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Global Economic Prospects and Policy Challenges
Prepared by Staff of the International Monetary Fund

INTERNATIONAL MONETARY FUND_____________________________________________________________

G-20: THE PATH FROM CRISIS TO RECOVERY
October 2011
KEY POINTSThe global economy has entered a dangerous phase. Policy makers must act boldly to finish
the job they began in 2009, lest the gains from the recovery since then be lost. Collective
action can put the global economy on a path to strong, sustainable, and balanced growth.

Adverse feedback loops between the real economy and the financial sector have intensified,
as private and public sector balance sheets have weakened, uncertainty has been
exacerbated by policy indecision, and demand rebalancing has stalled. Even assuming thatpolicies prevent downside risks materializing, projections are for an anemic recovery in majoradvanced economies and a cyclical slowdown in emerging economies. Global growth isexpected to fall to about 4 percent in 2011–12.

Downside risks are severe. The immediate risk is that the global economy tips into adownward spiral of increased uncertainty and risk aversion, dysfunctional financial markets,
unsustainable debt dynamics, falling demand, and rising unemployment. Even in a less severe
scenario, key advanced economies could suffer from a protracted period of low growth.

Policy action along three key fronts will help break the adverse feedback loop between
weaker growth and confidence, fiscal tensions, and financial fragilities. This includes wellcalibrated fiscal adjustment to reassure markets; liquidity provision in the euro area to avoid
deeper dislocation and relieve funding strains; and building banks’ capital buffers in Europe.

In advanced G-20 economies, fiscal sustainability must be restored through credible mediumterm consolidation plans. Countries with high debt and facing market pressure must press
ahead with “growth-friendly” consolidation now. In others, fiscal policy should navigate
between the perils of undermining credibility and undercutting recovery, and facilitate a pickup in private demand. To alleviate prevailing market pressures in the euro area, the ECB
should continue its extended liquidity operations and sustain the Securities Market Program(SMP) alongside the support provided by the European Financial Stability Facility (EFSF) for as
long as necessary to stabilize issuance costs for banks and sovereigns. At the same time,banks should be urged to build capital buffers in a coordinated fashion, using national public
and euro area resources, including the EFSF, if necessary.

In emerging G-20 economies, near-term policy should focus on responding to spillovers frommoderating growth in advanced economies and heightened global risk aversion in financial
markets, subject to available policy space. In key surplus economies, fostering sustained,
inclusive medium-term growth requires removing distortions, implementing structural andfinancial reforms, and moving to a more market-based exchange rate.

2

THE GLOBAL CONJUNCTURE
1.

Global activity has weakened
and confidence has fallen sharply.
Weakening
economic
activityandheightened financial stress are reinforcing
each other, reflecting, fundamentally, theinadequate repair of balance sheets acrossmajor advanced economies. The dual
rebalancing acts needed to secure strong,sustainable, and balanced growth—ahandover from public to private demandin major advanced economies, andstronger domestic demand growth inexternal surplus economies—have stalled.

2.

Mutually-reinforcing
macrofinancial stresses have risen again, andsharply. Concerns over the sustainabilityof public debt in the euro area haveintensified and broadened to some of thearea’s core economies, heightening fears
over the health of the area’s banks. Bank
equity prices have fallen sharply, credit
default spreads have widened, andfunding access for some banks has been

reduced. The direct spillover to EU banksfrom the perceived increase in sovereign
credit risks from high-spread countries
since the outset of the crisis is estimatedat around €200 billion.1 Spillovers outsideof the euro area are intensifying, withfinancial institutions reliant on wholesalefunding also coming under pressure.
Thanks to exceptional liquidity support
from key central banks, interbank funding
stresses are still less elevated than at thetime of the collapse of Lehman Brothers in
2008, and equity prices are still above
post-Lehman lows. However, sovereign
debt stresses are now more elevated inEurope, and this has led to higher
perceived risks of some European banks.
Figure 2. Spreads(basis points)
450
400
350
300
250
200
150
100
50
0

Figure 1. Cumulative Spillovers from High-Spread EuroArea Sovereigns to the European Union Banking System(billions of euros)

Libor-OIS
Spreads

Bank CDS
Spreads

Lehman 1/

Euro United
area States

Euro United
area States

Sovereign CDS
Spreads
Current 2/

Euro United
area States

1/ Worst during period September 15, 2008 to April 30, 2009.
2/ October 3, 2011 or latest available.

