Abstract

The global economy has deteriorated further since the release of the July 2012 WEO Update, and growth projections have been marked down (Table 1.1). Downside risks are now judged to be more elevated than in the April 2012 and September 2011 World Economic Outlook (WEO) reports. A key issue is whether the global economy is just hitting another bout of turbulence in what was always expected to be a slow and bumpy recovery or whether the current slowdown has a more lasting component. The answer depends on whether European and U.S. policymakers deal proactively with their major short-term economic challenges. The WEO forecast assumes that they do, and thus global activity is projected to reaccelerate in the course of 2012; if they do not, the forecast will likely be disappointed once again. For the medium term, important questions remain about how the global economy will operate in a world of high government debt and whether emerging market economies can maintain their strong expansion while shifting further from external to domestic sources of growth. The problem of high public debt existed before the Great Recession, because of population aging and growth in entitlement spending, but the crisis brought the need to address it forward from the long to the medium term.

The global economy has deteriorated further since the release of the July 2012 WEO Update, and growth projections have been marked down (Table 1.1). Downside risks are now judged to be more elevated than in the April 2012 and September 2011 World Economic Outlook (WEO) reports. A key issue is whether the global economy is just hitting another bout of turbulence in what was always expected to be a slow and bumpy recovery or whether the current slowdown has a more lasting component. The answer depends on whether European and U.S. policymakers deal proactively with their major short-term economic challenges. The WEO forecast assumes that they do, and thus global activity is projected to reaccelerate in the course of 2012; if they do not, the forecast will likely be disappointed once again. For the medium term, important questions remain about how the global economy will operate in a world of high government debt and whether emerging market economies can maintain their strong expansion while shifting further from external to domestic sources of growth. The problem of high public debt existed before the Great Recession, because of population aging and growth in entitlement spending, but the crisis brought the need to address it forward from the long to the medium term.

Table 1.1.

Overview of the World Economic Outlook Projections

(Percent change unless noted otherwise)

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Note: Real effective exchange rates are assumed to remain constant at the levels prevailing during July 30–August 27, 2012. When economies are not listed alphabetically, they are ordered on the basis of economic size. The aggregated quarterly data are seasonally adjusted.

The quarterly estimates and projections account for 90 percent of the world purchasing-power-parity weights.

Excludes the G7 economies (Canada, France, Germany, Italy, Japan, United Kingdom, United States) and euro area countries.

The quarterly estimates and projections account for approximately 80 percent of the emerging market and developing economies.

Indonesia, Malaysia, Philippines, Thailand, and Vietnam.

The current WEO projections include South Sudan. However, for sub-Saharan Africa, the forecast comparison with the July 2012 WEO Update does not include South Sudan because South Sudan was not included in the July projections. The World and Emerging Market and Developing Economies aggregates also are not directly comparable with the July 2012 WEO Update for the same reason, but South Sudan’s weight in these aggregates is very small.

Simple average of prices of U.K. Brent, Dubai, and West Texas Intermediate crude oil. The average price of oil in U.S. dollars a barrel was $104.01 in 2011; the assumed price based on futures markets is $106.18 in 2012 and $105.10 in 2013.

Six-month rate for the United States and Japan. Three-month rate for the euro area.

Recent Developments

Indicators of activity and unemployment show increasing and broad-based economic sluggishness in the first half of 2012 and no significant improvement in the third quarter (Figure 1.1). Global manufacturing has slowed sharply. The euro area periphery has seen a marked decline in activity (Figure 1.2, panel 1), driven by financial difficulties evident in a sharp increase in sovereign rate spreads (Figure 1.2, panel 2). Activity has disappointed in other economies too, notably the United States and United Kingdom. Spillovers from advanced economies and homegrown difficulties have held back activity in emerging market and developing economies. These spillovers have lowered commodity prices and weighed on activity in many commodity exporters (see the Special Feature).

Figure 1.1.
Figure 1.1.

Global Indicators

The global manufacturing cycle has turned down again. Industrial production has slowed sharply in advanced and emerging market and developing economies and so has world trade. The deterioration is broad based. Unemployment in advanced economies remains appreciably above precrisis levels and is elevated in eastern Europe and the Middle East and North Africa.

Source: IMF staff estimates.Note: US = United States; EA = euro area; CIS = Commonwealth of Independent States; DA = developing Asia; EE = emerging Europe; LAC = Latin America and the Caribbean; MENA = Middle East and North Africa.1 Australia, Canada, Czech Republic, Denmark, euro area, Hong Kong SAR, Israel, Japan, Korea, New Zealand, Norway, Singapore, Sweden, Switzerland, Taiwan Province of China, United Kingdom, and United States.2 Argentina, Brazil, Bulgaria, Chile, China, Colombia, Hungary, India, Indonesia, Latvia, Lithuania Malaysia, Mexico, Pakistan, Peru, Philippines, Poland, Romania, Russia, South Africa, Thailand, Turkey, Ukraine, and Venezuela.3 Sub-Saharan Africa (SSA) is omitted due to data limitations.4 The Growth Tracker is described in Matheson (2011). Within regions, countries are listed by economic size.
Figure 1.2.
Figure 1.2.

Euro Area Developments

The crisis in the euro area has deepened. Activity is contracting, mainly due to deep cutbacks in production in the periphery economies, because financial and fiscal conditions are very tight. Sovereign issuers and banks in the periphery are struggling to attract foreign investors. Their sovereign debt spreads have risen appreciably, and their banks rely increasingly on the European Central Bank (ECB) for funding. As a result, they have cut back domestic credit.

Sources: Bloomberg Financial Markets; national central banks; and IMF staff estimates.1Greece, Ireland, Italy, Portugal, and Spain.2Ten-year government bonds.

The result of these developments is that growth has once again been weaker than projected, in significant part because the intensity of the euro area crisis has not abated as assumed in previous WEO projections. Other causes of disappointing growth include weak financial institutions and inadequate policies in key advanced economies. Furthermore, a significant part of the lower growth in emerging market and developing economies is related to domestic factors, notably constraints on the sustainability of the high pace of growth in these economies and building financial imbalances. In addition, IMF staff research suggests that fiscal cutbacks had larger-than-expected negative short-term multiplier effects on output, which may explain part of the growth shortfalls (Box 1.1).

The Crisis in the Euro Area Intensified

Notwithstanding policy action aimed at resolving it, the euro area crisis has deepened and new interventions have been necessary to prevent matters from deteriorating rapidly. As discussed in the October 2012 Global Financial Stability Report (GFSR), banks, insurers, and firms have swept spare liquidity from the periphery to the core of the euro area, causing Spanish sovereign spreads to hit record highs and Italian spreads to move up sharply too (Figure 1.2, panel 2). This was triggered by continued doubts about the capacity of countries in the periphery to deliver the required fiscal and structural adjustments, questions about the readiness of national institutions to implement euro-area-wide policies adequate to combat the crisis, and concerns about the readiness of the European Central Bank (ECB) and the European Financial Stability Facility/European Stability Mechanism (EFSF/ESM) to respond if worst-case scenarios materialize.

These concerns culminated in questions about the viability of the euro area and prompted a variety of actions from euro area policymakers. At the June 29, 2012, summit, euro area leaders committed to reconsidering the issue of the seniority of the ESM with respect to lending to Spain. In response to escalating problems, Spain subsequently agreed on a program with its European partners to support the restructuring of its banking sector, with financing of up to €100 billion. Also, leaders launched work on a banking union, which was followed up recently with a proposal by the European Commission to establish a single supervisory mechanism. Leaders agreed that, once established, such a mechanism would open the possibility for the ESM to take direct equity stakes in banks. This is critical because it will help break the adverse feedback loops between sovereigns and banks. Moreover, in early September, the ECB announced that it will consider (without ex ante limits) Outright Monetary Transactions (OMTs) under a macroeconomic adjustment or precautionary program with the EFSF/ESM. The transactions will cover government securities purchases, focused on the shorter part of the yield curve. Importantly, the ECB will accept the same treatment as private or other creditors with respect to bonds purchased through the OMT program.

The anticipation of these initiatives and their subsequent deployment set off a relief rally in financial markets, and the euro appreciated against the U.S. dollar and other major currencies. However, recent activity indicators have continued to languish, suggesting that weakness is spreading from the periphery to the whole of the euro area (Figure 1.3, panel 2). Even Germany has not been immune.

Figure 1.3.
Figure 1.3.

Current and Forward-Looking Growth Indicators

Purchasing managers’ indices for the manufacturing sector do not yet point to a significant reacceleration of activity—they remain below the level of 50, indicating falling output. The deterioration is particularly pronounced in the periphery of the euro area. Investment in machinery and equipment has also weakened, especially in the euro area. Furthermore, the pace of stock building has moved into a lower gear. Consumption has shown greater resilience, especially in emerging market and developing economies. Somewhat lower oil prices may support consumption in the advanced economies. However, higher food prices will harm many households, especially in emerging market and developing economies.

Sources: Haver Analytics; and IMF staff calculations.Note: Not all economies are included in the regional aggregations. For some economies, monthly data are interpolated from quarterly series.1Argentina, Brazil, Bulgaria, Chile, China, Colombia, Hungary, India, Indonesia, Latvia, Lithuania, Malaysia, Mexico, Peru, Philippines, Poland, Romania, Russia, South Africa, Thailand, Turkey, Ukraine, and Venezuela.2Australia, Canada, Czech Republic, Denmark, euro area, Hong Kong SAR, Israel, Japan, Korea, New Zealand, Norway, Singapore, Sweden, Switzerland, Taiwan Province of China, United Kingdom, and United States.3Greece, Ireland, Italy, and Spain.4Purchasing-power-parity-weighted averages of metal products and machinery for the euro area, plants and equipment for Japan, plants and machinery for the United Kingdom, and equipment and software for the United States.5Based on deviations from an estimated (cointegral) relationship between global industrial production and retail sales.6U.S. dollars a barrel: simple average of spot prices of U.K. Brent, Dubai Fateh, and West Texas Intermediate crude oil. The dashed lines indicate projected oil price in April 2012 WEO and current WEO.

Output and employment Weakened again in the United States

The U.S. economy also has slowed. Revised national accounts data suggest that it came into 2012 with more momentum than initially estimated. However, real GDP growth then slowed to 1.7 percent in the second quarter, below the April WEO and July WEO Update projections. The labor market and consumption have failed to garner much strength. The persistent weakness has prompted another round of policy stimulus by the Federal Reserve. Because of ongoing political gridlock, the fiscal cliff will not be addressed before the November elections. On the positive side, the housing market may be stabilizing, albeit at depressed levels, and private credit has continued to expand despite retrenchment in the U.S. market by EU banks.

Domestic Demand Continued to Lose Momentum in Key emerging Market economies

Policy tightening in response to capacity constraints and concerns about the potential for deteriorating bank loan portfolios, weaker demand from advanced economies, and country-specific factors slowed GDP growth in emerging market and developing economies from about 9 percent in late 2009 to about 5¼ percent recently. Indicators of manufacturing activity have been retreating for some time (Figure 1.3, panel 1). The IMF staff’s Global Projection Model suggests that more than half of the downward revisions to real GDP growth in 2012 are rooted in domestic developments.

