CHAPTER I PROSPECTS AND POLICY CHALLENGES
Author: International Monetary Fund. Research Dept.
Language:
English
Keywords:
WEO; U.S. dollar; current account; monetary policy; fiscal policy; exchange rate; consumer confidence; consumer demand; Oil prices; Consumer prices; Current account balance; Asia and Pacific; Europe
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Abstract

Since the publication of the October 2000 World Economic Outlook, the prospects for global growth have weakened significantly, led by a marked slowdown in the United States, a stalling recovery in Japan, and moderating growth in Europe and in a number of emerging market countries. Some slowdown from the rapid rates of global growth of late 1999 and early 2000 was both desirable and expected, especially in those countries most advanced in the cycle, but the downturn is proving to be steeper than earlier thought. Given the rapid policy response by the U.S. Federal Reserve and a number of other central banks, and with most advanced countries—with the important exception of Japan—having considerable room for policy maneuver, there is a reasonable prospect that the slowdown will be short-lived. However, the outlook remains subject to considerable uncertainty and a deeper and more prolonged downturn is clearly possible. Against this background, macroeconomic policies—particularly on the monetary side—will need to be proactive to guard against the possibility of a steeper than expected downturn.

Since the publication of the October 2000 World Economic Outlook, the prospects for global growth have weakened significantly, led by a marked slowdown in the United States, a stalling recovery in Japan, and moderating growth in Europe and in a number of emerging market countries. Some slowdown from the rapid rates of global growth of late 1999 and early 2000 was both desirable and expected, especially in those countries most advanced in the cycle, but the downturn is proving to be steeper than earlier thought. Given the rapid policy response by the U.S. Federal Reserve and a number of other central banks, and with most advanced countries—with the important exception of Japan—having considerable room for policy maneuver, there is a reasonable prospect that the slowdown will be short-lived. However, the outlook remains subject to considerable uncertainty and a deeper and more prolonged downturn is clearly possible. Against this background, macroeconomic policies—particularly on the monetary side—will need to be proactive to guard against the possibility of a steeper than expected downturn.

Given the strength of activity in early 2000, and with the signs of greater than expected weakening coming late in the year, global output in 2000 grew an estimated 4.8 percent, very close to the projection in the last World Economic Outlook (Table 1.1 and Figure 1.1). However, activity in 2001 will slow markedly, with global growth now projected at 3.2 percent, 1 percentage point lower than earlier expected. Within this, GDP growth in the United States has been revised downward by 1.7 percentage points to 1.5 percent, the lowest level for a decade. Growth projections have also been marked down significantly in the other major currency areas. Activity in Europe should nonetheless remain reasonably robust, but in Japan growth is projected to fall to 0.6 percent. In emerging markets, the revisions to the outlook vary, depending in part on the closeness of linkages with the United States. Growth has been marked down substantially in emerging Asia and Latin America—although activity in China and India is expected to remain relatively well sustained, providing an important source of stability. In contrast, most countries in the Middle East, Central and Eastern Europe, the Commonwealth of Independent States and Africa have been less affected, although growth in Turkey is likely to decline sharply as a result of the recent crisis.

Table 1.1.

Overview of the World Economic Outlook Projections

(Annual percent change unless otherwise noted)

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Note: Real effective exchange rates are assumed to remain constant at the levels prevailing during February 19-March 16, 2001.

Using updated purchasing-power-parity (PPP) weights, summarized in the Statistical Appendix, Table A.

Indonesia, Malaysia, the Philippines, and Thailand.

Simple average of spot prices of U.K. Brent, Dubai, and West Texas Intermediate crude oil. The average price of oil in U.S. dollars a barrel was $28.21 in 2000; the assumed price is $25.50 in 2001 and $22.50 in 2002.

Figure 1.1.
Figure 1.1.

Global Indicators1

(Annual percent change unless otherwise noted)

Global growth is projected to slow markedly in 2001, while inflation remains subdued.

1Shaded areas indicate IMF staff projections. Aggregates are computed on the basis of purchasing-power-parity weights unless otherwise indicated.2Average growth rates for individual countries, aggregated using purchasing-power-parity weights; these shift over time in favor of faster growing countries, giving the line an upward trend.3GDP-weighted average of 10-year (or nearest maturity) government bond yields less inflation rates for the United States, Japan, Germany, France, Italy, the United Kingdom, and Canada. Excluding Italy prior to 1972.

Some slowdown in global growth from the very high rates of late 1999 and early 2000 had been long anticipated by most forecasters. By the end of 2000, activity—particularly in the United States—was clearly weakening significantly (Box 1.1). This was in part the result of the appropriate earlier tightening of monetary policy in the United States to address rising demand pressures; and during most of the second half of the year policies appeared broadly on track to achieve this through a moderation in the pace of economic advance. As experience over the past several decades has shown, however, soft landings are not easy to achieve. In the event, a series of shocks—including higher energy prices; a reassessment of corporate earnings prospects, accompanied by a sharp fall in equity markets, particularly of technology stocks, and slowing growth in the technology sector; and a tightening of credit conditions—appear to have combined to generate a marked slowdown in domestic demand growth, and a sharp weakening in consumer and business confidence (Figure 1.2).

Figure 1.2.
Figure 1.2.

Selected European Union Countries, Japan, and United States: Indicators of Consumer and Business Confidence1

Confidence has fallen back markedly in the United States; in Europe, business confidence has also weakened, although consumer confidence remains reasonably well-sustained.

Sources: Consumer confidence for the United States, the Conference Board; for European countries, the European Commission. Business confidence for the United States, the U.S. Department of Commerce, Purchasing Managers Composite Diffusion Index; for European countries, the European Commission; and for Japan, Bank of Japan.11ndicators are not comparable across countries.2Percent of respondents expecting an improvement in their situation minus percent expecting a deterioration.

The further setback to the already fragile recovery in Japan is an additional source of concern. Following very strong growth in the first quarter of 2000 (partly due to temporary factors), activity appears to have stagnated, weighed down by weak consumer confidence, slowing business investment, and weakening external demand, while deflation has persisted. Activity in 2001 will be helped by policy initiatives, including the November 2000 fiscal stimulus package and the recent shift to a new monetary framework, as well as the depreciation of the yen since late 2000, but business investment and exports appear to be weakening and there is as yet little sign of a pickup in consumer confidence, which is essential to underpin a sustained recovery, or in bank lending. Moreover, with limited room for policy maneuver and continued fragilities in the financial and corporate sectors, the economy remains vulnerable to additional shocks.

In an environment of slowing global growth, commodity prices are expected to weaken (Appendix I). Oil prices have retreated from their late 2000 high, and—while their continued volatility remains a concern and much continues to depend on the production decisions of the Organization of the Petroleum Exporting Countries (OPEC) in coming months—the risks may now be on the downside. Nonfuel prices are expected to remain broadly unchanged, in part reflecting the continued strength of the dollar; however, if global demand slows more than expected, prices would likely weaken, adversely affecting commodity producers, including many poor countries. As oil prices fall back, headline inflation in most industrial countries has begun to stabilize and—with wage increases moderate—underlying inflation remains generally subdued. Inflation remains a concern in some faster growing European countries and in a number of developing and transition countries, but, in general, inflationary risks do not materially circumscribe policymakers’ freedom of action at this stage.

In financial markets, after a respite in January 2001 the fall in U.S. equity markets accelerated through early April in the face of continued weak earnings reports, with additional sharp declines in the technology sector and in broader market indices, although sentiment has since stabilized and, as the World Economic Outlook went to press, equity prices rebounded in the initial aftermath of the latest cut in U.S. interest rates. Weakness in U.S. equity markets has been mirrored in other mature markets, and broader equity indices have fallen back significantly from earlier peaks (Figure 1.3). Increased expectations of a U.S. slowdown, along with tightening bank lending standards, falling corporate profits, the global downgrading of the technology sector, and a pickup in default rates, have also reduced investors’ appetite for risk taking. Although long term government bond yields have fallen—in part also reflecting buybacks and expected Federal Reserve interest rate easing—corporate credit spreads have widened since last summer, and there is much greater differentiation in spreads between risk classes, notably in the high yield market (although high yield rates have fallen back somewhat following the cuts in U.S. interest rates). In currency markets, the euro has strengthened only modestly against the U.S. dollar since its low in October 2000, and still appears undervalued in terms of medium-term economic fundamentals (see Chapter II). As concerns about the sustainability of the Japanese recovery have intensified, the yen has weakened significantly to about its mid-1999 level.

