How Stable is the Global Economy? Speech by Anne O. Krueger, First Deputy Managing Director, IMF
February 11, 2005
Anne O. Krueger
First Deputy Managing Director
International Monetary Fund
At the Stanford Institute for Economic Policy Research: Economic Summit
Stanford, California, February 11, 2005
Use the free Adobe Acrobat Reader to view the accompanying presentation slides.
Good morning. I'm delighted to be here today, in such distinguished company. My topic today, global economic stability, is one with which everyone at the IMF can identify—it is our raison d'etre. It is also of particular interest at this juncture because the currently benign global outlook provides an opportunity to take measures that will improve the robustness of the international economy and increase global stability in the future.
I want this morning to look at the medium term prospects in the light of the favorable short-term situation. I want to assess the progress already made in reducing vulnerabilities at the global level; and to examine the scope and need for going further. The short-term outlook remains good. The challenge for policymakers now is to build on the prospects for medium term growth, and to undertake policies that will enable them better to weather the inevitable future fluctuations in the international economy.
The current conjuncture
[Slide 1] 2004 was the best year for global GDP growth in decades. Most parts of the world recorded improved growth performance. The prospects for 2005 remain favorable, although growth is likely to be at a slower, more sustainable, pace: it is projected to falling from the estimated outturn for 2004 of about 5% to a under 4.5% this year.
[Slide 2] Global trade has also recovered strongly since the downturn in 2001, and continues to be an important engine of growth: it is currently expanding at something close to twice the rate of growth of world GDP.
There has also, in recent years, been a sharp fall in inflation worldwide. For much of the latter part of the twentieth century, high inflation was a major source of global economic instability. Durable reductions in inflation in many countries have greatly improved the prospects for sustained growth—and poverty reduction—in those countries. Lower inflation reduces the likelihood of sudden slowdowns resulting from efforts to halt rapidly accelerating inflation.
The improvements in performance and, in many cases, economic policies have been substantial and significant. The shift to floating exchange rates on the part of many emerging market countries has significantly reduced vulnerabilities. So, too, have major structural reforms in those, and other, economies. But now is the time, while the global economy is performing well, to take measures that will further improve the flexibility adaptability of economies going forward.
There will be another global economic downturn, though we cannot know when; the challenge is to be as well-prepared as possible.
The sources of global growth
Perhaps the most striking feature of global economic performance in 2004 was the widespread nature of the upturn. The US economy continued to be a principal engine of growth. Japan recorded stronger performance in 2004 than we have seen for some years. Among the industrial economies, the euro area was almost alone in continuing to grow at a lackluster pace.
In the emerging market and transition economies, improvements in growth performance have been widespread. We have seen rapid growth not just in emerging Asia—including China and India—but in the transition economies of Europe, including Russia, the Ukraine and the new members of the EU—where growth performance has, so far, been largely unaffected by sluggish euro area growth. And we have seen a welcome, and heartening improvement in many parts of Africa and the Middle East, as improved macroeconomic management has started to bring rewards in the form of lower inflation, accelerating growth and improved economic stability.
Sharply improved growth performance permits policymakers to confront longer-term structural problems from a much stronger base. In many parts of the world, we have seen governments taking action to reduce the risk of being thrown off course by future downturns. In some emerging markets countries in particular, real progress has been made in increasing the resilience of economies to outside shocks.
The potential sources of global instability
It is precisely because so much has been achieved and because the short-term global outlook remains favorable that I want to argue more needs to be done. This is not the moment for policymakers to relax their guard—quite the opposite. A benign economic environment offers much the best prospect for undertaking the structural reforms that will strengthen economic performance over the longer term.
As I noted, the US economy continues to be an important engine—indeed the primary driver—of global growth. Concern about both the fiscal and, more important, current account deficits is understandable because of the potential impact on the outlook for global growth, and stability, if the deficits persist. We are all familiar with the policy debate surrounding the US deficits, and I don't want to pre-empt this afternoon's discussion on the US.
In the global context, however, it is the American current account deficit that gives greater cause for concern. But the US deficit is only one manifestation of the current global payments imbalance. This is a global problem, and it has to be addressed globally.
