Chapter

1. Global, U.S., and Canadian Outlook

Author(s):
International Monetary Fund. Western Hemisphere Dept.
Published Date:
October 2010
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The global economic recovery is proceeding, although signs of some moderation of growth are emerging, especially in advanced economies. The upswing in advanced economies is still muted amid balance sheet weaknesses in key sectors, and uncertainties persist over the strength of private demand as fiscal policy support is withdrawn. In contrast, many emerging economies are experiencing vigorous growth buoyed by domestic demand, supported by easy external financing conditions as well as their own remaining policy stimulus. In that context, the prospects of a sustained—though not permanent—period of low global interest rates will create challenges for emerging economies. Commodity prices are expected to remain robust, underpinned by continued strong demand from emerging Asia.

The Global Backdrop—A Recovery Still Led by Emerging Economies

The global recovery is proceeding, despite new bouts of market volatility and recent setbacks to growth in some countries (Figure 1.1). The world economy expanded by about 5 percent during the first half of 2010, underpinned by continued policy support and a stronger-than-anticipated recovery in emerging economies. Forceful policy actions restored market stability and lowered tail risks following worrying setbacks earlier in the year precipitated by the European sovereign debt crisis. Even so, there are increasing signs that economic activity is moderating, especially in advanced economies. Although part of this moderation is related to the natural unwinding of the inventory cycle, uncertainties have increased about the strength of the recovery in advanced economies, particularly as the policy stimulus begins to wane. A self-sustaining recovery of private demand has yet to take hold in advanced economies, reflecting continued weaknesses in household and financial sector balance sheets. Fixed capital investment has started to expand again on the back of strong cash flows of firms. However, consumer confidence remains frail, largely reflecting poor employment prospects, which in the case of the United States are aggravated by weaknesses in the housing market. Despite forceful responses by European policymakers, financing conditions in some European countries remain vulnerable to funding pressures, while Japan’s export-led recovery continues to be affected by weak U.S. demand and spells of yen appreciation.

Figure 1.1.Global recovery is being led by strong growth in emerging economies, with commodity prices remaining high.

Sources: Bloomberg; Haver Analytics; and IMF staff calculations.

The world recovery continues to be driven by strong growth in emerging economies, which expanded by more than 7½ percent during the first half of the year (compared with 2½ percent in all of 2009), with Asia in the lead together with a number of Latin American economies. Growth in these economies appears increasingly self-sustained on the back of robust domestic demand, just as the push from inventory rebuilding and the policy stimulus begins to lose steam. Capital inflows to emerging economies with good fundamentals remain strong, partly in response to easy monetary conditions in advanced economies and improving risk appetite (Figure 1.2).

Figure 1.2.Financial market conditions have stabilized, following short bouts of volatility related to problems in southern Europe.

Sources: Bloomberg; and IMF staff calculations.

Commodity prices have broadly stabilized after their strong rally in late 2009, sustained by strong demand from Asia and the lingering effects of tight markets before the global crisis. Looking forward, metal and oil prices are expected to remain near current levels—quite high in historical perspective—as there is just enough spare capacity in the extractive industries to meet growing demands in the period ahead.1 The recent surge in wheat prices, however, is expected to be short-lived.

In this context, IMF staff projects world growth in 2010 to exceed 4½ percent (about ½ percent higher than projected in the April 2010 Regional Economic Outlook: Western Hemisphere), which is consistent with a modest slowing of activity during the second half of this year. Looking further ahead, global growth is forecast to reach 4¼ percent in 2011, with output of emerging economies expanding at roughly 6½ percent. Growth in advanced economies is projected only at about 2 ¼ percent, which is low considering the depth of their earlier recession and will imply a continued substantial gap between actual and potential output.

Risks to the global outlook are tilted to the downside, given current dynamics in advanced economies. A further softening of real estate prices could undercut household and financial sector balance sheets, undermining the recovery in advanced economies. Another risk is that a further drop in confidence in the soundness of government finances in some European countries could trigger an adverse feedback loop between the sovereign and financial sectors, inflicting major damage to their recovery, and further constraining their fiscal space.

