Press Briefing by Michael Mussa, Economic Counselor and Director Research Department
September 30, 1998
September 30, 1998, 9:00 a.m.
International Monetary Fund
MR. ANJARIA: Good morning. Welcome to the press conference of the Economic Counselor and Director of Research of the International Monetary Fund, Mr. Michael Mussa, on the world economic outlook. You have received the publication, and I should like to say that the publication and the contents of this briefing are under embargo until 11 a.m. this morning.
MR. MUSSA: The world economic situation and prospects have weakened significantly since our last assessment in May. World GDP growth for this year is now expected to reach only 2 percent, versus 3.1 percent forecast last May. The main reason for this is the downturn in Asia, including Japan, which has turned out to be significantly deeper and more widespread than was anticipated by the Fund staff or by most other analysts just five months ago.
Next year, the downward revision of projected world growth is even larger, from 3.7 percent in May to 2.5 percent now. The balance of risk around even this revised forecast remains significantly to the downside, especially if present acute pressures on financing flows to virtually all emerging market economies persist for an extended period.
Comparing forecast growth for 1999 with the likely outcome for 1998, on the positive side, a number of Asian economies that are suffering substantial output declines this year should be able to stabilize or perhaps stage modest recoveries next year. In Korea and Thailand, a significant easing of monetary policy, made possible by the restoration of reasonable exchange rate stability, will aid recovery, along with dramatic improvements in external positions. Expanding fiscal deficits, reflecting weak activity and the widening of social safety nets, will help to support consumption in all of the key crisis economies. One of the essays in Chapter 2 of the WEO examines the prospects for recovery in these Asian economies in the near and medium term. In China, far and away the largest emerging market economy in East Asia, growth next year will be supported by a substantial easing of monetary policy in recent months and by large public works spending. Nevertheless, growth is expected to remain relatively subdued in comparison with earlier in this decade. Several other Asian emerging market economies, including Singapore and Taiwan Province of China, are also appropriately supporting growth with easier monetary and fiscal policies.
In Japan, it should be possible to avoid a repeat of the sharp output decline of 1998, the steepest of the postwar period, and achieve at least slightly positive growth for 1999, with support from a highly accommodative monetary policy, a sharply expansive fiscal policy, and a determined and credible program to address weaknesses in the banking sector.
On the other hand, growth in the United States and Canada next year is likely to be below the pace of 1998, which for the United States was clearly unsustainable. To guard against the risk that the slowdown might go too far, the Federal Reserve yesterday appropriately signaled its intention to ease monetary conditions as may be needed to confront domestic and external risks. Financial markets clearly anticipate further steps of easing in coming months. Canada should be able to do the same, with due regard to concerns about unwarranted depreciation of the exchange rate of the Canadian dollar.
The United Kingdom might well move to easier monetary conditions if the economy weakens further amid signs of waning inflationary pressures.
For continental Europe, growth still seems likely to be reasonably well sustained next year, with increasing support from domestic demand but rising worries about the external sector due to spreading problems in emerging markets, including Russia, mounting losses for European banks, and appreciating exchange rates for the euro area currencies against other industrial economies. Downward convergence of short-term interest rates in the euro area toward rates in the core countries should provide some additional monetary support for what is already a moderately accommodative policy stance. Explicit reductions in official interest rates below present core rates may well become appropriate if external or internal demand growth appears likely to weaken to an extent that threatens the recent pattern of modest reductions in unemployment in the largest European economies.
For the emerging markets beyond East Asia, growth next year now in general looks likely to fall well below 1998. The economic and financial crisis in Russia is part of this, but the main story is the recent sharp increase in pressures on virtually all emerging market economies from world financial markets. Even assuming that the present interest rate spreads for emerging market debt subside to less extreme levels, financing flows are likely to remain expensive and limited, putting upward pressure on domestic interest rates in emerging market economies and necessitating downward adjustments in trade deficits.
Latin America, in particular, will be affected, and the WEO forecasts for this region for both this year and next have already been written down significantly since May. The broader issue of global financial flows to emerging markets and the risks from a substantial and prolonged interruption of such flows is examined in another essay of Chapter 2 of the WEO.
Finally, before asking Mr. Larsen to provide some brief comments on Part II, that is Chapters 3, 4 and 5, of the present WEO, I would like to correct an impression about the Fund staff's policy recommendations in this period of global economic difficulty. Because a great deal of attention has been given to criticisms of Fund policy recommendations in some specific cases, the impression seems to have developed that the Fund staff has nothing to recommend but tighter monetary and fiscal policies--the tighter the better, everywhere and always. This, quite simply, is nonsense.
From the summary of policy recommendations in the present WEO that I have just given, the Fund staff is recommending that monetary policies be eased or that accommodative monetary policies be retained in countries accounting for 90 percent of world GDP. While we do believe that the United States budget surplus should not be squandered and that most continental European countries should pursue further consolidation at a gradual pace, we would certainly recommend that the automatic fiscal stabilizers be allowed to operate fully in these countries in the face of slower growth.
Explicit discretionary easing of fiscal policy is supported for a number of countries, notably Japan and several East Asian emerging market economies. Tighter policies are, indeed, recommended for a few countries, accounting for perhaps 10 percent of world GDP. These are countries that are under considerable pressure in terms of their external financing and sometimes also facing confidence or credibility problems at home. For these countries, unfortunately, there is no easy way out of present difficulties through the pursuit of easy monetary and fiscal policies. This is a situation that needs to be faced, not wished away.
MR. LARSEN: I will just give a very brief overview of the contents of the three analytic chapters in Part II of the WEO. I do want to emphasize that this time the World Economic Outlook comes in two parts. The two parts look alike, so do make sure that you pick up a copy of both Part I and Part II.
