition to baseline forecasts,
Euromonitor International has recently developed alternative pessimistic
scenarios for 36 economies to take into account the downside risks to our
outlook. In this note, we review three major downside risk scenarios for the
global economy in 2013-2014: a deterioration in the Eurozone debt crisis,
a Chinese hard landing and a US recession.
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2013 Euromonitor International
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Eurozone Debt Crisis Deterioration
The severity of the crisis would generate signicant spillover effects. The UK
economy would suffer the most outside the Eurozone, with GDP declining
by 2.4% relative to the baseline. Emerging market economies are also quite
vulnerable to this scenario. GDP in Brazil and China would fall by 2% in the
rst year relative to the baseline.
In this scenario, increasing fears of a restructuring of Italian and Spanish
sovereign debt cause major spikes in credit spreads, leading to a severe
recession. Relative to the baseline scenario, a deeper debt crisis would
cause a peak drop in GDP of 4.3% in the Eurozone core countries (for
example France, Germany and the Netherlands) and 7% in the Eurozone
periphery (for example Italy, Spain and Greece).
The main risk factor in this scenario is the weakness of the Eurozone
banks balance sheets. Even relatively healthy German and French banks
are operating with equity cushions worth only 1.5-3% of their assets. This
makes them vulnerable to small drops in the value of their loan portfolio.
The situation of Italian and Spanish banks is clearly worse. Eurozone banks
would face severe nancial stress due to signicant ownership of Eurozone
periphery debt, strong nancial links between the banks, and spillover
effects from lower output to higher default rates on private sector loans.
Several banks may require a government bailout.
The increased nancial markets turmoil would lead to a major credit crunch
in the Eurozone, amplied by collapsing business and consumer condence.
Lower availability of credit and higher uncertainty would generate sharp
drops in business investment, hiring and consumer spending.
The ECB would cut interest rates to zero, and there could be some
stabilisation of sovereign bond markets through the Outright Monetary
Transactions (OMT) programme. These actions would moderate the impact
of the nancial shock. But due to the zero lower bound on interest rates and
potential limits on the conduct and effectiveness of ECB asset purchases,
monetary policy would not be enough to prevent a large drop in economic
activity.
Scenario 1: The effects of Eurozone debt crisis deterioration on selected
economies
Source: Euromonitor International (Macro Model)
Note: Year on year quarterly real GDP growth, difference from baseline forecast
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2013 Euromonitor International
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Chinese Hard Landing
Chinese economic growth is expected to slow down signicantly over the
next decade in comparison to the 2000s. Annual GDP growth rates over the
next decade should be in the 6.5%-7.5% range. The baseline forecast calls
for a smooth deceleration. But there is roughly a 5%-10% probability that
this deceleration turns into a more severe downturn. In this hard landing
scenario Chinas GDP would fall by 4% in the rst year, and by a further
1.7% in the second year relative to the baseline.
A hard landing would be triggered by simultaneous defaults of several major
shadow banking system trusts and the announcement of a big increase in
the proportion of loans in default at one of the main state banks. These
events would lead to a severe tightening of credit to the private sector.
Tighter borrowing conditions and loss of business condence would lead
to a sharp drop in investment and employment. Eventually, a government
bail out of state banks and a reduction in nancial markets panic would
stabilize the situation, leading to a gradual recovery over the following
decade.
International spillovers would be signicant, especially in Asia. Japanese
GDP would fall by 1.4% relative to our baseline forecast in the rst year of
this scenario. Taiwans economy would take a major hit due to its close links
with China - its GDP would fall by almost 3% relative to the baseline.
Scenario 2: The effects of Chinese hard landing on selected economies
Source: Euromonitor International (Macro Model)
Note: Year on year quarterly real GDP growth, difference from baseline forecast
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2013 Euromonitor International
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US Recession
In this scenario, the US enters a recession during 2013-2014. GDP drops by
3.9% relative to our baseline forecast. Likely triggers of the recession are
growing doubts in nancial markets about the ability of the US government
to stabilise its long-term debt situation. Financial market concerns would be
amplied by the greater uncertainty of US households and businesses about
the future tax rates they will be facing over the coming decade. Increasing
nancial markets stress and scal policy uncertainty would lead to tighter
credit conditions and falling business and consumer condence. The
negative shocks to credit conditions, consumer and business condence
would cause signicant drops in consumer spending, business investment
and employment.
The central position of the US in the global economy implies signicant
international spillovers. In China GDP would decline by up to 1.9% in
comparison to our baseline forecast. GDP would decline by up to 1.5% in
Mexico and 2.6% in Canada relative to the baseline.
Scenario 3: The effects of US recession on selected economies
Source: Euromonitor International (Macro Model)
Note: Year on year quarterly real GDP growth, difference from baseline forecast
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2013 Euromonitor International
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Conclusion
Our baseline forecast assumes that the Eurozone crisis has been successfully
stabilised, that the US continues its gradual recovery without being hit by
new major shocks and that the transition of Chinas economy to slower
growth is smooth. This note has highlighted the key downside risks to
this baseline outlook. A worsening Eurozone nancial crisis in particular
remains the biggest risk, followed by the possibility of a more abrupt hard
landing in China.
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2013 Euromonitor International
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