Abstract

Since late 2001, a global recovery has been under way, with trade and industrial production picking up across the globe. However, after a strong first quarter, concerns about the pace and sustainability of the recovery have risen significantly. Financial markets have weakened markedly, with equity markets falling sharply since end-March accompanied by a depreciation of the U.S. dollar; financing conditions for emerging markets have deteriorated, particularly in South America and Turkey; and incoming data in both the U.S. and the euro area have fallen short of expectations. The recovery is still expected to continue, but global growth in the second half of 2002 and in 2003 will be weaker than earlier expected (Figure 1.1 and Table 1.1), and the risks to the outlook are primarily on the downside. With inflationary pressures generally subdued, macroeconomic policies in advanced countries will now need to remain accommodative for longer than had earlier seemed necessary; if incoming data were to suggest that the recovery is faltering, additional monetary easing would need to be considered. Attention also needs to focus on policies to reduce dependence on the United States as the global engine of growth, and to support an orderly reduction in the global imbalances, which remain a serious risk to the world economy.

Since late 2001, a global recovery has been under way, with trade and industrial production picking up across the globe. However, after a strong first quarter, concerns about the pace and sustainability of the recovery have risen significantly. Financial markets have weakened markedly, with equity markets falling sharply since end-March accompanied by a depreciation of the U.S. dollar; financing conditions for emerging markets have deteriorated, particularly in South America and Turkey; and incoming data in both the U.S. and the euro area have fallen short of expectations. The recovery is still expected to continue, but global growth in the second half of 2002 and in 2003 will be weaker than earlier expected (Figure 1.1 and Table 1.1), and the risks to the outlook are primarily on the downside. With inflationary pressures generally subdued, macroeconomic policies in advanced countries will now need to remain accommodative for longer than had earlier seemed necessary; if incoming data were to suggest that the recovery is faltering, additional monetary easing would need to be considered. Attention also needs to focus on policies to reduce dependence on the United States as the global engine of growth, and to support an orderly reduction in the global imbalances, which remain a serious risk to the world economy.

Figure 1.1.
Figure 1.1.

Global Indicators1

(Annual percent change unless otherwise noted)

After a sharp slowdown in 2001, global output is projected to pick up in 2002-03, although remaining below trend.

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; the aggregates shift over time in favor of faster growing countries, giving the line an upward trend.3GDP-weighted average of the 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 1972.4Simple average of spot prices of U.K. Brent, Dubai, and West Texas Intermediate crude oil.
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 July 19-August 16, 2002.

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

Includes Indonesia, Malaysia, the Philippines, and Thailand.

Includes Malta.

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 $24.28 in 2001; the assumed price is $24.40 in 2002, and $24.20 in 2003.

Since the turn of the year, a global recovery has been under way, led by the United States and underpinned by a pickup in global industrial production and trade (Figure 1.2). Even allowing for the recent substantial downward revision to GDP growth in 2001 in the United States, the global slowdown in 2000–01 has proved to be more moderate than most previous downturns. This owed much to an aggressive policy response, particularly following the events of September 11, in turn made possible by the improvement in economic fundamentals during the 1990s. Other contributing factors included the decline in oil prices in 2001; the resilience of the global financial infrastructure to a variety of substantial shocks; and a degree of good luck, in that the impact of the terrorist attacks on confidence proved surprisingly short lived.

During the first quarter of 2002, activity was surprisingly strong, with GDP growth in a number of regions—particularly North America and emerging markets in Asia—exceeding expectations. Since that time the pace of recovery has slowed, except in emerging markets in Asia, and incoming data have generally been weaker than expected. Forward-looking indicators—while still stronger than at end-2001—have also fallen back markedly (Figure 1.2). Domestic demand growth so far has been relatively weak outside North America and the United Kingdom, the cyclically most advanced of the major industrial countries, making the upturn elsewhere heavily dependent on external demand. Moreover, there is as yet limited evidence of a pickup in global investment, which will be critical to maintain the momentum of the projected upturn in the second half of the year.

Figure 1.2.
Figure 1.2.

Current and Forward-Looking Indicators

(Percent change from a year earlier unless otherwise indicated)

Current and forward-looking indicators have generally strengthened since late 2001, although there is as yet little evidence of a pickup in investment.

Sources: Haver Analytics. Business confidence for the United States, the National Association of Purchasing Managers; for the euro area, the European Commission; and for Japan, Bank of Japan. Consumer confidence for the United States, the Conference Board; for the euro area, the European Commission; and for Japan, the Economic Planning Agency. Leading indicators produced by OECD, Main Economic Indicators.1Australia, Canada, Denmark, euro area, Japan, New Zealand, Norway, Sweden, Switzerland, the United Kingdom, and the United States.2Argentina, Brazil, Chile, China, Colombia, Czech Republic, Hong Kong SAR, Hungary, India, Indonesia, Israel, Korea, Malaysia, Mexico, Peru, the Philippines, Poland, Russia, Singapore, South Africa, Taiwan Province of China, Thailand, Turkey, and Venezuela.32002:Q1-Q2 data for China, India, and Russia are interpolated.

