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- Published Date:
- October 2008
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World economic outlook (International Monetary Fund)
World economic outlook: a survey by the staff of the International Monetary Fund.—Washington, DC: International Monetary Fund, 1980–
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- Assumptions and Conventions
- Executive Summary
- Chapter 1. Global Prospects and Policies
- Global Economy under Stress
- Financial System in Crisis
- Deepening Housing Corrections
- Overstretched Commodity Markets
- Have Macroeconomic Policies Been Too Loose?
- Prospects for a Turnaround
- Policy Challenges for the Global Economy
- Appendix 1.1. Assessing and Communicating Risks to the Global Outlook
- Chapter 2. Country and Regional Perspectives
- United States and Canada: Prognosis for the Downturn
- Western Europe: Struggling with Multiple Shocks
- Advanced Asia: Responding to External Shocks
- Emerging Asia: Balancing Risks to Growth and Price Stability
- Latin America and the Caribbean: Navigating a More Perilous Environment
- Emerging Europe: Prospects for a Soft Landing
- Commonwealth of Independent States: Managing the Commodity Price Boom
- Sub-Saharan Africa: A Test of Policy Frameworks
- Middle East: Overheating Still a Concern
- Chapter 3. Is Inflation Back? Commodity Prices and Inflation
- Surging Commodity Prices: Origins and Prospects
- Commodity Price Shocks and Inflation
- Monetary Policy Responses to Commodity Price Shocks
- Summary and Conclusions
- Appendix 3.1. Recent Commodity Market Developments
- Appendix 3.2. Accounting for Food Price Increases, 2006–08
- Appendix 3.3 Estimating Inflationary Effects of Commodity Price Shocks
- Chapter 4. Financial Stress and Economic Downturns
- Chapter 5. Fiscal Policy as a Countercyclical Tool
- Understanding the Fiscal Policy Debate
- How Has Discretionary Fiscal Policy Typically Responded?
- Are Fiscal Policy Reactions Different in Emerging and Advanced Economies?
- The Macroeconomic Effects of Discretionary Fiscal Policy
- A Simulation-Based Perspective on Fiscal Stimulus
- Conclusions and Policy Considerations
- Appendix 5.1. Data and Empirical Methods
- Chapter 6. Divergence of Current Account Balances across Emerging Economies
- Annex: IMF Executive Board Discussion of the Outlook, September 2008
- Statistical Appendix
- What’s New
- Data and Conventions
- Classification of Countries
- General Features and Composition of Groups in the World Economic Outlook Classification
- List of Tables
- World Economic Outlook and Staff Studies for the World Economic Outlook, Selected Topics
- 1.1 The Latest Bout of Financial Distress: How Does It Change the Global Outlook?
- 1.2 House Prices: Corrections and Consequences
- 1.3 Measuring Output Gaps
- 2.1 EMU: 10 Years On
- 3.1 Does Financial Investment Affect Commodity Price Behavior?
- 3.2 Fiscal Responses to Recent Commodity Price Increases: An Assessment
- 3.3 Monetary Policy Regimes and Commodity Prices
- 4.1 Policies to Resolve Financial System Stress and Restore Sound Financial Intermediation
- 5.1 Differences in the Extent of Automatic Stabilizers and Their Relationship with Discretionary Fiscal Policy
- 5.2 Why Is It So Hard to Determine the Effects of Fiscal Stimulus?
- 5.3 Have U.S. Tax Cuts Been “TTT”?
