Where is the World Economy Heading?

Joshua Felman International Monetary Fund India
Presentation at NCAER January 30, 2008

Warning!

The views expressed in this presentation are personal and are not necessarily those of the IMF, its Executive Board, or its management.

Until recently, the world economy was humming along nicely

Growth was running around 5 percent, the fourth consecutive boom year

The best performance in three decades

 

Inflation was low The outlook seemed favorable

A little more than three months ago, the Dow Jones was at a record high

 And

now?

Activity is Decelerating Globally, Q4 over Q4
(growth in percent; Q4/Q4)
6

4

U.S.

2

Euro area
0

Japan
-2 00 01 02 03 04 05 06 07 08
Source: WEO Update January 2008.

Headline inflation in advanced economies has jumped
Headline Inflation
(in percent; yoy) 5 4 3 2 1 0 -1 -2 02 03

Euro area

U.S.

U.K.

Japan
04

Dec-07

05

06

07

Oil prices have reached very high levels, amid tight market conditions
Crude Oil Prices
(Brent futures options; U.S. dollars per barrel) barrel
90% confidence interval 70% confidence interval 50% confidence interval Nov-07 WEO baseline for Brent Dec-07 WEO baseline for Brent Spot price

7

140 130 120 110 100 90 80 70 60 50 40

OPEC Spare Capacity (in percent of world oil consumption)
Other OPEC

8
Forecast

7 6 5 4 3
Saudi Arabia

96-06 average

2 1 0

1/21

J an-06

J an-07

J an-08

30 J an-09

1996 1998 2000 2002 2004 2006 2008

Jan-08

It’s a brave new world!

Worse news

The 1.5 percent growth projected for the U.S. reflects mainly “carryover” from 2007 The q4/q4 figures give a better sense of the slowing growth momentum These show growth will fall to 0.8 percent this year, compared to 2.6 percent in 2007 And the risks are to the downside, not just in the U.S. but globally

Roadmap of Presentation

What went wrong with the global economy? Did Bernanke jump…or was he pushed? Will the rest of the world decouple? Will policy measures save the day?

Roadmap of Presentation

What went wrong with the global economy? Did Bernanke jump…or was he pushed? Will the rest of the world decouple? Will policy measures save the day?

A

series of unfortunate events

It started with subprime defaults…
Subprime Delinquency Rates

25 20 15 10 5 0

(percent of original balance)

ABX 07-1 Tranches
(price)

120 100 80

2000 2001 2002 2003 2004 2005 2006 2007 0 10 20 30 40 50 60 70 80 90
Months after Origination

60 40 20 0
Jan07 Apr07

BBB AAA AA A BBBJul07 Oct07 Jan08

6

Which threatened the capital of global banks

Risk aversion to banks shot up…
Spreads on interbank borrowing
(3-month LIBOR minus T-bill rate; in percent)
2.5

2.0

U.S.

Euro area

1.5

1.0

U.K.
0.5

Japan
0.0 J ul-07 Sep-07 N ov-07 J an-08

…and banks, in turn, became cautious about lending
Bank Credit and Lending Conditions
6 5 4 3 2 1 0 -1 -2 1989 1994 1999 2004 2009 -30 -20 -10 0 10 20 30 40 50

G-3 Lending Conditions
300 250 200 150 100 50 0 -50 -100 -150 1995 2000 2005
Tighter

Japan EU Average U.S.

Lending survey (advanced 6 quarters, right scale) U.S. bank loans (qoq percent change, left scale)

11

Markets became worried about a U.S. recession…
Equities and Inflation-Linked Bonds Equity Sector Rotation

140
1600 3

(1/1/2006 = 100)

1500 2 1400 1 1300
5-year TIPS yields (percent, right scale) S&P 500 (left scale)

120

100

Utilities S&P 500 Financials Consumer Discretionary

1200 Jan-06

Jul-06

Jan-07

Jul-07

0 Jan-08

80 Jan-06

Jul-06

Jan-07

Jul-07

Jan-08

4

The next domino: “monoline” guarantors, which insured many CDOs and municipal bonds
Financial Guarantors 5-year CDS Municipal Bond Spreads (basis points) (basis points) 800 1200
1100 1000 900 800 700 600 500 400 300 200 100 0 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08

Ambac Radian PMI

MBIA MGIC

600

AA A

400

BBB AAA

200

0 Jan-07

Apr-07

Jul-07

Oct-07

Jan-08

14

Markets hope central banks will save the day
United States (in percent)
5.00 4.75 November WEMD 4.50 4.25 January WEMD 4.00 3.75 3.50 3.25 3.00 2.75 2.50 2.25 2.00 Nov-07 Feb-08 May-08 Aug-08 Nov-08

Euro Region (in percent)
5.00 4.75 November WEMD 4.50 January WEMD 4.25 4.00 3.75 3.50 3.25 3.00 2.75 2.50 2.25 2.00 Nov-07 Feb-08 May-08 Aug-08 Nov-08

5

Roadmap of Presentation

What went wrong with the global economy? Did Bernanke jump…or was he pushed? Will the rest of the world decouple? Will policy measures save the day?