Chapter 3 explores what the Asian crisis might portend for the region's long-term growth prospects. The analysis attempts to answer the question of whether the crisis countries essentially are facing a very serious cyclical episode so that once the excesses that had built up prior to the crisis have been worked out, the region should tend to revert to its very impressive long-term growth trend. Further work will obviously be required to fully shed light on this important question, but the evidence discussed in the chapter does seem to justify the conclusion that the trends in the crisis countries were not sustainable before the crisis and that the region unquestionably was heading for a significant slowdown, even in the absence of a crisis. This conclusion is based on the growing capital intensity of output observed in the region in recent years, the tendency for the efficiency of new investments to decline, substantial evidence of strains in the financial system due to a growing burden of nonperforming assets, and signs of overcapacity and losses in the industrial sector and considerable overbuilding and asset price inflation.
How did this come about? The discussion in the chapter focuses in particular on the apparent inability of institutions and economic policies in these countries to continue to effectively intermediate the very large and growing volume of saving being generated in these economies, all the more since the high domestic saving rates were being complemented by large and growing inflows of foreign capital. The bottom line of the analysis is that the Asian countries undoubtedly can return to growth trends that are impressive by international standards, albeit perhaps not quite as steep as in the past. For this to be possible, they will need to put in place fundamental reforms that foster stronger productivity growth and reduce the speed of capital accumulation to a more sustainable rate.
Chapter 4 reviews the origins of Japan's economic problems, which are very much related to the asset price boom and bust of the late 1980s. It discusses the role of economic policies in the repeated attempts to stimulate the economy and also the scope that exists today for monetary and fiscal measures to help initiate economic recovery. This chapter particularly looks at the problems in the financial sector and discusses some of the latest proposals for cleaning up the banking system, a sine qua non for achieving a strong and durable recovery.
Chapter 5, finally, discusses the policy issues facing the euro area. This is, in fact, the only chapter that does not have the word "crisis" in its title. But it does contain the word "challenges." Clearly, the adoption of a single common currency will bring many benefits and has the potential to help to improve Europe's growth performance and reduce unemployment. But to realize this potential, other policies need to adapt to the new environment. Although a single monetary policy may help to reduce cyclical divergences among the participating countries, it is by no means certain that that will happen. This implies that there may well be periods when the level of interest rates determined centrally by the European Central Bank may not completely suit an individual member country. Sometimes the level of interest rates may be too easy and sometimes it may feel a bit too tight. This underscores the need for fiscal policy to play a much more countercyclical role in the future, in contrast to the procyclical role of fiscal policy often observed in the past among the members of the future euro area. In order to do that, of course, you need to create a certain room for fiscal policy to operate in that way over the cycle, which underscores the importance of meeting the objectives of the Stability and Growth Pact. Structural reforms are also needed to allow countries to draw the full benefits from the euro. Of course, labor market reforms would also be necessary without the euro, but we think the consequences of not reforming may be more serious in some circumstances under the single monetary policy and the single currency.
QUESTION: Comparing last year with next, the WEO shows the U.S. current account deficit almost doubling, to $290 billion, while the euro area surplus barely budges, at around $110 billion. Is it a problem that so much of the current account adjustment to the Asian crisis is falling on the U.S.?
MR. MUSSA: I think at the present time that development is more of a solution than it is a problem. But looking beyond next year it will probably be more of a problem than a solution. The U.S. economy has been growing particularly rapidly over the past couple of years, especially in terms of domestic demand growth, and so the widening U.S. current account surplus from the U.S. perspective up to this stage has really not been a problem. It has helped to relieve some of the inflationary pressures, as has the very strong foreign exchange value of the U.S. dollar.
Looking forward, our forecast for U.S. growth is that it will be about in line with potential, perhaps a little below potential, helping to relieve some pressures in labor markets. If it were to fall substantially below potential, of course, unemployment would begin to rise in a manner that would be undesirable. But even if that plays out as we expect, I think there is considerable reason to doubt that a U.S. current account deficit in excess of 3 percent of GDP is sustainable in the medium term and that the rest of the world economy will on a sustained basis want to ship capital to the U.S. to finance such a deficit. That suggests that, over the course of time, the dollar will need to correct downward, on average, against the currencies of other trading partners, perhaps implying some upward pressure on inflation rates in the United States.
Associated with that correction of the U.S. current account position, domestic demand in the U.S. will need to grow less rapidly than GDP. That is a fact of national income accounting. If world output growth is to be sustained at a reasonable level, domestic demand growth in the rest of the world will need to grow more rapidly than GDP. That brings us to the European Union, and particularly the euro area, which in the past three years has been benefitting in terms of its output growth exceeding demand growth by roughly half a percentage point of GDP per year. That situation over the next couple of years will need to turn around, and output growth in the euro area in particular is going to need to be sustained much more by internal demand growth, with the external sector making a negative contribution to overall growth in the euro economy area. That necessitates, on the other side, that domestic demand growth in the euro area needs to strengthen significantly in comparison with the experience of the past three years.
QUESTION: Mr. Mussa, two questions: one on Japan and one on your overall world prediction.
On Japan, Mr. Miyazawa announced yesterday and again stated today in Tokyo that Japan is planning to come to these Annual Meetings with a proposal for a large, possibly $30 billion, aid program for the region to help the recovery there, to stimulate growth. Yesterday, the World Bank speculated that a $10 billion stimulus would create 1 percent GDP growth in the ASEAN-4 and some of the more troubled nations in East Asia. Since it is now a matter of public record that Japan is planning to push ahead with a multibillion dollar aid package for the region, my question to you is: would you welcome that? In your view, as an IMF economist, would that be a good thing for the region; is that a positive step? That is the first question.