- 6.1 Current Account Determinants for Oil-Exporting Countries
- 6.2 Sovereign Wealth Funds: Implications for Global Financial Markets
- 6.3 Historical Perspective on Growth and the Current Account
- A1 Economic Policy Assumptions Underlying the Projections for Selected Economies
- 1.1 Overview of the World Economic Outlook Projections
- 2.1 Advanced Economies: Real GDP, Consumer Prices, and Unemployment
- 2.2 Advanced Economies: Current Account Positions
- 2.3 Selected Asian Economies: Real GDP, Consumer Prices, and Current Account Balance
- 2.4 Selected Western Hemisphere Economies: Real GDP, Consumer Prices, and Current Account Balance
- 2.5 Selected Emerging European Economies: Real GDP, Consumer Prices, and Current Account Balance
- 2.6 Commonwealth of Independent States (CIS): Real GDP, Consumer Prices, and Current Account Balance
- 2.7 Selected African Economies: Real GDP, Consumer Prices, and Current Account Balance
- 2.8 Selected Middle Eastern Economies: Real GDP, Consumer Prices, and Current Account Balance
- 3.1 Contributions of Common Factors to Commodity Price Fluctuations
- 3.2 Selected Indicators of Spillovers across Major Food Commodity Prices
- 3.3 Global Oil Demand and Production by Region
- 3.4 Elasticity Estimates Used for Price Calculations
- 4.1 Descriptive Statistics on Financial Stress Episodes
- 4.2 Descriptive Statistics on Financial Stress, Slowdowns, and Recessions
- 4.3 Cross-Section Regressions
- 4.4 Six Major Periods of Financial Stress and Economic Contractions
- 4.5 Data
- 4.6 Average Yearly Share of Total Bank Assets of Banks in Sample
- 5.1 Macroeconomic Indicators around Downturns, with and without a Fiscal Impulse: All Economies
- 5.2 Real GDP Growth and Fiscal Impulse under Various Initial Conditions: All Economies
- 5.3 Real GDP Growth and Fiscal Impulse by Composition: All Economies
- 5.4 Responses of Real GDP to Discretionary Fiscal Policy Changes
- 5.5 List of Countries and Downturn Episodes
- 5.6 Discretionary Fiscal Policy and Growth: Regression Results with Arellano-Bond Dynamic Panel Estimator Using Elasticity-Based Fiscal Impulse Measure
- 5.7 Discretionary Fiscal Policy and Growth: Regression Results with Arellano-Bond Dynamic Panel Estimator Using Regression-Based Fiscal Impulse Measure
- 6.1 Determinants of the Current Account Balance
- 6.2 Duration Regressions of Persistent and Large Current Account Deficits
- 6.3 Explaining Differentiated Effects in Emerging Europe
- 6.4 List of Persistently Large Current Account Imbalance Episodes
- 6.5 Duration Analysis and Domestic Financial Sector Liberalization
- 6.6 Duration Analysis and Risk of Abrupt and Non-Abrupt Endings
- 1.1 Global Indicators
- 1.2 Current and Forward-Looking Indicators
- 1.3 Global Inflation
- 1.4 External Developments in Selected Advanced Economies
- 1.5 External Developments in Emerging and Developing Economies
- 1.6 Developments in Mature Credit Markets
- 1.7 Mature Financial and Housing Market Indicators
- 1.8 Emerging Market Conditions
- 1.9 Measures of Monetary Policy and Liquidity in Selected Advanced Economies
- 1.10 Measures of the Output Gap and Capacity Pressures
- 1.11 Global Outlook
- 1.12 Risks to the Global Outlook
- 1.13 Impact of Financial Shock on the Global Economy
- 1.14 Current Account Balances and Net Foreign Assets
- 1.15 Median Forecast Errors during Global Recessions and at Other Times, 1991–2007
- 1.16 Histograms of Forecast Errors, 1991–2007
- 1.17 Probability of Global Recessions
- 1.18 Illustrative GPM-Based 90 Percent Confidence Intervals
- 2.1 United States: Strains on Households
- 2.2 Western Europe: Slowing Demand and High Inflation
- 2.3 Japan: How Well Would the Economy Weather a Terms-of-Trade Shock?
- 2.4 Emerging Asia: Remaining Inflation Concerns
- 2.5 Latin America: Inflation Returns
- 2.6 Emerging Europe: Are Credit Booms Cooling Off?
- 2.7 Commonwealth of Independent States (CIS): Managing the Commodity Price Boom
- 2.8 Sub-Saharan Africa: The Mixed Blessing of High Commodity Prices
- 2.9 Middle East: Managing Inflation Pressures
- 3.1 Commodity Prices in Historical Context
- 3.2 Marginal Change in Energy Intensity, Commodity Inventories, and OPEC Spare Capacity
- 3.3 Grain and Oil Demand, Production, and Inventories in Comparison
- 3.4 Oil Supply Developments
- 3.5 Price Trends of Major Foods
- 3.6 Duration and Amplitude of Food and Crude Oil Price Cycles
- 3.7 Inflation around the World
- 3.8 Changes in International and Domestic Commodity Prices and Headline Inflation
- 3.9 The Relative Importance of Food and Energy
- 3.10 Monetary and Exchange Rate Policies
- 3.11 Commodity Price Pass-Through
- 3.12 Changes in Expected Inflation in Response to Changes in Actual Inflation
- 3.13 Activity, Interest Rates, and Inflation
- 3.14 Stylized Advanced Economy with Adverse and Favorable Supply Shocks
- 3.15 Stylized More-Vulnerable Emerging Market Economy with Adverse and Favorable Supply Shocks
- 3.16 Potential Costs of Delaying Interest Rate Hikes
- 3.17 Commodity and Petroleum Prices
- 3.18 World Oil Market Balances and Oil Futures Price
- 3.19 Developments in Food and Metal Markets
- 4.1 Financial Stress and Output Loss
- 4.2 Financial Stress Index
- 4.3 Financial Stress and Shocks
- 4.4 Contribution of Banking, Securities, and Foreign Exchange to Current Financial Stress Episode
- 4.5 Lag between Financial Stress and Downturns
- 4.6 Selected Macrovariables around Economic Downturns with and without Financial Stress
- 4.7 Banking-Related Financial Stress, Slowdowns, and Recessions
- 4.8 Cost of Capital and Bank Asset Growth around Banking Financial Stress Episodes
- 4.9 Selected Macrovariables around Financial Stress Episodes
- 4.10 Initial Conditions of Financial Stress Episodes
- 4.11 Financial Stress and Economic Downturns: Controlling for Four Main Shocks
- 4.12 The Procyclicality of Leverage in Investment and Commercial Banks
- 4.13 Procyclical Leverage and Arm’s-Length Financial Systems
- 4.14 Arm’s-Length Financial Systems, GDP Growth, and Bank Leverage
- 4.15 The Current Financial Stress Episode in the United States and Euro Area in Historical Context
- 5.1 How Often and Quickly Has Fiscal Stimulus Been Used in G7 Economies?
