Factory in Urlati, Romania. The IMF’s forecast of only a minor slowdown in growth depends on policy action in Europe (photo: Daniel Mihailescu/AFP)
World Forecast
Two other IMF reports were also released July 16. The update to the Global Financial Stability Report (GFSR) said that risks to financial stability increased in the second quarter of 2012 because of the continued slow global recovery and fears about the quality of bank assets in Europe. An update to the IMF’s Fiscal Monitor said that fiscal adjustment in both advanced and emerging economies is proceeding as expected.
The latest World Economic Outlook projects that the global economy will grow 3.5 percent this year, down 0.1 percentage points from the April forecast, and 3.9 percent in 2013, 0.2 percentage points lower (see table).
Risks to recovery
“More worrisome than these revisions to the baseline forecast is the increase in downside risks,” said Olivier Blanchard, the IMF chief economist and director of the IMF’s Research Department, which prepares the WEO.
The IMF emphasized that the relatively minor setback to the global outlook under its baseline projections is based on three important assumptions:
• that there will be enough policy action for financial conditions in the so-called euro area periphery, which includes Greece and Spain, to ease gradually through 2013;
• that U.S. fiscal policy does not tighten sharply in 2013; and
• that steps by some major emerging markets to stimulate growth gain traction.
The IMF said the most immediate risk to the global recovery is that delayed or insufficient policy action will further escalate the euro area crisis. “Simply put, the euro periphery countries have to succeed,” said Blanchard. The report cited agreements at the June 28 eurozone summit as a step in the right direction. It said the summit actions should help break the “adverse links between sovereigns and banks and create a banking union.” But the recent deterioration in sovereign debt markets demonstrates that timely implementation of these measures, together with further progress on banking and fiscal unions, must be a priority.
The WEO update also cited the possibility that growth in the United States would stall because of excessive fiscal tightening caused by political gridlock. “In the extreme, if policymakers fail to reach consensus on extending some temporary tax cuts and reversing deep automatic spending cuts,” the U.S. economy could face a steep decline of more than 4 percent of GDP in its fiscal deficit in 2013. That so-called fiscal cliff would cause a severe decline in U.S. growth, with “significant spillovers to the rest of the world.” Moreover, if the United States does not act promptly to raise its federal debt ceiling, there will be increased risk of financial market disruption and loss in consumer and business confidence.
Growth has slowed in a number of major emerging economies, especially Brazil, China, and India. This was due both to a weaker external environment and a sharp deceleration in domestic demand in response to capacity constraints and policy tightening. Overall, though, emerging markets have weathered the crisis well.
In contrast to the broad trends in the rest of the world, growth in the Middle East and North Africa will be stronger, as key oil exporters continue to boost oil production and drive up domestic demand, while activity in Libya rebounds after the 2011 unrest. Sub-Saharan Africa, which has been insulated from external financial shocks, is also expected to enjoy relatively robust growth in 2012–13.
Financial risks on the rise
Risks to financial stability have risen since the April GFSR, as the global recovery still struggles and fears about the quality of bank assets in Europe continue to roil financial markets, the IMF said in its latest update. Many of the same issues in Europe and the United States that the WEO identifies as threats to global growth, the GFSR says could threaten financial stability and erode financial markets’ confidence.
The GFSR update cited the summit agreement to create a Europe-wide banking union that will help break the negative links between governments and banks. It said the decision to create a single banking supervisor along with the direct injection of capital into banks from Europe’s rescue fund, known as the European Stability Mechanism, are significant steps to address the immediate crisis, but more needs to be done.
“The actions by European leaders constitute a significant step towards putting the monetary union in Europe on firmer ground,” said José Viñals, the IMF’s Financial Counsellor and head of the Monetary and Capital Markets Department that produced the GFSR.
The IMF said policymakers must take additional steps to build confidence in the progress they’ve made to date. In the short run, policymakers must resolve the uncertainty about bank asset quality and support the strengthening of banks’ balance sheets, through recapitalization, restructuring, or resolution. Countries must also deliver on their previously agreed policy commitments to strengthen public finances and enact sweeping structural reforms.
These steps must be complemented by more progress toward a full-fledged banking union and deeper fiscal integration. For the banking union, the steps toward a single regulator must be complemented by a pan-European deposit insurance guarantee scheme and bank resolution mechanism with common backstops.
The GFSR said if the fiscal cliff in the United States is not successfully resolved, there could be further downgrades of U.S. debt, which would have a negative impact on financial market confidence.
Emerging markets face challenges both at home and from abroad, the GFSR update said. On the domestic front, policymakers are confronted with slowing growth and the legacy of very rapid growth of credit that took place in the last few years. Many emerging markets also face volatile capital flows and concerns about rapid depreciation. Some countries still have room for monetary easing to respond to large adverse domestic or external shocks, while fiscal stimulus remains a second line of defense. The report warned that a large policy-induced credit stimulus could heighten asset quality concerns and potentially undermine GDP growth and financial stability in the years ahead.
Fiscal adjustment on track
Meanwhile the IMF’s Fiscal Monitor update said that fiscal adjustment is proceeding generally as expected in advanced and emerging economies. Advanced economy budget deficits are forecast to decline by about 0.75 percent of GDP this year and about 1 percent of GDP in 2012, a rate that strikes a compromise between restoring fiscal sustainability and supporting growth. In most emerging economies, deficits are projected to remain broadly unchanged over 2012–13, implying a slightly slower rate of adjustment than previously expected, something the report sees as appropriate given these countries’ generally stronger fiscal positions and the downside risks to the global economy.
However, the IMF does see some issues. “A focus on nominal deficit targets could lead to excessive tightening if growth weakens in advanced economies,” said Carlo Cottarelli, Director of the IMF’s Fiscal Affairs Department, which prepares the Fiscal Monitor. “For countries that have space to do so, focusing instead on the measures to be implemented to improve the public finances would be preferable.”
Both Spain and Italy are implementing sizeable deficit reductions in the next two years to regain market confidence, the IMF said. In the three euro area countries with programs supported by lending from the European Union and the IMF—Greece, Ireland, and Portugal—adjustment is proceeding, but the recent deterioration in the political and economic climate in Greece serves as a warning about the potential onset of “adjustment fatigue,” which remains a threat to continued reforms, the Fiscal Monitor said.
