Global Financial Stability Report

Global Financial Stability Report
GFSR Market Update

Global Financial Stability Still at Risk

January 25, 2011

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Nearly four years after the onset of the largest financial crisis since the Great Depression, global financial stability is still not assured and significant policy challenges remain to be addressed. Balance sheet restructuring is incomplete and proceeding slowly, and leverage is still high. The interaction between banking and sovereign credit risks in the euro area remains a critical factor, and policies are needed to tackle fiscal and banking sector vulnerabilities. At the global level, regulatory reforms are still required to put the financial sector on a sounder footing. At the same time, accommodative policies in advanced economies and relatively favorable fundamentals in some emerging market countries are spurring capital inflows. This means that policymakers in emerging market countries will need to watch diligently for signs of asset price bubbles and excessive credit.
Even though global economic growth has accelerated somewhat (see the World Economic Outlook Update), global financial stability has yet to be secured. The two-track global recovery—with advanced countries growing much more slowly than the rest of the world—continues to pose policy challenges. The slow growth prospects of advanced economies and the continued weakness in their fiscal balances have raised the market’s sensitivity to debt sustainability risks. The evident links between weak balance sheets of government and banking sectors have led to renewed pressures in funding markets in the euro area and widening strains. At the same time, accommodative monetary policies in advanced countries and relatively favorable fundamentals in emerging market economies have spurred capital flows to such economies. This creates upward pressure on asset markets in receiving countries, while raising the latent risk that inflows could reverse and, as a result, poses considerable policy challenges on how best to absorb the flows.
Notwithstanding these factors, financial market performance has been favorable thus far in early 2011, reflecting the more positive economic climate, ample liquidity, and expanding risk appetite. Equity markets in advanced and emerging market countries have risen since the October 2010 Global Financial Stability Report (GFSR). Commodity prices have taken off—with oil, food, metals, and raw material prices all rising rapidly. However, such positive developments have been notably absent for many advanced country sovereigns and their banking systems (Figure 1). In fact, there are now several cases in which sovereign credit default swap (CDS) spreads exceed those in large emerging market countries. Banks in those advanced economies also have elevated CDS spreads.

Interaction between Sovereign and Banking Sector Risks Has Intensified Despite improvements in market conditions since the October 2010 GFSR, sovereign risks within the euro area have on balance intensified and spilled over to more countries. Government bond spreads in some cases reached highs that were significantly above the levels seen during the turmoil last May. Pressures on Ireland were particularly severe and led to an EU-ECB-IMF program. Correlations between the average sovereign yields of Greece and Ireland and the yields of Portugal have remained high, but correlations have increased sharply in recent months with the yields of Spain, and to a lesser extent, Italy, as the tensions spread (Figure 2). While still contained to the euro area, the adverse interaction between the sovereign and banking risks in a number of countries has intensified, leading to disruptions in some funding markets. Figure 3 shows that CDS spreads written on financial institutions have increased the most in countries in which there has been the greatest sovereign stress—and this relationship is more positive now than in 2008. Smaller and more domestically-focused banks in some countries have found access to private wholesale funding sources curtailed. Many banks that have retained access have faced higher costs and are only able to borrow at very short maturities. Several countries, as well as their main banks, face substantial financing needs in 2011 as bank and sovereign debt-to-GDP ratios have risen substantially in the last several years (see IMF Fiscal Monitor Update and Figure 4). The confluence of funding pressures and continued banking sector vulnerabilities leaves financial systems fragile and highly vulnerable to deterioration in market sentiment. Little Progress on Deleveraging The build-up of gross debt accumulated by the private sector in a number of advanced markets has in most cases been only partly reversed, if at all (Figure 5). Private sector debt-to-GDP ratios should fall gradually over time as economic activity picks up, but the high current debt levels and the usual tendency for loan losses to lag the recovery could still pose risks to the banking system. Most countries' banking systems have reduced their vulnerabilities by increasing their Tier 1 capital ratios (Figure 6). However, improvements in the structure of funding have been more difficult to achieve. Moreover, some euro-area banking systems are particularly vulnerable to deterioration in the credit quality of their sovereign debt holdings. Even for countries that look better positioned along both these dimensions, there are still risks. In the United States, nonperforming loans related to commercial and residential real estate continue to pose downside risks to banks’ balance sheets, and the government debt-to-GDP ratio remains high. Still-high levels of private debt in some countries are likely to dampen both private sector demand for credit and banks’ willingness to lend, weighing on the economic recovery. Although accommodative monetary policies are appropriate to help spur recovery, low interest rates and the use of quantitative easing can have adverse financial stability side effects, including by encouraging riskier investments. Low rates also pose a challenge for fixed-income investors such as pension funds and insurance companies that rely on higher-yielding assets to match their long-term fixed liabilities. Resurgent Capital Flows to Emerging Market Economies Stronger economic fundamentals in some key emerging markets, along with low interest rates in