TWN Info Service on Finance and Development (Jan09/01)
28 January 2009
Third World Network

UN warns of gloomy economic outlook this year
Published in SUNS #6619 dated 16 January 2009

Geneva, 15 Jan (Kanaga Raja) -- The United Nations has projected, under a baseline scenario, that world output growth in 2009 will reach a meagre 1%, compared to 2.5% last year. The UN adds that if the present credit squeeze is prolonged and confidence in the financial sector is not restored in the coming months, the developed countries could enter into a deep recession in 2009.

This would bring economic growth in the developing countries down to 2.7%, dangerously low for their ability to sustain poverty reduction efforts and social and political stability.

This assessment is provided by the United Nations in its "World Economic Situation and Prospects 2009" report, the full version of which was released on Thursday. The Global Outlook chapter of the report was released on 1 December 2008 at the international financing for development conference in Doha.

The report, a joint product of the UN Department of Economic and Social Affairs, the UN Conference on Trade and Development (UNCTAD) and five UN regional commissions, provides an overview of recent global economic performance and short-term prospects for the world economy and of some key global economic policy and development issues.

To stave off the risk of a deep and global recession, the report recommends the implementation of massive, internationally coordinated fiscal stimulus packages that are coherent and mutually reinforcing and aligned with sustainable development goals. These should be effected in addition to the liquidity and recapitalization measures already undertaken by countries in response to the economic crisis.

It also recommends stronger regulation of financial markets and institutions, adequate international liquidity provisioning, an overhaul of the international reserve system and a more inclusive and effective global economic governance, to prevent against any future repetition.

At a media briefing Thursday, Heiner Flassbeck, Director of UNCTAD's Division on Globalization and Development Strategies, said that "we are looking into a very gloomy year" in 2009.

Recalling that when the UNCTAD Trade and Development report was launched last September and he had said that the outlook for 2009 might be 1-1.5% and that there was shock expressed at this lower rate, Flassbeck said, "Now, we are unfortunately in a position to say it may be even much less than 1-1.5%. It may be close to zero for the world as a whole."

Noting the three scenarios - baseline, optimistic and pessimistic - outlined in the World Economic Situation report, he said that the optimistic scenario can be forgotten for the moment. Pointing to what has happened in the last months all around the world where there has been a dramatic drop in incoming orders, in production and in the manufacturing sector, he said that given this dramatic drop that has been seen in the last quarter, "right now, we are close to the pessimistic scenario."

"For the world as a whole, the outcome could be zero or even slightly below zero."

With respect to the current crisis, he said that it is more than just the US sub-prime crisis that is unwinding and spilling over into the real economy. What is being seen is the unwinding of a number of speculative waves that has emerged in the last years that are all now unwinding at exactly the same time and at an unprecedented pace.

He referred to bubbles in commodities, stocks and speculative activities in currencies. Due to the shock that came from the sub-prime crisis, all these speculative positions are unwound now in a very short time. This is a global de-leveraging process, he said.

Responding to a question, he said that the unwinding of the speculative bubble in the US triggered many of the unwinding of other bubbles. What has been very clear is that there has been a degree of deregulation in many markets including first in the US financial market that led to the excesses that has been seen. Europe has done more or less the same thing.

"It was the dogma of the last 20 years that financial liberalization is the best thing of the world and you have to move savings around back and forth all the time and then the world will be a better place and the world economy will be more effective... we in UNCTAD were quite skeptical about that for a long time but nobody listened. Now, everybody listens. Now, we're all Keynesians."

He also noted that there had been a lot of discussion at the beginning of the crisis about "decoupling". Citing skepticism concerning the decoupling of developing countries and the Least Developed Countries, he said that it is now clear that there is no such thing as decoupling. "A systematic decoupling is nowhere."

The UNCTAD official also warned of the dangers of getting into a real deflationary situation. "We have moved from the danger of inflation to a danger of deflation again in a couple of months."

According to the World Economic Situation report, in the baseline scenario, world gross product is expected to slow to a meagre 1.0% in 2009, a sharp deceleration from the 2.5% growth estimated for 2008 and well below the more robust growth of previous years. At the projected rate of global growth, world income per capita will fall in 2009.

The baseline forecast assumes that it will take six to nine months for financial markets in developed countries to return to normalcy, assuming central banks in the United States, Europe and Japan provide further monetary stimulus from the end of 2008 and on into 2009.

Output in developed countries is expected to decline by 0.5% in 2009. Growth in the economies in transition is expected to slow to 4.8% in 2009, down 6.9% in 2008, while output growth in the developing countries would slow from 5.9% in 2008 to 4.6% in 2009.