MR. MUSSA: In general, as I mentioned in my opening remarks, the present environment in terms of financial flows to emerging market economies is really very tight. The Asian emerging market economies are somewhat better situated at the present moment because they have made a very dramatic and costly economic adjustment, but one which has moved their current accounts, in many cases, into substantial surplus. So they are less dependent on financing flows because their current accounts are registering large surpluses. Nevertheless, they will feel the effects of the tightening of general credit availability to emerging market economies.
We also have the situation where banks in Japan, because of difficulties in Japan and elsewhere, are pulling back on the availability of credit, not only in the domestic economy but also internationally. In that type of environment, it is important to get something going that will help to sustain financial flows to emerging market economies in Asia and elsewhere. So I think one should view the Japanese government effort in this regard in a quite positive light.
QUESTION: The second question is simply about your overall global projections. The WEO this year contains more caveats and conditional sentences and warnings than ever before. It seems to go beyond the normal caution of an economist. There are three sentences in particular that strike one: first, that considerable uncertainty remains about the near-term outlook; second, the sentence that the risks to these projections are predominantly on the downside; third, indeed, that a significantly worse outcome is clearly possible, potential for a broader and deeper economic downturn, et cetera. In that context, what is the possibility and to what extent is it reasonable to assume that your projection of 2 ½ percent world growth for 1999 may well have to be revised rather shortly? What are you signaling there? Are you signaling that it is indeed possible that this projection made in September 1998 will not hold?
MR. MUSSA: Absolutely.
QUESTION: I think you said, Mr. Mussa, in the opening remarks that Japan will enjoy slightly positive growth in 1999. I wonder if you could expand on that and on whether you believe that the fiscal measures currently in the process of being implemented will be sufficient to achieve a sustained recovery in Japan.
Second of all, what would be your prescribed solution for the banking sector recapitalization? There are many ideas being discussed in Japan right now: bailing out weak banks, nationalizing weak banks, nationalizing all of them, and getting rid of the weak ones and selling off the strong ones. What would be your preferred solution, and to what extent do you think public funds should be used in the resolution of that crisis?
MR. MUSSA: On the forecast, first, and the role of fiscal policy, the present Fund forecast, which is for positive one-half percent growth of GDP year over year in 1999, assumes essentially that the Japanese government will retain the present level of fiscal stimulus being provided during 1998, which as you know is a substantial amount of stimulus relative to where we were in 1997.
We have seen in Japan this year an extraordinary decline, not only in investment spending--which might well be expected in a situation of a weak economy, with problems in the banking system--but also a sharp decline in consumption spending. Our presumption is that that decline in consumption spending is not going to continue. The consumption spending will at least level out and perhaps show some modest recovery. That, together with a significant boost from public investment spending, will produce an economy that is roughly flat to slightly positive year over year.
The Japanese government has been talking about greater fiscal stimulus, and we certainly think that thinking in that direction is the right direction in which to be thinking at this stage. There is no threat that the Japanese economy will overheat next year. While the fiscal deficit is large and measures of gross debt of the Japanese government are also quite large, figures for the net debt are small, and long-term borrowing costs for the Japanese government are now below 1 percent. So, even quite large fiscal deficits and high levels of debt are actually not that expensive to finance at this stage and under these circumstances. So, fiscal stimulus is called for in this type of situation, and we would certainly not be restraining them on that side in these circumstances.
Will it provide the basis for sustained recovery? No. Sustained recovery in Japan, as elsewhere, requires that the private sector get moving in terms of demand. That means there needs to be a recovery of confidence in the household sector and in the business sector, and the key in both of those regards is an effort to forcefully and credibly and rapidly address the problems in the banking sector, which was your second question.
What needs to be done? I do not think there is a unique prescription that says, "This, and this in particular, needs to be done, and nothing else." But I think some things are clear that need to be part of the package. First, public funds do need to be injected into the banking system. The government guarantees, quite properly, deposits in Japan. It needs to stand behind those guarantees of deposits. More generally, while the Japanese banking system needs to consolidate from its levels of activity in the 1980s and early in this decade, Japan needs a strong and vibrant banking system as an essential element of its finance and payment system. It is not relevant, therefore, to think about closing most or all of the banks that are in deep difficulty. Even some insolvent banks that are insolvent under present economic conditions are worth keeping alive because of their long-term viability and capacity to contribute to the health and growth of the Japanese economy.
So a proper way of approaching this type of situation in the case of banks that are very poorly capitalized, is, one, to recognize the extent of their problems by providing much more credible estimates of what their problem loan situation really is and then injecting sufficient capital into them, with an appropriate haircut to present shareholders and perhaps some other creditors to put those institutions in a position where they can act in their own interest as reasonably well-capitalized banks to fulfil their role as credit intermediaries in the Japanese economy. For some banks that are insolvent or very close to insolvent, it may make sense for the government to "intervene" them and take them over, at least temporarily, and operate them under government auspices or some would say to nationalize them. Some banks may well be suitable for closure. The Japanese economy, probably, on a long-term basis, is somewhat overbanked, and the resources in terms of personnel and so forth that are deployed in that sector are somewhat larger than are required in the longer term, so there needs to be a rationalization of the banking system in Japan.
All of that does not need to be done overnight, but the difficulty is that many of these problems have been dragging along for nearly six years, not in the intense state in which they presently exist, in a very weak Japanese economy, but they have been simmering back there without being forcefully and credibly addressed. What needs to happen now is there need to be some dramatic and forceful steps to indicate that that process is now going to move ahead reasonably quickly to a constructive resolution of the problem.
QUESTION: I had two questions. One, in view of all the qualifiers and references to downside risks in your forecast, does that mean that we cannot rule out a global recession next year? Secondly, I am wondering if it is possible for you to quantify the cost of the global financial crisis in terms of jobs.