advanced countries, have led to a rebound in capital flows, after the significant drop at the height of the financial crisis. Net inflows to emerging market countries now represent around 4 percent of GDP in aggregate (Figure 7). By comparison, inflows prior to the crisis were above 6 percent of GDP. Capital inflows have been accompanied by a large increase in equity and bond issuance, potentially limiting some of their effects on the price of these assets. These capital flows may be partly driven by structural factors underlying changes in asset allocation decisions by institutional investors who are now looking at emerging market assets more favorably. However, these flows are also being driven by carry trades, in which investors hope to profit from interest rate differentials and expectations of exchange rate appreciation. Such expectations often accompany policies designed to temporarily limit exchange rate appreciation. Forward interest rates show that the current differential between emerging and advanced country policy rates is expected to rise, which will further increase the incentive for such carry trades. This suggests a vulnerability to reversals in response to, for instance, an unexpected rise in advanced country interest rates, a shift in growth prospects in emerging market countries, or a rise in risk aversion. Capital inflows are normally beneficial for recipient countries, but sustained capital inflows can strain the absorptive capacity of local financial systems. Retail flows into debt and equity mutual funds have been strong, particularly for equity funds, and could give rise to the formation of asset price bubbles if local assets are in limited supply (Figure 8). Although most measures of equity valuations are within historical ranges, “hot spots” appear to be emerging in the equity markets in Colombia and Mexico and, to a lesser extent, in Hong Kong SAR, India, and Peru. Inflows can also lead to a rapid increase in private sector indebtedness in recipient countries. As shown in Figure 9, in some economies in Asia and Latin America, nonfinancial private debt is approaching the maximum ratios reached between 1996 and 2010 (Brazil, Chile, China, India, and Korea, for example)1. While in some countries the change may represent financial deepening and healthy market development, in other countries it could signal an increase in risk, and it is important that country authorities remain vigilant. A further symptom of large capital inflows is that lower-rated entities gain greater market access to issue debt, lowering the average quality of assets held by investors. There has been an increase in the proportion of debt issued by lower-grade credits during the last two years. Policy Priorities Policy action is needed to ensure that the required restructuring and balance sheet repair take place—both for banks and sovereigns—and that regulatory reforms move forward. The time purchased with the extraordinary support measures of the past few years is running out. Low policy interest rates that are close to the zero bound are likely to have a diminishing effect over time. Fiscal stimulus and further government support of the financial sector are also becoming increasingly unpalatable politically. It is clear that monetary and fiscal policy support can be helpful in the short term, but that such support is no substitute for structural solutions to longstanding problems. Such solutions need to address sovereign risk and financial fragilities in a holistic and comprehensive fashion. Breaking the Adverse Sovereign-Financial Loop The root of the problem in many of the countries hit by the crisis—the detrimental interaction between sovereign and financial sector risk—must be addressed. This applies in particular to the euro- area countries where, despite the set-up of area-wide instruments, markets remain concerned about the lack of a sufficiently comprehensive and consistent strategy to repair fiscal balance sheets and the financial system. All countries with outsized debt levels—inside and outside the euro area—must make further medium-term, ambitious, and credible progress on fiscal consolidation strategies, together with better public debt management based on the Stockholm Principles2. In particular, in countries facing funding pressures, there is a continued need for the authorities to convince markets that they can, and will, reduce reliance on rollovers and lengthen the maturity structure of their debt. This process will inevitably involve other policies, in particular structural measures aimed at supporting potential growth. Solid movements in this direction have taken place in a number of euro- area countries, but sustained follow-through is still required. In the United States, the delay of a credible strategy for medium-term fiscal consolidation would eventually drive up U.S. interest rates, with knock-on effects for borrowing costs in other economies. The longer fiscal stabilization is stalled, the more likely there would be a sharper rise in Treasury yields, which could prove disruptive for global financial markets and the world economy. Another country with high debt levels, Japan, also needs to continue to work toward lowering those levels and ensuring fiscal sustainability in the face of an aging population. At the same time, financial system repair must be undertaken—strengthening the banking sector through well-targeted remedial actions, removing the tail risks, and establishing a better regulatory system. In the European Union, the steps listed below are needed to reduce uncertainty and help restore confidence in markets. Further rigorous and credible bank stress testing is required along with time-bound follow-up plans for recapitalization and restructuring of viable, undercapitalized institutions and closure of nonviable ones. The effective size of the European Financial Stability Facility should be increased and it should have a more flexible mandate. For countries where the banking system represents a large proportion of the economy, it is now even more essential to ensure access to sufficient funds, going beyond national backstops whenever necessary. Euro area-wide resolution mechanisms need to be deployed and strengthened as needed. The introduction of a pan-European bank resolution framework with an EU-wide fiscal backstop would help decouple sovereign and banking risks. The European Central Bank will need to continue to supply liquidity