Vanessa Rossi
(Former Chatham House Expert)

2008 was a disastrous year for the world economy and the financial system, with risks multiplying up and breaking out into a "perfect storm" by September. While there is now some hope that the worst of the turmoil is over for the banks, this is rather like emerging from the storm shelter to start the mopping up process and examine the cost of rebuilding. The world economy will remain deep under the flood water in early 2009, with collapsing consumer and investment spending cutting activity and job losses into the New Year. World trade plummeted at an astonishing rate at the end of 2008 and will be hard to turn around in 2009.

To appreciate the scale of this collapse in activity, effectively there has been a double recession. All the major developed economies plunged into a synchronized recession in mid-2008, only to be hit by the impact of the crash in the global financial system in the autumn. Adding recession on top of recession implies an almost unprecedented drop of 1-2% in GDP for the OECD bloc in 2009 and very little growth in the emerging market economies. Some countries will suffer even steeper recessions, especially those facing balance of payments crises. The weakest players have already sought assistance totaling $85 billion from the IMF.

The first stage of the recession should have been recognized earlier in the year - and policy should have been more reactive to this - but the second stage, and the speed and scale of the business losses in the last months of the year, went well beyond most expectations. An indicator of the severity of the downturn is the collapse in US car sales - already weak in early 2008, by autumn the sales numbers were down to thirty year lows. There is little hope of sales turning up quickly and, excluding a government bail out, the US car industry is facing bankruptcy. Unfortunately, given the momentum behind this downturn, and with job losses exacerbating the weakening in consumer spending, it is unlikely that the downward spiral can be halted quickly. Consumer spending is expected to drop by 1-3% in 2009 and trade and investment by 5-10%. World growth will be around zero.
Source: Own estimates and IMF, November 2008

Key Indicators to Watch in the New Year: US Policy and China's Industrial Growth

Policy efforts, from cuts in interest rates to fiscal packages, will take time to come into effect in the first half of 2009 and will not be able to prevent yet worse economic statistics emerging in the New Year. Nevertheless, impacts on sentiment should gain more traction once the new US administration has settled in. Many hopes are riding on Obama and it will be critical that the US quickly establishes some optimism for where the recovery can come from. The other major swing factor for the New Year will be China: can the government keep growth going? This will determine whether or not there is any chance of keeping world growth ticking over in early 2009 and what happens next in commodity markets. If China holds growth above 7% and the US sets policy on a plausible and positive course, then a wave of relief, and maybe even optimism, could emerge. But this is far from guaranteed.

In terms of a recovery in spending rather than sentiment, this may take many months - we could be looking for mushrooms in autumn rather than green shoots in spring. And there are various hazards to be negotiated on the way. For example, the recovery could be hampered by an exceptionally prolonged cycle for consumer durables, especially if deflation becomes a real threat.

But some signs of recovery will most likely be showing through by 2010. Emerging markets will be quick to reassume growth. Particularly Asia is in a strong position to benefit from any increase in global spending. Public finances and the banking sector are generally in good shape and low external debt coupled with substantial foreign exchange reserves stand this region in good stead for a robust recovery. Asian demand will also fuel growth in the energy and commodity producing region. Eastern Europe seems to be the biggest casualty of this recession and may struggle to recover from the downturn. Large external deficits and foreign debts, speculation in the housing market and consumption financed by excessive borrowing all pose challenges to a speedy revival. The repercussions are likely to be felt throughout the whole of Europe and the banking sector in spite of the aid flowing through from the IMF and EU.

Read More: