World Economic Outlook, April 2009 : Crisis and Recovery

Front Matter

Front Matter

Author(s):
International Monetary Fund. Research Dept.
Published Date:
April 2009
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    Contents

    Assumptions and Conventions

    A number of assumptions have been adopted for the projections presented in the World Economic Outlook. It has been assumed that real effective exchange rates remain constant at their average levels during February 25–March 25, 2009, except for the currencies participating in the European exchange rate mechanism II (ERM II), which are assumed to remain constant in nominal terms relative to the euro; that established policies of national authorities will be maintained (for specific assumptions about fiscal and monetary policies for selected economies, see Box A1); that the average price of oil will be $52.00 a barrel in 2009 and $62.50 a barrel in 2010, and will remain unchanged in real terms over the medium term; that the six-month London interbank offered rate (LIBOR) on U.S. dollar deposits will average 1.5 percent in 2009 and 1.4 percent in 2010; that the three-month euro deposit rate will average 1.6 percent in 2009 and 2.0 percent in 2010; and that the six-month Japanese yen deposit rate will yield an average of 1.0 percent in 2009 and 0.5 percent in 2010. These are, of course, working hypotheses rather than forecasts, and the uncertainties surrounding them add to the margin of error in the projections. The estimates and projections are based on statistical information available through mid-April 2009.

    The following conventions are used throughout the World Economic Outlook:

    • … to indicate that data are not available or not applicable;

    • – between years or months (for example, 2006-07 or January–June) to indicate the years or months covered, including the beginning and ending years or months;

    • / between years or months (for example, 2006/07) to indicate a fiscal or financial year.

    “Billion” means a thousand million; “trillion” means a thousand billion.

    “Basis points” refer to hundredths of 1 percentage point (for example, 25 basis points are equivalent to ¼ of 1 percentage point).

    In figures and tables, shaded areas indicate IMF staff projections.

    If no source is listed on tables and figures, data are drawn from the World Economic Outlook (WEO) database.

    When countries are not listed alphabetically, they are ordered on the basis of economic size.

    Minor discrepancies between sums of constituent figures and totals shown reflect rounding.

    As used in this report, the term “country” does not in all cases refer to a territorial entity that is a state as understood by international law and practice. As used here, the term also covers some territorial entities that are not states but for which statistical data are maintained on a separate and independent basis.

    Further Information and Data

    This version of the World Economic Outlook is available in full on the IMF’s website, www.imf.org. Accompanying it on the website is a larger compilation of data from the WEO database than is included in the report itself, including files containing the series most frequently requested by readers. These files may be downloaded for use in a variety of software packages.

    Inquiries about the content of the World Economic Outlook and the WEO database should be sent by mail, e-mail, or fax (telephone inquiries cannot be accepted) to

    World Economic Studies Division

    Research Department

    International Monetary Fund

    700 19th Street, N.W.

    Washington, D.C. 20431, U.S.A.

    Internet: www.imf.org/weoforum Fax: (202) 623–6343

    Preface

    The analysis and projections contained in the World Economic Outlook are integral elements of the IMF’s surveillance of economic developments and policies in its member countries, of developments in international financial markets, and of the global economic system. The survey of prospects and policies is the product of a comprehensive interdepartmental review of world economic developments, which draws primarily on information the IMF staff gathers through its consultations with member countries. These consultations are carried out in particular by the IMF’s area departments together with the Strategy, Policy, and Review Department, the Monetary and Capital Markets Department, and the Fiscal Affairs Department.

    The analysis in this report was coordinated in the Research Department under the general direction of Olivier Blanchard, Economic Counsellor and Director of Research. The project was directed by Charles Collyns, Deputy Director of the Research Department, and Jörg Decressin, Division Chief, Research Department.