to banks that need it and keep its Securities Markets Program active, while also recognizing that this is a temporary set of measures and will not solve the underlying problems. In the United States, efforts are needed to address the headwinds from the still-damaged real estate markets. It is important to find ways to mitigate the negative macro-financial linkages from the large “shadow inventory” of houses for sale (i.e., properties that are already in foreclosure or expected to default) that is likely to dampen house prices for some time to come and exacerbate negative home equity problems. Steps are also needed to revive securitization markets, while at the same time making sure that structured credit products are consistent with systemic stability. As emphasized in the conclusions of the recent Financial Sector Assessment Program, an overhaul is needed of the U.S. housing finance system, including the role of the mortgage-related, government-sponsored enterprises. These could be either privatized or converted to public utilities with an explicit (and explicitly funded) guarantee. The authorities should not delay efforts to create an action plan for the future. In many advanced countries, bank balance sheet and operational restructuring is necessary to preserve the long-term viability of financial institutions and hence reduce the implicit pressure on the sovereign balance sheet in these countries. In some banking systems, the problems are less cyclical and more structural in nature—namely chronically low profitability and fading business lines. Where durable solutions are not possible, effective resolution tools are required that can, in an increasingly complex and interconnected global financial system, preserve financial stability, while ultimately allowing losses to be borne by creditors rather than taxpayers. Governments need to consider carefully how, through better capital structures and possibly through restrictions on the scope and riskiness of activities, large financial institutions can be less of a threat to overall systemic stability and to sovereign balance sheets. Regulatory Reform Efforts Need to Continue At the global level, regulatory reform efforts have been moving forward, but increasingly suffer from a combination of fatigue and the sheer complexity of the issues. Progress has been made on microprudential banking regulation aimed at ensuring the solidity of individual institutions, though important gaps remain. Macroprudential policymaking, which aims to preserve the stability of the financial system as a whole, is still in its infancy in most countries, and there are concerns that systemic vulnerabilities may build up again before solid progress is made to prevent such a build-up. Financial systems will need to adjust to the new reforms, including as the recovery takes hold and interest rates rise. This will be more challenging for those countries, such as Japan, that have had low interest rates and a build-up of debt over a long period of time. New entities are being established to improve systemic oversight. They should waste no time in collecting and analyzing data and issuing policy advice, especially in light of the present low interest rate environment that could well be laying the ground for new financial vulnerabilities. The new European Systemic Risk Board has become operational this month, and markets will watch closely for strong risk warnings and recommendations. The new Financial Stability Oversight Council in the United States, which has already initiated regular meetings, needs to demonstrate that the financial stability arrangements and surrounding regulatory structure have been upgraded in light of the lessons from the crisis. Guidelines to identify systemically-important financial institutions and measure their contribution to systemic risk are being worked out, though how to mitigate the risks they pose to the financial system is still an open question. Particularly, how to deal with systemically-important nonbanks and markets is a difficult and outstanding issue. Moreover, methods to improve the quality of supervision and produce a fully functional cross-border resolution scheme are still on the “to do” list. Coping with Capital Inflows The need for macroprudential policymaking is also very relevant for emerging market economies facing absorptive constraints on capital inflows. These policies are complements, not substitutes, for traditional macroeconomic policies. So far, evidence of asset price bubbles and credit booms is still isolated to a few countries in a few sectors, but equity inflows and carry-trade activity are generally quite strong and these flows have to be watched carefully, particularly where leverage may be involved. Policymakers will need to be attentive and act in a timely manner when pressures from inflows are building up, since policies take time to work. Those facing strong inflows and maintaining procyclical policies need to move to a neutral policy setting. Countries with undervalued exchange rates should allow this price mechanism to operate to help offset inflow pressures. However, if currency appreciation is not an option, other means such as monetary and/or fiscal policy should be deployed. Macroeconomic policy responses may, however, need to be complemented by strengthened macroprudential measures (e.g., higher loan to value ratios, funding composition restrictions) and, in some cases, capital controls. Overall, while progress has been made and most financial sectors are on the mend, risks to global financial stability remain. Problems in Greece, and now Ireland, have reignited questions about sovereign debt sustainability and banking sector health in a broader set of euro-area countries and possibly beyond. The current detrimental interaction between financial system stability and sovereign debt sustainability needs to be dealt with in a comprehensive fashion, so as to break the adverse feedback loop that could spread beyond the smaller euro-area countries. Pressing forward with the regulatory reform agenda—for both institutions and markets—continues to be crucial. Without further progress in this field, global financial stability and sustainable growth will remain elusive. 1 Private sector debt includes domestic and cross-border bank credit, and domestic and international corporate debt. 2 See www.imf.org/external/np/mcm/Stockholm/principles.htm for a complete set of the principles.

