The economic recovery is under way, with upward revisions to global growth as financial markets normalized faster than expected and policy stimulus took effect. The upswing in advanced economies is still muted and dependent on policy support. In contrast, many emerging markets are experiencing a more vigorous upswing amid easy financing conditions and rising commodity prices.
The Global Backdrop—A Recovery with Uneven Speed
Extraordinary levels of fiscal and monetary stimulus are supporting a global recovery from the severe recession that followed the financial crisis. Fiscal expansions in the major countries—averaging about 2 percent of GDP in 2009 in the advanced G20 countries, and about 2½ percent of GDP in the emerging G20 countries—launched in the first part of 2009 began to have their full effects in the second half of the year. Highly expansionary monetary policies—with policy interest rates at their minimum and unconventional easing—that were deployed in a number of countries during the crisis have since supported both demand and financial stability. With confidence improving and financial conditions easing, global trade and manufacturing production recovered strongly, and commodity prices rebounded since their nadir early 2009 (Figure 1.1). Commodity prices are projected to remain high in 2010–11 on limited excess capacity in the sector and on the strong cyclical position of some key emerging markets. Nevertheless, potential inflationary pressures should not derail the recovery.
At the same time, signs of a self-sustaining recovery in private demand in the major economies remain scant. Consumption growth generally remained muted into 2010, notwithstanding substantial improvements in household confidence and tentative signs that the deterioration in labor markets is ending. Investment activity started to pick up in late 2009, but with financial intermediation not fully restored and excess capacity still high, prospects are poor for a sustained investment boom that would lead the recovery. Indeed, much of the recent strength in advanced economy demand reflected a sharp turn in the inventory cycle, reflecting the overshooting that deepened the recession when stock levels were slashed. Advanced economies are expected to register 2 percent growth in 2010, following a contraction of 3¼ percent in 2009—the slow recovery showing the persistent drag from consumer and bank balance sheet repairs and weak labor markets. Over the medium term, some permanent output loss is expected as the legacy of the crisis.
But an increasing number of emerging and developing countries are showing signs of strength in early 2010. During the recession, most of these countries avoided domestic financial instability and, where possible within domestic constraints, deployed their own stimulus to support activity. From mid-2009, growth in emerging and developing countries has been spurred by the sharp turnaround in global trade, and some countries have benefited from the recovery in global commodities prices, particularly for energy and metals. Emerging and developing economies are anticipated to post 6 percent growth in 2010, up from about 2 percent in 2009, led by strong growth in developing Asia.
Meanwhile, global financial conditions eased since the height of the global crisis but remain challenging in some segments—particularly for bank lending in advanced economies (Figure 1.2). Money markets have stabilized and the tightening in bank lending standards has moderated. That said, bank balance sheets remain under strain, with capitalization still weak and credit losses continuing to mount. Most financial intermediaries continue to deleverage, and borrowers without access to capital markets (consumers and SMEs) face credit constraints. On the other hand, capital markets have been buoyant, and investment grade borrowers—including emerging market sovereigns—were able by early 2010 to issue bonds at close to precrisis rates. Work is progressing with drawing regulatory lessons in the aftermath of the crisis (Box 1.1).
Global liquidity is ample, and risk aversion has declined from its crisis highs, easing conditions for emerging markets. With emerging market growth prospects improving, some emerging market economies have experienced sizable inflows since mid-2009, along with upward pressures on their currencies in some cases. Key asset valuations for advanced emerging markets have recovered to precrisis levels. However, fragile risk appetite and risks in selected countries could yet spur a retrenchment from risk-taking (as appears to have occurred earlier this year amid market concerns about Greece), dampening capital inflows to emerging and developing countries.
The “multispeed” recovery calls for country-specific adjustments to policy settings. In major economies, output gaps are large and the shift from public to private support to growth is still ongoing. At the same time, some emerging markets have already staged a private-demand driven recovery, are operating close to capacity, and are attracting capital inflows. The different challenges clearly call for variation in the speed and sequencing of postcrisis exit from supportive policies. In major advanced economies, exit will remain slow, their low monetary policy rates contributing to easy financing for emerging markets for some time. Over the medium term, exit policies—including gradual fiscal adjustment in the United States—should also contribute to slowly reducing policy shortcomings that gave rise to global imbalances (Box 1.2).
