In view of the significant events affecting world capital markets and the global economy during much of August-November 1998, the IMF staff’s projections for world growth in 1999 have been revised downward—although not substantially—to 2¼ percent in 1999 from the projections in the October 1998 World Economic Outlook of 2½ percent in 1999. (For 1998, the estimated growth has been revised up slightly.) These new projections, contained in an interim joint update of the IMF’s latest regular reports on the World Economic Outlook (see IMF Survey, October 19, 1998, page 305) and International Capital Markets(see IMF Survey, September 28, 1998, page 290), underscore the continuing costs of the Asian crisis, its repercussions, and the crises that afflicted financial markets in 1998.
Describing the revised projections in a press briefing held on December 21, Michael Mussa, IMF Economic Counsellor and Director of the Research Department, said that the most serious downside risks to the global economy that emerged as a result of the turbulence in global financial markets now seem to have subsided, and the relatively modest scale of the downward revisions to the global growth outlook since early September suggests that the situation may have begun to stabilize.
In addition to reassessing and updating the World Economic Outlook, the interim assessment sheds light on the sources and nature of the turbulence experienced in both mature and emerging financial markets and seeks to identify critical shortcomings in private and public risk-management systems.
Projections and Risks
The effective devaluation and unilateral debt restructuring announced by Russia in mid-August triggered a series of sharp market corrections, Mussa explained at the press briefing. The tension and turbulence that developed in several financial markets initially forced a widening of interest rate spreads and cut off new credit flows to emerging market borrowers.
The turbulence then spread to the deepest and most liquid of the world’s financial markets, producing sharp declines in industrial country equity prices, unusual volatility in the yields of highest grade government debt, a general rush to safety and a drying up of liquidity, and sharp movements in key exchange rates. These developments, Mussa said, led the IMF staff to further revise their projections for world growth downward.
The interim assessment suggests that, despite the downward revisions in growth projections, the danger of a worldwide recession appears to have diminished. Conditions in financial markets have calmed down since early October, Mussa said, thanks in part to timely actions by monetary authorities in North America, Europe, and Asia to ease monetary conditions. In addition, the Asian economies most caught up in the recent crisis—notably, Korea and Thailand—are making substantial progress with their stabilization and reform efforts, as evidenced by the strengthening of their exchange rates and equity markets. Also, Brazil, with substantial support from the international community, has undertaken a forceful program to correct its chronic fiscal imbalances and thereby help stabilize its own economy and halt the spread of contagion (see IMF Survey, December 14,1998, page 385).
Because of the calming in financial markets and the actions that helped bring it about, Mussa said, the IMF staff’s assessment of the near-term prospects for the world economy are actually “little changed from the way we saw things in early September” when the previous World Economic Outlook draft was put together. Indeed, he said, the forecast for world growth in 1998 has been revised up
A breakdown of the aggregate nevertheless reveals significant changes for individual countries, Mussa said. Among the industrial countries, most notably, the 1999 growth forecast for Japan has been revised down a full percentage point, standing now at -½ of 1 percent. Among the emerging market economies, the forecasts for Latin America have been revised down significantly, while that for China has been boosted somewhat.
As with any forecast, however, there are always risks, Mussa stressed, both on the upside—particularly in the United States where fourth quarter growth may be stronger than forecast and in Asia where there is potential for a more rapid recovery than projected in the interim assessment—and on the downside—such as in Latin America, where the risks are still “modestly on the downside.”
The “key message in the report is that the worst of this crisis is now behind us,” Flemming Larsen, Deputy Director of the Research Department, said at the press briefing. He warned, however, that this judgment comes with “considerable caveats,” and “we certainly do not believe that we are completely out of the woods.” A number of risks and uncertainties remain, Larsen said:
The speed of recovery of private capital flows to emerging markets may not be quite as rapid as assumed in the interim report’s projections.
The speed of recovery in Japan, which is dependent upon the implementation of necessary measures to stimulate the economy and speed up the restructuring and recapitalization of the banking system, is a key uncertainty.
The uneven pattern of trade adjustment in the wake of large shifts to surpluses in the Asian crisis countries has given rise to concerns about the sustainability of the corresponding very large U.S. current account deficit, as well as about a resurgence in protectionist pressures.
The strong recovery of stock markets, especially in the United States, may not be sustainable. The sustainability of the large imbalance that has built up in recent years between private saving and investment in the United States is a further cause for concern.
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In response to questions about the significant downward revision for Japan despite the government’s recent announcement of measures to help the economy, Larsen said that the downward revisions to the projections would have been even larger in the absence of the recent policy announcements. The current projection reflects very recent events, including the sharp appreciation of the yen in September, which has had a depressing influence on the economy and will require stronger domestic demand growth to offset it. On the plus side, the newly announced budget may well produce a different assessment of the fiscal stance, although it is still too early to say. A number of other measures are in the works, Larsen added, that could get the Japanese economy restarted during 1999.
