Perspectives on the Global Economic Landscape and the Role of the Dollar, Address by John Lipsky, First Deputy Managing Director, IMF

IMF News, July 22, 2008

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Perspectives on the Global Economic Landscape and the Role of the Dollar, Address by John Lipsky, First Deputy Managing Director, IMF

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• Published: July 22, 2008

Global outlook: growth, inflation, and financial conditions

• Global growth projections:
  • Global growth is projected to slow to around 4 percent in 2008 and 2009, compared with 5 percent in 2007.
  • Emerging economies: growth expected at around 7 percent in 2008 and 2009.
  • Advanced economies: growth will be below potential in 2008 and 2009.
• Inflation developments (year-on-year, May 2008 unless noted):
  • Advanced economies: headline inflation rose to 3½ percent; core inflation remained at 1¾ percent.
  • Emerging economies: headline inflation rose to 8½ percent; core inflation rose to 4¼ percent — highest rates since the late 1990s.
  • Deterioration in inflation expectations is identified as a potentially serious global risk.
• Monetary and fiscal policy implications:
  • Monetary policy must prioritize heading off inflationary pressure while being mindful of downside risks to growth.
  • In many emerging economies, central banks have raised policy interest rates, but real interest rates generally remain negative in some cases.
  • Risk that some countries have "fallen behind the curve" in tightening policy; some need further monetary tightening, greater fiscal restraint, and more flexible exchange rate management.
• Financial sector and credit conditions:
  • Credit deterioration is widening and deepening as economic conditions weaken.
  • Advanced-economy banks—especially in North America and Europe—are deleveraging and rebuilding capital, squeezing lending.
  • Increased inflation risks have reduced scope for monetary easing.
  • Advanced economy policymakers may need decisive and innovative measures, potentially including committing the public balance sheet—the "third line of defense".
• Energy market policy implications:
  • Demand-side: increase pass-through of international oil prices to domestic prices to elicit demand response; improve conservation and energy efficiency in advanced economies.
  • Supply-side: oil producers should foster investment in the oil sector and energy resources generally.

Putting the recent dollar decline in perspective

• Magnitude and timing:
  • The U.S. dollar has depreciated by about 25 percent in real effective terms since early 2002.
  • The largest previous sustained episode saw a depreciation of over 30 percent in real effective terms between 1985 and 1991.
  • In the current episode, half of the depreciation has taken place since 2006.
• Comparison with 1985–1991 episode:
  • In 1985–1991, the pace of depreciation was relatively gradual, with daily changes below 2-3 percent in nominal effective terms; movements broadly aligned with interest rate differentials.
  • Following the post-2002 decline, the Fund assesses the U.S. currency is the closest to its medium-term equilibrium value in a decade.
• U.S. current account behavior:
  • 1985–1991 episode: U.S. current account deficit narrowed from a high of 3½ percent of GDP in 1987 to about balance in 1991.
  • Current episode: U.S. current account widened initially to reach an all time high of nearly 7 percent of GDP in late-2005; moderated only in 2006 and remained at around 5 percent of GDP in Q1 2008.
• Factors explaining differences between episodes:
  • Oil trade balance: between 2004 and 2008, the U.S. oil balance is expected to have deteriorated by 1.3 percent of GDP; by contrast, 1987–1991 saw a very modest improvement in the oil trade balance of 0.1 percent of GDP.
  • War-related transfers: 1991 receipts associated with the first Gulf War amounted to as much as 0.7 percent of GDP; similar transfers did not occur in the current episode.
  • Underlying current account (excluding oil and transfers): improved by 2.7 percent of GDP in the previous episode vs 2.4 percent in the current period.
  • Long lags (up to 2 years) in current account response to exchange rate changes imply further improvement in the "underlying" current account may occur in coming years.

