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 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 preceded Metal Prices Global IP Percent change, year-on-year Source : World Bank.

Inflation surged High-income OECD Developing countries Median inflation rates: Jan 2000 to Dec 2008 Source: World Bank.

3. EFFECTS ON DEVELOPING COUNTRIES

Global industrial production plummets into 4 th quarter of manufacturing production, ch% (saar) Source: DEC Prospects Group. OECD Developing World

Developing exports in decline export volumes: ch% 3mma y/y Source: National Agencies through Thomson/Datastream. China India Jordan Mexico

..and corporate bond spreads have surged Basis points Emerging-market corporate bond (CEMBI) spreads Jan 2007 – Feb 2009 Source: JPMorgan

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

$ billions Net private debt and equity flows , projected 2009 Percent Percent of GDP (right axis) Private capital flows set to decline more sharply still in 2009 Source: World Bank, Projections: IIF (adjusted) 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 War II( World Bank) Sharp decline in GDP growth expected High-income Developing Source: Historical data: World Bank. Projections: IMF, adjusted Growth of real GDP, percent

The drivers of recovery Fiscal stimulus (2.5-3% of GDP in ICs; less in DCs) Lower interest rates (RIR near 0) Bank recapitalization, guarantees, restructuring Falling oil prices 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 points

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? 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

G-20 Policy Issues: Avoiding a Repeat Macro-Policies and Asset Price Bubbles Regulation of all Systematically Important Financial Institutions (Non-Banks) Transparency and Market-Making in Credit Default Swaps Rules on capital adequacy, extent of securitization, mortgage issuance Regulation of Credit Rating Agencies

How the world will change: some longer term implications Fiscal burden Monetary overhang Moral Hazard Nationalized Banks (and other firms?) Large reserve accumulation encouraged Retreat from globalization and the market paradigm?

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: AD. Imports : US Census. GDP :. GDP : US Bureau of Economic Analysis : Imports as a percentage of GDP: World Bank, Global Economic Monitor Percent

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