  • Growth is estimated to have weakened appreciably in developing Asia, to less than 7 percent in the first half of 2012, as activity in China slowed sharply, owing to a tightening in credit conditions (in response to threats of a real estate bubble), a return to a more sustainable pace of public investment, and weaker external demand. India’s activity suffered from waning business confidence amid slow approvals for new projects, sluggish structural reforms, policy rate hikes designed to rein in inflation, and flagging external demand.

  • Real GDP growth also decelerated in Latin America to about 3 percent in the first half of 2012, largely due to Brazil. This reflects the impact of past policy tightening to contain inflation pressure and steps to moderate credit growth in some market segments—with increased drag recently from global factors.

  • Emerging European economies, following a strong rebound from their credit crisis, have now been hit hard by slowing exports to the euro area, with real GDP growth coming close to a halt. In Turkey, the slowdown has been driven by domestic demand, on the heels of policy tightening and a decline in confidence. Unlike in 2008, however, generalized risk aversion toward the region is no longer a factor. Activity in Russia, which has benefited various economies in the region, has also lost some momentum recently.

Prospects Are for Sluggish and Bumpy Growth

Looking ahead, no significant improvement appears in the offing. The WEO forecast includes only a modest reacceleration of activity, which would be helped along by some reduction in uncertainty related to assumed policy reactions in the euro area and the United States, continued monetary accommodation, and gradually easier financial conditions. Healthy nonfinancial corporate balance sheets and steady or slowing deleveraging by banks and households will encourage the rebuilding of the capital stock and a gradual strengthening of durables consumption. In emerging market and developing economies, monetary and fiscal policy easing will strengthen output growth. However, if either of two critical assumptions about policy reactions fails to hold, global activity could deteriorate very sharply.

  • The first assumption is that, consistent with the October 2012 GFSR baseline scenario, European policymakers take additional action to advance adjustment at national levels and integration at the euro area level (including timely establishment of a single supervisory mechanism). As a result, policy credibility and confidence improve gradually while strains remain from elevated funding costs and capital flight from the periphery to the core countries. If these policy actions are not taken, the WEO forecast may be disappointed once again and the area could slide into the GFSR’s weak policies scenario, which is described in further detail below.

  • The second assumption is that U.S. policymakers avoid the fiscal cliff and raise the debt ceiling, while making good progress toward a comprehensive plan to restore fiscal sustainability.

Fiscal Adjustment Will Continue but Not in Many Emerging Market Economies

Fiscal adjustment has been detracting from activity in various parts of the world and will continue to do so over the forecast horizon in the advanced economies but not in the emerging market and developing economies. The October 2012 Fiscal Monitor discusses the trends.

In major advanced economies, general government structural balances are on course to tighten by about ¾ percent of GDP in 2012, which is about the same as in 2011 and in line with the April 2012 WEO projections (Figure 1.4, panel 1). In 2013, the tightening is projected to increase modestly to about 1 percent of GDP, but its composition across countries will be different (see Table A8 in the Statistical Appendix). In the euro area, much adjustment has already been implemented and the pace of tightening will diminish somewhat. In the United States, the budget outlook for 2013 is highly uncertain, given the large number of expiring tax provisions and the threat of automatic spending cuts and in the context of highly polarized politics. The fiscal cliff implies a tightening of more than 4 percent of GDP, but the WEO projection assumes that the outcome would be only a 1¼ percent of GDP reduction in the structural deficit, which is slightly more than in 2012, mainly on account of expiring stimulus measures, such as the payroll tax cut, and a decline in war-related spending. The budget outlook has also become uncertain in Japan, where a political impasse has delayed approval of budget funding for the remainder of the fiscal year ending in March 2013. Earthquake-related spending has lent support to growth in 2012 but will decline sharply in 2013. As a result, there will be a fiscal withdrawal of about ½ percent of GDP. This withdrawal could be much larger if the political impasse is not resolved soon.

Figure 1.4.
Figure 1.4.

Fiscal Policies

In 2012, fiscal policy became more contractionary in the advanced economies. It became much less contractionary in the emerging market and developing economies, where the fiscal deficit is expected to be about 1½ percent of GDP—much lower than the 6 percent of GDP level projected for the advanced economies. However, before the crisis, emerging market and developing economies were running surpluses. Over the medium term, many should strengthen their fiscal positions to rebuild room for policy maneuvering. The main challenges with respect to deficit reduction lie, however, in the advanced economies, where public debt is in excess of 100 percent of GDP and rising.

Source: IMF staff estimates.1G7 comprises Canada, France, Germany, Italy, Japan, United Kingdom, and United States.

In emerging market and developing economies, no significant fiscal consolidation is on tap for 2012–13, following a 1 percent of GDP improvement in structural balances during 2011 (Figure 1.4, panel 1). The general government deficit in these economies is expected to remain below 1½ percent of GDP, and public debt levels are expected to decline as a share of GDP, toward 30 percent. Fiscal prospects, however, vary across economies. Policy will be broadly neutral in China, India, and Turkey in 2012 and 2013. In Brazil, policy will be broadly neutral in 2012 and tighten somewhat in 2013. In Mexico, there will be a roughly 1 percent of GDP fiscal tightening in 2012, followed by a modest further fiscal withdrawal in 2013. Russia is loosening noticeably in 2012, but its stance is projected to become broadly neutral in 2013.

Monetary Policy Is Expected to Support Activity

Monetary policy has been easing and will remain very accommodative, according to market expectations (Figure 1.5, panel 1). The ECB recently launched its OMT program (see above) and broadened collateral requirements. The Federal Reserve recently announced that it would purchase mortgage-backed securities at a pace of $40 billion a month, consider additional asset purchases, and employ its other policy tools until economic conditions improve. It also extended its low-interest-rate guidance from late 2014 to mid-2015. Earlier, the Bank of England had expanded its quantitative easing program. Various advanced economies recently cut policy rates (Australia, Czech Republic, Israel, Korea) or postponed rate hikes. The Bank of Japan expects a roughly 5 percent of GDP monetary expansion during the coming year on account of its Asset Purchase Program and estimates that this would suffice to push inflation up to its 1 percent goal. It recently eased its monetary policy further by expanding its asset purchase program ceiling for government bonds.

Figure 1.5.
Figure 1.5.

Monetary Policies

Expectations are for very accommodative monetary policies in the major advanced economies. Real interest rates are also low in many emerging market and developing economies, and several economies have cut their policy rates in the past six months. However, only a few economies implemented large cuts. Over the medium term, policy rates will have to be raised, but considering the downside risks to the outlook, many central banks can afford to hold steady now or ease further. In advanced economies, central bank balance sheets have expanded appreciably, but their size is not unusual compared with those of various emerging market economies.

Sources: Bloomberg Financial Markets; and IMF staff estimates.Note: BR = Brazil; CL = Chile; CN = China; CO = Colombia; ID = Indonesia; IN = India; KR = Korea; MX = Mexico; MY = Malaysia; PE = Peru; PH = Philippines; PL = Poland; RU = Russia; TH = Thailand; TR = Turkey; ZA = South Africa. BOJ = Bank of Japan; ECB = European Central Bank; Fed = Federal Reserve.1Expectations are based on the federal funds rate for the United States, the sterling overnight interbank average rate for the United Kingdom, and the euro interbank offered forward rates for Europe; updated September 13, 2012.2Bank Indonesia rate for Indonesia; the Central Bank of the Republic of Turkey’s effective marginal funding cost estimated by IMF staff for Turkey.3ECB calculations based on the Eurosystem’s weekly financial statement.

The Bank of England launched some innovative measures. Under its Funding for Lending Scheme (FLS), banks and building societies will be able to borrow U.K. Treasury bills in exchange for less liquid collateral. Banks may borrow bills in an amount equal to 5 percent of their June 2012 stock of loans to the U.K. nonfinancial sector, plus any expansion of lending from that date until the end of 2013. Swap fees will be lower for banks that maintain or expand rather than cut their lending. These measures should encourage bank lending and ease access to wholesale credit by improving the quality of assets held by banks.

Emerging market and developing economies launched a variety of easing measures in response to softening activity and inflation. Many postponed anticipated tightening, and some cut policy rates, including Brazil, China, Colombia, Hungary, the Philippines, and South Africa (Figure 1.5, panel 2). However, only Brazil cut aggressively, also easing macroprudential measures to further encourage lending. On the whole, real interest rates in many emerging market and developing economies are still relatively low and credit growth is high. For these reasons, many central banks have chosen to hold steady.

Financial Conditions Will Remain Very Fragile

Despite the summer 2012 market rally, financial vulnerabilities are higher than in the spring, according to the October 2012 GFSR. Confidence in the global financial system remains exceptionally fragile. Bank lending has remained sluggish across advanced economies (Figure 1.6, panels 2 and 3). U.S. credit standards have been easing modestly for some time, although not yet for residential real estate. In the euro area, by contrast, lending surveys point to a further tightening of standards and falling loan demand. Bank credit has contracted sharply in the periphery, and credit growth slowed to a crawl in the core economies amid large increases in periphery credit spreads.

Figure 1.6.
Figure 1.6.

Recent Financial Market Developments

Equity markets recently registered large losses and have been very volatile. Policy pronouncements have had large effects. Bank lending conditions are gradually easing from very tight levels in the United States but are continuing to tighten in the euro area. U.S. credit to households and nonfinancial firms is growing again; euro area credit remains in the doldrums, amid cutbacks in the periphery.

Sources: Bank of America/Merrill Lynch; Bloomberg Financial Markets; Haver Analytics; and IMF staff estimates.1Weighted average of the Spanish IBEX and Italian FTSEMIB using September 13, 2012, market capitalizations.2Percent of respondents describing lending standards as tightening “considerably” or “somewhat” minus those indicating standards as easing “considerably” or “somewhat” over the previous three months. Survey of changes to credit standards for loans or lines of credit to firms for the euro area; average of surveys on changes in credit standards for commercial and industrial and commercial real estate lending for the United States; diffusion index of “accommodative” minus “severe,” Tankan (survey of lending attitudes of financial institutions) for Japan.

Increased risk aversion has dampened capital flows to emerging markets (Figure 1.7, panel 1), although local-currency debt has continued to attract inflows throughout the euro area crisis. Concerns center on slowing domestic growth and heightened financial vulnerabilities. Sovereign and corporate spreads edged up (Figure 1.7, panel 2). Emerging market banks have been tightening lending standards in the face of rising nonperforming loans and worsening funding conditions (Figure 1.7, panel 4). Survey responses suggest that tightness in global funding markets played a major role in this regard. Indicators for loan demand are still expansionary in all major regions (Figure 1.7, panel 5). Credit growth itself fell off its very high pace but remains elevated in many economies.

Figure 1.7.
Figure 1.7.