United States—Recovery Is Still Policy Driven
Policy stimulus and the inventory cycle have propelled a recovery in U.S. economic activity (Figure 1.3). GDP rose by 5.6 percent (seasonally adjusted annual rate) in the fourth quarter of 2009, reflecting acceleration in investment and a slowdown in inventory destocking (the latter of which contributed more than half of GDP growth). The contribution of net exports swung from negative to positive, as export growth picked up amid the revival of global demand, while import growth eased.
Recent Developments in Financial Regulation Reforms
The ongoing financial regulatory reform process—spearheaded by the G20—is aimed at addressing the inadequacies in the regulatory framework that the crisis has revealed. The process is gradually yielding recommendations at both the national level and internationally, which is generating some regulatory uncertainty for the financial sector.
Proposals are most advanced in the area of strengthening bank capital. Enhancements to the Basel II capital framework—specifying higher capital requirements for banks’ trading books and some securitizations—were announced in mid-2009, and are to be implemented by end-2010.
Other reform proposals (announced in December 2009) focusing on bank capital and liquidity are yet to be finalized, with the final calibration for capital requirements announced by end-2010 and implementation by end-2012. The proposals target:
Improving the quality of bank capital (by increasing the share of common equity in Tier 1 capital; harmonizing the definition of Tier 2 capital internationally; and enhancing the risk coverage of the capital framework, for example, with respect to counterparty risk).
Supplementing risk-based capital requirements with a leverage ratio, with details yet to be worked out.
Dampening procyclicality (by conservative adjustments to capital adequacy to reflect stressed periods; forward-looking provisioning; building up target capital buffers; and upward adjustment of capital buffers after a period of rapid credit growth). Work on the details of the proposals is ongoing.
Addressing systemic risk and interconnectedness (through a better-calibrated asset value correlation factor in internal ratings that would imply higher capital requirements for exposures to large regulated financial firms or to unregulated leveraged entities such as hedge funds).
Reducing the reliance on external ratings in the capital adequacy framework.
Introducing internationally common standards of minimum high quality liquidity buffers, with the dual aim of (i) being able to meet liquidity outflows over a 30-day stress period; and (ii) matching liability and asset profiles over a 1-year horizon.
Recommendations in other areas are less advanced. The framework for macroprudential supervision is still evolving, with a view to alleviating credit cycles and interconnectedness risks. Discussions on issues related to systemic risk and systemically important institutions are complicated by, among other things, political and legal issues. On the agenda are extending the regulatory perimeter, introducing differential prudential regulations for systemically important institutions, possibly creating a systemic risk regulator, setting up a resolution framework for systemically important institutions, and rethinking regulator issues in the OTC derivative and securitization market.
Of course, these proposals do not cover all areas where improvements would be needed to strengthen financial stability. Ensuring adequate supervisory responses, improving risk management and governance in the financial sector, and leveling the playing field internationally (by proper and consistent implementation of prudential standards) and across sectors (by stepping up lagging reforms in the insurance sector and securities markets) remain outstanding tasks.Note: This box was prepared by Aditya Narain and Kornélia Krajnyák.
Rebalancing Global Demand: What Will Take Up the Baton from the U.S. Consumer?
What could take up the slack in global demand left by lower U.S. consumption as U.S. households strengthen their balance sheets in coming years? The task of filling that gap is nontrivial: U.S. private consumption is among the largest quanta in the global economy, amounting to $9.3 trillion in 2006—the last full precrisis year (see figure, upper panel). Suppose that this level is permanently lower by 10 percent—roughly corresponding to the percentage difference between staff’s projected consumption over the medium term versus the level that would have prevailed if consumption had continued to grow at precrisis rates from 2007 forward. What type of adjustment in other quanta—say, U.S. exports and (the counterpart) imports of partner countries—would be necessary to fill that gap? (Of course, making up for a permanently lower growth rate of consumption would pose still larger challenges—but for simplicity, let us deal with levels rather than growth rates.)