World Economic Outlook Update

Global Recovery Advances but Remains Uneven

January 25, 2011

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The two-speed recovery continues. In advanced economies, activity has moderated less than expected, but growth remains subdued, unemployment is still high, and renewed stresses in the euro area periphery are contributing to downside risks. In many emerging economies, activity remains buoyant, inflation pressures are emerging, and there are now some signs of overheating, driven in part by strong capital inflows. Most developing countries, particularly in sub-Saharan Africa, are also growing strongly. Global output is projected to expand by 4½ percent in 2011 (Table 1 and Figure 1: CSV|PDF), an upward revision of about ¼ percentage point relative to the October 2010 World Economic Outlook (WEO). This reflects stronger-than-expected activity in the second half of 2010 as well as new policy initiatives in the United States that will boost activity this year. But downside risks to the recovery remain elevated. The most urgent requirements for robust recovery are comprehensive and rapid actions to overcome sovereign and financial troubles in the euro area and policies to redress fiscal imbalances and to repair and reform financial systems in advanced economies more generally. These need to be complemented with policies that keep overheating pressures in check and facilitate external rebalancing in key emerging economies.

The global recovery is proceeding

Global activity expanded at an annualized rate of just over 3½ percent in the third quarter of 2010. A slowdown from the 5 percent growth rate of the second quarter of 2010 was expected, but the third-quarter rate was better than forecast in the October 2010 WEO, owing to stronger-than-expected consumption in the United States and Japan. Stimulus measures were partly responsible for the strengthened outturn, especially in Japan. More generally, signs are increasing that private consumption—which fell sharply during the crisis—is starting to gain a foothold in major advanced economies (Figure 2: CSV|PDF). Growth in emerging and developing economies remained robust in the third quarter, buoyed by well-entrenched private demand, still-accommodative policy stances, and resurgent capital inflows.


During the second half of 2010, global financial conditions broadly improved, amid lingering vulnerabilities. Equity markets rose, risk spreads continued to tighten, and bank lending conditions in major advanced economies became less tight, even for small and medium-sized firms. Nonetheless, pockets of vulnerability persisted; real estate markets and household income were still weak in some major advanced economies (for example, United States), and securitization remained subdued. And, in an echo of last May’s events, financial turbulence reemerged in the periphery of the euro area in the last quarter of 2010. Concerns about banking sector losses and fiscal sustainability—triggered this time by the situation in Ireland—led to widening spreads in these countries, in some cases reaching highs not seen since the launch of the European Economic and Monetary Union. Funding pressures also reappeared, although to a lesser extent than during the summer. One key difference was more limited financial market spillovers to other countries. The turmoil in mid-2010 led to a spike in global risk aversion and a scaling back of exposures in other regions, including emerging markets. During the recent bout of turbulence, markets have been more discriminating: measures of risk aversion have not risen, equity markets in most regions have posted significant gains, and financial stresses have been limited mostly to the periphery of the euro area (Figure 3: CSV|PDF).

Table 1. Overview of the World Economic Outlook Projections (Percent change, unless otherwise noted)     Year over Year                     Difference from October 2010 WEO Projections   Q4 over Q4       Projections     Estimates Projections   2009 2010 2011 2012   2011 2012   2010 2011 2012   World Output 1 –0.6 5.0 4.4 4.5   0.2 0.0   4.7 4.5 4.4 Advanced Economies –3.4 3.0 2.5 2.5   0.3 –0.1   2.9 2.6 2.5   United States –2.6 2.8 3.0 2.7   0.7 –0.3   2.7 3.2 2.7   Euro Area –4.1 1.8 1.5 1.7   0.0 –0.1   2.1 1.2 2.0     Germany –4.7 3.6 2.2 2.0   0.2 0.0   4.3 1.2 2.7     France –2.5 1.6 1.6 1.8   0.0 0.0   1.7 1.5 1.9     Italy –5.0 1.0 1.0 1.3   0.0 –0.1   1.3 1.2 1.4     Spain –3.7 –0.2 0.6 1.5   –0.1 –0.3   0.4 0.8 1.9   Japan –6.3 4.3 1.6 1.8   0.1 –0.2   3.3 1.4 2.4   United Kingdom –4.9 1.7 2.0 2.3   0.0 0.0   2.9 1.5 2.6   Canada –2.5 2.9 2.3 2.7   –0.4 0.0   2.7 2.7 2.6   Other Advanced Economies –1.2 5.6 3.8 3.7   0.1 0.0   4.5 4.7 2.9     Newly Industrialized Asian Economies –0.9 8.2 4.7 4.3   0.2 –0.1   5.9 6.2 3.1 Emerging and Developing Economies 2 2.6 7.1 6.5 6.5   0.1 0.0   7.2 7.0 6.8   Central and Eastern Europe –3.6 4.2 3.6 4.0   0.5 0.2   4.3 3.5 3.9   Commonwealth of Independent States –6.5 4.2 4.7 4.6   0.1 –0.1   3.5 4.8 4.3     Russia –7.9 3.7 4.5 4.4   0.2 0.0   3.4 4.6 4.3     Excluding Russia –3.2 5.4 5.1 5.2   –0.1 –0.1   . . . . . . . . .   Developing Asia 7.0 9.3 8.4 8.4   0.0 0.0   9.1 8.6 8.4     China 9.2 10.3 9.6 9.5   0.0 0.0   9.7 9.5 9.5     India 5.7 9.7 8.4 8.0   0.0 0.0   10.3 7.9 8.0     ASEAN-5 3 1.7 6.7 5.5 5.7   0.1 0.1   5.1 6.4 5.2   Latin America and the Caribbean –1.8 5.9 4.3 4.1   0.3 –0.1   4.8 5.0 4.3     Brazil –0.6 7.5 4.5 4.1   0.4 0.0   5.2 5.1 4.0     Mexico –6.1 5.2 4.2 4.8   0.3 –0.2   3.2 5.0 4.5   Middle East and North Africa 1.8 3.9 4.6 4.7   –0.5 –0.1   . . . . . . . . .   Sub-Saharan Africa 2.8 5.0 5.5 5.8   0.0 0.1   . . . . . . . . .     South Africa –1.7 2.8 3.4 3.8   –0.1 –0.1   3.6 3.4 4.1 Memorandum                       European Union –4.1 1.8 1.7 2.0   0.0 –0.1   2.5 1.4 2.2 World Growth Based on Market Exchange Rates –2.1 3.9 3.5 3.6   0.2 –0.1   . . . . . . . . .                         World Trade Volume (goods and services) –10.7 12.0 7.1 6.8   0.1 0.2   . . . . . . . . . Imports                         Advanced Economies –12.4 11.1 5.5 5.2   0.3 0.1   . . . . . . . . .   Emerging and Developing Economies –8.0 13.8 9.3 9.2   –0.6 –0.1   . . . . . . . . . Exports                         Advanced Economies –11.9 11.4 6.2 5.8   0.2 0.3   . . . . . . . . .   Emerging and Developing Economies –7.5 12.8 9.2 8.8   0.1 0.2   . . . . . . . . . Commodity Prices (U.S. dollars)                       Oil 4 –36.3 27.8 13.4 0.3   10.1 –4.1   . . . . . . . . . Nonfuel (average based on world commodity export weights) –18.7 23.0 11.0 –5.6   13.0 –2.4   . . . . . . . . .                         Consumer Prices                       Advanced Economies 0.1 1.5 1.6 1.6   0.3 0.1   1.5 1.6 1.6 Emerging and Developing Economies 2 5.2 6.3 6.0 4.8   0.8 0.3   6.5 4.7 4.4 London Interbank Offered Rate (percent) 5                       On U.S. Dollar Deposits 1.1 0.6 0.7 0.9   –0.1 –0.5   . . . . . . . . . On Euro Deposits 1.2 0.8 1.2 1.7   0.2 0.4   . . . . . . . . . On Japanese Yen Deposits 0.7 0.4 0.6 0.2   0.2 –0.2   . . . . . . . . .   Note: Real effective exchange rates are assumed to remain constant at the levels prevailing during November 18–December 16, 2010. Country weights used to construct aggregate growth rates for groups of economies were revised. When economies are not listed alphabetically, they are ordered on the basis of economic size. The aggregated quarterly data are seasonally adjusted. 1 The quarterly estimates and projections account for 90 percent of the world purchasing-power-parity weights. 2 The quarterly estimates and projections account for approximately 78 percent of the emerging and developing economies. 3 Indonesia, Malaysia, Philippines, Thailand, and Vietnam. 4 Simple average of prices of U.K. Brent, Dubai, and West Texas Intermediate crude oil. The average price of oil in U.S. dollars a barrel was $78.93 in 2010; the assumed price based on futures markets is $89.50 in 2011 and $89.75 in 2012. 5 Six-month rate for the United States and Japan. Three-month rate for the Euro Area. The recovery is set to continue… The baseline projections below assume that current policy actions manage to keep the financial turmoil and its real effects contained in the periphery of the euro area, resulting in only a modest drag on the global recovery. This view reflects the limited financial spillovers observed so far across financial markets and regions, as well as the fact that policy responses following the Greek crisis helped limit its impact on the global recovery in the second half of 2010. The baseline also assumes that policymakers in emerging markets respond in a timely manner to keep overheating pressures in check. Activity in the advanced economies is projected to expand by 2½ percent during 2011–12, which is still sluggish considering the depth of the 2009 recession and insufficient to make a significant dent in high unemployment rates. Nevertheless, the 2011 growth projection is an upward revision of ¼ percentage point relative to the October 2010 WEO, mostly due to a new fiscal package passed in late 2010 in the United States that is expected to boost economic growth this year by ½ percent. A package with a similar growth impact passed in Japan is expected to sustain a moderate recovery in 2011. And although growth in the periphery of the euro area is marked down for this year, this is offset by an upward revision to growth in Germany, due to stronger domestic demand. In both 2011 and 2012, growth in emerging and developing economies is expected to remain buoyant at 6½ percent, a modest slowdown from the 7 percent growth registered last year and broadly unchanged from the October 2010 WEO. Developing Asia continues to grow most rapidly, but other emerging regions are also expected to continue their strong rebound. Notably, growth in sub-Saharan Africa—projected at 5½ percent in 2011 and 5¾ percent in 2012—is expected to exceed growth in all other regions except developing Asia. This reflects sustained strength in domestic demand in many of the region’s economies as well as rising global demand for commodities (Box 1). …and financial conditions in most regions are expected to remain stable Financial conditions are expected generally to remain stable or improve this year. Bank lending conditions in the major advanced economies are expected to ease further, and bond issuance by nonfinancial firms is also expected to strengthen. Amid generally sluggish recovery and continued high saving in key emerging Asian economies, real yields are likely to remain low through 2011. In the United States, the outlook for Treasury yields is uncertain: a gradually strengthening recovery and fiscal concerns may push up yields, while quantitative easing may hold them back. Financial stresses, however, are expected to remain elevated in the periphery of the euro area, where market participants are still concerned about sovereign and banking risk, the political feasibility of current and envisioned austerity measures, and the lack of a comprehensive solution. European sovereign peripheral spreads and bank funding costs are thus likely to remain elevated during the first half of this year, and financial turbulence could re-intensify. Under a baseline scenario in which contagion from turmoil in the euro area periphery is contained, emerging market capital inflows are expected to remain strong and financial conditions robust. Bond issuance by emerging market