MR. MUSSA: That second question is too difficult for me, so maybe I will ask Flemming or Graham to provide an estimate.
Do the downside risks include the possibility of a global recession? We need to be careful about what our definition is here. There is no year in the last 30 years in which world GDP year-over-year growth has been negative. At the beginning of this decade, in 1991, world GDP growth was just under 1 percent. In 1982, world GDP growth was barely half a percent, and 1983 was also a very weak year. Certainly, the early 1980s we would characterize as a global recession, and some would characterize the beginning of this decade also as a global recession.
So if we say that world GDP growth of 1 percent or less would be the standard for a world recession, our present forecast for this year, certainly, does not see a global recession, and our forecast for next year, even allowing for significant downside risks around that forecast, would not quite reach the threshold of global recession. But, clearly, we have been approaching that state. That has happened in a situation in which this year North America and western Europe have continued to grow quite strongly. They have not experienced recession of any kind. But Asia, particularly the most intensely affected Asian economies, certainly has been experiencing very deep recessions. In some cases, one would even speak of depressions.
For next year, we look at the situation as being in some sense a little bit more balanced--that is, we think growth will slow down in North America somewhat, and while Asia will by no means experience a boom year or a year of vigorous recovery, we do not think it will experience another year of steep recession. We could get, however, a worse outcome than we are projecting if we saw continuation of negative growth in Asia, a sharper fall-off than we are forecasting in Latin America and other emerging markets, and, probably associated with that, a more substantial slowdown in North America and western Europe. That really is the scenario which would sort of push the world economy toward 1 percent growth or lower next year. That is not our forecast, and that is still a forecast that I would characterize as below the sort of mean; that is to say, the probability that we would see 1 percent growth or less at this stage is an outlier in the probability distribution of probable outcomes. It is not, however, an extreme outlier. It is a risk with which policy makers around the world need to be concerned.
MR. LARSEN: I cannot give you a measure of the cost in terms of employment. I will try to give you a different sort of measure of the cost of the crisis. If we consider that the crisis is essentially responsible for the slowdown in world growth to an estimated 2 percent in 1998 compared to a trend growth rate of somewhere between 3 3/4 and 4 percent in the world economy we have observed during the past quarter century, this shortfall of 1 3/4 to 2 percent of world GDP in a world economy that produces goods and services at a value of $30 trillion per year--as much as $40 trillion on a purchasing power basis--obviously represents a huge loss of output and, therefore, also of income of between $600 and $800 billion. This represents a huge number of jobs. How much is, actually, 1.7 or 2 percent of world GDP? It corresponds, essentially, to an economy of the size of Canada taking a year off and not producing anything in a full year. That is the magnitude of the output and income loss resulting from the crisis.
QUESTION: I have two questions relating to Latin America. First, in your forecast you said there is a kind of lower level of economic growth in Latin America for next year. My question on that is: how helpful can be the solution to the crisis in Brazil in terms of the IMF giving a financial package, I assume, next week?
My second question is on Mexico. There was a report in the Wall Street Journal saying that the Mexican government is discussing with the IMF a monetary policy, the same policy that is in place in Argentina. In other words, pegged to the dollar. Can you comment on that and also tell me what kind of advice you can give to the Mexican government in terms of monetary policy.
MR. MUSSA: In terms of the situation in Brazil, I think the reading here in the Fund is very similar to that of the Brazilian authorities. The Brazilian authorities recognize that the fiscal deficit is too large, even allowing for the fact that the fiscal deficit is a broader measure than most countries report and that it is being distorted now because of the high interest payments that the Brazilian government needs to make on its debt. Nevertheless, there is a medium-term need to reduce the fiscal deficit significantly and to start the debt-to-GDP ratio--which at 40 percent of GDP is not exceptionally large--on a downward rather than upward course. The original plan had been to move gradually to that situation over a two- to three-year time horizon. However, the deterioration in the external environment for emerging market finance, the upward spike in interest rate spreads, and apparently also concerns domestically about the government's fiscal program and the level of interest rates have increased the urgency of fiscal action to restrain the deficit. The Brazilian government has been taking such action for the current fiscal year, and President Cardoso has announced his intention to delineate a program that would carry forward that action on a vigorous basis to FY 1999. I think it is unfortunate that there is not a longer time horizon under which to undertake those adjustments, but the financing environment simply does not permit that, so vigorous action is called for.
The effect of such action should be to help to restore confidence inside Brazil and as far as Brazil's external credit is concerned, which would help to reduce interest rates both on Brazil's external and internal debt. However, in the present adverse financial environment for virtually all emerging markets, relying exclusively on fiscal policy measures may not be enough to support the necessary restoration of confidence. In that kind of environment, the provision of a substantial package of external financial support could be helpful in supporting the efforts of the Brazilian authorities. The effort will not work without the strong and determined efforts of the Brazilian government, to which President Cardoso has forcefully committed himself. The details, however, are yet to be fully elaborated. The Managing Director has indicated that the Fund and the international community more generally stand ready to support efforts in Latin America as may be needed to avoid a further spread of the contagion from the emerging market financial crisis.
With respect to Mexico's monetary policy, I myself am not aware of any urgent discussions to consider the introduction of a currency board arrangement or type of arrangement in Mexico. It would strike me, as an economist, that, while such an arrangement could, I think, have some important benefits, the present environment might not be the ideal one for considering its immediate implementation. The Mexican peso, it is true, has depreciated significantly against the U.S. dollar since the beginning of the year. That probably has helped to provide Mexico with some breathing space in terms of its adjustment to external financing pressures, to an extent that further depreciation of the peso at this stage would not, should we say, clearly be warranted. Nevertheless, moving to a firmly pegged exchange rate in an environment of international financial tension imposes additional burdens on the conduct of economic policy which may not be particularly wise to undertake at this time.
