EXECUTIVE SUMMARY

Global Economic Environment derailed by the reversal of the housing boom,

The global expansion is losing speed in the has spread quickly and unpredictably to inflict
face of a major financial crisis (Chapter 1). The extensive damage on markets and institutions
slowdown has been greatest in the advanced at the core of the financial system. The fallout
economies, particularly in the United States, has curtailed liquidity in the interbank market,
where the housing market correction contin- weakened capital adequacy at major banks, and
ues to exacerbate financial stress. Among the prompted the repricing of risk across a broad
other advanced economies, growth in western range of instruments, as discussed in more
Europe has also decelerated, although activity detail in the April 2008 Global Financial Stabil-
in Japan has been more resilient. The emerging ity Report. Liquidity remains seriously impaired
and developing economies have so far been less despite aggressive responses by major central
affected by financial market developments and banks, while concern about credit risks has
have continued to grow at a rapid pace, led by intensified and extended far beyond the sub-
China and India, although activity is beginning prime mortgage sector. Equity prices have also
to slow in some countries. retreated as signs of economic weakness have
At the same time, headline inflation has intensified, and equity and currency markets
increased around the world, boosted by the have remained volatile.
continuing buoyancy of food and energy prices. These financial dislocations and associated
In the advanced economies, core inflation has deleveraging are affecting both bank and non-
edged upward in recent months despite slow- bank channels of credit in the advanced econo-
ing growth. In the emerging markets, headline mies, and evidence is gathering of a broad credit
inflation has risen more markedly, reflecting squeeze—although not yet a full-blown credit
both strong demand growth and the greater crunch. Bank lending standards in the United
weight of energy and particularly food in con- States and western Europe are tightening,
sumption baskets. the issuance of structured securities has been
Commodity markets have continued to boom curtailed, and spreads on corporate debt have
despite slowing global activity. Strong demand risen sharply. The impact is most severe in the
from emerging economies, which has accounted United States and is contributing to a further
for much of the increase in commodity con- deepening of the housing market correction. In
sumption in recent years, has been a driving western Europe, the main spillovers have been
force in the price run-up, while biofuel-related through banks most directly exposed to U.S.
demand has boosted prices of major food crops. subprime securities and disruptions in interbank
At the same time, supply adjustments to higher and structured securities markets.
prices have lagged, notably for oil, and inven- Recent financial market stress has also had
tory levels in many markets have declined to an impact on foreign exchange markets. The
medium- to long-term lows (see Appendix 1.2). real effective exchange rate for the U.S. dollar
The recent run-up in commodity prices also has declined sharply since mid-2007 as foreign
seems to have been at least partly due to finan- investment in U.S. bonds and equities has been
cial factors, as commodities have increasingly dampened by reduced confidence in both the
emerged as an alternative asset class. liquidity of and the returns on such assets, as
The financial shock that erupted in August well as by the weakening of U.S. growth pros-
2007, as the U.S. subprime mortgage market was pects and interest rate cuts. The decline in the

xiv
 EXECUTIVE SUMMARY

value of the U.S. dollar has boosted net exports growth performance of emerging and develop-
and helped bring the U.S. current account ing economies has become less dependent on
deficit down to less than 5 percent of GDP by the advanced economy business cycle, although
the fourth quarter of 2007, over 1½ percent spillovers have clearly not been eliminated.
of GDP lower than its peak in 2006. The main
counterpart to the decline of the dollar has
been appreciation of the euro, the yen, and Outlook and Risks
other floating currencies such as the Canadian Global growth is projected to slow to 3.7 per-
dollar and some emerging economy currencies. cent in 2008, ½ percentage point lower than at
However, exchange rate movements have been the time of the January World Economic Outlook
less marked for a number of countries with large Update and 1¼ percentage points lower than the
current account surpluses—notably China and growth recorded in 2007. Moreover, growth is pro-
oil-exporting countries in the Middle East. jected to remain broadly unchanged in 2009. The
Direct spillovers to emerging and developing divergence in growth performance between the
economies have been less pronounced than in advanced and emerging economies is expected to
previous periods of global financial market dis- continue, with growth in the advanced economies
tress, although capital inflows have moderated generally expected to fall well below potential.
in recent months and issuance activity has been The U.S. economy will tip into a mild recession
subdued. A number of countries that had relied in 2008 as the result of mutually reinforcing
heavily on short-term cross-border borrowing cycles in the housing and financial markets,
have been affected more substantially. Trade before starting a modest recovery in 2009 as
spillovers from the slowdown in the advanced balance sheet problems in financial institu-
economies have been limited so far and are tions are slowly resolved (Chapter 2). Activity
more visible in economies that trade heavily with in western Europe is also projected to slow to
the United States. As a result, growth among well below potential, owing to trade spillovers,
emerging and developed economies has contin- financial strains, and negative housing cycles in
ued to be generally strong and broadly balanced some countries. By contrast, growth in emerging
across regions, with many countries still facing and developing economies is expected to ease
rising inflation rates from buoyant food and fuel modestly but remain robust in both 2008 and
prices and strong domestic demand. 2009. The slowdown reflects efforts to prevent
Underpinning the resilience of the emerging overheating in some countries as well as trade
and developing economies are their increasing and financial spillovers and some moderation in
integration into the global economy and the commodity prices.
broad-based nature of the current commodity The overall balance of risks to the short-term
price boom, which have boosted exports, foreign global growth outlook remains tilted to the
direct investment, and domestic investment in downside. The IMF staff now sees a 25 percent
commodity-exporting countries to a greater chance that global growth will drop to 3 per-
degree than during earlier booms. As explored cent or less in 2008 and 2009—equivalent to a
in Chapter 5, commodity exporters have been global recession. The greatest risk comes from
able to make progress toward diversifying their the still-unfolding events in financial markets,
export bases, including by increasing manufac- particularly the potential for deep losses on
turing exports, and the share of trade among the structured credits related to the U.S. subprime
emerging and developing economies themselves mortgage market and other sectors to seriously
has increased. Strengthened macroeconomic impair financial system balance sheets and cause
frameworks and improved institutional envi- the current credit squeeze to mutate into a
ronments have been important factors behind full-blown credit crunch. Interaction between
these favorable developments. As a result, the negative financial shocks and domestic demand,