€60

€80

€200

€300

3.

There are now clear signs of areal slowdown in emerging economies.
Spillovers from moderating growth in1

Spillovers from . . .

Greek sovereign
Irish & Portuguese sovereign
Belgian, Spanish & Italian sovereign
High-spread euro area banking sector

This is not a measure of capital needs of banks.
The methodology and caveats applying to thisexercise are explained in the September 2011
Global Financial Stability Report (Box 1.3).

3
advanced economies and heightened
global risk aversion have contributed to aslow down and dimming of prospects inemerging economies. This is reflected in amoderation of PMIs, industrial production,and merchandise exports, as well as infinancial market indicators.

while reversing some of the preceding
appreciation, are accelerating and largely
reflect rising global growth concerns,
higher risk aversion and the unwinding ofcarry trades in some markets, and fallingcommodity prices.
Figure 3. Em erging Market Countries'
Exchange Rates against the U.S. Dollar 1/(2010 GDP-weighted index; Jan. 1, 2010 = 100)

Emerging Economies: IP, PMI, andExports
100(Percent; 3mma annualized)

80
60

115

68

Industrial production
Merchandise exports
PMI (index; >50 = expansion; RHS)

110

64

105

60

40
20
0

100

56

95

52

90
85

48

-20
-40

44

-60

40

Oct.11

-80
05

06

07

08

09

10

Latin America
Emerging Asia
Emerging Europe
Selected Commodity Exporters 2/

120

10/3/201180
Jan-10Jul-10Jan-11

Jul-11

Sources: Bloomberg L.P., and IMF, World Economic
Outloook (WEO).
1/ Country groups are based on WEO classif ications
unless otherwise specif ied.
2/ Includes Australia and Canada.

36

11

Source: IMF, Global Data Source.

5.

Commodity prices have fallen
and are being affected by the same
global factors as exchange rates inemerging economies. In particular, theoutlook for demand has deteriorated andrisk aversion has increased. Commodities
more sensitive to the economic cycle, suchas metals, have fallen most sharply but
recent declines have been broad andinclude both crude oil and food. This also

MSCI Stock Market Index(Jan. 2005=100)
300
Industrial

250

Emerging

200
150
100
50
05

06

07

08

09

10

11

Source: IMF, Global Data Source.

4.

Exchange rates of emerging
economies and some commodity
exporters have experienced sizable
depreciations against the U.S. dollar
and Japanese yen. Depreciations havebeen larger for emerging economies withdeeper, more liquid financial markets,
flexible exchange rates, and geographicalproximity to the euro area. These moves,Figure 4. IMF Daily Commodity Price Indices(Jan. 3, 2011 = 100)
135
125
115
105
95
MetalsFood
Agricultural Raw Materials
Energy8575
65Jan-11

10/3/2011
Mar-11

May-11

Source: Bloomberg L.P.

Jul-11

Sep-11

4
Figure 5. Global Real GDP Growth(percent; quarter over quarter annualized)
15
Emerging

10
World

5
Advanced

0
-5
12Q4

05

06

07

08

09

10

11

-10

12

Sources: IMF, Global Data Source; and IMF staff
estimates.

partly reflects supply factors, including
increased oil output from OPEC members,
notably Saudi Arabia, to offset supply
losses from Libya and upward revisions tostill-low grain inventories in the UnitedStates. Physical activity in commodity
markets is still robust, largely due toemerging markets and China, but slowing
activity
indicators
suggestsomemoderation ahead.

6.

Against this backdrop, staff
projects a weak, uneven, and bumpy
recovery, subject to major downside
risks. The September 2011 World
Economic Outlook projections show that
the United States, euro area, and Japanare projected to grow by only around
1½ percent in 2011–12, reflecting weakfinancial and household balance sheetsthat are holding back private demand. In
emerging and developing economies, amixture of weaker external demand,
capacity constraints, and policy tightening
is expected to lower growth from about
7½ percent in 2010 to 6 percent in 2012.
Crucially, these projections assume thatcurrent policy commitments will be met
and thus macro-financial conditions will
not deteriorate further. If downside risks
were to materialize, growth would besubstantially lower.

7.