sovereigns and firms is expected to remain robust in 2011. Low interest rates in mature markets and fairly strong investor appetite will continue to pose upside risks to emerging market flows and asset prices, despite some recent slowdown of inflows. Box 1. Economic Outlook for Sub-Saharan Africa Most countries in sub-Saharan Africa have recovered quickly from the global financial crisis, with the region projected to grow 5½ percent in 2011. But the pace of the recovery has varied within the region. Output growth in most oil exporters and low-income countries (LICs) is now close to precrisis highs. The recovery in South Africa and its neighbors, however, has been more subdued, reflecting the more severe impact of the collapse in world trade and elevated unemployment levels that are proving difficult to reduce. Prior to the recent global crisis, sub-Saharan Africa enjoyed a period of strong growth. Growth in the region’s 29 LICs was particularly impressive at more than 6 percent during 2004–08, second only to developing Asia. This reflected the improved political environment, favorable external conditions, and sound macroeconomic management. These strong initial conditions helped most countries in the region weather the worst effects of the food and fuel price hikes of 2007–08 and the subsequent global financial crisis. Many countries supported output by injecting fiscal stimulus and lowering interest rates. As a result, LICs in the region continued to grow at nearly 5 percent in 2009, although output fell in the region’s middle-income countries—a grouping dominated by South Africa. In most of the oil-exporting countries growth slowed, with the notable exception of Nigeria. Most countries in the region have now returned to precrisis growth rates. In 2011, LICs are projected to grow by 6½ percent. Domestic demand is being supported by automatic stabilizers, expansion in public investment and social support programs, and continued monetary accommodation. Growing trade ties with Asia are also playing a role in the region’s recovery, primarily through commodity markets. Output growth has rebounded in South Africa, but high unemployment and subdued confidence are expected to continue to dampen the pace of recovery, restricting growth to about 3½ percent in 2011. Risks remain weighted to the downside, however. The pace of recovery in Europe, the dominant trade partner for most non-oil-exporting countries in sub-Saharan Africa, is modest and uncertain. More immediately, the sharp pickup in fuel and food prices stands to make a significant impact on many non-oil-exporting countries. Rising food prices are likely to affect the urban poor in particular, given the high share of food in their consumption baskets. In response, governments will need to consider targeted social safety nets, with attendant fiscal costs. Managing these pressures, particularly against the backdrop of elevated fiscal deficits and narrowing output gaps, will be an important challenge for the region in 2011—a year with a busy political calendar, including perhaps 17 national elections. With recovery at hand in most countries in the region, the emphasis of macroeconomic policies needs to shift: Countercyclical fiscal policy helped support output growth during the crisis, but has resulted in wider fiscal deficits across the board. With growth in most countries now approaching potential, the consistency of these wider deficits with financing and medium-term debt sustainability considerations should be reviewed. To promote growth and poverty reduction, attention also needs to be given to the appropriateness of the composition of government spending and revenue sources. Inflation remains in check in most countries, and the monetary stance seems appropriate. But policymakers should remain alert to potential pressure from rising commodity prices—particularly with growth approaching potential levels. Other policy areas requiring sustained attention include more intensive monitoring and sounder regulation of the financial sector, continuing policy improvements targeted at the business environment, and robust public financing mechanisms to plan and control government spending, including infrastructure investment. Commodity prices will remain high, and inflation is rising in some emerging economies Prices for both oil and non-oil commodities rose considerably in 2010, in response to strong global demand but also to supply shocks for selected commodities. Upward pressure on prices is expected to persist in 2011, due to continued robust demand and a sluggish supply response to tightening market conditions. As a result, the IMF’s baseline petroleum price projection for 2011 is now $90 per barrel, up from $79 per barrel in the October 2010 WEO. As for non-oil commodities, weather-related crop damage was greater than expected in late 2010, and price effects are expected to unwind only after the 2011 crop season. As a result, non-oil commodity prices are expected to increase by 11 percent in 2011. Near-term risks are now to the upside for most commodity classes. The uptick in consumer price inflation in emerging economies in 2010 was attributable partly to rising food prices. But the recent bout of high food price inflation has been quite persistent, straining the budgets of low-income households and beginning to feed into overall price inflation in a number of economies. More important, rapid growth in emerging and developing economies has narrowed or in some cases closed output gaps in these economies. Accordingly, overheating pressures are starting to materialize in some cases. Consumer prices in these economies are projected to rise 6 percent this year, an upward revision of ¾ percentage point relative to the October 