xv
 EXECUTIVE SUMMARY

particularly through the housing market, rent inflation is uncomfortably high, prospects
remains a concern for the United States and to point to its falling back below 2 percent during
a lesser degree for western Europe and other 2009, in the context of an increasingly negative
advanced economies. There is some upside outlook for activity. Accordingly, the European
potential from projections for domestic demand Central Bank can afford some easing of the
in the emerging economies, but these econo- policy stance. In Japan, there is merit in keeping
mies remain vulnerable to trade and financial interest rates on hold, although there would be
spillovers. At the same time, risks related to some limited scope to reduce interest rates from
inflationary pressures have risen, reflecting the already-low levels if there were a substantial dete-
price surge in tight commodity markets and the rioration in growth prospects.
upward drift of core inflation. Beyond these immediate concerns, recent
financial developments have fueled the continu-
ing debate about the degree to which central
Policy Issues banks should take asset prices into account in
Policymakers around the world are facing a setting monetary policy. In this context, Chapter
diverse and fast-moving set of challenges, and 3 looks at connections between housing cycles
although each country’s circumstances differ, and monetary policy. It concludes that recent
in an increasingly multipolar world it will be experience seems to support giving greater
essential to meet these challenges broadly, tak- weight to house price movements in monetary
ing full account of cross-border interactions. In policy decisions, especially in economies with
the advanced economies, the pressing tasks are more developed mortgage markets where
dealing with financial market dislocations and “financial accelerator” effects have become more
responding to downside risks to growth—but pronounced. This could be achieved within a
policy choices should also take into account risk-management framework for monetary policy
inflation risks and longer-term concerns. Many by “leaning against the wind” when house prices
emerging and developing economies still face move rapidly or when prices have moved out of
the challenge of ensuring that strong current normal valuation ranges, although it would not
growth does not drive a buildup in inflation be feasible or desirable for monetary policy to
or vulnerabilities, but they should be ready to adopt specific house price objectives.
respond to slowing growth and more difficult Fiscal policy can play a useful stabilizing role
financing conditions if the external environ- in advanced economies in the event of a down-
ment deteriorates sharply. turn in economic activity, although it should not
jeopardize efforts aimed at consolidating fiscal
positions over the medium term. In the first
Advanced Economies place, there are automatic stabilizers that should
Monetary policymakers in the advanced provide timely fiscal support, without jeopardiz-
economies face a delicate balancing act between ing progress toward medium-term objectives. In
alleviating the downside risks to growth and addition, there may be justification for addi-
guarding against a buildup in inflation. In the tional discretionary stimulus in some countries,
United States, rising downside risks to output, given present concern about the strength of
amid considerable uncertainty about the extent, recessionary forces and concern that financial
duration, and impact of financial turbulence dislocations may have weakened the normal
and the deterioration in labor market condi- monetary policy transmission mechanism, but
tions, justifies the Federal Reserve’s recent deep any such stimulus must be timely, well targeted,
interest rate cuts and a continuing bias toward and quickly unwound. In the United States,
monetary easing until the economy moves to a where automatic stabilizers are relatively small,
firmer footing. In the euro area, although cur- the recent legislation to provide additional

