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Transcript of a Press Conference Call on the World Economic Outlook, Chapters II and III
by Raghuram Rajan, Economic Counsellor and Director,
Research Department,
with David J. Robinson, Deputy Director,
Research Department,
and James Morsink, Chief, World Economic Studies Division,
Research Department
September 22, 2004
Washington, D.C.

OPERATOR: At this time all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will be given at that time. If you should require assistance during the call, please press star then zero.

I would now like to turn the conference over to our host, Mr. Bill Murray. Please go ahead.

MR. MURRAY: Thank you, and welcome, everyone, for coming today.

Before I introduce the speakers, let me just cover a few ground rules. A reminder that this briefing along with the texts that are now posted on the Online Media Briefing Center are under embargo until 2030 GMT today. That's 4:30 p.m. Washington time.

This briefing is focused on Chapters II and III of the World Economic Outlook. Chapter I, the global forecast segment of the WEO, will be released publicly on September 29th. We will deal with those questions at a press conference scheduled for the morning of September 29th here in Washington at IMF headquarters. So please focus today on the contents of the essays in Chapters II and III.

Let me now introduce the principal speakers today: Mr. Raghu Rajan, who is Economic Counsellor and Director of Research at the IMF, is here with me and will have some brief opening remarks shortly. With Raghu is David Robinson, the Deputy Director of Research, and also Jim Morsink, who is the Chief of the World Economic Studies Division of the Research Department.

In addition to the three principals, we also have all of the authors of the essays that were produced for Chapters II and III of the WEO. So when question time comes, certainly we can delve into these essays more deeply with the authors.

Now, let me turn the table over to Raghu, who, as I said, has some opening remarks. Thank you.

MR. RAJAN: Thank you very much. Good morning and thank you for being here.

The analytical chapters are, as always, on topical issues, but we do a little more work on them and offer more detailed analysis. Let me offer some of the main findings of each chapter.

I'll start with the chapter on demographics. How will demographic change affect the global economy?

Now, it's well known that populations are aging in industrial countries and will strain government finances in the years to come. I think less well known is the fact that growth rates in these countries will also slow.

By contrast, in some developing countries, like India and some countries in Africa, they will have a demographic dividend in that the relative size of their working-age population will increase, as a result of which they should have stronger growth over the next 20 to 30 years.

So demographic change is going to change the balance between savers and dissavers. Countries like Japan and those in Europe, which now have significant deposits of current account balances, will actually start dissaving, and their current account balances will worsen, while many developing countries which have negative current account balances will start saving some more.

Now, the challenges posed by population aging for developed countries are serious, but sometimes we make too much of them. Policymakers sometimes overstate the magnitude of the challenges by focusing on single-point solutions. For example, if countries wanted to maintain their current ratio of workforce to population, using immigration alone they would have to have cumulative immigration of over 30 percent of population, and that's clearly politically infeasible in many countries.

However, if they use multiple policies, such as increasing participation rates, extending work lives, and allowing more immigration, the numbers involved, which the chapter documents, seem far more feasible both politically and even economically.

Now, given these solutions are quite feasible, the chapter also stresses that action is needed quickly. For example, pension reforms will become increasingly difficult to implement as populations age because the reforms will hit the age who will become politically more powerful. Even in the United States, which has a relatively young population because of immigration, the time that it has to undertake reforms is fairly limited because the elderly in the United States are politically more conscious and more likely to vote. So time is running out for these reforms, and they have to be done quickly.

Let me turn now to the essay on housing in Chapter II. It's entitled "The Global Housing Price Boom." And the key findings of the essays are, first, even though housing is not traded internationally—it's not, as economists call it, "a traded good"—house price movements across industrial countries have become surprisingly highly synchronized. Indeed, this present housing boom is a global phenomenon with only a few exceptions of countries that are not participating, like Germany and Japan.

Now, in some industrial countries, such as Australia, Ireland, Spain, and the United States—the United Kingdom, I should say, house price increases in recent years cannot be explained by movements in fundamentals alone. While, of course, it is possible that our models don't capture everything, based on these models we see the possibility of a slowing of house price growth in these countries to be most likely relative to other countries.

Because of the correlation of house prices, of course, there's an additional risk; that is, that the slowing of house price growth starting from these countries spreads to other countries, and there becomes a more generalized house price slowdown.

Now, we also think that common factors across countries are likely to be responsible for a slowdown, and the most likely common factor is going to be rising interest rates. And it is important, therefore, that anticipating this risk that any change in interest rates, any movement upwards in interest rates should be gradual. And to effect the graduality, it is important that monetary policies start making the changes now so that, in fact, the changes can be gradual.

Let me turn now to the essay on "Learning to Float: The Experience of Emerging Market Countries since the Early 1990s." The IMF has been advocating greater exchange rate flexibility for some countries, notably China. However, policymakers have expressed concern about the risks of exchange rate flexibility, macroeconomic risks such as higher inflation. And this essay looks at the past experiences of countries that have made the move to see if these concerns are justified. And essentially it finds that voluntary transitions to more exchange rate flexibility were not, I repeat, not associated with an increase in macroeconomic instability. And, in part, it was because these countries that transitioned took some time to strengthen their monetary and financial policy frameworks.

