TWN Info Service on Finance and Development (Oct12/03)
16 Oct 2012
Third World Network

IMF lowers growth forecasts, prospects now bleaker
Published in SUNS #7456 dated 11 October 2012

Geneva, 10 Oct (Kanaga Raja) -- The International Monetary Fund (IMF) has revised downwards its forecast for global growth made earlier this year, and has now projected it to grow by 3.3 percent this year, and 3.6 percent in 2013.

This "gloomier" outlook for the global economy has been portrayed in the IMF's World Economic Outlook (WEO), released just as the annual meetings of the IMF/World Bank take place this week in Tokyo, Japan.

According to the WEO, the recovery has suffered new setbacks, and uncertainty weighs heavily on the outlook, a key reason being that policies in the major advanced economies have not rebuilt confidence in medium-term prospects. "Tail risks, such as those relating to the viability of the euro area or major US fiscal policy mistakes, continue to preoccupy investors," it said.

The WEO forecast thus sees only a gradual strengthening of activity from the relatively disappointing pace of early 2012. Projected global growth, at 3.3 and 3.6 percent in 2012 and 2013, respectively, is weaker than in the July 2012 WEO Update, which was in turn lower than in the April 2012 WEO.

"A key issue is whether the global economy is just hitting another bout of turbulence in what was always expected to be a slow and bumpy recovery or whether the current slowdown has a more lasting component. The answer depends on whether European and US policymakers deal pro-actively with their major short-term economic challenges."

For the medium term, the IMF emphasised, important questions remain about how the global economy will operate in a world of high government debt and whether emerging market economies can maintain their strong expansion while shifting further from external to domestic sources of growth.

Indicators of activity and unemployment show increasing and broad-based economic sluggishness in the first half of 2012 and no significant improvement in the third quarter. Global manufacturing has slowed sharply. The euro area periphery has seen a marked decline in activity, driven by financial difficulties evident in a sharp increase in sovereign rate spreads. Activity has disappointed in other economies too, notably the United States and United Kingdom.

Spillovers from advanced economies and homegrown difficulties have held back activity in emerging market and developing economies. These spillovers have lowered commodity prices and weighed on activity in many commodity exporters.

The result of these developments is that growth has once again been weaker than projected, in significant part because the intensity of the euro area crisis has not abated as assumed in previous WEO projections. Other causes of disappointing growth include weak financial institutions and inadequate policies in key advanced economies. Furthermore, a significant part of the lower growth in emerging market and developing economies is related to domestic factors, notably constraints on the sustainability of the high pace of growth in these economies and building financial imbalances.

Looking ahead, the IMF said that no significant improvement appears in the offing. The WEO forecast includes only a modest re-acceleration of activity, which would be helped along by some reduction in uncertainty related to assumed policy reactions in the euro area and the United States, continued monetary accommodation, and gradually easier financial conditions.

Healthy non-financial corporate balance sheets and steady or slowing de-leveraging by banks and households will encourage the rebuilding of the capital stock and a gradual strengthening of durables consumption. In emerging market and developing economies, monetary and fiscal policy easing will strengthen output growth.

However, the IMF warned, if either of two critical assumptions about policy reactions fails to hold, global activity could deteriorate very sharply.

The first assumption is that European policymakers take additional action to advance adjustment at national levels and integration at the euro area level (including timely establishment of a single supervisory mechanism for banks). As a result, policy credibility and confidence improve gradually while strains remain from elevated funding costs and capital flight from the periphery to the core countries.

The second assumption is that US policymakers avoid the fiscal cliff and raise the debt ceiling, while making good progress toward a comprehensive plan to restore fiscal sustainability.

"Fiscal adjustment has been detracting from activity in various parts of the world and will continue to do so over the forecast horizon in the advanced economies but not in the emerging market and developing economies."

The WEO said that in major advanced economies, general government structural balances are on course to tighten by about three-quarter percent of GDP in 2012, which is about the same as in 2011 and in line with the April 2012 WEO projections. In 2013, the tightening is projected to increase modestly to about 1 percent of GDP, but its composition across countries will be different.

