World trade has decelerated sharply. This ill omen portends severe risks in the months to come. The greatest risks are in the eurozone - where Italy is the fault line along which the most acute vulnerabilities lie.
In the three months ending in April, the annual pace of world trade growth dipped slightly below 4 percent, a sharp decline from 5.5 percent rate in the second half of 2017.
Trade growth in 2017 was both a barometer and cause of rare “synchronized” GDP growth with nearly every country experiencing buoyant conditions. That sweet spot is fading because the Chinese economy is slowing down.
With its huge size and extensive global trade relationships, changes in Chinese domestic economic priorities have a huge impact on trade and the world economic outlook. A blistering pace of Chinese imports propped world trade growth until January this year, and a slowdown since then in Chinese imports has dampened world trade.
The shift is a consequence of the attempt by Chinese leadership to diffuse a grossly oversized credit bubble. But reduced credit has squeezed investment in infrastructure projects and, hence, in the imports of goods and materials to support those projects. Recently, retail sales have also slowed.
China’s credit bubble may yet burst, causing global economic and financial mayhem. Even if the Chinese economy merely slows down, which it seems almost certain to, global trade deceleration will continue. If, in addition, the global trade war escalates, global economic conditions could deteriorate rapidly.
Growth deceleration is already evident in the eurozone. German growth relies to an extraordinary degree on exports to China and, not surprisingly, German industrial production has been in the doldrums in the past few months. Moreover, when German exporters face weaker growth prospects, they buy less from their largely European suppliers, which significantly dampens economic growth in Europe.
Italy will face the ill-effects of a global slowdown most acutely. After abysmal performance through much of the last decade, Italian GDP growth had picked up to annual rate of 1.8 percent in the second half of 2017. But that did not last. Already, Italian GDP growth is slowing and forecasts for the 2018 have are down to just above a 1 percent annual growth rate.
Even these forecasts may prove too optimistic. If world trade growth stays below 4 percent a year for an extended period of time—as now seems likely— the Italian economy will face headwinds via Germany’s slowdown and direct limits on exports to the rest of the world. In that case, the Italian economy would stop growing in the second half of 2018.
Italy could then face the perfect storm. The European Central Bank’s monetary policy is too tight for Italy. The real interest rate (the interest rate adjusted for inflation) for many Italian borrowers is above 2 percent. The euro is too strong for Italian exporters.
With such demanding monetary conditions, the Italian economy could tip over quickly into recession. The government’s already high debt burden on over 130 percent of GDP would rise rapidly. Delinquent borrowers would add to the pressure on the country’s fragile banks.
Italy is large. Italian government debt is €2.5 trillion, about the same size as the debt owed by the German and French governments. Italian banking assets are only slightly smaller than those of German and French banks.
An Italian financial crisis could run through the defences that eurozone authorities constructed during the prolonged crisis from 2009 to 2013. The signature lending facility, the European Stability Mechanism (ESM) may well be downgraded if called on support Italy financially. Credit rating agencies had briefly threatened to downgrade Germany and the ESM even during the Greek crisis, and the Greek government debt and financial system are about one-eight the size of Italy’s.
The ECB’s promise to buy unlimited quantities of bonds of a eurozone member country does not face technical limits—the ECB can, in principle, print money. But the ECB would almost certainly face political limits on it the scope of its actions.
To make good on its promise, the ECB would require a fiscal austerity program and deep reforms from the Italian government. Any Italian government that tried to deliver on such measures would face a public rebellion, fueling more political instability. Fear that the Italian government may end up defaulting on the debt that the ECB has bought will give other member states pause because they will be called on to top the ECB’s capital.
The world faces challenging prospects. If the Chinese credit bubble continues to grow, the global economy would hum for a while longer but the bubble could burst uncontrollably with dire consequences. Continuation of a controlled Chinese slowdown would dampen global growth, causing economic stress in the eurozone and sending tremors along Italy’s financial fault line. Throw into this mix a trade war, and it could be a cold and long winter.
Ashoka Mody is Visiting Professor of International Economic Policy at Princeton University and former deputy director of the International Monetary Fund’s European and Research Departments. His new book is Eurotragedy: A Drama in Nine Acts
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