    The primary contributors to this report are Ravi Balakrishnan, Jaromir Benes, Petya Koeva Brooks, Kevin Cheng, Stephan Danninger, Selim Elekdag, Thomas Helbling, Prakash Kannan, Douglas Laxton, Alasdair Scott, Natalia Tamirisa, Marco Terrones, and Irina Tytell. Toh Kuan, Gavin Asdorian, Stephanie Denis, Murad Omoev, Jair Rodriguez, Ercument Tulun, and Jessie Yang provided research assistance. Saurabh Gupta, Mahnaz Hemmati, Laurent Meister, and Emory Oakes managed the database and the computer systems. Jemille Colon, Tita Gunio, Shanti Karunaratne, Patricia Medina, and Sheila Tomilloso Igcasenza were responsible for word processing. Julio Prego provided graphics support. Other contributors include Kevin Clinton, Dale Gray, Marianne Johnson, Ondrej Kamenik, Ayhan Kose, Prakash Loungani, David Low, and Dirk Muir. Menzi Chinn and Don Harding were external consultants. Linda Griffin Kean of the External Relations Department edited the manuscript and coordinated the production of the publication.

    The analysis has benefited from comments and suggestions by staff from other IMF departments, as well as by Executive Directors following their discussion of the report on April 13, 2009. However, both projections and policy considerations are those of the IMF staff and should not be attributed to Executive Directors or to their national authorities.

    Joint Foreword to World Economic Outlook and Global Financial Stability Report

    Prospects

    Even with determined steps to return the financial sector to health and continued use of macroeconomic policy levers to support aggregate demand, global activity is projected to contract by 1.3 percent in 2009. This represents the deepest post–World War II recession by far. Moreover, the downturn is truly global: output per capita is projected to decline in countries representing three-quarters of the global economy. Growth is projected to reemerge in 2010, but at 1.9 percent it would be sluggish relative to past recoveries.

    These projections are based on an assessment that financial market stabilization will take longer than previously envisaged, even with strong efforts by policymakers. Thus, financial conditions in the mature markets are projected to improve only slowly, as insolvency concerns are diminished by greater clarity over losses on bad assets and injections of public capital, and counterparty risks and market volatility are reduced. The April 2009 issue of the Global Financial Stability Report (GFSR) estimates that, subject to a number of assumptions, credit write-downs on U.S.-originated assets by all holders since the start of the crisis will total $2.7 trillion, compared with an estimate of $2.2 trillion in the January 2009 GFSR Update. Including assets originated in other mature market economies, total write-downs could reach $4 trillion over the next two years, approximately two-thirds of which may be taken by banks. Overall credit to the private sector in the advanced economies is thus expected to decline during both 2009 and 2010. Because of the acute degree of stress in mature markets and its concentration in the banking system, capital flows to emerging economies will remain very low.

    The projections also assume continued strong macroeconomic policy support. Monetary policy interest rates are expected to be lowered to or remain near the zero bound in the major advanced economies, while central banks continue to explore unconventional ways to ease credit conditions and provide liquidity. Fiscal deficits are expected to widen sharply in both advanced and emerging economies, on assumptions that automatic stabilizers are allowed to operate and governments in G20 countries implement fiscal stimulus plans amounting to 2 percent of GDP in 2009 and 1½ percent of GDP in 2010.1

    The current outlook is exceptionally uncertain, with risks still weighing on the downside. A key concern is that policies may be insufficient to arrest the negative feedback between deteriorating financial conditions and weakening economies in the face of limited public support for policy actions.

    Policy Challenges

    The difficult and uncertain outlook argues for continued forceful action both on the financial and macroeconomic policy fronts to establish the conditions for a return to sustained growth. Whereas policies must be centered at the national level, greater international cooperation is needed to avoid exacerbating cross-border strains. Building on the positive momentum created by the April G20 summit in London, coordination and collaboration is particularly important with respect to financial policies to avoid adverse international spillovers from national actions. At the same time, international support, including the additional resources being made available to the IMF, can help countries buffer the impact of the financial crisis on real activity and limit the fallout on poverty, particularly in developing economies.

    Repairing Financial Sectors

    The greatest policy priority for ensuring a durable economic recovery is restoring the financial sector to health. The three priorities identified in previous issues of the GFSR remain relevant: (1) ensuring that financial institutions have access to liquidity, (2) identifying and dealing with distressed assets, and (3) recapitalizing weak but viable institutions and resolving failed institutions.

    The critical underpinning of an enduring solution must be credible loss recognition on impaired assets. To that end, governments need to establish common basic methodologies for a realistic, forward-looking valuation of securitized credit instruments. Various approaches to dealing with bad assets in banks can work, provided they are supported with adequate funding and implemented in a transparent manner.