Such scenarios of softer growth in advanced economies would mean, all things constant, somewhat lower growth in emerging and developing economies according to the strength of their real and financial linkages. However, for many economies, the strength and momentum of their own domestic demand are likely to dominate their near-term growth prospects if advanced economies do not suffer major setbacks.

Overall, the transition to healthy global growth in advanced countries is likely to be a protracted process. The dynamics of the recovery in advanced economies needs to change if the initial rebound is to morph into a sustained upswing. Demand needs to shift over time from public to private sources, given the widespread need to roll back large fiscal deficits, and financial institutions and markets need more repair and reform before credit can meaningfully support the recovery. Demand also needs to transit from deficit to surplus countries, with the implied exchange rate movement.

In this context, monetary policy should stay highly supportive in most of the advanced economies. More broadly, further progress is required in the healing of the capital base of financial intermediaries and greater clarity is needed on the details and timing of the full range of regulatory reforms. These would help financial markets and institutions provide more support, on a sounder basis, to consumption and investment.

Meanwhile, fiscal policy in many advanced economies should generally remain supportive through end-2010, and start to consolidate in 2011. The most urgent challenge is to put in place credible fiscal consolidation plans to achieve sustainable fiscal positions before the end of the next decade. These would have to include reforms to rapidly growing spending programs and entitlements, and broadening of tax bases. If lower-than-expected growth were to materialize, monetary policy should remain the first line of defense. Should growth soften considerably, some slowing in the pace of fiscal consolidation would be appropriate as long as credible plans for medium-term fiscal adjustment are in place.

Policy challenges for many emerging economies are different, as they will need to cope with the effects of relative success—including avoiding an eventual overheating or asset bubbles. Maintaining stability will depend on their ability to deal with surges in capital inflows in a context in which macroeconomic policies have to transit from earlier stimulus toward a neutral stance and eventual contractionary bias.

The timing and sequencing of exit from monetary and fiscal stimulus in emerging economies will vary according to country circumstances. Countries facing overheating and complications from capital inflows should withdraw fiscal stimulus quicker and rebuild policy buffers. Traditional tools may need to be supplemented, though not substituted, by macro-and microprudential policies to meet the needs arising from particular domestic circumstances. On the other hand, should a large setback to world growth materialize, supportive policies may have to be redeployed.

United States—Recovery Is Still Policy Driven

Thanks to a massive and sustained policy response, the U.S. economy has continued to recover from the worst recession since the Great Depression. Near-zero monetary policy rates and a doubling of the Federal Reserve’s balance sheet provided liquidity support to the economy. Fiscal stimulus measures added more than 1 percent to growth in 2009, with a smaller effect expected in 2010. Capital injections in major financial institutions, emergency lending, stress tests, and guarantees stabilized financial conditions and broke the adverse macrofinancial spiral. As a result, stimulus-sensitive components of demand bounced back, including auto and house purchases which were beneficiaries of targeted subsidies. The inventory adjustment cycle began to turn around in mid-2009, contributing massively to the recovery.

However, and as expected, the recovery has been modest by historical standards; a fact reinforced by revised national accounts showing that the recession was deeper and the recovery weaker than first estimated. Unlike the usual “V-shaped” episodes that characterized past U.S. business cycles, the ongoing recovery has been tame, with consumer spending particularly lackluster. Business investment levels are well below precrisis levels, even though investment recovered briskly in the first half of 2010, and residential construction remains in the doldrums. Persistently high unemployment rates and long unemployment duration are key factors in the weak recovery through their effects on private consumption and credit household risk (Figure 1.3). Moreover, the depressing effects emanating from the labor market will likely be more persistent than usual, as large sectoral and geographical skill mismatches are estimated to have interacted with weak housing conditions to raise structural unemployment (Box 1.1).

Figure 1.3.The U.S. recovery is losing strength, with the unwinding of the inventory cycle and weakness in private consumption.

