I. Global, U.S., and Canadian Outlook
- International Monetary Fund. Western Hemisphere Dept.
- Published Date:
- May 2009
Global and U.S. Outlook
Just two years ago, things were completely different. Growth was strong, house prices and equity markets soared, the world was awash with liquidity, and the global search for yield squeezed interest rates and credit spreads. Along the way, financial institutions and households alike became too heavily leveraged. Meanwhile, financial innovation—especially the creation of exotic securities that were both highly rated and high yielding—exploited cracks in the regulatory framework, and the prevailing light regulatory touch failed to identify or to forestall the buildup of vulnerabilities. The system seemed to promote a virtuous circle, as long as asset prices rose and growth continued apace (Box 1.1).
Box 1.1.Lessons from the Crisis and the Regulatory Reform Agenda
Excessive leverage and risk taking were at the root of the current crisis, bred by a long period of low real interest rates, high growth, and policy failures. Serious shortcomings in the approach to financial regulation were exposed. Regulators failed to stem excessive risk-taking, partly because links between tightly regulated and less-regulated institutions were inadequately assessed. Policy responses were also hampered by fragmented regulatory structures, inadequate disclosure of risks, and weaknesses in crisis management and bank resolution frameworks.
This has led to a global debate on the reforms needed to close the gaps in financial supervision and prevent the recurrence of problems that led to the current crisis. Five key areas arise as priorities for reforms:
- Expanding the perimeter of regulation by reevaluating what is considered a systemic institution, which would require strong regulation. A fatal flaw in supervision was lax oversight of nonbank financial institutions.
- Making consolidated supervision more effective. This would entail resolving shortcomings in legal frameworks and creating mechanisms that institutionalize information sharing and cooperation. In advanced countries, supervisors often lacked the information and capacity to see the links between different types of financial institutions and instruments within a country, as well as links among financial institutions across countries.
- Adapting existing regulatory and institutional practices to reduce procyclicality. The excessive credit growth prior to the crisis, as well as the rapid deleveraging currently under way, may have been exacerbated by procyclical features of regulatory frameworks.
- Strengthening public disclosure practices for systemic financial institutions and markets. The crisis revealed extensive gaps in financial data disclosure and the understanding of underlying risks. Financial activities expanded in areas with few or no disclosure requirements, leaving regulators ill-equipped to assess risk concentrations.
- Giving central banks a broader mandate for financial stability. Under the broader mandate, safeguarding financial stability would mean that central banks should try to arrest excessive credit expansion and sharp runups in asset prices, which might have helped avoid the loose credit conditions in advanced economies that contributed to the current crisis.
Real GDP Growth in Advanced Economies
Source: Haver Analytics.
But when asset prices and growth faltered, highly leveraged banks and households came under pressure, spinning into a vicious circle that in late 2008 culminated in a level of financial turbulence unseen in the postwar period, with major internationally active financial institutions failing or being intervened, and segments of capital markets freezing. In the wake of the financial turbulence, economic activity, employment, and trade all collapsed. Major economies underwent their sharpest declines in decades, with real GDP in the euro area and the United States falling by over 6 percent in the fourth quarter of 2008, and in Japan by over 12 percent (quarter-on-quarter, at a seasonally adjusted annualized rate).
Growth of Real Imports
Source: Haver Analytics.
Real GDP Growth
Source: IMF staff calculations.
While financial market conditions have improved from the stress levels reached in late 2008, strains remain pronounced. As a result, the near-term outlook for world growth is weaker than at any other time since the Great Depression. With financial markets in turmoil, firms and individuals starved of credit, and consumer confidence dropping amid rising unemployment and declining equity and housing wealth, IMF staff expect the world economy to contract by around 1½ percent in 2009 and grow only modestly in 2010. Trade volumes will be hit even more sharply, given widespread import compression and difficulties in trade finance, and capital flows into emerging markets will continue to fall substantially. What started as turbulence in advanced markets has now become a fully synchronous global recession, with advanced economies, emerging markets, and lowincome countries all entering severe downturns.
