World Economic Outlook -
April 2004

Other issues of the World Economic Outlook

Research at the IMF

Transcripts of video presentations on the analytical chapters of the April 2004 World Economic Outlook
by Nicoletta Batini, Nikola Spatafora, Thomas Helbing and Marco Terrones

Washington. D.C., April 14, 2004

Chapter II, Essay 1
How Will the U.S. Budget Deficit Affect the Rest of the World?
Nicoletta Batini

Hello, my name is Nicoletta Batini. In the latest edition of the World Economic Outlook there is an essay I prepared that examines "How will the U.S. budget deficit affect the rest of the world?". In this short presentation I will explain why the recent rise in the U.S. fiscal deficit, while useful in the short term, can be problematic for the global economy if it were maintained for some time, and what can be done to avert such negative repercussions.

Let me start with some background. From mid-2000 the United States have moved from high to low growth. Together with stimulative fiscal measures and extraordinary military and security-related spending, this has led to a 7 percentage point deterioration in the U.S. budget deficit-to-GDP ratio relative to FY 2000. So far this expansion supported output in the United States and abroad without yet pushing up long-term interest rates. However, sustained and large U.S. fiscal deficits have negative implications for global interest rates, productivity and income. They can also worsen the U.S. current account deficit, that is already record-high, and have an adverse impact on the dollar.

From a historical perspective, the speed of deterioration in the deficit from FY2000-FY2004 as a ratio to GDP is the fastest in the past fifty years. In level terms, the federal deficits are large but similar to those seen twenty years ago. Relative to the past, however, there are two main concerns with the current U.S. fiscal outlook.

First, absent corrective measures, it is likely that the deficit will remain around its current level in future years. Based on a set of somewhat optimistic assumptions, the administration projects that the deficit will fall by half its FY2004 level in the next five years. Under alternative plausible assumptions actual U.S. fiscal deficits—instead of halving—will probably stay close to their current level as a ratio to output over the next decade.

Second, today it may be harder than in the 1980s and 1990s to rebalance the deficit. In fact, even if the U.S. economy looks potentially stronger than in the 1980s, pressures on the budget are likely to increase steadily over coming years due to the retirement of the baby boom generation starting in 2012, and to the fact that people live longer. Moreover, today, the U.S. current account deficit is record-high and net foreign liabilities are accumulating fast, so the U.S. economy is more vulnerable to changes in sentiment in exchange rate markets.

What are the consequences for the rest of world of this expansion? A fiscal expansion in the United States can affect the world through four key channels. First, it boosts consumption and economic activity at home and abroad via the short-run "fiscal multiplier". Second, over the medium term, it causes global real interest rates to rise to rebalance saving, lowering global productivity growth and income by "crowding out" private consumption and private investment. Third, changes in tax rates affect U.S. incentives to work and save and hence economic vitality. Finally, the expansion puts further pressure on the U.S. current account position in the short term, and raises U.S. debt payments to the rest of the world over time. In the long run, this erodes the value of the dollar, lowers consumption in the United States and increases it elsewhere.

Empirical and/or model-based evidence supports the existence of these effects and is confirmed by simulations of a fiscal shock similar to the one recently experienced by the United States and obtained using the IMF's Multi-Region Econometric Model (MULTIMOD). As described in the essay, these simulations show that if the U.S. federal government does not reverse the tax cuts or cut spending in the future, the current fiscal expansion will reduce potential output by 3 ¾ percent below baseline in the United States in the long run, and by 4 ¼ percent in other industrial countries. A gradual consolidation, of the type envisaged by the administration in the FY2005 budget, gives similar short-term benefits but reduces the longer-term losses in U.S. and foreign output capacity by one half, through smaller crowding out. Finally, an early consolidation, whereby the fiscal stimulus is withdrawn at the same rate it was introduced, involves mildly lower real output over the 2005-2008 period, while cutting the long-term negative impact on potential output in the United States and the rest of the world by three fourths.

Protracted and large U.S. fiscal deficits also have important implications for the U.S. external position and the dollar. First, they exacerbate U.S. current account deficits, eroding in the long run the value of the dollar. Second, they reduce the macroeconomic room for maneuver in the face of subsequent negative disturbances in the U.S. economy. Third, by raising the level of U.S. debt, they can tarnish the confidence of international investors in U.S. assets, compounding the probability of sudden shifts in portfolios and a precipitous fall in the dollar.