One part of the adjustment would occur through lower imports, though the effect might not be very large. In particular, lower consumer spending would mean reduced imports of consumer goods—but about 70 percent of consumption is services, and consumer goods imports are modest in comparison. In 2006, imports of consumer goods totaled about $446 billion, against nominal private consumption of about $9.3 trillion (comparing NIPA-basis numbers). To be sure, this understates the importance of imports considerably, as it excludes automotive products ($256 billion including parts), as well as intermediate inputs that are transformed into consumer goods (for example, oil). Nevertheless, the comparatively low overall volume implies a modest impact even if consumer goods imports are sensitive (say, with an elasticity of 2) to consumption compression.
If the remaining adjustment fell on exports, it would require a very large increase—given exports of about $1.4 trillion, an increase of about 60 percent. Historical increases in U.S. exports have typically been somewhat smaller (see figure, lower panel). The largest trough-to-peak cumulative surges in real U.S. exports totaled about 40–45 percent, occurring over several years. In two of four instances, they coincided with a significant depreciation of the U.S. dollar. And in two episodes, they also coincided with (or came in the wake of) significant policy initiatives—the end of Bretton Woods in the early 1970s and the Plaza/Louvre period in the 1980s. Finally, export surges also were accompanied by periods of substantial partner country growth (cumulative growth of up to 15 percent). In short, surrounding circumstances were quite favorable to exports—and perhaps unusually favorable.
Of course, a counterpart increase in other countries’ total imports from the United States of the same magnitude would also be required. For example, the adjustment relative to the overall imports (from all countries) of the 15 countries with the largest external surpluses would be nontrivial, but not huge—12 percent. But U.S. exports are disproportionately bound for G7 countries—some US$400 billion go to the G7, almost twice that for Latin America and the Caribbean or Asia. Given the relatively modest share of U.S. exports that presently go to emerging market economies, if the adjustment fell on the top seven emerging market surplus economies, their imports would need to increase by about 45 percent; and if (for the sake of illustration) the adjustment fell solely on China, its overall imports would need to increase by about 100 percent. Using a rule of thumb for the elasticity of imports with respect to domestic demand of 2, this would imply increases in domestic demand in those countries of about half those magnitudes.
All these elements, and more, would likely need to come together to gradually fill in the U.S. consumption gap. U.S. exports and imports are quite small compared with private consumption, and they would need to adjust together to generate the required quantities. Relatedly, should a real depreciation in the U.S. dollar occur, the switch away from imports and toward exports may be better incentivized. And finally, domestic demand overseas would need to increase—as counterpart demand to the higher supply of U.S. exports.Note: This box was prepared by Charles Kramer and Kornélia Krajnyák.
Although the free fall of housing investment ended in mid-2009, it remained depressed through the year despite support from the Federal Reserve’s mortgage-backed securities purchase program and tax credits. Meanwhile, investment in nonresidential structures continued to contract sharply in the second half of 2009 owing to the ongoing deterioration in the commercial real estate market. Private consumption growth ticked down by late 2009, as spending on durables faded with the ending of the “cash for clunkers” program.
Labor market conditions have begun to stabilize but remain grim. In March 2010, the unemployment rate stood at 9.7 percent—still 2 percentage points above levels a year ago, and about 25-year highs. Long-term unemployment and labor underutilization (including discouraged workers) similarly remain elevated and are close to historical highs. Moreover, labor market conditions are much worse in sectors such as construction—which remains under pressure despite coming off its lows—and for Hispanic workers, for which March unemployment rates were 24.9 percent and 12.6 percent, respectively.
