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The World Economy on a Precipice Uri Dadush Carnegie Endowment for International Peace Beijing, March 2009 Main Points 1. Financial crisis has turned into a massive global recession 2. US sub-prime was the crisis trigger, but vulnerabilities run much deeper and wider 3. Despite improved fundamentals, developing countries are being engulfed by the crisis 4. Depression scenarios are no longer excludable, but most likely is an extended global recession 5. Bold policy steps essential – including to forestall protectionism 1. A MASSIVE, GLOBAL, CRISIS A massive, global, crisis [Y=f(K,L,E)] World output growth down from +3.5% p.a. in 20062007 to -5% (SAAR) estimated in the last six months Stock markets around the world fall about 60% from their peak in Summer 2007 In the U.S., unemployment set to rise from 4.5% in 2007 to 9% or higher in 2009 Oil prices fall from $150 at the peak in Spring 2008, to near $40; prices of metals also collapse Global Impact: all countries affected by financial turmoil since September Most affected: Russia, Ukraine, Hungary, Greece Least affected: China, United States, Philippines, Egypt Based on change in exchange rate, spreads, and stock market. 2. CAUSES Vulnerabilities and Triggers US vulnerabilities 1. Monetary and Fiscal policies too loose too long 2. Innovation and Regulatory Failure 3. Excessive household debt and bank leverage Global vulnerabilities 1. Demand Boom and Inflationary Pressures 2. Housing and Asset price boom 2. Large and widening external imbalances Triggers 1. Subprime securities collapse 2. Lehman failure A major sustained world boom preceded Percent change, year-on-year 10 75 Global IP 5 25 0 -25 Metal Prices -5 -10 -75 Jan-91 Jan-93 Jan-95 Source: World Bank. Jan-97 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Inflation surged Median inflation rates: Jan 2000 to Dec 2008 12 Developing countries 9 6 3 High-income OECD 0 Jan00 Jan01 Jan02 Source: World Bank. Jan03 Jan04 Jan05 Jan06 Jan07 Jan08 Jan09 3. EFFECTS ON DEVELOPING COUNTRIES Global industrial production plummets into 4th quarter of 2008... manufacturing production, ch% (saar) 15 Developing 10 5 0 World -5 -10 OECD -15 -20 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Source: DEC Prospects Group. Jul-08 Oct-08 Developing exports in decline export volumes: ch% 3mma y/y 35 25 China 15 India Mexico 5 -5 Jordan -15 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Source: National Agencies through Thomson/Datastream. ..and corporate bond spreads have surged Emerging-market corporate bond (CEMBI) spreads Jan 2007 – Feb 2009 Basis points 900 800 700 600 500 400 300 200 100 Brazil Source: JPMorgan Philippines Russia Turkey Ja n09 Ju l-0 8 Se p08 No v08 ay -0 8 M ar -0 8 M Ja n08 Ju l-0 7 Se p07 No v07 ay -0 7 M ar -0 7 M Ja n07 0 4. FORECAST AND RISKS World trade to contract in 2009 for the first since the early 1980s (World Bank) annual percent change in trade volumes 18 Developing country exports 15 12 9 6 3 0 World trade volume -3 1981 1984 1987 Source: World Bank. 1990 1993 1996 1999 2002 2005 2008 Private capital flows set to decline more sharply still in 2009 Net private capital flows to decline $165 bn in 2009(IIF). Net private debt and equity flows 1990-2008, projected 2009 $ billions Percent 1200 8 Percent of GDP (right axis) 1000 6 800 600 4 400 2 200 0 0 1990 1993 1996 1999 Source: World Bank, Projections: IIF (adjusted) 2002 2005 2008 External Finance shortfall in developing countries in 2009 ( World Bank) Private sector creditors shun emerging markets – net private capital flows fall to $160bn from $1 tril. In 2007 Higher borrowing costs as well as lower capital flows 104 of 129 developing countries will have current account surpluses inadequate to cover private debt coming due; Eastern Europe most affected. Financial gap of about $268 bn in 98 of the 104 countries in the base case In a low-case scenario, financial gap could be $700 bn. Global GDP to decline this year for the first time since World War II( World Bank) Sharp decline in GDP growth expected Growth of real GDP, percent Developing 8 6 4 2 0 High-income -2 1981 1985 1989 1993 Source: Historical data: World Bank. Projections: IMF, adjusted 1997 2001 2005 2009 The drivers of recovery 1. Fiscal stimulus (2.5-3% of GDP in ICs; less in DCs) 2. Lower interest rates (RIR near 0) 3. Bank recapitalization, guarantees, restructuring 4. Falling oil prices 5. Turn in the housing cycle/greed BUT….will the state remain credible?? Did the financial crisis culminate in early October? Spread between 3-month US$ Libor and policy interest rate, basis points 350 300 250 200 150 100 50 0 -50 1/2/07 5/2/07 9/2/07 1/2/08 5/2/08 Spread Today 9/2/08 1/2/09 Why the crisis could easily become protracted and deeper The intensity of the downturn to date Financial crises lead to longer downturns (3-4 years) and to bigger GDP declines (5% to 25% peak to trough) This financial crisis is big (judging by bailout costs and stock market decline to date) The size of debts in the US and UK is unprecedented Complexity of financial instruments Global spread of the crisis and coordination issues Is a depression possible? 20 US GDP, annual growth 15 Price 10 5 0 -5 volume -10 -15 1930 1941 1952 1963 Source: BEA 1974 1985 1996 2007 5. POLICIES G-20 Crucial Policy: Mitigating Recession 1. Fiscal Stimulus Size and burden sharing 2. Monetary Policy Quantitative Easing (which assets?) 3. Bank Restructuring Asset Purchases (“Bad Bank”) 4. Support to most vulnerable countries (IMF resources) 5. Preempting Protectionism Risk of Resurgent Protectionism The crisis has led to a large increase in uncertainty – regarding jobs, livelihoods, and the viability of firms …and a massive expansion of states’ non-neutral interventions into the economy creates room for the politicization of economic decisions Protectionism has been modest so far, but the risks of large deterioration are real Policymakers must take several steps to cement a joint commitment to trade openness and collaborative recovery We have not been here before: US economy is more trade dependent 1990 International dollars Percent 35,000 16.00 30,000 14.00 25,000 12.00 10.00 20,000 8.00 15,000 6.00 10,000 4.00 5,000 2.00 0 0.00 1929 1934 1939 1944 1949 1954 1959 1964 1969 1974 1979 1984 1989 1994 1999 2004 GDP per capita (left axis) Imports/GDP (right axis) Sources: GDP per capita: Angus Maddison, "Historical Statistics for the World Economy: 1-2006 AD. Imports 1920-1947: US Census. GDP 1920-1928: . GDP 1929-1948: US Bureau of Economic Analysis. 1948-2006: Imports as a percentage of GDP: World Bank, Global Economic Monitor Policy to Preempt Protectionism Visible and fair burden sharing on stimulus Moratorium on new trade restrictions through 2010 and formal monitoring and reporting in WTO Establish coordination councils on sensitive industries Reassert determination to conclude Doha by end 2009 Form a working group on WTO reform