U.S. Recession? Who Would Be Next?

Executive Summary

Financial markets in most countries have been in turbulence in recent days due, at least in part, to growing concerns about prospects of a U.S. recession and implications thereof for growth in foreign economies. Although our view is that the U.S. economy will narrowly miss recession in 2008, we proceed in this report under the assumption that the U.S. economy will indeed experience a downturn this year. Would the rest of the world follow the United States into recession? If not the entire world, then which countries would be most affected by an American recession?

The most direct way that an American recession would spread to the rest of the world is via the weaker exports to the United States. In that regard, Canada and Mexico stand out as being the most susceptible to an American downturn, especially a severe one. Although the European Union is the least exposed nation to exports to the United States, at least as measured as a percentage of local GDP, Europe does not have much cushion due to its relatively low overall GDP growth rate. Contrary to popular perceptions, the Chinese economy would not collapse if the United States experiences recession. Small open Asian economies, such as Singapore and Taiwan, might feel more of an impact, but these economies are better able to withstand an American downturn than they were during the last cycle. Most Latin economies probably would not fall apart either.

Economic fundamentals in many economies, especially in the developing world, have improved over the past decade. Many developing economies are no longer incurring sizeable current account deficits, which makes them less vulnerable to sudden outflow of foreign capital that would sharply weaken growth. Significantly lower inflation rates give foreign central banks more leeway to cut interest rates if growth starts to weaken, and fiscal policy could turn expansionary because fiscal deficits in many countries have largely been reined in. Although most countries have not completely "de-coupled" from the U.S. economy, they are better able to withstand an American downturn than they were previously.

U.S. Economic Weakness Spreads to the Rest of the World via Trade Flows

The media has been filled with stories recently about a looming U.S. recession. Although our view is that the U.S. economy will narrowly miss recession this year, our forecasted GDP growth rate would make 2008 the weakest year since 2002.1 Whether or not the United States experiences an actual recession this year, the rest of the world clearly will still feel the effects of slower U.S. economic growth. Our official forecast notwithstanding, let's proceed under the assumption that America will indeed slip into a recession in 2008. If that is the case, what other countries in the world would be at risk from a U.S. economic downturn?

The most direct way that a U.S. recession would spread to the rest of the world would be via trade flows. The American economy accounts for roughly 25% of global GDP, so a downturn in the United States would have a detrimental effect on most countries' total exports.2 Exhibit 1 shows exports to the United States as a percentage of GDP for major regions in the world.

Exhibit 1

Canada and Mexico Are the Most Exposed to a U.S. Downturn

The most exposed region to an American economic downturn is North America (i.e., Canada and Mexico), which should come as little surprise due to the proximity of those countries to the United States. Exhibit 2 shows that GDP growth rates in Canada and Mexico have been highly correlated historically with real import growth in the United States. Over the past few quarters, U.S. import growth has slowed but real GDP growth rates in Canada and Mexico have strengthened. Given extensive trade ties with the United States, however, it seems like just a matter of time before growth in Canada and Mexico slows as well. Indeed, monthly economic indicators suggest that the Canadian economy down-shifted a notch in the fourth quarter.

Exhibit 2

Does this mean that Canada and Mexico are doomed if the United States slips into recession? Not necessarily. Although the Canadian recession of 1990-91 was deeper and longer than the downturn the U.S. economy experienced at that time, Mexico escaped relatively unscathed. Likewise, the United States helped to pull Mexico into recession in 2000–2001, but Canada managed to continuing growing, albeit at sluggish pace, during those years. Either country could conceivably stay out of a recession if any American downturn in 2008 was relatively short and shallow, a la 1990–1991 and 2000–2001. Canada's abundant supply of natural resources, which are in high demand in the rest of the world, could help to support Canadian economic activity. However, it does not seem credible that Canada and Mexico could avoid recession if the U.S. economy contracted sharply.

