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Global crisis monitor
June/July 2009
Global crisis monitor www.eiu.com © The Economist Intelligence Unit Limited 2009

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Introduction
The worst downside risks for the global economy have not materialised but the outlook remains
exceptionally uncertain. The challenges for both developed and emerging markets are immense, this
year will be extremely testing for most businesses, and even beyond this year prospects are poor. To
help senior executives weather this economic storm, the Economist Intelligence Unit has updated its
answers to some of the questions most frequently asked by clients, following the publication of the
four previous editions of Global crisis monitor. In answering each question, we outline our current
forecast, explain our thinking, and highlight any key risks or alternative scenarios.
Q: How do we expect the financial crisis to progress and when will it end?
A: Despite some improvement in financial sentiment, pressures on the financial sector and real
economy remain intense. We do not expect another disorderly collapse of a major financial
institution like that of Lehman Brothers in September 2008, but this does not mean that the
financial sector is anywhere close to being healthy again. Still, government support for the banking
system now seems assured in all major economies. Governments will still allow small banks to go
bust, but the Lehman debacle has lowered the threshold for the size of companies considered “too
big to fail”. The chances that the US government will in effect nationalise several of the major US
banks has receded substantially. Nonetheless, bank lending to US companies and households is likely
to contract in the second half of 2009 and much of 2010 as banks adjust to a sharp rise in loan-
default risk, with a return to positive lending growth not before the second half of 2010. The risk that
bank lending might contract for longer remains very high. We expect spreads on riskier corporate
debt, which widened to their highest level since at least the early 1980s during the last three months
of 2008, to remain far above normal levels for the remainder of 2009 and much of 2010.
Key points to note:
The pressure on banks’ balance sheets remains extreme. Although sentiment in financial markets
has improved substantially, problems in the US residential mortgage market are still not fully
digested. Many banks are still using optimistic assumptions for the valuation of their loan books and
some of their securities. Stress tests by regulators in the US concluded that the top 19 banks needed
to raise their capital by only US$75bn, but this assessment was probably too lenient. Moreover,
strains are now much wider in scope than the US housing downturn. The recent global housing boom
had the longest duration, greatest synchronisation and largest total gain in house prices in recorded
history, and its reversal will lead to a sharp increase in defaults on residential mortgages in many
countries, not just the US. But many other asset markets (commercial mortgages, commodities,
equities, etc) had been buoyed by speculative investment with borrowed money, and these loans are
now also turning sour. Most importantly, the economic downturn will lead to a surge in defaults by
corporates and households. The sharp downturn in Eastern Europe will pose special challenges for
Western European banks, which have massive exposure to the region and to emerging markets more
generally. In addition, banks’ exposure to large unregulated markets, such as that for credit default
swaps, leads to considerable uncertainty about bank solvency. The test for this will come as
corporate bond defaults rise. Forthcoming regulatory changes that will require banks to hold more
capital against their loans will be a factor weighing on banks’ longer-term prospects.
Governments will continue to provide support. The turmoil after the collapse of Lehman Brothers on
September 15th 2008 showed the devastating impact of allowing a major bank to fail. As a
consequence, governments in all advanced economies have made containing the crisis their priority
and will use any measures necessary to do so—including providing capital injections to financial
institutions, massively boosting liquidity in the economy, nationalising banks and lending directly to
the non-bank sector. Initiatives to contain the instability caused by the bad assets remaining on
bank balance sheets—such as insuring the bad assets, transferring them to “bad banks” or
nationalising major banks that are particularly affected—will also provide relief. Governments are
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still in the process of learning, so policy errors remain a major source of risk. There is also a danger
that popular opposition to support for highly-paid bankers could lead to difficulties in getting key
rescue measures approved by parliaments or that conditions attached to approved measures are too
punitive to be effective. Finally, rising concerns about public finances could undermine rescue
efforts, either because governments become more reluctant to commit large resources or because
markets react to rescue efforts by demanding higher public bond yields, with implications for other
borrowers.
Q: How serious will the downturn be in the advanced economies?