- 5.2 How Strong Was the Fiscal Policy Response in G7 Economies?
- 5.3 How Have Fiscal Policy Responses Varied across Advanced Economies?
- 5.4 Is There a Bias toward Easing during Downturns in G7 Economies?
- 5.5 Did G7 Economies Respond to Erroneously Perceived Downturns?
- 5.6 Composition of Fiscal Stimulus during Downturns for Advanced and Emerging Economies
- 5.7 Fiscal Policy Responses in Downturns and Upturns
- 5.8 Macroeconomic Indicators after Downturns, with and without a Fiscal Stimulus
- 5.9 Changes in Real GDP Growth and Fiscal Policies under Various Initial Conditions
- 5.10 Effect of Fiscal Expansion in a Large Economy
- 5.11 Fiscal Expansion in a Large Economy Compared with a Small Open Economy with Monetary Accommodation
- 5.12 Effect of Fiscal Expansion in a Small Economy with Market-Risk-Premium Reaction
- 6.1 Patterns of Divergence in Current Account Balance
- 6.2 External Balances by Component
- 6.3 Current Account Balance, Saving, and Investment
- 6.4 Saving and Investment by Components
- 6.5 Growth Takeoffs
- 6.6 Current Account Reversals around Crises
- 6.7 Current Account Balance and Real GDP per Capita Growth
- 6.8 Patterns of Financial Development
- 6.9 Explaining the Current Account Balances of Emerging Asia and Emerging Europe
- 6.10 Explaining Current Account Balances: Results by Subregion
- 6.11 Deviation from Predicted Real Effective Exchange Rates
- 6.12 Residual Current Account Balance, Deviation of Real Effective Exchange Rate from Predicted Level and Stock of Reserves
- 6.13 Persistently Large Current Account Deficit and Surplus Episodes, 1960–2007
- 6.14 Duration of Large, Persistent Current Account Deficits, 1960–2007
- 6.15 Survival Functions of Deficit Episodes
- 6.16 Predicted Duration and Actual Length of Ongoing Deficit Episodes
- 6.17 Corporate Profitability and Productivity Growth
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 will remain constant at their average levels during August 18–September 15, 2008, 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 in industrial countries, see Box A1); that the average price of oil will be $107.25 a barrel in 2008 and $100.50 a barrel in 2009, and 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 3.2 percent in 2008 and 3.1 percent in 2009; that the three-month euro deposits rate will average 4.8 percent in 2008 and 4.2 percent in 2009; and that the six-month Japanese yen deposit rate will yield an average of 1.0 percent in 2008 and 1.2 percent in 2009. These are, of course, working hypotheses rather than forecasts, and the uncertainties surrounding them add to the margin of error that would in any event be involved in the projections. The estimates and projections are based on statistical information available through early October 2008.
The following conventions have been used throughout the World Economic Outlook:
- … to indicate that data are not available or not applicable;
- — to indicate that the figure is zero or negligible;
- – 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 percent point).
In figures and tables, shaded areas indicate IMF staff projections.
Minor discrepancies between sums of constituent figures and totals shown are due to 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 report on 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 in the report itself, consisting of 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, electronic mail, or telefax (telephone inquiries cannot be accepted) to:
World Economic Studies Division
International Monetary Fund
700 19th Street, N.W.
Washington, D.C. 20431, U.S.A.
E-mail: firstname.lastname@example.org Telefax: (202) 623-6343
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 (formerly Policy Development and Review Department), the Monetary and Capital Markets Department, and the Fiscal Affairs Department.
The analysis in this report has been coordinated in the Research Department under the general direction of Olivier Blanchard, Economic Counsellor and Director of Research. The project has been directed by Charles Collyns, Deputy Director of the Research Department, and Jörg Decressin, Division Chief, Research Department. The analysis has benefited from input during the early stages by Simon Johnson, the former Economic Counsellor and Director of Research.