Emerging Market Conditions

Emerging markets suffered capital outflows until recently, their equity markets declined, and their risk spreads widened somewhat. Banks are tightening credit standards in the face of credit and asset price booms and reduced external funding. However, demand for loans continues to expand.

Sources: Bloomberg Financial Markets; Capital Data; EPFR Global; Haver Analytics; IIF Emerging Markets Bank Lending Survey; and IMF staff calculations.Note: ECB = European Central Bank; LTROs = Longer-term refinancing operations; AFME = Africa and Middle East.1JPMorgan EMBI Global Index spread.2JPMorgan CEMBI Broad Index spread.

Financial conditions are likely to remain very fragile over the near term because implementing a solution to the euro area crisis will take time and the U.S. debt ceiling and fiscal cliff raise concerns about the U.S. recovery. Bank lending in the advanced economies is expected to stay sluggish—much more so in the euro area, where the periphery will suffer further reductions in lending. Most emerging markets will likely experience volatile capital flows. In economies where credit growth has already slowed appreciably, such as China, credit is likely to rebound further as project approvals are fast-tracked; elsewhere, growth rates are likely to move sideways or decline. External funding conditions are likely to have a larger impact on credit developments in emerging Europe than in other emerging market economies.

Activity Is Forecast to Remain Tepid in Many Economies

The recovery is forecast to limp along in the major advanced economies, with growth remaining at a fairly healthy level in many emerging market and developing economies. Leading indicators do not point to a significant acceleration of activity, but financial conditions have recently improved in response to euro area policymakers’ actions and easing by the Federal Reserve.

  • In the euro area, real GDP is projected to decline by about ¾ percent (on an annualized basis) during the second half of 2012 (Figure 1.8, panel 2). With diminishing fiscal withdrawal and domestic and euro-area-wide policies supporting a further improvement in financial conditions later in 2013, real GDP is projected to stay flat in the first half of 2013 and expand by about 1 percent in the second half. The core economies are expected to see low but positive growth throughout 2012–13. Most periphery economies are likely to suffer a sharp contraction in 2012, constrained by tight fiscal policies and financial conditions, and to begin to recover only in 2013.

  • In the United States, real GDP is projected to expand by about 1½ percent during the second half of 2012, rising to 2¾ percent later in 2013 (Figure 1.8, panel 1). Weak household balance sheets and confidence, relatively tight financial conditions, and continued fiscal consolidation stand in the way of stronger growth. In the very short term, the drought will also detract from output.

  • In Japan, the pace of growth will diminish noticeably as post-earthquake reconstruction winds down. Real GDP is forecast to stagnate in the second half of 2012 and grow by about 1 percent in the first half of 2013. Thereafter, growth is expected to accelerate further (Figure 1.8, panel 1).

Figure 1.8.
Figure 1.8.

GDP Growth

(Half-over-half annualized percent change)

Real GDP growth is projected to move sideways or accelerate modestly in 2012. Activity is expected to continue to contract during 2013 in the periphery economies of the euro area. In emerging Asia and Latin America, the projected acceleration is mainly driven by China and Brazil, which have been easing their macroeconomic policies in response to weakening activity.

Source: IMF staff estimates.

Fundamentals remain strong in many economies that have not suffered a financial crisis, notably in many emerging market and developing economies. In these economies, high employment growth and solid consumption (Figure 1.3, panel 3) should continue to propel demand and, together with macroeconomic policy easing, support healthy investment and growth. However, growth rates are not projected to return to precrisis levels.

  • In developing Asia, real GDP is forecast to accelerate to a 7¼ percent pace in the second half of 2012 (Figure 1.8, panel 3). The main driver will be China, where activity is expected to receive a boost from accelerated approval of public infrastructure projects. The outlook for India is unusually uncertain: For 2012, with weak growth in the first half and a continued investment slowdown, real GDP growth is projected to be 5 percent, but improvements in external conditions and confidence—helped by a variety of reforms announced very recently—are projected to raise real GDP growth to about 6 percent in 2013.

  • In Latin America, real GDP growth is projected to be about 3¼ percent for the second half of 2012. It is then expected to accelerate to 4¾ percent in the course of the second half of 2013 (Figure 1.8, panel 4). The projected acceleration is strong for Brazil because of targeted fiscal measures aimed at boosting demand in the near term and monetary policy easing, including policy rate cuts equivalent to 500 basis points since August 2011. The pace of activity elsewhere is not forecast to pick up appreciably.

  • In the central and eastern European (CEE) economies, improving financial conditions in the crisis-hit economies, somewhat stronger demand from the euro area, and the end of a boom-bust cycle in Turkey are expected to raise growth back to 4 percent later in 2013.

  • Growth is projected to stay above 5 percent in sub-Saharan Africa (SSA) and above 4 percent in the Commonwealth of Independent States (see Table 1.1). In both regions, still-high commodity prices and related projects are helping.

  • In the Middle East and North Africa (MENA), activity in the oil importers will likely be held back by continued uncertainty associated with political and economic transition in the aftermath of the Arab Spring and weak terms of trade—real GDP growth is likely to slow to about 1¼ percent in 2012 and rebound moderately in 2013. Due largely to the recovery in Libya, the pace of overall growth among oil exporters will rise sharply in 2012, to above 6½ percent, and then return to about 3¾ percent in 2013.

Cyclical Indicators Point to Slack in Advanced Economies

Cyclical indicators point to ample slack in many advanced economies but to capacity constraints in a number of emerging market economies (Figure 1.9). WEO output gaps in the major advanced economies are large, varying from about 2½ percent of GDP in the euro area and Japan to 4 percent in the United States for 2012 (see Table A8 in the Statistical Appendix). These gaps are consistent with weak demand due to tight financial conditions and fiscal consolidation. By contrast, most emerging market and developing economies that were not hit by the crisis continue to operate above precrisis trends. However, their potential growth rates in recent years are judged to have been higher than indicated by the 1996–2006 precrisis average, and therefore WEO output gap estimates do not signal much overheating.

Figure 1.9.
Figure 1.9.

Overheating Indicators for the G20 Economies

Domestic overheating indicators point to ample slack in the advanced economies—most indicators flash blue. By contrast, a number of yellow and red indicators for the emerging market and developing economies point to capacity constraints. External overheating indicators flash yellow or red for Japan and China—rather thanraising concerns, these are symptoms of an internal demand rebalancing process that has helped bring down global current account imbalances. However, in China, the rebalancing is overly reliant oninvestment. In Germany, which is the world’s other major surplus economy, the rebalancing process is lagging. The red indicators for Turkey point to external vulnerabilities. Credit indicators point to excesses in many emerging market and developingeconomies. Other financial indicators are mostly reassuring about overheating, except for Brazil.

Sources: Australia Bureau of Statistics; Bank for International Settlements; CEIC China Database; Global Property Guide; Haver Analytics; IMF, Balance of Payments Statistics Database; IMF, International Financial Statistics Database; Organization for Economic Cooperation and Development; and IMF staff estimates.Note: For each indicator, except as noted below, economies are assigned colors based on projected 2012 values relative to their precrisis (1997–2006) average. Each indicator is scored as red = 2, yellow = 1, and blue = 0; summary scores are calculated as the sum of selected component scores divided by the maximum possible sum of those scores. Summary blocks are assigned red if the summary score is greater than or equal to 0.66, yellow if greater than or equal to 0.33 but less than 0.66, and blue if less than 0.33. When data are missing, no color is assigned. Arrows up (down) indicate hotter (colder) conditions compared with the April 2012 WEO predicted values for 2012.1Output more than 2.5 percent above the precrisis trend is indicated by red. Output less than 2.5percent below the trend is indicated by blue. Output within ±2.5 percent from the precrisis trend is indicated by yellow.2For the following inflation-targeting economies, the target inflation rate was used instead of the 1997–2006 average in the calculation of the inflation indicator: Australia, Brazil, Canada, Indonesia, Korea, Mexico, South Africa, Turkey, United Kingdom. For the non-inflation-targeting economies, red was assigned if inflation is approximately 10 percent or higher, yellow if inflation is approximately 5 to 9 percent, and blue if inflation is less than 5 percent.3The indicators for credit growth, house price growth, and share price growth refer to the latest2012 values relative to the 1997–2006 average of output growth.4Arrows in the fiscal balance column represent the forecast change in the structural balance as a percent of GDP over the period 2011–12. An improvement of more than 0.5 percent of GDP is indicated by an up arrow; a deterioration of more than 0.5 percent of GDP is indicated by a down arrow.5Real policy interest rates below zero are identified by a down arrow; real interest rates above 3 percent are identified by an up arrow. Real policy interest rates are deflated by two-year-ahead inflation projections.6Calculations are based on Argentina’s official GDP data. The IMF has called on Argentina to adopt remedial measures to address the quality of the official GDP data. The IMF staff is also using alternative measures of GDP growth for macroeconomic surveillance, including data produced by private analysts, which have shown significantly lower real GDP growth than the official data since 2008. The IMF staff’s estimate of average provincial inflation is used as a measure of inflation and to deflate nominal variables.

Amid sharply differing developments across advanced and emerging market and developing economies, the world unemployment rate is estimated to remain flat during 2012–13, near 6¼ percent (Figure 1.1, panel 2). Unemployment rates have on average declined below precrisis levels in emerging market and developing economies, but they remain elevated in advanced economies and are not expected to fall significantly during 2012–13.

  • In the United States, the unemployment rate dropped from close to 10 percent in 2010 to about 8 percent lately, where it is expected to remain through 2013. However, a large part of the decline is due to sluggish labor force expansion through 2011. In addition, more than 40 percent of those unemployed have been out of work for more than six months. In Europe, more than 1 in 10 labor force participants are projected to be unemployed through 2013; in Greece and Spain the ratio is 1 in 4 workers. More generally, almost half of all young labor force participants are without jobs in the periphery of the euro area. As in the United States, the number of long-term unemployed has also risen starkly, increasing the risk of hysteresis and skills atrophy.

  • In emerging market and developing economies, the unemployment record varies widely. Rates are very high in economies that were hit by the crisis, such as in many of the CEE and a few CIS economies, but relatively low in most parts of developing Asia and Latin America. Unemployment rates are projected to remain high in the MENA region, mainly among the oil importers. These economies face a number of challenges, ranging from major political changes, to social needs related to rapidly expanding populations, to decreased revenues from tourism—all of which are weighing on employment prospects in the short term.

The slowdown in global activity and ample slack in many advanced economies have meant that inflation has fallen (Figure 1.10, panels 1 and 2). In advanced economies, lower commodity prices reduced headline inflation to about 1½ percent as of July 2012, down from more than 3 percent in late 2011. Core inflation has been steady at about 1½ percent. In emerging market and developing economies, headline inflation has declined by almost 2 percentage points, to slightly under 5½ percent, in the second quarter of 2012; core inflation too has declined, although to a lesser extent. The forecast is for further easing of inflation pressure in the advanced economies, with headline inflation moving to about 1¾ percent in 2013; in emerging market and developing economies, headline inflation is projected to move broadly sideways.