A: In light of a number of more positive indicators, we have revised up our US forecast. We now
expect real GDP to contract by 2.6% in 2009 (March: 3.2% contraction). However, we have lowered
our forecast for Japan to a contraction of 6.9% (March: 6.4% contraction). We have also downgraded
the outlook for the euro area, which we now expect will contract by 4.5% in 2009 (March: 4%
decline). Next year, GDP is expected to decline by 0.7% in the euro area and rise by 1% in Japan and
1.4% in the US. The stronger performances of the US and Japan will reflect the impact of massive
fiscal stimulus in both countries. Growth will remain weak in subsequent years as earlier excesses will
take time to be absorbed, and 2011 will even see a renewed slowdown in the US, to 0.8%, as the
impact of fiscal stimulus fades and as household balance sheet retrenchment continues. 2009 will be
the first year since the second world war in which the US, Western Europe and Japan will all be in
recession, and it will also be the worst downturn in the US, Japan and the four biggest EU countries
(France, Germany, Italy and the UK) since at least the 1970s for the countries individually. We believe
that an outright collapse in economic activity in the US, with a peak-to-trough fall in GDP of at least
10% (the threshold for a depression), has only a 10% probability. Japan and Germany are at greater
risk of entering depression. Despite this, we believe that on a global scale a Great Depression-style
scenario (US GDP fell by 25% between 1929 and 1933) will be avoided. However, there is a high risk
that the sharp decline in 2009 could be followed by a Japan-style “lost decade” (the difference being
that Japan in the 1990s did not witness a sharp decline in GDP at the outset). Our forecast assumes
that the massive stimulus measures in the US and Japan will have a substantial impact, but we still
believe that the fiscal and monetary stimulus will merely postpone necessary adjustments in
household balance sheets. There is a chance that the measures will have a stronger stimulatory
effect, but this could be followed by a renewed sharp decline in GDP.
Key points to note:
Economies still have to absorb massive imbalances and confidence shocks. Following earlier
excessively loose lending standards and high leverage, credit is being pared back in many countries,
reducing the ability of consumers and companies to spend. Sharp falls in property and equity prices
are also greatly reducing household wealth, forcing consumers to save more to rebuild their balance
sheets. With demand much weaker and exceptionally high uncertainty about economic prospects,
confidence has fallen to record lows. This is discouraging private investment and employment. The
adverse feedback cycle between lower credit and weaker economic demand is placing further strains
on banks and will be hard to break.
Governments have learned from the Great Depression. The main reason for the collapse in output
during the Great Depression in the 1930s, an episode to which the current crisis is often compared,
was that policymakers allowed monetary and fiscal policy to tighten during the early stages of the
crisis. There are limits to comparing the Great Depression to the situation today, but where
similarities exist policymakers seem to have learned from the mistakes of that era. They have started
massive monetary easing, and substantial fiscal stimulus is in the works in many countries. These
factors will help to contain the downward spiral caused by weakening confidence and cyclical factors,
but they will not be able to avoid the adjustment needed to absorb earlier economic excesses. The
fiscal stimulus effectively means a partial shift of liabilities from the household sector to the public
sector, which is better able to cope with the burden. However, the strength of fiscal support also
makes it more likely that badly-needed adjustment will be postponed, raising the spectre of a
prolonged period of anaemic economic performance like that of Japan in the 1990s.
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Q: What are the chances of deflation in the advanced economies?
A: Because of the fall in commodity prices in late 2008, we are now forecasting negative full-year
inflation in the US and Japan in 2009, and only a very weak increase in consumer prices in the euro
area. However, the fall in prices for commodities and other raw materials will be good for GDP
growth, as it will raise consumer purchasing power in countries importing these goods. We estimate
that the chance of a more damaging episode of “proper” deflation in the US and the euro area—which
we define as a decline in the consumer price index excluding energy and food in year-on-year terms
for more than 12 months as a result of depressed demand—is 20% (down from 30% in March).
Deflation would reduce business revenues in nominal terms and would render servicing outstanding
debt more difficult. Particularly if the trend towards declining prices became entrenched, this could
seriously undermine growth prospects further ahead and lead to a performance similar to that of
Japan during its infamous “lost decade”. In Japan we expect inflation to remain negative for a
second year in 2010, but the impact will be less damaging than it would be in the US or the euro area
because inflationary expectations underlying recent corporate investment and borrowing decisions
were already very low.
In other countries, policymakers are so anxious to head off the risk of deflation that they are
injecting huge amounts of liquidity into the financial system. This has led to widespread fears that
inflation will take off once economic growth recovers. We believe that policymakers will be able to
mop up most of the excess liquidity relatively quickly. Consequently, we see only a 10% chance of a
surge in annual average inflation to more than 4% in the US or the euro area in any year between
2011 and 2013. However, getting the timing and scale of liquidity adjustment right will be difficult,
and uncertainty about the process will lead to considerable market volatility.