Sources: U.S. Bureau of Economic Analysis; U.S. Bureau of Labor Statistics; and IMF staff calculations.

Box 1.1.Labor Market Adjustment in the United States1

Historically, the sharp contraction in employment observed during the recent recession would be followed by a sharp recovery in coming years. However, jobs have lagged economic growth to a greater extent than usual in the last two complete recession cycles in the United States, giving rise to what has come to be known as “jobless recoveries.” An important question is whether the current recovery will also have little job creation.

Several factors are playing a role in determining the pace of employment growth:

  • Credit recovery: The recent recession was triggered by a financial shock unprecedented since the Great Depression that has hobbled credit. In general, strong and sustained U.S. recoveries usually come in the context of rapid rebounds in the credit cycle; however, credit conditions in the current recovery are likely to remain impaired as banks and households repair their balance sheets.

  • Unemployment duration: As was the case in the recessions of the early 1990s and early 2000s the current recession generated a surge in permanent layoffs and a large drag in labor force participation. Going beyond the experience of the past two recessions, the length of unemployment spells has reached highs not seen previously. Extensions of unemployment insurance benefits (although needed to support the unemployed) may affect the intensity of job search, limiting employment growth.

  • Labor hoarding: Involuntary part-time employment surged during the crisis, implying that firms can get more labor during the recovery partly by raising hours for existing employees, while not hiring new workers.

The speed of employment adjustment may also be hampered by reduced labor mobility and mismatches between the supply and the demand for labor skills. Estevão and Tsounta (2010) show that skill mismatches resulting from regional and industry-specific shocks have interacted with weak housing conditions, boosting the equilibrium unemployment rate by about 1½ percentage points by the end of 2009. The negative interaction between skill mismatches and housing conditions are probably related to the reduced labor mobility since the start of the crisis, which could be explained by the resulting capital losses an unemployed individual would suffer from trading a house in a depressed state for another in a more prosperous region.1

Increase in Skill Mismatch Index Since Onset of Recession

(Percent)

Sources: Haver Analytics, U.S. Bureau of Labor Statistics, U.S. Census Bureau, and IMF staff estimates.

Notes: 1st quartile [-11.1,5.7], 2nd quartile [6.3,11.6], 3rd quartile [12.3,16.9], 4th quartile [17.2,29.4].

Change in Foreclosure Rates, 2005–09

(Percentage points)

Sources: Mortgage Bankers Association, and authors’ calculations.

Notes: 1st quartile [0.6,0.96], 2nd quartile [0.97,1.56], 3rd quartile [1.6,2.69], 4th quartile [2.7,11.7].

Calculated as the percentage point change from 2005–09. Annual levels are the simple average of 12 months.

Other factors may help employment recovery. Batini, Estevão, and Keim (2010) find that a surge in uncertainty could help explain the larger-than-usual reaction of employment to output declines during the recent recession, and that the labor intensity of output is sensitive to the relative path of labor and capital costs. Hence, looking ahead, reduced uncertainties about the outlook could boost hiring, while credit constraints could affect investment more severely than hiring as the former tends to be lumpier. Moreover, the slow wage growth expected in the near term, given high unemployment and government programs to subsidize hiring, could also help boost the labor intensity of output.

Despite the existence of substantial cyclical unemployment in the economy, a possible increase in equilibrium unemployment rates underscores the role of targeted labor and housing policies to reduce joblessness. Effective measures to alleviate housing market strains, including further supporting loan modifications, could facilitate labor mobility, thus helping to clear state-level labor markets. Targeted policies aiming at retraining the unemployed and hiring the long-term unemployed (maybe through expanding the subsidies to net hiring adopted in March 2010) could reduce mismatches between supply and demand for labor skills and structural unemployment rates. Both interventions would add to the ongoing macroeconomic stimulus by allowing the cyclical recovery to make deeper inroads on unemployment rates.