Given the great uncertainty prevailing today, however, a more pessimistic scenario is entirely possible, the report warned.

In a more pessimistic scenario, both the fire sale of financial assets and the credit crunch would last longer, while monetary stimulus would prove ineffective in the short run and fiscal stimulus would turn out to be too little, too late. This would then lead to worldwide recession in 2009, with global output falling by 0.4%, and postpone recovery to, at best, the following year.

If the global credit squeeze is prolonged and confidence in the financial sector is not restored quickly, the developed countries would enter into a deep recession in 2009, with their combined gross domestic product (GDP) falling by 1.5%; economic growth in developing countries would slow to 2.7%, dangerously low in terms of their ability to sustain poverty reduction efforts and maintain social and political stability.

In this pessimistic scenario, the size of the global economy would actually decline in 2009 - an occurrence not witnessed since the 1930s.

Under a more optimistic scenario - factoring in an effective fiscal stimulus of between 1.5% and 2% of GDP by the major economies, as well as further interest rate cuts - the report forecasts that, in 2009, the developed economies could post a 0.2% rate of growth, and growth in the developing world would be slightly over 5%. In a more optimistic scenario, a large-scale fiscal stimulus coordinated among major economies would stave off the worst of the crisis, yet it would not prevent a significant slowdown of the global economy in 2009.

The report noted that developed economies are leading the global downturn, the majority of them already experiencing a recession in the second half of 2008. Meanwhile, through international trade and finance channels, the weakness has spread rapidly to developing countries and the economies in transition, causing a synchronized global downturn in the outlook for 2009. Such a globally synchronized slowdown may be the first of its kind in the post-war era.

According to the report, the crisis should have taken no one by surprise. That analysts and policymakers are now expressing bewilderment at the extent of the crisis suggests not only a gross underestimation of the fundamental causes underlying the crisis but also unfounded faith in the self-regulatory capacity of unfettered financial markets.

The report noted that it has repeatedly pointed out in the past that the apparent robust growth pattern that had emerged from the early 2000s came with high risks. Growth was driven to a significant extent by strong consumer demand in the US, stimulated by easy credit and underpinned by booming house prices, and by very high rates of investment demand and strong export growth in some developing countries, notably China. Growing US deficits in this period were financed by increasing trade surpluses in China, Japan and other countries accumulating large foreign-exchange reserves and willing to buy dollar-denominated assets.

At the same time, increasing financial deregulation, along with a flurry of new financial instruments and risk-management techniques (mortgage-backed securities, collateralized debt obligations, credit default swaps, and so on), encouraged a massive accumulation of financial assets supported by growing levels of debt in the household, corporate and public sectors.

Severe problems in US mortgage markets and increasing volatility in interest-rate spreads in the markets for interbank and emerging market lending surfaced in August 2007 as early signs of emerging global financial turmoil. Despite massive liquidity injections and an increasingly loose monetary policy stance in the US, Japan and parts of Europe, the turmoil continued into 2008. Major warning signs came with the collapse of Bear Stearns, the fifth-largest investment bank in the US, which had to be rescued by joint action of the US Federal Reserve (Fed) and JPMorgan Chase.

In September 2008, the financial turmoil intensified once again, this time turning into a global financial tsunami characterized by a severe credit freeze, a precipitous sell-off in stock markets worldwide and the collapse or near collapse of major financial institutions in the US and Europe.

The report said that the continued housing slump in the US triggered the collapse of this financial house of cards. House prices continued to decline in 2008 at an annual rate of about 17%. Mortgage delinquency rates surged, particularly for sub-prime loans. By the third quarter of 2008, financial institutions worldwide had written down a total value of about $700 billion worth of asset-backed securities, of which more than $500 billion related to the commercial banking sector.

A number of large financial institutions came under severe financial stress and were cut off from access to long-term capital and short-term funding markets. In the US, these included the two government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, as well as Lehman Brothers, American International Group (AIG), Inc. and Washington Mutual.

[In its Quarterly Review of December 2008, the Basel-based Bank for International Settlements has noted that in the wake of the mid-September failure of Lehman Brothers, global financial markets seized up and entered a new and deeper state of crisis. As the money market funds and other investors were forced to write off their Lehman-related investments, counter-party concerns mounted in the context of large-scale redemption-driven asset sales. The ensuing sell-off affected all but the safest assets and left key parts of the global financial system dysfunctional.