Europe Is Not Completely Immune from a U.S. Downturn

On the other end of the spectrum, the exports from the European Union to the United States are equivalent to only 2% of EU GDP, making the region the least directly exposed to the U.S. economy as a percentage of local GDP. Although it may seem that the European Union has little to fear, the effects on EU growth from an American downturn may be more significant than what first meets the eye. Although domestic demand has been the primary driver of Euro-zone GDP growth over the past few years, net exports have also made positive contributions to growth over that period. In addition, the relatively low growth rate in the Euro-zone gives the region less cushion should the U.S. economy slip into recession.3 In our view, the Euro-zone should not be complacent about a potential U.S. recession.

On the other hand, the American economy would not necessarily pull down the Euro-zone with it, especially if any U.S recession were relatively minor. As noted above, domestic demand has been the primary driver of Euro-zone GDP growth over the past few years. In addition, ECB monetary policy is not exceptionally tight at present. Indeed, some ECB policymakers believe policy should be tightened further to insure that inflation expectations to do not rise.

The United Kingdom may fare a bit worse from a U.S. recession than most countries in continental Europe. U.K. economic growth is starting to weaken. and the recent softening in the housing market could have a knock-on effect on consumer spending, the main driver of British GDP growth over the past few years. Moreover, monetary policy in the United Kingdom is currently more restrictive than policy in the Euro-zone. Although British export exposure to America is comparable to ratios across the Channel, the last thing the U.K. economy needs at present is the shock of a significant downturn in exports to the United States.

Exhibit 3
Asian Growth Surely Would Slow, but Not Collapse

What about the developing world? Exhibit 3 shows that growth in the developing world generally has slowed in past U.S. downturns. That said, the developing world appears to have "de-coupled" from the U.S. economy in the past few years. That is, real GDP growth in the United States has slowed but economic growth in developing countries has strengthened. Is the developing world now immune to a recession in the United States?

Let's start with Asia, where exports to the United States are equivalent to 7% of the region's GDP. The popular perception is that Asian economic growth, especially growth in China, is driven by exports of consumer products to the United States. If this perception has any basis in fact, then Asia could slow sharply if the U.S. economy slips into recession.

However, Exhibit 4, which shows that the correlation between U.S. import growth and growth in Chinese industrial production is quite low, casts some doubt on the notion that Chinese economic growth is driven by the whims of U.S. consumers. Although American import growth plunged in 2001 as the U.S. economy slid into recession, growth in Chinese industrial production barely budged. More recently, U.S. import growth has been weakening, but Chinese IP growth has strengthened. There must be much more to Chinese economic growth than simply exports to the United States.

Exhibit 4

Indeed, Chinese economic growth springs largely from two sources. First, high savings rates finance robust growth in capital spending. Second, migration of millions of rural underemployed workers gives the teeming factories in the coastal provinces a source of cheap labor. Although net exports have made positive contributions to Chinese GDP growth over the past few years, the real drivers of the Chinese economic growth are capital accumulation and sizable increases in the productive labor force. A downturn in the U.S. economy surely would cause the overall rate of Chinese GDP growth to slow, but it would not lead to a collapse of the Chinese economy as recent history demonstrates. U.S. GDP growth slowed sharply from 3.7% in 2000 to only 0.8% in 2001. In contrast, Chinese GDP growth only edged down from 8.0% in 2000 to 7.5% the following year. An American recession certainly would be felt in China, but the Chinese economy likely would not collapse.

Some of the very open economies in Asia (e.g., Taiwan, Singapore and Hong Kong) could be affected more than China from a downturn in the United States. In our view, however, these economies are better able to withstand a significant American slowdown than they were during the last U.S. recession. Most Asian countries plunged into deep recessions in the late 1990s after a series of financial and economic crises swept through the region. Although economic growth turned positive again in 1999, the battered economies were not strong enough to withstand the U.S. downturn in 2001 that was centered in the tech industry, a key export of many Asian economies. Consequently, the region slipped back into recession early in the decade.