Figure 1.10.
Figure 1.10.

Global Inflation

(Twelve-month change in the consumer price index unless noted otherwise)

Headline inflation has declined everywhere, helped by lower commodity prices. In the emerging market and developing economies, core inflation has declined too. In advanced economies, it has remained stable around 1½ percent. House price developments increasingly diverge across economies. In various smaller advanced and a number of emerging market and developing economies, upward pressure remains, notwithstanding already high prices.

Sources: Haver Analytics; and IMF staff calculations.1Boom-bust countries: Bulgaria, Croatia, Cyprus, Czech Republic, Denmark, Estonia, Finland, France, Greece, Iceland, Ireland, Italy, Latvia, Lithuania, Malta, Netherlands, New Zealand, Poland, Russia, Slovak Republic, Slovenia, South Africa, Spain, Turkey, Ukraine, United Kingdom, United States.2Upward pressure countries: Australia, Austria, Belgium, Canada, Colombia, China, Hong Kong SAR, Hungary, India, Israel, Malaysia, Norway, Philippines, Switzerland, Singapore, Serbia, Sweden, Uruguay.

This inflation forecast assumes broadly unchanged commodity prices, but sharply rising food prices raise increasing concern (see the Special Feature and Box 1.5). Thus far, price pressures do not encompass all major food crops, unlike in 2007–08. As discussed further below, monetary policy should not react to food-price-driven increases in headline inflation unless there are significant risks for second-round effects on wages. Governments may need to scale up targeted social safety net measures and implement other fiscal measures (such as reducing food taxes) where there is fiscal space to do so. Also, countries should avoid any restrictions on exports, which would exacerbate price increases and supply disruptions. Over the longer term, broader policy reforms are necessary to reduce global food price volatility.

The Outlook Has Become More Uncertain

Risks to the WEO forecast have risen appreciably and now appear more elevated than in the April 2012 and September 2011 WEO reports, whose policy assumptions and hence growth projections for advanced economies proved overly optimistic. Although standard risk metrics suggest that downside risks are much higher now than only a few months ago, upside risks appear higher too, although to a lesser extent. This may be a reflection of the fact that many market participants have a bimodal view of global prospects: the recovery could be set back if European and U.S. policymakers fail to live up to expectations, but it could also be stronger if they deliver on their commitments. The most pertinent near-term risks—escalation of the euro area crisis and fiscal policy failures in the United States—are quantified and discussed with the help of scenarios. In addition, this section considers a variety of medium- and long-term risks and scenarios.

Risks for a Serious Global Slowdown Are Alarmingly High

The WEO’s standard fan chart suggests that uncertainty about the outlook has increased markedly (Figure 1.11, panel 1).1 The WEO growth forecast is now 3.3 and 3.6 percent for 2012 and 2013, respectively, which is somewhat lower than in April 2012. The probability of global growth falling below 2 percent in 2013—which would be consistent with recession in advanced economies and a serious slowdown in emerging market and developing economies—has risen to about 17 percent, up from about 4 percent in April 2012 and 10 percent (for the one-year-ahead forecast) during the very uncertain setting of the September 2011 WEO.

Figure 1.11.
Figure 1.11.

Risks to the Global Outlook

Risks around the WEO projections have risen, consistent with market indicators, and remain tilted to the downside. The oil price and inflation indicators point to downside risks to growth, while S&P 500 options prices and the term spread suggest some upside risk.

Sources: Bloomberg Financial Markets; Chicago Board Options Exchange; Consensus Economics; and IMF staff estimates.1The fan chart shows the uncertainty around the WEO central forecast with 50, 70, and 90 percent confidence intervals. As shown, the 70 percent confidence interval includes the 50 percent interval, and the 90 percent confidence interval includes the 50 and 70 percent intervals. See Appendix 1.2 in the April 2009 World Economic Outlook for details.2The values for inflation and oil price risks enter with the opposite sign, because they represent downside risks to growth.3GDP measures the dispersion of GDP forecasts for the G7 economies (Canada, France, Germany, Italy, Japan, United Kingdom, United States), Brazil, China, India, and Mexico. VIX = Chicago Board Options Exchange S&P 500 Implied Volatility Index. Term spread measures the dispersion of term spreads implicit in interest rate forecasts for Germany, Japan, United Kingdom, and United States. Oil measures the dispersion of one-year-ahead oil price forecasts for West Texas Intermediate. Forecasts are from Consensus Economics surveys.

The IMF staff’s Global Projection Model (GPM) uses an entirely different methodology to gauge risk but confirms that risks for recession in advanced economies (entailing a serious slowdown in emerging market and developing economies) are alarmingly high (Figure 1.12, panel 1). For 2013, the GPM estimates suggest that recession probabilities are about 15 percent in the United States, above 25 percent in Japan, and above 80 percent in the euro area.

Figure 1.12.
Figure 1.12.

Recessions and Deflation Risks

Risks for a prolonged recession and for sustained deflation are elevated in the euro area, notably in periphery economies. The risk of deflation continues to be a problem in Japan. In other areas, the risks are minimal.

Source: IMF staff estimates.1Emerging Asia: China, Hong Kong SAR, India, Indonesia, Korea, Malaysia, Philippines, Singapore, Taiwan Province of China, and Thailand; Latin America: Brazil, Chile, Colombia, Mexico, and Peru; remaining economies: Argentina, Australia, Bulgaria, Canada, Czech Republic, Denmark, Estonia, Israel, New Zealand, Norway, Russia, South Africa, Sweden, Switzerland, Turkey, United Kingdom, and Venezuela.2For details on the construction of this indicator, see Kumar (2003) and Decressin and Laxton (2009). The indicator is expanded to include house prices.

Risk Scenarios for the Short Term

As emphasized, immediate risks relate to the assumptions about the sovereign debt crisis in the euro area and about the U.S. budget, both of which could negatively affect growth prospects. Furthermore, oil prices could again provide a shock.

A further deepening of the euro area crisis

The euro area crisis could reintensify again. The OMT program will reduce risks from self-fulfilling market doubts related to the viability of the Economic and Monetary Union (EMU) most effectively if it is implemented decisively. However, serious risks remain outside this safety net—posed, for example, by rising social tensions and adjustment fatigue that raise doubts about adjustment in the periphery or by doubts about the commitment of others to more integration.

The downside scenario developed here uses the IMF staff’s Global Integrated Monetary and Fiscal Model (GIMF) to consider the implications of an intensification of euro area sovereign and banking stress. Unlike in the WEO forecast and GFSR baseline scenario, European policymakers in this scenario do not strengthen their policies, as discussed in further detail in the weak policies scenario in the October 2012 GFSR. In this scenario, the forces of financial fragmentation increase and become entrenched, capital holes in banking systems expand, and the intra-euro-area capital account crisis increasingly spills outward. Within the GIMF, this scenario features the following shocks relative to the WEO forecast (Figure 1.13): lower credit, mainly in the periphery; higher sovereign risk premiums for the periphery; modestly lower premiums for the core sovereigns, which benefit from a flight to safety; an even larger fiscal consolidation in the periphery; and increases in corporate risk premiums for all (including non-European) advanced and emerging market economies. Capital flight from the euro area and emerging markets is assumed to benefit the United States, and its sovereign risk premium falls. Monetary policy is constrained at the zero interest rate floor in the advanced economies, and the assumption is that they do not proceed with additional unconventional easing. Emerging market economies, by contrast, are assumed to ease as growth and inflation fall, which considerably reduces the impact of the external shock on their economies.

Figure 1.13.
Figure 1.13.

Upside and Downside Scenarios

(Percent or percentage point deviation from WEO baseline)

The Global Integrated Monetary and Fiscal Model (GIMF) is used to consider a scenario in which policy is initially unable to prevent the intensification of euro area sovereign and banking stress as well as a scenario in which policy action quickly alleviates the current level of stress. The model contains two blocks of euro area countries, those with acute fiscal sustainability issues (referred to as “periphery”) and those with less acute fiscal sustainability issues (referred to as “core”).

The intensification-of-stress scenario (red bars) assumes that policymakers delay taking sufficient action to prevent a sharp intensification of financial stress. Consequently, deleveraging by euro area banks leads to a sharp credit contraction in periphery countries but milder contraction elsewhere. Credit in periphery countries falls €475 billion below the WEO baseline in 2013, while that in the core countries falls by €50 billion. Concerns about fiscal sustainability raise periphery sovereign spreads 350 basis points in 2013; however, subsequent policy action results in spreads falling thereafter and returning fully to baseline by 2016. The core countries’ sovereign risk premium is assumed to decline by 50 basis points in 2013 as a flight to quality within the euro area occurs. Sovereigns in the periphery are forced into more front-loaded fiscal consolidation, averaging an additional 2 percentage points of GDP in 2013. Risk concerns are also assumed to spill over to all other regions, with corporate risk premiums rising by 50 basis points in advanced economies and 150 basis points in emerging market and developing economies in 2013. The capital flight is assumed to benefit the U.S. sovereign, with the risk premium falling by 50 basis points in 2013. Monetary policy is constrained at the zero interest rate floor in the G3 countries (euro area, Japan, United States), whereas elsewhere monetary policy eases to help offset the impact on market interest rates of rising risk premiums.

In the scenario in which policy is able to alleviate the stress (blue bars), credit in the euro area expands relative to the baseline and sovereign spreads decline. In the periphery countries, credit expands by roughly €225 billion relative to the baseline, and sovereign spreads decline by roughly 200 basis points in 2013. In other advanced economies, corporate spreads fall by 50 basis points in 2013, and in emerging markets, the decline is 100 basis points.

Source: GIMF simulations.Note: EA = euro area; MENA = Middle East and North Africa; SSA = sub-Saharan Africa.1Core countries are Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Luxembourg, Malta, Netherlands, Slovak Republic, and Slovenia.2Periphery countries are Greece, Ireland, Italy, Portugal, and Spain.

In this scenario, output in the euro area core would fall by about 1¾ percent relative to the WEO projections within one year; in the periphery, the decline would be about 6 percent. Output losses in non-European economies would be about 1 to 1½ percent. Chapter 2 provides further details for the various regions.

Stronger-than-expected euro area policies

This second GIMF scenario assumes that national policymakers follow up the latest ECB actions with a more proactive approach toward domestic adjustment and EMU reforms. The details are discussed in the complete policies scenario in the October 2012 GFSR. This scenario requires regaining credibility through an unflinching commitment to implementing already agreed plans. Policymakers need to build political support for the necessary pooling of sovereignty that a more complete currency union entails. It envisages that they quickly introduce a road map for banking union and fiscal integration and deliver a major down payment. Examples of possible action include implementation of a bank resolution mechanism with common backstops or a pan-European deposit insurance guarantee plan (for both, concrete proposals still need to be spelled out) and concrete measures toward fiscal integration. Under this scenario (Figure 1.13), the euro area begins to reintegrate as policy credibility is restored and capital flight reverses. Relative to the WEO forecast and the GFSR baseline scenario, credit expands by roughly €225 billion and sovereign spreads decline by about 200 basis points in 2013 in the periphery of the euro area. Economic growth resumes in the periphery and picks up in the core. In other advanced economies, corporate spreads fall by 50 basis points; in emerging market economies, by 100 basis points. Output would then be roughly ½ to 1 percent higher within one year in most other parts of the world.