The dollar decline, global imbalances, and multilateral responses

• Impact of dollar depreciation:
  • The dollar decline is helping to narrow the U.S. current account deficit and to shift growth toward tradable sectors, thereby contributing to reducing global imbalances.
  • However, depreciation has been insufficient to fully alleviate imbalances and risks; new misalignments may be emerging and risks shifting.
• Cross-country currency movements and misalignments:
  • Currencies of many flexible-exchange-rate economies have appreciated markedly.
  • IMF view: the euro is now overvalued relative to medium-term fundamentals.
  • Many current-account surplus countries, including China, remain substantially undervalued despite small real effective appreciations; limited adjustment in inflexible regimes has not supported rebalancing.
  • In some cases, recent real appreciation is driven largely by accelerating inflation.
• Multilateral Consultation on Global Imbalances (participants: United States, the euro area, Japan, China, Saudi Arabia):
  • Mutually consistent policy plans included:
  • U.S.: reduce current account deficit via greater domestic saving and improved net export performance.
  • China: structural reforms and increased flexibility of the renminbi with respect to a basket of currencies to support rebalancing toward domestic consumption.
  • Saudi Arabia: increase infrastructure and social spending to alleviate supply bottlenecks and reduce current account surplus.
  • Euro area: further progress on growth-enhancing reforms.
  • Japan: continued structural reform, including fiscal consolidation.
  • Implementation challenges noted:
  • Sharp rise in oil prices has outstripped near-term Saudi stabilization efforts.
  • U.S. fiscal consolidation is being delayed by the slowdown and a fiscal stimulus package.
  • China has made some progress but exchange rate flexibility has been incremental.
  • Result: global imbalances are projected to remain high in the near term while global growth slows.
• Policy stance:
  • IMF continues to view the Multilateral Consultation policy plans as relevant but recognizes they must be implemented flexibly given changed circumstances.
  • Acceptance that large imbalances may persist longer than previously envisaged, especially with very large surpluses in oil-exporting countries due to high commodity prices.

The dollar as a reserve currency and medium-term reserve dynamics

• Current reserve shares and trends:
  • The dollar accounted for nearly two-thirds of central bank international reserve holdings in Q1 2008.
  • Emerging economies have an average dollar share of around 60 percent; this share has remained roughly unchanged since 2004.
• Structural shifts affecting reserve demand:
  • Successful introduction of the euro and the rise of emerging economies have altered the international currency landscape since the 1985–1991 episode.
  • On a market-exchange-rate basis, the euro area and the United States each account for roughly ¼ of world GDP.
  • On a PPP basis, the euro area accounts for 16 percent of world GDP compared with a bit over 20 percent for the United States.
  • Euro area exports (including intra-regional exports) account for 30 percent of world exports vs 8 percent for the United States; intra-regional exports account for 50 percent of euro area exports.
• Prospects for greater diversification:
  • In the longer run, demand for dollar assets and reserves depends on global developments (e.g., persistently high oil prices increasing surpluses in oil-exporting countries).
  • If oil exporters invest surpluses through more diversified vehicles such as Sovereign Wealth Funds, demand for dollar assets could decline from that source; IMF model-based simulation suggests the effect on the dollar would be very modest.
  • Trend toward floating exchange rate regimes worldwide implies broader diversification of reserves over time, but the dollar is expected to continue playing the central role in international reserves for the foreseeable future.
• Renminbi considerations:
  • The renminbi may grow in international importance as China’s economy grows, but this would require:
  • full currency convertibility,
  • an opening of the capital account,
  • significantly more developed financial markets,
  • a track record of low and stable inflation.

Key policy recommendations and concluding perspectives

• General policy priorities:
  • Maintain control of inflation; align monetary and exchange rate policies to keep inflation under control while being mindful of growth risks.
  • In emerging economies with rising underlying inflation and supply constraints, more assertive policy tightening is needed.
  • In advanced economies, timely adjustment will be required as recoveries take hold.
• Financial sector and macro-financial policy:
  • Innovative and decisive measures may be required to restore confidence in the financial sector; consider committing public balance sheets where appropriate.
  • Appropriate structural policies across countries are needed to restore demand-supply balances in energy markets.
• Exchange rate and multilateral policy:
  • The substantial dollar depreciation to date has moved the dollar close to its medium-term equilibrium and is helping to reduce the U.S. current account deficit.
  • Sustaining this outcome while reducing other currency misalignments would help sustain global growth and reduce global imbalances.
  • Shared global responsibility is essential; implementation of mutually consistent policy plans (as in the Multilateral Consultation) remains relevant but must be flexible.
• Role of the IMF:
  • The IMF plans to play an active and appropriate role in achieving progress on rebalancing and in supporting policies that sustain growth while reducing imbalances.

Source: Address by John Lipsky, First Deputy Managing Director, International Monetary Fund, At the Brookings Institution, Washington, DC, July 22, 2008.

References

• Japan and the IMF
• United States and the IMF
• People's Republic of China and the IMF
• Saudi Arabia and the IMF
• Speeches
• PRESS CENTER
• Commodity Prices and Global Inflation
• Dealing with the Financial Turmoil: Contingent Risks, Policy challenges, and the Role of the IMF
• The Role of Policies to Foster Oil Sector Investment in a Global Context
• https://www.imf.org/en/home