Managing Economic Spillovers
The way economic shocks have unfolded since the 2008 crisis clearly demonstrate that world is interconnected like never before, in multiple and complex ways. It further underscores the need for all to better understand how developments in one country can have spillovers – economic, financial, and even political—on other countries that can be thousands of miles away.
It used to be that advanced economies were the sources of spillovers. For example, monetary policy in the United States, Europe, and Japan, has always had an impact on capital flows to emerging markets. This certainly continues, except that now we also have emerging economies as emitters of spillovers, both regionally and globally. Think of China, Russia or Brazil in this regard.
According to IMF Director, Christine Lagarde, there are currently two such shocks causing spillovers at the global stage, whose implications for the world economy we must try to understand.
She noted that first; China is in the midst of a welcome transition to a slower but more sustainable growth path. This transition partly explains the cooling of global growth, and especially trade. IMF’s estimates suggest that a one percentage point decline in China’s growth could reduce global GDP by about 0.2 percentage points.
Lagarde said that this is not trivial, and it contributes to what our Chief Economist Maurice Obstfeld recently said: “the Holy Grail of robust and synchronized global expansion remains elusive” – and that is despite massive monetary stimulus in recent years.
The second spillover comes from the oil market. The IMF Chief said that s slow global recovery, a downward shift in expected demand from China, and ample supply have all contributed to a drop in oil prices by some 70 percent from their peak. And as you know very well, despite a small rebound since late 2015, futures markets suggest that prices are likely to stay low for longer.
But how do these spillovers play out in the world economy? According to Lagarde, at the global level, the fall in oil prices led to a redistribution of income across countries – from heavy exporters such as Saudi Arabia, Russia and Norway to net importers such as the United States, Germany, Japan, China and India.
Faced with such a drastic fall in prices and rising financial pressures, many of the commodity exporters had to adjust. She said that most countries cut government spending sharply and reduced investment, in the energy sector and elsewhere.
She noted that Exchange rates were allowed to depreciate.
“Think of the 25 percent real effective depreciation in Brazil or the 15 percent depreciation in Russia. A few countries had to go further and abandon fixed exchange rates, such as Kazakhstan – a country I just visited – and others should also do so, such as Nigeria. These changes helped reduce the need for excessive fiscal adjustment –by limiting the domestic currency loss of commodity revenues,” explained Lagarde.
The IMF Chief added, “At the same time, countries with large financial and policy buffers were in a better position to smooth the adjustment. This is the case in Norway, where the sovereign wealth fund, the Government Pension Fund Global, helped buffer the impact of the oil price downturn on the economy.”
However, even countries with ample buffers such as Saudi Arabia and Russia required significant adjustment and a rethinking of their fiscal and growth plans.
She added, “So clearly the impact on oil exporters was severe—perhaps more than anticipated. But oil exporters represent a much smaller share of global GDP than oil importers, less than 15 percent. One could therefore have thought that the oil price decline would be “a shot in the arm” for the global economy. After all, oil importers would enjoy a “windfall income” and a boost to growth from lower prices. Additional spending by importers would exceed the contraction by exporters, and growth would rebound.”
Well, that oil “windfall” turned out to be more like a breeze. Lagarde said that it was perhaps most noticeable in the United States, where private consumption has been strong, and to some extent in the Euro area where demand also picked up. But in Japan, consumption remained virtually flat.
So compared with past cycles, Lagarde said that lower oil prices have not helped overcome the drag from other factors causing slow growth and asymmetric recoveries in oil importers – such as public and private sector debt overhang, slow credit growth, weak employment and low wage growth, and rising inequality, to name a few.
Moreover, nations are seeing a slight widening of global current account imbalances, which had narrowed substantially after 2008. While China’s transformation has been a key contributor to the reduction in imbalances in recent years, other countries went in the opposite direction. Lagarde asserts that in 2015, the external deficit in the U.S. increased while the surpluses in the euro area and Japan have widened.
These changes reflect the asymmetric recoveries and associated large exchange rate movements across major currencies. If continued, this trend would lead to a further widening of stock imbalances, or growing disparities between creditor and debtor countries, which could raise global risks. This points to the need for better balancing global demand to reinvigorate global growth and contain external imbalances through active use of policy space.
Lagarde noted however that making a case to policy makers that something needs to be done to reduce global imbalances is always a hard sell. She said that their interests are of course geared towards the domestic economy, and growth usually remains the first priority.
“Reflecting this priority, we managed to agree on some principles at the IMF Spring Meetings. First, it was widely accepted that monetary policy can no longer be the only game in town. And second, fiscal and structural policies need to step up to boost aggregate demand and growth potential – to form a three-pronged policy approach in advanced and emerging countries alike.
What is left is to make these principles more concrete, and in the process reconciling domestic objectives and external stability considerations,” the IMF Boss explained.
But what if domestic and external objectives are not aligned? In such cases, Lagarde said that understandably, domestic issues should take priority. She stressed however that countries need to take into account the spillovers from their actions.
“The emphasis here is on the appropriate mix of domestic policies – a balanced approach that limits the undesirable spillovers and beggar-thy- neighbor effects. And while external considerations can temporarily take a back seat to domestic objectives, policies will need to be reoriented over time to address external stability objectives,” Lagarde pointed out.