    Bank recapitalization must be rooted in a careful evaluation of the prospective viability of institutions, taking into account both writedowns to date and a realistic assessment of prospects for further write-downs. As supervisors assess recapitalization needs on a bank-by-bank basis, they must assure themselves of the quality of the bank’s capital and the robustness of its funding, its business plan and risk-management processes, the appropriateness of compensation policies, and the strength of management. Viable financial institutions that are undercapitalized need to be intervened promptly, possibly utilizing a temporary period of public ownership until a private sector solution can be developed. Nonviable institutions should be intervened promptly, which may entail orderly closures or mergers. In general, public support to the financial sector should be temporary and withdrawn at the earliest opportunity. The amount of public funding needed is likely to be large, but the requirements will rise the longer it takes for a solution to be implemented.

    Wide-ranging efforts to deal with financial strains in both the banking and corporate sectors will also be needed in emerging economies. Direct government support for corporate borrowing may be warranted. Some countries have also extended public guarantees of bank debt to the corporate sector and provided backstops to trade finance. Additionally, contingency plans should be devised to prepare for potential large-scale restructurings if circumstances deteriorate further.

    Supporting Aggregate Demand

    In advanced economies, room to further ease monetary policy should be used forcefully to support demand and counter deflationary risks. With the scope for lowering interest rates now virtually exhausted, central banks will have to continue exploring less conventional measures, using both the size and composition of their own balance sheets to support credit intermediation.

    Emerging economies also need to ease monetary conditions to respond to the deteriorating outlook. However, in many of those economies, the task of the central bank is further complicated by the need to sustain external stability in the face of highly fragile financing flows and balance sheet mismatches because of domestic borrowing in foreign currencies. Thus, although central banks in most of these economies have lowered interest rates in the face of the global downturn, they have been appropriately cautious in doing so to maintain incentives for capital inflows and to avoid disorderly exchange rate moves.

    Given the extent of the downturn and the limits to monetary policy action, fiscal policy must play a crucial part in providing short-term support to the global economy. Governments have acted to provide substantial stimulus in 2009, but it is now apparent that the effort will need to be at least sustained, if not increased, in 2010, and countries with fiscal room should stand ready to introduce new stimulus measures as needed to support the recovery. However, the room to provide fiscal support will be limited if such efforts erode credibility. In advanced economies, credibility requires addressing the medium-term fiscal challenges posed by aging populations. The costs of the current financial crisis—while sizable—are dwarfed by the impending increases in government spending on social security and health care for the elderly. It is also desirable to target stimulus measures to maximize the long-term benefits to the economy’s productive potential, such as spending on infrastructure. Importantly, to maximize the benefits for the global economy, stimulus needs to be a joint effort among the countries with fiscal room.

    Looking further ahead, a key challenge will be to calibrate the pace at which the extraordinary monetary and fiscal stimulus now being provided is withdrawn. Acting too fast would risk undercutting what is likely to be a fragile recovery, but acting too slowly could risk inflating new asset price bubbles or eroding credibility. At the current juncture, the main priority is to avoid reducing stimulus prematurely, while developing and articulating coherent exit strategies.

    Easing External Financing Constraints

    Economic growth in many emerging and developing economies is falling sharply, and adequate external financing from official sources will be essential to cushion adjustment and avoid external crises. The IMF, in concert with others, is already providing such financing for a number of these economies. The G20 agreement to increase the resources available to the IMF will facilitate further support. Also, the IMF’s new Flexible Credit Line should help alleviate risks for sudden stops of capital inflows and, together with a reformed IMF conditionality framework, should facilitate the rapid and effective deployment of these additional resources if and when needed. For the poorest economies, additional donor support is crucial lest important gains in combating poverty and safeguarding financial stability be put at risk.

    Medium-Run Policy Challenges

    At the root of the market failure that led to the current crisis was optimism bred by a long period of high growth and low real interest rates and volatility, together with a series of policy failures. These failures raise important medium-run challenges for policymakers. With respect to financial policies, the task is to broaden the perimeter of regulation and make it more flexible to cover all systemically relevant institutions. Additionally, there is a need to develop a macroprudential approach to both regulation and monetary policy. International policy coordination and collaboration need to be strengthened, including by better early-warning exercises and a more open communication of risks. Trade and financial protectionism should be avoided, and rapid completion of the Doha Round of multilateral trade negotiations would revitalize global growth prospects.