QUESTION: In recent years, the U.K. economy has to a degree been running parallel with the U.S. economy, and suddenly you are suggesting that it has diverged sharply and the U.K. economy is turning down much more dramatically than the U.S., despite the fact they are both suffering from rising imbalances in net trade. I was wondering what is it specifically about the U.K. that is causing this, and, secondly, whether you think the Bank of England should cut interest rates, not just that it might?
MR. HACCHE: There has already been a significant slowing of the U.K. economy since early last year, first owing to a slowing down in the growth of net exports, and since early this year a slowing of domestic demand. The slowing of domestic demand is reflecting a tightening of both fiscal and monetary policies and a tightening of monetary conditions more generally, reflecting the appreciation of sterling since 1996. Looking ahead, we expect these factors to continue to exert a slowing influence on growth to a greater extent than in the United States, largely reflecting the greater tightening of monetary policy, which has been needed to restrain inflation, to keep it within the target. With the slowing of growth that is now projected and with the apparent moderation in the growth of average earnings since the summer, we now see some possibility emerging, as Governor George has indicated, of possibly an easing of monetary policy if the prospect emerges of inflation falling below the 2 ½ percent target.
QUESTION: I have a question on the EMU and the ECB. What is the correct policy mix in the EMU? In your analysis, you are going to the monetary policy and fiscal policy. There is also a foreign exchange policy with some new ideas coming from the next German government. They are mentioning target zones between euro and dollar. Also, these ideas are well known in Paris. What is your opinion about the future role of the euro in the foreign exchange market and the ideas of targeting with dollar and yen. Is it realistic?
MR. MUSSA: Let me ask Mr. Larsen to comment on the question about the policy mix, and then I might say a word or two about the target zone issue.
MR. LARSEN: The policy mix at present is a mix that is characterized by a relatively accommodating monetary policy, a slightly expansionary monetary policy in the core countries, and a fiscal policy which unfortunately has turned slightly expansionary in 1998, following the tremendous efforts made by the members of the future euro area to reduce budget deficits and bring them in line with the Maastricht criteria in recent years. There do seem to have been some slippages. There may be some adjustment fatigue. It is not a huge deterioration, but it is probably going a bit too far in the wrong direction.
Looking ahead, we hope that fiscal policy will get back on track toward reducing structural deficits further, but, at the same time, if there were to be a sharper slowdown in activity in Europe stemming from the deteriorating external environment than we project at present, there would be scope for letting the automatic stabilizers operate. We think that, if there were a sharper slowdown in activity than expected at present, a primary policy response ought to be a further easing of monetary conditions. Monetary conditions will, of course, tend to ease somewhat if the convergence of interest rates in the euro area does take place toward the lower end of the present range of interest rates, which we understand seems to be the intention. There is, certainly, the flexibility for further reductions in interest rates in Europe, should this be warranted by the external environment and the impact of the external environment on growth in Europe.
MR. MUSSA: On the exchange rate issue, certainly our judgment has been that there have been occasions over the past two to three decades when exchange rates among the major currencies have moved to an extent and with a speed that has been decidedly unhelpful from the standpoint of the general stability of the world economy. In such circumstances, it is desirable to resist these types of exchange rate developments. We had an episode of that in early 1995 when the dollar depreciated unreasonably against both the Japanese yen and key European currencies. Some constructive actions were taken to resist those developments and, indeed, a significant correction of the yen was achieved.
There are, however, other circumstances in which the movement of major currency exchange rates, even though quite significant, may be helpful from a broader macroeconomic perspective. So, while at present the U.S. dollar is at a level that would seem not consistent with a desirable medium-term position of the U.S. current account balance--that is to say, the deficit implied by the current level of the U.S. dollar is too large for the medium term--in the present cyclical situation, it has generally been helpful to the world economy, the United States and Japan and western Europe, to have had a dollar that is comparatively strong relative to medium-term fundamentals at this time. There will come a time, sometime in the future, undoubtedly, in which having a dollar which is relatively weak in comparison with its medium-term fundamentals will be appropriate from a cyclical perspective.
A system of target zones that is rigid and narrow does not allow this type of flexibility and differentiation of movement. At least, I believe it is difficult to get it into an agreement on target zones. In addition, a system of relatively narrow and firm target zones is not viable unless monetary policy is committed in a serious and significant way to defend those target zones. At least up to this point, on neither side of the Atlantic has there been a general perception that devoting monetary policy in a much more serious and significant way to the pursuit of exchange rate objectives rather than the other more traditional objectives of monetary policy is a desirable way to go. You would need to make that decision, at least in my judgment, in order to have any chance of instituting a viable system of reasonably firm and comparatively narrow target zones for major currency exchange rates.
QUESTION: In the World Economic Outlook, you say that Argentina has a large current account deficit, which is still a matter of concern, and then you point out that Argentina has a too-large trade exposure to Brazil. Finally, you are predicting an increase in the unemployment rate. I thought we were a real model for emerging markets, so I wonder why you are writing these sentences.
MR. MUSSA: Well, hopefully, because we believe that they accurately describe the situations and policy concerns. Argentina's trade and current account deficits have been growing rapidly over the past couple of years, as the Argentine economy has recovered from the tequila crisis. It is true that an important part of the deficit does reflect capital imports to support investment. Nevertheless, especially in an environment where world financial markets are looking with intense concern at virtually all emerging markets, a large--certainly, a large and growing--current account deficit has to be viewed as an important source of vulnerability. The situation in that regard for Latin America has changed today from what it was six months ago. Six months ago, while capital flows to Asia had fallen very dramatically, capital flows to Latin America remained very well sustained. But the financing environment for Latin America, looking forward, is simply not as generous as it was and was assessed to be likely to continue to be a few months ago.