The United States has been the epicenter of the global turbulence. While the U.S. economy has officially been in recession since December 2007, there has been a particularly sharp downturn in most activity indicators since last fall. In the fourth quarter, real GDP shrank at one of the fastest rates of the postwar period, and the first quarter of 2009 is likely to be nearly as bad. More than 600,000 jobs were lost in each of the past 4 months, and the unemployment rate is now up to 8.5 percent, a 25-year high. Consumer confidence has hit new lows, and—some unexpected strength in January and February notwithstanding—real spending remains on a declining trend. Business fixed investment is plummeting, and a massive housing inventory overhang continues to weigh on residential construction, as well as prices. Collapsing foreign demand and dollar appreciation driven by flight-to-quality have led to a sharp drop in exports, compounding these difficulties. As a result, industrial production has fallen considerably, putting capacity utilization at new lows. This economic slack, in turn, has dampened price pressures and raised the specter of deflation.
Financial markets have endured dizzying gyrations since the last REO and remain considerably stressed. The bankruptcy of Lehman Brothers in September 2008 led to a period of remarkable turmoil, with liquidity drying up, money market, credit default swap (CDS), and corporate spreads spiking, and equities falling sharply. This turbulence prompted policy interventions—including the introduction of the $700 billion Troubled Asset Relief Program in October as well as a variety of new Federal Reserve facilities aimed at private credit markets—that forestalled a systemic collapse but have not yet returned financial conditions to normal. Equity prices continued to drop through early March, particularly for financial institutions, and remain far below pre-Lehman levels. Financial spreads are still elevated and bank lending standards are still tight.
But successive expansions of the policy framework hold out the hope that financial stability can be reestablished. The Federal Reserve appropriately cut the policy rate target to near zero in December, committed to keeping it there for a long period, and has aggressively used both the size and composition of its balance sheet to unblock key credit markets. Congress in record time passed a multiyear fiscal stimulus package worth more than 5 percent of GDP. The U.S. Administration has put forward a housing plan with a number of new measures to limit preventable foreclosures and stabilize home prices. And most important, it laid out in February a sensible Financial Stability Plan that includes conducting forward-looking stress tests of the largest banks, recapitalizing them as needed, and leveraging private capital to clean toxic assets from bank balance sheets under a Public-Private Investment Fund, whose details were further fleshed out in March.
Selected Financial Market Indicators
Sources: Bloomberg, L.P.; and IMF staff calculations.
United States: Forecasts for Growth and Inflation
Sources: Haver Analytics; and IMF staff calculations.
Some important aspects of the financial sector strategy, however, have yet to be announced, and implementation seems likely to take time. Clarity is still lacking on the strategy regarding possible government ownership of banks and on procedures for dealing with any nonviable but systemic banks. With stress test results not yet announced (as of May 3), and resolution likely to take some time beyond that, IMF staff expect financial conditions to remain at their current stressed levels through the first half of the year, starting to normalize only in the third quarter. Our earlier research, detailed in the November 2008 REO, suggests that macrofinancial linkages take up to two years to play out fully, and our projected trajectory of financial conditions implies a significant and protracted drag on growth.
IMF staff have thus marked growth down substantially to –2.8 percent in 2009 and to zero in 2010. The revision is justified mostly by financial conditions but also by weak incoming data, diminished export prospects, and a smaller and more backloaded stimulus package than was earlier assumed. Following steep declines in 2008Q4 and 2009Q1, according to IMF projections, the economy would start to benefit from fiscal stimulus. The impact of earlier financial shocks would continue to be felt, however, and growth would only get back to potential by the second quarter of 2010. The economy would have undergone nearly two years of subpar growth. Moreover, the unemployment rate would continue rising for several quarters more, peaking above 10 percent, and the output gap would close only by the end of 2014. All told, this would be the longest postwar recession as well as the most costly in terms of forgone output.
Slow growth in the revised forecast manifests itself in high unemployment, low and, for a while, even negative, inflation, and sharply decreasing imports. Given large projected output gaps, even growth in the recovery phase fails to put substantial pressure on wages and prices. Indeed, 12-month core CPI inflation is expected to be modestly negative through the end of 2010. Effective Federal Reserve communications are expected to anchor long-term inflation expectations—which currently remain at 2.4 percent—and prevent the onset of a deflationary spiral. With domestic demand shrinking, substantial import compression is forecasted, with volumes recovering only slightly in 2010. Moreover, while the rate of import growth is projected to eventually recover, the level of imports fails to rebound to its previous path. Exports are marked down even more severely than imports, however, and with the additional impact of higher oil prices, the current account deficit is wider than in the previous forecast, narrowing only to around 3 percent of GDP by 2014.