Figure 1.3.
Figure 1.3.

Financial Market Developments

Notwithstanding lower interest rates, mature and emerging equity markets continued to decline through early April, driven by the fall in the NASDAQ. The euro has modestly appreciated against the U.S. dollar, while the yen has fallen back on rising concerns about the sustainability of the Japan’s recovery.

Sources: Bloomberg Financial Markets, LP; European Central Bank; IMF Treasurer’s Department, Nikkei Telecom; and WEFA, Inc.1 Average of the month.2 Three month deposit rate; euro area data prior to January 1999 reflect Germany.3 Ten-year government bond rate. To December 1998, euro area yields are calculated on the basis of harmonized national government bond yields weighted by GDP. Therefore, the weights are nominal outstanding amounts of government bonds in each maturity band.

As a result of developments in mature markets, the environment faced by emerging markets has changed for the worse.1 As technology valuations in mature markets declined, emerging equity markets fell back sharply, in a number of cases also reflecting increased investor concerns about domestic and external risks. In tandem with developments in U.S. high yield paper—widely regarded as a competing asset class—spreads on emerging market bonds widened in the last quarter of 2000, and financing conditions tightened markedly, exacerbated by crises in Argentina and Turkey. Following the cuts in U.S. interest rates in January, emerging equity markets initially strengthened and financing conditions improved, permitting a number of countries to cover a substantial proportion of their annual public sector external financing requirement. However, in parallel with developments in mature markets, equity prices subsequently fell back and financing conditions deteriorated (although both have stabilized recently). Spillover effects from the renewed financial crisis in Turkey, culminating in the floating of the Turkish lira in mid-February, have so far been limited, but economic difficulties in Argentina appear to have had more of an impact, particularly on spreads in neighboring countries.

To date, the effects of the global economic slowdown have been seen primarily in those countries with close trade ties to the United States, including Canada and Mexico, and emerging Asia. In Canada and Mexico, the effect will be partly cushioned by solid domestic demand growth; in emerging Asia, where confidence had already been weakened by a variety of domestic and external factors, the impact may be more substantial and would be compounded by a larger-than-expected deterioration in Japan. In other countries, where a key concern is the impact through financial markets and the knock on effects through consumer and business confidence, the effects have as yet been more moderate, although important risks remain. However, looking forward to the remainder of 2001, much will depend on how deep and prolonged the slowdown in the United States proves to be. This remains subject to considerable uncertainty. However, there are a number of reasons to believe that the slowdown may be relatively moderate and short-lived:

  • First, long-term interest rates in the United States have fallen during 2000 and, more recently, short-term rates have been cut significantly. This should begin to have a direct effect on U.S. activity in the second half of the year, providing support to the global economy, although the pace of this recovery may be slowed by the recent further decline in equity prices. Lower oil prices will also be helpful.

  • Second, with inflationary risks receding, policymakers in most advanced economies have substantial room to maneuver, which some countries, most notably the United States, but also including Australia, Canada, and the United Kingdom, have begun to use; Japan, where the scope for adjustment is much less, has also moved to ease monetary policy in the context of its new monetary framework. Moreover, given the substantial strengthening in fiscal positions in recent years (see Chapter III), most countries have room for fiscal easing as a second line of defense, or have already moved to somewhat easier fiscal stances.

  • Third, while a number of countries continue to face serious difficulties, external and financial vulnerabilities in emerging markets have been generally reduced since the 1997–98 crises, and the shift away from soft exchange rate pegs has improved their ability to manage external shocks (Figure 1.4). (See Chapter IV.)

Figure 1.4.
Figure 1.4.

External Vulnerabilities in Developing Countries

External vulnerabilities have generally declined since the 1997–98 crises, although debt and financing requirements in Latin America remain high, and there has been a general shift toward hard pegs and/or more flexible exchange rate regimes.

1Including Malta and Turkey.2 Current account balance plus total amortization due.3Defined as percentage of countries (weighted by purchasing-power-parity GDP) that have a fixed but adjustable exchange rate regime. Covers the major emerging market countries in each region; based on Stanley Fischer, “Exchange Rate Regimes: Is the Bipolar View Correct?” Distinguished Lecture on Economics in Government, AEA Meetings, January 2001 (available at www.imf.org).

How Well Do Forecasters Predict Turning Points?

The rapid change in the U.S. economic outlook has taken most people by surprise, with the Consensus forecast for real GDP growth in 2001 falling from 3.7 percent in September 2000 to 1.7 percent in April 2001, the most rapid adjustment in expectations since the early 1990s when the United States entered its last recession (see the first figure). As much previous work has indicated, the failure to predict major slowdowns or contractions in activity has been a notable feature of forecasts of the U.S. economy for many years.1 A recent paper reviews the experience with forecasts of a broad sample of advanced and emerging economies during the 1990s, based on the projections published in the private sector Consensus Forecasts.2 It finds that, in April of the year before a recession year (defined as a year of negative real GDP growth), the Consensus mean forecast—averaged across the 60 episodes of recessions—was for 3 percent growth (see the second figure). By October, the mean forecast had been trimmed to about 2 percent, with a further trimming down to zero by April of the year of the recession. These downward revisions suggest that forecasters were clearly aware a slowdown was in progress. By October, the forecasts catch up with the reality of a recession, but still underestimate the actual decline.3 A similar pattern is observed around business cycle troughs—forecasters are initially slow to adjust their projections, but then steadily adjust their forecasts upward to catch up to the reality of an upturn. As the paper also notes, since errors in official and the Consensus forecasts are highly correlated, such problems are not confined to the private sector.4

uch01fig01

Consensus Forecast of U.S. Growth in 1991 and 2001

(Percent)

This evidence on the difficulties forecasters experience in predicting recessions highlights several points. First, identifying recessions is a complex task, even when they are occurring. This is why most recessions are determined to be such after the event, not during it. Even more important, the upward bias in projections is what would be expected if one focuses only on periods of recession. A forecaster needs to assess the probability of an outright recession against that of a more mild slowing of activity. Hence, one would expect growth over episodes of recession to be systematically over predicted—essentially, a worse-than-expected outcome does indeed occur when an economy moves into a recession.

uch01fig02

Consensus Forecast of Growth in Recession Years1

(Percent)

Source: IMF staff estimates.1 Averaged across 60 periods of recession.

However, the fact that forecasters tend to make steady upward or downward revisions to their projections—not just over recessions, but more generally—raises the question of whether forecasts themselves are efficient. As noted cogently by William Nordhaus:

  • If I could look at your most recent forecasts and accurately say, “Your next forecast will be 2 percent lower than today’s,” then you can surely improve your forecast.5

Why might forecasters violate notions of forecast efficiency and prefer to adjust their forecasts in a smooth manner toward the actual? Nordhaus suggests two reasons: fear that “jumpy” or “jagged” forecasts will be treated as signs of inconsistency; and that forecasters tend to stay away from issuing “outlier” forecasts—a strategy that works well in most years since outliers are, by definition, rare events.6 In addition, reported headline forecasts may not capture shifts in the weights the forecaster attaches to different scenarios, which could change significantly. To the extent that this is the case, such behavior can make the revisions in the Consensus forecast smooth and also guide it away from outlying values and indeed in some instances toward convergence to a forecast value that is far from the actual value.

While this is difficult to test for, in particular because Consensus forecasts by their nature contain a degree of serial correlation, preliminary evidence suggests forecasts may indeed contain a degree of inefficiency.7 Hence there may be room to improve the Consensus forecasts by adjusting for the degree of serial correlation in forecast revisions in the past (on the other hand, preliminary analysis indicates that the dispersion of forecasts tends to rise only when the level of the forecast has started to fall significantly). For example, a simple correction applied to U.S. growth projections from the Consensus forecasts over the period 1990 to 2000 would reduce the mean absolute error of the forecast by nearly 10 percent, and similar effects appear to be true of other major economies.8 As forecasters become more aware of this bias, it is to be hoped that forecasts themselves will become more efficient and this serial correlation will be eliminated.

1

See for example, Victor Zarnowitz, “The Record and Improvability of Economic Forecasting,” NBER Working Paper No. 2099 (Cambridge, Mass.: National Bureau of Economic Research, July 1987); and David Fintzen and H.O. Stekler, “Why Did Forecasters Fail to Predict the 1990 Recession,” International Journal of Forecasting, Vol. 15 (July 1999), pp. 309-23.