In the euro area, much adjustment has already been implemented and the pace of tightening will diminish somewhat.

In the United States, the budget outlook for 2013 is highly uncertain, given the large number of expiring tax provisions and the threat of automatic spending cuts and in the context of highly polarised politics. The fiscal cliff implies a tightening of more than 4 percent of GDP, but the WEO projection assumes that the outcome would be only a one and a quarter percent of GDP reduction in the structural deficit, which is slightly more than in 2012, mainly on account of expiring stimulus measures, such as the payroll tax cut, and a decline in war-related spending.

In emerging market and developing economies, no significant fiscal consolidation is on tap for 2012-13, following a 1 percent of GDP improvement in structural balances during 2011. The general government deficit in these economies is expected to remain below one and a half percent of GDP, and public debt levels are expected to decline as a share of GDP, toward 30 percent.

The WEO notes that with many economies in fiscal consolidation mode, a debate has been raging about the size of fiscal multipliers. The smaller the multipliers, the less costly the fiscal consolidation. At the same time, activity has disappointed in a number of economies undertaking fiscal consolidation.

So, the IMF said, a natural question is whether the negative short-term effects of fiscal cutbacks have been larger than expected because fiscal multipliers were underestimated.

According to the IMF, based on data for 28 economies, its main finding is that the multipliers used in generating growth forecasts have been systematically too low since the start of the Great Recession.

Despite the summer 2012 market rally, financial vulnerabilities are higher than in the spring, said the WEO, adding that confidence in the global financial system remains exceptionally fragile.

"Financial conditions are likely to remain very fragile over the near term because implementing a solution to the euro area crisis will take time and the US debt ceiling and fiscal cliff raise concerns about the US recovery. Bank lending in the advanced economies is expected to stay sluggish - much more so in the euro area, where the periphery will suffer further reductions in lending. Most emerging markets will likely experience volatile capital flows."

According to the WEO, the recovery is forecast to limp along in the major advanced economies, with growth remaining at a fairly healthy level in many emerging market and developing economies. Leading indicators do not point to a significant acceleration of activity, but financial conditions have recently improved in response to euro area policymakers' actions and easing by the Federal Reserve.

In the euro area, real GDP is projected to decline by about three-quarter percent (on an annualised basis) during the second half of 2012. With diminishing fiscal withdrawal and domestic and euro-area-wide policies supporting a further improvement in financial conditions later in 2013, real GDP is projected to stay flat in the first half of 2013 and expand by about 1 percent in the second half. The core economies are expected to see low but positive growth throughout 2012-13. Most periphery economies are likely to suffer a sharp contraction in 2012, constrained by tight fiscal policies and financial conditions, and to begin to recover only in 2013.

In the United States, real GDP is projected to expand by about one and a half percent during the second half of 2012, rising to two and three-quarter percent later in 2013. Weak household balance sheets and confidence, relatively tight financial conditions, and continued fiscal consolidation stand in the way of stronger growth. In the very short term, the drought will also detract from output.

In Japan, the pace of growth will diminish noticeably as post-earthquake reconstruction winds down. Real GDP is forecast to stagnate in the second half of
2012 and grow by about 1 percent in the first half of 2013. Thereafter, growth is expected to accelerate further.

Fundamentals remain strong in many economies that have not suffered a financial crisis, notably in many emerging market and developing economies. In these economies, high employment growth and solid consumption should continue to propel demand and, together with macroeconomic policy easing, support healthy investment and growth. However, growth rates are not projected to return to pre-crisis levels.

In developing Asia, real GDP is forecast to accelerate to a seven and a quarter percent pace in the second half of 2012. The main driver will be China, where activity is expected to receive a boost from accelerated approval of public infrastructure projects. The outlook for India is unusually uncertain: For 2012, with weak growth in the first half and a continued investment slowdown, real GDP growth is projected to be 5 percent, but improvements in external conditions and confidence - helped by a variety of reforms announced very recently - are projected to raise real GDP growth to about 6 percent in 2013.