The U.S. debt ceiling and fiscal cliff

The U.S. fiscal cliff could entail significantly more fiscal tightening (by about 3 percent of GDP) than assumed in the WEO projections. A recent Spillover Report (IMF, 2012e) finds that if this risk materializes and the sharp fiscal contraction is sustained, the U.S. economy could fall into a full-fledged recession. The global spillovers would be amplified through negative confidence effects, including, for example, a global drop in stock prices. The impact of hitting the debt ceiling is more difficult to model. Political delays before the previous deadline, in summer 2011, led credit rating agencies to downgrade the United States, and major market turmoil ensued. At this stage, markets appear to consider the fiscal cliff a tail risk, given that Congress has in the past eventually reached a compromise to resolve similar high-stakes situations. However, this implies that, should this risk actually materialize, there would be a great shock to confidence that would quickly spill over to financial markets in the rest of the world. Notice that risks for a sudden fiscal withdrawal are also present in Japan: however, if they materialize, they will probably have spillovers that are not as large as those from the U.S. fiscal cliff.

A renewed spike in oil prices

If either the euro area or U.S. downside scenario were to materialize, oil prices would likely fall substantially. But there is also an important risk that intensified geopolitical tensions could boost oil prices. The April 2012 WEO included a scenario featuring oil supply disruptions that showed that a 50 percent increase in oil prices due to less supply would lead to a 1 to 1½ percent decline in output in many parts of the world. The latest distribution of options prices for oil—which is skewed to the upside, implying a downside skew for the distribution of global growth—suggests that this scenario remains relevant for the global economy (Figure 1.11, panel 2).

Risk Scenarios for the Medium Term

A large number of risks and scenarios can be envisaged for the medium term. This section focuses on two specific risk scenarios and one general risk scenario that appear pertinent for policymakers at this juncture. The specific risk scenarios relate to large central bank balance sheets and high public debt—they are directly relevant for monetary and fiscal policy in the advanced economies. The general risk scenario is for globally lower growth over the medium term. This is akin to the experience following the shocks of the 1970s, but this time rooted in other shocks and policy failures—and, for the advanced economies, similar to the experience of Japan after the mid-1990s.

Risks related to swollen central bank balance sheets

The concern is that the vast acquisition of assets by central banks will ultimately mean a rise in the money supply and thus inflation (Figure 1.5, panel 3). However, as discussed in previous WEO reports, no technical reason indicates this would be inevitable. Central banks have more than enough tools to absorb the liquidity they create, including selling the assets they have bought, reverting to traditionally short maturities for refinancing, raising their deposit rates, and selling their own paper. Furthermore, in principle, central bank losses do not matter: their creditors are currency holders and reserve-holding banks; neither can demand to be paid with some other form of money.2 The reality, however, may well be different. A national legislature may see such losses as a symptom that the central bank is operating outside its mandate, which could be of concern if it led to efforts to limit the central bank’s operational independence. A related concern is that economic agents may begin to doubt the capacity of central banks to fight inflation. Two scenarios come to mind:

  • Public deficits and debt may run out of control, causing governments to lean on central banks to pursue more expansionary policies with a view to eroding the real value of the debt via inflation. Similarly, losses on holdings of euro area, Japanese, and U.S. (G3) government securities may cause emerging market economies’ central banks or sovereign wealth funds to buy fewer G3 government assets, investing instead in better opportunities at home and triggering large depreciations of G3 currencies.

  • Policymakers may falsely perceive central bank balance sheet losses to be damaging to their economies. Such perceptions may make central banks more hesitant to raise interest rates, because doing so would decrease the market value of their asset holdings. The mere appearance of such hesitation may lead private agents to expect an increase in inflation.

Risks related to high public debt levels

Public debt has reached very high levels, and if past experience is any guide, it will take many years to appreciably reduce it (see Chapter 3). Risks related to public debt have several aspects. First, when global output is at or above potential, high public debt may raise global real interest rates, crowding out capital and lowering output in the long term.3 Second, the cost of debt service may lead to tax increases or cutbacks in infrastructure investment that lower supply. Third, high public debt in individual countries may raise their sovereign risk premiums, with a variety of consequences—from limited scope for countercyclical fiscal policies (as evidenced by the current problems in the euro area periphery) to high inflation or outright default in the case of very large increases in risk premiums.

Simulations with the GIMF suggest that an increase in public debt in the G3 economies of about 40 percentage points of GDP raises real interest rates almost 40 basis points in the long term (Box 1.2). This simulation and discussion necessarily abstracts from the potential long-term benefits of fiscal stimulus. The 2009 stimulus, for example, was likely instrumental in averting a potential deflationary spiral and protracted period of exceedingly high unemployment, macroeconomic conditions that general equilibrium models such as the GIMF are not well suited to capture. Bearing this in mind, the simulation suggests that in the long term the higher debt lowers real GDP by about ¾ percent relative to a baseline without any increase in public debt. This is because of the direct effect of higher interest rates on investment and the indirect effect via higher taxes or lower government investment. The GIMF simulations indicate that within the G3 the negative effects would be larger, with output 1 percent below baseline projections. The loss of output over the medium term would be even larger if, for example, savings were to drop more than expected because of aging populations in the advanced economies or if the consumption patterns of emerging market economies with very high saving rates align more quickly than expected with those of advanced economies.

Scenarios that involve very high levels of debt and high real interest rates may not only result in lower growth but may also involve a higher risk of default when fiscal dynamics are perceived to be unstable. This combination of high debt and high real interest rates can lead to bad equilibriums, when doubt about the sustainability of fiscal positions drives interest rates to unsustainable levels.

Disappointing potential output and growing risk aversion

Looking beyond the near term, a concern is that output growth may disappoint in both advanced and emerging market economies, albeit for different reasons, and will precipitate a general flight to safety. As noted, growth outcomes have already disappointed repeatedly, including relative to the September 2011 and April 2012 WEO projections. These disappointments could be symptomatic of medium-term problems.

  • In advanced economies that suffered from the financial crisis, prospects for employment remain dim, and many workers may ultimately drop out of the labor force. Banks are in the middle of an arduous process of lowering their leverage and strengthening their funding models. High public debt and, for some economies, external liabilities could mean new bouts of instability and generally low growth. Projections for these economies already incorporate marked-down estimates for potential output relative to precrisis trends, typically by 10 percent or more (Figure 1.14, panel 1). However, output could be lower still over the medium term.

  • In response to forecast errors and policy changes, estimates for the medium-term output levels of emerging market economies have been marked down (relative to September 2011 estimates)—by about 3 percent for Brazil, 5 percent for China, and 10 percent for India, for example—and there may be more to come (Figure 1.14, panel 4). The April 2012 WEO already featured a downside scenario with weaker potential output in emerging Asian economies. Given recent disappointments elsewhere, this scenario is broadened to other emerging market economies. In fact, many emerging Asian and Latin American economies have seen growth above the 10-year precrisis average, and the IMF staff sees further scope for such high growth, as evidenced by WEO output gap estimates that point to slack (Figure 1.14, panel 1). The findings of Chapter 4 justify this optimism to some extent: there are indications of growing resilience on the part of emerging market and developing economies, mainly reflecting stronger policies. However, the chapter’s findings suggest that less frequent adverse funding and terms-of-trade shocks have also played a role in these economies’ recent strong performance, and the frequency of such shocks could increase again. Moreover, strong credit growth, which likely supported demand, cannot continue at the present pace without raising concerns about financial stability in many of these economies (Figure 1.14, panels 2 and 3). In short, there may be less cyclical slack and scope to grow over the medium term than suggested by IMF staff projections.

Figure 1.14.
Figure 1.14.

Output in Emerging Market and Developing Economies

Output in emerging market and developing economies in Asia and Latin America is above precrisis trends, but WEO output gap estimates still see some slack. Amid disappointment relative to output projections, estimates for medium-term output have been lowered. For China and India, the reduction amounts to 5 to 10 percentage points by 2016; for all emerging market and developing economies, the reduction amounts to about 3½ percentage points. Buoyant activity in many emerging market and developing economies has been driven partly by better policies and partly by high credit growth and favorable terms-of-trade shocks. In many economies, the high credit growth will be difficult to sustain at present rates without weakening bank balance sheets. Also, future improvements in the terms of trade may be more limited. Thus, there are risks that medium-term output could surprise further on the downside.

Sources: IMF, International Financial Statistics; and IMF staff estimates.Note: AE = advanced economies; AR = Argentina; BR = Brazil; CEE = central and eastern Europe; CIS = Commonwealth of Independent States; CN = China; CO = Colombia; DA = developing Asia; EM = emerging market economies; HK = Hong Kong SAR; ID = Indonesia; IN = India; LAC = Latin America and the Caribbean; MY = Malaysia; SSA = sub-Saharan Africa; TR = Turkey.1Precrisis trend is defined as the geometric average of real GDP level growth between 1996 and 2006.2Nominal credit is deflated using the IMF staff’s estimate of average provincial inflation.3Relative to September 2011 WEO.

The scenario used to model lower potential output and the global macroeconomic implications is the IMF staff’s Global Economy Model. Figure 1.15 shows the impact of downward revisions to medium-term output growth by about ½ percent in the United States, the euro area, and Latin America and by about 1 percent in Asia. Along the transition path to lower equilibrium output is a flight into the most liquid and safest assets—mainly cash—because of growing concern about prospects, and private and public risk premiums increase temporarily. In this scenario, global growth for 2013–16 is only about 2 to 3 percent, or 1½ to 2 percentage points below the baseline WEO forecast. The euro area and Japan would experience several years of stagnation or recession, whereas the United States would see positive but very modest growth. Eventually, advanced economies have some scope to ease monetary policy as the zero bound no longer binds, which helps support growth toward the very end of the WEO horizon and bring inflation back toward the baseline. Growth in emerging Asia would be closer to 5 to 6 percent, rather than 7 to 8 percent; in Latin America, it would be about 2½ percent rather than 4 percent as weaker global growth translates into significantly weaker demand for commodities. The price of oil falls by roughly 30 percent after three years, with prices for non-oil commodities falling by roughly 20 percent. These drops, in turn, lower growth in Africa and the Middle East. Developments in the real world could easily be much worse than the model suggests. The reason is that the model does not consider the social and political ramifications of rising unemployment; nor can it do justice to the adverse feedback loops between activity, banks, and sovereigns that can be triggered by unusually large shocks.

Figure 1.15.
Figure 1.15.