2

Prakash Loungani, “How Accurate Are Private Sector Forecasts? Cross Country Evidence from Consensus Forecasts of Output Growth,” International Journal of Forecasting (forthcoming).

3

The “actual” values used here are initial estimates, taken wherever possible from the May World Economic Outlook of the following year. These initial estimates are used in preference to final GDP data, which often reflect data revisions, re-benchmarking, and other such unforecastable changes.

4

An earlier study of World Economic Outlook forecasts also found that they had substantially the same errors as private sector forecasts. See Michael Artis, “How Accurate are the IMF’s Short-Term Forecasts? Another Examination of the World Economic Outlook,” in Staff Studies for the World Economic Outlook (Washington: International Monetary Fund, December 1997).

5

William D. Nordhaus, “Forecasting Efficiency: Concepts and Applications,” The Review of Economics and Statistics, Vol. 69 (November 1987), pp 667-74.

6

Indeed, a recent study finds that individual forecasters tend to conform to the mean (consensus) forecasts; in particular, an individual’s forecast is strongly influenced by the consensus forecast of the previous month. See Giampiero Gallo, Clive Granger, and Yongil Jeon, “The Impact of the Use of Forecasts in Information Sets,” Working Paper No. 99-18 (San Diego: University of California at San Diego, Department of Economics, August 1999).

7

Serial correlation is particularly likely in averages of forecasts, because the individual projections may have been made at different times. Even if the individual forecasts do not contain serial correlation, averaging forecasts of different vintages will cause serial correlation.

8

For this illustration, the corrected forecast is obtained by adding to the recent forecast a multiple of the revision in the forecast made six months ago. The multiple depends on the relationship between past forecast errors and past forecast revisions. For details, see Oliver Kim, Steve C. Lim and Kenneth W. Shaw, “The Use of Forecast Revision in Reducing Built-in Biases in Mean Analyst Forecasts,” Journal of Accounting Research (forthcoming). The procedure could in principle be generalized to account for more than two forecasts and possible differences in the adjustment factor depending on the stage of the business cycle.

Against this background, the World Economic Outlook’s baseline scenario projects that activity in the United States picks up during the second half of the year, while growth in Europe remains reasonably robust, and the recovery in Japan resumes in 2002. In emerging markets, external financing conditions would gradually improve during the remainder of the year, consistent with a modest pickup in private capital flows. While global growth in 2001 would still slow significantly, it would remain well above earlier troughs and return to close to trend in 2002.

This scenario is certainly plausible, but it is far from assured. On the positive side, if confidence were to rebound quickly, it is possible that the pickup in the United States—and therefore in the global economy—could be more rapid than presently projected. However, with equity markets weak, the risks of a less favorable outcome are clearly significant. Experience suggests that when turning points are reached, the shift in momentum is often more pronounced than previously expected. As has been highlighted in many previous editions of the World Economic Outlook, this may be particularly the case given the substantial imbalances that have developed during the expansion, including the high current account deficit and the apparent overvaluation of the U.S. dollar, the negative personal saving rate, and—despite recent declines—equity markets that are still richly valued by historical standards. These imbalances are closely linked to expectations of continued strong productivity growth in the United States relative to other countries; and the extent, manner, and speed with which they unwind will depend on how those expectations evolve in a climate of slowing growth. In this connection, one risk is that the virtuous “new economy” circle of rising productivity, rising stock prices, increased access to funding, and rising technology investment that contributed to the strong growth in the 1990s (see Chapter II) could go into reverse.

If the slowdown in the United States were to prove deeper and more prolonged, this would pose several interlinked risks for the global outlook that would significantly increase the chance of a more synchronized and self-reinforcing downturn developing:

  • First, over the past several years, the strong expansion in the U.S. economy has been instrumental in stabilizing global activity in the face of weak demand elsewhere. Unfortunately, with the recovery in Japan stalling, and potential growth in Europe still modest, the present slowdown in the United States is unlikely to be offset by higher demand growth elsewhere. In these circumstances there would be a greater risk of spillovers to other countries through financial market and confidence effects. The global economy would also become more vulnerable to adverse shocks, such as a sharper-than-expected weakening of activity in Japan.

  • Second, as discussed extensively in recent issues of the World Economic Outlook, there would be a greater risk that the current account imbalances in the major currency areas, and the apparent misalignments among the major currencies, could unwind in a disorderly fashion. Historical experience suggests that current account deficits of the size that presently exists in the United States have not been sustained for long, and that adjustment is generally accompanied by a significant depreciation. Since the projections in the World Economic Outlook, like those of many other forecasters, assume constant real exchange rates, the baseline scenario shows relatively little change in global current account imbalances. As discussed in Appendix II, in a scenario allowing for a gradual adjustment in exchange rates—as has most often been the case in past episodes—these imbalances could adjust in a relatively manageable and nondisruptive fashion, especially if accompanied by stronger growth in Europe and Japan. However, in an environment where U.S. growth slows sharply, the portfolio and direct investment flows that have been financing the U.S. current account deficit could adjust more abruptly. This would heighten the risk of a more rapid and disorderly adjustment, possibly accompanied by financial market turbulence in both mature and emerging markets. Large swings in exchange rates could also limit the room for policy maneuver.

  • Third, given that financial risks often tend to be underestimated in periods of rapid expansion, lower growth could expose fragilities in financial markets. Further downward revisions to expectations of corporate profit growth could intensify pressures on equity markets in the United States and elsewhere, with adverse effects on wealth, investment, confidence, and risk aversion—which would also directly affect demand for emerging market assets. Slower growth would also add to pressures on financial and corporate sectors, particularly in those countries where significant weaknesses remain.

To illustrate these risks, the World Economic Outlook also includes a “harder landing” scenario, based on the assumption of a further significant fall in U.S. equity valuations and in consumer and investor confidence in the United States and Japan, associated with a substantial and abrupt depreciation of the U.S. dollar against other currencies. As a result of the abrupt changes in financial market valuations and loss of confidence, the rebalancing of global demand is accompanied by a significant, generalized slowdown in output. Compared to the baseline scenario, global output falls by slightly over 1 percentage point through 2001 and 2002, with the impact varying from 1½ percentage points in the United States to 1 percentage point in other advanced countries. In developing countries, the impact is about one-half of that for the global economy, largely reflecting the fall in demand for net exports, but could be significantly larger if external financing conditions deteriorated sharply. Overall, this would result in a global slowdown broadly comparable to that experienced in 1998. Were the financial weakness to occur but the U.S. dollar depreciation to be delayed, the output loss would be larger in the United States as the increase in net exports would be more limited, and conversely the output losses in other advanced economies would be smaller.

Recent issues of the World Economic Outlook have called for policies in the main currency areas to be consistent with a rebalancing of growth and demand among the three main currency areas, supportive of an orderly resolution of global imbalances. This process is now clearly under way; however, it is taking place entirely through lower growth in the United States, with activity elsewhere doing little to offset this decline. With inflationary pressures easing, and downside risks to activity more pronounced, a proactive approach to macroeconomic policies is required, aimed at supporting a reasonably smooth transition to more sustainable growth rates in the United States; strengthening the expansion in Europe; and reenergizing the stalling recovery in Japan:

  • In the United States, the aggressive reduction in interest rates that began in January has been appropriate. Monetary policy should remain the first line of defense, and further interest rate cuts may be needed in coming months. Moderate and relatively front loaded tax cuts could also provide useful support to activity, while minimizing the adverse impact on savings and the current account over the medium term.

  • In Japan, the new monetary framework introduced in March, including the commitment to maintain it until inflation turns positive, is welcome and should be aggressively implemented. Given the very high level of public debt, the gradual fiscal consolidation under way should be maintained, with fiscal easing a last resort to forestall outright recession. However, the main policy requirement is to vigorously address underlying structural weaknesses, particularly in the financial sector, while seeking, to the extent possible, to minimize the adverse short-term impact on growth. The recently announced package of structural measures is a welcome step forward, but it will need to be implemented forcefully and supplemented with other steps.

  • In the euro area, with increasing signs that activity is slowing, and underlying inflationary pressures expected to ease looking forward, there is scope for a moderate downward adjustment in interest rates; and the European Central Bank (ECB) will need to move rapidly if signs of weakness become more accentuated or the euro appreciates sharply. Recent tax cuts, fortuitously timed from a cyclical perspective, will also help support activity in some countries and at this point no additional fiscal stimulus appears necessary beyond the automatic stabilizers. A more ambitious approach to structural reform, notably in labor markets, pensions, and health, is needed to raise potential growth and to ensure long-run fiscal sustainability.