Note: This box was prepared by Marcello Estevão.1 Nevada, Florida, and California were hit particularly hard by the housing bubble (accounting for more than half of all foreclosures); Ohio and Michigan suffered from the manufacturing collapse; and New York hosted the restructuring of financial institutions. Lower interstate labor mobility is also documented in Ferreira, Gyourko, and Tracy (2010).

Looking ahead, balance-sheet strains in the household, financial, and public sectors pose headwinds to growth. The household saving rate has already risen to about 6 percent in the second quarter of 2010, and household deleveraging and weak labor markets point to continued lackluster consumption. Larger financial institutions have managed to rebuild capital ratios, in part by shedding risk, but protracted effects of the crisis on the quality of existing loans will maintain pressures on institutions’ balance sheets. The federal debt held by the public nearly doubled between 2007 and 2010 to about 65 percent of GDP—the highest since 1950—raising the need for decisive fiscal consolidation.2

Thus, the U.S. outlook is for a continued gradual recovery, with contained inflation. The economy is projected to expand by 2.6 percent in 2010—somewhat lower than the 3.1 percent projected in the last Regional Economic Outlook: Western Hemisphere. Revisions reflect stronger-than-anticipated imports during the second quarter and weaker housing outlook (following declines in house sales after the expiry of a homebuyer tax credit). Growth is projected to reach 2.3 percent in 2011, as the output gap narrows, the inventory cycle matures, and the fiscal stimulus fades. The unemployment rate is likely to decline gradually; this along with substantial excess capacity in product markets will keep a lid on inflation.

Risks around this baseline scenario are tilted to the downside. The backlog in mortgage foreclosures could push down housing prices. Possible further stress in commercial real estate would hurt small and medium-sized banks, thus crimping credit provision to firms. Both factors could trigger negative macrofinancial feedback loops. Very large economic slack feeds the risk of persistent deflation, although this is still only a tail risk given stable medium-term inflation expectations. On the upside, a brisk recovery in confidence could release pent-up consumption and investment from current very low levels. Looking into the medium term, risks associated with higher interest rates are growing, owing to concerns over how fiscal balances will affect borrowing costs once private demand recovers (Box 1.2).

Box 1.2.The Financing of U.S. Federal Budget Deficits—and Its Global Implications

Despite rapidly rising public debt, long-term bond yields in the United States recently have been restrained owing to cyclical and safe-haven factors. Higher private saving, weak corporate investment, subdued inflation, and a flight to the relative safety of U.S. government bonds amid financial market strains in Europe have all contributed to keep interest rates low. Recent Federal Reserve purchases of Treasury debt (and closely substitutable debt of Government Sponsored Enterprises) also have helped. In the future, however, given the large expected debt issuances, financing conditions are likely to tighten as private investment recovers and safe-haven flows abate.

An analysis of investment flows suggests that, in the future, the bulk of Treasury bond purchases will have to be made by domestic investors. Foreign purchases will be dampened by unwinding safe-haven flows. In addition, World Economic Outlook (WEO) projections of reserve accumulation in emerging markets suggest limits on the size of new purchases by official holders. In those circumstances, domestic holders would have to pick up the slack, implying a significant shift in their portfolio allocations. Indeed, absent such a reallocation, the projected supply of Treasury debt for 2015 would exceed estimated demand (calculated on the basis of WEO forecasts of key variables) by a significant margin—about 30 percent of GDP, similar in size to the projected increase in the debt stock between 2010 and 2015.

Purchases of U.S. Treasury Debt in 2008–09

Sources: U.S. Treasury TIC data; Board of Governors of the Federal Reserve, Flow of Funds of the United States; and IMF staff calculations.

