The global economy remains well on the road to robust recovery from the Covid-19 crisis. That is the good news for 2022. Less comforting, it will be a bumpy ride over the next few months as governments impose fresh restrictions to tackle the emergence of new variants, while higher inflation will lead to monetary policy divergence that could unsettle financial markets.
At Scope Ratings, we estimate global growth will ease to around 4.5% next year from its rapid 5.8% early recovery rebound estimated this year. However, that lower estimate remains well above its long-run potential of around 3%.
Risk to the economic outlook in 2022 is mostly on the downside. Output will expand by around 3.5% in the US, 4.4% in the euro area, 3.6% in Japan and 4.6% in the UK. China will grow nearer its longer-run trend of 5% – normalising from its high 2021 growth but also dampened by restructuring within the property sector and supervisory tightening.
A modest slowdown in recovery during the current quarter and first three months of next year – if not an outright fall in output – is possible as governments, notably in Europe, take new measures to slow rates of Covid-19 infection as the omicron variant goes global. Restrictions on those who are not vaccinated are being phased in. The economic rebound ought then to pick up speed again by the spring of 2022.
The pandemic’s choke point in the advanced world remains capacities of health systems to cope with surges in more serious cases, hence re-imposition of partial lockdown and vaccination requirements. More reassuring is that the risk Covid-19 poses to economic recovery ought to continue moderating with time as governments adopt more targeted responses, the virus becomes more transmissible but less lethal and businesses and people adapt to working under more stringent public health restrictions.
As we slowly exit this pandemic crisis, inflation is a concern. Inflationary pressures are likely to remain more persistent than central banks project, running above pre-crisis averages even after price changes begin to moderate substantively during 2022.
Higher and more persistent inflation has both good and bad implications for sovereign credit ratings. Somewhat higher inflation supports higher nominal economic growth, helping reduce debt-to-gross domestic product ratios, and curtails a long standing risk of deflation in the euro area and Japan. However, rising interest rates push up debt servicing costs, especially for governments with high debt and running budget deficits. Emerging economies, with weakening currencies and subject to capital outflows, are especially at risk.
Under this context, monetary policy is set to diverge notably among the world’s largest economies. As central banks withdraw some crisis-era monetary stimuli, the process could crystallise risks associated with high debt and frothy asset prices.
This is especially true for the UK and US, where inflation is likely to continue testing central bank mandates of keeping price increases to around 2%. The Bank of England and Federal Reserve will increase rates next year.
By contrast, inflation is much less of a concern for the Bank of Japan, while inflation might remain below 2% in the long run in the euro area. The Bank of Japan and European Central Bank are expected to maintain their current lending rates throughout 2022. The ECB will halt the pandemic emergency purchase programme next year, although it and other asset purchase facilities may be adapted while markets adjust. The sharp increase in euro area inflation to 4.9% in November is likely to test the ECB’s resolve in keeping policies accommodative.
In this respect, any reduced capacity central banks have in calming financial markets might expose latent risk associated with debt accrued in the past, should high inflation increasingly constrain monetary room for manoeuvre. The latest statistics from the Bank for International Settlements show non-financial sector debt of global reporting countries hitting a new high of $225tn in the second quarter of 2021, equivalent to 273% of GDP.
Diverging monetary policy puts pressure on central banks otherwise reluctant to tighten policy to protect currencies from further depreciation, which may further stress underpinning inflation. Central banks are now holders of significant amounts of government debt. The resulting fiscal dominance might slow normalisation of monetary policy, although any such delay could accentuate inflation risk.
Still, we ought not be overly pessimistic. Monetary policy innovations during the pandemic – such as the flexibility the ECB introduced with the PEPP – has enhanced the resilience of sovereign borrowers during crisis phases, assuming such innovative monetary instruments are available for redeployment in future downturns.
* Sovereign borrowers with a stable outlook make up more than 90% of Scope’s 36 publicly rated sovereign states, indicating that there is less of a likelihood of ratings changes in 2022 compared with 2021, although economic risks could present upside and downside ratings risk.
Dennis Shen is Director of Sovereign and Public Sector Ratings at Scope Ratings.