Now, this is not meant to be, however, an excuse for countries to say we need to fix everything before we move because a number of countries actually did some of the improvements after their transition. For example, a number of countries adopted inflation targeting regimes after their transition.

So the bottom line in some sense is that while caution is good, countries can be overly cautious, requiring that every institution be in place before they adopt flexible exchange rates.

Let me turn to the last essay, "Has Fiscal Behavior Changed under the EMU?" As you know, a number of countries in Europe have now a common currency, the euro, and because they have a common currency, monetary policy becomes much less adaptable to the specific needs of particular countries, which means the burden has to be taken by fiscal policy. And this essay focuses on how fiscal policy has been and essentially concludes that it's been disappointing in terms of effecting macroeconomic stabilization.

In particular, fiscal policy actions in most euro area countries have tended to exacerbate fluctuations instead of dampening them, and this is, of course, disturbing because fiscal policy is the only large policy instrument available to these countries.

Now, in the run-up to the monetary union—that is, before the adoption of the euro—countries tightened in both good times and bad times in an attempt to reduce deficits and debt and meet the qualification, in some sense, requirements. Now, that policy pattern has been reversed to a certain extent under the Stability and Growth Pact because under the Stability and Growth Pact countries have tended to loosen both in good times—these are times when revenue windfalls allowed them to do a lot of new spending and to reduce taxes—but also in bad times, when there is a natural tendency to run in deficit.

So given that there is a general bias towards looseness in both good times and bad times, there is a bias towards increasing deficits and increasing debt in the long run. And, of course, given the chapter that we talked about where the costs of aging populations are looming large and looming closer, it is important that euro area countries break this vicious cycle, and especially the key priority in the reform of the SGP should be to enforce greater fiscal restraint in good times.

So those are some of the results of the essays in the chapters. Let me turn it back to Bill.

MR. MURRAY: Okay, great. Thanks, Raghu.

I guess now we'll open the conference call to questions from the press.

QUESTIONER: Hi. I have a question about the housing essay. On page 17, there's a paragraph that suggested that, at least for the U.S., the analysis does not find compelling evidence suggesting that a real house price drop is in the offing. Given what you said about the fact that the movements tend to be connected and you're expecting a drop in Ireland and Australia and those other countries, why would this be the case? And can you elaborate on what you mean that the analysis does not find evidence of—compelling evidence of a house drop price in the U.S.?

MR. RAJAN: Well, first, we don't necessarily expect a drop. If there is a drop, it is likely to be in those countries. And the reason we think it's going to be focused on those countries is that's where we see the biggest difference between what one might think are fundamentals driving housing prices and the actual level of housing prices. That's one reason why we expect more of, if at all, a slowdown in the United States rather than an actual serious drop, because in the United States the distance between actual house prices and fundamentals is not as great as in some of these other countries.

But let me turn it over to David if he has any other...

MR. ROBINSON: No, I think that's fundamentally right, Raghu. We expect to see slowing growth in house prices in the United States as interest rates rise, and I think that's what's shown by the simulations that we present in that chapter. And it's consistent with slowing growth elsewhere.

In addition, it is also a historical fact that house prices for the U.S. as a whole have never fallen. Now, of course, history is not always a good guide for the future, but that is another factor to keep in mind.

QUESTIONER: Okay. Just to be clear, you're expecting house prices to continue to rise but at a slower rate than in the past few years.

MR. RAJAN: That's right. We first expect a slowdown, and that's really the maximum likelihood as to what will happen.


QUESTIONER: Good morning. I guess along those same lines, I have a question. It's not clear to me exactly why or how you judge that fundamentals are out of whack in the U.K. in housing. On Table 2-1, what is the key—where is that—which indicator here is important? Is it mortgage loans or ownership ratio? Or where [inaudible]?

MR. ROBINSON: Let me start perhaps by directing you to a different place which may be helpful to look, which is Box 2.1, where we go through an analysis of the factors affecting—that sort of fundamentally affect house prices.

QUESTIONER: Oh, I see. Yes.

MR. ROBINSON: And then we sort of try and see how much of the house price growth that we have seen in individual countries, we explain by those fundamentals. And if we can't explain a large chunk of it, then there is at least a prima facie question about whether prices have gone ahead of fundamentals. Obviously, as Raghu said, the model doesn't necessarily include absolutely everything.

When we look at that, and if you look at the factors set out in Table 2.1 of that box, I mean, we find that key factors, for example, are growth in real disposable income, short-term interest rates, population growth in terms of fundamentals. There are some others. And also we find that the housing affordability ratio is very important; that is, the less affordable things become, then there's a tendency for prices to start to revert back to mean.

And the other thing that we find important is that there's a degree of persistence; that is, if house prices are increasing last year, there's a tendency also for them to increase this year.