In Latin America, real GDP growth is projected to be about three and a quarter percent for the second half of 2012. It is then expected to accelerate to four and three-quarter percent in the course of the second half of 2013. The projected acceleration is strong for Brazil because of targeted fiscal measures aimed at boosting demand in the near term and monetary policy easing, including policy rate cuts equivalent to 500 basis points since August 2011. The pace of activity elsewhere is not forecast to pick up appreciably.

In the central and eastern European (CEE) economies, improving financial conditions in the crisis-hit economies, somewhat stronger demand from the euro area, and the end of a boom-bust cycle in Turkey are expected to raise growth back to 4 percent later in 2013.

Growth is projected to stay above 5 percent in sub-Saharan Africa (SSA) and above 4 percent in the Commonwealth of Independent States. In both regions, still-high commodity prices and related projects are helping.

In the Middle East and North Africa (MENA), activity in the oil importers will likely be held back by continued uncertainty associated with political and economic transition in the aftermath of the Arab Spring and weak terms of trade - real GDP growth is likely to slow to about one and a quarter percent in 2012 and rebound moderately in 2013. Due largely to the recovery in Libya, the pace of overall growth among oil exporters will rise sharply in 2012, to above six and a half percent, and then return to about three and three-quarter percent in 2013.

"Risks to the WEO forecast have risen appreciably and now appear more elevated than in the April 2012 and September 2011 WEO reports, whose policy assumptions and hence growth projections for advanced economies proved overly optimistic."

The WEO's standard fan chart suggests that uncertainty about the outlook has increased markedly. The WEO growth forecast is now 3.3 and 3.6 percent for 2012 and 2013, respectively, which is somewhat lower than in April 2012.

The probability of global growth falling below 2 percent in 2013 - which would be consistent with recession in advanced economies and a serious slowdown in emerging market and developing economies - has risen to about 17 percent, up from about 4 percent in April 2012 and 10 percent (for the one-year-ahead forecast) during the very uncertain setting of the September 2011 WEO, said the IMF.

The IMF staff's Global Projection Model (GPM) uses an entirely different methodology to gauge risk but confirms that risks for recession in advanced economies (entailing a serious slowdown in emerging market and developing economies) are alarmingly high. For 2013, the GPM estimates suggest that recession probabilities are about 15 percent in the United States, above 25 percent in Japan, and above 80 percent in the euro area.

According to the IMF, immediate risks relate to the assumptions about the sovereign debt crisis in the euro area and about the US budget, both of which could negatively affect growth prospects. Furthermore, oil prices could again provide a shock.

It explained that the euro area crisis could re-intensify again. The OMT (Outright Monetary Transactions) program will reduce risks from self-fulfilling market doubts related to the viability of the Economic and Monetary Union (EMU) most effectively if it is implemented decisively. However, serious risks remain outside this safety net - posed, for example, by rising social tensions and adjustment fatigue that raise doubts about adjustment in the periphery or by doubts about the commitment of others to more integration.

The downside scenario developed here uses the IMF staff's Global Integrated Monetary and Fiscal Model (GIMF) to consider the implications of an intensification of euro area sovereign and banking stress, the IMF said, adding that unlike in the WEO forecast and GFSR (Global Financial Stability Report) baseline scenario, European policymakers in this scenario do not strengthen their policies.

"In this scenario, the forces of financial fragmentation increase and become entrenched, capital holes in banking systems expand, and the intra-euro-area capital account crisis increasingly spills outward."

Within the GIMF, this scenario features the following shocks relative to the WEO forecast: lower credit, mainly in the periphery; higher sovereign risk premiums for the periphery; modestly lower premiums for the core sovereigns, which benefit from a flight to safety; an even larger fiscal consolidation in the periphery; and increases in corporate risk premiums for all (including non-European) advanced and emerging market economies.