Notwithstanding the upturn, global financial markets have weakened significantly.1 Industrial country equity markets have fallen sharply—and with surprising synchronicity—since end-March (Figure 1.3). This has reflected a combination of factors, including downward revisions of earlier—and always optimistic—profit forecasts; concerns about the sustainability of the recovery; and widespread concerns about accounting and auditing practices, particularly in the United States. While a portion of those losses have been recouped since late July, markets remain volatile. In the face of increased risk and uncertainty, demand for government bonds and high-quality corporate paper has risen, which—together with expectations that monetary tightening will be postponed—has driven long-run interest rates down significantly. Spreads for riskier borrowers have risen, and risk appetite has also declined, although not to the point of outright risk aversion. In currency markets, the U.S. dollar has depreciated markedly against the euro and yen, although more moderately in trade-weighted terms. In part, this appears to have reflected a diminution in the attractiveness of U.S. assets, a slowdown in euro area institutions’ diversification away from euro-denominated assets,2 and growing concerns about the large U.S. current account deficit.

Figure 1.3.
Figure 1.3.

Developments in Mature Financial Markets

Equity markets have fallen sharply since end-March, accompanied by a depreciation of the U.S. dollar, and some increase in risk aversion.

Sources: Bloomberg Financial Markets, LP; State Street Bank; and IMF staff estimates.1IMF/State Street risk appetite indicators.

While the timing of market adjustments is always difficult to predict, these developments should not be particularly surprising. Recent issues of the World Economic Outlook and the Global Financial Stability Report have explicitly warned about the risk of a further decline in equity markets, and the overvaluation of the U.S. dollar has also been a long-standing concern in these pages. From a medium-term perspective, recent developments in equity and currency markets may help reduce global imbalances, but—as discussed in detail in Box 1.1—they make the short-term outlook more difficult. The fall in equity markets, if sustained, will significantly affect U.S. consumption and investment, although the impact will be partly offset by lower long-run interest rates as well as the weaker dollar. In the euro area and Japan, the effect of equity market declines is smaller, but not negligible; however, long-term interest rates have fallen less than in the United States and stronger currencies will weaken exports, so far the mainstay of recovery. This is of particular concern in Japan, where the upturn is likely to be weakest, and which has least room for offsetting policy maneuver.

There has also been substantial turbulence in many emerging markets, partly reflecting higher risk aversion and global uncertainties but also, more fundamentally, country-specific factors. From mid-April, sentiment toward Latin America and Brazil in particular has deteriorated, prompted by rising political uncertainties and concerns about debt dynamics. As spreads rose, these concerns became increasingly self-reinforcing, culminating in mid-June with a full–scale sell-off of emerging market debt and a decline in emerging market financing (Figure 1.4). Since early August, financing conditions have improved, led by Brazil where spreads have tightened significantly since the announcement of a new IMF package, accompanied by a commitment by the major presidential candidates to pursue sound economic policies. However, spreads still remain at high levels, and unsecured access remains difficult to subinvestment-grade borrowers in Latin America. Equity markets in most emerging markets have fallen back over recent months, although developments in foreign exchange markets have been mixed. In some Latin American countries and Turkey, currencies have fallen sharply against the dollar, and by even more in trade-weighted terms. Elsewhere, currencies have generally risen against the dollar, but weakened against the euro and yen. With some exceptions, this has generally resulted in a modest depreciation in trade-weighted exchange rates.

Figure 1.4.
Figure 1.4.

Emerging Market Financial Conditions

Emerging market spreads have risen markedly, particularly in Argentina and Brazil, accompanied by signs of increased contagion

Sources: Bloomberg Financial Markets, LP; and IMF staff estimates1Average of 60-day rolling cross-correlation of emerging debt markets

How Will Recent Falls in Equity Markets Affect Activity?

Industrial country equity markets have fallen precipitately between late March and early September of this year, with prices down by one-fifth or so in all major industrial countries. Indeed, over these five months the fall in prices is of a comparable magnitude to that between the bursting of the technology bubble in early 2000 and late March this year, with the exception of Japan (first table). While any fall in equity values of this size and speed is notable, this one is of particular interest for several reasons. First, it has been accompanied by additional significant shifts in asset prices, including a depreciation of the dollar against other major currencies as well as a generalized decline in long-term interest rates as fears of inflation and expectations of monetary tightening recede. Second, the recent fall has been widespread, while over the previous two years it was focused on the technology sector. Third, the timing is unusual as activity is recovering from the downturn in 2001, and partly reflects concerns over accounting scandals.

Changes in Equity Prices

(Percent)

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Source: Datastream.

Average March 25–29, 2002 to September 2–6, 2002.