The primary contributors to this report are Roberto Cardarelli, Kevin Cheng, Stephan Danninger, Mark De Broeck, Selim Elekdag, Thomas Helbling, Anna Ivanova, Florence Jaumotte, Daehaeng Kim, Michael Kumhof, Subir Lall, Tim Lane, Douglas Laxton, Daniel Leigh, Valerie Mercer-Blackman, Jonathan Ostry, Alasdair Scott, Sven Jari Stehn, Steven Symansky, Natalia Tamirisa, and Irina Tytell. Toh Kuan, Gavin Asdorian, Ioan Carabenciov, Huigang Chen, To-Nhu Dao, Stephanie Denis, Nese Erbil, Angela Espiritu, Elaine Hensle, Patrick Hettinger, Annette Kyobe, Susana Mursula, Jair Rodriguez, Bennett Sutton, and Ercument Tulun 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, Laura Leon, Patricia Medina, and Sheila Tomilloso Igcasenza were responsible for word processing. Other contributors include Steven Barnett, Rudolf Bems, Irineu de Carvalho Filho, Stijn Claessens, Kevin Clinton, David Coady, Gianni de Nicolò, Ondrej Kamenik, Julie Kozack, Luc Laeven, Prakash Loungani, Dirk Muir, Krishna Srinivasan, Emil Stavrev, Stephen Tokarick. External consultants include Joshua Aizenman, Antonio Fatás, Christopher Meissner, and Hyun Song Shin. Linda Griffin Kean of the External Relations Department edited the manuscript and coordinated the production of the publication. Lucy Scott Morales provided editorial assistance.
The analysis has benefited from comments and suggestions by staff from other IMF departments, as well as by Executive Directors following their discussions of the report on September 17 and 19, 2008. 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.
Having just joined the IMF, I can take very little credit for this edition of the World Economic Outlook. I regret it: Like its predecessors, this is a remarkable document which gives the reader a clear sense of what is happening in the world economy. I thank Simon Johnson, Charles Collyns, Jörg Decressin, and their team for their work.
Chapters 1 and 2 assess the state and the evolution of the world economy, an exercise that has rarely been so difficult. The world economy is decelerating quickly—buffeted by an extraordinary financial shock and by still-high energy and commodity prices—and many advanced economies are close to or moving into recession.
Developments in financial markets have dominated the news in recent weeks. The subprime crisis that unfolded in 2007 has now morphed into a credit crisis that has caused major disruption to financial institutions in the United States and Europe. Intensifying solvency concerns about a number of the largest U.S.-based and European financial institutions have pushed the global financial system to the brink of systemic meltdown. The effects on the real economy have been limited so far. In part, this may be because tax rebates in the United States supported consumption, while strong nonfinancial corporate balance sheets and profitability have allowed firms to use their own funds rather than borrow. But neither of these factors can be expected to last for very long. Credit conditions have become significantly tighter in recent weeks, threatening the ability of nonfinancial firms and a number of emerging economies to raise capital. The U.S. and European authorities have taken extraordinary measures, including massive liquidity provision, intervention to restore weak institutions, extension of guarantees, and recent U.S. legislation to use public funds to buy troubled assets from banks. But it is not yet clear that these measures will be sufficient to stabilize markets and bolster confidence, and the situation remains highly uncertain.
This is not the only shock buffeting the world economy. Prices of oil and basic commodities have reached historically high levels in recent months. In advanced economies, a combination of real wage flexibility, well-anchored inflation expectations, and prospects of sharply reduced activity have helped to limit rises in core inflation. But in emerging and developing economies, the impact has been much more damaging. Real wages have fallen substantially. Oil exporters have found it difficult to dampen overheating economies.
Looking to the future, it is necessary to assess how these shocks will likely work their way through the world economy. Our forecasts are based on three major assumptions. The first is that commodity and oil prices are likely to stabilize, relieving pressure on inflation and giving more room, if needed, for expansionary policies. The second is that U.S. housing prices and activity will hit bottom within the next year, leading to a recovery of residential investment. The third is that, although credit will remain tight, the elements of a systemic solution to the financial crisis are now being put in place and will prevent a further worsening of financial intermediation. It is this combination that leads us to forecast that world growth will begin to recover at the end of 2009, albeit at a very slow pace. There is, however, more than the usual amount of uncertainty, and the downside risks are far from negligible.
As usual, this World Economic Outlook also tackles a number of topically important issues in greater depth. Chapter 3 examines the threat that the recent boom in commodity prices could unwind the past two decades’ progress against inflation. To be sure, the fall in some prices—notably for oil—since mid-July has eased some of the pressure, but it is too early to relax. Commodity prices are likely to remain much higher in real terms than in recent decades, and this shift in relative prices will need to be absorbed without triggering second-round effects on price and wage formation. This task is likely to be easier in the advanced economies, where widening output gaps are helping to restrain inflation pressures. Moreover, these economies are much less commodity-intensive than they were in the 1970s and have more flexible labor markets and well-established monetary policy frameworks that have largely succeeded in anchoring inflation expectations. However, emerging and developing economies are more vulnerable to inflation spillovers–because of their greater resource intensity, less-well-established policy frameworks, and more rapid rates of growth. In many of these economies, second-round effects are already increasingly visible, and although slowing global growth and softening commodity prices should help rein inflation back in, risks remain that continued inflationary excesses will degrade hard-earned inflation-fighting credentials, requiring even tougher action in the future to put the cork back in the bottle.