  • In emerging markets, prospects depend critically on maintaining investor confidence. External financing conditions have recently deteriorated and, given the uncertain global outlook and continued economic difficulties in some emerging market countries, are likely to remain volatile in the period ahead. This underscores the need to maintain prudent macroeconomic policies and to press ahead with corporate, financial, and—especially in the transition economies—institutional reforms, particularly in those countries that lag in this process.

The slowdown in global growth will clearly hurt the poor, both directly and through lower commodity prices, although the impact may be mitigated by the fact that two-thirds of the poorest live in south Asia and China, where activity is expected to remain relatively strong. In a number of the poorer countries, debt relief under the Enhanced Heavily Indebted Poor Country (HIPC) Initiative will release substantial resources to finance anti-poverty measures; provided those resources are used efficiently and are supported by comprehensive reform programs, this will help reduce poverty and boost growth over the medium term. To assist these efforts, the advanced economies have a special responsibility to increase aid flows, which are well below the United Nations’ target of 0.7 percent of GDP; to promote peace and political stability, particularly in the war-torn regions of Africa; and to provide further assistance to fight the spread of the HIV/AIDS epidemic, which has become the most serious threat to human welfare and economic development on the African continent.

A major barrier to the progress of poorer developing countries remains the trade regimes in the advanced economies, which generally discriminate against the goods that poor countries produce most efficiently, in particular food and textiles and clothing (although quotas under the Multifiber Arrangement are due to be phased out by 2005). With a new round of multilateral trade liberalization on the horizon, it is important to recall that open trade is a major route for providing the benefits of globalization to poor countries. While developing countries also need to improve their trade systems (the case of Africa is discussed in more detail in Chapter II), it is essential for the advanced countries to recognize the substantial benefits that open export markets can provide to developing countries in general and to poor countries in particular. In this regard, the recent decision by the European Union to provide the poorest nations with immediate free access for most products is very welcome, particularly given the importance of the EU market for such countries. In addition, recent measures providing for significant market opening for the poorest nations have also been taken or announced by Canada, Japan, Korea, New Zealand, Norway, and the United States. Still more can and should be done by these and other countries to eliminate remaining barriers to the exports of the poorest countries.

How Hard a Landing in the United States?

After a strong start, economic growth in the United States slowed sharply during the course of 2000 (Figure 1.5). Real GDP expanded at a 5¼ percent annual rate in the first half of 2000, outpacing even the most optimistic projections of potential growth, and the Federal Reserve appropriately raised interest rates in response to increasing inflationary risks. Growth slowed to an annual rate of just 1 percent in the fourth quarter, reflecting mainly the surge in energy prices and the tightening of financial conditions, including the drop in the NASDAQ and U.S. dollar appreciation. During the course of the year, warnings of slower sales and earnings growth resulted in substantial markdowns in the valuations of many leading high-tech companies, and the U.S. dollar retreated modestly from its peak. At the turn of the year, business and consumer confidence dropped sharply. The downturn in activity has been most severe in manufacturing. While personal spending growth is decelerating, consumer demand and residential construction appear to have provided moderate support to real activity in the first quarter of 2001.

Figure 1.5.
Figure 1.5.

United States: Sharp Slowdown and Persistent Imbalances

(Percent change from four quarters earlier unless otherwise noted)

After a strong start, growth slowed sharply during 2000. Nevertheless, the growth of unit labor costs accelerated, the external current account deficit widened, and the real exchange rate appreciated.

Sources: Bloomberg Financial Markets, LP; Bureau of Labor Statistics; and WEFA, Inc.1 Non farm-business sector.2 Real effective exchange rate based on consumer prices indices.

More than the usual amount of uncertainty surrounds the outlook at the current juncture. The World Economic Outlook’s baseline forecast envisages weak growth in the first half of 2001, reflecting rapid inventory adjustment and a slowdown in investment spending. This is followed by a pickup in activity, supported by lower short-and long-term interest rates, but slowed by the lagged effects of recent declines in equity prices on investment and consumption. This yields growth of 1½ percent for 2001 as a whole and 2½ percent for 2002. An upside risk is the stimulative impact of tax cuts, which have not yet been legislated. However, there is a significant downside risk that the imbalances built up during the long expansion—including equities that have remained richly valued by historical standards, high levels of corporate and household debt, and possible overinvestment in some sectors (notably telecommunications)—could unwind in a less orderly fashion, exacerbated by further declines in confidence and increases in risk aversion in financial markets.

The strength of domestic demand relative to output growth in 2000 led for the third consecutive year to a substantial widening of the external current account deficit. The gap was 4½ percent of GDP in 2000—significantly larger than in other major advanced economies (Table 1.2). With the fiscal surplus increasing, the widening deficit entirely reflected increasing private investment and declining household saving. Substantial capital inflows, partly in response to the perceived increase in trend productivity growth in the United States, led to further appreciation of the U.S. dollar. Past experience suggests that current account deficits of this magnitude are not usually sustained for very long (see Box 1.2), and that adjustment usually involves slower real income growth and gradual but significant real depreciation over a few years.2

Table 1.2.

Selected Economies: Current Account Positions

(Percent of GDP)

article image

Calculated as the sum of the balances of individual euro area countries.

Although core CPI inflation has edged up to about 2¾ percent, the slowdown has diminished inflationary risks. If activity continues to grow at below-potential rates, as expected, pressures on resource utilization should ease, albeit with a lag. At the same time, however, labor markets remain tight by historical standards, and the growth rate of unit labor costs is rising. Also, a sharp depreciation of the U.S. dollar could boost import prices. The balance of these factors will depend crucially on the evolution of labor productivity. At the present stage, the risk of an abrupt acceleration in inflation appears modest, allowing policymakers breathing room to reassess the underlying inflation situation as the extent of the slowdown in real activity becomes more clear. With the balance of risks shifting increasingly to slower growth, the timely and significant interest rate cuts in the first four months of 2001 were welcome. Some further easing would be called for if economic and financial conditions remain weak. In the financial system, there has been a slight increase in nonperforming loans and in defaults on corporate paper, partly attributable to the kinds of overreaching typically experienced during strong economic periods. Nevertheless, banks remain quite profitable by historical standards and have an average capital ratio of 12 percent, more than two percentage points above the minimum level required to be considered well capitalized.

At this stage, monetary policy remains the preferred response to cyclical developments. But unlike the situation that prevailed at the time of the October 2000 World Economic Outlook, moderate and relatively front-loaded tax cuts guided by structural considerations could now be useful from a cyclical perspective, while minimizing the adverse impact on savings and the external current account balance over the medium term. A multiyear tax plan enacted in phases would be preferable, with each phase put in place only once it is clear that sufficient budgetary resources will be available to finance it. The surpluses of the Social Security and Medicare Health Insurance trust funds should be preserved to help meet future pension and health care costs.

In Canada, the U.S. slowdown is an important factor behind the projected moderation of growth from 4¾ percent in 2000 to 2¼ percent in 2001. The economy is very open to trade, with 86 percent of exports (which amount to 37 percent of GDP) destined for the United States, and it produces non-energy commodities, whose prices are expected to remain weak. While previous interest rate increases will dampen demand for durable goods, housing, and business investment, activity should be supported by the buoyant labor market, income tax reductions, and solid consumer and business confidence. The main downside risk is a deeper and more prolonged downturn south of the border. Given the downside risk to growth, and with core inflation remaining around the middle of the 1–3 percent official target range, the interest rate cuts in January, March, and April were welcome. The Bank of Canada will need to remain alert to the possibility that activity slows faster than expected. Recently enacted income tax cuts have been fortunately timed, and the fiscal position remains sound. To further reduce the government debt-to-GDP ratio over time, the government should dedicate the bulk of any projected budget surpluses to debt reduction. To enhance labor market flexibility and lower structural unemployment, new measures are needed to reduce the frequency of employment insurance use and eliminate regional extended benefits.