The forecast is substantially more pessimistic than consensus for 2010, but IMF staff nonetheless consider risks around the baseline to be tilted to the downside. The most recent Consensus Forecast envisages a –2.8 percent contraction in 2009, in line with our projection, but then a rapid rebound in 2010, with growth at +1.7 percent. While a V-shaped pattern was indeed characteristic of past U.S. business cycles, this seems unlikely this time, given delays in fixing the financial system and long-lasting impacts of financial shocks on growth. With our forecast so far to the left of Consensus, it is natural to consider upside risks, and indeed, a positive scenario would have the U.S. Administration quickly fleshing out and implementing a plan for cleaning up the banks, confidence quickly being restored, and growth recovering relatively rapidly. Given political constraints and heightened global uncertainty, however, Fund staff see as more likely an adverse scenario in which consensus on a financial rescue takes substantially longer to achieve, financial conditions continue to worsen, and real activity remains depressed for several years.
Consumer Price Inflation and Output Gap
Sources: Haver Analytics; and IMF staff calculations.
U.S. Import Volumes
Source: IMF staff calculations.
The U.S. turmoil will have a pronounced effect on industrial countries across the globe, and perhaps none is more exposed than Canada. About three-fourths of Canadian exports are bound for the United States, and about one-fourth of Canadian corporate finance is sourced there, leaving Canada well open to spillovers. And indeed, the traces of such spillovers quickly became evident in 2008. Money and credit spreads widened, stocks plummeted in tandem with U.S. shares, and bank lending standards tightened as segments of capital markets dried up. Combined with the long slide in commodities prices, ebbing global demand and tighter financial conditions prompted GDP to contract by 3.4 percent in the fourth quarter, and indicators point to a much deeper contraction in early 2009.
The IMF staff’s baseline scenario is for a sharp contraction in early 2009—the worst since 1981 when GDP plunged by 2.9 percent—followed by a return to positive growth over time as the full effects of accommodative monetary and fiscal policies are felt. The recession and weak commodity prices will continue to depress inflation, with core inflation at low levels. Downside risks prevail as larger negative spillovers would occur if U.S. real and financial conditions are worse than the staff’s current forecast, entailing risks of weaker growth, as well as more prolonged low inflation or deflation (a tail risk under the baseline).
But despite its high exposure to U.S. economic activity and financial markets, Canada is well positioned to weather the downturn. A sound macroeconomic framework resulted in a decade of fiscal surpluses and price stability. In turn, this has left room for aggressive policy responses, in the form of a large fiscal stimulus and cuts in policy rates to record lows. And importantly, a strong regulatory framework, along with conservative banking practices, has preserved financial stability in a turbulent world. While nonbanks have taken a significant hit from the equity market rout, in stark contrast to major banking systems elsewhere, no Canadian bank has needed public capital injections and none have used public guarantees.
Banks’ Nonprice Lending Conditions for Corporations
Source: Haver Analytics.
Soundness of Selected Banking Systems, 2008–09
Source: Global Competitiveness Report 2008–09.
1/ Based on quarterly instead of monthly data.
That said, Canadian banks face a challenging credit cycle, with output set to contract further before the effects of policy stimulus in train are fully felt. In particular, record-high household debt in combination with falling incomes, rising unemployment, and wealth erosion from equity and housing price deflation, are already squeezing household balance sheets and spurring a rise in defaults. The structure of Canada’s financial system will mitigate these risks—about half of mortgages are guaranteed, the remainder have low loan-to-value ratios, and underwriting standards overall are stronger than in the U.S. market—but asset quality will weaken and credit costs will rise. Fortunately, the authorities have proactively augmented their toolkit for dealing with financial instability, including capital injections if needed, while taking steps to prop up sagging segments of securities markets. Looking ahead, the main tasks for policies will be to remain watchful and ready to respond further if downside risks materialize.