CHAPTER I. CONTAINING THE RISKS TO THE GLOBAL ECONOMY (2024)

The outlook for the global economy has deteriorated further in recent months, with growth continuing to weaken in almost all major regions of the world. The tragic events of September 11 and their aftermath, as well as evidence that the world economy was weaker than expected in the period before the attacks, contributed to a sharp deterioration in confidence across the globe, accompanied by a flight to quality in both mature and emerging markets, and a deterioration in emerging market financing conditions. As a result, prospects for global recovery have been set back significantly, and the IMF's projections for global growth have been marked down substantially since the October 2001 World Economic Outlook, by 0.2 percentage point to 2.4 percent in 2001, and by 1.1 percentage point to 2.4 percent in 2002 (Table 1.1 and Figure 1.1). While there are good reasons to expect a recovery to get under way in 2002, the outlook remains highly uncertain, and there is a significant possibility of a worse outcome, which could involve lower growth and external financing difficulties for many countries. Correspondingly, the primary challenge for policymakers is how best to support the prospects for recovery, and to limit the risks attendant on a deeper and longer downturn should that occur.

Since late 2000, growth has slowed sharply in almost all major regions of the world, accompanied by a marked decline in trade growth, significantly lower commodity prices, and deteriorating financing conditions in emerging markets (Figure 1.2). Before the terrorist attacks of September 11, there appeared a reasonable prospect of recovery in late 2001, although—as stressed in the October 2001 World Economic Outlook—the situation remained fragile and vulnerable to unexpected developments, and a significant danger of a deeper and more prolonged downturn remained. Data since that time indicate that the situation before the attacks was in fact weaker than earlier projected in many regions, including the United States, Europe, and Japan, as well as in a number of emerging market economies in Asia and Latin America.

The tragic events of September 11 exacerbated an already very difficult situation in the global economy. Following the attacks, consumer and business confidence have further weakened across the globe (Figure 1.3), and there was also a significant initial impact on demand and activity, particularly in the United States, although there are some signs that this is now beginning to stabilize. There was an initial generalized shift away from risky assets in both mature and emerging markets, including a substantial deterioration in financing conditions for emerging market countries. Over the ensuing period, how-ever, financial markets have generally strengthened, reflected in a recovery in equity markets and most recently signs that the earlier flight to quality has begun to reverse (including a decline in high yield and many emerging market bond spreads to pre-September 11 levels). Movements in major exchange rates have on net been moderate, with the U.S. dollar appreciating modestly against the euro and the yen. As the outlook for global growth has weakened, commodity prices have fallen back further, especially for oil.

At present, the outlook is subject to great uncertainty, evident for example in the sharp increase in dispersion in private sector forecasts (Figure 1.4). It remains very difficult to judge how quickly confidence will rebound and how financial market conditions will develop, with much continuing to depend on noneconomic factors, including the progress in the war against terrorism. Notwithstanding these uncertainties, there are a number of factors that will help to support recovery during 2002. First, policymakers have generally moved quickly to support activity. Monetary policy has been eased substantially in most major industrial countries, most notably the United States, where nominal short-term interest rates are now at a 40-year low, and an additional fiscal package is also under discussion. Together with the earlier macroeconomic stimulus already in the pipeline, these measures will provide significant support to activity in the course of 2002. Second, as discussed in Chapter II, oil prices have weakened sharply, reflecting weaker global demand and OPEC's continued difficulties in coordinating production cuts, particularly among non-OPEC producers. This will help support global activity, although there are clearly negative effects for oil producers, including a number of highly indebted countries. Third, the completion of ongoing inventory corrections will provide support to demand. Finally, the strengthening of economic fundamentals in many countries in recent years—notably lower inflation, generally improved fiscal positions, stronger external financial positions in many emerging market countries, especially Asia, and a shift toward more flexible exchange rates—has increased the room for policy maneuver and resilience to external shocks. Partly as a result, there appears to have been greater investor discrimination among countries than in some earlier episodes (see the Appendix to this chapter).

A particularly disturbing feature of the current slowdown is its synchronicity across nearly all regions (Figure 1.5), the most marked for at least two decades. To a considerable extent, this synchronicity is the result of common shocks, including the increase in oil prices and the bursting of the information technology (IT) bubble, both of which had a worldwide impact. Increased international linkages, particularly in the financial and corporate sectors, have played a role—a trend that is likely to continue. The synchronicity of the downturn may also reflect delays in implementing structural reforms, notably in Japan and the euro area, which have meant that these countries have been less well placed to take up the slack when the long expansion in the United States came to an end.