Sustainability of the U.S. External Current Account

The rise in the U.S. external current account deficit to high levels in recent years has raised doubts about its sustainability and concerns regarding the potential impact that a rapid and disorderly correction of this imbalance might have. The deficit rose from 1½ percent of GDP in 1995 to nearly 4½ percent in 2000 (compared with its average during the previous two decades of 1½ percent). The financing of the deficit in 2000 absorbed an estimated 7½ percent of the savings of the rest of the world, in contrast to the 2½ percent absorbed on average during most of the last two decades. Rapid U.S. GDP growth and relatively weaker growth in other parts of the world, notably Europe and Japan, as well as a sharp increase in the real foreign exchange value of the U.S. dollar driven in large part by capital inflows, contributed to the rise in the deficit (see the figure). The domestic counterpart has been a significant rise in investment.

A number of observers have argued that such high levels of the deficit cannot persist.1 If they were to continue for an extended period, U.S. net external liabilities would rise to an extremely high level and U.S. assets would represent a growing portion of world portfolios that foreign investors might, at some point, become unwilling to hold. This situation would run the risk of large adjustments in the current account and the external value of the dollar, potentially leading to substantial dislocations in the global economy and disruptions in U.S. and world financial markets. Indeed, some observers argue that the risks arise not so much from the size of the U.S. deficit or the outstanding U.S. net liability position as from the suddenness of any adjustment.2 While the experience of recent decades suggests that external adjustment has typically been gradual, there was a sharp fall in the real value of the dollar associated with the current account adjustment of the late 1980s.

uch01fig03

United States

(Annual percent change unless otherwise noted)

Sources: United States Bureau of Economic Analysis; and IMF staff estimates.1 Defined in terms of unit labor cost based on 1989-91 trade weights.

Conventional trade equations imply that trade depends upon economic activity and real exchange rates. Accordingly, mechanisms that might lead to significant external adjustment on the trade side include:

  • Changes in cyclical positions. After the robust growth in output of the last few years, the U.S. economy in 2000 was probably in a more cyclically advanced state than the euro area and (especially) Japan. While uncertainties about the levels and the underlying growth rates of potential complicate any assessment of the size of this effect, current staff estimates suggest that “cyclical” factors might currently be adding around ½ percent of GDP to the U.S. current account deficit.

  • Changes in underlying growth performance. The recent expansion of the U.S. current account deficit has coincided with increases in the estimated potential growth rate of the U.S. economy, and downgrades in the euro area and Japan. Clearly, an increase in potential growth rates in the euro area and Japan could help to reduce the U.S. current account deficit.3 In addition, even if current potential growth trends continue, the U.S. deficit may not deteriorate as much as implied by conventional trade models, as one of the predictions from these models—that faster growing countries have trend depreciations in their real exchange rates or their external positions—is not consistent with the historical experience.4 However, this effect is unlikely to imply a long-term improvement in the U.S. current account deficit.

  • Exchange rate adjustment. A depreciation of the real value of the U.S. dollar from current levels (which may partly reflect capital inflows associated with robust U.S. growth—see Chapter II) is likely to be the main mechanism by which the U.S. current account deficit is reduced over the medium term. This would presumably be associated with a slowing of U.S. domestic demand, in particular investment. Given the size of the U.S. current account deficit, and the relatively small share of trade in the economy, the implied exchange rate adjustment could be significant.

Appendix II of this Chapter reports a scenario in which the U.S. dollar gradually depreciates against other advanced economies. Over the medium term this generates a significant improvement in the external position of the United States, as domestic demand (in particular, investment) falls and external demand rises. From the historical record, such a gradual adjustment in underlying imbalances remains the most likely outcome.5 However, a more abrupt adjustment remains a possibility.

1

See, for example, Catherine Mann, “Is the U.S. Current Account Deficit Sustainable?” in Finance and Development (March 2000), pp. 42-45; and Francis Schott, “Is the U.S. Current Account Deficit Sustainable?” in Business Economics (July 2000), pp. 72-73.

2

Maurice Obstfeld and Kenneth Rogoff, “Perspectives on OECD Economic Integration: Implications for U.S. Current Account Adjustment,” paper presented at the Federal Reserve Bank of Kansas City symposium (August 2000).

3

See the discussion of alternative scenarios in Appendix II of this Chapter for more on this issue.

4

Rather, income elasticities for exports appear to vary systematically with long-term growth performance. See Paul Krugman, “Differences in Trade Elasticities and Trends in Real Exchange Rates,” European Economic Review, Vol. 33 (May 1989), pp. 1031–54. The case of the United States is analyzed in Martin Cerisola, Hamid Faruqee, and Alex Keenan, “Long-Term Sustainability of the U.S. Current Account Balance,” in United States: Selected Issues, IMF Staff Country Report No. 99/101 (Washington: International Monetary Fund, September 1999).

5

See Caroline L. Freund, “Current Account Adjustment in Industrial Countries,” International Finance Discussion Paper No. 692 (Washington: Board of Governors of the Federal Reserve System, December 2000).

Will Japan’s Fragile Recovery Continue?

In Japan, the recovery is stalling, reflecting in part the global slowdown but also the continuing weakness of consumer confidence and underlying problems with the financial system. The 1¾ percent increase in economic activity in 2000 was driven mainly by a strong first quarter, boosted by one-time factors, including a delay in wage bonuses from December to January and a shift in imports associated with Y2K concerns (Figure 1.6). Thereafter, private consumption was weighed down by uncertainties regarding future economic prospects, and industrial activity was dampened by the slowdown in foreign demand and the downturn in the information technology cycle. Bank lending continued to contract, reflecting weak credit demand and ongoing financial system weaknesses. Public investment and external demand are estimated to have made negative contributions to growth after midyear, reflecting the waning of the November 1999 fiscal stimulus package and the slowdown in partner countries.

Figure 1.6.
Figure 1.6.

Japan: Recovery Faltering

(Percent change from four quarters earlier unless otherwise noted)

Sustained growth will depend on aggressive action to address financial system weakness, especially as the scope for fiscal or monetary stimulus is limited.

Sources: Bloomberg Financial Markets, LP; WEFA; Nomura database; and IMF staff estimates (general government data, 1999-2000).1Adjusted for impact of consumption tax increase in April 1997.2Average of the month.3 Excluding social security.

The growth forecast for 2001 has been marked down to ½ percent, reflecting the economy’s vulnerability to the global electronics cycle as well as the impact of sharp declines in equity prices on confidence. Concerns over unemployment are likely to restrain household spending, and slowing world demand for electronic equipment threatens to dampen business investment. Indeed, the recent Tankan survey showed a significant drop in business confidence. Fiscal policy should give a temporary boost to public investment around the second quarter, as the November 2000 stimulus package comes on stream, and the impact of the global slowdown should be cushioned by the depreciation of the yen. An important downside risk is the effect of falling stock prices and deteriorating economic conditions on the financial system. Market analysts are concerned that, at current stock prices, banks and life insurance companies face latent losses on their equity portfolios, which will directly reduce their capital once mark-to-market accounting comes into effect in April 2001, and doubts remain about the extent to which they have recognized and provisioned against problem loans. A sharper-than-expected slowdown in Japan would have a significant adverse impact on the rest of the world, especially Asia.

The faltering recovery is particularly regrettable after a decade of disappointing performance, punctuated by repeated recessions, and characterized by a series of adverse macroeconomic shocks and failures to decisively resolve important structural reform challenges. In particular, current weak growth reflects slow adjustment to the sharp fall in asset prices in the early 1990s, as well as the slow adaptation to globalization and technological change.3 The prolonged slump in business investment reflects mainly excessive fixed assets and debt in the corporate sector, while lending was undermined by financial system weaknesses, including persistent bad loans and low core profitability, as financial institutions clung to low-margin corporate lending and were slow to expand fee-generating activities. Sluggish performance also reflects the slow shift in the main engines of growth from capital accumulation and exports to innovation and productivity gains.

Weak growth in the 1990s persisted despite expansionary macroeconomic policies. Monetary policy was progressively eased, with the overnight call rate falling from more than 8 percent in 1991 to effectively zero in 1999, but ongoing financial sector problems—which undermined bank lending—largely offset easier monetary policy. Fiscal policy was loosened through a series of stimulus packages, which raised the structural general government deficit by more than 6 percentage points of GDP between 1991–99. However, in practice the impact was relatively small, reflecting in part the lack of fiscal transparency and increasing concerns about growing fiscal imbalances.