    Olivier Blanchard

    Economic Counsellor

    José Viñals

    Financial Counsellor

    The Group of 20 comprises 19 countries (Argentina, Australia, Brazil, Canada, China, France, Germany, India, Indonesia, Italy, Japan, Mexico, Republic of Korea, Russia. Saudi Arabia, South Africa, Turkey, United Kingdom, and United States) and the European Union.

    Executive Summary

    The global economy is in a severe recession inflicted by a massive financial crisis and acute loss of confidence. While the rate of contraction should moderate from the second quarter onward, world output is projected to decline by 1.3 percent in 2009 as a whole and to recover only gradually in 2010, growing by 1.9 percent. Achieving this turnaround will depend on stepping up efforts to heal the financial sector, while continuing to support demand with monetary and fiscal easing.

    Recent Economic and Financial Developments

    Economies around the world have been seriously affected by the financial crisis and slump in activity. The advanced economies experienced an unprecedented 7½ percent decline in real GDP during the fourth quarter of 2008, and output is estimated to have continued to fall almost as fast during the first quarter of 2009. Although the U.S. economy may have suffered most from intensified financial strains and the continued fall in the housing sector, western Europe and advanced Asia have been hit hard by the collapse in global trade, as well as by rising financial problems of their own and housing corrections in some national markets. Emerging economies too are suffering badly and contracted 4 percent in the fourth quarter in the aggregate. The damage is being inflicted through both financial and trade channels, particularly to east Asian countries that rely heavily on manufacturing exports and the emerging European and Commonwealth of Independent States (CIS) economies, which have depended on strong capital inflows to fuel growth.

    In parallel with the rapid cooling of global activity, inflation pressures have subsided quickly. Commodity prices fell sharply from midyear highs, causing an especially large loss of income for the Middle Eastern and CIS economies but also for many other commodity exporters in Latin America and Africa. At the same time, rising economic slack has contained wage increases and eroded profit margins. As a result, 12-month headline inflation in the advanced economies fell below 1 percent in February 2009, although core inflation remained in the 1½–2 percent range, with the notable exception of Japan. Inflation has also moderated significantly across the emerging economies, although in some cases falling exchange rates have dampened the downward momentum.

    Wide-ranging and often unorthodox policy responses have made limited progress in stabilizing financial markets and containing the downturn in output, failing to arrest corrosive feedback between weakening activity and intense financial strains. Initiatives to stanch the bleeding include public capital injections and an array of liquidity facilities, monetary easing, and fiscal stimulus packages. While there have been some encouraging signs of improving sentiment since the Group of 20 (G20) meeting in early April, confidence in financial markets is still low, weighing against the prospects for an early economic recovery.

    The April 2009 Global Financial Stability Report (GFSR) estimates write-downs on U.S.-originated assets by all financial institutions over 2007–10 will be $2.7 trillion, up from the estimate of $2.2 trillion in January 2009, largely as a result of the worsening prospects for economic growth. Total expected write-downs on global exposures are estimated at about $4 trillion, of which two-thirds will fall on banks and the remainder on insurance companies, pension funds, hedge funds, and other intermediaries. Across the world, banks are limiting access to credit (and will continue to do so) as the overhang of bad assets and uncertainty about which institutions will remain solvent keep private capital on the sidelines. Funding strains have spread well beyond short-term bank funding markets in advanced economies. Many nonfinancial corporations are unable to obtain working capital, and some are having difficulty raising longer-term debt.

    The broad retrenchment of foreign investors and banks from emerging economies and the resulting buildup in funding pressures are particularly worrisome. New securities issues have come to a virtual stop, bank-related flows have been curtailed, bond spreads have soared, equity prices have dropped, and exchange markets have come under heavy pressure. Beyond a general rise in risk aversion, this reflects a range of adverse factors, including the damage done to advanced economy banks and hedge funds, the desire to move funds under the “umbrella” provided by the increasing provision of guarantees in mature markets, and rising concerns about the economic prospects and vulnerabilities of emerging economies.