I would not say that Argentina has too large a trade exposure to Brazil. Argentina has large trade flows with Brazil. This is, by and large, desirable. MERCOSUR trade liberalization by both Brazil and Argentina has been a considerable success. The point is that, with large trade flows between Brazil and Argentina, if an accident happens in Brazil, that is going to have a larger effect on Argentina than would have been the case a decade ago, when trade flows between those two countries, undesirably as a general matter, were much smaller than they are today.
With regard to the unemployment rate going up a little bit, this is not what we wish to see happen. It is a consequence largely of an adverse change in external circumstance which now makes it necessary for the Argentine authorities to pursue a somewhat tighter fiscal policy than was otherwise being planned and because of an adverse change in the external financing environment which, given Argentina's monetary arrangements--indeed, regardless of the nature of Argentina's monetary arrangements--will tighten domestic monetary and credit conditions in Argentina, simply because the external financing environment has become much less hospitable and there is no way to shelter the domestic economy from that effect. Those things will slow the growth rate of the Argentine economy. With a slower growth rate, unemployment is going to edge up a little bit. That is what is in the forecast. It is not something we would desire to see happen, but it is the forecast of what we think is most likely to happen.
QUESTION: In your opening statement, you said that financial markets expect a further easing of U.S. interest rates in coming months. Can you give us some idea of the extent of easing that you personally foresee in coming months.
MR. MUSSA: First, in terms of the financial markets, before the Fed action, I think they were anticipating about 75 basis points of easing, as measured by the futures rate on federal funds between last Friday, let us say, and some time in the early part of next year. I have not looked at the futures quotations today. My guess is that they must remain about the same, so financial markets are broadly anticipating another 50 basis points of movement.
In terms of what I see, I think it is desirable that the Federal Reserve meet as it does, roughly every six weeks or so, evaluate what conditions are at that time and what prospects are looking forward, and make a decision about whether to ease short-term interest rates, leave them alone or in some circumstances tighten them. I doubt that we will be looking at a situation where it will be prudent and plausible for the Federal Reserve to tighten interest rates over the next six months or so, but later next year one can never be certain. We think things are going to slow down a fair bit in the U.S. economy, but they look pretty solid for the third quarter, and there is no indication yet that in the fourth quarter growth will be below potential to any significant extent.
So I think the Federal Reserve is right in its general policy stance to recognize that the world economic environment has changed, probably it has changed for something more than a month or two, and that is going to have an impact on the U.S. economy and, hence, implications for U.S. monetary policy, which it is well to recognize and signal in an initial 25 basis point cut in interest rates.
Conceivably, one could have moved 50 basis points yesterday. I certainly would not have been adverse myself to such a movement. On the other hand, I would have tightened interest rates in the United States another 25 or 50 basis points during the first half of 1997. My personal preference is for a little bit more aggressive movement in monetary policy, and I would have been more aggressive tightening a year and a half ago, and I would be more aggressive easing now. Maybe it is just that I am more aggressive than they are. But I think they have sent the right signal about the direction of movement.
There has been plenty of demonstration over the course of the last dozen years or so that the Federal Reserve is prepared to move pretty swiftly and by substantial amounts when they see the information coming on screen that warrants such movement, and the nature of their actions has clearly not been to simply wait for the economic data that describes the past behavior of the economy to be forthcoming before they act; that is, they recognize that monetary policy needs to be forward looking if it is to play its role effectively. We certainly saw that in their decision yesterday, and no indication in the backward-looking data at all that would have suggested an easing of monetary policy at this stage, given the performance of the U.S. economy, based clearly on the perceptions of what the Federal Reserve sees going forward, which is a less buoyant picture of the U.S. economy than people were perceiving 6 or 12 weeks ago.
QUESTION: Let me turn to the greater Chinese area for a second. The IMF forecast for China this year is a GDP growth rate of 5.5 percent, which is significantly lower than the official target of 8 percent. The CPI forecast for China is zero percent. A zero percent CPI growth rate for China has never been seen before. Can you explain that a little bit? Also, can you touch on Hong Kong's and Taiwan's economic forecasts.
MR. LARSEN: The greater Chinese area, as you called it, is of course very closely integrated with the rest of Asia, including with the countries that are now in crisis and, in most cases, in quite deep recession. That means that some of the tremendous expansion there has been in intra Asian trade in recent years is going to suffer quite a setback, and China is feeling this compression in intra asian trade just like all other countries in Asia and, for that matter, in the rest of the world are. But, because of the substantial trade links, China will, of course, not be able to escape these consequences to some extent.
There are also other reasons why we think that the Chinese economy is slowing--and we believe we can observe that it is slowing--including problems in its own construction industry. There have been signs of overbuilding that will need to be worked off. There have also been indications of very large accumulation of unsold inventories in many Chinese industries, which obviously cannot go on forever.
On the positive side, the Chinese authorities have appropriately resorted to significant fiscal stimulus, given the difficult external environment. This will help cushion the slowdown, but probably cannot avoid a slowdown of the order of magnitude that we are projecting.
Hong Kong, SAR has been hit very severely by the crisis in Asia, being even more closely integrated with the crisis countries than mainland China, and we are seeing the consequences of the contraction in trade. Hong Kong also had difficulties in its own economy, with problems of overheating, a very hot property market, some overcapacity that is now being worked off, and adjustment of asset prices. So the Hong Kong economy is probably going to contract this year as a result of the repercussions of the crisis and some of its own problems at home. Hong Kong, SAR, has also been able to resort to some fiscal measures to stimulate activity, which would help to cushion the contraction.
