A Brief Survey of Global Economic Developments, Remarks by Rodrigo de Rato, Managing Director of the International Monetary Fund

June 9, 2005

Remarks by Rodrigo de Rato
Managing Director of the International Monetary Fund
At the Spanish Confederation of Savings Banks
(Confederacion Española de Cajas de Ahorros)
Madrid, June 9, 2005

As Prepared for Delivery

1. It is a great pleasure to be here today, and especially to be among so many friends and familiar faces. The theme of your meetings in the next two days is corporate social responsibility. As you prepare to consider this important subject—in particular the role that savings banks and related institutions can play in this regard—it might be helpful to have as context an overview of current economic conditions and challenges in the world. Accordingly, I will devote my remarks this morning to a survey of global economic developments.

The Global Economy - Recent Developments

2. As you know, global economic growth was very strong in 2004, with the rate of expansion being the highest in nearly 30 years. The expansion was underpinned by accommodative macroeconomic policies, improving corporate balance sheets, and supportive financial market conditions. Importantly, last year's economic performance was recorded not just in growth, but also in a significant rise in per capita incomes in all regions of the world. Sub-Saharan Africa, in particular, posted its highest GDP increase in a decade. These encouraging results were due partly to strong global demand and prices for commodity exports, but they also point to better policies in a number of countries.

3. For this year, growth is expected to slow moderately, but still remain above trend at around 4¼ percent. This positive overall picture, however, should not lead us to overlook some growing divergences across regions. In particular, the global expansion has become less balanced, and is projected to remain so. Growth has been stronger than expected in the United States, China, and most emerging market and developing countries. In contrast, the performance of Europe and Japan has been disappointing, reflecting—to different extents—faltering exports and weak final domestic demand.

4. Related to this growth pattern, global current account imbalances have also widened. The U.S. current account deficit was a record 5.7 percent of GDP for 2004. This deficit has not yet been moderated by the depreciation of the U.S. dollar over the past year. The effects of the dollar's fall have been offset by continued strong domestic demand relative to its trading partners, and higher oil prices. The U.S. current account deficit is matched by corresponding surpluses in emerging Asia, Japan, oil-producing countries in the Middle East and the Commonwealth of Independent States (CIS), and—to a much lesser extent—the euro area. In emerging Asia and the oil-producing countries, external reserves have continued to rise sharply, with a significant portion believed to be held in U.S. dollars.

5. Partly reflecting these developments, over the last eight months, the U.S. dollar has largely depreciated, although it has strengthened recently. The dollar's movement has been matched by appreciations of industrial and emerging market currencies, including several in emerging Asia. To date, the adjustments in the dollar have been orderly. With options market data suggesting that implied volatility remains moderate, markets appear optimistic that this will continue to be the case.

6. Concerning inflation and inflationary pressures, these remain relatively subdued. The second-round effects from recent higher oil prices appear not to have been significant. And with monetary tightening under way in most cyclically advanced countries, inflationary expectations are generally well grounded. For that reason, inflation is expected to remain moderate in the near future. However, as the global economic expansion continues and labor market conditions tighten, inflationary pressures could rise further, and will need to be monitored closely. This is more likely to be the case if labor productivity growth were to weaken at the same time. In addition, monetary policy management could also become increasingly difficult in some emerging market economies, notably in Asia and the CIS. Strong external inflows can be expected to add to inflationary pressures in these regions, especially in the absence of greater upward exchange rate flexibility. In Latin America, where some countries have had recurrent bouts of inflation, central banks have already begun monetary tightening to help restrain expectations.

7. Financial market conditions remain generally favorable, and they continue to support the global economic upswing, although uncertainty has increased. Policy rates in most countries remain close to zero in real terms, although there has been some tightening in conditions recently. Long-run interest rates remain below long-term levels, and credit spreads have widened somewhat from their lows. As for equity markets, these have risen lately, following a modest correction from their earlier strong performance. Emerging market external borrowing has also been strong to date, and many countries have nearly completed their 2005 financing needs. These developments partly reflect improved fundamentals, including well-grounded inflationary expectations, strengthening corporate balance sheets, and reduced external vulnerabilities in emerging markets. However, the current conditions also reflect highly accommodative monetary conditions across the globe, a continuing search for yield by investors, and—in the case of low long-run interest rates—ample liquidity and supply of funds. Correspondingly, financial conditions could tighten markedly, particularly in the event of unexpected shocks.

8. In the specific case of Europe, interest rates will in time have to be raised, but key considerations argue for maintaining an accommodative policy stance. First, inflationary pressures appear set to ease and inflation expectations are well-anchored, not least reflecting the credibility of the European Central Bank. Second, wage setting has fundamentally improved and there are no indications of second-round effects. Third, liquidity, credit, and asset price developments do not yield robust cautionary signals for the area as a whole. At the same time, the case for a rate cut at this juncture is not yet evident. Headline inflation remains above 2 percent and signals on prospects for the recovery over the balance of the year are mixed. But, with inflation headed for rates well below 2 percent, a cut in interest rates would be appropriate if the economy's weakening became more pervasive or the euro appreciated sharply on a multilateral basis.

Short-Term Risks

9. Despite the generally favorable outlook, recent economic indicators suggest an "emerging soft patch" in the major industrial countries, mostly attributed to the lagged impact of higher oil prices. If oil prices were to continue falling, after reaching nominal peaks in March, this soft patch is expected to be mild and temporary. In this connection, the underlying crude oil market continues to be driven by strong demand, particularly in the United States and China, and long-dated futures remain high. At the same time, there is very little upstream excess capacity. Growth is declining in non-OPEC supply, and there are uncertainties about OPEC's ability to cope with increasing demand. The future price of oil therefore poses one risk to the economic outlook.