    An important side effect of the financial crisis has been a flight to safety and return of home bias, which have had an impact on the world’s major currencies. Since September 2008, the U.S. dollar, euro, and yen have all strengthened in real effective terms. The Chinese renminbi and currencies pegged to the dollar (including those in the Middle East) have also appreciated. Most other emerging economy currencies have weakened sharply, despite the use of international reserves for support.

    Outlook and Risks

    The World Economic Outlook (WEO) projections assume that financial market stabilization will take longer than previously envisaged, even with strong efforts by policymakers. Thus, financial strains in the mature markets are projected to remain heavy until well into 2010, improving only slowly as greater clarity over losses on bad assets and injections of public capital reduce insolvency concerns, lower counterparty risks and market volatility, and restore more liquid market conditions. Overall credit to the private sector in the advanced economies is expected to decline in both 2009 and 2010. Meanwhile, emerging and developing economies are expected to face greatly curtailed access to external financing in both years. This is consistent with the findings in Chapter 4 that the acute degree of stress in mature markets and its concentration in the banking system suggest that capital flows to emerging economies will suffer large declines and recover only slowly.

    The projections also incorporate strong macroeconomic policy support. Monetary policy interest rates are expected to be lowered to or remain near the zero bound in the major advanced economies, while central banks continue to explore ways to use both the size and composition of their balance sheets to ease credit conditions. Fiscal deficits are expected to widen sharply in both advanced and emerging economies, as governments are assumed to implement fiscal stimulus plans in G20 countries amounting to 2 percent of GDP in 2009 and 1½ percent of GDP in 2010. The projections also assume that commodity prices remain close to current levels in 2009 and rise only modestly in 2010, consistent with forward market pricing.

    Even with determined policy actions, and anticipating a moderation in the rate of contraction from the second quarter onward, global activity is now projected to decline 1.3 percent in 2009, a substantial downward revision from the January WEO Update. This would represent by far the deepest post–World War II recession. Moreover, the downturn is truly global: output per capita is projected to decline in countries representing three-quarters of the global economy, and growth in virtually all countries has decelerated sharply from rates observed in 2003-07. Growth is projected to reemerge in 2010, but at just 1.9 percent would be sluggish relative to past recoveries, consistent with the findings in Chapter 3 that recoveries after financial crises are significantly slower than other recoveries.

    The current outlook is exceptionally uncertain, with risks weighed to the downside. The dominant concern is that policies will continue to be insufficient to arrest the negative feedback between deteriorating financial conditions and weakening economies, particularly in the face of limited public support for policy action. Key transmission channels include rising corporate and household defaults that cause further falls in asset prices and greater losses across financial balance sheets, and new systemic events that further complicate the task of restoring credibility. Furthermore, in a highly uncertain context, fiscal and monetary policies may fail to gain traction, since high rates of precautionary saving could lower fiscal multipliers, and steps to ease funding could fail to slow the pace of dele-veraging. On the upside, however, bold policy implementation that is able to convince markets that financial strains are being dealt with decisively could revive confidence and spending commitments.

    Even once the crisis is over, there will be a difficult transition period, with output growth appreciably below rates seen in the recent past. Financial leverage will need to be reduced, implying lower credit growth and scarcer financing than in recent years, especially in emerging and developing economies. In addition, large fiscal deficits will need to be rolled back just as population aging accelerates in a number of advanced economies. Moreover, in key advanced economies, households will likely continue to rebuild savings for some time. All this will weigh on both actual and potential growth over the medium run.

    Policy Challenges

    This difficult and uncertain outlook argues for forceful action on both the financial and macroeconomic policy fronts. Past episodes of financial crisis have shown that delays in tackling the underlying problem mean an even more protracted economic downturn and even greater costs, both in terms of taxpayer money and economic activity. Policymakers must be mindful of the cross-border ramifications of policy choices. Initiatives that support trade and financial partners—including fiscal stimulus and official support for international financing flows—will help support global demand, with shared benefits. Conversely, a slide toward trade and financial protectionism would be hugely damaging to all, a clear warning from the experience of 1930s beggar-thy-neighbor policies.