Taiwan Province of China, of course, is also being affected, but again it has some leeway to stimulate its economy, to stimulate domestic demand. And it has done so, which is helping limit the contraction.
QUESTION: I have two questions, if I may. The first is that there has been much talk of a need to restore market and investor confidence in the crisis economies in emerging markets. Can you point to anything in this report that would be inclined to restore such confidence?
Secondly, on Russia. There is a long history of the crisis in Russia in this report, but, as far as what happens in the future, there is a kind of wish-list of various things that need to be done, in fairly shorthand form. Would it be fair to say that the IMF has thrown up its hands in despair at Russia's political problems and there really is nothing else that can be done? If so, what implications does that have for the prospects for restoring confidence?
MR. MUSSA: I think in the WEO there is a good deal in terms of the policy prescription to help restore investor confidence. I tried to cover some of that in my opening remarks. I think we do need to move to easier monetary policies, generally, around the world, and that is what we are recommending for 90 percent of the world economy.
In countries that are under particularly intense pressure and that have substantial fiscal deficits, there a tightening of fiscal policy, even though it has a short-term adverse effect on growth, is certainly a key measure to restore confidence. To some extent, also, financial markets need to right themselves. In the aftermath of the Russian default and in the scramble of hedge funds and other speculative investors to meet margin calls and other problems, there has been a spike upward in interest rates, which should be able to resolve itself gradually over time if that situation is not allowed to get out of hand. The Federal Reserve was, of course, active in securing a more orderly unwinding in the case of Long-Term Capital Management, and that may not be the last such episode.
With respect to Russia and whether we are in a state of despair, I have known the Managing Director, now, reasonably well for seven years, and I have never been able to describe his mood as one of despair. So I do not think we are in a mood of despair about Russia. But there is no question that, in order to re-establish reasonable economic stability in Russia, firm actions need to be taken by the Russian government. This is not something that international support can resolve. They need a credible fiscal policy, they need a disciplined monetary policy, and they need to get moving again in a positive direction with their structural reform efforts. It may be wishful to think that the present political environment is going to produce that, but I think the reality of the economic situation in Russia is at some point, and probably some point before very much longer, going to compel more constructive action to deal with the crisis there.
QUESTION: If we remember presentations of this kind a few years ago, maybe two years ago, of the IMF about the World Economic Outlook and compare them with the situation today, would you say, Mr. Mussa, that in this time period the IMF has made any mistakes, significant mistakes, and if so what ones?
MR. MUSSA: I am not going to describe all of the mistakes that we potentially have made, because that would take us several hours, I fear. I like to keep my own personal list of mistakes that I think I have made. I do recall recommending in March of 1995 that the Federal Reserve should tighten U.S. monetary policy as part of a coordinated effort to resist undue depreciation of the dollar. It turned out that that was precisely the moment at which the U.S. economy was slowing down very dramatically, and within a month I had to reverse that advice and instead argue that they should ease U.S. monetary policy, notwithstanding the fact that the dollar was quite weak at that time.
I could go down the list of the G-7 countries. With seven years and seven countries, there have been 49 opportunities on an annual basis to make significant mistakes. Maybe we have nearly 100 if we have both monetary and fiscal policy. While I have missed a few of those opportunities, there have been several where I think my own policy advice has been not entirely what is appropriate.
In the case of Japan, there was a very substantial tightening of fiscal policy, amounting to almost 3 percentage points of GDP between the summer of 1996 and the summer of 1997. That is an issue which is discussed in the present World Economic Outlook. I think it is clear, at least in retrospect, that while Japan should have been moving toward fiscal consolidation in the medium term as the economy recovered, there was too much fiscal consolidation too soon in 1997. Nevertheless, that was an action that was broadly endorsed, not by everyone in the international community, or indeed everyone in the International Monetary Fund, but if you go back and read the Annual Reports of the International Monetary Fund and the description of what our policy advice was to Japan, we were generally supportive of a very substantial fiscal consolidation at that time. As I say, I think in the light of hindsight most people would conclude that that was too much too soon. I point this out as only one example.
There have been a lot of questions raised also about our policy advice in the Asian crisis economies. We discussed this in a couple of boxes in Chapter 2 of the WEO. I think, in the case of monetary policy, when you have a national currency that has been depreciated very enormously by market pressures and you have a large volume of foreign currency denominated debt of domestic banks and businesses, monetary conditions have to be firmed at least moderately in order to resist overwhelming depreciation. Thailand and Korea were somewhat tardy in taking those efforts, but did take them, and that helped stabilize the situation. They have now been able to bring interest rates down again. In Korea, they are below the level of when the Asian crisis started, and the Koreans are moving to ease them further. In Indonesia, where they did not really tighten monetary policy, except for a very brief period, and then injected massive quantities of liquidity into the banking system, we had a disaster, and the exchange rate just depreciated out of sight. So I think those who argue that monetary policy should have been eased rather than tightened in those economies are smoking something that is not entirely legal.
On the fiscal policy side, the situation varies from country to country. There is, again, a box in this WEO that discusses that situation. My personal view for Thailand is that the initial fiscal tightening in the August program was appropriate under the assumptions under which we and everybody else were operating at the time. Questions have been raised about whether the further fiscal tightening that was undertaken in the autumn of last year was entirely appropriate. I think those are reasonable questions to ask. I would note, however, as is discussed in the WEO, that the stance of fiscal policy in all of these economies has shifted very considerably, and they are all now, this year and next year, projected to run quite significant fiscal deficits. Part of the reason for that, of course--and, again, there is a chart in the WEO which shows this--is that not only our forecast but everybody's forecast of economic performance in the Asian crisis economies did not foresee the magnitude of the recession that has befallen these countries and that is now apparent.