A weak recovery means thatunemployment will remain high inmany economies. In the United States,
exceptionally high job losses during thecrisis followed lackluster employment
generation during the previous decade,leaving households more worried than any
time since the 1980s about future income
prospects.
Persistently
highunemployment may result in a permanent
loss of work skills. Unemployment rates
are also high in Europe, especially in thecrisis-hit economies, as well as inemerging economies such as the Middle
East and North Africa region, where
structural unemployment has contributed
to political instability.

KEY RISKS
8.

Downside risks have increased
and are severe. The overarching risk is ofa global “paradox of thrift” as households,
firms, and governments around the world
reduce demand, with many advanced
economies unable to lower policy rates

further. Immediate risks are centered in
the major advanced G-20 economies,
principally the euro area and the UnitedStates. Uncertainties about the program in
Greece are fuelling market fears of adisorderly default that would have large
spillover effects.

5




Sovereign debt and bank funding
pressures in the euro area: Highsovereign funding costs and low
growth rates risk undermining fiscal
sustainability and raising alreadyintense pressure on banks holding
such sovereign debt. Conditions in
European wholesale funding markets
could worsen further, due to heavy
reliance on these markets. The
financial stress already spreading to
the rest of the world would escalate.
While deleveraging by banks isalready taking place, in an extreme
case, major unexpected defaults or
failures in the financial system could
trigger large adverse spillovers in thereal economy, notably by banks
further cutting back their lending andshrinking sharply their balance sheets.
Householdandpublicdebt
sustainability in the United States:
Household and fiscal stresses could
produce severe downside scenarios.
Recent declines in financial asset
priceshavefurther
reducedhousehold net wealth already hit bythehousing
marketcollapse,
damaged confidence, and contributed
to lower spending growth. Debt
deflation could weigh on activity formany years. Sharp near-term fiscal
cutbacks
without
long-term
expenditure or revenue reforms
would further weaken the outlook for
growth. Continued low growth,without necessary fiscal medium-term
consolidation, could cause an increasein risk premiums and interest rates on

U.S. bonds, with adverse effects for
public debt sustainability.

9.

Emerging G-20 economies could
be hit severely by a further downturnand an intensification of financial stressin advanced economies.


There are now clear signs of a real
slowdown in several emerging
economies. A further deterioration in
global financial conditions, including
due to funding stress among euroarea or wholesale-funding dependentbanks or concerns about fiscal
sustainability in major advanced
economies, raises the risks of abrupt
and potentially large capital outflows.
Notwithstanding their resilience sofar, emerging G-20 economies exhibit
vulnerability to shifts in global risk
aversion—recent
exchangerate
depreciations have been associatedwith a pick-up in capital outflows
from local markets and increased
demand for hedging of currency risk.
The experience of 2008 underscoresthat capital reversals can intensify
rapidly and economies that have large
direct linkages with the euro areabanking system would be most at
risk.



Trade-dependent
emerging
economies would be especiallyvulnerable to a sustained downturnin advanced economy growth, butalso market stresses that impede
the provision of trade financing.
Weaker global growth would reduce
commodity prices and adversely
affect the export revenues of6commodity exporters. Analysis ofdownside scenarios for GDP growthin advanced economies suggests thatsuch effects could be substantial.

0.0

Figure 6. GDP Losses in Downside
Scenario 1/(percent of baseline GDP)

-0.5
-1.0
-1.5



Weakerglobaldemandandintensified global financial stress
could
exposeunderlying
vulnerabilities from excessive credit
growth (e.g., borrowing by local
government
vehicles,incautious
infrastructure projects, expanding offbalance sheet activities by banks, andproperty bubbles). Declining real
activity and volatile capital flows
could therefore undercut high realestate prices in various emerging
economies, raising nonperforming
loans, and thereby setting off anotherdeleveraging cycle.

-2.0
-2.5

United States
Euro Area
Japan
Emerging Asia
Latin America

-3.0
-3.5
-4.0
0

1

2

3

4

1/ The scenario assumes major turbulence in the euro areabanking sector and weakened medium-term growth prospects
in the United States. See the September 2011 World Economic
Outlook for more details of a similar exercise.

10.

Global risks are closely linked
and rise and fall together. Furthermore,
as elaborated in the IMF Spillover Reports,
when risks materialize, they are rapidlytransmitted across the world by financial
and commodities markets. This would
compound the negative effects from tradechannels.

