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Recent trends in the global economy and near term outlook

Andris Strazds

Adviser

04.11.2014

Global Economy

Where is the growth?

Source: IMF’s World Economic Outlook, October 2014

Global activity and trade in the first half of 2014 were weaker than expected


Growth in emerging market economies is slowing down


The U.S. economy is back on track


The shale energy boom has played an important role in the U.S. recovery

Recovery in the euro area is still fragile

GDP growth (annualized quarterly percentage change)


Sovereign bond spreads in the euro area have come down, but differences in lending conditions to SMEs are still substantial


Asset quality review by the ECB a significant step towards getting lending in the euro zone going again

• The ECB is taking over supervision of the largest euro area banks from the national regulators on 4 November 2014

• The asset quality review and stress tests carried out earlier this year identified capital shortfalls totalling EUR 25 billion at 25 euro area banks

• Banks with shortfalls to submit capital plans by 10 November 2014

• Banks with capital shortfalls will have 6 – 9 months to remedy the situation

• Improved bank capitalization should contribute to recovery of the lending market in euro area

European CIS countries are close to stagnation


Growth in Asia is holding up


Overview of the World Economic Outlook projections by the IMF

Overview of Euro area projections by the European Commission

Inflation in the euro area below that in the U.S. and the medium term target of close to but below 2%


Central Bank balance sheet paths to diverge going forward

• The U.S. Fed announced the end of Quantitative Easing on 29 October 2014

• The ECB announced additional monetary policy easing in June and September of 2014 and started purchases of asset backed securities (ABS) in October 2014

• Bank of Japan is continuing agressive monetary easing

U.S. Fed expected to start raising rates in 2015


Key near term risks going forward

• Geopolitical risks

• Risks from a financial market correction

• Volatility resulting from monetary policy normalization in the United States

• Protracted period of low inflation in the euro area

• Risk of stagnation and lower potential growth in a number of advanced economies

• Considerably slower growth in China

Policy recommendations

• Both continued support to demand and supply side policies needed

• Increased public investment in most current account surplus countries (other than China)

• (Continued) structural reforms in the (former) current account deficit countries

• Macroprudential tools (such as loan-to-value, debt-service-to-income ratios) to limit credit booms in a number of smaller advanced economies

Policy recommendations: Euro area

• Reestablish confidence in banks and improve financial intermediation in the euro area

• Cost-effective active labor market policies, measures to lower the opportunity cost of employment, and better-targeted training programs

• Complete the single market in services, including a single digital market

• Make progress with free trade agreements

• More closely integrate energy platforms and policies

Fiscal Outlook

The fiscal outlook

• Immediate fiscal pressures have lowered (due to low interest rates)

• However, underlying fiscal vulnerabilities persist (as shown by high debt levels)

• Moreover, growth is weaker than expected and inflation remains low

Advanced economies: Proceeding with consolidation while supporting employment and growth

Emerging market economies: Consolidation postponed; It is time to rebuild fiscal buffers

Job creation is at the top of political agenda

• Global unemployment exceeds 200 million people

• In AEs: raising concerns about permanent skills and human capital erosion associated with long-term unemployment and inactivity

• In EMEs: informality remains high and job creation insufficient to absorb the large number of young people entering the labor market

Do lower taxes mean higher employment?

Impact of social security contribution (SSC) cuts

Targeted SSC cuts: Successful examples

Targeted SSC cuts: Not so successful examples

Financial Stability

Global financial stability assessment

• An increase in risk appetite has driven the search for yield and pushed up market and liquidity risks

• Credit risks have declined, reflecting favorable funding conditions and improved asset quality

Accommodative monetary policies have led to

• Increased economic risk taking

– Improving the outlook for capital expenditure (especially in Japan, the US, and the UK)

• And possibly too much financial risk taking, as reflected in

– Compressed credit spreads

– Low volatility

– Elevated and highly correlated asset prices

Banks have become stronger

But they also need to adjust business models

• Return-on-equity has fallen to a historically low level.

• Investors demand high returns from banks, with the cost of equity having risen since before the crisis

• As a result, banks accounting for 80% of total assets of the largest institutions currently have a so-called “return-on-equity gap”

Transition needs are large

What should banks do?

• Reprice current business lines

• Re-allocate capital away from low-risk assets

• Retrench from some activities

• Restructure weak banks

• Resolve unviable banks

• Move away from cross-subsidization

Shadow banking has increased

• Financial intermediaries or activities involved in credit intermediation outside the regular banking system, and thus lacking a formal safety net

It constitutes about one-fourth of total financial intermediation worldwide

Benefits and risks of shadow banking

• Can complement traditional banking by expanding access to credit or by supporting market liquidity, maturity transformation, and risk sharing

• The global financial crisis revealed that, absent adequate regulation, shadow banking can put the stability of the financial system at risk

• However, assessing risks associated with recent developments in shadow banking remains difficult, largely because of a lack of detailed data

Role of financial policy

• Support Economic Risk Taking

– Improve flow of credit to the economy

• Facilitate banks’ transition to new business models

• Encourage (safe) non-bank credit

• Address Excessive Financial Risk Taking

– Macroprudential policies as a first line of defense

– Address rising market liquidity risks in shadow banking

• Prevent market runs

• Prepare contingency measures