Having overcome the worst period of the financial crisis, the world economy is getting back on the growth path. Meanwhile, risks have risen sharply amid renewed financial turbulence around the world. The World Economic Outlook Update, released by the IMF on July 8, discussed this issue. Edited excerpts follow:
Global indicators of real economic activity remained strong through April and stabilized at a high level in May. Industrial production and trade posted double-digit growth; consumer confidence continued to improve, and employment growth resumed in advanced economies. Overall, macroeconomic developments during much of the spring met expectations of a modest but steady recovery in most advanced economies and strong growth in many emerging and developing economies. World economic growth is projected at about 4.5 percent in 2010 and 4.25 percent in 2011.
Nevertheless, recent turbulence in financial markets—reflecting a drop in confidence about fiscal sustainability, policy responses and future growth prospects—has called a prosperous outlook into question. Crucially, fiscal sustainability issues in advanced economies came to the fore during May, fuelled by initial concerns over fiscal positions and competitiveness in Greece and other vulnerable euro area economies.
In principle, the renewed financial turbulence could spill over to the real economy through several channels, involving changes in domestic and external demand and in relative exchange rates. The supply of bank credit could be curtailed by heightened uncertainty about financial sector exposure to sovereign risk as well as increased funding costs, notably in Europe. Moreover, lower consumer and business confidence could suppress private consumption and investment. Given trade and financial linkages, the ultimate effect could be substantially lower global demand.
Against this uncertain backdrop, the overarching policy challenge is to restore financial market confidence without choking the recovery.
In the euro area, well-coordinated policies to rebuild confidence are particularly important. Immediate priorities in the financial sphere include: making the new European Stabilization Mechanism fully operational, resolving uncertainty about banks' exposure to sovereign debt, ensuring European banks have adequate capital buffers, and continuing liquidity support.
On a global level, policies should focus on implementing credible plans to lower fiscal deficits over the medium term while maintaining supportive monetary conditions, accelerating financial sector reform, and rebalancing global demand.
Recently renewed financial strains underscore the urgent need to reform financial systems and restore the health of banking systems. In many advanced economies, more progress is needed on bank recapitalization; bank consolidation, resolution and restructuring; and regulatory reform.
Last but not least, the ongoing rebalancing of global demand must be supported by bold policy action. To some extent, financial markets and capital flows are already facilitating global demand rebalancing through currency pressures, although many economies have been resisting them by building up reserves.
In economies with excessive external surpluses, the transition toward domestic sources of demand should continue, helped by structural policies to reform social safety nets and to improve productivity in the service sector as well as, in a variety of cases, more flexible exchange rates. In economies with excessive external deficits, fiscal consolidation and financial sector reform should help rebalance demand.