Chapter 4 addresses what is clearly a central concern for the global economy: What will be the impact of the current financial crisis on economic activity? It is now all too clear that we are seeing the deepest shock to the global financial system since the Great Depression, at least for the United States. Are we then doomed to a slump in output as occurred in the 1930s? As Chapter 4 shows, the historical record is mixed. Periods of financial stress have not always been followed by recessions or even by economic slowdowns. However, the analysis also shows that when the financial stress does major damage to the banking system—as in the current episode—the likelihood increases of a severe and protracted downturn in activity. This is clearly demonstrated by the experiences of many economies that have struggled with virulent financial crises over the past decades, for example, the Nordic countries and Japan. Moreover, economies with more-arm’s length or market-based financial systems seem to be particularly vulnerable to sharp contractions in activity in the face of financial stress. This is because leverage tends to be more procyclical in these economies—the risks of a credit crunch are greater. Does this mean that the United States—with a market-based financial system par excellence—is heading for a deep recession? Not necessarily, because, as the chapter shows, other factors also matter. Two sources of support for the U.S. economy are the quick and strong reaction of the Federal Reserve to lower policy rates and the robust state of the U.S. nonfinancial corporate sector. Low indebtedness and high profits have helped U.S. businesses ride the financial storm. However, the longer the financial crisis continues, the less likely it is that nonfinancial firms will be able to support strong growth.
Chapter 5 takes a fresh look at an old debate—about the value of fiscal policy as a countercyclical tool—which has taken on new relevance as the global economy slows and as turbulence in financial markets has raised questions about the effectiveness of monetary policy. The findings are not very encouraging for proponents of fiscal activism: fiscal multipliers—the impact of discretionary fiscal stimulus on output—are generally found to be quite low, and sometimes even to operate in the wrong direction, especially in economies with high debt levels where a turn to expansionary fiscal policy may raise doubts about long-term debt sustainability. This does not necessarily mean that policymakers should abandon fiscal policy as a countercyclical tool, but it does underline that fiscal initiatives, when needed, must be well targeted to have the maximum short-run impact without undermining long-run fiscal rectitude.
It is also worthwhile to consider whether the role of fiscal policy as a macroeconomic stabilizer could be enhanced by strengthening the broader fiscal framework. Two options are worth considering. First, there is the possibility that automatic stabilizers could be boosted by making regular tax and transfer programs more cyclically responsive. For example, the generosity of unemployment insurance systems could be automatically increased when the economy is in a downturn and jobs are harder to find. Second, steps could be taken to strengthen the overall governance structure for fiscal policy—thereby reducing the risk of “debt bias” by ensuring that fiscal easing during a downturn is balanced by tightening during expansions. Improved governance could bolster the credibility and thus the effectiveness of fiscal stimulus. Recognizing the pros and cons of these approaches, I do feel they are worthy of consideration.
Finally, Chapter 6 tries to solve an important puzzle: Why have the current account balances of emerging economies been so divergent in recent years, with some economies in emerging Asia registering large surpluses and others, particularly in emerging Europe, sustaining very large and long-lasting deficits? There is no single answer, but the chapter suggests that important contributors have been emerging Europe’s rapid financial liberalization and capital account opening, particularly in those economies integrating rapidly into the European Union, and the focus in emerging Asia on building large stocks of international reserves as self-insurance in the wake of the Asian crisis of 1997–98. This leaves open the question of whether the recent patterns will be sustained. Certainly the turbulent global environment is putting a strain on economies with large current account deficits and commensurately large external financing requirements.
Economic Counsellor and Director, Research Department
The world economy is entering a major downturn in the face of the most dangerous financial shock in mature financial markets since the 1930s. Global growth is projected to slow substantially in 2008, and a modest recovery would only begin later in 2009. Inflation is high, driven by a surge in commodity prices, but is expected to moderate. The situation is exceptionally uncertain and subject to considerable downside risks. The immediate policy challenge is to stabilize financial conditions, while nursing economies through a period of slow activity and keeping inflation under control.
Global Economy under Stress
After years of strong growth, the world economy is decelerating quickly (Chapters 1 and 2). Global activity is being buffeted by an extraordinary financial shock and by still-high energy and other commodity prices. Many advanced economies are close to or moving into recession, while growth in emerging economies is also weakening.
The financial crisis that first erupted with the U.S. subprime mortgage collapse in August 2007 has deepened further in the past six months and entered a tumultuous new phase in September. The impact has been felt across the global financial system, including in emerging markets to an increasing extent. Intensifying solvency concerns have led to emergency resolutions of major U.S. and European financial institutions and have badly shaken confidence. In response, the U.S. and European authorities have taken extraordinary measures aimed at stabilizing markets, including massive liquidity provision, prompt intervention to resolve weak institutions, extension of deposit insurance, and recent U.S. legislation to use public funds to purchase troubled assets from banks. However, the situation remains highly uncertain as this report goes to press.