2010 WEO. Signs of overheating are also becoming apparent in some countries via rapid credit growth or rising asset prices. The picture is quite different in advanced economies, where still-ample economic slack and well-anchored inflation expectations will generally keep inflation pressures subdued. Inflation is expected to remain at 1½ percent this year, unchanged from 2010 and a slight upward revision from the October 2010 WEO. Downside risks remain elevated Downside risks arise from the possibility of tensions in the euro area periphery spreading to the core of Europe; the lack of progress in formulating medium-term fiscal consolidation plans in major advanced economies; the continued weakness of the U.S. real estate market; high commodity prices; and overheating and the potential for boom-bust cycles in emerging markets. On the upside, there are risks from stronger-than-expected business investment rebounds in major advanced economies. The risk of financial turmoil spreading from the periphery to the core of Europe is a by-product of continuing weakness among financial institutions in many of the region’s advanced economies, and a lack of transparency about their exposures. As a result, financial institutions and sovereigns are closely linked, with spillovers between the two sectors occurring in both directions. Although the periphery accounts for only a small portion of the euro area’s overall output and trade, substantial financial linkages with countries in the core, as well as financial spillovers through higher risk aversion and lower equity prices, could generate a slowdown in growth and demand that would hinder the global recovery. In particular, continued market pressures could result in serious funding pressures for major banks and sovereigns, increasing the likelihood that problems spill over to core countries. Figure 4 (CSV|PDF) presents an alternative scenario that illustrates how larger spillovers can subtract from growth. The scenario—which is broadly similar to the one presented in the July 2010 WEO Update—assumes that a large shock followed by insufficiently rapid and strong policy action results in significant losses on securities and credit in the euro area periphery. This causes capital ratios to fall substantially in several countries, both in the periphery and the core. Under such a scenario, European banks tighten lending conditions by a similar magnitude as during the collapse of Lehman Brothers in 2008. As a result, euro area growth is reduced by about 2½ percentage points relative to the baseline. Assuming that financial spillovers to the rest of the world are limited—with the increase in bank-lending tightness in the United States about half that in Europe—global growth in 2011 is lower by about 1 percentage point than in the baseline. But if financial contagion to the rest of the world is more severe—resulting in a spike in generalized risk aversion, a drying up of liquidity, and sharp falls in equity markets—the impact on global growth would be substantially larger, amplified by balance sheet weaknesses in other major advanced economies. Another downside risk stems from insufficient progress in developing medium-term fiscal consolidation plans in large advanced economies. The recently implemented stimulus measures in the United States and Japan make it more challenging to ensure medium-term fiscal sustainability. Therefore, it has become even more important to formulate more credible plans to bring debt down over the medium term. On the upside, business investment could rebound faster than currently expected in key advanced economies, underpinned by strong corporate sector profitability. In emerging economies, key risks relate to overheating, a rapid rise of inflation pressures, and the possibility of a hard landing. In the near term, upside risks to growth have risen, driven by accommodative policies, strong terms-of-trade gains for commodity exporters, and resurgent capital inflows. If, however, policymakers fall behind the curve in responding to nascent overheating pressures and asset price bubbles, macroeconomic policies in key emerging economies could be setting the stage for boom-bust dynamics in real estate and credit markets and, eventually, a hard landing in these economies. With emerging markets now accounting for almost 40 percent of global consumption and more than two-thirds of global growth, a slowdown in these economies would deal a serious blow to the global recovery—and to the rebalancing that needs to take place. Decisive policy actions are needed to lessen risks and sustain growth Despite the signs of near-term decoupling—between the periphery and core of Europe, between financial stresses and the real economy, and between advanced and emerging economies—the global economy remains tightly interconnected. A host of measures are needed in different countries to reduce vulnerabilities and rebalance growth in order to strengthen and sustain global growth in the years to come. In the advanced economies, the most pressing needs are to alleviate financial stress in the euro area and to push forward with needed repairs and reforms of the financial system as well as with medium-term fiscal consolidation. Such growth-enhancing policies would help address persistently high unemployment, a key challenge for these economies. They would also produce beneficial spillovers to emerging economies, where the main policy challenge is to respond appropriately to capital inflows, keep overheating pressures in check, and facilitate external rebalancing. In the euro area, comprehensive, rapid, and decisive policy actions are required to address downside risks. Important steps at both the national and the euro-area-wide level have been