The persistently weak growth performance of the euro area is one factor contributing to the US current account deficit. More rapid growth in Europe would ease pressure on the global imbalances. But Europe's growth prospects depend crucially on structural reforms that would lead to more flexible and responsive economies. A few moments ago I mentioned the significant and widespread improvements in inflation performance in recent years. One indicator of the lack of flexibility in the euro area economies is the extent to which inflation has been stickier than might have been expected in economies where demand has been so weak. Inflation is relatively low in the euro area—but not as low as other aspects of macroeconomic performance would imply at this juncture.
A more buoyant Japan would also help ease global payments imbalances. After a year of rapid growth to the middle of 2004, growth has slowed in recent quarters—a result, in part, of a correction in the IT sector. But economic activity should firm over the course of 2005 thanks to much improved fundamentals. Over the medium term, however, further structural reforms will be needed to boost growth prospects at a time of rapid demographic change.
Emerging markets: achievements and challenges
Further structural reforms are needed in emerging market economies, too. Much has been achieved, and I do not want to underplay what governments in many countries have done to strengthen resilience over the longer term. When so much effort has already been expended, though, all the more reason to press on at a time when the reform environment is largely favorable.
So what have emerging market governments done—and where do they need to do more?
[Slide 3] I've already mentioned the shift to flexible exchange rate regimes. That measure alone has greatly enhanced the flexibility of many economies. But the public debt burden of many emerging market economies remains a central concern. Debt levels rose during the last recession as governments struggled to offset some of the effects of the downturn. This has left them with virtually no room for maneuver. A significant reduction in debt levels is essential if debt sustainability is to be achieved over the medium and longer term; and if governments are to have any room for maneuver with counter-cyclical policy and successfully to reduce vulnerability to outside shocks and changes in the economic cycle. A start has been made, but as the figures show, debt is falling more slowly than it rose; and much more remains to be done to bring debt down to more acceptable levels .
[Slide 4] At the same time, there has been some improvement in emerging markets' fiscal balances: in the past couple of years primary surpluses have begun to rise, while overall budget deficits have started to fall. But with overall fiscal balances in the 3-5% range, ratios of debt to GDP are falling relatively slowly in all but the most rapidly-growing economies.
[Slide 5] When we look at the regional breakdown we can see that this pattern holds for Asia, though there is still a long way to go before budget balances return to the levels before the Asian crisis of the late 1990s; and Latin America, where a long term trend of improvement has yet to be established.
[Slide 6] Budget balances are also improving in Africa and the Middle East; and, much more sharply, in the transition economies.
These are welcome improvements. But debt to GDP ratios are still uncomfortably high in many emerging market economies—especially at this point in the cycle, when debt levels should be falling much more rapidly. Such high debt ratios in an upturn mean there is no room for governments to operate counter-cyclical policy in a downturn. And, right now, spreads on emerging market debt are at extremely low levels. Should these spreads rise markedly, the vulnerability of the more highly-indebted emerging markets could increase significantly.
[Slide7] As a share of GDP, emerging market debt levels have just started to fall below those of industrial economies. But this crossover is very recent and very small—and insufficient. Industrial countries can carry more debt than emerging markets. Emerging market countries simply have less room for maneuver—the evidence is that debt-GDP ratios not much above half the prudent levels for industrial countries may be sustainable for most emerging economies.
Going by past experience, emerging market countries with debt to GDP ratios of more than 40% are much more likely to experience difficulties in debt servicing—historically some two thirds of all such problems occurred in countries with ratios above 40%; and half of all debt servicing problems were encountered in countries with ratios of 60% or above.
Turkey and Brazil
Let's look for a moment at two countries with Fund programs that have made impressive progress in recent years, Brazil and Turkey. They illustrate both the progress that has been made and the challenges that remain. Both countries have benefited from significant reductions in inflation rates and accelerating growth at a time when they have been making great strides in reducing their debt burdens and restructuring their debt profile.
Brazil experienced a major crisis in early 1999 when, in the wake of the Asian and Russian crises, the government was forced to abandon its fixed exchange rate regime and introduce wide-ranging reforms. Yet by the middle of 2002, less than three years ago, Brazil was widely seen as being on the brink of another crisis, brought about by speculation about the economic policies that might follow the 2002 presidential election.