The IMF's projections now envisage a deeper and more prolonged global slowdown than fore-seen in the October 2001 World Economic Outlook (where the forecast was completed before the September 11 events). Global GDP growth is now projected at 2.4 percent in 2001, and is expected to remain at about that level in 2002 (a reduction of about 1 percentage point from the forecast made prior to the attacks).¹ However, with the recovery picking up during 2002 as the positive impact of the factors described above begins to be felt, global growth for 2003 as a whole would be expected to bounce back strongly:

• Among the industrial economies, the recession in the United States is expected to be followed by a recovery during 2002 as the positive factors noted above take effect. Canada is expected to follow a similar pattern, reflecting its close integration with the United States. Projections for the euro area have been reduced markedly, especially for Germany, reflecting both the weaker-than-expected situation before the September 11 attacks as well as the aftermath. The outlook for Japan has become increasingly worrying, and the economy is now expected to experience two consecutive years of contraction for the first time in the postwar period, and the situation in the banking system is of increasing concern.

• Among emerging market countries, the effects of recent events vary widely, depending on the structure of the economy and the strength of economic fundamentals. The impact has been particularly heavy in Latin America, where a number of countries may be affected by the deterioration in external financing conditions, the precarious situation in Argentina, weaker external demand, including the marked downturn in tourism, and lower commodity prices, especially oil. In emerging Asia, growth is expected to remain reasonably robust in China and to a lesser extent India, which are less exposed to external developments; elsewhere, notwithstanding additional policy stimulus and the generally beneficial effect of lower oil prices and lower global interest rates, growth has been marked down sharply owing to weakening external demand and the further deterioration in the IT sector. In the Middle East, growth will be adversely affected by lower oil prices and production, and in some cases weaker remittances and tourism revenues. In Turkey, the outlook has been affected by weaker external demand, especially for tourist services, and more difficult financing conditions. In contrast, the impact of recent events in the Commonwealth of Independent States is expected to be modest, buoyed by strong domestic demand in Russia. Growth in central and eastern Europe also expected to remain reasonably resilient, owing mainly to the benefits of lower oil prices and supportive policies.

• The poorest countries are being hurt by weaker external demand and falling commodity prices, with oil exporters particularly affected. Nonfuel commodity exporters will also be affected by further weakness in already depressed prices, especially for agricultural commodities, although for some the benefits from lower oil prices will limit the increase in external financing requirements. On the macroeconomic side, while the outlook for individual countries varies widely, growth is projected to be relatively well sustained for the group as a whole. However, this may understate the impact on poverty, as lower prices for agricultural goods will hurt rural areas, where most of the poor live, while the benefits of lower oil prices tend to accrue in urban areas.

As already noted, there are unusually large uncertainties and risks to the forecast. With substantial policy stimulus in the pipeline, particularly in the United States, faster-than-expected progress in the war on terrorism in Afghanistan, and possible downside risks to oil prices, there is a possibility that recovery in 2002 could come more rapidly than presently expected. This outturn also appears to be expected in financial markets given the recovery in equity markets, and the steepening of yield curves. Were that to occur, policy-makers would need to begin to withdraw a portion of the stimulus that is now in the pipeline. However, given the already difficult situation for the global economy, and the large costs associated with a deeper slowdown, the possibility of a worse outcome remains the major policy issue at the current juncture. There are four interlinked areas of risk (whose implications for the outlook are discussed in more detail in Chapter III):

• Confidence and activity in the United States may pick up more slowly than currently expected. For instance, the effects of the terrorist attacks themselves may prove more prolonged; or recovery may be more severely hampered by the imbalances accumulated in the past, including overinvestment, particularly in the IT sector, and consumers' relatively high indebtedness.² In addition, there are also downside risks to activity in the other major currency areas. With no major region providing substantive support to activity, further weakness in any one area would reinforce the already synchronized downturn. This could result in a renewed withdrawal from risk taking in financial markets, as well as even lower commodity prices, both of which would adversely affect developing countries in general and emerging market economies in particular.

• The outlook for many emerging market countries will continue to depend on developments in global risk aversion and the period for which bond issuance is largely limited to only high grade borrowers, as well as the extent of the squeeze generated by refinancing pressures in the meantime. While the recent decline in spreads is encouraging, market access for many countries remains limited. Financing pressures could become significantly larger and more widespread if the global outlook deteriorates further, or the resolution of a credit event in a major emerging market proves disorderly and prolongs or exacerbates difficult market conditions.