Heightened risks of an adverse financial market response of this kind are particularly worrisome for emerging market economies with large levels of debt denominated in foreign currencies, as such countries are particularly sensitive to higher global real interest rates or to the value of the dollar.

In short, the analytical results presented in my essay confirm that the U.S. fiscal stimulus supported growth in the United States and abroad in recent years, and suggests that significant benefits could now be obtained from a more ambitious consolidation path over the medium term than the one that has been proposed by the administration. An earlier consolidation would in fact contain losses in potential output going forward, minimize the risk of an adverse financial market response and, at the same time, safeguard emerging markets. In addition, the longer consolidation is postponed the larger the increase in government debt and debt service, increasing the size of future fiscal adjustments needed to stabilize the fiscal position, limiting room for maneuver in response to unexpected events, and complicating preparation for the fiscal pressures from an aging population.

With both the United States and global economies in recovery mode, an early withdrawal of fiscal stimulus over the next few years in a way that pays due attention to incentives to work and invest in the United States would seem to be a sensible and prudent way of balancing short- and long-term economic goals.

That concludes my discussion of the essay. I hope you enjoy reading it.

Chapter II, Chapter II, Essay 2
China's Emergence and Its Impact on the Global Economy
Nikola Spatafora

Hello, my name is Nikola Spatafora. I want to talk to you about an essay in the latest edition of the World Economic Outlook. This essay examines the likely impact of China's future growth on the global economy. It was prepared by a team consisting of Yongzheng Yang, Tarhan Feyzioglu, and myself.

Let me start by providing some background. Over the last 20 years, and after a long period of isolation, China's role in the global economy has increased sharply. Its GDP has grown at an average annual rate of over 9 percent; its share of world trade has risen from less than 1 percent to 5½ percent. As a result, China is now the world's sixth-largest economy and the fourth-largest trader in the world. Also, China's economic weight and its integration into the world economy are likely to continue increasing rapidly, as long as the necessary structural reforms are implemented.

Given all this, will be the likely impact of China's continued growth on different countries and sectors. We try to identify who will reap the largest opportunities, and who will bear the heaviest adjustment burden. And we discuss the policies required to maximize the benefits, while minimizing the adjustment costs. So, what do we find?

First, China's growth and integration experience so far are broadly in line with previous historical episodes of rapid integration, including the post-World War II experience of Japan, the NIEs, and ASEAN-4. Still, in the long-run China is likely to play a much larger global role than any of these economies. China itself clearly stands to gain the most from its rapid growth and continued integration into the global economy.

Second, the impact on the rest of the world as a whole will be more limited, but also beneficial. Individual sectors could suffer significant losses. However, such costs will typically be offset by gains in other sectors. In particular, advanced economies will benefit from cheaper labor-intensive imports, and greater demand for their skill-intensive goods and services. Other developing countries will see increased opportunities for exports to China, both of primary commodities and of manufactures. Also, China's growth could also stimulate dynamic productivity gains in other countries.

Having said that, countries whose factor endowments are similar to China's, and which compete most closely with it in world markets, will need to undertake sizable adjustments and display considerable flexibility in their product and labor markets. Otherwise, increased competition from China could lead to significant losses.

More generally, individual countries will maximize their gains from China's emergence, and minimize the associated costs, by increasing the flexibility of their economies for structural reforms. A successful response to China's growth will involve significant inter-sectoral mobility. As resources move to more productive areas, transitional problems may arise, particularly for less-skilled workers. There will be a temptation to mitigate such problems through protectionism or subsidies. This should be resisted. Rather, affected countries will fare better by speeding up their own liberalization and integration. In particular, developing countries will need to ease obsticles to the absorption of less-skilled workers and to the movement of workers across sectors. Developing countries will also need to increase their investment in workers' training and skill-upgrading.

Overall, the impact on most other economies of China's continued integration is likely to prove relatively limited in comparison with other prospective global changes over the next decade or two, such as continuing trade liberalization. Developing countries themselves need to ensure that their economies are flexible enough to meet the challenge of China's integration. However, accelerated multilateral trade liberalization (for instance of agricultural products) could significantly aid this process. Finally, I would like to stress that the importance of structural reforms to enhance flexibility will be magnified if China's emergence is accompanied by that of India and other large developing countries.
Well, that's it. I hope you enjoy reading the essay!