Average March 27–31, 2000 to March 25–29, 2002.

This box examines the likely impact of these equity price falls on activity, and how they may be mitigated or exacerbated by changes in other asset market prices. A fall in equity markets affects the real economy through three main channels: it increases borrowing costs for households and corporations as collateral is eroded; it raises the cost of equity capital for firms, lowering investment; and it reduces household wealth and hence consumption.1 The size and nature of these effects differ considerably across countries, depending on the size of the equity market, the proportion of equities held by households, and the extent to which corporations rely on equity markets for funding. In general, it is found to be largest in countries with market-based financial systems, including North America and the United Kingdom, characterized by high equity market capitalization, broader ownership of equities by households, and significant financing of firms through equity issues. In contrast, the impact in bank-based economies—such as continental Europe and Japan—is generally found to be smaller, although not negligible (and because banks in these countries have large equity holdings, there can be substantial effects on their balance sheets, particularly in Japan given the precarious state of the banking system and negative impact of falling equity prices on bank capital). In both cases, the impact of equity markets on activity appears to have been increasing over time, as financial systems get deeper and more flexible, a trend that is likely to continue in the future.

It should be emphasized at the outset that any calculation of the impact on activity is highly speculative as asset prices can move rapidly (particularly in volatile trading conditions of the type experienced lately) and estimated impacts on activity are imprecise, and in any case can vary with circumstances. With these caveats in mind, the second table reports rough estimates of the impact on consumer spending assuming that the equity price falls as of the first full week in September are sustained. The calculations are based on IMF staff estimates of the marginal propensities to consume, after two years, out of equity wealth of 4¼ cents per dollar in the United States and the United Kingdom and 1 cent in the euro area and Japan. (See “Is Wealth Increasingly Driving Consumption?” Chapter II in the April 2002 World Economic Outlook.)2 Such numbers are broadly consistent with other academic work and with macroeconomic models such as MULTIMOD or Oxford Analytics.

Impact on Activity of Asset Price Changes, Late March to Early September 20021

(Percent of GDP unless otherwise stated)

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Source: IMF staff calculations.

Average March 25–29 versus September 2–6, 2002

Government bond yield, except in the case of the United States where AAA corporate bonds were used, adjusted for the change in projected inflation between the April 2002 World Economic Outlook and this one.

Coefficients on the bond yield are –0.55 for the United States, –0.35 for the United Kingdom, and –0.27 for the euro area and Japan; on the real effective exchange rate –0.05 for Japan and the United States, –0.07 for the euro area, and –0.18 for the United Kingdom. The coefficients are derived from the Goldman-Sachs financial conditions index for the United States and United Kingdom (although in the United States, Goldman Sachs uses A bonds rather than AAA bonds), and IMF staff estimates of a similar index for the euro area and for Japan (where the coefficient on bond yields was made equal to that in the euro area).

Taken in isolation, the estimated fall in consumer spending from equity prices is about 1 percentage point of GDP in the United States and the United Kingdom and a ¼ percentage point in the euro area and Japan over the next two years, reflecting different propensities to consume out of wealth. That said, other sources of private wealth can provide an offset. In particular, buoyant housing markets can provide some support to demand (especially as the stock of housing wealth is estimated to be larger than that of equities, and an increase in housing wealth has a larger impact on consumption than a similar increase in equity wealth). Over recent years, real house prices have risen significantly in the United Kingdom and some smaller European countries, and to a lesser extent the United States and France, but have declined in Japan and Germany (see the figure).

The second table also reports the likely first-year impact of associated changes in monetary conditions over the past five months, comprising changes in effective exchange rates and lower long-term interest rates (short-term policy interest rates have remained unchanged in the major economies except Canada). Lower long-term rates and exchange rate depreciation boost activity in the United States and, to a lesser extent, the United Kingdom, while in Japan, and the euro area to a lesser extent, the erosion in activity due to the appreciation in the exchange rate is estimated to be somewhat larger than the benefit from lower real long-term interest rates.3

The net result of all of these asset price changes is likely to be a broad-based slowdown in activity in industrial countries. Aggregating the impact is complicated by the fact that wealth effects are generally thought to have a longer-lasting effect than interest and exchange rates, peaking after about two years rather than one, and because aggregation compounds the uncertainties inherent in each individual calculation. That said, it appears reasonable to assume that the effects of lower wealth will outweigh looser monetary conditions in the United States (taking into account the potential impact on investment), although—as in France—this may be partly offset by continuing strength in the housing market. In the United Kingdom, buoyant household consumption suggests that the effect of housing prices may have more than offset the adverse effects of equity market declines. In other major economies, the appreciation in the effective exchange rate will be a more important factor, exacerbating the decline in the value of equities and, in the case of Japan and Germany, housing.

ch01ubx01fig01

Real Residential Price Indices

(Logarithmic scale; 1992 = 100)

Source: Bank for International Settlements.