1 Includes hedge funds and nonprofits.

2 Banks, mutual funds, pension funds, and insurers.

Over the medium term, higher real interest rates will likely be necessary to facilitate the portfolio shifts. Assuming—in line with the empirical literature—that one percentage point of GDP in excess U.S. federal debt supply increases long-term bond yields by 2–5 basis points, the debt effect could raise long-term interest rates by 60–150 basis points in the medium term (see also Laubach, 2009). Adding this effect to the yield increases due to gradual normalization of monetary policy and macroeconomic conditions leads to a projection for the 10-year bond yield of slightly above 6 percent by 2015. That said, the near-term movements in yields are highly uncertain as U.S. Treasury debt continues to benefit from its safe-haven status.

What would this mean for borrowing costs for emerging markets? IMF staff research on the relationship between emerging market sovereign bond spreads and U.S. federal government bond yields suggests that a 100-basis points increase in the long-term U.S. federal government bond yield would add about 35 basis points to emerging market bond spreads (see Celasun, 2009). The increase in the U.S. federal debt-to-GDP ratio (by about 30 percent of GDP from current levels) would also have a further direct impact of about 50 basis points on emerging market sovereign spreads. As a result of these effects on emerging market spreads and the underlying Treasury long-term bond yields, the average yield on emerging market sovereign debt would increase by about 185 basis points, assuming IMF staff’s medium-term projections for the U.S. federal debt. Lower public debt or enhanced growth prospects in emerging market countries relative to those in the United States would have a tendency to offset these effects.

Note: This box was prepared by Oya Celasun and Martin Sommer based on Celasun and Sommer (2010).

Given the relatively weak outlook, it would be advisable for policies to maintain a supportive tilt for some time (Figure 1.4). The Federal Reserve has continued to elaborate its exit strategy while signaling exceptionally low policy rates for an extended period. It has also recently stated that it would provide further monetary accommodation if needed to support the recovery and bring inflation, over time, to levels consistent with its mandate. Thus, market participants expect no significant monetary policy rate tightening until end-2011. The 2011 budget proposal includes additional short-term support to the economy, although it projects some fiscal withdrawal next year. If downside risks to growth were to materialize, immediate actions to reduce the deficit could reasonably be backloaded, as long as credible plans for medium-term fiscal adjustment are in place. Under such a scenario, policies to alleviate structural problems in the housing and labor markets (Box 1.1) could be considered within the budget framework.

Figure 1.4.Monetary conditions are projected to remain easy for a longer period, amid weak housing and employment conditions.

Sources: Haver Analytics; National Association of Relators; U.S. Bureau of Economic Analysis; U.S. Bureau of Labor Statistics; U.S. Census Bureau; and IMF staff calculations.

Beyond the near term, the main policy challenges for the United States are getting its fiscal imbalances under control and implementing the recent reform of financial supervision and regulation. The draft FY2011 budget proposes measures aimed at reducing the Federal fiscal deficit to 4 percent of GDP by the middle of the decade, which is not enough to stabilize the debt-to-GDP ratio even under more optimistic growth assumptions.3 A new Fiscal Commission has been charged with recommending measures to reduce the Federal deficit by an additional 1 percent of GDP, although under the staff assumptions a larger effort would be needed to stabilize the debt ratio over the medium term. In the long term, moderation of health care cost inflation is needed to limit government transfers to Medicare and Medicaid; this raises the profile of the newly created Independent Payments Advisory Board, whose cost-control recommendations would be directly implemented unless voted down in Congress.

The recent reform of financial supervision and regulation in the United States, if well implemented, could be a major step toward addressing weaknesses exposed by the 2008 crisis, while bolstering market discipline and stability through better transparency and less complexity (Box 1.3).

Canada—Strong Recovery with Elevated Risks

The Canadian economy has emerged strongly from the recession since the second half of 2009, driven by robust domestic demand (Figure 1.5). This turnaround, with GDP already back to its precrisis level, reflected a decisive policy response to the crisis and strong fundamentals, including a healthy financial sector.

Figure 1.5.Canada’s growth is rebounding on the back of strong domestic demand and stimulative policies.

Sources: Bloomberg; Haver Analytics; and IMF staff calculations.

Among the main policy measures, the recovery was boosted by a fiscal stimulus, which added about 0.6 percentage point to growth in 2009, and emergency liquidity measures by the federal government and the central bank, including through the purchase of insured mortgages and an all-time-low policy rate for an extended period.