    Advancing Financial Sector Restructuring

    The greatest policy priority at this juncture is financial sector restructuring. Convincing progress on this front is the sine qua non for an economic recovery to take hold and would significantly enhance the effectiveness of monetary and fiscal stimulus. In the short run, the three priorities identified in previous GFSRs remain appropriate: (1) ensuring that financial institutions have access to liquidity, (2) identifying and dealing with distressed assets, and (3) recapitalizing weak but viable institutions. The first area is being addressed forcefully. Policy initiatives in the other two areas, however, need to advance more convincingly.

    The critical underpinning of an enduring solution must be credible loss recognition on impaired assets. To that effect, governments need to establish common basic methodologies for the realistic valuation of securitized credit instruments, which should be based on expected economic conditions and an attempt to estimate the value of future income streams. Steps will also be needed to reduce considerably the uncertainty related to further losses from these exposures. Various approaches to dealing with bad assets in banks can work, provided they are supported with adequate funding and implemented in a transparent manner.

    Recapitalization methods must be rooted in a careful evaluation of the long-term viability of institutions, taking into account both losses to date and a realistic assessment of the prospects of further write-downs. Subject to a number of assumptions, GFSR estimates suggest that the amount of capital needed might amount to $275 billion–$500 billion for U.S. banks, $475 billion–$950 billion for European banks (excluding those in the United Kingdom), and $125 billion–$250 billion for U.K. banks.1 As supervisors assess recapitalization needs on a bank-by-bank basis, they will need assurance of the quality of banks’ capital; the robustness of their funding, business plans, and risk management processes; the appropriateness of compensation policies; and the strength of management. Supervisors will also need to establish the appropriate level of regulatory capital for institutions, taking into account regulatory minimums and the need for buffers to absorb further unexpected losses. Viable banks that have insufficient capital should be quickly recapitalized, with capital injections from the government (if possible, accompanied by private capital) to bring capital ratios to a level sufficient to regain market confidence. Authorities should be prepared to provide capital in the form of common shares in order to improve confidence and funding prospects and this may entail a temporary period of public ownership until a private sector solution can be developed. Nonviable financial institutions need to be intervened promptly, leading to resolution through closures or mergers. Amounts of public funding needed are likely to be large, but requirements are likely to rise the longer it takes for a solution to be implemented.

    Wide-ranging efforts to deal with financial strains will also be needed in emerging economies. The corporate sector is at considerable risk. Direct government support for corporate borrowing may be warranted. Some countries have also extended their guarantees of bank debt to firms, focusing on those associated with export markets, or have provided backstops to trade finance through various facilities—helping to keep trade flowing and limiting damage to the real economy. In addition, contingency plans should be devised to prepare for potential large-scale restructuring in case circumstances deteriorate further.

    Greater international cooperation is needed to avoid exacerbating cross-border strains. Coordination and collaboration is particularly important with respect to financial policies to avoid adverse international spillovers from national actions. At the same time, international support, including from the IMF, can help countries buffer the impact of the financial crisis on real activity and, particularly in the developing countries, limit its effects on poverty. Recent reforms to increase the flexibility of lending instruments for good performers caught in bad weather, together with plans advanced by the G20 summit to increase the resources available to the IMF, are enhancing the capacity of the international financial community to address risks related to sudden stops of private capital flows.

    Easing Monetary Policy

    In advanced economies, scope for easing monetary policy further should be used aggressively to counter deflation risks. Although policy rates are already near the zero floor in many countries, whatever policy room remains should be used quickly. At the same time, a clear communication strategy is important—central bankers should underline their determination to avoid deflation by sustaining easy monetary conditions for as long as necessary. In an increasing number of cases, lower interest rates will need to be supported by increasing recourse to less conventional measures, using both the size and composition of the central bank’s own balance sheet to support credit intermediation. To the extent possible, such actions should be structured to maximize relief in dislocated markets while leaving credit allocation decisions to the private sector and protecting the central bank balance sheet from credit risk.

    Emerging economies also need to ease monetary conditions to respond to the deteriorating outlook. However, in many of those economies, the task of central banks is further complicated by the need to sustain external stability in the face of highly fragile financing flows. To a much greater extent than in advanced economies, emerging market financing is subject to dramatic disruptions—sudden stops—in part because of much greater concerns about the creditworthiness of the sovereign. Emerging economies also have tended to borrow more heavily in foreign currency, and so large exchange rate depreciations can severely damage balance sheets. Thus, while most central banks in these economies have lowered interest rates in the face of the global downturn, they have been appropriately cautious in doing so to maintain incentives for capital inflows and to avoid disorderly exchange rate moves.