Developments in equity markets in industrial countries also feed through to emerging market countries. Given the increasing correlation between equity markets across the world, declines in industrial country equity markets have been mirrored in most emerging markets (although country-specific factors continue to play an important and in some cases offsetting role). With financial systems in most developing countries still largely bank-based, and equity markets often small, the direct impact on activity in general will be moderate (although most countries will be affected by weaker activity in industrial countries).

In practice, the indirect impact through financial markets is often more important. On the positive side, as discussed above, lower equity prices have been accompanied by lower interest rates in industrial countries, which benefits emerging market countries. However, the general shift out of risky assets has raised spreads for emerging markets. Since late March, the rise in the emerging market bond index plus spread has been on the order of 2 percentage points (with a similar increase in spreads in U.S. junk bonds, generally regarded as being in the same asset class), significantly larger than the fall in bond rates, implying some tightening of financing conditions for the average borrower.

In sum, recent movements in asset prices appear to be providing a downward impetus to global activity, although the main sources vary across regions, with equity declines dominating in North America and the United Kingdom, exchange rate appreciation mattering more in the euro area and Japan, and increasing bond spreads being the main conduit to emerging markets.

Note: The main authors of this box are Tamim Bayoumi and David J. Robinson.1See “Asset Prices and the Business Cycle,” in the May 2000 World Economic Outlook, for a detailed description of the channels through which asset price movements affect activity.2Estimates of the impact on investment are less precise, but could raise the impact by one-half or more.3It should, however, be noted that futures markets also imply a greater change in the expected monetary stance in the euro area than elsewhere, which is not reflected in changes in bond yields. In addition, the appreciation in the euro may help support activity in the short term by reducing inflation and boosting real incomes.

While the global recovery is expected to continue, it will be weaker than earlier expected. Global growth is projected at 2.8 percent in 2002, rising to 3.7 percent in 2003, underpinned by the turn in the inventory cycle and continued accommodative policies, with interest rate increases in the United States and the euro area now expected to be deferred to 2003. While global growth in 2002 is the same as that projected in the April 2002 World Economic Outlook, this reflects the stronger-than-expected outturn in the first quarter of 2002, as well as upward revisions for Asia, partly offset by much lower growth in Latin America. From the second quarter onward, the pace of recovery has generally been marked down to reflect the impact of recent financial market developments (Figure 1.5); correspondingly, GDP growth in 2003 is somewhat lower than earlier projected. Looking across individual countries and regions, we find the following:

Figure 1.5.
Figure 1.5.

Global Outlook

(Percent change from four quarters earlier)

While GDP growth is expected to continue to pick up during 2002 and 2003, the recovery will be slower than earlier anticipated.

Sources: Haver Analytics; and IMF staff estimates.1Australia, Canada, Denmark, euro area, Japan, New Zealand, Norway, Sweden, Switzerland, the United Kingdom, and the United States.2Hong Kong SAR, Korea, Singapore, and Taiwan Province of China.3Indonesia, Malaysia, the Philippines, and Thailand.4Czech Republic, Hungary, Israel, Poland, Russia, South Africa, and Turkey.5Argentina, Brazil, Chile, Colombia, Mexico, Peru, and Venezuela.
  • Among the industrial countries, the recovery in the United States is now expected to be considerably weaker than earlier thought with GDP growth in 2002—and more so 2003—marked down significantly (Table 1.2). In the euro area, projections have also been reduced; in the short run GDP growth will be boosted by a turn in the inventory cycle, but final domestic demand growth is likely to pick up more slowly than previously expected. In Japan, where the economy appears to have bottomed out, GDP growth has been revised upward in both 2002 and 2003. However, with final domestic demand still weak, there are downside risks to the outlook given the appreciation of the yen and the more subdued recovery elsewhere.

  • The outlook for the major emerging market countries has become increasingly diverse. In Latin America, the outlook has seriously deteriorated, and output is expected to decline in 2002. Growth is picking up in Mexico and is expected to in Chile; both countries are relatively open and have strong credit ratings. However, Argentina is experiencing an almost unprecedented collapse in economic activity (outside transition and conflict countries), Uruguay is facing serious difficulties, and the outlook for Brazil, Venezuela, and a number of smaller countries has deteriorated markedly. In emerging markets in Asia, in contrast, the recovery has so far proved stronger than expected, driven by the rebound in global trade and a nascent recovery in information technology (see Appendix 1.1), and in some countries—notably China, India, and Korea—domestic demand. While there are signs that final domestic demand growth is becoming more broadly based, the recovery remains dependent on external demand, and the prospect of a weaker global recovery has added to downside risks. In the Middle East, while the outlook for oil prices is somewhat stronger, the forecast has remained broadly unchanged; however, the difficult security situation has affected growth in Israel and its neighbors. GDP growth in Turkey has somewhat exceeded expectations, although political turmoil and a sharp deterioration in financial indicators, combined with its large financing needs, have increased risks looking forward. The outlook for the countries in transition remains solid, underpinned by strong growth in Russia and Ukraine, and in central and eastern Europe, by buoyant foreign direct investment.