At the same time, the combination of the surge in food and fuel prices under way since 2004 and tightening capacity constraints has propelled inflation to rates not seen in a decade. As analyzed in Chapter 3, consumer price rises have been particularly strong in emerging and developing economies. This acceleration reflects the high weight of food in consumption baskets, still-quite-rapid growth, and less-well-anchored inflation expectations. Notably, countries that have adopted inflation-targeting regimes have generally fared better. In the advanced economies, oil price increases have pushed up headline inflation, but underlying inflation pressures seem contained.
The recent deterioration of global economic performance follows sustained expansion built on the increasing integration of emerging and developing economies into the global economy. In hindsight, however, lax macroeconomic and regulatory policies may have allowed the global economy to exceed its “speed limit” and may have contributed to a buildup in imbalances across financial, housing, and commodity markets. At the same time, market flaws, together with policy shortcomings, have prevented equilibrating mechanisms from operating effectively and allowed market stresses to build.
Recovery Not Yet in Sight and Likely to Be Gradual When It Comes
Looking ahead, financial conditions are likely to remain very difficult, restraining global growth prospects. The baseline projections assume that actions by the U.S. and European authorities will succeed in stabilizing financial conditions and avoiding further systemic events. Nonetheless, even with successful implementation of the U.S. plan to remove troubled assets from bank balance sheets, counterparty risk is likely to remain at exceptionally high levels for some time, slowing down the return to more liquid conditions in key financial markets. Furthermore, additional credit losses are very likely as the global economy decelerates. In this setting, financial institutions’ ability to raise new capital will remain very challenged. Accordingly, as discussed in the October 2008 Global Financial Stability Report, the required deleveraging will continue to be a protracted process, implying that limits on the pace of credit creation–and on activity–will be present at least through 2009.
Nonetheless, several factors are expected to lay the groundwork for a gradual recovery to emerge later in 2009:
- Commodity prices are projected to stabilize, albeit at 20-year highs. The adverse terms-of-trade effects of the more than 50 percent increase in oil prices during 2008 should begin to unwind in 2009, boosting consumption in oil-importing countries.
- The U.S. housing sector is expected to finally reach bottom in the coming year, ending the intense drag on growth that has been present since 2006. The eventual stabilization of house prices should help restrain the financial sector’s mortgage-related losses, and the recent intervention in the two government-sponsored enterprises, Fannie Mae and Freddie Mac, should help support the availability of credit to the housing sector. Although the housing cycle and related adjustment might lag in other advanced economies, the overall impact of the financial crisis will be severely felt.
- Notwithstanding cooling of their momentum, emerging economies are still expected to provide a source of resilience, benefiting from strong productivity growth and improved policy frameworks. Of course, the longer the financial crisis lasts, the more they are likely to be affected.
Against this backdrop, the baseline growth projections have been marked down significantly relative to the July 2008 World Economic Outlook Update. On an average annual basis, global growth is expected to moderate from 5.0 percent in 2007 to 3.9 percent in 2008 and 3.0 percent in 2009, its slowest pace since 2002. The advanced economies would be in or close to recession in the second half of 2008 and early 2009, and the anticipated recovery later in 2009 will be exceptionally gradual by past standards. Growth in most emerging and developing economies would decelerate below trend. On the inflation front, the combination of rising slack and stabilizing commodity prices is expected to contain the pace of price increases, bringing inflation back below 2 percent in 2009 in advanced economies. In emerging and developing economies, inflation would ebb more gradually, as recent commodity price increases continue to feed through to consumers.
There are substantial downside risks to this baseline forecast. The principal risk revolves around two related financial concerns: that financial stress could remain very high and that credit constraints from deleveraging could be deeper and more protracted than envisaged in the baseline. In addition, the U.S. housing market deterioration could be deeper and more prolonged than forecast, while European housing markets could weaken more broadly. Inflation risks to growth are now more balanced because commodity prices have retreated as the global economy slows. At the same time, potential disruptions to capital flows and the risks of rising protectionism represent additional risks to the recovery.
The connections between financial stress and economic downturns are explored in Chapter 4, which compares recent experience to earlier episodes. The analysis indicates that financial stress that is rooted in the banking sector typically has more adverse economic effects than stress in stock markets or exchange rates and that the shift toward more-arm’s-length financial intermediation may have increased the impact. Initial conditions appear to affect the outcomes. Thus, the relatively healthy nonfinancial corporate balance sheets in the United States and western Europe at the beginning of the current downturn provide a source of resilience, but would be at risk from a sustained period of financial stress.