POLICIES
11.

Policy responses are urgently
needed to decisively reduce rising
uncertainty and fear. The world economy
has entered a dangerous phase in which
negative developments could quickly run
beyond the control of policy makers.
Policy actions along three fronts will help
break the adverse feedback loop between
weaker growth and confidence, fiscal
tensions, and financial fragilities:Credible medium-term fiscal plans,
which would create space forproviding further support for
fledgling
recovery,andwellcalibrated and appropriately paced

fiscal adjustment in the near term toanchor investor confidence. This needtobesupportedby
rapid
implementation of structural reforms
to raise growth and enhance debt
sustainability;Continued liquidity provision andmeasures to stabilize issuance costs
for banks and sovereigns in Europe
in the short-run. This is an imperative
for avoiding deeper dislocation andrelieving funding strains that remain atheightened levels, notably because of
the uncertainty about Greece; and7Support for banks to rebuild capital
buffers in a coordinated fashion,using public funds if necessary.

12.

Financial
repair:strengthen
capital buffers; restructure and resolve
weak banks. Along with addressing
sovereign tensions, removing uncertainty
about the resilience of banks is the top
priority for the euro area. Recovery inadvanced economies will need readilyavailable credit to allow easy monetaryconditions to pass through. Building bankcapital buffers will help to achieve this bybreaking the adverse feedback loop
betweenrisingsovereign
spreads,
deteriorating bank funding, and flagging
activity. Policymakers should urge banks inneed of capital to raise it from private
sources, and either restructure or resolve
weak banks. But public capital injections
may also be necessary. National backstops
should be used where fiscal space exists.
Ultimately, in some European cases, thismay well entail the use of pooled euroarea resources, including EFSF funds. Thismight necessitate additional measures to
Figure 7. European Bank Core Tier 1 Ratios(percent of risk-weighted assets)
35

13.

Fiscal repair: achieve sustainablebalances, while supporting growth.
Advanced G-20 economies must articulatecredible medium-term fiscal consolidationplans with specific measures embedded ina realistic macroeconomic framework. This
would create more policy space for nearterm support to growth and employment
if needed. In the event of a further
significant slowdown in growth, a numberof these economies have scope to slow
their current pace of consolidation, if
offset by a commitment of additionaltightening later.
In the United States, the proposed
American Jobs Act would provide
needednear-term
support.
However, parallel and credible
medium-term fiscal adjustment planthat raises revenues and contains thegrowth of entitlement spending
remains essential.
Figure 8. Change in Cyclically Adjusted Primary
Balances(percent of GDP)

30

Projected adjustment (2010-15)

25

Remaining adjustment needed until 2020 to achieve
illustrative debt targets 1/

20
15

make the facility more effective.
Importantly, countries that do implement
strong recapitalization programs should
not be left to fall into a downward spiralfor lack of adequate external support.

10 percent

8 percent

6 percent1050Sources: European Banking Authority; and IMF staff estimates.
Note: Includes core Tier 1 capital at end-2010, actual equity
raising in from January to April 2011, and commitments madeby April 2011 for equity raisings and government support.

Japan
GreeceIrelandU.S.
Portugal
U.K.
Spain
FranceCanadaItaly
Germany

-2
0
2
4
6
8
10
12
14
16
Source: IMF, FAD staff calculations.
1/ To reduce the gross debt ratio to 60 percent by 2030 (netdebt target of 80 percent for Japan) or stabilize the debt ratio
at end-2012 levels if the ratio is below 60 percent. After 2020,
the primary balance must be maintained at its prevailing level
until 2030 to ensure that public debt reaches its target ratio by
2030.

8


Japan’s near-term fiscal stance isappropriate given the need torebuild after the earthquake, but acomprehensive and ambitious plan toput public debt on a sustainablefooting over the medium term
remains essential.

In most other advanced G-20
economies (e.g., Australia, Canada,
Germany, Korea, and the United
Kingdom),currentplans
areappropriate, but near-term tightening
should also slow if growth threatens
to be substantially lower thanprojected,
withcompensatingstronger medium-term adjustment.



14.

Economies facing adverse private
funding conditions—such as thosewith
IMFandEU-supported
programs—have little choice but to
press
ahead
with
current
consolidation plans.