Chapter III
Fostering Structural Reforms in Industrial Countries
Thomas Helbling

Hello, my name is Thomas Helbling. I would like to talk to you about the chapter on "Fostering Structural Reforms in Industrial Countries" in the latest edition of the World Economic Outlook. The Chapter was prepared by a team comprising. Dalia Hakura, Xavier Debrun, and myself.

Based on industrial countries' experience with implementing structural reforms, the chapter distills four lessons for the design of structural reforms that should improve their political viability. But let me start by providing some background.

There is broad consensus about the substantial benefits to be derived from structural reforms.However, actual reforms have frequently fallen short of desirable reforms, and the need for reforms remains acute in many areas and countries.

The chapter's basic conjecture is that reforms can lack political viability, which reflects political and economic constraints. To understand the interaction between these constraints and reforms, the chapter studies under what circumstances structural reforms in industrial countries were undertaken over the last two and a half decades. It looks at five areas in which important reforms have taken place--the financial sector, international merchandise trade, labor markets, product markets, and tax systems.

The chapter first establishes that some sectors have reformed more than others. Substantial reforms have been recorded in the financial sector, select product markets, and international merchandise trade, where the overall nature of the structural policy regime has changed. Minor reforms dominated in labor markets and tax systems.

What explains these differences? The chapter provides three reasons.

First, short-term costs are obstacles to reform in some areas. Reforms are costly to some because of lower protection from competition and price flexibility. While these costs are immediate, the gains from reforms tend to materialize over time.

The uneven distribution of costs and benefits over time, together with some uncertainty about their magnitudes, reduces incentives for reforms because policymakers tend to focus on the short-term costs of reforms and heavily discount the long-run benefits in view of short election cycles.

Second, the distributional impact of reform costs varies across sectors. In the labor market and tax domains, reforms can inflict immediate costs on potentially more households and firms than in other areas and they can involve visible redistribution effects. In addition, fiscal sustainability often requires that tax reforms be accompanied by politically difficult expenditure adjustment.

Third, the extent of competition differs. Labor markets and tax systems have been less exposed to international competition than other areas, reflecting the limited mobility of labor and much of the tax base. Hence, outside pressure for reforms arising from the adverse effects of reforms elsewhere on domestic competitiveness has been weaker. Similarly, competitive pressures from domestic sources can also weaken opposition to reform because with weaker pricing power, opponents have less incentive for costly political mobilization. Unlike financial or product markets, labor markets have only recently been exposed to such pressures, especially from product market liberalization.

The chapter also establishes that there have been important cross-country differences in the scope and speed of reform. The analysis highlights the following reasons (although I should mention that the chapter considers many more determinants).

First, there were differences in initial structural policy conditions. Countries with more restrictive initial structural policies generally tended to reform more than those with less restrictive ones. We interpret this as evidence that government regulation was perceived as costly in highly regulated economies, which favored political mobilization for reforms.

Second, macroeconomic conditions differed. Difficult macroeconomic conditions are often said to be a major determinant of reforms because they reveal the shortcomings of the status quo, which can weaken opposition to reform. We found evidence in favor of this proposition.
Both recoveries after a prolonged period of weak growth and weak economic growth in the current period were generally associated with more structural reforms.

Third, there were differences in fiscal positions. We found that reforms were more likely at times when countries had strong enough fiscal positions to accommodate the compensation of losers from reforms through budgetary transfers.

Fourth, dimensions of openness varied across countries. We found that countries tended to reform more if their three main industrial country trading partners had implemented reforms, if they were bound by international commitments, or if they were more open to trade. This reinforces that international spillovers have been an important force behind reforms.

Finally, let me now turn to the four lessons for the design of structural reforms in industrial countries.First, recovery from a downturn is a good time to start reforms. Historically, reforms during recoveries were, on average, more ambitious in scope and often more likely than during good times. At the current juncture, reforms efforts should be stepped up.

Second, since reforms feed on each other, it is important to invest political capital to launch the reform momentum. The evidence shows that earlier reforms in other areas fostered reforms in labor markets and tax systems and that combining reforms can make them more acceptable politically.