In light of the deteriorating outlook and continued deflation, the introduction of a new monetary policy framework in March was welcome and it should be aggressively implemented (Box 1.3). Given the high level of public debt, the very gradual fiscal consolidation currently under way is appropriate for now, and fiscal easing should only be considered as a last resort in the event that stimulus is needed to forestall an outright recession (Table 1.3). To prepare for the lengthy period of fiscal consolidation that will eventually be needed, the authorities need to take immediate steps to elaborate their medium-term fiscal framework. Key elements of the strategy will need to include the production of consolidated fiscal accounts on a timely basis, the implementation of rigorous cost-benefit vetting of public works, the introduction of taxpayer identification numbers to widen the personal income tax net, and reform of public health care spending.

Table 1.3.

Major Advanced Economies: General Government Fiscal Balances and Debt1

(Percent of GDP)

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Note: The methodology and specific assumptions for each country are discussed in Box A1.

Debt data refer to end of year; for the United Kingdom they refer to end of March.

Data before 1990 refer to west Germany. For net debt, the first column refers to 1988-94. Beginning in 1995, the debt and debt-service obligations of the Treuhandanstalt (and of various other agencies) were taken over by general government. This debt is equivalent to 8 percent of GDP, and the associated debt service to ½ to 1 percent of GDP.

Includes one-off receipts from the sale of mobile telephone licenses equivalent to 2.5 percent of GDP in 2000 for Germany, 0.6 percent of GDP in 2001 for France, 1.2 percent of GDP in 2000 for Italy, and 2.4 percent of GDP in 2000 for the United Kingdom.

While macroeconomic policy can play some role, the prospects for a return to sustained growth in the medium term depend most critically on the implementation of fundamental reforms in the banking and corporate sectors. To aid this process, the government recently announced a package of measures—including the accelerated disposal of nonperforming loans by the major banks, measures to reduce banks’ equity holdings, and guidelines to aid corporate restructuring and debt forgiveness—which are designed to accelerate the pace of bank and corporate sector restructuring (see Box 1.3). To minimize the adverse short-run impact of these needed structural reforms, the government also announced plans to enhance the social safety net. These new reforms are a welcome step forward, but they will need to be supplemented with other measures. Further, the regulatory and supervisory framework needs to be vigorously applied, particularly in light of the scheduled reimposition of limited deposit insurance in April 2002, including through enforcing more rigorous loan classification standards and more aggressive provisioning against problem loans. To improve the environment for corporate restructuring as banks and firms agree on debt forgiveness in exchange for restructuring plans, a number of complementary reforms are also needed, including to land regulations and to relevant parts of the tax and legal system. Other priority areas for reform include: the deregulation of the telecommunications, power, transportation, and housing sectors; strengthening the role of outside auditors and directors on corporate boards to improve governance; and encouraging private defined-contribution pensions to enhance labor mobility across firms.

Japan’s Recent Monetary and Structural Policy Initiatives

The Japanese authorities have recently taken a number of welcome steps to enhance the monetary policy framework and to accelerate the pace of bank and corporate sector restructuring. These policy decisions were taken with the aim of ending the current period of deflation and bringing about the fundamental reforms necessary in the banking and corporate sectors to underpin strong, sustained growth over the medium term.

Monetary Policy Framework

On March 19, in response to mounting evidence that the economic recovery had stalled, the Bank of Japan announced that it was adopting a new framework for monetary policy based on:

  • A quantitative target for outstanding current account balances at the central bank (mainly consisting of central bank reserves), rather than a target for the overnight interbank call rate. The current target for banks’ balances held at the central bank is ¥5 trillion, about ¥1 trillion above the average balance held in the months prior to the policy change.

  • Stepped-up outright purchases of long-term government bonds, if needed, to achieve the reserves target. In a significant departure from its earlier policy of purchasing a fixed amount of government bonds in the secondary markets each month, the Bank of Japan signaled its willingness to step up outright purchases of long-term government bonds in the secondary market (rinban operations), if necessary, to ensure the smooth provision of liquidity.1

  • A commitment to maintain this new policy until year-on-year CPI inflation (excluding perishables) has stably reached zero or above. Following the announcement, the overnight call rate, which is now market-determined, declined to effectively zero. Moreover, the Bank of Japan’s increased commitment to combat deflation has underpinned market expectations that short-term interest rates will stay near zero at least through mid-2002.

The Bank of Japan’s willingness to tread new ground and its stated commitment to at least stabilize consumer prices are welcome signs of greater flexibility in dealing with the current deflationary environment. This new approach goes further than merely returning to the zero interest rate policy and provides scope for the Bank of Japan to inject further stimulus to the economy if needed in the future. It also improves policy transparency—the objective of stabilizing consumer prices is more clearly defined than the previous zero-interest rate policy that sought to maintain zero interest rates until “deflationary concerns were dispelled”—and should help to reduce deflationary expectations. However, to be most effective the Bank of Japan will need to follow through in using the scope provided by the framework to clearly demonstrate its determination to combat deflation.

Financial and Corporate Restructuring

On April 6, in response to concerns about the pace of bank and corporate restructuring, the government announced a package of measures designed to accelerate the pace of such restructuring. The main elements of the package were:

  • Accelerated disposal of nonperforming loans by the major banks. The plan calls for the major banks to dispose of existing nonperforming loans (NPLs) already classified as “in danger of bankruptcy” and below over a two-year period and new NPLs within three years of their being classified as such. Banks will periodically be required to disclose their progress toward loan disposal, and the situation will be monitored by the Financial Services Agency.

  • Measures to reduce banks’ equity holdings. To reduce banks’ exposure to market risk and curtail cross shareholdings, the plan calls for a yet-to-be-determined limit on banks’ equity holdings relative to capital. As a temporary measure, a Bank Shareholdings Acquisition Corporation (BASAC) will be established, with public sector financial support, to buy the banks’ excess equity holdings at market prices.

  • The promotion of corporate restructuring. Guidelines are to be established to guide the process of corporate restructuring and debt forgiveness, with the participation of the authorities along the lines of the London Approach.

  • Other measures to support restructuring. These include steps to enhance the social safety net and to improve liquidity in the real estate market. Tax reform measures are also under consideration for inclusion in the package at a later date.

While the new emphasis on banking and corporate issues is welcome, the package will need to be implemented vigorously and complemented by additional measures to maximize its impact. One important way to enhance the package would be to broaden coverage to include disposal of NPLs by the regional banks (given that the major banks make up less than half of the assets of deposit taking institutions). In addition, supervision should continue to be strengthened, including to ensure appropriate classification of the large stock of loans to watch list borrowers a significant part of which—according to market analysts—may in fact be impaired, with appropriate levels of provisioning to reflect a realistic forward looking assessment of prospects of loan recovery. The need to provision against newly downgraded loans may well result in some banks becoming undercapitalized, which could require a further injection of public capital, with appropriately strict conditionality to address moral hazard concerns. The equity purchase scheme in the package needs to be designed to minimize distortions, ensure transparency, and limit the amount of public funds at risk. Finally, it will be essential to ensure that corporate restructuring agreements under the scheme involve sufficiently deep adjustment to restore the long term viability of firms being restructured.

Thus, while the new proposals make a welcome step forward, they will need to be implemented with vigor, and supplemented with other steps to encourage the broad-based bank and corporate restructuring needed to lay the basis for sustained recovery in Japan.

1

However, long-term government bonds effectively held at the central bank cannot rise above the outstanding issue of bank notes.

Can Domestic Demand Sustain European Growth?

Growth in the euro area is expected to be cushioned by domestic demand, although the global slowdown and financial market weakness are having an adverse impact on activity (Table 1.4). Real GDP growth eased during the course of 2000, mostly reflecting the negative effect of higher oil prices on purchasing power, particularly in Germany (Figure 1.7). In recent months, business confidence has weakened and signs of slowing industrial activity have intensified. Looking ahead, growth in 2001 is expected to remain relatively well sustained at about 2½ percent, exceeding growth in the United States for the first time since 1991. Household spending is expected to be underpinned by expanding disposable income, reflecting both continued employment growth and personal income tax cuts in some countries. While business sentiment has declined markedly in some countries, the vulnerability of business investment is likely to be limited by high levels of capacity utilization and full order books, the fall in long-term interest rates, and the relative importance of bank lending (rather than market-based finance). Among the major economies, growth has the greatest momentum in France, driven by relatively strong final domestic demand. In addition, France has more limited vulnerability to external developments, reflecting a lower share of manufacturing in value added, a smaller proportion of capital goods in exports, and weaker trade linkages with the United States and Asia. In Germany and Italy, final domestic demand has been much weaker, although in both countries (particularly in Germany) tax cuts should support private consumption during 2001. Weakening external demand will help reduce overheating pressures in the countries on the periphery, especially Ireland, which receives substantial U.S. foreign direct investment and whose economy is relatively technology intensive, but may exacerbate already large current account deficits, including in Portugal and—to a lesser extent—Greece.