[In an environment of tension over the continued viability of Lehman Brothers, financial market developments entered a completely new phase, said BIS, adding that the spotlight was now being turned on the ability of key financial institutions to maintain solvency in the face of accumulating losses. The trigger for this new and intensified stage of the credit crisis came on 15 September, when, following failed attempts by the US authorities to broker a takeover by another financial institution over the weekend, Lehman Brothers Holdings Inc filed for bankruptcy protection, one of the biggest credit events in history. The turmoil in financial markets intensified and quickly spread from credit and money markets into the global financial system more broadly.

[The BIS noted that Lehman was managed as a global firm, which involved in particular the centralisation in the United States of its funding activities. Despite the global nature of the firm, separate administration and bankruptcy applications were filed by Lehman outside the United States and by the parent firm in New York. These filings in different jurisdictions made this one of the first truly global bankruptcies of a large and complex financial institution. The complexity of the Lehman operation, and the takeover of its US broker-dealer subsidiary immediately after the holding company's bankruptcy filing, raised questions related to the use of different legal procedures across countries for a collapsed firm that was previously managed and run along global product lines.

[One manifestation of the resulting issues concerns Lehman's prime brokerage activities. Lehman provided prime brokerage services to a large number of hedge funds. As part of these prime brokerage relationships, hedge funds placed investment assets with Lehman's broker-dealer units in different jurisdictions. These assets, posted as collateral for funding activities, could then be reused by Lehman to meet its own obligations, a process called re-hypothecation. Given its insolvency, many of Lehman's prime brokerage clients suddenly lost access to (and, potentially, part of their claims on) their collateral assets for the duration of the administration process. They were thus forcibly locked into positions of changing value whose future accessibility would depend on different legal proceedings and contractual arrangements in various jurisdictions.

[To the extent that this resulted in adjustments to the size and location of hedge funds' activities with their prime brokers, the reallocation of funds across jurisdictions, combined with attempts to reduce leveraged risk exposures, would generate potentially sizeable asset sales and withdrawals from individual prime brokerage accounts. These transactions, in turn, would add to pressures in funding and securities lending markets in the wake of the Lehman bankruptcy. In effect, the BIS spotlighted the absence of a global framework for dealing with bankruptcies of global firms, and the problems caused to various creditors.]

According to the World Economic Situation report, September 2008 marked a sea change in the international financial landscape, including the end of independent investment banking in the US and an end to previous faith in the virtues of unfettered financial markets. Investment banks either went bankrupt, merged with other commercial banks, or converted themselves into commercial banks. Between September 2007 and October 2008, 16 banks in the US filed for bankruptcy, and more than 100 out of some 7,000 banks are on the Fed's watch list.

The intensification of the global financial crisis from late September-October 2008 onwards heightened the risk of a complete collapse of the global financial system. In response, policymakers worldwide, particularly those in major developed countries, drastically scaled up their policy measures in October.

Most importantly, said the report, they made two strategic changes in the way they deal with the crisis. First, the initial piecemeal approach was abandoned and replaced with a more comprehensive one. Second, unilateral national approaches have given way to more international cooperation and coordination. Totalling about $4 trillion, these policy measures aimed at unfreezing credit and money markets by re-capitalizing banks with public funds, guaranteeing bank lending and insuring bank deposits. Interbank lending rates retreated somewhat following the start of the large-scale bailout.

Given the stark erosion of confidence and massive destruction of financial capital over the past year, it will take months, if not years, before beleaguered banks significantly revive lending and fraught investors see confidence restored, said the report, adding that it will take even longer for these policy measures to show their effects in terms of a regaining of strength in the real economy.

According to the report, there had been complacency about the impact of the global financial crisis on developing countries and the economies in transition. In fact, the broader international economic environment for developing countries and the economies in transition has deteriorated sharply, and since October 2008 the financial stresses have shifted rapidly towards these economies.

The cost of external borrowing has risen considerably and capital inflows are reversing. Both currency and commodity markets have become extremely volatile, with the exchange rate depreciating at an alarming pace in several countries and prices of primary commodities tumbling. Export growth in these economies is decelerating and the current-account balances of many countries have shifted back into a rising deficit. These economies are facing even bigger challenges in the outlook for 2009.

The report noted that to ensure sufficient stimulus at the global level, it will be desirable to coordinate the fiscal stimulus packages internationally. By coordinating fiscal stimulus internationally, the positive multiplier effects can be amplified through international economic linkages, thereby providing greater stimuli to both the global economy and the economies of individual countries.

The failure to create a truly inclusive system of global economic governance - for adequate counter-cyclical policies in the short term and appropriate regulatory reform in the medium term - has frustrated a coordinated, comprehensive and inclusive international response to the current crisis. There is no legitimate forum, other than the United Nations itself, in which the interests of all countries can be articulated, considered and reconsidered to ensure more inclusive and equitable - and thus credible and effective - global economic governance.

