As we tried to convey in the Greenbook, the staff outlook for the global economy over the remainder of this year and next is a bit weaker than last time and less certain. The factors behind this change in tone with respect to global prospects can be grouped into three categories: (1) recent developments that are broadly global in nature, in particular global financial market developments; (2) consequences for key foreign economies of the downward revision to our forecast for U.S. real growth; and (3) developments that essentially are external to the U.S. economy and are being driven by economic and political shocks abroad.
The sharp decline and heightened volatility in equity prices over the intermeeting period was a common feature across most global stock markets. European equity prices were particularly hard hit. As in the United States, the effects of the resulting loss of wealth on total spending are partially offset by the declines that have occurred in many long-term interest rates. But long rates in the other major industrial countries generally moved down less than did those in U.S. markets. Although foreign stock markets seemed to take their cue primarily from movements in U.S. markets, issues of corporate governance and accounting accuracy have also arisen with respect to some large foreign firms. And a general reduction in the willingness on the part of investors to bear risk seems to be widespread. Certain sectors, such as European insurance firms, have been particularly penalized in the current market environment.
We expect that these less favorable financial conditions will weigh on confidence and spending abroad. Indeed, we have some early readings on confidence that indicate such a reaction. Negative wealth effects are to be expected particularly in the United Kingdom and Canada, where our research tells us that consumers are quite sensitive to wealth changes. The contractionary effects of these financial market developments should be cushioned, however, by the absence of monetary tightening on the part of most major foreign central banks in the near term. Although in June we had incorporated such tightening into the forecast, we share the view currently reflected in short-term interest rate futures that monetary policy will remain generally accommodative into next year in the major foreign industrial countries.
As we noted in the Greenbook, several of the regions that evidenced strength in the first half of the year, in some cases more than we were expecting, depended for that strength on their export sectors. This was the case in Japan, in emerging Asia, and to some extent in Europe. For Japan and emerging Asia, a significant part of the rebound in exports was in the high-tech sector. Continued recovery in that sector depends broadly on global developments. But a key risk to ongoing expansion in these export-dependent economies is a negative surprise in U.S. output growth.
The downward revision made to the outlook for the U.S. economy fed directly into our less optimistic outlooks for Canada and Mexico. Canada has been something of an outlier among the industrial countries during the first half of this year, recording rapid output growth in both quarters and strength in final domestic demand. In response, the Bank of Canada has raised its policy rate a total of 75 basis points since April. We expect Canadian growth to slow to a more sustainable rate, and we have edged projected growth down a bit more to reflect the somewhat weaker path for U.S. real GDP this time than in the June Greenbook. Similarly, we are looking for recovery to become established in Mexico, the one bright spot in our outlook for Latin America. However, we have shaded our projection for Mexico in light of the less favorable U.S. projection.
Finally, a series of developments in the past several weeks in a few foreign countries, importantly several in South America, have cast significant gloom over the foreign outlook. To some degree, problems in these countries have interacted to reinforce the negative effects being felt in each and to raise the risk of a serious collapse in economic activity and stability in the region. Because of the size of its economy and the extent of its participation in global financial markets, Brazil is arguably the most important of the potential crises brewing in South America.
The proximate cause of Brazil’s current financial distress is concern on the part of investors, both domestic and foreign, about the future course of economic policy in Brazil as a result of the election to be held in October. The current government has generally followed policies since the January 1999 crisis that have met with market approval. But there is nothing that this government can do to ensure the continuation of such policies. And statements alone by the candidates have not been reassuring to markets, especially in light of the long-standing differences in political positions and sources of support of the three principal candidates. Spreads on Brazilian dollar- denominated debt rose from 1,500 basis points to around 2,400 basis points over less than two weeks, as political news swayed markets. Reports circulated that international banks were withdrawing trade credits and similar short-term lines.
After the Greenbook was finalized, the IMF announced an extension and enlargement of Brazil’s existing IMF program that will total about $30 billion. One important feature of this new program is that only $6 billion is to be disbursed this year, with the remainder slated for 2003, after the new government is in place. Thus the program should create strong incentives for the new government, regardless of who wins, to follow policies consistent with the program in order to obtain those funds. Market participants now understand that those incentives are in place and that, because of the IMF commitment, the Brazilian government could have sufficient resources to manage its sovereign debt in 2003.
To be successful the program has to result in lower spreads and improved
exchange rate stability for Brazil following the election and perhaps much sooner. To
help in that regard, the program gives Brazilian officials more scope to use their
existing reserves to provide liquidity to bond markets and to intervene in the foreign
exchange market. Although the program is large and designed to reassure markets, it
is something of a gamble. Enough capital needs to remain in Brazil for the private
economy to function reasonably between now and the election. After the election,
market-compatible policies need to be followed—either because of the incentives
created by the IMF program or because, once elected, the new president will have to
weigh election rhetoric against the cold light of reality in making his choices.
Following the announcement, spreads first narrowed sharply and the real appreciated.
However, investor enthusiasm for the loan package is already waning. The real has
subsequently more than reversed its post-announcement gains, despite intervention
support for the currency, and spreads have backed up to more than 2,300 basis points.
The Greenbook baseline forecast is for Brazil to weather this storm. Output is
expected to stagnate during the rest of this year, as turbulent financial conditions and
heightened uncertainty disrupt economic activity. But low growth is projected to
resume next year as financial conditions improve. However, the risk that financial
conditions will instead deteriorate further and force some kind of debt standstill
and/or capital controls before the election even takes place is certainly present. In
that situation, the incentives for the new government, once elected, to follow market-
compatible policies would be greatly reduced. If that is the course followed by
Brazil, the pressures on other South American countries and their financial systems
will intensify and prospects for even low growth of economic activity in the region
will be sharply reduced. That concludes our report. We’d be happy to take any