Household balance sheet repair:In the United States, halting the spiral of
foreclosures, falling house prices anddeteriorating household spending isessential. To help work off problems in the
housing sector, expanding the existing
mortgage refinancing and modification
programs would be helpful, although theauthorities’ existing efforts in this area
face a plethora of political and technicalconstraints. More radically, consideration
could also be given to allowing the courts
to modify the terms of residential
mortgages.

15.

Monetary
policy:maintainaccommodation. Given falling confidence
and activity as well as well-anchoredinflation expectations, monetary policy inadvanced G-20 economies should remainvery accommodative. There is scope forlower ECB policy rates. The Federal
Reserve, Bank of England, and Bank ofJapan should stand ready to continue theirdeployment of unconventional measuresand take further steps if needed.
Prudential authorities will need to bewatchful of risks flowing from low interest
rates.

16.

Emerging G-20 economies need
to be nimble in dealing with potentiallyadversespillovers
fromadvanced
economies, and continue to strengthen
macroeconomic
policyframeworks.
Monetary policy should be the first
response to spillovers from advanced
economies as long as inflationarypressures remain in check. Fiscal positions
should generally aim at rebuilding policy
space. However, if growth begins to slow
substantially, emerging economies withfiscal space (China, Indonesia, Mexico, andSouth Africa) should ease the pace ofconsolidation, including by allowing
automatic stabilizers to fully operate. Most
emerging G-20 economies need to bolster
their financial stability frameworks to copewith volatile capital flows, including
notably from sharp swings in global risk
aversion.

9

COLLECTIVE ACTION
17.

Collective action can set thestage for a return to strong,sustainable, and balanced growth.
Policies should fit individual country
circumstances, but if all economies work
together, the risks of downward spirals
can be significantly reduced and astronger, more even recovery achieved.
This is true for the urgent challenges faced
today—notably addressing pressures in
the financial system—and over the
medium term.

18.

External rebalancing, now more
important than ever, requires collective
action. Households in advanced deficit
economies must continue deleveraging, inpart to ensure that ongoing fiscal
consolidation is not offset by deteriorationin the private saving-investment balance.
At the same time, sustained, more
inclusive, growth in emerging surplus
economies that lowers saving—including
through reduced distortions, better
pension, healthcare, and education
systems, together with less (sterilized)
interventioninforeignexchangemarkets—can help offset weaker demandin major advanced economies andsupport global growth.

19.

Coordinatedpolicies
could
achieve impressive gains for the global
economy. Simulations prepared by IMF
staff in collaboration with OECD staff for
the Mutual Assessment Process suggestthat joint actions by G-20 members aimed
at the priorities above could result in an

overall increase of
1½ percent by 2016.

world

GDP

by

20.

Coordination is essential toreduce the likelihood and impact ofanother crisis. Significant progress has
been made, but countries urgently needto implement agreed regulatory reforms,
while enhancing prudential supervision
anddomestic
resolution
toolkits.
Multilateral consistency is crucial in three
specific areas: systemic capital surcharges
forsystemicallyimportantbanks;
coordinated crisis management that guideinformation exchange and cross-borderbankresolutions.;
andgreatertransparency, in particular of the shadowbanking system, and, as appropriate,
expansion of the supervisory perimeter.
Further progress will require increased
cooperation from all stakeholders.

21.

The G-20 must strive to provide
further
impetustoensuringasuccessful completion of the WTO Doha
Round. A Doha conclusion would boost
global welfare and send a strong signal forinternational cooperation by providing
new market access and adding security to
trading
relationships
andlimiting
protectionist potential. In the meantime,
maintaining the credibility of themultilateral trading system is crucial given
Doha’s paralysis. Policymakers must resist
rising trade protectionist pressures arisingfrom high unemployment in advanced
economies and the lack of exchange rate
appreciationinsomeemerging

10
economies. In addition, G-20 economies
shouldalso
resist“financial
protectionism.” In particular, in the context
of deleveraging to improve the balance
sheet positions, banks should be
discouraged from relying largely on
liquidating their foreign asset holdings,
since this can have deleterious spillover
effects.

22.

The path to recovery has
narrowed, but the path is still open, if
action is taken now. Countries must
adopt comprehensive action across allpolicy levers, and implement them in a
globally-coordinated way to securestrong, sustainable, and balanced growth.