Key points to note:
Commodity-price falls and economic weakness will depress inflation. Commodity prices, the main
cause of recent high inflation, fell dramatically in the second half of 2008. They have recovered some
ground in recent months but remain well below the peaks seen in 2008. This has led to a sharp
decline in headline inflation rates. The effect will be strongest in mid-2009 (because the peak in
commodity prices was in mid-2008). The impact of base effects will fade in the second half of 2009.
However, the severe weakening of the advanced economies will undermine pricing power for
producers and retailers. This factor takes considerable time to have an effect, so downward pressure
on prices will persist. The bargaining power of employees will also be reduced, leading to weaker
wage growth and hence lower consumer price inflation.
Q: Will there be a break-up of the euro area?
A: We see only a 10% chance (unchanged from March) of one or more countries leaving the euro area
during 2009 or 2010, despite increased speculation about such a possibility. Fears about
deteriorating public finances and a potential break-up of the euro area led to a surge in government
bond-yield spreads between euro area members earlier this year. Concerns about public debt in
several euro area countries have risen, and there are fears that some euro area countries might use
an exit from the euro area in effect to restructure their national debt. In 2005 the then Italian
welfare minister, Roberto Maroni (now interior minister), called for the reintroduction of the lira.
This was followed by the then prime minister, Silvio Berlusconi (now back in power), calling the euro
a “disaster”. In normal times, leaving the euro area would be very costly: investors would treat a
country that abandoned the single currency in order to redenominate its national debt in the new
currency (at a favourable exchange rate) almost like one that had defaulted, making access to capital
much more difficult. This, in theory, ought to make leaving the euro highly unappealing. However,
the more markets begin to price in the expectation of a country’s exit from the euro, the smaller the
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deterrent becomes as much of the damage (in terms of costlier access to capital) is already done. This
could be a self-reinforcing dynamic, as politicians would then have fewer qualms about making
populist calls for an exit from the euro, further heating up market suspicions. However, recent
statements by euro area politicians suggest that policymakers are fully aware of this and are
preparing measures to provide financial support should a euro area member state come into
financing difficulties. The IMF, with enhanced capital available for rescue packages, would also help.
The willingness to provide such support reflects, in particular, concerns about the impact of an exit
on other euro zone countries, as investors would become much more cautious about putting money
into other high-risk member states.
Key points to note:
Reasons to stay in the euro area are strong. Euro membership has helped to dampen currency
volatility and to contain surges in bond yields during the crisis. Also, a devaluation during the
current global crisis would be of limited use given that export markets are so weak that exports
would hardly react to any gains from greater competitiveness (although import substitution would
still help). The impact on the financial sector would also be severe. Apart from the concerns
mentioned above and the fact that support from other member states to avoid a break-up would
probably be forthcoming, there would also be major practical, legal and political obstacles to leaving
the euro zone. These would include determining which bank accounts would be redenominated in the
new currency and which would be left in euros, overcoming the fact that there is no legal basis for
leaving the euro area, and dealing with the likely negative implications for European co-operation in
other areas.
Q: How badly will emerging markets be hit?
A: The financial and economic crisis will seriously hit most major emerging markets. Among the 30
biggest emerging markets (in purchasing-parity-adjusted GDP terms, going down to countries such
as Chile, Vietnam and the Czech Republic), we now expect 20 to experience a full-year GDP
contraction in 2009 (unchanged from March). This compares to 11 contractions during the year of
the Asian financial crisis in 1998 and none between 2004 and 2007. Although economic prospects
have improved, the risk of negative GDP growth will also be high in several of the remaining ten
countries (with China a notable exception; we also do not expect GDP to decline in India). Some of
the biggest countries expected to shrink this year are Russia, Mexico and South Korea (although
South Korea less than previously expected because of massive fiscal stimulus). Eastern Europe will
perform particularly badly, although most of the countries there do not make it into the top-30 list.
The chance of foreign-payments crises for many countries is also high.
Key points to note:
Many emerging markets are heavily exposed to the global crisis. Emerging markets are heavily
exposed to the global crisis through several channels. Many countries (particularly in Eastern
Europe) rely on external financing that has largely dried up. Most emerging markets have also
experienced substantial falls in the value of their currency, and despite some recovery this makes it
more difficult to service debt denominated in US dollars, euros or Japanese yen. Most emerging
markets are also heavily exposed to the advanced economies through the export sector, which is
often an important driver of employment and investment. We expect world trade to contract by 8.2%
in 2009, and demand for cyclically sensitive goods, durable consumer goods and capital goods will be
particularly poor. The risk of protectionism in developed economies is also rising, which could
further undermine export-oriented countries. Commodity exports are a key source of external
revenue for many emerging markets, so the decline in commodity prices and in commodity demand
that has occurred since mid-2008 is still having severe negative repercussions for these countries
(although, of course, commodity importers benefit).