Underlying macroeconomic policies were judged to be sound. But electoral uncertainty led to concerns about the sustainability of Brazil's large public debt, and the markets grew nervous about whether a new government would maintain sound macro policies.
As you know, a Fund-supported program was agreed during this pre-election period, committing the new government to maintenance of the fiscal and monetary framework. All three major Presidential candidates undertook to maintain the policy framework should they be elected. In the context of the Fund program, the financial markets were rapidly reassured.
The economic policies backed by the Fund program, coupled with key ongoing structural reforms, have seen a remarkable transformation in Brazil's economic fortunes. The floating exchange rate regime, introduced in 1999, has undoubtedly helped smooth the adjustment process. And prudent fiscal policies—including a primary surplus of 4.6% of GDP in 2004—have paved the way for more rapid growth and falling inflation. Growth accelerated last year to about 5.2% and is expected to come in at around 3.7% this year, while inflation has fallen from 12.5% in 2002 to 7.6% at the end of 2004, and is projected to be at 5.1% by the end of this year.
[Slide 8] The country's external financing needs have fallen sharply: and are now down to about a third of their peak in 1999.
[Slide 9] Over the same time period, Brazil's (gross) external debt position has improved markedly since 1999. As a percentage of GDP it still has a considerable way to go before reaching the levels of the mid-1990s; but as a percentage of exports, the ratio is already below mid-1990s levels.
[Slide 10] Total public debt remains relatively high: both as a percentage of revenues and as a percentage of GDP it is still significantly above the levels seen even in the late 1990s. But the ratios have started to improve slowly. As a result of measures taken by the government, there has been an improvement in the structure of public debt, although here, too, the position has not yet re-attained that of a decade ago. The reserve position has improved since 2001, but reserves need to be built up further.
In other words, a great deal has been achieved in Brazil; and we can already see the rewards of a sound macroeconomic framework in terms of growth and the scope for poverty reduction. Yes, there is still a way to go. But Brazil's program remains on track. Sticking with the current macroeconomic framework has resulted in GDP growth and lower inflation. The vulnerabilities are being reduced and continuation of sound policies augurs well for the future.
There are many similarities with the situation in Turkey. The economic crisis that started in 1999 and came to a head with the banking crisis of 2000-1, led to wholesale economic reforms. Here, too, reforms were supported by a Fund program; here, too, a floating exchange rate has been an important factor in making rapid adjustment possible; and here, too, successive governments have displayed impressive commitment to the reform program. As a result, recent progress has been remarkable—especially given Turkey's long record of prematurely-abandoned reforms.
Strengthened fiscal policy has been a cornerstone of Turkey's macroeconomic framework, just as it has of Brazil's. In both cases, strong fiscal controls play a critical role in creating the conditions for rapid growth and falling inflation.
[Slide 11] In Turkey, inflation had been above 60% since the mid-1980s. It has now fallen from more than 70% just three years ago to below 10% today—the first time since the 1960s that inflation has been in single digits.
[Slide 12] Growth last year was close to 8%, the third consecutive year of rapid expansion. During that three year period, growth has averaged just under 7%.
[Slide 13] And this at a time when the government has been running a primary balance close to 7% of GNP—in 2004, exceeding the government's 6.5% target. Note that this represents an extraordinary swing of 7 percentage points of GDP in the fiscal balance in a relatively short time period—and tightening fiscal policy was accompanied by accelerating growth, as it was in Brazil.
In addition, the Turkish government has undertaken a number of critical structural reforms, especially in the banking sector, that strengthen the domestic financial system.
[Slide 14] So Turkey, too, has achieved much—but there is still some way to go before we can be sure that the progress made so far will prove as durable as we hope. It will take several more years of adherence to the current policies to put Turkey's economy on a sound footing. External debt, though falling, is still high, at 60% of GNP.
[Slide 15] And although falling, net public debt is still nearly 70% of GNP, a large part of which is either foreign exchange indexed or denominated, or linked to very short term interest rates, making it vulnerable to movements in exchange rates or interest rates.