  • Among the poorest countries, GDP growth in Africa has held up surprisingly well, supported by improved macroeconomic policies, fewer conflicts, and debt relief under the HIPC (heavily indebted poor countries) Initiative. Serious problems exist in certain parts of the continent, however—most importantly, a deepening famine in southern Africa. Growth in 2003 is projected to pick up to 4.2 percent, aided by stronger commodity prices. However, it should be noted that—in part due to unanticipated natural disasters and conflicts—WEO forecasts have consistently overestimated African growth in the past.3

Table 1.2.

Advanced Economies: Real GDP, Consumer Prices, and Unemployment

(Annual percent change and percent of labor force)

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

Consumer prices excluding interest rate components.

Inflationary pressures across the globe remain relatively subdued and—despite some concerns in the euro area—wage increases have generally been moderate. Partly reflecting the pickup in global activity, commodity prices have turned upward. Since early August, spot oil prices have risen markedly owing to concerns about a further deterioration in the security situation in the Middle East (at the time the World Economic Outlook went to press, oil price futures for 2003 were about 5 percent higher than assumed in the WEO baseline). Nonetheless, inflation is expected to remain moderate in 2003, a testament to the increased effectiveness and credibility of anti-inflationary policies in both industrial and emerging markets in recent years. However, deflation remains a serious issue in Japan, and will be exacerbated by the recent appreciation of the yen; it is also a concern in China and Hong Kong SAR, although in these cases the recent depreciation of the U.S. dollar will be helpful. In contrast, inflationary risks have sharply increased in a number of countries in Latin America, especially Argentina, where, despite some recent progress, a sustainable monetary framework is not yet in place.

Developments since the first quarter have intensified concerns about the durability and sustainability of the recovery. While it is possible that the outlook could be better than projected, for example if productivity growth in the United States were to surprise on the upside, the risks to the forecast—judged in April to be relatively balanced—are primarily to the downside.

  • The recovery continues to depend heavily on the outlook for the United States, especially with the pickup in western Europe not yet self sustaining and domestic demand growth in Japan likely to remain constrained by banking and corporate sector difficulties for some time. There is a significant risk of a more subdued recovery, especially if the impact of recent equity market declines in both the United States and Europe proves greater than presently expected; if housing markets, which have been providing significant support to demand in the United Kingdom and some smaller European countries, and to a lesser extent the United States (Box 1.1), were to weaken; if final domestic demand in Germany, which has a strong influence on the rest of the euro area, remains weak; or if the tentative recovery in Japan is derailed by adverse shocks—such as an appreciation of the yen—as on previous occasions in the 1990s. Such an outcome would clearly also have an important impact on emerging market economies.

  • Oil prices could spike sharply if the security situation in the Middle East were to deteriorate further. Depending on its extent and duration, this increase could have a significant negative effect on global growth both directly and indirectly through its effects on confidence (see Appendix 1.1). It would also increase the likelihood of other risks to the outlook occurring, and exacerbate their impact.

  • Equity markets remain very volatile, and could fall further. While a considerable portion of the irrational exuberance that characterized stock valuations in the late 1990s may now have been eliminated, recent accounting and auditing scandals have seriously weakened confidence. The U.S. authorities have moved quickly to strengthen corporate governance and auditing, and other initiatives are also under consideration. It is encouraging that the deadline for certification of financial statements by major U.S. corporations in mid-August passed without significant disruption. Nonetheless, there remains a risk that markets could overshoot on the downside—particularly if new accounting scandals were to emerge or if productivity growth and profitability disappointed—with the impact aggravated by relatively high levels of corporate and household debt in some countries. The fall in equity markets could also pose risks for some financial institutions, particularly in Europe and Japan.

  • Risks in emerging markets, in particular South America and Turkey, have increased. As described above, the tightening in emerging market financing conditions has resulted in a serious deterioration in the outlook for a number of countries in South America, and has begun to affect a number of those elsewhere. To date, most countries outside South America retain access to global capital markets, and—with some exceptions—flexible exchange rate regimes have facilitated a relatively smooth adjustment to the movements in major currencies. The prospect of more widespread contagion is also reduced by the relatively low level of capital flows, as well as less extensive leverage in global financial markets (Table 1.3). Nonetheless, were problems in South America to intensify—especially if accompanied by weaker growth in industrial countries—the potential for a more widespread impact on the emerging market asset class, including through cross-border bank lending, would increase significantly.