Lower Global Growth Scenario

(Percent or percentage point deviation from baseline)

This scenario uses the IMF’s Global Economy Model to trace the global macroeconomic implications of slower potential growth and temporarily higher risk premiums. For the United States and the euro area, this scenario assumes that annual potential output growth is ½ percentage point below baseline over the WEO horizon, whereas for Japan, growth is ¼ percentage point below baseline. In emerging Asia, potential growth is assumed to be 1 percentage point lower than baseline. For Latin American and all remaining countries, it is assumed that potential growth is ½ percentage point below baseline. It takes until mid-2015 before it becomes clear that potential growth will be lower until end-2017. For advanced economies, this raises debt-sustainability concerns, and sovereign risk premiums rise by 50 basis points by 2016 before gradually returning to baseline. As sovereign risk premiums rise, advanced economies gradually tighten fiscal policy. The fiscal balance improves by 1 percent of GDP by 2016, and then gradually returns to baseline once the debt-to-GDP ratio declines and risk premiums moderate. In emerging market and developing economies, lower growth prospects raise concerns about the viability of some private investment, and corporate risk premiums rise, particularly in the tradable sector. In this sector, corporate risk premiums peak roughly 200 basis points above baseline in 2016 in emerging Asia and about 150 basis points above baseline in Latin America. In the G3 (euro area, Japan, United States), monetary policy is constrained by the zero bound on nominal policy interest rates. For the first few years, interest rates cannot ease at all relative to the baseline, and beyond that, there is only limited scope for easing.

GDP growth in all regions is well below the WEO baseline between 2013 and 2016, with global growth roughly 2 percentage points lower in 2015. Eventually, advanced economies have scope to ease monetary policy, which helps support growth toward the end of the WEO horizon and bring inflation back toward the baseline. Lower global growth translates into weaker demand for commodities, and the price of oil falls by roughly 30 percent after three years, with non-oil commodities falling by roughly 20 percent.

Source: IMF staff estimates.Note: EM = emerging market and developing economies; MENA = Middle East and North Africa; SSA = sub-Saharan Africa.1Excluding South Africa.

Policy Requirements

Five years after the onset of the Great Recession, the recovery remains tepid and bumpy, and prospects remain very uncertain. Unemployment is unacceptably high in most advanced economies, and workers in emerging market and developing economies face a chronic struggle to find formal employment. Aside from the legacies of the crisis, uncertainty itself is likely to weigh on output (Box 1.3).

A basic challenge for policymakers is thus to move away from an incremental approach to policymaking and address the many downside risks to global activity with strong medium-term fiscal and structural reform programs in order to rebuild confidence. In the euro area, action is also needed to address the current crisis and, over the medium term, to complete the EMU. Only after substantial progress is made on these various fronts will confidence and demand strengthen durably in the major advanced economies. Investors will be reassured that public debt is a safe investment and that advanced economy central banks have scope to use monetary policy to maintain low inflation and forestall renewed bouts of financial instability. Policymakers in emerging market and developing economies will need to balance two priorities: rebuilding policy buffers so as to maintain hard-won increases in the resilience of their economies to shocks and supporting domestic activity in response to growing downside risks to external demand.

Addressing the Euro Area Crisis

Despite policy progress, the euro area crisis has deepened. Unless recent ECB actions are followed up with more proactive policies by others, the WEO forecast and GFSR baseline scenario may once again prove overly optimistic and the euro area could slide into the weak policies scenario, with deleterious consequences for the rest of the world.

Ensuring market confidence in the viability of the EMU will require robust action on multiple fronts. Sovereigns under stress must continue to adjust, and support for these countries and their banks needs to be provided via the EFSF and the ESM to relieve funding pressures and break the adverse feedback loops between sovereigns and banks. Meanwhile, the ECB’s commitment to act on secondary markets via the OMT program is very important to address elevated risk premiums due to convertibility concerns, and monetary policy should be very accommodative to support demand. Anticrisis measures must be anchored by the vision of—as well as reasonably fast and tangible progress toward—a more complete monetary union.

  • EU partners should support countries making adequate adjustment efforts but still subject to market pressure. While economies in the periphery must continue to adjust their fiscal balances at a pace they can bear, it is essential to ensure their access to funding at reasonable cost. Common resources can be channeled via the EFSF or the ESM—and countries in need should request those resources, with the goal of preserving or regaining market access.

  • Direct equity injections into banks are key to cutting bank-sovereign loops in the near term. For this to happen, the ESM needs to be made operational as soon as possible, and a single supervisory mechanism—a precondition for the ESM to take a stake in banks—should be established quickly, following up on the European Commission’s proposals to that effect. Viable banks should be recapitalized, but those that are nonviable should be resolved, in part to minimize fiscal costs.

  • An integrated regulatory and supervisory structure—a banking union—is indispensable for the smooth functioning of integrated financial markets in the EMU. Such a union should rest on four pillars: common supervision, harmonized regulation, a pan-European deposit guarantee scheme, and a pan-European resolution mechanism with common backstops. The last two building blocks are critical, and proposals for them still need to be spelled out.

Fiscal integration would provide critical tools to support a banking union, improve fiscal discipline, and enhance adjustment to idiosyncratic shocks while preventing them from becoming systemic. The immediate priority is to establish a common fiscal backstop for a banking union anchored on a single supervisory mechanism. More generally, fiscal risk sharing is an integral component of common currency areas. However, mutual support needs to be complemented by stricter and more robustly enforced rules and greater coordination of national policies—including through swift approval and sensible implementation of the Fiscal Compact (at the country level). There are different ways to achieve ex ante risk sharing, but all approaches would benefit from a clear road map.

Rebuilding Room for Fiscal Policy Maneuvering

Fiscal adjustment has become necessary in many cases to strengthen confidence in sovereign balance sheets and in many other cases because the prospects for future potential output—and hence revenue growth—are substantially less promising than they were before 2008. Unless governments spell out how they intend to effect the necessary adjustment over the medium term, a cloud of uncertainty will continue to hang over the international economy, with downside risks for output and employment in the short term.

Fiscal adjustment should be gradual and sustained, where possible, supported by structural changes, as, inevitably, it weighs on weak demand. Developments suggest that short-term fiscal multipliers may have been larger than expected at the time of fiscal planning (Box 1.1). Research reported in previous issues of the WEO finds that fiscal multipliers have been close to 1 in a world in which many countries adjust together; the analysis here suggests that multipliers may recently have been larger than 1 (Box 1.1).4 There are other reasons for avoiding abrupt adjustments: fiscal problems can be rooted in structural problems that take time to address, and sharp expenditure cutbacks or tax increases can set off vicious cycles of falling activity and rising debt ratios, ultimately undercutting political support for adjustment. The historical record for public debt reduction suggests that a gradual, sustained approach supported by structural changes offers the best chance for success within today’s constraints (Chapter 3).

To build credibility, governments should commit to measures and medium-term targets that are actually under their control. They must clearly explain how they will react to such setbacks as unexpected slowdowns in activity or increases in funding costs. Except in economies facing acute financing constraints, automatic stabilizers should be allowed to operate freely. Budget forecasts must be based on realistic assumptions about the negative short-term impact of adjustment on output and employment. Similarly, projections for the evolution of debt ratios should be based on realistic, not optimistic, assumptions about the growth of potential output and interest rates. In short, fiscal policy must be transparent, realistic, and predictable, and although geared toward medium-term objectives, it should be a stabilizing factor against short-term downturns or booms. Clear analogies can be drawn with the practice of successful monetary policy.

Among the advanced economies, planned fiscal adjustment is sizable over the near term. The main policy shortfalls, discussed in more detail in the October 2012 Fiscal Monitor, relate to the need for stronger commitment to a sound fiscal framework:

  • To anchor market expectations, policymakers need to specify adequately detailed medium-term plans for lowering debt ratios, which must be backed by binding legislation or fiscal frameworks. Among large advanced economies, the United States lacks such a plan, and Japan’s medium-term plan needs to be strengthened, notwithstanding the welcome legislative passage of the doubling of the consumption tax. U.S. authorities must now urgently deal with the debt ceiling and the fiscal cliff, which would severely affect growth in the short term; the Japanese authorities also need to quickly approve funding for this year’s budget.

  • Countries should go much further in reducing the growth of aging-related expenditures—an issue that they cannot avoid forever—because such reductions can greatly improve debt dynamics without detracting severely from demand in the short term.

  • More countries need to define targets in structural or cyclically adjusted terms and prepare contingency plans for coping with shocks. The first line of defense against shocks should be automatic stabilizers and monetary policy, including unconventional support and measures to improve the transmission of already low policy rates to demand. But these efforts might not suffice. Should growth fall significantly short of WEO projections, countries with room to maneuver should smooth their planned adjustment over 2013 and beyond.

  • Emerging market and developing economies typically have much lower public debt than do advanced economies and therefore less urgent need for fiscal adjustment, but they still should rebuild room for policy maneuvering. Deficits are appreciably larger than before 2008, even in countries that were not hit by the crisis. These countries have typically experienced a relatively quick recovery and are operating above precrisis trends. Therefore, now is an appropriate time for them to adopt fiscal consolidation to fully restore their flexibility to deal with unexpected adverse contingencies. They should leave the task of supporting demand in response to greater-than-expected external weakness to monetary policy.

Among the major emerging market economies, more effort is needed in India, Russia, and, over the medium term, Turkey. China, also slowing, is different for two reasons: first, the authorities are trying to rebalance economic growth toward consumption, which will require expanding social support programs, and second, less scope is available for credit growth because the economy is still digesting a large expansion of credit released in response to the Great Recession. Similarly, the major oil exporters are also increasing spending to address social challenges, which is helping to rebalance global demand. Over the medium term, however, these economies will need to bring spending growth down to more sustainable levels.

Supporting Adjustment with Liquidity

In many advanced economies, ample liquidity provision continues to be essential given the weakness of demand and the very protracted implementation periods for fiscal, financial, and structural adjustment. Prudential authorities must ensure that they control the risks that may be created by the extended period of low yields and exceptionally easy access to central bank funding. Easy credit provides incentives for excessive risk taking and also gives banks easy options for postponing desirable restructuring. Over time, very low interest rates may distort the efficient investment of savings, which is an underlying function of the financial system. Credible medium-term fiscal adjustment programs and banking system restructuring are extremely valuable supports to the monetary policy objective of keeping inflation expectations firmly anchored at a low rate while maintaining financial stability.

A widespread concern is that monetary stimulus is not reaching all markets evenly. Households and small companies struggle to obtain bank loans, whereas large corporations are paying record low rates in bond markets. In the euro area, bank lending is slumping in the periphery but still growing in Germany. Changes in borrower risk premiums in response to changes in economic conditions and tighter bank lending policies in response to strained capital and funding are playing important roles. However, large differences in financing conditions do not mean that monetary policy is not working. The actions taken by central banks have forestalled worse outcomes. In some euro area economies, such as France and Italy, credit has thus far fared better during the current recovery than during the post-1993 recovery, despite a much larger drop in output (Figure 1.16, panels 3–6). The same holds in comparison with U.S. credit after 1989 (Figure 1.16, panels 1 and 2). More generally, liquidity provision has prevented a collapse of the banking systems in the periphery economies.

