Subdued Growth, Diminished Prospects, Action Needed

By Maurice Obstfeld

(Versions in عربي, , 中文Français, 日本語, Русский, and Español)

At the start of 2016, turbulence in financial markets has returned amid renewed concern about risks to global economic growth. The fundamental forces that underlay our October World Economic Outlook projections have not dissipated, and in some respects have intensified, leading us to trim our expectations for future medium-term growth of the world economy.

In the World Economic Outlook Update released today, we still, however, expect growth to pick up this year in most countries.

Despite the modesty of the reduction we see in general growth prospects and the promise of improvement in coming years, downside risks to our central scenario have intensified. In our view, a focus on these risks is the main factor driving recent developments in financial markets.

We may be in for a bumpy ride this year, especially in the emerging and developing world.

Fundamental to the current global conjuncture are the same three forces we highlighted in October: China’s slower growth and rising financial-market risks amid a process of macroeconomic rebalancing away from the traditional industrial and construction sectors; the fall in commodity prices, notably the price of oil; and asynchronous trends in monetary policies, especially between the United States and most other advanced economies. The effects continue to play out. Since mid-October, for example, the price of base metals has declined a further 15 percent while that of oil has declined a further 40 percent.

Paradoxically, while risk-averse investors have focused on the potential negative impacts of these developments, each of them is two-sided and carries a silver lining that should make the negative effects on total world growth less dire than markets now seem to expect—especially over the longer term. China’s rebalancing is essential for its transition to a more sustainable and resilient consumption-based growth model; lower commodity prices benefit consumers and lower production costs; and the Federal Reserve’s well communicated interest-rate increase of December reflects the relatively strong performance of the United States economy, still the world’s largest. Yet, these changes also pose big adjustment challenges for many countries, and it is those that dominate the medium-term outlook.

Global outlook

What are the specific numbers? We project that global economic growth of 3.1 percent in 2015 will accelerate to 3.4 percent in 2016 and 3.6 percent in 2017. The 2016 and 2017 figures are both 0.2 percentage point below the levels we hoped for in October. While emerging market and developing economies account for more than two-thirds of this downward revision, we project they will accelerate moderately in both 2016 and 2017, compared to last year. Advanced economies will accelerate slightly in both 2016 and 2017, but likewise, to growth rates slightly below those that the last World Economic Outlook foresaw.

As always, aggregate averages conceal considerable diversity among individual countries. The small downgrade in our projection of advanced-economy growth is driven by slightly less optimism about the United States. Growth prospects for the euro area, the United Kingdom, and Japan are broadly unchanged.

Looming large in the emerging and developing group are countries facing especially severe multiple challenges and strongly negative 2015 growth, for example, Brazil and Russia (along with its CIS neighbors), whose sharp contractions this year should decelerate over the coming two-year period. However, while reduced from earlier years, growth looks better in other Latin American economies and in emerging and developing Europe. Growth prospects in parts of Asia have diminished somewhat as a result of the unexpectedly big external spillovers from China’s growth transition. In contrast, India, a major net commodity importer, continues to grow at the fastest pace among large emerging economies.

Downside risks

There are a number of specific downside risks to our scenario, and as always, events in an important stressed economy can spill over to others through effects on trade, asset and commodity prices, and confidence.

One downside risk is that China’s economy could encounter rough patches where growth slows more than expected, directly affecting trade partners while disturbing foreign exchange and other financial markets worldwide. We have maintained our 2016 and 2017 growth assessments for China in light of the robust development of its service and “new economy” sectors, as well as fiscal policy actions aimed at supporting demand. But the picture could change farther down the road. Continued strong growth in China is dependent on its authorities’ prompt, decisive action to address remaining imbalances and legacies of past ones. In addition, clear communication of a coherent overall policy strategy, including with respect to the yuan’s exchange rate, is critical both for domestic stability and that of markets abroad.

Depreciating currencies have been useful shock absorbers for many emerging and developing economies, but could eventually expose corporate balance-sheet weaknesses where there are foreign-currency exposures. Related, private capital inflows to emerging and frontier markets came to a virtual halt in the third quarter of 2015, with China accounting for most of the fall. The acceleration and broadening of this trend is a potential threat despite the enhanced buffers provided by international reserves. Another stress indicator is the general increase in sovereign spreads in Latin America and Africa; and a further increase in global risk aversion, for whatever reason, could lead to even tighter financial conditions for vulnerable economies.

Finally, political and geopolitical risks have intensified, not receded, in recent months. Prominent among these, refugee outflows from Syria and Iraq are imposing extreme burdens on neighboring countries and have spilled over into Europe, sparking political discord within the European Union and threatening its current framework for free labor mobility. Rapid absorption of refugees into labor markets will ultimately lift output, but will place up-front demands on public budgets. As difficult as are the challenges for the receiving countries, we must not lose sight of the source-country security concerns that give rise to both internal and external displacements. These impose immense costs, first of all on the refugees themselves.

Need for action

In advanced economies, currently projected growth rates are too low rapidly to reduce high unemployment and other legacies of recent crises, or to spark strong growth in real wages. In emerging and developing economies, currently projected growth rates substantially slow convergence to higher incomes. Action is needed. Policy recommendations must be country-specific, but at a general level there are three priorities.

First, to support aggregate demand in the face of subdued activity and, in some countries, continuing deflationary pressures.

Second, to support economic efficiency and long-term economic growth in the face of evidence that potential growth rates have fallen worldwide over the past decade. An important element here is structural reform, which will be a main theme of the April 2016 World Economic Outlook.

A final need is to further strengthen and widen the international safety net, bolstering global resilience to whatever may lie ahead.

See also Obstfeld video and Infographic.

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