    Looking further ahead, a key challenge will be to calibrate the pace at which the extraordinary monetary stimulus now being provided should be withdrawn. Acting too fast would risk undercutting what is likely to be a fragile recovery, but acting too slowly could risk overheating and inflating new asset price bubbles.

    Combining Fiscal Stimulus with Sustainability

    In view of the extent of the downturn and the limits to the effectiveness of monetary policy, fiscal policy must play a crucial part in providing short-term stimulus to the global economy. Past experience suggests that fiscal policy is particularly effective in shortening the duration of recessions caused by financial crises (Chapter 3). However, the room to provide fiscal support will be limited if efforts erode credibility. Thus, governments are faced with a difficult balancing act, delivering short-term expansionary policies but also providing reassurance about medium-term prospects. Fiscal consolidation will be needed once a recovery has taken hold, and this can be facilitated by strong medium-term fiscal frameworks. However, consolidation should not be launched prematurely. While governments have acted to provide substantial stimulus in 2009, it is now apparent that the effort will need to be at least sustained, if not increased, in 2010, and countries with fiscal room should stand ready to introduce new stimulus measures as needed to support the recovery. As far as possible, this should be a joint effort, since part of the impact of an individual country’s measures will leak across borders, but brings benefits to the global economy.

    How can the tension between stimulus and sustainability be alleviated? One key is the choice of stimulus measures. As far as possible, these should be temporary and maximize “bang for the buck” (for example, accelerated spending on already planned or existing projects and time-bound tax cuts for credit-constrained households). It is also desirable to target measures that bring long-term benefits to the economy’s productive potential, such as spending on infrastructure. Second, governments need to complement initiatives to provide short-term stimulus with reforms to strengthen medium-term fiscal frameworks to provide reassurance that short-term deficits will be reversed and public debt contained. Third, a key element to ensure fiscal sustainability in many countries would be concrete progress toward dealing with the fiscal challenges posed by aging populations. The costs of the current financial crisis—while sizable—are dwarfed by the impending costs from rising expenditures on social security and health care for the elderly. Credible policy reforms to these programs may not have much immediate impact on fiscal accounts but could make an enormous change to fiscal prospects, and thus could help preserve fiscal room to provide short-term fiscal support.

    Medium-Run Policy Challenges

    At the root of the market failure that led to the current crisis was optimism bred by a long period of high growth and low real interest rates and volatility, along with policy failures. Financial regulation was not equipped to address the risk concentrations and flawed incentives behind the financial innovation boom. Macroeconomic policies did not take into account the buildup of systemic risks in the financial system and in housing markets.

    This raises important medium-run challenges for policymakers. With respect to financial policies, the task now is to broaden the perimeter of regulation and make it more flexible to cover all systemically relevant institutions. In addition, there is a need to develop a macroprudential approach to regulation, which would include compensation structures that mitigate procyclical effects, robust market-clearing arrangements, accounting rules to accommodate illiquid securities, transparency about the nature and location of risks to foster market discipline, and better systemic liquidity management.

    Regarding macroeconomic policies, central banks should also adopt a broader macroprudential view, paying due attention to financial stability as well as price stability by taking into account asset price movements, credit booms, leverage, and the buildup of systemic risk. Fiscal policymakers will need to bring down deficits and put public debt on a sustainable trajectory.

    International policy coordination and collaboration need to be strengthened, based on better early-warning systems and a more open communication of risks. Cooperation is particularly pressing for financial policies, because of the major spillovers that domestic actions can have on other countries. At the same time, rapid completion of the Doha Round of multilateral trade talks could revitalize global growth prospects, while strong support from bilateral and multilateral sources, including the IMF, could help limit the adverse economic and social fallout of the financial crisis in many emerging and developing economies.

    The lower end of the range corresponds to capital needed to adjust leverage, measured as tangible common equity (TCE) over total assets, to 4 percent. The upper end corresponds to capital needed to raise the TCE ratio to 6 percent, consistent with levels observed in the mid-1990s (see the April 2009 GFSR).

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