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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 2006-2007 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
Global IP

Metal Prices
-5

-10
Jan-91 Jan-93 Jan-95 Jan-97 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09

Source: World Bank.


Inflation surged

Median inflation rates: Jan 2000 to Dec 2008

12
Developing countries

3
High-income OECD
0
Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan-
00 01 02 03 04 05 06 07 08 09
Source: World Bank.
3. EFFECTS ON DEVELOPING
COUNTRIES
Global industrial production plummets into 4th quarter of
2008...
manufacturing production, ch% (saar)

15
Developing
10

0
World

-5

-10 OECD

-15

-20
Source: DEC
Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08
Developing exports in decline
export volumes: ch% 3mma y/y

35

25 China

15
Mexico India
5

-5
Jordan

-15
Source: National Agencies through
Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08
..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

0
07

08
07

08

09
7

8
7

8
07

08
7

8
-0

-0
l-0

l-0
-0

-0
v-

v-
n-

n-

n-
p-

p-
ar

ar
ay

ay

Ju
Ju

No

No
Ja

Ja

Ja
Se

Se
M

M
M

Brazil Philippines Russia Turkey


Source: JPMorgan
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

0
World trade volume
-3

1981 1984 1987 1990 1993 1996 1999 2002 2005 2008
Source: World Bank.
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


$ billions 1990-2008, projected 2009 Percent
1200 8

1000 Percent of GDP


(right axis) 6
800

600 4

400
2
200

0 0
1990 1993 1996 1999 2002 2005 2008

Source: World Bank, Projections: IIF (adjusted)


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

8 Developing

0 High-income

-2
1981Source:1985 1989World 1993
Historical data: 1997 2001 2005 2009
Bank. Projections: IMF, adjusted
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

-50
1/2/07 5/2/07 9/2/07 1/2/08 5/2/08 9/2/08 1/2/09

Spread Today
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 volume

-10

-15
1930 1941 1952 1963 1974 1985 1996 2007

Source: BEA
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
G-20 Policy Issues: Avoiding a Repeat

 Macro-Policies and Asset Price Bubbles

 Regulation of all Systematically Important Financial Institutions (Non-Banks)

 Transparency and Market-Making in Credit Default Swaps

 Rules on capital adequacy, extent of securitization, mortgage issuance

 Regulation of Credit Rating Agencies


How the world will change: some longer
term implications

 Fiscal burden

 Monetary overhang

 Moral Hazard

 Nationalized Banks (and other firms?)

 Large reserve accumulation encouraged

 Retreat from globalization and the market paradigm?


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