Global economy to face more stress scenarios in 2008-09, says Moody’s

Rarely has the global economy faced as high a level of “transition risk” in recent years as it does today, Moody’s Investors Service said in a new report. While the central scenario remains rather robust, the probability of a highly adverse outcome has increased somewhat, with a number of plausible stress scenarios meriting serious consideration.

The central zone of uncertainty is evidently the US, where the impact of the liquidity and credit crisis on the economic outlook remains unclear, Moody’s noted.

“It is essential for any micro-level credit analysis to take account of the broader economic and financial context and thus to consider the credit risk implications of a decidedly less favourable outcome for the world economy,” explained Pierre Cailleteau, Moody’s Chief International Economist and author of the report.

The Moody’s report explains what the rating agency views as the baseline for the global economy in 2008-2009 as well as the key factors and developments that underpin this scenario. It then discusses the three possible global risk scenarios.

“This is not a forecasting exercise, but rather contingency planning based on plausible but unlikely scenarios,” Cailleteau added.

Moody’s regards the global economic and financial scenario for 2008-09 as one of continued solid growth globally, increased differentiation between advanced and emerging economies with the US facing recessionary headwinds, low to moderate global inflation, still buoyant international trade, somewhat narrowing global imbalances, a slowly subsiding stress on financial markets, with banking re-intermediation denting bank profits and weighing on credit extension, but not leading to a severe credit crunch.

“In other words, the central scenario for 2008-09 does not mark the end of either the ‘Great Moderation’ (i.e. high growth, low inflation and low volatility) or the ‘Interest Rate Conundrum’ (the unusual situation of having very low long-term interest rates despite a buoyant world economy). In this scenario, some financial pain continues to be absorbed, especially as the US economy confronts recessionary forces, while the engines of a globalised economy continue to fire,” Cailleteau explained.

There are many downside risks to this scenario, and a few upside risks.

In fact, the degree of uncertainty around this central scenario is unusually high. Moody’s identified three plausible stress scenarios:

1) Sharp decoupling: the first risk scenario is a variant of the baseline outlook where the US economy embarks on a prolonged period of slow growth, while the rest of the world economy remains more (emerging economies) or less (Europe and Japan) strong. In this risk scenario, the dollar declines against those currency that are not pegged to it, severe inflationary pressures take hold in the emerging economies and oil prices continue to rise.

2) Stagflation: the second scenario assumes the combination, in the US, of a recession and a significant increase in inflation, triggered by a sharp broad-based depreciation of the dollar in a context where the disinflationary impact of Asia‘s surplus labour supply is brought to an end. This also marks the end of the current low long-term interest rate environment, the need for massive official exchange rate interventions — which contributed to maintaining interest rates low despite buoyant growth — fading away.

3) Stagnation: this scenario envisages a broad-based slowdown of the world economy and a severe risk repricing that calls into question the sustainability of much of the debt raised in recent years. The global deleveraging process claims victims in many different places, including some emerging countries.