At the end of last year, in December of last year, positive growth was still expected in all of those economies, except Thailand. It has been necessary and desirable to adapt the policy stance in all of these economies as conditions have evolved in a manner that was not anticipated at an earlier date.
QUESTION: A question about Brazil. You said that the details of the financial package are being developed, but could you please give us an outline of what that package will look like and what vigorous actions the Fund expects from the Brazilian government.
MR. MUSSA: I would suggest you consult the Managing Director on that issue tomorrow. I do not have information about it, even if I were prepared to give it, which I am not.
QUESTION: Just another question, please. The tone about Brazil in the report is substantially different from the high praise of the Brazilian authorities that was emanating from the Fund before. Now we see references to the delayed response in monetary policy in Brazil. Is that the right impression, now?
MR. MUSSA: Monetary policy is not a set-it-and-forget-it type of policy. Brazil was, I think, doing quite well and financing flows to Brazil remained quite generous through the early part of this summer. Then, after Russia devalued and defaulted, there was a dramatic change in external conditions. The question is: how much and how rapidly did you respond to that very sharp change? There, we think there was a little bit of a delay in terms of the vigor of the response. In contrast, in October of last year, the response was very rapid after the Hong Kong disturbance. But there is no doubt now that Brazilian monetary policy has been tightened very substantially to resist the capital outflow. Now, that level of interest rates cannot be sustained indefinitely, from the standpoint of either the impact on the economy or the impact on the fiscal situation, so it is very important to bring in the reinforcement of a tightening of fiscal policy so monetary policy can be relieved of some of that pressure. But it is monetary policy that possesses the capacity to react very quickly, essentially instantaneously, to these developments. When one comes under intense pressure, it is the strategy of the Civil War General Nathan Bedford Forrest--get there firstest with the mostest--that is what monetary policy needs to do in that type of situation.
QUESTION: Your forecast for British growth is 1.2 percent. With significant downside risks, it looks like there could be a recession. Could you quantify that risk.
Secondly, on global interest rates, with hindsight, would you have asked for or recommended a global easing in rates much earlier than you have done?
MR. MUSSA: Graham answered earlier on the United Kingdom economy. Actually, I think the forecast of 1.2 percent growth now is probably a pretty good central estimate. There is obviously a downside risk that the outcome could be slower than that, but there is also some upside potential as well. You want to remember that the United Kingdom's most important trading partner is the rest of Europe, and the situation there still looks reasonably solid. Obviously, the general risks and concerns about the world economy will impact the U.K., so maybe there is a marginal bias to the downside, but I would not push it for the U.K.
With respect to global interest rate actions, you want to remember that stock markets in the industrial countries peaked in mid-July. On July 17, the Dow hit 9,300, its all-time peak. Within a few days, one way or the other, we also had peaks in the key European markets. Emerging markets, while credit flows had been reduced from what they were through the summer of last year, had actually revived from where they were in December, January, and February. The Russian devaluation and default did not create, but it triggered a kind of sea change in world financial markets. Interest rate spreads for all emerging markets spiked up in a matter of days by 1,300 basis points.
On capital flows to emerging markets, we have some figures on gross flows to emerging markets. After the slowdown in the winter, they recovered to the order of $20 billion or so a month through July. In August, they fell to $2 ½ billion. Since the middle of August, there have effectively been zero new gross flows in our measure of them. There has been a very sharp spike-up in spreads, also, for lesser quality credits in most of the industrial countries, including a widening of spreads for Italy and some other European countries versus the deutsche mark. German interest rates have been pushed down, along with rates on the U.S. dollar. Very large unprecedented movements. Ten standard deviations out in the distribution. That is why Long-Term Capital Management got into the difficulty it did. We had a millennial event; that is, something which the probabilistic model said would happen once in a thousand years happened in the middle of August, and it caught some people a bit off guard.
There has been an important change in financial market conditions that has occurred within the last month and a half, roughly. A lot of times, events of this kind reflect an initial panic which calms down after a while. So you do not want to make monetary policy decisions on the basis of momentary and perhaps temporary changes in financial market conditions. But I think the Federal Reserve, looking at the situation six weeks after the event and seeing, obviously, that things had far from calmed down completely, and recognizing that there are going to be consequences going forward, has signaled an intention to change the direction of monetary policy action in the United States. I think the countries participating in EMU have also signaled an intention to change something about monetary policy. Before, the expectation had been that interest rates in the euro area would probably converge up in the core countries and down in the other countries to something close to the average for the euro area by the end of this year or the beginning of next year. Now, very clearly, the intention seems to be to allow downward convergence to the interest rates prevailing in Germany, France, the Netherlands, and so forth, which means about the degree of effective easing of short-term interest rates which the Federal Reserve has just engineered yesterday. I think the Federal Reserve has signaled quite clearly that it is going to look at the situation carefully and is prepared to consider very actively the possible need for further easing down the road. We will need to see what the future European system of central banks will be prepared to do, but at least our view is that they require a similar flexibility in their attitude, recognizing that Europe is not in the same economic situation as the United States is and monetary policy has a more accommodative stance in Europe than it does in the United States, but they have larger margins of slack in Europe than exist in the United States.
So this is an environment in which monetary policy needs to be alert and active to the risks. It is not, however, in my judgment, an environment in which coordinating monetary policy actions between the Federal Reserve and Europe makes a particular degree of sense. I think Chairman Greenspan's remarks in that regard were misinterpreted when he spoke to the Congress two weeks ago. What I interpreted him to be saying is: The Federal Reserve is not going to wait for the Europeans before we act. And that turned out, in the event, to be the correct interpretation.