Are the problems just in the financial sector? Or have they spread to the real economy?

In December, the problem became “real”!
 

The ISM manufacturing survey fell to its lowest level since 2002 Unemployment rate spiked ½ percentage point to 5 percent, similar to what happened prior to the previous recession Payrolls suffered their steepest decline in four years

Not a blip, but a trend
U.S. Private Payrolls
(thousands; 3-month moving average; monthly net change; seas. adj.)
300

200

Total Other

100

0

-100

Housingrelated
03 04 05 06 07

-200

While the housing market continued to deteriorate… 
The decline in housing starts and permits is showing no sign of bottoming

Foreclosure rate is now higher than that of the severe recession of the early 1980s Putting downward pressure on house prices

…and the outlook is grim
U.S. House Price Expectations 1/
(average annual change; in percent)
2 9/17/2007 10/31/2007 1/18/2008 -2 -4 -6 -8 -10 -12 08 09 10 11 12 0

1/ RPX 25 MSA Composite: Forward Term Structure.

What are the implications?

Financial pressure on households could grow:

Falling housing prices could impair their ability to refinance to avoid ARM resets (1.8 million expected in next two years) Job losses could lead to additional credit difficulties

Banks might respond by tightening credit further Combination of financial pressure and credit curbs could slow consumption Investment could follow

No wonder Bernanke is worried!

Roadmap of Presentation

What went wrong with the global economy? Did Bernanke jump…or was he pushed? Will the rest of the world decouple? Will stimulus save the day?

Linkages: not just trade any more!

 

Traditionally, economists would examine the impact of U.S. recessions on the rest of the world by tracing out trade linkages – the effects on exports But in the 21st century, trade tells only a part of the story Globalization has created new crossborder linkages
 

In 2000, the IT industry collapsed simultaneously all over the world In 2008, the key linkage is financial

Financial innovation – securitization – has turned a non-traded good (mortgages) into traded financial products (CDOs, ABS)

Banks all around the world are exposed to subprime
Especially in Europe  But even in Asia

With predictable consequences for their share prices
130

(FTSE sectoral indices; 1/1/2007=100)
Korea Germany Australi a

130

120

120

110

110

100

100

90

90

80

Italy

80

70

France U.S. 1/21
Jul-07 Oct-07 Jan-08 Jan-07 Apr-07 Jul-07

70

Japan
60

60

U.K. 1/21
Oct-07 Jan-08

50 Jan-07 Apr-07

50

Effects are still to come
 

Market estimates that subprime losses amount to $250-$400 billion Only a portion of this has been disclosed Much of the undisclosed losses are assumed to be in Europe What happens when these losses are acknowledged?

Housing: also not just a U.S. issue!

Prices have actually risen much faster in Europe And now they, too, have begun to slow

Several Advanced Economy Housing Markets Look Stretched
House Prices
(1997q1=100)
U.S. U.K. Ireland Italy Germany Spain France

Housing Valuation Ratios
(1997-2006; percent change)
price/ disposable income price/ rent U.S. price/ disposable income U.S. price/ rent

200

500

150

400

100

300

50
U.S.

200

0

100
-50
It Ge aly rm an y Ir el an d U. K. Fr an ce Sp ai n

0 97Q1 99Q1 01Q1 03Q1 05Q1 07Q1

U. S.

Will Divergent Growth in Emerging Markets Continue?
10

(in percent; yoy)

8

Emerging Markets

6

World
4

2

Advanced Economies
0 00 01 02 03 04 05 06 07 08
Source: WEO Update January 2008.

Convergence ahead!

IMF forecasts Emerging Market growth will slow to 6.9 percent in 2008 from 7.8 percent last year

Developing Asia will slow by 1 percentage point, to a still-rapid 8.6 percent But there are downside risks

Emerging market growth has depended heavily on capital inflows
(cumulative flows; in billions of U.S. dollars) Net Flows to Emerging Market Funds 1/

100

80

60

Equity funds

40

20

Debt funds
0 2004Q 1

2005Q 1

2006Q 1

2007Q 1

Q4

1/ Flows from United States and Europe.

