NOTE: This op-ed is from the forthcoming issue of Longitude, a monthly on international affairs.
The recovery is underway, but it remains fragile and uneven. This is the essence of the message delivered by the International Monetary Fund (IMF) at the April ministerial meetings in Washington, echoed by the assessment of the International Monetary and Financial Committee (IMFC). While this is not at all a new message, new risks have materialized while others have become dormant. After the great recession, emerging market and developing economies (EMDEs) were the primary driver of global growth, accounting for 87 percent from 2009 to 2013. It now appears that many advanced economies are undergoing a more stable recovery, while weaknesses and vulnerabilities in EMDEs have surfaced. In fact, growth prospects in EMDEs have generally decreased from the previous World Economic Outlook (WEO) released in October and they are now projected to account for 70 percent of global growth in 2014. Russia has seen the sharpest downgrade of its growth projections for 2014, while emerging and developing Europe has also see downward revisions due to heightened geopolitical risks from the conflict in the Ukraine which could carry spillovers. Growth prospects for Latin America also weakened amid tighter financial conditions, lower commodity prices, and supply-side constraints.
In advanced economies, the outlooks for the United States, the United Kingdom, and Germany are favourable. The Eurozone is expected to emerge from its double dip recession in 2014, but growth remains stronger in the core. However, growth projections have also been raised for a few of the countries under stress, most notably Spain and Portugal. Italy lags behind with a growth projection of only 0.6 percent this year, in line with last October’s forecasts. Spain, on the other hand, has been the great surprise: its forecast of 0.9 percent GDP growth this year is more than 4 times what the IMF had assumed 6 months ago.
The key risk in advanced economies is what the IMF calls ‘low-flation’. Inflation is expected to remain subdued in advanced economies over the medium term: hovering around 1.5 percent over the next two years and slowly climbing to 1.8 percent by 2019. Indeed, in the major economies of the United States, Japan, and the Eurozone, inflation is below target. While in the former two economies the underlying data appears to be moving in the right direction with inflation expected to gain ground, this is less evident in the Eurozone. Eurozone inflation is expected to average 0.9 percent in 2014 and only slowly climb to 1.6 percent by 2019, below the ECB’s target of close to but less than 2 percent. The persistence of low-flation exposes the Eurozone to deflation risks as its economy becomes more vulnerable to adverse shocks. In fact, the IMF estimates a 20 percent probability of deflation by the fourth quarter of 2014. Inflation outcomes have important implications for debt dynamics which remain vulnerable in the countries under stress. The IMF currently projects that the debt-to-GDP ratio in Spain and Italy will rest at 102 and 122 percent by 2019, respectively. If inflation were to fall to zero percent and remain at that level over the medium term, Italy’s debt-to-GDP ratio would make no improvement by 2019, resting at 134 percent. Spain’s would continue to rise over the medium term from its current level of 94 percent to approximately 111 percent by 2019. Against this backdrop, the statement by Mario Draghi, the President of the ECB, remained optimistically cautious. Although he recognized that risks in the euro area remain on the downside, he also reaffirmed his belief that ‘both upside and downside risks to the outlook for price development remain limited, and broadly balanced over the medium term’.
In the US, the recovery is gaining steam driven by increasing resilience in private demand. If anything, there are growing concerns within the IMF membership regarding the spillovers from its monetary policy as the Federal Reserve continues to wind down and eventually withdraws from its extraordinarily accommodative stance. In discussing recent capital flows sparked by US tapering, the Finance Minister of Brazil, Guido Mantega, representing Brazil and its constituency of developing economies in South America, indicated that monetary policy spillovers ‘deserve more analysis from the IMF and more attention by central bankers in countries that issue reserve currencies’. While acknowledging that the exit from unconventional monetary policies in advanced economies will be necessary as the economic recovery strengthens, Mantega stressed that in the absence of cooperative actions by advanced economies, EMDEs will continue to have ‘incentives to build up reserves, strive for competitive exchange rate, contain current account deficits and adopt capital flow measures […] according to individual country circumstances’.
In slight contrast, reflecting a view that recent financial turmoil in EMDEs is as much a product of weak fundamentals, as a direct result of tapering of US unconventional monetary policy, the IMFC has warned that EMDEs should allow exchange rates ‘to respond to changing fundamentals and to facilitate external adjustment’, and that prudential and capital control measures should be used to mitigate instability created by volatile capital flows. Not unsurprisingly, US Treasury Secretary Jack Lew re-stated a long-running position of the US, by ‘call[ing] on the IMF to strengthen its assessments of exchange rates and reserve accumulation’. His statement occurred against the backdrop of the recent depreciation of the Chinese currency against the dollar and the record level of foreign reserve assets accumulation by People’s Bank of China (PBoC) this past year. By the end of 2013, China’s official reserves stood at $3.8 trillion, an increase of $509.7 billion over the previous year.
Contrary to the prevailing views among participants, Yi Gang, the Deputy Governor of the PBoC, provided a more pessimistic view of the global recovery noting that ‘the global economy remains fraught with challenges’ while adding that ‘economic fundamentals remain generally solid’ in EMDEs. On China’s economy, Gang was generally optimistic about achieving the government’s growth target of 7.5 per cent, as was the IMF, and reiterated their ability to effectively implement stabilizing macroeconomic policies, while continuing reform efforts.
Summing up, no significant new messages emerged from the most recent IMF’s WEO and the ensuing ministerial appraisal. General trends align with the rhetoric over the past year and policy prescriptions are more or less aligned with those since the height of the crisis. Importantly though, the sources of weakness in the global economy appear to have now shifted from advanced to emerging economies, as the recovery in the major advanced economies strengthens and monetary policy appears to be on a track towards ‘normalization’. The Eurozone, however, continues to be a source of risk in the global economy as the focus shifts from sovereign debt concerns to the risk of deflation.
Domenico Lombardi is Director of the Global Economy Program at the Centre for International Governance Innovation (CIGI), Canada
Samantha St. Amand is a Research Associate in the Global Economy Program at the Centre for International Governance Innovation (CIGI), Canada