Compared with the United States, a sounder banking system and a more resilient household net worth (down about 1 percent peak-to-trough during the crisis) underpinned a stronger labor market rebound—with employment already back to precrisis levels—and an impressive recovery in consumption spending. Similarly, an upturn in residential investment supported growth, with housing sales reaching historic highs at end-2009, while investment in machinery and equipment benefited from a less leveraged corporate sector and sharp increases in commodity prices. As was also the case in the United States, a strong inventory cycle emerged in early 2010, following sharp drawdowns in early 2009. Meanwhile, financial conditions have remained favorable, reflecting low funding costs and the absence of financial system strains evident in other countries. At the same time, the strong Canadian dollar continues to be a drag on growth.

As in the United States, output growth in Canada seems to be moderating. Following very strong growth in late 2009 and early 2010, recent data suggest a slowdown in the pace of expansion—although above potential—as external demand eases, policy stimulus is withdrawn, inventory accumulation dissipates, the housing market cools down, and consumers deleverage. IMF staff expects a continued gradual recovery, with inflation contained and steadily improving labor market conditions. Canadian real GDP is projected to expand by about 3 percent in 2010—in line with that projected in the last Regional Economic Outlook: Western Hemisphere—and by about 2¾ percent in 2011. Domestic demand is expected to remain the main driver of growth, even amid gradual dissipation of fiscal stimulus. Inflation pressures are expected to remain muted against a backdrop of a still sizable output gap, despite some near-term price effects from the harmonization of federal and provincial sales taxes. In view of this stronger outlook, the Bank of Canada was the first G-7 central bank to raise interest rates this summer.

Box 1.3.Highlights of the 2010 U.S. Financial Regulatory Reform

In July 2010, President Obama signed into law a comprehensive package of reforms that lays the foundation for a stronger, more resilient financial system. Even if it missed the opportunity for bolder streamlining of the regulatory architecture, the Financial Reform Act is far reaching and could have significant cross-border implications, given strong interlinkages with the global financial system. The new legislation addresses weaknesses in supervision and regulation exposed by the crisis, and is expected to bolster market discipline and stability through better transparency and less complexity, if well implemented.

Key features of the new legislation:

  • Stronger systemic oversight. The Act creates a fourteen-member Financial Stability Oversight Council (FSOC), which is chaired by the Treasury Secretary and empowered to: (i) recommend changes in prudential requirements; (ii) designate financial firms, activities, or market utilities as systemic; and (iii) approve the breakup of large and complex companies if they threaten financial stability. Its work is to be supported by a new Office of Financial Research (OFR) in the Treasury.

  • Redesign of the regulatory architecture. The Act abolishes the Office of Thrift Supervision but creates four new entities (in addition to the FSOC and OFR, it creates an independent Consumer Financial Protection Bureau and a Federal Insurance Office). The Federal Reserve retains supervision over Bank Holding Companies (BHCs) and member state-chartered banks, and is responsible for designating systemically important nonbank financial companies.

  • Stronger microprudential regulation and supervision. New capital and leverage standards will be issued for all BHCs, bank subsidiaries, and systemically important nonbank financial companies. Systemic firms will be held to especially stringent standards, ranging from “living wills” to tighter prudential requirements. Riskier activities, such as proprietary trading and sponsoring or investing in private equity and hedge funds, will be curtailed.

  • Regulated derivative markets. Structured products will be subject to stricter disclosure and transparency requirements and originators of uninsured mortgage-backed securities will be subject to an additional 5 percent “skin in the game” requirement. Higher capital requirements will be imposed on companies with large swap positions, whereas over-the-counter swaps will go through third-party central clearing and exchange trading, with data collected for surveillance purposes.