Third, use international spillovers. Policymakers who seek to advance reforms should use international spillovers to their advantage. For example, if a specific market that would benefit from reforms is still sheltered from international competition, it should help to focus first on reforms that reduce protection to add to pressures for reforms.

Fourth, build fiscal flexibility. The experience shows that strong fiscal positions helped reforms. To have the fiscal flexibility to support reforms, countries should, therefore, seek to improve their fiscal positions when needed.

That concludes my discussion of the chapter.I hope you enjoy reading it.

Chapter IV
Are Credit Booms in Emerging Markets a Concern?
Marco Terrones

Hello, my name is Marco Terrones. In the latest edition of the World Economic Outlook there is a chapter that looks at the question of whether Credit Booms in Emerging Markets Are a Concern? which was prepared by Enrique Mendoza and myself.

In this short presentation I would like to explain why the chapter concludes that credit booms in emerging markets are a cause for concern, and what can be done about them.

Let me first start by providing some background.

Credit has expanded rapidly in several emerging market countries in the recent past. For example, real credit to the private sector has grown faster than 20 percent per year in some east Asian and eastern European countries in the past two years. There are good reasons for credit to grow rapidly—including cyclical upturns, favorable external financing conditions, financial deepening, and improved medium-term prospects—but credit growth can sometimes be excessive. These episodes of excessive credit expansion are called "credit boom". Although the role of credit in emerging market crises of the past decade has received some attention, the severe economic cost and empirical characteristics of credit booms have not heretofore been systematically documented. This chapter analyzes credit booms in 28 emerging market countries between 1970-2002.

The main findings of the chapter are as follows:

  • Credit booms pose significant risks for emerging market countries, because they are typically followed by sharp economic downturns and financial crises. Real GDP usually falls about 5 percent below trend after a credit boom, reflecting severe contractions in consumption and—especially—investment. About three-fourths of credit booms are associated with a banking crisis, and almost seven-eights with a currency crisis.
  • Credit booms are synchronized across countries. This synchronization of credit booms suggests that common influences on capital flows and financial liberalization likely played important roles. Indeed, credit booms seem to be more likely when there are high capital inflows.
  • Credit booms are not easy to identify ex ante, calling for policymakers to make difficult judgments. Policymakers should be most concerned if a rapid credit expansion is accompanied by other signs of growing macroeconomic, financial, and corporate imbalances. In particular,
    • Credit booms are often linked to investment booms, current account deficits, and increases in the production and relative price of nontradable goods, but not to a rise in inflation. Importantly, therefore, maintaining price stability does not seem to prevent a credit boom/bust.
    • At the same time, banks tend to raise the share of their assets devoted to private credit and increase the share of their nondeposit liabilities, including external borrowing.
    • Finally, firms that produce nontradable goods usually experience increases in leverage and declines in expected profitability.

What should policymakers do if the preponderance of the evidence suggests that there is a significant risk of a credit boom developing? Policymakers need to consider one or more of the following policy actions:

  • Improving the surveillance of the banking system. As credit booms often involve a shift towards private credit, whose quality turns out ex post to be worse than initially thought, bank supervisors could consider improving the enforcement of capital adequacy requirements. Similarly, given the increase in the share of nondeposit liabilities, stricter monitoring of bank borrowing and, in some cases, reducing the incentive for short-term external borrowing could be considered.
  • Increasing the scrutiny of corporate borrowing. As credit booms are usually associated with rapid increases in corporate leverage, it could be desirable to enhance the monitoring of firms' accounting practices and assess whether they are fully satisfying disclosure requirements.
  • Tightening macroeconomic conditions, even though inflation is subdued. A credit boom is typically accompanied by an unsustainable strengthening of domestic demand and followed by a severe contraction of domestic demand, so in some cases it may be appropriate to restrain credit growth by tightening monetary policy.

To reduce the risk of future credit booms, policymakers in emerging market countries should strive to improve institutions. Credit booms are less frequent and—if they occur—less costly in industrial countries, where institutions are stronger. The priorities should be to strengthen macroeconomic policy frameworks, financial sector regulation and supervision so as to encourage prudent risk management, corporate sector transparency, and statistics to ensure timely, comprehensive, and high-quality macroeconomic, financial, and corporate sector data. Such efforts would not only serve as preemptive strikes against credit booms, but also help foster financial development and thus economic growth.

That concludes my discussion of the chapter, I hope you enjoy reading it.