Speech

International Monetary Fund
At the Meeting of ASEM (Asia-Europe Meeting) Finance Ministers
Tianjin, China, June 25-26, 2005

Good morning to you all. I have been asked by the meeting organizers to provide the IMF's perspective on the global economic outlook and the policy challenges confronting policy-makers in Europe, Asia, and the other major regions of the world economy.

Let me begin with some remarks on recent developments and near-term prospects.

• The global expansion remains generally solid, underpinned by strong corporate balance sheets, still accommodative macroeconomic policies, and supportive financial conditions. While recent data suggests that global growth has slowed in recent months, in part reflecting the further rise in oil prices, the slowdown is likely to be temporary if oil prices stabilize. We expect global growth in 2005 and 2006 to be broadly in line with the 4.3-4.4 percent projected in our Spring World Economic Outlook, although risks remain slanted to the downside.

• The regional growth divergences that have characterized the recovery have widened. The United States and Chinese economies continue to account for the greater part of global growth. Growth in the rest of emerging Asia has slowed somewhat, after a strong year in 2004. Japan's economy grew at an unexpectedly rapid rate in the first quarter, and the underlying fundamentals are clearly on the mend. But the euro area, although including some strong performers, continues to languish, and recent political developments add to uncertainty there.

• Global current account imbalances continue to increase. The U.S. external current account deficit reached 5.7 percent of GDP (1.6 percent of world GDP) in 2004, and Japan's surplus rose to 3.7 percent of GDP (0.4 percent of world GDP). Emerging Asia continues to run a large surplus, although, with higher oil prices, its surplus is now matched by the combined surpluses of the Middle East and Russia.

• Global financial conditions remain very favorable. Long-term bond yields have fallen in recent weeks, although some emerging market and corporate spreads have risen above their historical lows. Nonetheless, many borrowers have been able to take advantage of what are exceptional conditions to lock in favorable rates.

• To date, higher oil prices have not significantly affected core inflation or inflationary expectations. However, unit labor costs and other indicators of inflationary pressures are rising in some more cyclically advanced countries, including the United States-and the pace of monetary policy tightening may have to be quickened if signs develop that underlying inflation is picking up.

Risks

Although the short-term outlook remains positive overall, there are a number of risks that warrant mention.

• Oil prices are already well above the levels projected in the IMF's spring forecasts. With the market remaining tight, a further increase in prices and continued oil market volatility pose a risk to the outlook.

• Financial conditions could tighten abruptly-a risk heightened by the very low benchmark yields, renewed dollar strength, and stimulative environment for risk-taking. For example, an unexpected pick-up in inflation in the United States could lead to an abrupt increase in interest rates-with adverse effects on export and output growth in US trading partners.

• The slow domestic demand growth in the European economies might be unexpectedly prolonged. In Europe, our projections assume a fairly marked pickup in domestic demand during the second half of 2005. However, slow wage growth and lagging confidence have been holding back consumption, and the result of the recent referenda might conceivably sap the confidence of corporate investors.

• In Japan, recent developments give us some confidence that recovery will finally be sustained, and a pickup in domestic demand is particularly welcome, but in light of lingering vulnerabilities, the risk of a relapse remains.

Looking beyond the immediate risks, the world economy is threatened by two underlying vulnerabilities: global imbalances and looming fiscal pressures.

• On present trends, global current account imbalances will widen in the near term and not improve materially in the foreseeable future. It is not possible to forecast precisely the consequences of growing imbalances, but there is a significant risk that they will culminate in a disorderly adjustment. A disorderly adjustment would cause financial and economic distress in many countries, not just the United States-with open Asian economies likely to be particularly affected.

• Medium term fiscal positions in many countries remain very difficult, and the onset of pressures from aging populations is approaching rapidly. In Europe, the fiscal impact of aging will require substantial adjustments in pension and other benefits over time. In Asia, aging is a particular problem for Japan, but will entail increased expenditure on public pensions and other aging-related expenditure in other Asian countries as well.

Turning to economic policy choices in the major regions of the world economy, let me note first that the current environment provides a favorable opportunity to address the medium-term risks and implement corrective measures.

• The appropriate stance of monetary policy needs to vary substantially across regions. In the more cyclically advanced regions or countries, a bias toward tightening should be maintained. In the euro area, given the benign inflationary outlook, interest rates should remain firmly on hold until signs of a sustained recovery emerge, and a reduction in rates should be considered if the weakening in activity becomes more pervasive. In Japan, a highly accommodative stance should be maintained until deflation is decisively beaten.

• With external imbalances growing, the implementation of the strategy endorsed by the IMFC to address global imbalances has been disappointingly slow and a catalyst is sorely needed. Because the problem is shared, all of the world's regions need to play their part. Of particular concern, there are increasing signs that this lack of progress is contributing to rising protectionist pressures.

• Consequently, it is all the more important that the major countries put in place, in concert, a set of measures that will reassure investors that current account imbalances can be rectified over the medium-term:

• In the United States, the authorities have committed to halve the nominal deficit by FY2009 and to enhance budgetary discipline in the next fiscal year. Nonetheless, a more ambitious medium-term budget to eliminate the deficit excluding social security over the next five years is desirable. Social security reform remains a priority, and even more important is the reform of federal health programs, in light of their huge unfunded liability.

• In Europe, measures are needed to increase labor utilization and labor market flexibility and to increase competition in product markets, though the recent failure of the referenda may make structural reforms politically more difficult. Regarding fiscal policy, following the recent agreement on reforms to the SGP, the governments need to demonstrate their resolve to undertake more sustained fiscal consolidation. A faster pace of fiscal consolidation based on high-quality measures is needed in countries with weak budget positions.

• In Japan, further steps to foster a self-sustaining expansion in domestic demand are needed. Priorities are continued efforts to liberalize labor and product markets and improve the efficiency of the financial sector. The authorities' goal of achieving a primary balance excluding social security over the medium term is a useful basis for a consolidation strategy. A more ambitious adjustment may be necessary, however, to stabilize the public debt.

• In China the introduction of greater exchange rate flexibility would be in China's own interest, particularly since it would facilitate monetary control. There are now no major technical impediments to exchange rate regime reform and, given the strength of China's economy, conditions are favorable for an early initial move. Greater flexibility in the renminbi also could encourage some other Asian economies to increase the flexibility of their exchange rates.

• Elsewhere in Asia, financial sector reforms are needed to ensure that clearly profitable investment projects will not lack for financing, and that creditworthy households with adequate collateral may borrow when appropriate.

• Finally, the importance of a successful conclusion to the Doha Round is hard to overstate. The Round offers a concrete opportunity for us to give impetus to growth and to counter protectionism in what is still a favorable economic climate overall. It is critically important that countries use the December 2005 WTO Ministerial Conference meeting in Hong Kong to agree on specific policy packages.

Thank you for your attention. I look forward to a stimulating discussion.