Advanced economies must address their financial vulnerabilities, which were at the root of the crisis

The world economy is facing turbulence. There are certain well-marked developments that threaten to slow down the recovery. While there is considerable unanimity on this point, there is far less agreement on whether the global economy is merely facing a rough patch or heading towards a serious downturn something from which it will take years to recover.

At the global level, growth has been at its weakest since recovery began almost two years ago. However, as the International Monetary Fund in its latest update to its flagship publication World Economic Outlook (June 17) points out that there have been ‘offsetting' changes across various economies. Weak growth in some regions is balanced by robust growth elsewhere.

The IMF believes that the present turbulence in global economic growth will be temporary. But there are others who hold a more pessimistic view.

According to the IMF, overall, the global economy expanded at an annualised rate of 4.3 per cent in the first quarter of 2011. Its forecasts for 2011-12 are broadly unchanged. However, activity is slowing down temporarily and downside risks have increased again. The global expansion remains unbalanced. Growth in several advanced economies is still weak in relation to the deep recession from which they are climbing out. In many advanced economies, there has been a mild slowdown in the second quarter of 2011. Growth in most emerging and developing economies continues to be strong.

IMF report: key issues

Unexpected weakness but compensating strengths elsewhere: As pointed out, the IMF's earlier (April) target for global growth of 4.3 per cent for the current year is intact. That is because the negative surprises were compensated by more positive ones elsewhere, leaving the overall estimation of global growth no better or worse than before. For instance, Japan is expected to post a negative growth of 0.7 per cent during this year. The projection is sharply lower by 2.1 percentage points than the IMF's April projection. But the IMF, like many other forecasters, expects Japan to bounce back with a positive growth in 2012.

The U.S economy too disappointed in part due to ‘transitory' factors such as higher commodity prices, bad weather and supply-chain disruptions in the wake of Japan's natural disasters.

In contrast, the major economies in the euro area — Germany and France — posted a robust growth. This surprised many observers. Growth in developing and emerging economies has been on expected lines. Global employment continued to pick up including in many advanced economies.

A major negative surprise was the devastating tsunami and earthquake in Japan, which inflicted enormous damage not only on its economy but also through the well established trade and manufacturing linkages on the global economy. The disasters have caused serious supply disruptions affecting industrial production and consumer spending.

Inflation

At the global level, inflation has risen to 4 per cent in the first quarter of 2011 from 3.5 per cent in the last quarter of 2010. This is higher than what was anticipated. Higher commodity prices have been the principal factor. Among advanced economies, core inflation remained subdued in the U.S. and Japan and rose moderately in the euro area. Inflation has become broad-based in the developing economies reflecting a higher share of food and fuel in consumption as well as accelerating demand-side pressures.

Financial volatility has increased primarily because markets are more concerned with sovereign risks arising from developments in the periphery of the euro area and persistent housing market weakness observed in the U.S. Symptoms include rising sovereign credit default swap spreads in certain euro area countries and retreating global stock prices.

For emerging and developing economies, the environment remains by and large conducive. However, capital inflows continue to remain fickle, reflecting the downside risks to the global economy and domestic concerns such as inflation.

Growth will slow down in the second quarter of 2011 but will pick up in the later part of the year.

However, there would be increasing downside risks. The problem areas, already discussed, include spillover of loss of confidence from the periphery of the euro area and market concerns over possible setbacks to U.S. recovery. If these risks materialise, they will reverberate across the world.

Fiscal challenges also pose major risks to recovery. These include fiscal imbalances in the euro area, the large near term fiscal adjustment in the U.S. in the context of a still fragile recovery and medium term fiscal sustainability in the U.S. Overheating pressures in some key economies have intensified.

Policies must steer away from unbalanced growth: For securing the transition from recovery to expansion there has to be a concerted action by several countries to address diverse challenges.

The key fiscal priority for major advanced economies, especially the U.S. and Japan, is to implement credible and balanced fiscal consolidation programmes focussed on medium term debt sustainability.

Advanced economies must also address their financial vulnerabilities, which were at the root of the crisis. Depending on individual circumstances, monetary policy in these countries ought to be accommodative.

For emerging and developing economies, including India and China, the challenge is to expeditiously tighten macroeconomic policies and use exchange rate flexibility and macro prudential tools, possibly including capital controls, to help contain boom-bust cycles.

RELATED NEWS

Social costs of jobless recoveryJanuary 29, 2011

Minimising risks to recoveryJanuary 19, 2011