Chapter 6 raises concerns about countries with sustained large current account deficits. These concerns may be particularly relevant as global deleveraging reduces the availability of external financing for emerging economies. The analysis seeks to explain large divergences in current account behavior across the emerging world and relates the large deficits in emerging Europe to capital account liberalization, financial reform, and opportunities created by European economic convergence. However, sustained large deficits can end abruptly, and rigid exchange regimes heighten such risks. In fact, many economies with large current account deficits have already experienced a much greater impact from the financial market turmoil than those with small current account deficits or surpluses.
Policymakers between a Rock and a Hard Place
Policymakers around the world today face the daunting task of stabilizing financial conditions while simultaneously nursing their economies through a period of slower growth and containing inflation. Multilateral efforts take on particular importance in current circumstances, including policy initiatives to remedy the financial turmoil, alleviate the tightness in commodity markets, and support low-income economies burdened by high food import bills.
Country authorities are actively pursuing policies intended to stabilize financial conditions. Achieving this daunting task will require comprehensive responses that address the systemic problems–dealing with troubled assets, fostering the rebuilding of bank capital, and restoring liquid conditions in funding markets–while being mindful of taxpayer interests and moral hazard considerations. Approaches at the national level should be internationally coordinated to deal with joint problems and to avoid creating adverse, cross-border incentives.
The U.S. initiative to purchase real-estate-related assets should help over time to reduce the pressure on banks from distressed assets, and thus support a return of stable funding sources and confidence. However, public funds are also likely to be needed to help banks rebuild their capital bases. In western Europe, restoring confidence now requires a decisive commitment to concerted and coordinated action to facilitate timely recognition of troubled assets and bank recapitalization. A key task will be to develop cooperative agreements, adapted to a broad range of circumstances, including for resolving stress in large cross-border institutions and ensuring consistency in approaches to expanding deposit insurance.
Macroeconomic policies in the advanced economies should aim at supporting activity, thus helping to break the negative feedback loop between real and financial conditions, while not losing sight of inflation risks.
- Rapidly slowing activity and rising output gaps should help contain inflation. Moderating inflation pressure and the deteriorating economic outlook already provide scope for monetary easing in some cases, notably in the euro area and the United Kingdom, where short-term interest rates are quite high.
- Regarding fiscal policy, automatic stabilizers play a useful role in buffering shocks to activity and should be left to operate freely, provided that adjustment paths are consistent with long-term sustainability. Discretionary fiscal stimulus can provide support to growth in the event that downside risks materialize, provided the stimulus is delivered in a timely manner, is well targeted, and does not undermine fiscal sustainability. In the current circumstances, available fiscal room should be focused on supporting stabilization of the financial and housing sectors as needed, rather than for more broad-brush stimulus. In due course, offsetting adjustments to fiscal policies will be needed to safeguard medium-term consolidation objectives.
Macroeconomic policy priorities vary considerably across emerging and developing economies, as policymakers balance growth and inflation risks.
- In an increasing number of economies, the balance of risks has now shifted toward concern about slowing activity as external conditions deteriorate and headline inflation starts to moderate. This shift would justify a halt to the monetary policy tightening cycle, particularly where second-round effects on inflation from commodity prices have been limited, and a turn to easing would be called for if the outlook continues to deteriorate. In the face of sharp capital outflows, countries will need to respond quickly to ensure adequate liquidity, while using the exchange rate to absorb some of the pressure. Furthermore, they should step up efforts to improve capabilities to prevent, manage, and resolve financial stress, including through contingency planning.
- However, in a number of other countries, inflation pressures are still a concern because of sharp food price increases, continued strong growth, tightening supply constraints, and accelerating wages, notably in the public sector. Although the recent moderation in international commodity prices may ease some of the pressure, the gains in reducing inflation in recent years are being jeopardized; once credibility is eroded, rebuilding it will be a costly and lengthy process. In these countries, additional monetary policy tightening may still be called for.
- Countries with heavily managed exchange rate regimes are facing significant challenges. More flexible exchange rates would help contain inflation pressures by providing greater scope for monetary adjustment and provide more room for maneuver in the face of capital outflows. Of course, other considerations feed into choices of exchange rate regimes, including, for example, the degree of financial development and the diversity of the export base.
- Fiscal policy can play a supportive role in macroeconomic management. Greater restraint in public spending would help ease inflation pressures in a number of countries still facing overheating concerns. This is particularly important for current account deficit countries with pegged exchange rates. In the oil-exporting economies with currencies pegged to the U.S. dollar, spending can be focused on relieving supply bottlenecks. While emerging economies have greater scope than in the past to use countercyclical fiscal policy should their economic outlook deteriorate, the analysis in Chapter 5 cautions that this is unlikely to be effective unless confidence in sustainability has been firmly established and measures are timely and well targeted. More broadly, general food and fuel subsidies have become increasingly costly and are inherently inefficient. Targeted programs that help poor families meet rising living expenses are a preferred option.