With respect to trade policy developments, the report noted that the failure to complete the Doha Round reflects deep-seated differences in policy concerns between developing and developed countries.

After nine days of intense negotiations at the ministerial level, the Doha Round broke down once again at the end of July. In the crucial area of agriculture, of a "to-do list" of 20 issues, 18 had seen some narrowing of positions. On one issue, the special safeguard mechanism (SSM) - which would allow developing countries to raise tariffs on agricultural products temporarily in order to deal with import surges and price falls - there was a clear divergence between developed countries (led by the US) and others (led by India) on the so-called "trigger" (the size of the import surge needed to trigger the tariff increase), said the report.

According to the report, the difficulty in dealing with the special safeguard scheme was, however, not the sole reason negotiations collapsed; rather, the breakdown appears to have reflected more deep-seated policy concerns among developing countries about the direction the Doha Round had taken, as well as fresh worries related to the state of the world economy.

The structural weaknesses, evident in the stop-and-start history of the Doha Round since its inception in 2001, refer to persistent concerns among developing countries related to their not being allowed to define the Round's development content, as originally envisaged in the Doha Ministerial Declaration and subsequently agreed ministerial texts.

This revived memories of the Uruguay Round negotiations which, despite the promises at the time, finally came to be viewed as a lopsided bargain. Such unease surfaced relatively early on in the process, particularly in academic and civil society circles, leading to political controversy over the treatment of such issues as cotton subsidies as well as over the perceived neglect of a series of development-related issues which were either left outstanding at the end of the Uruguay Round or became apparent during its implementation.

More recently, in July 2007, the Secretary-General of UNCTAD proposed five key objectives that needed to be attained for the Doha Round to realize its development promise. These objectives embraced critical issues such as real market access for developing countries' exports of goods and services; improvements in multilateral trade rules to address existing asymmetries between developed and developing countries; adequate policy space for developing countries to align trade agreements with national development strategies and to allow a more effective special and differential treatment of developing countries; "development solidarity" in meeting the implementation costs implied in the adjustments that developing countries would be required to undertake; and coherence between regional and multilateral trade agreements.

Failure to make real headway on these counts would appear to go a long way in explaining why the negotiations could not reach a successful and balanced conclusion, said the report.

In addition, the critical situation of the world economy at the time of the July 2008 ministerial meetings may also have acted as a further constraint. There were already clear signs, particularly in the US, that financial markets had become fragile, with potentially catastrophic consequences for all countries if a crisis were to break and spread to the real economy. The July ministerial meetings also coincided with growing concerns in many developing countries about their food and energy security.

It hardly seems surprising, therefore, that one of the stumbling blocks leading to the halt of negotiations related to provisions allowing developing countries to temporarily increase tariffs on agricultural products in times of economic and social difficulty. It is also not surprising, therefore, that the WTO ministerial meeting scheduled for December 2008 was cancelled, as positions had not changed and no progress in the negotiations was to be expected.

Now, the overriding issue for trade negotiators is the financial crisis that has already caused economic problems in advanced countries and is rapidly spreading to developing countries. There is growing recognition that global financial conditions weigh heavily in shaping trade patterns. Therefore, the financial architecture should not be set aside from trade negotiations. In particular, it has become evident that unregulated finance in a global setting has also expressed itself through commodity and currency speculation, leaving countries totally unprotected in a largely liberalized trading system.

Hence, said the report, the present circumstances call not only for meaningful reforms of the institutional arrangements that emerged from Bretton Woods to address new threats to global economic stability but also for a more integrated perspective on the reform agenda which would move beyond the false dichotomy between trade and finance issues.

Regulating trade and finance should be considered jointly. Moreover, a proper, fair and well-regulated system of global finance and currency exchanges has to be in place for development concerns truly to become the centre of multilateral trade negotiations. At this critical juncture, as policymakers seek a stable and efficient system for global finance, it is important that it not be separated from the goal of a fair and inclusive system for international trade which allows for the full participation of developing countries in line with their development objectives and potential.

Devising a coherent, rule-based and authentically multilateral international system requires an integrated approach. Given the open channels between the international trade, financial and banking systems, a truly global, cooperative and non-partisan approach to tackling the most important issues, such as commodity and currency speculation, must be found, said the report.

But developing countries have only a limited voice in international financial institutions. The global institution that possesses the most credibility for implementing such an approach is therefore, more than ever, the United Nations, the report concluded. +