Back-to-back recessions resulted in stagnant investment spending in many Asian economies for nearly a decade. However, pent-up demand, especially in nonresidential construction, has led to an upturn in capital spending across the region in the past year or so. In addition, consumer spending has accelerated. Therefore, domestic demand has become an important economic driver again, and consequently growth in the region is not as dependent on exports to the United States as it was even a few years ago.

Asia Is Becoming Increasingly More Important for Latin America

According to Exhibit 1, the rest of Latin America has significantly less export exposure to the U.S. economy than Mexico. That said, exports to the United States are equivalent to 6% of Latin GDP, and a U.S. downturn undoubtedly would slow growth in the region. But would the U.S. economy pull Latin America down with it?

The region may be able to withstand a U.S. recession better than it has in the past because Asia is becoming an increasingly important export destination for most Latin countries. Latin America is rich in resources, and its exports to Asia have boomed over the past few years. For example, Latin exports to China have risen six-fold since 2000. Although the United States continues to represents the largest single export market for Latin America, the fast-growing economies of Asia offer some offset for Latin America. Moreover, we believe most developing countries, including those in Latin America, are better able to withstand a significant slowdown in the U.S. economy than they were in past cycles.

Most Developing Economies Less Susceptible to a U.S. Downturn due to Stronger Economic Fundamentals

The underlying economic fundamentals in most developing countries have improved dramatically over the past decade. Whereas the developing world racked up significant current account deficits in the 1990s, it is now incurring sizable surpluses (see Exhibit 5). Therefore, most developing countries are less susceptible to a sudden outflow of foreign capital that would lead to significantly slower economic growth. In addition, inflation in the developing world has receded from double-digit rates about a decade ago to low-single-digit rates currently, which gives central banks in developing economies more leeway to ease monetary policy should growth start to slow. Fiscal policy could also turn expansionary because most developing economies no longer incur large fiscal deficits. Finally, high personal savings rates in many developing economies can help to support consumer spending if income growth should start to slow.

Exhibit 5

Conclusion

Some analysts have claimed recently that many countries have "de-coupled" from the U.S. economy. That is, these economies are not as dependent on U.S. economic growth as they once were, and they would be little affected by an American recession. In our view, this "de-coupling" thesis is overblown. The U.S. economy accounts for approximately 25% global GDP, and turning one-quarter of the world's output negative certainly would have an effect on other nations. As income in export industries in foreign economies slows, the multiplier effects in the economy will lead to slower growth in consumer and business spending in those economies as well.

So, what foreign countries would be most affected by an American recession? Due to their extensive trade ties with the United States, Canada and Mexico stand at the top of the list. The European Union has the lowest direct export exposure to the United States, at least when measured as a percentage of local GDP, but its relatively low GDP growth rate does not give it much cushion should exports to the United States fall sharply. Contrary to popular perceptions, the Chinese economy would not collapse should America slide into recession. Indeed, Chinese growth slowed only mildly during the last U.S. recession. Small open Asian economies would likely be affected more than China, but those economies are better able to cope with a U.S. downturn than they were a few years ago.

Obviously, the effects on foreign economies depend on the severity of any U.S. recession. The deeper and longer the recession, the greater impact it would have on the rest of the world. Although a U.S. recession could conceivably last longer than the last two relatively mild and short recessions, it probably would not approach the severity of the 1981-82 downturn when GDP contracted 2.3%. In an effort to wring inflation out of the economy, the Fed tightened policy significantly prior to that recession. It did not let up until the economy had weakened significantly. Although housing and the ongoing credit dislocations will continue to weigh on the economy, Fed policy has turned accommodative and the Bush administration and Congress recently agreed on a fiscal stimulus package.

Although most regions of the world are not immune to the effects of an American recession, many are better able to withstand a downturn in the United States than they were in past cycles. China is starting to emerge as an important driver of growth for many other Asian economies, although it will be a number of years before China replaces the United States as the world's largest economy. More important, the underlying fundamentals of many foreign economies have improved significantly over the past decade or so, leaving them less susceptible to the knock-on effects that a U.S. recession would entail as well as giving them the wherewithal to respond appropriately with macroeconomic policies should growth weaken.

Wachovia Corporation

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