Table 1.4.

Advanced Economies: Real GDP, Consumer Prices, and Unemployment

(Annual percent change and percent of labor force)

article image

Consumer prices are based on the retail price index excluding mortgage interest.

Consumer prices excluding interest rate components; for Australia, also excluding other volatile items.

Figure 1.7.
Figure 1.7.

Euro Area: Growth Moderating, but Still Reasonably Robust

(Percent change from four quarters earlier unless otherwise noted)

Growth slowed during 2000, with both private consumption and business investment easing. Despite falling unemployment, domestic price pressures remain contained.

Sources: Eurostat; European Central Bank; European Commission; IMF, International Financial Statistics; and IMF staff estimates.1 Dow Jones EURO STOXX index.2 Three month center moving average.3 Prior to 1999, Bundesbank repo rate.

Monetary policy has been on hold since the ¼ percentage point tightening in October 2000. Underlying inflation is expected to remain steady in 2001 at 1½ percent, with little evidence thus far of pass-through effects from last year’s higher energy prices or the weaker euro to wages, though inflation is higher in countries on the periphery. The moderation of broad money growth and indicators of underlying inflation—including unit labor costs, profit margins, services price inflation, and core inflation purged of indirect energy effects—point to muted domestic price pressures. At the same time, the fall in external demand has become more pronounced. Given the shift in the balance of inflation risks, a moderate cut in interest rates is now appropriate, with a larger one being in order if the exchange rate were to appreciate sharply or indications of the impact of the global slowdown were to mount.

At this stage fiscal policy is not needed to support activity, given the flexibility to use monetary policy to provide stimulus, though fiscal execution should allow the full play of automatic stabilizers. The structural fiscal balance in the euro area as a whole is expected to remain broadly unchanged in 2001, with a deterioration in Germany (¾ percent of GDP) offset by improvements elsewhere, including in France and Spain. Reductions in personal and corporate income taxes in Germany, France, Italy, and the Netherlands are expected to improve labor supply incentives, reduce investment distortions, and increase these countries’ attractiveness to foreign investors. Tax cuts need to be accompanied by spending restraint in the future to allow medium-term budget targets to be met. In most countries, structural spending cuts should be targeted mainly on subsidies, social transfer programs, and public employment. Countries with overheating pressures should avoid loosening fiscal policies, even if they have a significant fiscal surplus, as in Ireland, and—if monetary policy is eased during the year—may need to consider offsetting fiscal measures.

While the near-term growth outlook in the euro area is still quite favorable relative to North America and Japan, policymakers should not be satisfied with a potential growth rate estimated at 2½ percent. Although important progress has been made in some areas of structural reform, unemployment remains high and a deepening and acceleration of market-oriented reforms are needed, especially of pension systems, labor markets, and product markets. Rising pension and health care costs remain serious medium-term challenges (see Chapter III). In Germany, pension reform that will lay the foundation for a funded “second pillar” to supplement the public pension pillar is moving through the legislative process, albeit with some compromises. In many other euro area countries as well, the establishment of a similar funded “second pillar” will be essential to reduce the burden of aging populations on public pensions and diminish the need for further increases in social contribution rates that could harm labor market performance. Cuts in benefits provided under public pensions—through, among other actions, increases in the retirement age—beyond levels currently envisaged will also be needed in the longer run. Controlling public health care costs will depend on measures to improve cost-sharing and administrative capacity.

Further reductions in unemployment over the medium term will depend largely on additional progress in addressing labor market rigidities. Germany shows signs of greater flexibility in de facto working conditions and wages, but legal changes are needed to allow employers and workers to reach wage agreements more in line with firm-level conditions. In France, the 35-hour work week initiative has proceeded relatively smoothly to date, but with the legislation being extended to small firms, flexible implementation—including the relaxation of restrictions on allowable annual overtime hours—will be needed as the labor market tightens. In Italy, the main challenge is to raise employment in the south by linking wages to productivity to achieve greater geographic wage differentiation. In Spain, the priorities are fostering part-time work, reducing dismissal costs to stimulate the growth of employment, and increasing flexibility in wage bargaining.

Additional product market reforms will also be important to increase potential growth rates. Germany has recently implemented impressive reforms in the telecommunications and energy sectors, but further actions are needed, including the liberalization of shop opening hours, and privatization of financial institutions and of the remaining state holdings in public utility companies. Similarly, in France, the recent progress in privatization is welcome, although there is further scope for liberalization of the financial system, especially with regard to administered interest rates, and of the telecommunications and energy sectors. In Italy, the large privatization program in recent years provides a good basis for additional measures, including further liberalization of the energy sector, reform of the legal framework governing nonlisted companies, and vigorous implementation of the simplifications in public administration and licensing procedures.

With its greater openness to trade and financial flows, the United Kingdom is more vulnerable than the euro area to external developments. Growth is showing signs of moderating and the forecast for 2001 is now at 2½ percent, with the balance of risks tilted downward. Domestic demand growth is projected to moderate, despite a strong pickup in public spending, and the external balance is expected to continue to make a negative contribution to growth. Notwithstanding high levels of resource utilization, core inflation has been below target, hovering around 2 percent, reflecting the strength of sterling against the euro, wage moderation, and—more recently—softening economic activity. As inflationary pressures remain subdued, the Bank of England’s interest rate cuts in February and April were appropriate, and there remains room for further easing if the growth outlook were to deteriorate further. The March 2001 budget envisages a reduction of the public sector surplus from 1½ percent of GDP in 2000/01 to ½ percent of GDP in 2001/02. While this expansion most likely can be accommodated without overheating, it could contribute to a policy mix that may tend to keep sterling elevated. Over the medium term, the large planned increase in public investment in infrastructure and human capital should help to raise productivity growth. However, it would be better to avoid returning to a budget deficit, so as not to reduce the pool of national savings available for private investment.

Other advanced European economies are even more open than the United Kingdom and thus more vulnerable to external developments. Growth in Switzerland is expected to slow sharply from 3½ percent in 2000 to 2 percent in 2001, because of the relatively high importance of the U.S. export market. Growth in Sweden is projected to decline from 3½ percent to 2½ percent, reflecting mainly lower external demand but also the impact of declining stock prices, particularly in the technology sector, on domestic demand. At the same time, low unemployment in both countries, as well as in Denmark and Norway, is expected to support both consumption and investment in 2001, as firms seek ways around skill shortages. On the whole, monetary policy in these countries is well positioned to react quickly and aggressively to sharper-than-envisaged weakness in activity. In Iceland, where the current account deficit has widened sharply, fiscal policy needs to play a supporting role in addressing domestic and external imbalances, accompanied by early measures to strengthen the financial system; the recent floating of the currency, together with the adoption of inflation targeting, is welcome and will help promote long-term financial stability.

How Will the Global Slowdown Affect Asia?

In emerging Asia, GDP growth rose to 7.1 percent in 2000, buoyed by the continuing recovery from the 1997-98 crisis (Table 1.5). However, following rapid growth in the first half of the year, the pace of activity has since fallen back markedly, and in 2001 regional growth is expected to decline to 5.7 percent. While a slowdown from the high growth rates during the recovery period was expected, this also reflected a series of shocks, including higher oil prices; slowing growth in the United States, the fall in the NASDAQ, and the downturn in the global electronics cycle; political uncertainties; and in a number of countries, concerns over the lagging pace of corporate and financial restructuring. The slowdown was accompanied—and exacerbated—by a sharp decline in regional equity markets, declining portfolio inflows, and in some cases downward pressure on exchange rates.

Table 1.5.

Selected Asian Countries: Real GDP, Consumer Prices, and Current Account Balance

(Annual percent change unless otherwise noted)

article image

In accordance with standard practice in the World Economic Outlook, movements in consumer prices are indicated as annual averages rather than as December/December changes during the year, as is the practice in some countries.

Percent of GDP.

Developing Asia, newly industrialized Asian economies, and Mongolia.

Bangladesh, India, Maldives, Nepal, Pakistan, and Sri Lanka.

Cambodia, China, Lao People’s Dem. Rep., Mongolia, and Vietnam.