  • Stronger crisis management, resolution, and systemic liquidity arrangements. The Act gives authority for the liquidation of failing systemically important financial firms, the cost of which is not borne by taxpayers. The Federal Deposit Insurance Corporation (FDIC) deposit insurance coverage is raised to $250,000 per depositor, funded by a broader assessment base and a higher FDIC statutory minimum reserve ratio. The Federal Reserve is limited to provide system-wide liquidity support for solvent firms.

Implementation challenges:

  • Rule making and regulatory complexity. The implementation of the Act calls for extensive rules writing and reports, which will require close cooperation both domestically and with G-20 and other international initiatives to avoid mutually inconsistent rules that could widen the scope for regulatory arbitrage. The legislation’s failure to streamline the complex U.S. regulatory system, as recommended in the U.S. Financial System Stability Assessment (FSAP), will complicate coordination via the FSOC.

  • Cross-border coordination. Many of the reforms are also being considered by the international standard setters, the G-20, the Financial Stability Board, and others. Every effort should be taken to coordinate these efforts internationally to ensure a “race to the top” rather than pushing transactions to less stringent jurisdictions. Continued international efforts will also be needed for dealing with the resolution of global financial conglomerates. The “living wills” required by the Act could help identify tensions with legal frameworks in foreign jurisdictions and catalyze the preparation of coordinated ex ante crisis management frameworks.

  • Housing. The Act leaves untouched the housing government-sponsored enterprises, and action on this front is critically important given their weakened financial situations.

Note: This box was prepared by Andrea Maechler.

Risks in Canada are also tilted to the downside, mostly stemming from possible external shocks, although domestic factors also pose some risk. Globally, and particularly in the United States—Canada’s main trading and financial partner—private demand might be insufficient to sustain the recovery amid stubbornly high unemployment rates. Domestic downside risks include a larger-than-expected downturn in the housing market (in the context of a highly indebted household sector), as real estate prices in regions remain somewhat above levels implied by fundamentals.

Implications for the Latin American and Caribbean Region

The global recovery is spurring exports from Latin America, with further buoyancy added for commodities exporters. Following a steep collapse of global trade, trade flows started to pick up in mid-2009, and a continued recovery in 2010–11 will remain a pull factor, particularly for more trade-oriented economies and those with stronger trade linkages with Asia.

Although the weak recovery in advanced economies will weigh on global demand, growth in emerging economies is likely to be strong enough to continue supporting trade and commodity prices and favoring Latin American and Caribbean commodity exporters (see also Box 2.2).

Weak employment growth prospects in the United States and Europe will further restrain the recovery in tourism, constraining the pace of recovery in tourism-dependent economies. At the same time, weakness in the U.S. housing market and tepid construction activity suggest that construction employment will remain subdued. Given the sector’s strong links with workers’ remittances—most clearly for the case of Mexico and Central America—remittances may recover only slowly from current depressed levels.

On the positive side, the United States will contribute for some time to the ongoing financial push under way as a number of countries in the region faces fluid access to international financial markets. The expected low federal funds rate (likely to persist for some time), weak domestic credit demand in the United States, and improving risk appetite—combined with the attractive risk profile of some Latin American markets—will continue to drive private capital to the region. This poses important policy challenges, as discussed in the following chapter.

Not soon, but perhaps over the medium term, increased public indebtedness in the United States may also put sizable pressure on borrowing costs in Latin America, though this is likely to occur only after private demand in the United States and other advanced economies regains its momentum.

Note: This chapter was prepared by Luis Cubeddu and Marcello Estevão with contributions from Gustavo Adler, Oya Celasun, and Evridki Tsounta.

For a more detailed discussion of the commodity price outlook see World Economic Outlook, September 2010.

Balanced-budget requirements have limited state-level borrowing but have forced sharp expenditure cuts that are projected to continue in the next couple of years.

Measures to reduce the federal deficit include (among others): (i) the expiration of the 2001 and 2003 tax cuts for upper-income taxpayers; (ii) broadening of the corporate tax base; and (iii) savings from a freeze on non-security discretionary spending. Significant savings are also expected from scaled-down overseas military operations.

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