Speech

World Economic Outlook Press Conference (Singapore) -- Opening Remarks by Kenneth Rogoff, Economic Counsellor and Director of Research Department, IMF

October 15, 2002

Thank you for coming today. I am here to discuss the global economy with special focus on Asia. However, to anticipate some of your likely questions, I will preface my opening remarks with a brief statement on the economic effects of the recent tragedy in Bali.

Economic analysis is ill-equipped to come to grips with the human tragedy of terrorist attacks where consequences for our sense of safety, our sense of well-being, go infinitely beyond anything that can be captured in numbers.

Trying to assess the impact at this juncture of the most recent global terrorist incident, which occurred in Bali, is speculative at best. It is clearly a blow, but how long-lasting and broad-based the effects will be is impossible to say.

It is plausible that the economic affects on regional growth next year will be limited, but that outcome is of course sensitive to how the security situation evolves, how policy responds, and above all on the impact on business and consumer confidence, both domestically and in the rest of the world. Indonesia has a broad economic base—natural resources and light manufacturing—and its economy has made notable progress on a number fronts.

The security issue is not just a regional issue, it is a global one. The costs of dealing with security include heightened insurance premiums, higher costs for protection and surveillance, and many indirect costs, some resulting from investors' heightened perception of risk. I want to emphasize that the long-term outlook for the global economy is still dominated by very positive trends in technology and productivity. But the impact of terror eats into this at least a little, if nothing else slowing the gains from increased globalization. The adverse effects on trade in goods and on the migration people are arguably akin to having a `terror tax' on the global economy.

Overall, even recognizing the great uncertainty, and how the most recent event comes at a time where the global recovery is tepid, with the balance of risks tilted to downside—per our report, the International Monetary Fund's World Economic Outlook—the appropriate economic policy response is clearly to remain calm, and to focus on economic fundamentals.

Turning now to the global economy:

• Although there are continuing indications that a global recovery is underway, it now seems likely to be weaker than anticipated a few months ago. The sell-off in global equity markets, softer than expected indicators of real activity, and further market turmoil in parts of Latin America all suggest that the pace of activity will recover more gradually than previously thought.



• Our world growth projection for this year is still 2.8 percent. Our 2002 estimate is exactly the same as in the April World Economic Outlook. For next year, however, our estimate of global growth has dropped by 3 tenths of 1 percent to 3. 7 percent, which is still probably close to the global economy's potential growth rate. We do see upside risks to this forecast, particularly from continuing positive news about long-term productivity trends, not to mention short- term boosts from monetary stimulus in the pipeline and the inventory rebound. And while tepid, our baseline most definitely does call for a recovery across the major economic regions. However, the balance of risk has shifted to the downside.



• With that introduction, let me review our projections by region. In our baseline view, the pace of recovery in the United States is now expected to be slower than earlier thought with GDP growth in 2002—and more so 2003—marked down substantially. In the euro area, projections have also been reduced somewhat with domestic demand likely to pick up more slowly than previously expected. In Japan, although we have raised our projections, domestic demand remains weak and there are clear downside risks to the outlook given the more subdued recovery elsewhere.



• The prospects for the major emerging market countries have become increasingly diverse. In Latin America, the outlook has seriously deteriorated; the rebound projected for 2003 relies heavily on a benign outcome in Brazil. The outlook for transition countries remains solid. In Central Europe prospects vary but activity will be affected by the sluggish recovery in the euro area. Growth in Africa, which was better sustained than in many other regions during the downturn, is expected to strengthen next year, with the outlook for much of the region continuing to depend heavily on commodity market developments, and on political stability. In the Middle East, while the outlook for oil prices is stronger, the forecast has remained broadly unchanged, reflecting in part security concerns in several countries.



• In emerging Asia, in contrast, the recovery has so far proved stronger than expected, and there are signs of domestic demand growth becoming established more broadly, not just in China and Korea. The recovery in 2002 has been fastest in the NIEs, and the downturn for in China and India last year was relatively modest.

For the world as a whole, although the pace of recovery has slowed, the outturn is still not expected to be nearly as bad as it could have been given the successive significant shocks we have faced—in part a testimony to the resilience of the global economy and the strong collaborative policy response. Nevertheless, there remain a number of substantial risks and vulnerabilities.

• First, the dependence of the global recovery on the United States is quite apparent. There is little evidence to suggest that the pickup in Europe is self sustaining; indeed, the slowdown in domestic demand growth in the euro area, which has fallen behind that of GDP since early 2000—is striking. In Japan, deflation continues apace even while the BOJ has significantly increased base money, indicating the stubbornness of the problem, and suggesting the need for still more action.