  • While the fall in the dollar has so far been orderly, the U.S. current account deficit remains very high, and—as discussed in Chapter II—a more abrupt and disruptive adjustment cannot be ruled out. Given the synchronicity of the global slowdown, the U.S. current account deficit has improved very little since 2000, and in the short run appears likely to widen (Table 1.4). The question is not whether the U.S. deficit will be sustained at present levels forever—it will not—but more when and how the eventual adjustment takes place. While history is modestly reassuring, the overvaluation of the dollar has not yet been corrected and an abrupt and disruptive adjustment remains a significant risk. A particular concern is that medium-term growth in countries with surpluses—including Japan, emerging markets in Asia, and to a lesser extent Europe—is constrained to differing degrees by structural problems. This makes it more difficult to achieve an orderly rebalancing of domestic demand from deficit to surplus countries, increasing the prospect that the adjustment in the U.S. current account will be accompanied by weaker global growth. Moreover, if in some countries current account surpluses do not decline, the adjustment that will fall on other countries—and therefore the potential appreciation in their exchange rates—will be correspondingly greater.

Table 1.3.

Emerging Market Economies: Net Capital Flows1

(Billions of U.S. dollars)

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Net capital flows comprise net direct investment, net portfolio investment, and other long- and short-term net investment flows, including official and private borrowing. Emerging markets include developing countries, countries in transition, Korea, Singapore, Taiwan Province of China, and Israel.

Excludes Hong Kong SAR.

Because of data limitations, “other private capital flows, net” may include some official flows.

A minus sign indicates an increase.

The sum of the current account balance, net private capital flows, net official flows, and the change in reserves equals, with the opposite sign, the sum of the capital and financial account and errors and omissions. For regional current account balances, see Table 27 of the Statistical Appendix.

Includes Korea, Singapore, and Taiwan Province of China in this table.

Includes Israel and Malta.

Table 1.4.

Selected Economies: Current Account Positions

(Percent of GDP)

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

With macroeconomic policies in most industrial countries still accommodative, a shift to a more neutral stance will eventually be needed. At the same time, however, the short-term outlook has deteriorated, and the risks appear to be primarily on the downside; inflation remains relatively subdued; and anti-inflationary credibility is high. The situation varies somewhat across countries, reflecting their relative cyclical positions, as well as the relative risks associated with greater equity market and exchange rate uncertainty (Box 1.2). However, in most cases the balance of risks appears to favor maintaining relatively accommodative policies for longer than earlier seemed necessary, and in Japan further easing is warranted. If incoming data were to suggest that the recovery is faltering, additional monetary easing would also need to be considered elsewhere. Against this background, the main policy priorities appear to be the following.

Market Expectations of Exchange Rate Movements

After continuing to strengthen in the face of last year’s global downturn, the U.S. dollar has fallen sharply against other major currencies since mid-April. Yet it remains well above longer-term historical values, while the U.S. current account deficit has swelled to a record level. These developments raise the question of whether a much larger, and possibly disorderly, adjustment in major exchange rates presents a risk to the global outlook.

In assessing this issue, it is interesting to consider how market participants view the outlook for exchange rates, both in terms of direction and volatility. Futures and options prices can be used to shed light on market perceptions, specifically by constructing implied “probability density functions” (PDFs) for future exchange rate values. Under the assumption that market participants are risk neutral, PDFs indicate the perceived likelihood of the exchange rate reaching different levels at a future date.1

ch01ubx02fig01

U.S. Dollar Implied Risk and Volatilities

Implied Risk-Neutral Probability Density Functions (Yen per U.S. dollar; 3-month horizon)

Sources: Bloomberg Financial Markets, LP; and IMF staff estimates.

Such implied PDFs for the yen-dollar rate are shown in the figure (top panel). They reflect expectations for the 3-month-ahead level of the exchange rate at three different dates: January 2, 2002, June 27, 2002, and August 16, 2002. The mean of the yen-dollar PDF shifted down over this period, in line with the appreciation in the yen against the dollar. Indeed, covered interest arbitrage ensures that the mean of the PDF (i.e., the forward rate in markets) equals the spot rate plus an adjustment for the interest differential on short-term assets in the two currencies. As interest rates have been stable in recent months, so has the gap between spot and forward exchange rates. The forward yen-dollar rate implies further yen appreciation, as the short-term interest rate on yen assets is below that on U.S. dollar assets; conversely, the forward euro-dollar rate implies euro depreciation given the higher yield on euro assets.

Because of the mechanical link between spot rates, forward rates, and the interest differential, “higher moments” of the PDF often reveal more interesting information about market expectations. For instance, the expected volatility of the future exchange rate is reflected in the variance of the implied PDF. The path of expected volatility for the yen-dollar and euro-dollar rates since mid-2001 is shown in the figure (middle panel). Expected volatility rose following the onset of dollar weakness in April. The rise in euro-dollar volatility was particularly sharp during June, but most of this increase was retraced over the summer. Yen-dollar volatility has been more stable, showing only a modest increase from the trough in the spring. On balance, these data do not suggest that markets perceive an abnormally high risk of abrupt currency movements relative to recent history.