Policy Frameworks in Need of Reform
The deteriorating performance of the global economy has raised concerns about the choice of macroeconomic policy frameworks and the appropriateness of policies affecting financial and commodity markets.
Operationalizing “Leaning against the Wind”
The current exceptional environment has heightened interest in developing policies that would be better geared toward avoiding asset price booms and busts, including through stronger policy responses in boom times. A promising approach would be to introduce a macroprudential element into the regulatory framework to weigh against the inherent procyclicality of credit creation. Consideration could also be given to extending monetary policy frameworks to provide for “leaning against the wind” of asset price movements, especially when these are rapid or seem to be moving prices seriously out of line with fundamentals, although this raises complex issues.
Moreover, interest has increased in making fiscal policy frameworks more credible and thus making fiscal policy more effective as a countercyclical tool. The Achilles heel of an active fiscal policy remains political economy settings that foster short-term decision-making. As a result, many countries fail during good times to build room for effective discretionary stimulus during downturns, or are struggling with addressing long-term fiscal sustainability challenges. Chapter 5 suggests that the shift toward more rules-based policy frameworks—analogous to constrained discretion in monetary policy—and the stronger fiscal governance mechanisms that can be observed in a growing number of countries could boost the effectiveness of fiscal policy in combating downturns.
Plugging Gaps in Regulatory and Supervisory Infrastructures
As well as dealing with the immediate systemic threats, determined efforts are being marshaled to address the manifold weaknesses revealed by the current financial turbulence. As laid out in the October 2008 Global Financial Stability Report, a central objective is to ensure more effective and resilient risk management by individual institutions, including by setting more robust regulatory capital requirements and insisting on stronger liquidity management practices and improved disclosure of on- and off-balance-sheet risk. Another important task is to strengthen crisis resolution frameworks.
Moreover, the financial turmoil has revealed that national financial stability frameworks have failed to keep up with financial market innovation and globalization, at the price of deleterious cross-border spillovers. Greater cross-border coordination and collaboration among national prudential authorities are needed, particularly for the purposes of preventing, managing, and resolving financial stress both in markets and in major financial institutions.
Fostering Energy Conservation and Greater Oil and Food Supply
The recent decline in commodity prices should not detract from efforts to relieve strains in commodity markets. There is little concrete evidence that rising investor interest in commodities as an alternative asset—or outright speculation—had a systematic or lasting impact on prices. However, the combination of unusual swings in market sentiment and greater financial market liquidity may have contributed to short-term price dynamics in some circumstances. Accordingly, the focus should be on policies to encourage better balance between supply and demand in the longer term and to avoid measures that could exacerbate market tightness in the short term. This could include greater pass-through of international price changes to domestic markets and greater energy conservation. Lower biofuel subsidies in the advanced economies could also relieve short-term pressures on food prices. In general, priority should be given to strengthening the supply response to higher prices. For now, greater donor support for the poorest economies will be crucial to address the humanitarian challenges raised by the surge in food prices.
Unwinding Global Imbalances
The surge in commodity prices has led to a further widening in global imbalances, with wider current account surpluses in oil exporters and larger deficits in oil importers. Of course, exporters’ intent to save some of the additional revenues is sensible: to date, the associated recycling of funding from surplus to deficit countries is working well. At the same time, the U.S. non-oil deficit has fallen substantially, in part reflecting the depreciation of the U.S. currency back toward a real effective rate that is broadly consistent with medium-term equilibrium. However, U.S. dollar depreciation has occurred mainly against the euro and some other flexibly managed currencies.
The multilateral strategy endorsed by the International Monetary and Financial Committee in 2005 and elaborated by the Multilateral Consultation on Global Imbalances in 2006 and 2007 remains relevant but needs to be applied flexibly. U.S. fiscal consolidation remains a key medium-term objective, but recent countercyclical fiscal stimulus and public support to stabilize financial institutions have been warranted. Further effective appreciation of the renminbi would contribute to China’s broader strategy to shift the sources of growth toward internal demand and to increase the effectiveness of monetary policy. A slowdown in spending growth in Middle Eastern oil exporters would help reduce overheating in their economies, as would a heightened focus on relieving supply bottlenecks. At the same time, product and labor market reforms in the euro area and Japan would raise potential growth.
Finally, rising protectionist pressures on both trade and capital flows reflect a worrisome risk to the prospective recovery. Breaking the current Doha Round deadlock would help strengthen the open multilateral trading system, an important underpinning of strong global growth in recent years. At the same time, sovereign wealth funds (SWFs) continue to grow as investment vehicles for surplus countries. The set of principles and practices recently agreed by SWFs for their governance, investment, and risk management (the “Santiago Principles”) will contribute to reducing concerns about these types of funds that could lead to counterproductive restrictions on such inflows. Moreover, guidelines for recipient countries, which are under development at the Organization for Economic Cooperation and Development, would help reassure the SWFs of fair, transparent, and open access to markets.