…and the rise in risk aversion has already dampened private bond issuance Emerging Market Private Sector Gross External Bond Issuance
80 70 60 50 40 30 20 10 0 -10 Q205 Q305 Q405 Q106 Q206 Q406 Q107 Q207 Q307 Q407 Q105 Q306 Africa Latin America Asia Middle East Europe
(US$ billions)

17

Rising food and fuel inflation could bite
(in percentage points of annual inflation)
0.5

Effects of Oil Price Increase
5

Effects of Oil and Food Price Increase
Food 4 Fuel

0.4

0.3

3

0.2

2

0.1

1

0.0
It a R ly us si Ja a G pa er n m an y U . Fr K. an Ca ce na da U .S In . di a Br az Ch il in a

0
It a R ly us si Ja a G pan er m an y U .K Fr . an Ca ce na da U .S . In di a Br az Ch il in a
Estimated Impact of a 10 percent Oil and an 10 percent Food Price Increase on Annual Headline CPI inflation, selected countries

Estimated Impact of a 10 percent Oil Price Increase on Annual Headline CPI inflation, selected countries.

And asset price booms could turn into busts
House Prices
200

Stock Market Indices
(1/1/2007=100)
China China
240

(2000Q1=100)

220

200

150

180

U.S. Brazil
100

India

160

Thailand Singapore

140

Russia

120

Hong Kong
50 00Q1 02Q1 04Q1

U.S.
07Q3
06Q1
J an-07 May-07 Sep-07

100

1/22
J an-08

80

Roadmap of Presentation

What went wrong with the global economy? Why did Bernanke jump? Will the rest of the world decouple? Will policy measures save the day?

First task: restoring the financial system to health

This requires addressing problems of:
Liquidity  Capital

Where do we stand?

Central banks have eased funding strain
Average Libor and Policy rates in Euro area, UK, US (in percent)
6.0 5.8 5.5 5.3 5.0 4.8 4.5 4.3 4.0 J an-07 Mar-07 May-07 J ul-07 Sep-07 Nov-07 J an-08
50 bp Fed cut

ECB €95 bn liquidity injection

Average policy rate Average 3-month Libor

75 bp Fed cut

3

Some banks are aggressively writing down exposures and rebuilding capital
  

What about bank capital?

Citigroup – raised $22 bn, 24 percent of capital UBS -- $15 bn, 43 percent of capital Merrill Lynch -- $14 bn, 36 percent of capital

Typically, central banks assist the process by pushing short rates well below longterm rates
 

Since banks borrow short and lend long, this increases their margins The yield gap has indeed risen

But yield gap is still too narrow to rebuild profitability

10-year minus 3-month Treasury yields
(basis points)
500 400 300 200 100 0 -100 2000

2002

2004

2006

2008

3

Lower interest rates should reduce mortgage rates, allowing homeowners to refinance and free up funds for consumption They should also reduce firms’ borrowing costs, encouraging investment Where do we stand?

Task two: Easing financial strains on households and firms

Long term government bond yields have fallen
Long-Term Interest Rates
6

(in percent; 10-yr Govt. Bond)

5

U .S.

U .K.

4

3

Euro area

1/22
2 J an-05 J an-06 J an-07 J an-08

But corporate and mortgage interest rates remain high
U.S. Interest Rates
(in percent)
9

8

7

6

J um bo m ortgages C orporate, A-AAA C orporate, B (rhs) B C onform ng M i ortgages
J an-07 J ul-07

5

1/22
J an-08 4

State of play

Summing up, there some progress, but more clearly needs to be done But what?

What could be done?

Financial sector:

Encourage transparency – spur banks to recognize their losses and recapitalize quickly

Households/businesses:

U.S. is planning a $150 bn fiscal package (1.1 percent of GDP) of tax cuts and business incentives But questions remain:
 

Will tax cuts be an effective stimulus? Will the higher deficit be prove temporary, or do longterm damage to the fiscal position?

Is there room for further monetary easing – considering the high levels of headline inflation?

Core inflation is firmly under control…

5

Core Inflation
(in percent; yoy)
4

U.S. Euro area

3 2 1 0

U.K.

Japan

-1
Dec-07

-2

02

03

04

05

06

07

And inflation expectations seem stable
(from 10-year inflation-indexed bonds)
3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 05 06 07
1/22

U.K. (RPI) Canada (20-yr) U.S.

Euro area (5-yr)

Japan

08

But the scope for easing remains unclear

Typically, inflation declines during U.S. slowdowns, led by sharp falls in commodity prices But will this happen now that rapidlygrowing China and India have become major sources of demand? And if headline inflation does not ease, what will happen to inflation expectations?

Summary

The world economy is facing headwinds, which originated in the U.S. and seem likely to spread to Europe and Asia The IMF forecasts that global growth will still remain brisk – but the downdraft is very strong Further policy action may be needed to support growth – but with headline inflation high, the scope for such

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