I stressed at the outset the importance of the widespread reductions in inflation achieved in most countries in recent years. Nowhere are the benefits of such reductions more apparent than in Brazil and Turkey. Both are countries with records of high inflation and economic instability. The tight fiscal policies that successive recent governments in both countries have pursued have enabled both countries significantly to reduce their vulnerability to shocks. Interestingly, in both countries accelerating growth rates have accompanied fiscal tightening, contrary to popular belief.
Of course, further reductions in public and external debt levels will require current policies to be sustained over the medium term, just as the Fund programs and the national budgets envisage.
I chose Brazil and Turkey in part because they are large, systemically important countries, and in part because they have been particularly successful in pursuing economic policy reform. But their experience is not untypical of many emerging market countries in recent years. Significant progress has been made in achieving macroeconomic stability—especially when compared with the experience of all too many countries in the 1980s and 1990s. But the progress made so far serves, above all, to underline the importance for all countries of persisting with sound policies and structural reforms, so that the full benefits of the policies put in place can be realized. That is the only route to lasting improvements in economic performance, and reduced economic vulnerability over the medium term.
Let me conclude by returning the question posed by the title of this session—How stable is the global economy? Ultimately, of course, this in an unanswerable question. By their nature, shocks are unpredictable. They always come from unexpected quarters. So we cannot know how stable the global economy is over the medium and longer term, because we do not—and cannot—know what events we need to guard against.
So we have to work with what we know. And from our experience of previous crises, we have accumulated knowledge about how to reduce, though not eliminate, the impact of unexpected and adverse events.
We know that prudent macroeconomic policies—a sound framework aimed at delivering, and maintaining, low inflation and effective fiscal control—offer the best prospect for sustained rapid growth that brings rising living standards and poverty reduction.
We know how important are the benefits that low inflation brings. Governments have come to recognize that sustained low inflation makes all kinds of decision-making easier; and their citizens like it too. There is a strong incentive to keep it low, and that in turn provides a strong incentive to persist with other sound policies as well.
We also know that the general shift to floating exchange rates that took place during the 1990s and more recently has significantly reduced rigidities in economies and therefore an important source of potential instability. We know that strong financial sectors are also important—more so than we had previously recognized.
And we know that stability will be improved in the short term and growth prospects will be enhanced over the medium term by a wide range of structural reforms. We've seen evidence of this in countries like Brazil and Turkey where, for example, banking sector and other structural reforms have helped reinforce the fiscal and monetary policy frameworks that have been established.
The contribution that structural reforms can make to the effective conduct of macroeconomic policy can hardly be overestimated. There are enormous benefits to be had from reforms aimed at making labor markets more flexible; at strengthening the financial sector; at improving tax collection and administration; at improving public expenditure management; and at building healthy institutions and developing enforceable property rights. The more robust economies are, and the more flexible, the better they will withstand adversity and the more it will be possible to moderate the impact of, for example, global downturns.
These may be medium term objectives, but that does not make them any the less urgent. Policymakers inevitably have to act within existing political constraints—and these usually serve as a brake on reform momentum. But the constraints that make change difficult to push through are significantly weaker in periods of economic upturn. A benign environment offers the best possible prospect for pushing ahead with reforms. Waiting for the next downturn, or the next bout of economic trouble, will only make vital reforms more difficult to introduce and implement.
This is not a zero-sum game. One economy does not protect itself at the expense of another. The less vulnerable economies are to downturns in the cycle, the more likely it is that such downturns will be more moderate in their impact on other economies, and thus the global economy will be more stable.
The current global environment is, taken as a whole, about as promising as it has been for some time. There are clouds on the horizon: continuing geopolitical uncertainty; the global payments imbalances; uncomfortably high energy prices. But last year's growth performance was impressive by any standard. And low inflation globally has provided a significantly improved environment for economic policymaking.
But this is the easy part. The conjuncture is benign, sound policies are—relatively—easier to pursue and the rewards quicker to appear. The old adage is true—it really does make sense to fix the roof while the sun is shining. Longer term stability will come only if governments follow prudent fiscal policies and undertake reforms during good times.