xvi
 EXECUTIVE SUMMARY

stimulus for an economy under stress seems advanced economies and the increased stress
fully justified, and room may need to be found in financial markets. In some countries, further
for some additional public support for housing monetary policy tightening may be needed to
and financial markets. In the euro area, auto- keep inflation under control. With a flexible
matic stabilizers are more extensive and should exchange rate regime, currency appreciation
be allowed to play out fully around a deficit will tend to provide useful support for monetary
path that is consistent with steady advance- tightening. Countries whose exchange rates are
ment toward medium-term objectives. Coun- heavily managed vis-à-vis the U.S. dollar have less
tries whose medium-term objectives are well in room to respond because rising interest rates
hand can provide some additional discretionary may encourage heavier capital inflows. China
stimulus if needed. However, in other countries, and other countries that have diversified econo-
the ability to allow even automatic stabilizers to mies would benefit from moving toward more
operate in full may be limited by high levels of flexible regimes that would provide greater
public debt and current adjustment plans that scope for monetary policy. For many Middle
are insufficient for medium-term sustainability. Eastern oil exporters, the exchange rate peg to
In Japan, net public debt is projected to remain the U.S. dollar constrains monetary policy, and
at high levels despite recent consolidation it will be important that the current buildup in
efforts. In the context of an economic down- fiscal spending be calibrated to account for the
turn, automatic stabilizers could be allowed to cyclical position of these economies and that
operate, but their impact on domestic demand priority be given to spending aimed at alleviat-
would be small, and there would be little scope ing supply bottlenecks.
for additional discretionary action. Fiscal and financial policies can also play use-
Policymakers need to continue strong efforts ful roles in preventing overheating and related
to deal with financial market turmoil in order to problems. Expenditure restraint can help
avoid a full-blown crisis of confidence or a credit moderate domestic demand, lessen the need
crunch. The immediate priorities, explored in for monetary tightening, and ease pressures
more detail in the April 2008 Global Financial from short-term capital inflows. Vigilant finan-
Stability Report, are to rebuild counterparty confi- cial supervision—promoting appropriately tight
dence, reinforce the capital and financial sound- lending standards and strong risk management
ness of institutions, and ease liquidity strains. in domestic financial institutions—can pay divi-
Additional initiatives to help support the U.S. dends both by moderating the demand impulse
housing market, including possible use of the from rapid credit growth and by reducing the
public sector balance sheet, could help to reduce buildup of balance sheet vulnerabilities.
uncertainties about the evolution of the financial At the same time, policymakers should be
system, although care would be needed to avoid ready to respond to a more negative external
inducing undue moral hazard. Longer-term environment, which could undercut trade
reforms include improving mortgage market performance and stifle capital inflows. In many
regulation, promoting the independence of rat- countries, strengthened policy frameworks and
ing agencies, broadening supervision, strength- public sector balance sheets will allow for more
ening the framework of supervisory cooperation, use than in the past of countercyclical monetary
and improving crisis resolution mechanisms. and fiscal policies. In China, the consolidation
of the past few years provides ample room to
support the economy through fiscal policy, such
Emerging and Developing Economies as by accelerating public investment plans and
Emerging and developing economies face the advancing the pace of reforms to strengthen
challenges of controlling inflation while being social safety nets, health care, and education. In
alert to downside risks from the slowdown in the many Latin American countries, well-established

xvii
 EXECUTIVE SUMMARY

inflation-targeting frameworks would provide is being made in implementing the strategy

the basis for monetary easing in the event of endorsed by the International Monetary and
both a downturn in activity and an alleviation Financial Committee and the more detailed
of inflation pressures. Automatic fiscal stabiliz- policy plans laid out by participants in the
ers could be allowed to operate, although there IMF-sponsored Multilateral Consultation
would be little room for discretionary fiscal on Global Imbalances aimed at rebalanc-
stimulus, given still-high public debt levels. Some ing domestic demand across countries, with
emerging and developing economies that have supportive movements in real exchange rates
large current account deficits or other vulner- (see Box 1.3). This road map remains relevant
abilities and are reliant on capital inflows may but should be used flexibly to take account of
need to respond by tightening policies promptly the changing global context. Reducing trade
to maintain confidence. barriers also remains an important priority,
but the slow progress toward completing the
Doha Round has been disappointing. Rising
Multilateral Initiatives and Policies trade has been a key source of the recent strong
Broadly based efforts to deal with global performance of the global economy—and
challenges have become indispensable. In the the recent progress toward global poverty
event of a severe global downturn, there would reduction—and a renewed push in this area
be a case for providing temporary fiscal sup- remains essential.
port in a range of countries that have made Recent commitments to developing a post-
good progress in recent years in securing sound Kyoto framework for joint action to address
fiscal positions. Providing fiscal stimulus across climate change are very welcome. As discussed
a broad group of countries that would benefit in Chapter 4, efforts to adapt to and mitigate
from stronger aggregate demand could prove the buildup of greenhouse gases have impor-
much more effective than isolated efforts, given tant macroeconomic consequences. The chapter
the inevitable cross-border leakages from added finds that these macroeconomic consequences
spending in open economies. It is still early to can be contained, provided efforts to limit
launch such an approach, but it would be pru- emissions are based on effective carbon pricing
dent for countries to start contingency planning that reflects the damages emissions inflict. Such
to ensure a timely response in the event that carbon pricing should be applied across coun-
such support becomes necessary. tries to maximize the efficiency of abatement,
Reducing risks associated with global cur- should be flexible to avoid volatility, and should
rent account imbalances remains an important be equitable so as not to put undue burdens on
task. It is encouraging that some progress the countries least able to bear them.

xviii