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Japan’s Nemesis Threatens Europe

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Pacific Money

Japan’s Nemesis Threatens Europe

As Japan struggles to contain deflation, the eurozone may see prices begin to fall.

Japan may finally be starting to show progress against deflation after a 15-year fight that has divided economic opinion. But now the International Monetary Fund (IMF) has warned the dreaded malaise could hit Europe, too.

Announcing Tuesday the first increase in its global growth forecast for nearly two years, the IMF said in an update to its World Economic Outlook that the world economy would expand by 3.7 percent this year, up from 3 percent in 2013, picking up speed to 3.9 percent average growth in 2015.

The forecasts exceeded the 3.2 percent and 3.4 percent rises in world economic growth recently tipped by the World Bank for this year and next, although the IMF had a similar rationale for its increased optimism.

“The basic reason behind the stronger recovery is that the brakes to the recovery are progressively being loosened,” Olivier Blanchard, the IMF’s chief economist and director of its Research Department, said in a statement.

“The drag from fiscal consolidation is diminishing. The financial system is slowly healing,” he added.

The IMF said global activity had strengthened in the second half of 2013, helped by improved demand in advanced economies, which are expected to see higher growth in 2014. It kept its forecasts unchanged for developing economies, which despite higher exports are facing generally subdued domestic demand.

Yet despite the rosier picture, the IMF warned of new risks from very low inflation in advanced economies, principally the eurozone.

“Inflation is projected to remain below target for some time. If people’s expectations of future inflation drift down in response, actual inflation could turn out even lower than projected. That would increase real debt burdens and raise real interest rates, hampering growth,” the organization said.

Asia’s Mixed Picture

The report painted a mixed picture for the Asia-Pacific region, with Japan expected to slow while developing Asia picks up speed.

Boosted by Abenomics, Japan is expected to maintain last year’s 1.7 percent GDP growth rate in 2014. However, the IMF cut 0.2 percentage point from its forecast for 2015, predicting a deceleration to just 1 percent growth next year as this April’s consumption tax hike weighs on consumer spending.

The IMF’s Blanchard said at a press conference that Japan’s growth had come from fiscal stimulus and exports, but consumption and investment needed to start contributing.

“Investment so far has been weak. And the Japanese government will continue to face the challenge of achieving enough fiscal consolidation to reassure debt holders while not slowing down the recovery…that’s going to be for many years to come a difficult challenge,” he said.

The IMF expects an improved performance from developing Asia, with growth rising gradually from 6.5 percent last year to 6.8 percent by 2015, up from its previous forecast.

Following the past year’s 7.7 percent GDP growth rate, China is predicted to cool to 7.5 percent growth in 2014 and 7.3 percent next year, “in part because of policy measures to slow credit growth and raise the cost of capital.”

The IMF’s Thomas Helbling, chief of the World Economic Studies Division, told the same news conference that the investment-to-GDP ratio in the world’s second-biggest economy had been unsustainable, with the financial sector facing the after-effects of its previous boom in rising nonperforming loans.

Meanwhile, India is expected to see better times with a rise in growth from a subpar 4.4 percent last year to 5.4 percent in 2014 and 6.4 percent next year, helped by “stronger structural policies supporting investment.”

Blanchard: Japan OK, Europe Troubling

Amid the general optimism, the IMF warned of the growing threat of deflation, but not from the usual suspect.

“I think there are two places in the world which are places where there’s reason for concern [on deflation]…The first one is Japan because it has a history of deflation. Over this stage, in the short run we’re not very worried. We are not sure that they’ll reach the 2-percent goal that they have set for themselves by the date they hope, but we think that inflation will remain positive,” Blanchard said.

“The part of the world where we worry more is the eurozone where you have nearly a recovery in the core, but you have very weak demand in the south…if we look at inflation swaps, they give a 10-percent to 20-percent probability to inflation turning negative.”

Despite the IMF’s caution, the Bank of Japan left policy unchanged Wednesday, as predicted by market economists, with the nation’s central bank forecasting a 1.9 percent rise in core consumer prices in fiscal 2015.

On developing Asia, the IMF said China needed to make faster progress on “rebalancing domestic demand from investment to consumption.” Other emerging economies needed to heed the risk of sudden sharp capital flow reversals, particularly those with domestic weaknesses and related external current account deficits.

“In short, recovery is indeed strengthening. But as we’ve said many times in the past, and we’ll continue to say for some time, much work remains to be done,” Blanchard concluded.

For the world leaders meeting in Davos this week, the champagne may have to remain on ice for a little longer.