Exit strategies for recovery from the global recession

Following the deepest global recession in recent history, the global recovery is off to a stronger start than we had earlier anticipated.

The International Monetary Fund expects global output to rise by 4 per cent in 2010.

But the recovery is proceeding at different speeds across the various regions and is still heavily dependent on extraordinary policy support.

In most advanced economies, growth is likely to be sluggish.

The recovery is being led by key emerging Asian economies, notably China, India, Indonesia, and Korea thanks to buoyant domestic demand and stimulus measures.

Policymakers now face a critical policy challenge.

Given the still-fragile nature of the recovery, withdrawing policy support too early may undermine growth momentum, while leaving policy support for too long could lead to overheating and asset bubbles.

The key challenge remains to exit at the right time, pace and sequencing.

Macroeconomic policy stimulus should be maintained in major advanced countries, but may need to be unwound sooner in key emerging markets.

In advanced economies where the recovery is expected to be weak, central banks should maintain low interest rates in 2010 given that underlying inflation is expected to remain subdued and unemployment is expected to remain high.

On the fiscal front, due to the still-fragile nature of the recovery, policies need to remain supportive of economic activity in the near term and the stimulus planned for 2010 should be implemented.

Growing concerns

However, countries facing growing concerns about fiscal sustainability need credible medium-term consolidation plans.

Financial markets have recovered strongly since the peak of the crisis, thanks to improving economic fundamentals and policy support.

Risk appetite has returned, equity markets have improved, corporate bond issuance has reached record levels, and capital markets have re-opened.

As a result, systemic risk receded somewhat. All this is good news.

However financial stability remains fragile.

Continued de-leveraging pressure on banks suggests that bank credit will remain weak for some time.

New risks are emerging as a result of the extraordinary policy support.

Concerns over sustainability and political uncertainty have led to a widening of the sovereign spreads in some small countries in Europe.

There is a risk that public debt issuance in the coming years could crowd out private sector credit growth, gradually raising interest rates for private and public borrowers and putting a drag on the economic recovery.

In other countries much work is still needed to repair damage to the financial system from the crisis.

In many advanced countries and some hard-hit emerging market countries, banking systems are still stressed and unable to play a proper role in channeling credit to worthy borrowers.

In most advanced economies, policymakers still have to address an overhang of bad loans.

Moreover, bank restructuring needs to gain pace, including through liquidation of nonviable financial institutions.

The absorption of failed financial institutions has led to an exacerbation of the “too-important-to-fail” problem and the associated moral hazard.

The shortening of bank funding maturities is raising the need to address a rapidly advancing “wall of maturities”.

This leads me to my next topic—regulatory reform.

Major failures of regulation and supervision created dangerous financial fragilities that led to the current crisis.

The major regulatory reform proposals are centered on strengthening bank capital and liquidity.

Some enhancements to the Basel II capital framework were announced in July 2009, to be implemented by end 2010.

Financial system

How should a new financial system look?

The IMF is working with the Financial Stability Board and other international agencies to craft a more stable and secure financial system.

The new regulatory framework should put more weight on financial stability.

But avoiding excessive regulation that could stifle innovation and the benefits of a more globally integrated financial system is important.

The increased regulatory burden imposed by higher capital and liquidity requirements is likely to lower returns, increase the cost of capital, and restrain risk-taking.

The IMF has a role in helping countries transition to a healthier financial system, and in ensuring a level playing field.

One point is clear. We cannot return to the financial system of yesterday.

We must move forward to set up a financial system where macro and micro regulations complement each other and help to reduce systemic risks.

To tackle all these challenges, international policy collaboration will need to be more effective.

The G-20 has emerged as a key forum for the world’s major economies to discuss policy priorities.

The G-20 leaders launched a framework for strong, sustainable and balanced global growth.

Re-balancing growth

Going forward, re-balancing growth is essential.

This will require shifting toward internal demand in economies with large and persistent current account surpluses and shifting toward external demand in economies with large and persistent current account deficits.

To achieve strong, sustainable, and balanced global growth will require collaborative policy efforts by both advanced and emerging economies.

The G-20 has asked the IMF to assist countries by developing an analysis of the consistency of individual country policy frameworks.

In this way, the world’s largest economies will be accountable to each other for adopting policies needed to ensure strong, stable and sustainable growth.

Portugal is the Deputy Managing Director, IMF.