Figure 1.16.
Figure 1.16.

Crisis Comparisons

(Index; years from crisis on x-axis)

Credit appears to be doing better after the Great Recession than after previous recessions associated with credit crises. For example, domestic credit in the United States has held up better than after 1989, notwithstanding a much sharper drop in output. The same holds for credit in France and Italy when compared with the European exchange rate mechanism (ERM) crisis, although real credit is now falling in Italy. In Spain, credit is doing less well, consistent with a larger drop in output. Overall, these output and credit developments suggest that low policy rates and unconventional measures have, thus far, helped avert a much deeper credit crunch. However, more action is needed to sustain and improve credit, especially in the euro area periphery.

Sources: IMF, International Financial Statistics; and IMF staff calculations.Note: Latest 2012 credit data are based on June 2012 levels.

Specific monetary policy requirements vary across economies. In many advanced economies, the stance should remain very accommodative, given that inflation expectations are well anchored, headline and core inflation are receding, and activity is typically well below potential. Policymakers should continue to help reduce risk premiums and improve the transmission of monetary policy to the real economy, with direct interventions in key asset markets or with measures to strengthen banks’ incentives to lend, such as the Bank of England’s FLS. The specific policy requirements for the major economies are the following:

  • The Federal Reserve has recently adopted strong measures to ease monetary and financial conditions, consistent with high unemployment and headline inflation that is projected to drop below 2 percent. The traction of these and previous unconventional measures would be greatly enhanced if more progress were made in mortgage debt relief for overly burdened households and in the reform of the housing market.

  • In the euro area, underlying inflation pressure is low—core inflation has been running about 1½ percent for some time, with tax and administrative price hikes contributing about ¼ to ½ percentage point. Headline inflation is forecast to decline to about 1½ percent during the course of 2013, and risks from domestic wages and profits are to the downside—the IMF staff’s Global Projection Model suggests that the probability of falling prices is unusually high, reaching almost 25 percent (Figure 1.12, panel 2). This projection gives the ECB ample justification for keeping policy rates very low or cutting them further.

  • In Japan, inflation is forecast to remain near zero in 2012 and 2013. The easing of monetary policy announced in September is welcome and should help support economic growth and an exit from deflation. However, further easing of monetary policy may be needed to accelerate achievement of the Bank of Japan’s (BoJ’s) inflation goal of 1 percent, supported by enhanced communication of the policy stance and framework. Any further easing by the BoJ could include purchasing Japanese government bonds with longer maturities, as well as selected private paper.

Among emerging market and developing economies, policy requirements differ, but many can afford to wait and see or to ease policy further because of downside risks to activity. Headline and core inflation are generally declining. The main reason for caution is that although credit growth rates have recently come down, they remain at fairly elevated levels (Figure 1.14, panels 2 and 3). Supervisory and macroprudential measures should be employed to counter any emerging credit bubbles, such as in real estate.

  • In emerging Asia, headline and core inflation rates have been low or declining. In many economies, inflation is forecast to be close to 3 percent over the medium term. Credit has expanded rapidly in a number of these economies (China, India) and is still expanding quickly in some (Indonesia and, to a lesser extent, Malaysia); several have also seen booming real estate prices. Various economies’ currencies are undervalued relative to medium-term fundamentals (China, Malaysia, Thailand). Considering this credit and exchange rate picture, these countries should wait and see or consider modest further easing of monetary policy stances and rely mainly on fiscal policy to support demand. Those with less fiscal space could proceed to more monetary easing, provided macroprudential measures keep credit growth in check. Those with high inflation (India, Vietnam) cannot afford to loosen monetary policy unless they slow down domestic demand with more fiscal adjustment.

  • In Latin America, many economies are forecast to operate with inflation near or below 5 percent in 2013, which is appreciably less than in 2011. High credit growth rates bear watching. Considering the downside risks to the global growth outlook, many central banks can afford to hold steady; if these risks materialize, they can reduce policy rates. High or rising real estate prices or growing household debt burdens, notably in Brazil, call for continued vigilence by policymakers. Central banks in economies with relatively high inflation (Argentina, Venezuela) will need to tighten further.

  • Inflation rates are low or forecast to decline noticeably in many emerging European economies, typically to about 3 percent. There is therefore room for easing in various economies in response to very high unemployment rates and sluggish activity. Much higher and more volatile inflation in the CIS stands in the way of lower policy rates. The same holds for a number of economies in the MENA region and SSA.

Sharp increases in food prices present significant challenges for policymakers on many fronts (see the Special Feature). Regarding monetary policy, the concern is that the heavy weight of food in the consumption baskets of poorer households could trigger a push for higher wages and thus second-round effects on inflation. In this setting, monetary policymakers need to communicate that they will tighten policy if threats of second-round effects build. Until they do, however, central banks should not react to food prices, which would destabilize output and inflation over the medium term.5

Advancing Global Demand Rebalancing

The slowdown in global trade and activity has been accompanied by a marked narrowing of global imbalances, and this is projected to persist (Figure 1.17, panel 1).6 As discussed in the April 2012 WEO and a recent IMF Pilot External Sector Report (IMF, 2012d), most of this narrowing reflects weaker domestic demand from crisis-stricken, external-deficit economies rather than stronger demand from external-surplus economies. But healthier adjustments have taken place—improvements in fiscal balances in external-deficit economies, resilient domestic demand in China, and more social spending by oil exporters—which are bringing down their large surpluses.

Figure 1.17.
Figure 1.17.

Global Imbalances

Global current account balances narrowed sharply during the Great Recession and are not projected to widen again, except for the contribution of emerging Asia. Exchange rate developments since the onset of the crisis have been consistent with global demand rebalancing. However, the appreciation of external surplus currencies has stopped during the past eight months. IMF staff assessments suggest that current account balances remain larger than desirable in emerging Asia and weaker elsewhere. Sustained accumulation of international reserves in these economies is contributing to global current account imbalances and associated vulnerabilities that are larger than desirable.

Sources: IMF, International Financial Statistics; and IMF staff estimates.Note: CHN+EMA: China, Hong Kong SAR, Indonesia, Korea, Malaysia, Philippines, Singapore, Taiwan Province of China, and Thailand; DEU+ JPN: Germany and Japan; LAC: Latin America and the Caribbean; OCADC: Bulgaria, Croatia, Czech Republic, Estonia, Greece, Hungary, Ireland, Latvia, Lithuania, Poland, Portugal, Romania, Slovak Republic, Slovenia, Spain, Turkey, and United Kingdom; OIL: oil exporters; ROW: rest of the world; US: United States.1Classifications are based on the IMF staff’s Pilot External Sector Report (2012d), which covers Australia, Belgium, Brazil, Canada, China, euro area, France, Germany,Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Malaysia, Mexico, Netherlands, Poland, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Thailand, Turkey, United Kingdom, and United States.2These economies account for 12.3 percent of global GDP.3These economies account for 7.3 percent of global GDP.4These economies account for 4.8 percent of global GDP.5Estimated differences between cyclically adjusted current accounts and those consistent with fundamentals and desirable policies (percent of GDP).6Bahrain, Djibouti, Egypt, Iran, Jordan, Kuwait, Lebanon, Libya, Oman, Qatar, Saudi Arabia, Sudan, Syria, United Arab Emirates, and Yemen.7Bulgaria, Croatia, Hungary, Latvia, Lithuania, Poland, Romania, and Turkey.

In the euro area, imbalances have narrowed but mainly because of lower demand in the deficit economies of the periphery; labor costs have adjusted relative to the core but this process has much further to go (Figure 1.18, panels 1–3). Adjustments in surplus economies toward stronger, domestic-demand-driven growth are at an early stage. External indicators for Germany, the main surplus country, suggest that its internal demand rebalancing process is less advanced than that of Japan or China (see Figure 1.9). Furthermore, major adjustment is still needed in the deficit economies, notably Greece and Portugal, to reduce their net foreign liabilities to 35 percent of GDP, the indicative guideline under the European Commission’s Macroeconomic Imbalance Procedure (Figure 1.18, panel 4).

Figure 1.18.
Figure 1.18.

Euro Area Imbalances

Current account imbalances have also narrowed within the euro area, reflecting mainly a collapse of demand in the deficit economies in the periphery rather than stronger demand in surplus economies, such as Germany and the Netherlands. Since the onset of the crisis, unit labor costs have grown less in the deficit economies than in the surplus economies, but more adjustment will be needed. Reducing global and euro area current account imbalances will also require further policy changes. In external-deficit economies, these include reducing large fiscal deficits, slowing entitlement spending, and, within the euro area, reforming labor and product markets. In external-surplus economies, policies should improve social protection and remove a variety of distortions.

Sources: Eurostat; and IMF staff estimates. Note: PPP = purchasing power parity.1Greece, Ireland, Italy, Portugal, Spain.2Excludes five periphery economies.3Classifications based on the IMF Staff’s Pilot External Sector Report (2012d), which covers Australia, Belgium, Brazil, Canada, China, euro area, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Malaysia, Mexico, Netherlands, Poland, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Thailand, Turkey, United Kingdom, and United States.4Austria, Belgium, Finland, Germany, Luxembourg, and Netherlands.5Required adjustment of the trade balance between 2012 and 2020 to lower net foreign liabilities to 35 percent of GDP by 2030, assuming that the nominal external interest rate is 3 percent and that the nominal GDP growth rate stays at the level projected for 2017.6Germany, Netherlands.

Despite recent improvements, global imbalances and the associated vulnerabilities are likely to remain well above desirable levels unless governments take additional, decisive action (IMF, 2012d). The current account positions of the G3 economies are all estimated to be weaker and their real effective exchange rates stronger than desirable because of unduly large fiscal deficits (Figure 1.17, panel 3). By contrast, in many Asian economies, including China, Korea, Malaysia, Singapore, and Thailand, current account positions are stronger and currencies weaker than they would be with a more desirable set of policies. Several of these economies have accumulated very high levels of official reserves or have internal distortions that hold back consumption (Figure 1.17, panel 4). Among the large economies of the euro area, policies that would result in stronger domestic demand for Germany and stronger competitiveness for France, Italy, and Spain would be beneficial.

It must be emphasized that the policies that would most effectively lower global imbalances and related vulnerabilities serve the self-interests of the countries concerned, even when considered purely from a domestic viewpoint (Figure 1.18, panel 5). Many external-deficit economies need strong medium-term fiscal adjustment programs—the need is urgent for the United States. In the euro area, much of the planned adjustment in the periphery economies would be warranted regardless of their external positions, and such fiscal efforts must be complemented with structural reforms to labor and product markets that help rebuild competitiveness. The requirements for emerging market economies with external surpluses and undervalued currencies are to cut back official reserve accumulation, adopt more market-determined exchange systems, and implement structural reforms, for example, to broaden the social safety net.