Despite upward revisions to growth projections, prospects remain for a muted recovery. The IMF forecasts growth of 3.1 percent in 2010—significantly stronger than the 1.5 percent projected in the 2009 October World Economic Outlook, but still weaker than in previous recessions. Growth would decelerate to 2.4 percent in 2011, as the output gap narrows, the inventory cycle matures, and the fiscal stimulus fades. The unemployment rate would decline gradually, lagging the recovery in activity (as is typical historically). Inflationary pressures would remain contained, with substantial excess capacity in labor and product markets. Overall, the profile of the recovery would be consistent with an economy pushing against the twin headwinds of weaknesses in household and financial institution balance sheets.
Risks are relatively balanced in 2010, but tilted to the downside for 2011. In the near term, residential housing and commercial real estate pose downside risks to growth. However, these are broadly counterbalanced by a stronger than expected inventory cycle. But beyond the very near term, downside risks predominate, including the risks of a worse outcome in the real estate markets with higher-than-anticipated foreclosure rates. Over the medium term, risks associated with higher interest rates are growing owing to concern over fiscal balances.
In this context, U.S. macroeconomic policy is likely to maintain a highly supportive tilt for the future (Figure 1.4). Although the U.S. Federal Reserve has continued to elaborate its exit strategy and wind down emergency liquidity facilities, it has also continued to signal that the policy rate is set to remain at exceptionally low levels for an extended period (see Box 1.3). Consistent with this, futures markets and private forecasters expect no significant tightening in Federal Reserve policy during 2010, with some expecting the Federal Reserve to remain on hold through mid-2011. Fiscal policy is stimulative in 2010—including through recent initiatives to extend support to the jobless and the labor market—and the 2011 budget proposal includes additional short-term support to the economy and jobs. But beyond the near term, the main macroeconomic policy challenge for the United States is getting its fiscal imbalances under control. Although the recent health care reform will increase coverage and modestly help reduce medium-term deficits, determined further fiscal adjustment (including steps to raise revenues and control medical costs) will be key for the medium-term fiscal outlook. Absent adjustment, staff project public debt to rise above 100 percent of GDP over the next decade—with growing risks associated with higher interest rates resulting from fiscal concerns.
U.S. Monetary Policy: How Low for How Long?
An unprecedented easing of monetary policy has been a central element of the U.S. policy response to the crisis. The Federal Reserve has deployed unconventional monetary policy measures—a variety of innovative liquidity facilities along with “credit easing” measures to support financial market functioning. As financial strains faded, many of these facilities have wound down, particularly those aimed at liquidity conditions. Asset purchases continued through end-March but at a decreasing pace. As the crisis broke, the Federal Reserve successively cut rates (from 5¼ percent), bringing the target to 0–25 basis points by December 2008, an all-time low.
How soon would the Federal Reserve be likely to reverse its easing cycle? Incoming data and the outlook suggest a highly accommodative stance for some time. Economic slack remains high: the unemployment rate has ticked down from the 26-year high of 10 percent, but it is still elevated and likely to decline only gradually. Meanwhile, core inflation has continued to soften, and long-term inflation expectations have remained stable. And although financial conditions have considerably improved, they remain on the tight side.
Market data are consistent with expectations that the Federal Reserve would remain highly accommodative in the near term. Market analysts also predict a gradual tightening. At end-2006, the federal funds futures curve priced in a policy rate at about 5 percent over the coming 24 months. (Federal funds futures prices should be read with care. Contracts are somewhat illiquid, particularly at longer tenors, and may include a term premium.) By end-2008—with the Federal Reserve target at an all-time low—the curve had collapsed, showing rates persisting at low levels. Since then, the federal funds curve has steepened, now pricing in an implied policy rate of about 2 percent in two years—still a low level. The Blue Chip panel of forecasters predicts a path broadly consistent with the federal funds futures market. Some analysts, particularly those with more bullish economic forecasts, predict faster tightening. But others—notably those at two large investment banks—see no Federal Reserve tightening until mid-2011.
In summary, although “how low” and “how long” can be debated, the consensus is that U.S. monetary policy will remain highly accommodative for a long time. Indeed, the latest Federal Open Market Committee statement again noted that “the Committee … continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.” Accordingly, U.S. monetary policy is likely to tilt global financial conditions—including for capital flows to emerging market countries—to the easy side for some time to come.Note: This box was prepared by Charles Kramer.