10. Similarly, there is also a risk that financial market conditions could tighten significantly. Despite positive signs—such as falling 10-year rates—we should not rule out a sharp rise in U.S. long-run interest rates. This would adversely affect domestic demand, especially if driven by a rise in inflationary expectations, or weaker foreign demand for U.S. assets. And if higher U.S. rates led to higher long-run interest rates elsewhere, it would also raise the risk of a synchronized decline in housing markets. This will be of particular concern in regions where housing prices are already elevated, with household balance sheets being vulnerable to rising rates. Higher U.S. rates could also adversely affect emerging market spreads, which could dampen the enthusiasm for borrowing. In addition, and as discussed below, the U.S. current account deficit remains at record levels. Its potential to cause a possibly disorderly depreciation of the U.S. dollar cannot be ruled out.

11. The increasingly unbalanced global expansion is also another risk factor for the global economy. As I mentioned earlier, global growth remains unduly dependent on the United States and China. If this situation persists, it will further widen global imbalances, increasing the potential for abrupt corrections in currency and capital markets. The risks for a more significant slowdown later on will also be raised, especially if growth in the U.S. and China were to weaken simultaneously.

Medium-Term Vulnerabilities

12. In some respects, industrial and developing countries are better placed to manage these risks than they were in the past. Macroeconomic policy frameworks, particularly on the monetary side, have improved, and economies have generally become more flexible, albeit to differing extents. And given the importance of a strong banking system to economic stability, it is encouraging to note that financial institutions by and large are now more resilient to shocks. Banking systems that are free from political influence, in particular, are to be welcomed. Further, external vulnerabilities in emerging markets have also been reduced significantly. That said, the scope for short-term policy maneuver in response to the unexpected is limited. A combination of shocks—such as lower global growth, higher interest rates, and rising oil prices—could create significant difficulties for many emerging market and developing countries. Moreover, three overarching global vulnerabilities remain. Although these vulnerabilities are essentially medium-term in nature, they increasingly affect the short-term outlook.

13. First, I return again to the issue of the deepening global imbalances. Here, our projections suggest little improvement in the foreseeable future. The U.S. external deficit has so far been financed relatively easily, aided by continued capital inflows from around the world. However, the demand for U.S. assets is not unlimited. As underscored by the market reactions to rumors of possible central bank reserve diversification, a continuing sharp rise in U.S. net external liabilities will carry increasing risks. These imbalances should therefore be addressed immediately, through the following actions: medium-term fiscal consolidation in the United States; greater exchange rate flexibility in emerging Asia, supported by continued financial sector reform; and continued structural reforms to boost medium-term domestic demand and growth in Europe and Japan. This combination of measures is generally agreed as being necessary, but their implementation has lagged.

14. Second, fiscal positions in many countries remain very difficult, posing a significant medium-term threat to macroeconomic stability. In the largest industrial countries, fiscal deficits remain high, with Canada being a notable exception. Projected improvements, in addition to being generally unambitious, are also in many cases not underpinned by credible measures. In the case of emerging markets, while fiscal indicators have generally improved, many countries still have a long way to go to bring public debt-to-GDP ratios to sustainable levels. Further, the fiscal implications of having to accommodate aging populations, particularly in the euro area and Japan, remain largely unaddressed.

15. Europe, in particular, has failed to narrow its structural fiscal imbalances since 2000. At the same time, public debt has risen. This region needs to move aggressively to address the unsustainability imbedded in the looming demographic shock that will be presented by an aging population. This will require not only further entitlement reforms, but also achievement of a roughly balanced structural fiscal position for the area as a whole by the end of the current decade, when the population's aging is set to accelerate. Whether at the national or area-wide level, credible rules-based fiscal frameworks will be key to meeting this challenge.

16. Third, structural weaknesses continue to constrain growth in key areas, and increase countries' vulnerability to shocks. The challenges faced by different regions and countries vary widely, but they include:

• Rigid labor and product markets in the euro area;
• Corporate and financial sector weaknesses in Japan and much of emerging Asia;
• Unfavorable investment climates in Latin American countries;
• Weak banking supervision systems in central and eastern Europe; and
• For the Middle East, a need to greater develop institutional infrastructure for non-oil sector development.

17. Beyond the potential risks to macroeconomic stability, these three vulnerabilities pose significant downside risks to short-term global growth. In particular, history suggests that even an orderly adjustment in the U.S. current account imbalance is likely to be accompanied by slower U.S. growth. Given the constraints I described earlier, this is unlikely to be offset by stronger activity elsewhere. At the same time, rising public debt will put upward pressure on long-run interest rates. It will also limit the scope for policy adjustment in response to unexpected shocks. Finally, structural rigidities limit the ability of countries to take full advantage of technological change and globalization's opportunities.


18. All of this is not to paint a negative picture for the world economy in 2005. In fact, as I pointed out at the beginning of these remarks, global GDP growth is projected at a healthy 4.3 percent for this year. Growth this year will be slightly lower than last year, but still above historical trends. The U.S. economy, in particular, is set to continue expanding. We are also expecting to see gradual recovery in the euro area and Japan, as well as a strengthening of activity in much of emerging Asia. China's economic momentum remains very strong, and growth in India also remains quite robust.

19. These are important and positive indicators which provide an ideal context for your discussion over the next two days. Globalization and economic expansion have brought prosperity and advancement to many in the world. Yet, it is important that we step back periodically to consider how best to share the global economy's fruits with even more of society. I therefore applaud the Spanish Confederation of Savings Banks for bringing focus to the theme of corporate social responsibility.


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