Explaining the revisions in prospects for Latin America, Larsen said they reflected several factors, including international trade linkages, the projected slowdown in growth in the United States, and higher rates of interest and reduced availability of foreign financial flows. Although interest rates have come down significantly since September 1998, Larsen said, they remain much higher than they were before the Russian crisis in August. Recent developments in commodity prices, including oil markets, are also likely to have a depressing effect on domestic demand and the level of imports that can be sustained in several Latin American countries.
Sources of Turbulence
The recent turbulence in global financial markets was unusual for a period characterized by relatively strong macroeconomic policies and conditions in many of the advanced economies, including, in particular, the United States, the interim assessment notes. The volatility reflected a sudden heightened perception of, and aversion to, risk following Russia’s effective debt default in August and an associated flight to quality. Emerging markets were particularly affected, but the repercussions were not limited to these countries. The global flight to quality led to sharp increases in spreads on financial assets in some of the deepest capital markets in the world, especially in the United States, and to sharp volatility in the dollar-yen exchange rate.
The extraordinarily high degree of turbulence experienced in financial markets, Mussa said at the press briefing, appeared to be substantially out of proportion with the magnitude of the triggering events—the Russian crisis and the near- collapse and last-minute bailout of Long-Term Capital Management, a major U.S. hedge fund. This mismatch between apparent cause and effect is not only a mystery but a serious cause for concern, Mussa said. The massive turbulence in markets apparently grounded in sound fundamentals raises questions about the working and design of financial markets—questions about transparency, the internal risk management and control procedures of some of the largest internationally active financial institutions, and the adequacy of prudential supervision and systemic financial market surveillance.
Charles Adams, Assistant Director in the Research Department, speaking at the press conference, mentioned that in the process of compiling the interim report, the IMF staff looked at the nature and sources of the turbulence to see what lessons could be drawn about policies and actions that could minimize the risk of future turbulence. For several years before the Asian crisis, there had been a repricing of risks, a narrowing of spreads, and, during 1998, a buildup of vulnerabilities—that is, a lot of positions based on risk spreads remaining low or continuing to narrow. The events in Russia triggered a global reassessment of the value of risk, Adams said, which set in motion a chain reaction of portfolio rebalancing and changing of positions that was exacerbated by a high degree of leverage in the system. Looking at the events in a broader context, Adams said, “we have identified serious shortcomings in three main lines of defense”: private risk- management schemes of individual financial institutions, prudential oversight, and financial market supervision. “These systems,” he said, “failed to prevent a buildup in leveraged positions, which crumbled after the Russian default, giving rise to the subsequent bout of severe turbulence.”
In response to a question about appropriate defense measures, Mussa said that private sector financial institutions need to take a look at their own risk assessment and management systems. The private sector needs to concern itself with how key financial institutions that lent money to hedge funds and other speculative investors are assessing and managing the risks they are undertaking in their various financial operations, he said. As for appropriate action on the supervision and regulation side, Mussa said the Basle Committee on Banking Supervision has been looking carefully at the issue of capital adequacy standards, especially as they relate to banks’ growing off-balancesheet activity, which accounts for an increasing slice of their total earnings. A key issue, Mussa said, is how the capital and other standards coming out of the Basle Committee can be adapted to deal with the changing structure of the business of modern, large, internationally active commercial banks.
Garry Schinasi, Chief of the Capital Markets and Financial Studies Division, said that among the reforms under consideration by the Basle Committee was a shift from rules-based to risk-focused capital standards. There is also, he said, a more general trend toward looking at risk-management systems and operational controls rather than trying to monitor every risk that a bank takes.
Responding to Risks
The interim update marks the second consecutive year that global economic developments have warranted a public update of the semiannual World Economic Outlook. At the press conference, Mussa was asked if the IMF was concerned about its credibility, given its prediction in December 1997 that the three Asian countries most affected by financial crisis that had received IMF support for their programs would not suffer recessions. Yet, all three had experienced massive recessions in the past year. Mussa agreed that the IMF, as indeed virtually all other forecasters, had underestimated the severity of the downturn. This underscored, he said, the importance of focusing not only on the central forecast but also on the potential for different outcomes.
One important lesson from the presence of risk, Mussa said, is that policy is not inert in the face of emerging developments in economies and financial markets. “We have seen a forceful indication of that in the past three months.” If there had been no policy response to the conditions that were developing in world financial markets in September and early October, Mussa concluded, “this interim assessment of the world economic outlook and capital market developments would look considerably darker than it does today.”
The World Economic Outlook and International Capital Markets: Interim Assessment, December 1998, will be available in January 1999 for $36.00 (academic rate: $25.00) from IMF Publication Services. See page 15 for ordering information.