• The imbalances in the global economy—including the large U.S. current account deficit and surpluses elsewhere, the apparent overvaluation of the U.S. dollar, and richly valued equity markets by historical standards—remain an important source of risk. As discussed in Chapter II, mature equity markets appear to be pricing in a relatively rapid recovery—although they remain well below their levels in March, when the U.S. recession began—and currency options market data suggest that expectations of a sharp depreciation in the U.S. dollar have not increased since the attack. However, it remains unclear whether asset markets have fully priced in the deterioration in corporate credit quality and earnings prospects that has occurred thus far. An abrupt adjustment remains possible, particularly if the global growth outlook were to prove worse than expected, especially given the recent reduction in market liquidity—notably in the markets for credit swaps and derivatives—and the financial difficulties faced by some major market participants, including insurance companies.

• Slowing growth and a further flight to quality in financial markets would increase pressure on corporate and financial sectors across the globe. This is of particular concern in Japan, where banks are highly exposed to developments in equity and bond markets, but may also become more important in other countries in Asia and Latin America.

Against this background, the primary challenge faced by policymakers is how best to support the prospects for recovery and to limit the risks attendant on a deeper and longer recession. In doing so, a variety of factors need to be taken into account. First, given the synchronicity of the slowdown, policies in both industrial and developing countries must be viewed in a global perspective to ensure that there is adequate global demand. Second, the nature of the policy response is affected by the uncertainty in the out-look, and—with inflationary pressures across the globe increasingly subdued—the relatively higher costs associated with a weaker-than-projected outlook (Box 1.1). Finally, account also needs to be taken of existing fiscal frameworks, like the Stability and Growth Pact in the euro area, and country specific constraints, like Japan's already very high fiscal deficit and government debt.

Given the degree of uncertainty and the constraints on fiscal policies in a number of countries, monetary policy—the most flexible instrument—has appropriately played the primary role to date. Nonetheless, fiscal policy should also play a role, particularly through the operation of the automatic stabilizers, and it will be important that countries do not interpret their individual constraints too rigidly, particularly if the situation deteriorates further. From a global perspective, there are two potential concerns. First, policy easing in the United States could exacerbate already large imbalances, including the large external current account deficit. While this should not constrain short-term macroeconomic policies in present circ*mstances, policies over the medium term—both in the United States and elsewhere—must be consistent with reducing those imbalances. Second, given the increasingly difficult external environment, many emerging market countries have been forced to restrain domestic demand to maintain the confidence of international investors. The aggregate effect is of particular importance in certain regions, but also adds a further downward impulse to global demand, which—while presently moderate from a global perspective³—could become larger if the situation were to deteriorate further.

Against this background, there is a need for a coordinated and collaborative policy response by the international community.⁴ In industrial countries, which remain the key engines of growth in the world economy, economic policies should help to sustain demand, especially given the synchronized nature of the slowdown. To date, monetary policy has appropriately been eased, and further room remains if necessary, including through a more aggressive approach to monetary easing in Japan. On the fiscal side, additional stimulus presently under consideration in the United States could be helpful if implemented sufficiently rapidly, while demand is still weak. It should be carefully designed to shore up consumer confidence and boost activity in the short run, without exacerbating medium-term fiscal pressures (see Box 3.2). In Europe, the automatic stabilizers should be allowed to operate in full, while in Japan the second supplementary budget will go a significant way toward avoiding a withdrawal of stimulus in 2002, and thereby reducing downside risks to activity. Structural reforms in Japan and Europe remain crucial, both to improve growth potential and boost confidence, and to help reduce global imbalances over the longer term.

In developing and emerging markets, there is considerably less room for policy maneuver, although where it exists it should be used. From the domestic policy perspective, early adjustment where necessary remains critical, accompanied by structural reforms—particularly of financial and corporate sectors—to help reduce vulnerability. For its part, the international community should provide strong support for such efforts, both through the international financial institutions and other channels. Particularly if the global situation were to deteriorate further, due attention will need to be paid to the appropriate mix between adjustment and financing. For the poorest countries, additional concessional financing may be required. In this connection a rapid increase in official development assistance toward the U.N. target takes on additional urgency.

Finally, there remains an important question as to the potential long-term impact of increased security concerns on economic activity. The main channel through which productive potential could be affected is through higher “transactions” costs associated with greater uncertainty—such as greater spending on security; higher levels of inventories; lower investor appetite for risk; and a shift away from globalization. While these costs are real, it is impossible to estimate their size with any certainty at this stage. As discussed in Chapter II, while there will be a short-term impact on productivity, such costs would have to be both large and long lived to have a significant impact on medium- and long-term growth trends. Nonetheless, this reinforces the need to press forward with structural and other reforms designed to increase long-run productive potential. The agreement reached at the World Trade Organization meetings in Doha in November to launch a new trade round is therefore of particular importance and could contribute substantially to global economic growth over the medium term.