Another interesting feature of implied PDFs is their “skew.” Skew reflects asymmetries in the shape of the two sides of the PDF, which arise when markets perceive the risk of equal-sized currency movements in opposite directions as differing. In practice, skew is measured by the cost of insuring against a dollar depreciation relative to a dollar appreciation of the same degree—the risk-reversal price.2 Recent data on risk-reversal prices are shown in the figure (bottom panel). The relative cost of insuring against dollar depreciation versus both the euro and yen has risen significantly since the begining of the year. This suggests that markets place greater weight on the possibility of a sharp dollar depreciation relative to the forward rate than was the case earlier, even as the spread between the forward and spot rate has remained roughly constant.

It must be emphasized that the assumption of risk neutrality is needed to interpret PDFs as measures of market expectations. Furthermore, the value of market expectations as predictors of future exchange rates depends on whether markets efficiently use all available information. Many studies have indicated that the forward rate is a biased predictor of the future spot rate, indicating that at least one, and possibly both, of these assumptions do not hold.3 There has been less conclusive analysis of the relationship between higher moments of implied PDFs and future exchange rates, so it is more difficult to gauge their usefulness as predictors of exchange rate movements or volatility.

Independent of the forecasting power of market expectations, however, implied PDFs provide information that is potentially useful in assessing the interaction between market developments and policy actions. For instance, an environment of high uncertainty about future exchange rates could raise concerns about excessive market reactions to policy initiatives, while a significant skew in expectations implies the risk of large one-way movements in rates. Either situation might create a rationale for taking a cautious approach to policy actions to avoid destabilizing currency markets. Recent market information does not suggest that perceptions of volatility or asymmetric outcomes have become abnormal from a historical perspective, suggesting that policies would not be constrained by concerns about exceptional market sensitivity.

Note: The main authors of this box are Peter Breuer and Guy Meredith.1The risk-neutrality assumption implies that changes in options prices reflect changes in expected volatility (“riskiness”), as opposed to investor attitudes toward risk. See Breuer (2002) for an approach to accounting for risk aversion in constructing PDFs.2A risk reversal is the price of an out-of-the-money foreign currency call option relative to the price of an equally out-of-the-money short foreign currency put option.3See Meredith and Ma (2002).
  • Macroeconomic policies in industrial countries should continue to be supportive of activity. In the United States, the Federal Reserve has held interest rates steady, and a continued accommodative stance remains appropriate; if the outlook weakens further, additional interest rate cuts should be considered. With the budget deficit (excluding social security) projected to remain in deficit in coming years, medium-term fiscal consolidation is a priority (Table 1.5), especially in view of impending demographic pressures. In the euro area, concerns about inflationary pressures have been mitigated by the appreciation of the euro as well as the weaker-than-expected recovery. Correspondingly, the scope for easing has increased, and should be used if activity remains weak and inflationary pressures ease as expected. In Japan, aggressive monetary easing remains essential to address deflationary pressures. If structural reforms—which could adversely affect activity in the short run—are significantly accelerated, further steps to contain the withdrawal of stimulus that is in prospect from the latter part of FY2002 may be desirable.

  • In emerging markets, the deterioration in the outlook has partly reflected lower risk appetite and contagion, but country-specific factors—including political uncertainties and concerns about debt dynamics—have played a more important role. Particularly in Latin America and Turkey, a restoration of financial market confidence will require that these issues be comprehensively addressed. Elsewhere, policy priorities vary widely, as described in detail below. However, given the more difficult global economic outlook, macroeconomic policies in countries with room for policy maneuver—as in industrial countries—will likely have to remain accommodative longer than earlier expected.

  • Medium-term policies should continue to foster sustained and broad-based economic growth and an orderly reduction in global imbalances. Since the mid-1990s, much attention has been given to the pickup in productivity growth in the United States, particularly in relation to other major industrial countries. This pickup appears due in part to the greater flexibility of the U.S. economy (Box 1.3). In the euro area, flexibility can be boosted by reform of labor and product markets—measures that would also help raise employment rates, which remain well below U.S. levels. In Japan, reform of banking and corporate sectors takes center stage; despite different circumstances, that is also a priority for emerging markets in Asia. Higher potential growth in the rest of the world is desirable in its own right, but would also help reduce dependence on the United States as the global engine of growth, and promote an orderly correction of the global imbalances. Beyond that, as discussed in the Global Financial Stability Report, there is a clear need to strengthen corporate governance and transparency in the United States and elsewhere. While corporate malpractice has been a common feature of past technological revolutions, the weaknesses in accounting and auditing practices likely exacerbated the information technology (IT) bubble and contributed to the global imbalances. The recent reform package in the United States provides a welcome improvement in the framework for regulating corporate governance and accounting; the challenge going forward will be to ensure its effective implementation and enforcement.