Now, in terms of the U.K. in particular, if you look at the chart on page 5, you'll see a breakdown of actual house price growth and some of the explicands in those bars, and you'll see that we can explain some of the house price growth in terms of higher short-term interest rates—that's one of the biggest components—

[Inaudible comment.]

MR. ROBINSON: lower short-term interest rates, thank you. And less in terms of some other smaller items. And there's a fairly large chunk that we cannot explain, I think on the order of 15 to 20 percent, and that's the reason why we conclude that there may be overvaluation of house prices in the U.K. relative to fundamentals.

If you want a more detailed breakdown, then I think we can certainly provide that to you separately.

QUESTIONER: Okay. Thank you.

QUESTIONER: Yes, I have a question on fiscal policy in Europe. You mention here that you would like to see an improvement of the credibility of the enforcement mechanisms and sanctions for breaches. Now, in the proposals on the table from the European Commission, there is talk of allowing prolonged slowdown to be considered as justification for this breach of the 3 percent besides the exceptional circumstance that it is now. Are you concerned that this implies a watering-down of the Stability Pact? And, more generally, are you concerned about—what's your assessment of the proposals of the European Commission?

MR. RAJAN: Our main concern from this essay is really that we should focus on strengthening incentives in good time, and that's clearly very important and we need more teeth in the Growth and Stability Pact.

Of course, a lot of the discussion is on what changes to do in bad times at this point, including what you've just talked about. But we think that strengthening incentives in good times would be a good thing. And, of course, the debate on what precisely to do to increase the credibility of the enforcement and when, in fact, harsh penalties are credible or not, whether the absence of penalties can be credible or not, is an ongoing debate. And the essay doesn't say anything on that.

QUESTIONER: Thank you. It's also again on fiscal policy, and it's on—do you think that the reform that is now on the table is a step on the good direction? And, also, would you say that this flexibility in the face of temporary violations—I'm wondering what you understand about temporary. You are talking on the very short term, like a year, or could it be something more like three years?

MR. ROBINSON: Okay. First, in terms of whether the European Commission's proposals are a step in the right direction, yes, I think that we do think that they're a very important step in the right direction. The European Commission has started a debate on this issue. It's obviously not completed yet, but we think these suggestions are basically very sensible.

In terms of showing flexibility in the face of temporary violations and asking me to define how short temporary is, I mean, I don't think I'm going to try and take that on in terms of, you know, if it's a year, it's temporary; if it's a year and a day, it's not temporary.

I think the fundamental point that we're trying to make is that if you have a violation which is likely to lead to a permanent increase in the deficit and in debt, that is something that is a matter of concern. If, on the other hand, it's likely to turn around with a strong degree of credibility in a reasonable period of time, then it's something that's of somewhat less concern. There are obviously judgments that have to be made on that, taking into account country-specific circumstances.

QUESTIONER: Thank you.

QUESTIONER: Yes, good morning. I have a question about the chapter on "Learning to Float." You mentioned that the IMF had been advocating a foreign exchange regime change in China. Taking the example of India, Brazil, and Chile that you highlighted in your essay, what kind of measures should the Chinese Government take from one of these—from these countries, Brazil, India, and Chile, to move to a greater flexibility in their foreign exchange regime?

MR. RAJAN: That's a very good question. Let me answer very quickly: one of the important lessons certainly from India that one can take is that you don't need full capital account convertibility in order to have a flexible exchange rate. It is possible to have flexibility without going that route, and I think the IMF has been advising China that going to full capital account convertibility is neither desirable nor essential.

However, there are other institutions which need to be strengthened, including the capital markets and the banking system. And I think China is in the process of certainly strengthening the banking system and trying to get more market-based lending criteria in there and cleaning out the bad loans. And this is consistent with what some of these countries have done.

Now, also strengthening the quality of markets and the foreign exchange markets is something that is important, and that is also underway. But let me...

Okay. So my sense is those are some of the major—I won't say lessons that China has to learn because it's actually doing some of these things in the process of hopefully moving towards flexibility.

QUESTIONER: Sorry. In terms of monetary policy, do you think that they could adopt inflation targeting, just like Brazil did? Would it help?

MR. RAJAN: They certainly could, but it isn't necessary, as the essay points out. For example, India doesn't have an inflation targeting regime but has a flexible exchange rate. Clearly, you need some kind of a monetary anchor, but you could have other forms of monetary anchors other than adopting an inflation targeting regime.

Now, if they move in that direction, it wouldn't be a bad thing, and that includes the full paraphernalia that comes with an inflation targeting regime, including greater transparency of monetary policy and so on. It would also imply a more market-based system there, which I think they're in the process of bringing into place. But, again, let me emphasize, it's not an essential criteria for moving towards flexibility.

MR. MURRAY: Okay. Well, if there are no further questions, I guess this is the last call, if anybody does want to—I'll give you a few seconds to weigh in.

If not, I would suggest that if you have any follow-up questions, drop me an e-mail and I will forward them to the authors for handling. My e-mail address is the initial W, for William and then my surname, M-u-r-r-a-y at Again, The embargo is 2030 GMT, 4:30 p.m. Washington time today.

Thanks for joining us.


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