Furthermore, monetary policy is constrained at the zero interest rate floor in the advanced economies, and the assumption is that they do not proceed with additional unconventional easing. Emerging market economies, by contrast, are assumed to ease as growth and inflation fall, which considerably reduces the impact of the external shock on their economies.

In this scenario, the WEO projected that output in the euro area core would fall by about one and three-quarter percent relative to its projections within one year; in the periphery, the decline would be about 6 percent. Output losses in non-European economies would be about one to one and a half percent.

The second GIMF scenario assumes that national policymakers follow up the latest ECB (European Central Bank) actions with a more proactive approach toward domestic adjustment and EMU reforms. This scenario requires regaining credibility through an unflinching commitment to implementing already agreed plans. Policymakers need to build political support for the necessary pooling of sovereignty that a more complete currency union entails. It envisages that they quickly introduce a road map for banking union and fiscal integration and deliver a major down payment.

Examples of possible action include implementation of a bank resolution mechanism with common backstops or a pan-European deposit insurance guarantee plan (for both, concrete proposals still need to be spelled out) and concrete measures toward fiscal integration.

Under this scenario, the euro area begins to reintegrate as policy credibility is restored and capital flight reverses. Credit expands by roughly 225 billion euros and sovereign spreads decline by about 200 basis points in 2013 in the periphery of the euro area. Economic growth resumes in the periphery and picks up in the core. In other advanced economies, corporate spreads fall by 50 basis points; in emerging market economies, by 100 basis points. Output would then be roughly half to one percent higher within one year in most other parts of the world.

The IMF further said that the US fiscal cliff could entail significantly more fiscal tightening (by about 3 percent of GDP) than assumed in the WEO projections. A recent Spillover Report (IMF, 2012) finds that if this risk materialises and the sharp fiscal contraction is sustained, the US economy could fall into a full-fledged recession. The global spillovers would be amplified through negative confidence effects, including, for example, a global drop in stock prices.

Acknowledging that the impact of hitting the debt ceiling is more difficult to model, the WEO notes that political delays before the previous deadline, in summer 2011, led credit rating agencies to downgrade the United States, and major market turmoil ensued. At this stage, markets appear to consider the fiscal cliff a tail risk, given that Congress has in the past eventually reached a compromise to resolve similar high-stakes situations. However, this implies that, should this risk actually materialise, there would be a great shock to confidence that would quickly spill over to financial markets in the rest of the world.

The IMF also envisaged a large number of risks and scenarios for the medium term, highlighting two specific risk scenarios and one general risk scenario that appear pertinent for policymakers at this juncture. The specific risk scenarios relate to large central bank balance sheets and high public debt - they are directly relevant for monetary and fiscal policy in the advanced economies. The general risk scenario is for globally lower growth over the medium term.

"Looking beyond the near term, a concern is that output growth may disappoint in both advanced and emerging market economies, albeit for different reasons, and will precipitate a general flight to safety," it added, noting that growth outcomes have already disappointed repeatedly, including relative to the September 2011 and April 2012 WEO projections. "These disappointments could be symptomatic of medium-term problems."

Five years after the onset of the Great Recession, the WEO summarises, the recovery remains tepid and bumpy, and prospects remain very uncertain. Unemployment is unacceptably high in most advanced economies, and workers in emerging market and developing economies face a chronic struggle to find formal employment.

A basic challenge for policymakers is thus to move away from an incremental approach to policymaking and address the many downside risks to global activity with strong medium-term fiscal and structural reform programs in order to rebuild confidence. In the euro area, action is also needed to address the current crisis and, over the medium term, to complete the EMU. Only after substantial progress is made on these various fronts will confidence and demand strengthen durably in the major advanced economies.

Policymakers in emerging market and developing economies will need to balance two priorities: rebuilding policy buffers so as to maintain hard-won increases in the resilience of their economies to shocks and supporting domestic activity in response to growing downside risks to external demand, the WEO concluded. +