taken since May, including measures to strengthen fiscal balances and introduce structural reforms, the stepping up of extraordinary liquidity support and the introduction of the Securities Markets Program by the European Central Bank (ECB), and the establishment of the temporary European Financial Stability Facility (EFSF), to be succeeded by the permanent European Stability Mechanism (ESM) after 2013. But additional strengthening of national policy actions to further secure fiscal sustainability and rekindle growth continues to be key in many countries. Markets remain skittish about potential losses in the region’s banks and have not been assuaged by stress tests conducted to date. New stress tests that are more realistic, thorough, and stringent will increase clarity. They will need to be followed quickly by recapitalization. Markets also need to be reassured that sufficient resources are available from the center to deal with downside risks and that the overall policy approach is consistent. Hence the EFSF as well as the envisioned permanent ESM must have the ability to raise sufficient resources and deploy them in a flexible manner, as needed. In the meantime, the ECB will need to continue to provide liquidity and remain active in securities purchases to help preserve financial stability. More generally in the advanced economies, there is a need for continued progress to repair and reform financial systems. This is a critical element of the normalization of credit conditions and would help reduce the burden on monetary and fiscal policy to support the recovery. The specific financial sector policies needed are discussed in more detail in the January 2011 Global Financial Stability Report Update. The vulnerability of sovereigns emphasizes the urgency of moving toward more sustainable fiscal paths—not just by countries in the euro area periphery, but also by major advanced economies. In the near term, emerging signs of a handoff from public to private demand in many large advanced economies suggests that countries can push forward in formulating and implementing credible medium-term consolidation plans. Although some targeted measures in the United States are justifiable at this juncture given the still weak labor and housing markets, the recently implemented stimulus is expected to deliver only a relatively small growth dividend (given its size) at a considerable fiscal cost. The U.S. fiscal deficit is now projected at 10¾ percent in 2011 (more than double that in the euro area), and gross government debt is projected to exceed 110 percent of GDP in 2016. The absence of a credible, medium-term fiscal strategy would eventually drive up U.S. interest rates, which could prove disruptive for global financial markets and for the world economy. It is thus even more critical that policies be put in place to bring debt down over the medium term. Such measures could include entitlement reforms, caps on discretionary spending, reforms of the tax system to boost fiscal revenue, and the establishment or strengthening of fiscal institutions. Fiscal issues are discussed in more detail in the January 2011 Fiscal Monitor Update. At the same time, monetary accommodation needs to continue in the advanced economies. As long as inflation expectations remain anchored and unemployment stays high, this is the right policy from a domestic perspective. Furthermore, it seems to have had an effect: following the news in August that a second round of quantitative easing was imminent, long-term rates fell to new lows in the United States. Although U.S. Treasury yields have since increased, particularly in the last quarter of 2010, this seems primarily attributable to the improving outlook for the U.S. economy, a fact corroborated by the strong performance of equity markets. From an external perspective, however, there is concern that quantitative easing in the United States could result in a flood of capital outflows toward emerging markets. The recent slowdown in capital inflows to emerging markets suggests that such effects may be limited so far (Figure 5: CSV|PDF). In contrast, monetary tightening should begin or continue in emerging economies where overheating pressures are starting to emerge. Recent policy rate hikes by various countries are welcome in this regard, although in some of them more nominal exchange rate appreciation would have been preferable. Such tightening can, however, exacerbate the strong capital inflows that many of these economies are now experiencing. Therefore, prudential measures to keep increases in credit or asset markets from becoming excessive should also be considered. The renewed surge in capital inflows to some emerging markets, whether driven by stronger fundamentals in the emerging economies themselves or by looser monetary policy in advanced economies, requires an appropriate policy response. A number of these economies quickly overcame the crisis and have continued to run current account surpluses (Figure 6: CSV|PDF), yet their real effective exchange rates remain close to precrisis levels—that is, the response to renewed capital inflows has been to accumulate even more foreign exchange reserves. For these countries, allowing the currency to appreciate would help combat overheating pressures and facilitate a healthy rebalancing from external to domestic demand. In other countries where the currency is above levels consistent with medium-term fundamentals, fiscal adjustment can help lower interest rates and restrain domestic demand. Macroeconomic policy responses may, however, need to be complemented by strengthened macro-prudential measures (for example, higher loan-to-value ratios, funding composition restrictions) and, in some cases, capital controls.