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)

U.S.
4

Euro area

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 Euro area U.S.

1
U.K.

-1

Japan Dec-07
-2
02 03 04 05 06 07
Oil prices have reached very high levels, 7
amid tight market conditions
Crude Oil Prices OPEC Spare Capacity
(Brent futures options; U.S. dollars per (in percent of world oil
barrel)
barrel consumption) 8
140
90% confidence interval Forecast
70% confidence interval Other OPEC
130 7
50% confidence interval
Nov-07 WEO baseline for Brent
120
Dec-07 WEO baseline for Brent
6
Spot price
110

100 5

90
4
96-06 average
80
3
70
Saudi
60 Arabia 2
50
1
40
1/21
30 0
J an-06 J an-07 J an-08 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?

Aseries of unfortunate
events
 It started with subprime
defaults…
Subprime Delinquency Rates ABX 07-1 Tranches
(percent of original balance) (price)
25 120

20 100

80
15
2000 60
10 2001
2002
2003 40
BBB
2004 AAA
5 2005
2006 20 AA
A
2007 BBB-
0 0
Jan- Apr- Jul- Oct- Jan-
0 10 20 30 40 50 60 70 80 90 07 07 07 07 08
Months after Origination 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 Nov-07 J an-08
 …and banks, in turn, became cautious
about lending
Bank Credit and G-3 Lending Conditions
Lending Conditions
300
6 -30
250 Japan EU Average U.S.
5 -20
200
4 -10

3 0 150
Tighter
2 10 100
1 20
50
0 30

-1 40
0
-2 50 -50
1989 1994 1999 2004 2009
-100
Lending survey (advanced 6 quarters, right scale)
-150
U.S. bank loans (qoq percent change, left scale) 1995 2000 2005
11
 Markets became worried about a U.S.
recession…
Equities and Inflation-Linked Bonds Equity Sector Rotation
(1/1/2006 = 100)
140

1600 3

1500 120
2

1400

100 Utilities
1
1300 S&P 500
5-year TIPS yields (percent, right scale) Financials
S&P 500 (left scale) Consumer Discretionary
1200 0 80
Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 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
1200 (basis points) 800 (basis points)
1100
1000
Ambac MBIA AA
900 600
800 A
Radian MGIC
700
400 BBB
600
500
PMI AAA
400
300 200
200
100
0
0
Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08

14
Markets hope central banks will save the day

United States Euro Region

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

100
Other

Housing-
-100
related

-200
03 04 05 06 07
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 0
1/18/2008
-2

-4

-6

-8

-10

-12
08 09 10 11 12

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 cross-
border 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) 130

120 Korea 120

Australi
Germany a
110 110

100 100

90 90

80 Italy 80

70 70
France
Japan

60 U.S. U.K. 60

1/21 1/21
50 50
Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08
 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 Housing Valuation
(1997q1=100) Ratios
U.S. Germany (1997-2006; percent change) 200
U.K. Spain price/ disposable income
Ireland France
Italy price/ rent
150
500 U.S. price/ disposable income

U.S. price/ rent

400 100

300 50

200 U.S.
0

100
-50

Ge aly
d

ce

y
n
K.

S.
0

an
an

ai
U.

U.
an

It
Sp

rm
el

Fr

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

Ir
 Will Divergent Growth in Emerging Markets
Continue?
(in percent; yoy)
10

8 Emerging Markets

World

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

100 Funds 1/

80

60
Equity funds

40

20

Debt funds

0
2004Q1 2005Q1 2006Q1 2007Q1 Q4

1/ Flows from United States and Europe.

 …and the rise in risk aversion has
already dampened private bond
Emerging Market Privateissuance
Sector Gross External Bond Issuance
(US$ billions)
80
70 Africa
Latin America
60
Asia
50 Middle East
40 Europe
30
20
10
0
-10
Q205

Q305

Q405

Q106

Q206

Q406

Q107

Q207

Q307

Q407
Q105

Q306

17
 Rising food and fuel inflation could bite
(in percentage points of annual inflation)
Effects of Oil Price Effects of Oil and Food
0.5 Increase Price Increase
5

Food Fuel
0.4
4

0.3
3

0.2 2

0.1 1

0
0.0

Ch il
y
R ly

Ca ce
da

a
Ja a

Fr .
G pan

a
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.K

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az
an
si

di

in
Ch il
y

Ca ce

a
R ly

da

a
Ja a

Fr K.
er n

a
In .

an
na
.S

az

U
an

It

us
si

In
di
G pa

in

Br
a

m
.
an
na
U

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us

Br
m

er

Estimated Impact of a 10 percent Oil Price Estimated Impact of a 10 percent Oil and an 10
Increase on Annual Headline CPI inflation, percent Food Price Increase on Annual Headline
selected countries. CPI inflation, selected countries
 And asset price booms could turn into busts
House Prices Stock Market Indices
(2000Q1=100) (1/1/2007=100)
200 240

China
220
China

200

150
180

U.S.
India 160
Brazil
140
100 Thailand
Russia
Singapore 120

100
Hong Kong U.S.
07Q3 1/22
50 80
00Q1 02Q1 04Q1 06Q1 J an-07 May-07 Sep-07 J an-08
 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 ECB €95 bn 50 bp Fed cut

liquidity
5.8 injection

Average policy rate 75 bp

5.5 Fed cut
Average 3-month Libor
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 3
 What about bank
capital?
 Some banks are aggressively writing down
exposures and rebuilding 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 long-
term 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

-100
2000 2002 2004 2006 2008

3
 Task two: Easing
financial strains on
households and firms
 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?
Long term government bond yields have fallen

Long-Term Interest Rates

(in percent; 10-yr Govt. Bond)
6

U U
5 .S. .K.

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

J umbo mortgages 5
Corporate, A-AAA
Corporate, BB (rhs)
Conforming Mortgages 1/22
4
J an-07 J ul-07 J an-08
 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 long-
term 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.
3

Euro area
2

1
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
U.K.
(RPI)
3.0
Canada
(20-yr)
2.5
U.S.

2.0
Euro area
(5-yr)
1.5

Japan
1.0

0.5

1/22
0.0
05 06 07 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 rapidly-
growing 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