Foreign reserves and savings will provide a safety net, but not a fail-safe one. Some emerging-
market economies, notably in Asia, have built massive war chests of foreign reserves, which should
help to protect them in situations in which it is difficult to get foreign exchange. These economies
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are much better prepared for the current crisis than they were ahead of the last round of emerging-
market turmoil in the late 1990s. However, reserves can be depleted quickly (as has recently been
seen in Russia), and improved fundamentals are of little use when countries are hit by an external
shock as massive as the current one.
Q: How badly will China be hit?
A: We forecast that official Chinese GDP growth will fall to about 7.2% in 2009 (March forecast: 6%).
This is a sizeable slowdown from the previous peak of 13% in 2007 (in fact comparable in terms of
percentage points to the decline in the US). The forecast is for a slight further increase to 7.6% in
2010. The main risk is that domestic stimulus, particularly through government-directed bank
lending, is too strong. This would lead to even higher GDP growth in 2009 and potentially in 2010,
but then a substantial fall-off in GDP growth in late 2010 and in 2011.
Key points to note:
China faces both external and domestic problems. For an economy of its size, China has unusually
large exposure to global demand. Exports account for around 20% of domestic value added (and 36%
of GDP). The export sector also accounts for a substantial share of gross fixed investment (which is by
far the most important component of total GDP) and employment. The sharp decline in the global
economy is hitting China badly, although capital controls reduce the risk of major strains from
capital outflows. The government has reacted by introducing massive stimulus measures, including
fiscal stimulus and encouragement to banks to lend generously. This has already led to a sharp rise in
credit growth to more than 30% year on year. The problem is that the government may be reluctant
to maintain this level of stimulus, out of concern to avoid creating overcapacity. If this happens, a
substantial withdrawal of stimulus may lead to a renewed decline in growth unless foreign demand
returns.
Q: Will the massive fiscal expansion in the US lead to a dollar collapse?
A: Concerns are rising that the massive rise in federal government liabilities and a potential decline
in foreign governments’ demand for US Treasuries could lead to a crisis of confidence in the US
dollar. However, we still believe that there is only a 30% chance of a crisis of confidence in 2009-10
severe enough to drag the US dollar substantially below US$1.60:€1 (unchanged from March). This is
based on our view that the US dollar will keep its status as the international reserve currency owing
to the lack of alternatives in the medium term.
Key points to note:
The federal government faces a sharp rise in liabilities. The US government and the Federal Reserve
have taken on massive liabilities in order to address the financial crisis. The economic downturn is
putting heavy pressure on tax revenues, while the new administration of Barack Obama, the
president, has passed a fiscal stimulus package worth US$787bn. There is also a substantial risk that,
given the fundamental imbalances built up in previous years, the stimulus will only temporarily lift
output and then evaporate, leading to continued weakness in revenues and potentially calls for
further large spending projects. Although many of the financial rescue measures will be kept off the
federal government’s balance sheet, some initiatives will still have a big impact on the deficit and
the federal debt.
There are few alternatives for low-risk investments. The US dollar will continue to be supported by
the fact that it remains the predominant international reserve currency. There is little prospect of it
losing that status in the near future, despite recent steps by Chinese policymakers to raise the
international profile of the renminbi. Hopes for a greater role for the renminbi will remain unrealistic
as long as capital-account restrictions remain in place, which is likely to be the case for the next
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decade at least. The euro area and the UK have also been hit hard by the financial crisis, so they are
in no position to challenge the global role of the US dollar. Meanwhile, Japan remains too closed an
economy to be a viable alternative for investments. The appreciation of the US dollar during the
worst of the crisis in late 2008 and early 2009 has shown that the currency has kept its safe-haven
status. There is a good chance that demand for US assets from foreign central banks and sovereign
wealth funds will decline as emerging-market current-account surpluses shrink. But this will be
largely offset, at least in the near term, by a massive flight to safety as private investors move their
assets out of equities and other riskier investments.
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Global crisis monitor www.eiu.com © The Economist Intelligence Unit Limited 2009