Canada—Recovery Is Getting Entrenched
By contrast with the United States, domestic demand has remained relatively resilient in Canada. Canada was significantly affected by the global recession, with a sizable drop in output amid the worldwide collapse in trade and commodity prices (Figure 1.5). Nevertheless, Canada’s financial sector remained relatively unscathed through the recession, thanks to rigorous regulation and prudent bank practices. Domestic demand also remained resilient—steady consumption growth reappeared in the second half of 2009, and the housing market was robust, with construction activity and housing prices posting gains. In labor markets, the unemployment rate rose during the crisis, but trended below U.S. rates—for the first time in several decades—although employment tended to post positive growth since mid-2009 (compared with continued, albeit narrowing, declines in U.S. employment). Meanwhile, financial conditions are favorable, reflecting low funding costs and the absence of financial system strains evident in some other countries.
The strengthening Canadian dollar, however, has taken the edge off the support to external demand from the recovery in global economic activity. On the back of the rebound in commodity prices and the unwinding of the “flight to quality” trade in the U.S. dollar, the loonie (Canadian dollar) has strengthened vis-à-vis the U.S. dollar and since last October has been close to parity versus the U.S. dollar. Reflecting the strengthening of the currency, Canada’s export recovery has been muted, and the current account continues to show deficits.
Well-tuned macroeconomic policies have been instrumental in supporting Canada’s resilience, and growth is expected at about 3 percent both in 2010 and 2011. A fiscal stimulus of 2 percent of GDP in both 2009 and 2010 is helping to bolster demand, but has not challenged Canada’s fiscal credibility, the legacy of over a decade of consolidation prior to the crisis. Similarly, extraordinary monetary easing, with the policy rate at its effective lower bound and a conditional commitment to maintain the rate at its low, along with ample provision of liquidity, has underpinned both demand and financial stability. At the same time, medium-term inflation expectations have remained well anchored at about the Bank of Canada’s 2 percent inflation objective, testament to the credibility of the inflation-targeting framework.
Implications for the Latin American and Caribbean Region
The global recovery is spurring exports from Latin America, with further buoyancy added for commodities exporters. After the earlier collapse of global trade, trade flows started to pick up in mid-2009, but volumes are still significantly below precrisis levels. The continued recovery of global trade in 2010–11 and a normalization of crossborder production linkages will remain a significant pull factor for the region’s exporters. At the same time, strong growth in emerging Asia should continue supporting commodity prices and favoring LAC commodity exporters, primarily by stimulating domestic demand.
Amid the global upturn, some drag will be associated with macroeconomic conditions in the United States, particularly in 2011 when U.S. growth slows (Figure 1.6). Persistent softness in U.S. consumption as households adjust their balance sheets and build up their savings over the next few years will weigh on demand for consumer imports. Slow improvements in the labor market situation will further restrain the recovery in tourism—causing a delayed start to the upswing in tourism-dependent economies in the LAC region. At the same time, weakness in the U.S. housing market and tepid construction activity suggest that construction employment will remain subdued. Given the sector’s strong links with workers’ remittances to Latin America, this clouds prospects for a quick rebound in remittances, which for many countries are 10 percent or more below precrisis levels.
In contrast, the United States will likely contribute to the ongoing financial push that a number of countries in the region face. Over the past quarters, ample global liquidity, recovery in risk appetite and improving growth prospects have directed capital flows toward some emerging regions, including Latin America. Given prospective developments in U.S. monetary policy—with supportive monetary conditions for a sustained period—and financial markets, this trend is likely to continue. A low federal funds rate, weak domestic credit demand in the United States, and further improving risk appetite—combined with the attractive risk profile of some Latin American markets—could continue to drive capital flows to selected markets and put upward pressure on asset prices in the region. With these financial push and pull factors sustained, easy external financing conditions and pressures from capital flows are expected to remain a feature of the regional landscape for a sustained period.