Global Economy: Continuing Recovery But Clouds on the Horizon

IMF Blog, July 8, 2010

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Canonical URL: Global Economy: Continuing Recovery But Clouds on the Horizon

Author: Olivier Blanchard
Date: July 8, 2010
Core message: Two opposing forces — stronger-than-expected near-term activity versus emerging fiscal and financial clouds (originating in Greece and extending to Europe) — create uncertainty for the recovery.

World growth forecast for 2010: about 4½ % (revised up from April forecast of around 4¼ %).
World growth forecast for 2011: about 4¼ % (broadly unchanged).
Advanced countries growth forecasts: 2.6% for 2010 and 2.4% for 2011.
- Implication: these low growth rates imply that high unemployment will remain a central issue.
Emerging and developing economies growth forecasts: 6.8% in 2010 and 6.4% in 2011.
- Revisions: an upward revision of 0.5% for 2010 and a small downward revision of 0.1% for 2011.
Short-term performance: the world economy expanded at an annualized rate of over 5 % in the first quarter of 2010, with stronger-than-expected growth in the United States, Europe, Japan, Brazil, and India.
Recent indicators suggest some slowdown of demand, but it is too early to assess significance.

Trigger: worries about fiscal solvency in Greece spread to concerns about fiscal solvency elsewhere and then to banking solvency, producing financial turbulence and disruptions in market financing, including a freeze in the interbank market in Europe.
Baseline assumption: policy responses will be adequate and will limit effects on the real economy.
Even under adequate policy responses, four main macroeconomic implications are likely:
- A depreciation of the Euro.
- A tightening of bank lending, especially (but perhaps not only) in Europe.
- The need for fiscal consolidation, which, even if well executed, is likely to affect demand and growth adversely in the short run.
- A near-term reallocation of capital flows.

Rationale: fiscal stimulus in 2008–2009 was necessary; now countries must return to a sustainable fiscal path.
Key objective: establish a credible roadmap to stabilize the ratio of debt to GDP over the medium term, with the goal of decreasing it substantially over the longer term.
- G-20 commitment: advanced economies committed to fiscal plans that will stabilize or reduce government debt to GDP ratios by 2016.
Two paths to credibility:
- Passing reforms that improve medium- and long-term outlooks (example cited: increases in the retirement age in line with higher life expectancy).
- Instituting fiscal rules (example cited: limits on the growth of spending over time).
Guidance on timing and pace:
- Adjustment should start soon.
- Avoid excessive front-loading or too sharp a cut in deficits this year or next year, as that would be counterproductive given the fragile recovery and limited offset from already very accommodative monetary policy.
- Current plans for 2011, which imply an average decrease in the cyclically adjusted deficit in advanced G-20 countries, of about 1.25%, strike the IMF as roughly appropriate.
Noted shortfalls: many countries still lack ambitious entitlement reforms and, in many cases, better fiscal rules.

Prior to European problems: capital flows to emerging market countries were steadily increasing.
Impact of European events: a partial reversal as higher risk aversion led investors to repatriate funds, decreasing capital flows to emerging markets.
Outlook: the reversal is expected to be temporary; the trend is continuing strong capital flows to emerging market countries.
Two policy considerations for emerging markets managing inflows:
- These flows are largely driven by good fundamentals and likely to be long lasting; limiting their overall size through controls or fighting their exchange-rate effects through reserve accumulation may be difficult and eventually self-defeating.
- Many emerging market countries would benefit from a shift from external to internal demand to sustain growth amid lower exports to advanced countries and to better satisfy domestic needs.
- Achieving this requires structural reforms and exchange rate appreciations.
- The IMF notes decisions by China to boost internal demand and allow for more flexibility of the yuan as welcome steps.

The IMF remains cautiously optimistic about the pace of recovery but identifies clear dangers and policy challenges.
Key determinants of the outcome:
- How Europe deals with fiscal and financial problems.
- How advanced countries proceed with fiscal consolidation (timing, pace, credibility).
- How emerging countries rebalance their economies toward more internal demand.

Olivier Blanchard, July 8, 2010 — Global Economy: Continuing Recovery But Clouds on the Horizon