There are now increasing signs that global recovery is taking hold. After a hesitant beginning in the first half of the year, activity is expected to pick up steadily—although unevenly across the major regions—during the second half of 2003 and in 2004. As a result, global growth is projected to rise from 3¼ percent in 2003 to about 4 percent next year. Led by the United States, this recovery should be supported by policy stimulus in the pipeline, a gradual diminution of the aftereffects of the bubble, the projected decline in oil prices, and lower—although still significant—geopolitical tensions. Financial markets have remained remarkably resilient, despite being tested by the bursting of the equity bubble, corporate governance scandals, and geopolitical developments, and will be a further source of strength going forward.

The balance of risks has also significantly improved: the predominance of downside risks that characterized the outlook when we last met has diminished, although important concerns remain. On the upside, as financial market developments underscore, GDP growth may pick up more quickly than currently projected—most obviously in the United States, where productivity growth remains robust, corporate balance sheet restructuring is most advanced, and policy stimulus is the largest. At the same time, however, there are a number of significant downside risks. These include continued uncertainties about the outlook for demand in the aftermath of the asset market bubble; the risk of a further sharp rise in industrial country long-term interest rates, especially if not accompanied by expectations of higher growth; the associated difficulties that could arise in countries where housing prices have been rising rapidly; and, despite improvements in financing conditions, the substantial vulnerabilities still confronting some key emerging market economies. More broadly, the growing imbalances in current account positions among the major regions—reflecting in part the excessive dependence of global growth on the United States—together with the medium-term fiscal pressures facing many industrial and emerging market economies, remain significant concerns. Furthermore, following the setback at the WTO Ministerial in Cancún, there is a risk of increased trade protectionism, which would undermine one of the key pillars of economic progress over the past half century.

With inflationary pressures very subdued, and the pace and durability of a renewed recovery as yet uncertain, macroeconomic policies should remain generally supportive. Industrial countries should maintain an accommodative stance of monetary policy for the time being. In Japan, a more aggressive monetary easing is desirable to address deflation and, with inflation very low elsewhere, there would be scope in most regions for further monetary easing if recovery falters or inflation significantly undershoots policy objectives. On the fiscal side, the automatic stabilizers should be allowed to operate, but in most countries the focus needs to shift increasingly toward medium-term consolidation to address impending pressures of population aging. In the major financial centers, further progress is needed to bolster investor confidence by strengthening corporate governance, and improving the transparency and supervision of large institutional investors including pension funds, insurance companies, and the U.S. mortgage agencies.

In emerging markets, policy priorities vary widely across regions. While financing conditions have recently improved, it remains critical for many countries—particularly in Latin America—to underpin these improvements by ensuring that the pace of fiscal consolidation and structural reform is sustained.

Short-term Prospects for the Major Currency Areas

Global recovery is being led by the United States, given the increasing strength of recent data and forward indicators. Supporting these improvements is the substantial monetary and fiscal stimulus now in place and continued rapid productivity growth. Indeed, the economic upturn could be stronger than the staff presently projects, although such optimism needs to be tempered by concerns arising from still-stretched household balance sheets, particularly when viewed against the risk of a fall in housing prices, substantial excess capacity, and the continued softness in the labor market. Over the medium term, the vulnerabilities arising from the record current account deficit, now accompanied by an even larger government deficit, also pose significant risks.

Although tentative signs of improvement are appearing in the euro area, short-term prospects remain subdued—especially among the largest economies. Domestic demand remains weak, reflecting the continued over-leveraging of corporate balance sheets and the impact of rising unemployment on consumer confidence and spending. The euro's appreciation over the last year—despite some recovery in the dollar in recent months—may also constrain the pace of recovery. With the overall policy stance less supportive, the projected pickup is expected to be relatively gradual, supported by some strengthening in private consumption and investment (underpinned by lower interest rates and higher business confidence), and by the expected improvement in external demand.

The 2003 and 2004 growth projections for Japan have been revised up substantially following the surprisingly strong second quarter outturn, the stock market pickup, and heightened optimism about the U.S. recovery. While these latest developments in Japan are encouraging, the outlook is still clouded by entrenched deflation and weaknesses in corporate, financial, and public sector balance sheets. Hence, the pace of recovery may remain moderate.

Developing Countries

Overall growth among developing countries is projected to remain relatively robust—reaching 5 percent in 2003 and 5½ percent in 2004, supported by the expected strengthening in the major industrial countries. Prospects and vulnerabilities vary widely across regions and individual countries, however.

In Latin America, a tentative recovery now appears to be emerging in much of the region. Growth is expected to pick up further—to about 3½ percent—in 2004, helped by stronger global growth, substantial real exchange rate depreciations in some countries over recent years, and improved emerging bond market conditions. The region continues to face important vulnerabilities, however, especially regarding external financing conditions and, in some cases, from political uncertainty. For the rebound in economic activity in Argentina to be sustained, credible progress will be needed with plans to restructure public and private debt and to strengthen the banking system. In Brazil, continued reform efforts and fiscal discipline remain critical to continue the recent improvements in financial market confidence.

Countries in emerging Asia have recovered quickly from the slowdown in the first half of 2003, helped by the reduction in SARS-related concerns and, in some cases, by timely policy stimulus. Looking at the largest economies, growth is strong in China and also robust in India. Very rapid money and credit growth in China raises the prospect of even stronger growth but also points to a risk of overheating in some sectors of the economy. The global cycle remains a key determinant of cyclical developments in the entire region. While the role of domestic demand has grown in recent years, incentives for domestically-sourced growth may still be blunted by the depreciation of effective exchange rates in some countries in the region and the rapid buildup of foreign exchange reserves, especially over the past 18 months.