  • Continued efforts are required to strengthen resilience to future economic shocks. In industrial countries, aging populations pose a serious threat to future fiscal and economic stability, particularly in Japan, many countries in Europe, and to a lesser degree the United States. While the solutions are multidimensional—raising potential growth would help substantially—accelerated reforms of pension and health systems, supported by medium-term fiscal consolidation, are now urgent. Fiscal issues are also a key concern in Latin America, where high levels of public debt constitute a continuing and major source of vulnerability and constrain the scope for countercyclical policies, and increasingly in Asia, where public debt has risen sharply recently. With Asia facing a period of substantial structural change, particularly as it adapts to the challenges and opportunities posed by China’s rapid development, completion of remaining corporate and financial sector reforms is also a priority.

Table 1.5.

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.

Percent of potential GDP.

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.

Excludes one-off receipts from the sale of mobile telephone licenses (the equivalent of 2.5 percent of GDP in 2000 for Germany, 0.1 percent of GDP in 2001 and 2002 for France, 1.2 percent of GDP in 2000 for Italy, and 2.4 percent of GDP in 2000 for the United Kingdom). Also excludes one-off receipts from sizable asset transactions.

Since the mid-1990s, most countries in Africa have made substantial progress in achieving macroeconomic stability, but GDP growth remains well below what is needed to achieve sustained poverty reduction. In part, this reflects low investment and savings, but it also reflects the low efficiency with which existing resources are used.4 Low efficiency, in turn, stems from a host of problems, including the impact of conflicts and disease, weak institutions and infrastructure, poor governance, and low life expectancy, the last much exacerbated by the HIV/AIDS pandemic. The New Partnership for Africa’s Development, put forward by African leaders in late 2001, sets out a bold and consistent strategy to address these issues. But while the first responsibility lies with Africa’s governments and people, external support is also essential. The G-8 Africa Action Plan announced at the Kananaskis Summit in June—along with the commitment to double aid flows at the Monterrey Summit three months earlier—is therefore particularly welcome. Higher aid flows will, over time, result in a large increase in public expenditures in recipient countries. Correspondingly, receiving countries will need to press ahead with efforts to improve their absorptive capacity, including strengthening public expenditure management systems and addressing governance issues. This would be facilitated if, on the donors’ side, new aid commitments were as concrete and predictable as possible.

Reversal of Fortune: Productivity Growth in Europe and the United States

The surge in labor productivity growth in the United States since the mid-1990s has attracted significant attention—not just for its beneficial effects on output performance, earnings, and inflation, but also because it has not been matched elsewhere, particularly in Europe. This box assesses the level and growth rate of productivity in the United States and four major European countries in recent years and shows the following: (1) the persistent differences in GDP per capita between the United States and Europe are due much more to differences in labor utilization than those in labor productivity (as measured by output per hour); (2) productivity growth in Europe exceeded that in the United States up to the mid-1990s, but since then European performance has slackened while the United States has picked up and taken a lead; and (3) there is a consensus that high tech sectors have played an important role in the acceleration of productivity growth in the United States; these benefits are yet to be fully realized in Europe.

Following rapid catch-up in the three decades after World War II, GDP per capita in Europe since the late 1970s has generally settled at about 65–70 percent of the U.S. level (see the table). This persistent gap does not appear to be due to differences in productivity (output per hour); rather it reflects marked differences in the operations of labor markets and in labor utilization. Three elements stand out: labor force participation rates, especially of females and of individuals aged 55 and above, are substantially lower in continental Europe; unemployment rates are much higher in Europe; and average annual hours worked per employee are about 20 to 30 percent lower than in the United States. These three elements more than account for the gap in GDP per capita between the United States and the major continental economies; output per hour in France, Germany, and Italy is similar to, or exceeds, the U.S. level. The United Kingdom has similar high rates of participation and employment to the United States but, as on the continent, hours worked are lower; overall, output per hour appears to be lower than in the United States.

Growth and Productivity in the United States and Europe

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Sources: IMF staff estimates and Organization for Economic Cooperation and Development (2002).

Growth data for Germany—average from 1992–95 only.

The past decade reveals some striking differences in the factors driving growth in output per capita across the two regions. For much of the 1990s, U.S. GDP growth per capita exceeded that in Europe. In the first half of the decade, however, growth in output per hour in the United States lagged substantially behind that in Europe. This continued the trends that had been evident since as far back as the 1960s, with the average annual growth in U.S. productivity per hour less than half that in Europe (as well as in Japan). (See the figure.) Indeed, it was this persistent shortfall in U.S. productivity growth that led to pessimistic assessments of U.S. productivity and growth prospects in the 1980s and even as late as the mid-1990s (see, for instance, Gordon, 1996). Over this period, however, the United States was able to maintain its lead in terms of GDP per capita through higher utilization of labor, as noted above. Moreover, during the first half of the 1990s, the relative weakness in hourly productivity growth in the United States was more than offset by stronger employment growth and total hours worked, leading to a widening differential with Europe in terms of GDP per capita.

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