Financial turbulence complicates global recovery, says IMF

The world economy looks like an obstacle course in a thick fog. After the pandemic came the war in Ukraine, and just when things seemed to be looking up, financial turbulence is now clouding the outlook. Following an upward revision of two-tenths of a percentage point at the end of January, the International Monetary Fund (IMF) has lowered its growth forecast for the global economy this year by one tenth of a point to 2.8%, according to its World Economic Outlook report presented Tuesday at the agency’s spring meetings in Washington D.C.

Pierre-Olivier Gourinchas, Economic Counsellor and Director of Research at the IMF, took the opportunity to stress that the IMF had already warned in October that the next risk on the list was a financial crisis. However, the storm seems to be abating and the central scenario that the agency is handling is that the crisis caused by the collapse of Silicon Valley Bank, Signature Bank and Credit Suisse has been “contained.” Hence, the impact on global forecasts is expected to be small. The IMF has lowered its growth forecast for 2024 by another tenth of a point to 3.0%.

In fact, the year had started with a handful of good news. “The reopened Chinese economy is rebounding strongly. Supply chain disruptions are dissipating, while war-induced disruptions in energy and food markets are abating. Simultaneously, the massive and synchronized tightening of monetary policy by most central banks should start to bear fruit, with inflation moving back towards target,” said Gourinchas.

However, “tentative signs in early 2023 that the world economy could achieve a soft landing — with inflation coming down and growth steady — have receded amid stubbornly high inflation and recent financial sector turmoil.”

After 3.4% growth in 2022, the world economy will slow down this year because of developed countries, especially in Europe. Eurozone growth will fall from 3.5% in 2022 to 0.8% this year, according to IMF estimates, which even expect a 0.1% contraction in Germany. Spain, lagging behind in the recovery from the pandemic, will grow by 1.5% this year, double that of Italy and France, but far from the 5.5% of 2022. And the United Kingdom will go from posting 4% growth last year to a 0.3% drop in the economy in 2023. The United States is holding up better, sliding from 2.1% in 2022 to 1.6% this year and 1.1% in 2024.

Meanwhile, growth will hardly slow down in the emerging countries as a whole and will accelerate in some of them, with China and India as the main drivers. Latin America, however, will also slow down: after posting 4% growth in 2022, it will grow by only 1.6% this year and 2.2% next year. For Brazil, the IMF is forecasting an increase in gross domestic product (GDP) of 0.9% this year and 1.5% in 2023, while Mexico is expected to experience GDP growth of 1.8% and 1.6%.

Gourinchas warned that inflation has become somewhat more entrenched than expected. The headline rate is falling sharply because of the staggering effect, discounting energy and food price increases from a year ago, when the Ukraine war began. However, core inflation, which excludes energy and food, has not yet peaked in many countries.

The Fund’s chief economist stressed the labor market’s resilience to tighter monetary conditions. He is not convinced that there is a risk of an uncontrolled wage-price spiral. Rather, he believes that companies have been able to defend margins by raising prices without raising wages at the same pace and should be able to absorb some recovery in real wages.

But beyond inflation, the other risk that Gourinchas dwelled on in “I-told-you-so” style is the financial one: “More worrisome are the side effects that the sharp monetary policy tightening of the last year is starting to have on the financial sector, as we have repeatedly warned might happen. Perhaps the surprise is that it took so long. Following a prolonged period of muted inflation and low interest rates, the financial sector had become too complacent about maturity and liquidity mismatches. Last year’s rapid tightening of monetary policy triggered sizable losses on long-term fixed-income assets and raised funding costs.”

After a prolonged period of subdued inflation and low interest rates, he explained, the financial sector had become too complacent about maturity and liquidity mismatches. The rapid tightening of monetary policy over the past year has led to substantial losses on long-term fixed-income assets and raised funding costs.

But in both the brief instability in the UK bond market last fall and the recent banking turmoil in the United States, “financial and monetary authorities took quick and strong action and, so far, have prevented further instability.”

The financial storm, therefore, is adding uncertainty, but so far it has not taken a very severe toll. The IMF has calculated alternative scenarios. In one, banks, faced with rising financing costs and the need to act more prudently, reduce lending further, which would lead to a three-tenths of a percentage point reduction in growth this year.

In another, much more severe scenario, a sharp tightening of global financial conditions— a so-called ‘risk-off’ event —could have a dramatic impact on credit conditions and public finances, especially in emerging market and developing economies. It would precipitate large capital outflows, a sudden five percent increase in yield spreads, a dollar appreciation in a rush to safety, and major declines in global activity amid lower confidence, household spending and investment. “In such a severe downside scenario, global growth could slow to one percent this year, implying near stagnant income per capita. We estimate the probability of such an outcome at about 15 percent,“ says the report. A 15% probability of occurrence is a little harder than rolling a 6 on a die.

Therefore, the IMF stresses that regulators and supervisors must act now to ensure that financial fragilities do not lead to a full-blown crisis by strengthening surveillance and actively managing market stress. It also indicates that in the event of a systemic financial crisis looming, it will be necessary to adjust economic and monetary policy to safeguard both the financial system and activity. “It is important to stress that this is not where we are, even if more financial tremors are bound to occur,” Gourinchas stressed.

Very subdued growth, inflation that refuses to let up, and rising financial risks are all threatening the recovery of an economy that is also facing a long phase of low growth of around 3% per annum over the next five years, the lowest since 1990. The world has a rocky road ahead, says the Fund.

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