Robust growth is expected to continue in the countries of central and eastern Europe and the Commonwealth of Independent States. While recent growth has been driven by buoyant domestic demand, the outlook for central and eastern Europe remains heavily influenced by developments in the euro area. Energy market developments will continue to have a key influence on prospects for Russia and other energy exporters in the CIS. Going forward, sustained growth will require progress with fiscal consolidation in many countries and an array of structural reforms, including measures to support EU and EMU participation by countries in central and eastern Europe, and to foster private sector development in the CIS. In Turkey, financial conditions and the short-term outlook have improved and, to sustain this, the authorities will need to continue their strong policy actions.

In the Middle East, while the quick end to the conflict in Iraq is a positive factor, the fragile security situation remains a major source of uncertainty. GDP growth forecasts in the region have been revised upward in 2003 owing to higher oil production, but the projected fall in oil prices will adversely affect the growth and fiscal outlook for oil exporters in 2004. Stronger and broader-based growth needs to be supported by lowering the relatively large share of government consumption in economic activity, strengthening institutions, and improving the security situation.

Africa has also experienced surprisingly resilient growth during the global downturn, reflecting improved macroeconomic policies in an increasing number of countries, higher commodity prices, and debt relief under the Heavily Indebted Poor Countries (HIPC) initiative. Growth is expected to reach 3¾ percent this year and over 4¾ percent in 2004. Even at these levels, however, growth remains far too low to meet the Millennium Development Goals, underscoring the need for sustained implementation of the broad strategy set out in the New Partnership for Africa's Development (NEPAD)—including macroeconomic, institutional, and social policy reforms—as well as for additional external assistance, as discussed below.

Policies to Strengthen Medium-term Growth and Reduce Imbalances

While short-term indicators and prospects are looking more encouraging, it remains critical to press ahead with policies needed to support sustained medium-term growth and to address outstanding vulnerabilities, in advanced and developing countries alike. Key issues and policy requirements include the following.

Reducing the large current account imbalances across the major regions and, associated with these, the heavy dependence of global growth on the United States. While they persist, these imbalances give rise to the risk of increased exchange rate volatility and protectionist pressures. A collaborative approach is central to reducing these concerns. This should include structural measures to boost growth outside the United States—especially through labor and product market reforms in Europe, corporate and financial restructuring in Japan, and wide-ranging reforms to improve the level and resilience of growth in emerging markets. And also critical are steps to increase national saving in the United States—notably through strengthening the medium-term fiscal position, which is now headed toward undesirably large deficits. While the depreciation of the dollar over the past 18 months has been in the direction implied by medium-term fundamentals, it would be desirable for the necessary currency adjustments to be spread more broadly. In this regard, greater upward exchange rate flexibility in emerging Asia—where reserves have grown rapidly over recent years and where several countries are relatively well placed from a cyclical perspective to absorb such change—would also help the global adjustment process.

Strengthening medium-term fiscal positions to rein in the buildup of public debt and prepare for impending pressures from population aging. While the pace of consolidation should be influenced by cyclical considerations, significant progress over the medium term is essential in many countries. Associated with this, pension and health sector reforms are needed in almost all industrial countries and in many emerging economies to address the pressures from aging populations. Furthermore, with public debt levels in emerging market economies having increased to about 70 percent of GDP on average (see the Figure), strong and sustained fiscal and structural policy reforms are needed to reduce vulnerabilities and ensure medium-term debt sustainability. Key measures include reforms to the tax system and its administration, improved expenditure control, and steps to improve the overall transparency and credibility of fiscal policy. Emerging market borrowers should also take advantage of the current relatively favorable external financing environment to improve the structure of their liabilities, while continuing to pursue measures to deepen local securities markets.

Improving growth prospects and reducing poverty in developing countries. This will require determined efforts among developing countries themselves and by the advanced economies. Priorities for developing countries include improving institutions to underpin political stability and the quality of governance; strengthening macroeconomic policy frameworks; promoting competition, trade, and foreign investment; and developing physical and social infrastructure, including the education and health care sectors. It is notable that per capita GDP growth in Africa has been significantly stronger in countries that have made the most progress with such reforms. These domestic reform efforts need to be supported by increased assistance from the international community, particularly through higher aid flows, debt relief, and—most important of all—easing of industrial country restrictions on developing country exports.

In this regard, and in view of the disappointing outcome of the Cancún Ministerial, it is critical at this time for all countries to work with renewed commitment toward a successful conclusion of the Doha Development Round and to resist protectionist pressures. As illustrated by the widespread economic progress achieved over the past half century, an open and rules-based multilateral trading system is key to boosting global growth and lasting poverty reduction. The multilateral trading system is the only viable way to protect the interests of the weaker countries, and to ensure that the gains from trade can be fully realized. The Fund stands ready to do what it can to help ensure that the rewards to trade liberalization are ultimately realized.

In summary, then, encouraging signs of global recovery are now appearing. But, with conditions still fragile in many regions and important vulnerabilities persisting, macroeconomic policies need to remain supportive for the time being. Looking forward, it will be critical to seize the opportunity of a renewed recovery to press ahead with the policies—both domestic and multilateral—that are needed to support sustained strong growth and to address the key medium-term vulnerabilities that confront us.