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 precededA major sustained world boom preceded

Metal Prices

Global IP

Percent change, year-on-year

Source: World Bank.

-10

-5

0

5

10

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

-75

-25

25

75

Inflation surged

High-income OECD

Developing countries

Median inflation rates: Jan 2000 to Dec 2008

Source: World Bank.

0

3

6

9

12

Jan-00

Jan-01

Jan-02

Jan-03

Jan-04

Jan-05

Jan-06

Jan-07

Jan-08

Jan-09

3. EFFECTS ON DEVELOPING COUNTRIES

Global industrial production plummets into 4th quarter of 2008... manufacturing production, ch% (saar)

-20

-15

-10

-5

0

5

10

15

Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08

Source: DEC Prospects Group.

OECD

Developing

World

Developing exports in decline export volumes: ch% 3mma y/y

-15

-5

5

15

25

35

Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08

Source: National Agencies through Thomson/Datastream.

China

India

Jordan

Mexico

..and corporate bond spreads have surged

Basis pointsBasis points

Emerging-market corporate bond (CEMBI) spreadsJan 2007 – Feb 2009

Source: JPMorganSource: JPMorgan

0

100

200

300

400

500

600

700

800

900

Jan-

07

Mar

-07

May

-07

Jul-0

7

Sep-0

7

Nov-07

Jan-

08

Mar

-08

May

-08

Jul-0

8

Sep-0

8

Nov-08

Jan-

09

Brazil Philippines Russia Turkey

4. FORECAST AND RISKS

World trade to contract in 2009 for the first since the early 1980s (World Bank)

Source: World Bank.

annual percent change in trade volumes

World trade volume

Developing country exports

-3

0

3

6

9

12

15

18

1981 1984 1987 1990 1993 1996 1999 2002 2005 2008

$ billions$ billionsNet private debt and equity flows

1990-2008, projected 2009 PercenPercentt

Percent of GDP(right axis)

Private capital flows set to decline more sharply still in 2009

Source: World Bank, Projections: IIF (adjusted)

0

200

400

600

800

1000

1200

1990 1993 1996 1999 2002 2005 2008

0

2

4

6

8

Net private capital flows to decline $165 bn in 2009(IIF).

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 Global GDP to decline this year for the first time since World War II( World Bank) War II( World Bank) Sharp decline in GDP growth expectedSharp decline in GDP growth expected

High-income

Developing

Source: Historical data: World Bank. Projections: IMF, adjusted

Growth of real GDP, percent

-2

0

2

4

6

8

1981 1985 1989 1993 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 pointsSpread between 3-month US$ Libor and policy interest rate, basis points

-50

0

50

100

150

200

250

300

350

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?

-15

-10

-5

0

5

10

15

20

1930 1941 1952 1963 1974 1985 1996 2007

US GDP, annual growth

Source: BEA

volume

Price

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

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

Percent

0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

1929 19341939 19441949 19541959 19641969 19741979 19841989 19941999 2004

0.00

2.00

4.00

6.00

8.00

10.00

12.00

14.00

16.00

GDP per capita (left axis) Imports/GDP (right axis)

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