Improving Growth Prospects with Structural Policies

Structural problems shape much of the legacy of the Great Recession. They also contribute to wide global current account imbalances, which have exacerbated the crisis in the euro area. The impact on growth of reforms to alleviate these structural problems can be significant. In an upside policy scenario produced by the IMF staff for the G20 Mutual Assessment Process, most of the 2½ percent increase in global output is generated by reforms to labor and product markets and the beneficial spillovers via international trade (IMF, 2012e). Through confidence and wealth effects and by facilitating relative price adjustments, structural reforms can promote aggregate demand, particularly investment, over time. But these benefits are unlikely to accrue unless such reforms are supported with macroeconomic policies that lower uncertainty and improve confidence among investors.

Structural policies in crisis-hit economies

Household debt and bank restructuring: Although only a few countries have adopted effective household debt restructuring programs, others should consider following their lead. Programs in the United States got off to a sluggish start, but the recent expansion of the modification and refinancing programs is welcome. Further steps would help support a recovery of the housing market. These could include participation by government-sponsored enterprises in the principal reduction program, implementation of the administration’s proposal to further expand refinancing, timely expansion of the program aimed at fostering conversion of foreclosed properties into rental units, and permitting mortgages to be modified in bankruptcy courts. Other economies suffering from housing market slumps may also benefit from policies to directly alleviate household debt.7

Progress in financial sector reform, which is critical to building a safer global economy, has been patchy. Chapter 3 of the October 2012 GFSR observes that a host of regulatory reforms are under way but that the structure of financial intermediation remains largely unchanged and vulnerable. Areas that require further attention from policymakers include a global-level discussion of the pros and cons of direct restrictions on business models, monitoring and a set of prudential standards for nonbank financial institutions that pose systemic risks, incentives for the use of simpler financial products, further progress on recovery and resolution planning for large institutions, and cross-border resolution. Crucially, none of the current or prospective reforms will be effective in the absence of enhanced supervision, incentives for the private sector to follow the reforms, and the political will to deliver progress.

Bank restructuring has advanced on a broader front. Many countries have adopted programs to strengthen bank balance sheets and to tide banks over during temporary liquidity difficulties. Capital bases have been strengthened: between 2008 and 2011, for example, large European and U.S. banks raised common-equity-to-asset ratios by about one-fifth and one-third, respectively. They also reduced their reliance on wholesale funding, although such funding remains extensive in Europe. However, the worsening euro area crisis and weak global economy are posing increasingly severe banking difficulties. Prudential authorities must continue to push balance sheet repair and, where necessary, impose losses on bank stakeholders and force recapitalization. This may require the injection of public funds or the winding-up of weak institutions. In the periphery economies of the euro area, external support in the form of equity injections is critical to breaking the vicious feedback loops between deteriorating sovereigns and weakening banks.

Labor and product market reform: Progress has been uneven. A number of countries, especially in the euro area, are beginning to take action to improve the functioning of their labor markets, but there has been less action to tackle stubborn long-term unemployment or to reform the markets for products and, especially, for services.

Labor market reforms can boost employment in various ways. Reforms can lower hiring and firing costs or reduce minimum wages when they are high enough to undercut employment of the young or the less skilled. Such reforms are under way in Italy and Spain. Trilateral agreements between unions, employers, and their governments can be an important element of reform efforts by helping coordinate relative labor cost adjustment, which is essential for realigning competitiveness between deficit and surplus economies in the euro area. Unions and employers can also develop more flexible collective wage bargaining agreements, as they have done with much success in Germany. To the extent that large-scale wage cuts occur in deficit economies, households may need help to cope with their debt burdens, underscoring the significance of effective household debt restructuring programs. Active labor market policies can have very positive effects on employment by promoting better job matching and supporting education and vocational training for workers displaced by sector-specific shocks, such as the collapse of construction activity in Spain and the United States. Labor force participation can be buoyed by subsidies for jobs filled by the long-term unemployed or jobs created by small and mediumsize firms, many of which are finding it hard to obtain credit.

In various economies, especially in Europe, reform of the services sector should be accelerated, not least to help generate more employment over the medium term. Stronger competition and lower barriers to entry would help ensure that lower wages result in more job creation rather than higher profits for firms. The business environment in various euro area economies also needs to be improved by reducing procedures and costs that weigh on entrepreneur-ship and by streamlining bankruptcy proceedings to better defend property rights and facilitate exit of inefficient firms (Barkbu and others, 2012).

Structural reforms to facilitate global demand rebalancing

Structural reforms will be important in boosting growth and fostering global demand rebalancing while reducing associated vulnerabilities. In surplus countries such as China and Germany, reforms are needed to boost domestic demand; in deficit countries such as Brazil and India, they are needed to improve supply.

  • In Germany, structural reforms will be needed to boost the relatively low level of investment and, more generally, increase potential growth from domestic sources. In the near term, the underlying strength in the labor market should foster a pickup in wages, inflation, and asset prices, and this should be seen as part of a natural rebalancing process within a currency union. By way of example, inflation in Germany and the Netherlands, the other major surplus economy in the euro area, would have to be about 3 to 4 percent to keep euro area inflation close to the ECB’s target of “below but close to 2 percent,” if inflation in Greece, Ireland, Italy, Portugal, and Spain were kept around zero to 1 percent and inflation elsewhere remained in line with the ECB target. This underscores the importance of wage and spending adjustments in the surplus economies for the proper functioning of the EMU.

  • Previous reports for China have stressed the need for better pension and health care support to lower precautionary saving and boost consumption. Progress is being made on these fronts, but the measures will take time to exert their effects on demand. Meanwhile, support for demand continues to come mainly from measures that support more investment. An obvious risk is that the quality of bank lending could be further lowered, adding to already ample capacity in the export sector or boosting already-high real estate prices.

  • In India, there is an urgent need to reaccelerate infrastructure investment, especially in the energy sector, and to launch a new set of structural reforms, with a view to boosting business investment and removing supply bottlenecks. Structural reform also includes tax and spending reforms, in particular, reducing or eliminating subsidies, while protecting the poor. In this regard, the recent announcements with respect to easing restrictions on foreign direct investment in some sectors, privatizations, and lowering fuel subsidies are very welcome.

  • Brazil’s consumption boom has been a large component of its strong growth performance, and domestic saving and investment remain relatively low. Reforms could usefully focus on further developing the defined-contribution pillar of the pension system, streamlining the tax system, and developing long-term financial instruments.

Special Feature: Commodity Market Review

The first section of this special feature discusses developments in commodity prices, and the second confirms that fluctuations in demand have played a key role in the drop in prices during the second quarter of 2012. The important complementary role of supply developments is discussed for energy markets in the third section and for food markets in the fourth, as these contributed to sharp price increases during the third quarter of 2012. The special feature concludes with the outlook for commodity markets.

Price Developments during 2012

Broad developments

After a robust recovery during 2009–10, the IMF’s Primary Commodities Price Index (PCPI) stayed essentially flat during 2011 and then fell during the second quarter of 2012, only to stage a comeback in the third quarter (Figure 1.SF.1). The PCPI is a weighted average of prices for 51 primary commodities, grouped into three main clusters—energy, industrial inputs (mainly base metals), and edibles (of which food is the main component—Table 1.SF.1). Among the three clusters, energy and base metal prices declined during the second quarter by nearly 30 and 20 percent, respectively, from their first quarter peaks. Although metal prices have leveled off during the third quarter, energy prices increased sharply once again, by about 13 percent (through August). Food prices remained broadly flat until mid-June, but have increased since then, by about 10 percent.

Figure 1.SF.1.
Figure 1.SF.1.

IMF Commodity Price Index

(2005 = 100)

Source: IMF, Primary Commodity Price System.
Table 1.SF.1.

Indices of Market Prices for Nonfuel and Fuel Commodities, 2009–12

(2005 = 100, in U.S. dollar terms) 1

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Source: IMF, Primary Commodity Price System.

Weights are based on 2002–04 average world export earnings.

Provisional.

Average petroleum spot price. Average of U.K. Brent, Dubai Fateh, and West Texas Intermediate, equally weighted.

Energy prices

The prices of petroleum, natural gas, and coal together have a weight of nearly two-thirds in the PCPI; petroleum alone accounts for more than half of the index. The average petroleum spot price (APSP)—a simple average of the Brent, Dubai, and West Texas Intermediate (WTI) crude oil varieties—increased from a low of $35 a barrel in late 2008 to a high of $120 a barrel in March 2012. Since then, oil prices declined during the second quarter only to climb back during the third, albeit with some volatility. Implied volatility remained moderate when compared with the spikes after the Libyan revolution in 2011 but picked up during the summer months (Figure 1.SF.2).

Figure 1.SF.2.
Figure 1.SF.2.

Oil Prices and Volatility

Sources: Bloomberg, L.P.; and IMF staff calculations.Note: As of September 11, 2012.1Average petroleum spot price (APSP) is a simple average of Brent, Dubai Fateh, and West Texas Intermediate (WTI) spot prices.2CBOE = Chicago Board Options Exchange.

Metal and food prices

These two components comprise the remaining third of the PCPI, each receiving a similar weight. After a strong rally earlier in 2012, base metal prices declined in tandem with petroleum prices—albeit less sharply—during the second quarter and have leveled off somewhat during the third quarter (Figure 1.SF.3). After remaining broadly flat for much of the year, food prices started to pick up strongly in mid-June. Grain and soybean prices rose, offsetting the weakness in seafood, sugar, and vegetable oil prices. Implied volatility also rose significantly (Figure 1.SF.4).

Figure 1.SF.3.
Figure 1.SF.3.

Base Metal Spot Prices

(Indices; January 1, 2007 = 100)

Sources: Bloomberg, L.P.; and IMF staff calculations.Note: As of September 11, 2012.
Figure 1.SF.4.
Figure 1.SF.4.

Food Prices and Volatility

Sources: Bloomberg, L.P.; and IMF staff calculations.Note: As of September 11, 2012.1ATM = at the money.

Economic Activity and Commodity Prices

A tight link with demand

Fluctuations in economic activity and in the outlook are the primary determinants of short-term commodity price movements, with some caveats. First, on occasion, causality goes the other way: supply disruptions can sometimes lead to price spikes and declines in economic activity (Hamilton, 2008). Second, developments on the supply side or concerns about supply depletion can be important enough to break the tight connection between economic activity and commodity prices even if they are not significant enough to derail economic activity (see Benes and others, 2012, for the case of oil prices). Third, concerns that speculative commodity trading has decoupled price movements from economic activity have been a constant refrain during the past few years despite the lack of conclusive supporting evidence.1

These caveats notwithstanding, a tight link between economic activity and commodity price fluctuations is evident in the data, and this appears to be the leading factor behind the broad commodity price declines during the second quarter. Commodity markets rallied somewhat in early 2012 on the back of recovering market confidence in response to the European Central Bank’s longer-term refinancing operations as well as better-than-expected global growth in the first quarter. However, with renewed setbacks to the global recovery in the beginning of the second quarter, leading indicators pointed to a synchronized slowing in the momentum of global act