The impact of these shocks has varied across the region. In China and India, which account for three-quarters of regional output (excluding Japan), exposure to external developments is moderate and growth in activity is expected to be relatively well maintained. Elsewhere, while activity will in most cases be cushioned by lower U.S. interest rates and to a modest degree by lower oil prices, the effect will be significantly greater. Growth is expected to slow sharply in a number of the newly industrialized and ASEAN countries, with the extent of the slowdown depending on their cyclical positions; vulnerability to external shocks (Figure 1.8); and country-specific factors, such as political uncertainties. Given the improvement in macroeconomic fundamentals over the past three years, combined with more flexible exchange rate management, these countries are in general better placed to manage external shocks than in the past. Nonetheless, the impact of the global slowdown will still be substantial, and would be significantly exacerbated in the event of a harder landing in the United States, a deeper-than-expected slowdown in Japan, or a sharp depreciation of the yen.

Figure 1.8.
Figure 1.8.

Selected Asian Countries: The Impact of Weakening External Demand

A number of newly industrialized and ASEAN economies are vulnerable to weaker external demand, especially for technology goods.

Source: IMF staff estimates.1 Goods.2 Excluding imported intermediate inputs used in those exports.

In China, the largest economy in the region, activity remained robust during 2000, propelled by rising exports, recovering private consumption, and higher public spending; inflation turned modestly positive as deflationary pressures receded. Given the deterioration in the external environment, GDP growth is expected to moderate to 7 percent in 2001 while inflation remains subdued. The fiscal deficit in the 2001 budget reflects an appropriately expansionary policy stance, although a modest mid-year spending package may be required if the heightened downside risks to growth materialize. Over the medium term, the scope for further stimulus will be constrained by the need to tackle the substantial off-budget liabilities relating to bank and SOE restructuring, and pension liabilities. As elsewhere, financial and enterprise reforms remain the central priority. Asset Management Companies have now taken over a substantial proportion of nonperforming loans, but need additional powers and political support to move forward with enterprise restructuring. Given the ongoing structural changes in the economy, including those associated with accession to the World Trade Organization (WTO), greater exchange rate flexibility will also be desirable at the appropriate time. In Hong Kong SAR, after a strong “V-shaped” recovery, growth is expected to slow markedly to 3.5 percent in 2001, in part reflecting slowing export growth in the Mainland, the weakening regional situation, and falling retail sales. Activity in Taiwan Province of China is also expected to weaken, mainly reflecting the downturn in the global electronics cycle, as well as financial sector problems.

Turning to South Asia, GDP growth in India slowed to 6.4 percent in 2000, owing to a second consecutive year of below average monsoons and a weakening of industrial output. Overall activity is expected to slow further to about 5.6 percent in 2001, as a rebound in agricultural production is offset by continued sluggishness in manufacturing and the effect of the devastating earthquake in Gujarat. Inflation increased sharply in 2000 and early 2001, but this appears to have mainly reflected the effects of adjustments in administered fuel prices, and price pressures have recently begun to ease. Despite India’s heavy reliance on imported oil, the impact of higher world prices on the current account deficit has been largely offset by buoyant exports and sluggish non-oil imports. The weakness of the rupee and the downward pressure on international reserves that emerged in 2000 have eased, aided by higher remittances from expatriate Indians, and the Reserve Bank of India was able to lower its Bank rate in February and March 2001. The central challenge for India’s policymakers remains to sustain—and indeed improve upon—the economy’s strong growth during the 1990s to support meaningful poverty reduction. This will require major structural reforms that improve the environment for private investment and a substantial reduction in the overall public sector deficit, which—at 10-11 percent of GDP—consumed one-half of overall gross domestic saving in 2000/01. The government’s 2001/02 budget suggests that the fiscal deficit may remain high, especially once privatization receipts are excluded from the calculation and taking into account the possibility that activity may be slower than expected. Nonetheless, the budget included welcome signs that the commitment to structural reform has been reinvigorated, and proposed fiscal responsibility legislation also signals an encouraging willingness to take the steps necessary to achieve medium-term fiscal consolidation. In Pakistan, the depreciation of the rupee and the tightening of monetary policy in the second half of 2000 helped reverse the decline in official reserves, which had reached dangerously low levels. After bumper harvests of major crops last year, manufacturing output has started to pick up, but a severe drought is now casting a shadow over growth prospects for 2001-2002. The recent resolution of tariff disputes with independent power producers will boost investor confidence, but an enduring improvement in consumer and investor sentiment will require accelerated structural reforms to strengthen private sector activity and improve fiscal performance.

Turning to the remaining newly industrialized and ASEAN economies, activity is expected to slow most markedly in those countries where the recovery is furthest advanced; while this is expected, in a number of cases the slowdown has been exacerbated by domestic and external developments. This is particularly the case in Korea, where domestic confidence and demand have been weakened by concerns about the pace of corporate restructuring, and exports—particularly of electronics goods—have slowed sharply. In Singapore and Malaysia, which are also advanced in the recovery, domestic demand remains relatively strong—notwithstanding some weakening in confidence in Malaysia on account of concerns over corporate restructuring—but slowing external demand is a serious concern. Elsewhere, the recovery has been much slower, and is in danger of weakening further. In the Philippines, while recent political uncertainties have now been resolved, they have been accompanied by substantial fiscal slippages. In Thailand, the recovery has been held back by weak consumer and investor sentiment, as well as by policy uncertainty and the slow pace of debt restructuring. Despite a pickup in activity in 2000, the economic and political situation in Indonesia remains very fragile, with deteriorating market sentiment reflected in continued downward pressure on the rupiah. Debt restructuring and asset recovery remain key to maintaining a sound macroeconomic framework, supported by safeguards to minimize the risks associated with ongoing fiscal decentralization. In a number of these countries, where inflation and fiscal sustainability are not a concern, there has been scope for moderate interest rate reductions, and, in some cases, for easing the pace of fiscal consolidation. However, the central challenge throughout the region remains to accelerate the pace of reform in the financial and corporate sectors. Although further restructuring could hamper activity in the short run, it is critical to boost domestic and external confidence (the gains from which would partly offset the short term negative impact), reduce financial risks, and to provide a basis for a sustained recovery in investment.

In Australia and New Zealand, strong export growth has continued, underpinned by strong external demand and highly competitive exchange rates, which continued to depreciate during much of 2000.4 This provided strong support to activity—although in both cases the impact was offset by weakening domestic demand during the year—and also contributed to a significant reduction in current account deficits, which have been quite high by international standards. While activity in New Zealand has remained robust, domestic demand in Australia slowed sharply in the fourth quarter of 2000, although this largely reflected the impact of the mid-2000 changes in the tax regime on housing investment. In both countries, activity in 2001 will be adversely affected by the weakening external environment. With underlying inflationary pressures easing, both countries have reduced interest rates, and there is room for additional cuts if activity were to weaken further. On the structural side, Australia has successfully completed a major tax reform, recently enacted measures aimed at fostering innovation, and is preparing to tackle welfare reform (although less progress is being made on labor market deregulation). In New Zealand, despite some evidence of a pickup in productivity growth in the 1990s, the growth dividend from 15 years of reform appears to have been less than might have been expected. While the new government’s focus on human capital development is appropriate, the authorities need to monitor closely the effects of recent measures that could reduce labor and product market flexibility.

How Will the Global Slowdown Affect Latin America?

In Latin America and the Caribbean, GDP growth picked up to 4.1 percent in 2000, aided by buoyant U.S. demand, higher oil prices, and a recovery in domestic demand from the depressed levels of 1999 (Table 1.6). Within this, performance differed markedly across the region, with the strongest growth rates experienced in Mexico, Chile, and Brazil, underpinned by generally sound macroeconomic policy frameworks. Modest expansions are under way in the Andean region, with activity hampered in some cases by political uncertainties, while Argentina continues to struggle to escape recession. Notwithstanding the positive impact of higher oil prices for many countries, the regional current account deficit improved only slightly, partly reflecting a strong rebound in domestic demand from the depressed levels of 1999. While vulnerability indicators have generally improved, the regional external financing requirement is the highest among developing country groups (Figure 1.3 and Table 1.7).

Table 1.6.

Selected Western Hemisphere Countries: Real GDP, Consumer Prices, and Current Account Balance

(Annual percent change unless otherwise noted)

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In accordance with standard practice in the World Economic Outlook, movements in consumer prices are indicated as annual averages rather than as December/December changes during the year, as is the practice in some countries.

Percent of GDP.