• Japan urgently needs to end its deflation with monetary easing as a lynchpin of any successful larger restructuring plan. Though I recognize the attendant risks, particularly to exchange rate and inflation rate overshooting, I think there is a very compelling case for the Bank of Japan to sharply increase its quantitative easing, and to accompany its actions with a communication strategy emphasizing both its ability and commitment to restoring a positive inflation rate. I do not pretend this is an easy undertaking, and those who believe that the BOJ can just turn a dial and smoothly increase inflation from say, minus one to plus two percent, are naïve. Given Japan's liquidity trap, and the need to rely on increases in base money to restore inflation, there is a substantial risk that the inflation rate will overshoot its target, possibly by a substantial amount. However, given the Bank of Japan's very strong anti-inflation credibility record, and a clear communication strategy, it should be possible to anchor medium-term and long-term inflation expectations. Certainly the benefits to restoring inflation would be far greater, and the attendant risks far less, if the BOJ's actions were accompanied by a broader economic restructuring, including of the banking and corporate sectors.



• Finally, the rest of the world, especially major industrialized countries, could support Japan, and ease the attendant risks to its trading partners by engaging in a modest reflation themselves to reduce exchange rate overshooting effects and support global demand. A supportive response is potentially important because there is likely to be some degree of exchange rate overshooting even if the inflation hike can be managed smoothly. This level of cooperation would be extraordinary, but the end to Japan's prolonged deflation would itself be an extraordinary event, with many benefits over the longer term for the global economy.



• But with the US the most obvious engine of growth, there is a risk of a more subdued recovery. Although consumption is still holding up, consumer sentiment has seen marked declines. The likelihood of a worsening in labor market conditions, or the drop in equity prices, further affecting consumption cannot be ruled out, especially given the relatively high indebtedness of the household sector. Meanwhile, capacity utilization rates in manufacturing remain low, acting as a drag on new investment. It is this risk of weaker consumption, combined with question marks about whether business fixed investment will really pick up in the fourth quarter as we expect, that has increased uncertainty about US prospects.



• If we continue indefinitely with the US always serving as the locomotive for world growth, there is significant risk that the present I constellation of current account imbalances will be exacerbated, unless Europe and Japan find a way to achieve significantly higher growth themselves.



• Second, there has continued to be a massive decline in equity prices over the past two years. Although price earning ratios are now in line with the average of the last fifteen years, given the prevalent environment of weak risk appetite, some further pressures in equity markets cannot be ruled out. That said, given the positive developments in productivity trends, a sharp further drop in equity prices would, absent any dramatic underlying negative news, require an extraordinarily high degree of risk aversion. As the saying on Wall Street goes, when prices drop enough, eventually greed begins to overcome fear.



• Lower long-term interest rates and rising house prices in many countries have offset some of the adverse effects of stock market declines on activity. Nevertheless, our concern is that given the relative magnitude of equity price declines and house price increases, it is possible that the huge wealth losses inflicted by the stock market declines could have a more marked impact on domestic demand than currently expected. There is also the risk of a correction in house prices in some countries, compounding the negative effects of the equity market sell-off. I should note, however, that despite the sharp rise in housing prices, most economic models do not suggest a broad-based bubble.



• Third, risks in emerging markets appear to have increased. Of course, there are considerable divergences across emerging markets regions: in Asia, activity has been growing strongly in sharp contrast to Latin America. The chart before you shows the marked difference in industrial production performance. A similar picture hold for exports—the recovery in emerging Asia came earlier and appears stronger than in other regions, especially Latin America. Markets are also becoming more discriminating—as illustrated by differential changes in sovereign bond spreads and in domestic equity markets. Greater transparency, and implementation of standards and codes have likely played a role. The prospect of more widespread contagion is also reduced by the relatively low level of capital flows in the recent past. Nonetheless, were problems in South America to intensify—especially if accompanied by weaker growth in industrial countries—the potential for , spillover effects could increase substantially.



• Even in the absence of spillover effects, the increased downside risks to the outlook in industrial countries, and the associated weaker prospects for external demand for exports from emerging markets, points to heightened risks to the outlook for emerging markets, especially the highly open economies in Asia.



• An additional risk for Asia relates to the volatility of semiconductor prices. Over the past decade, the production of semiconductors has increased sharply in many Asian countries. Since semiconductors, like primary commodities, have highly volatile prices and react strongly to the industrial country cycle, this has increased vulnerability to external shocks.



• Last, but certainly not least, there are risks emanating from the oil market: oil prices have rebounded sharply in recent months largely reflecting concerns about military conflict in the Middle East. The futures market is projecting prices to rise further before easing next year; but the outlook depends heavily on the extent of supply disruptions. Were oil prices to remain even at current levels, they could have substantial adverse effects on the world economy. We have estimated that a sustained $10 a barrel increase after six months lowers global growth by about 0.3 percent, not including confidence and financial market effects. The effects on Asia are likely to be somewhat larger than for the world as a whole—0.4 percent instead of 0.3 percent—reflecting the region's status as a net importer.



• Let me end by noting that, in spite of the risks I have highlighted, the global economy is on a path to recovery, and we remain cautiously optimistic about the outlook. In contrast to the spring, however, I must underscore the word cautious instead of the word optimistic.