In the two months since the premiere issue of this bulletin appeared, the preconditions for economic recovery have begun to develop. Most importantly, the global credit crunch is easing and blood is beginning to flow to the patient’s heart again. Signs of stabilization―though scattered and sometimes contradictory―have begun to emerge. 

However, it is still too early to say that a sustained recovery is imminent. Global industrial production is currently down about 13 percent over last year, and while it may rise in the coming months due to inventory correction, the outlook beyond remains murky. GDP forecasts for 2009 are still being marked down to reflect a weaker than expected start to the year. World GDP is expected to decline by 2.5 to 3.5 percent this year and world trade is expected to drop by 12 to 15 percent―only the second year since World War II in which world trade has fallen.

The preconditions for economic recovery have begun to develop, but it is still too early to say that a sustained recovery is imminent.

These rates of decline are almost without precedent, and, even as they abate, they continue to place enormous strain on firms, households, and governments across the world, indicating that recovery could take much longer than the rebounding stock market implies. As the G8 heads of state prepare to meet in L’Aquila early next month, they must resist the growing chorus of voices arguing for withdrawal or dilution of stabilization measures such as fiscal stimulus and bank rescues. In the current circumstances, withdrawing support too early carries much greater risks than maintaining it for too long.

Preconditions for a Recovery

One can identify four developments that have significantly improved the likelihood that a recovery will begin in the next year. Together, these developments may well have averted a descent into global depression.

First, financial rescue operations―including stress tests in the United States―and massive liquidity injections have helped reestablish confidence in the banks, whose profitability has also been boosted by the steepening yield curve. Though credit remains tight relative to historical norms, it is becoming more readily available, and risk premia have declined across the board. Interbank lending spreads have narrowed by 280 basis points since their October panic high, and corporate bond spreads have declined by 248 basis points since March.

The sharp rise in yields on ten-year government bonds in recent months has fueled fears that inflationary expectations are taking hold; long-term interest rates in developed countries have risen by 0.75 percent to 1.75 percent since bottoming out in December. However, increases have so far mainly affected government bonds in developed countries and (modestly) U.S. mortgage rates, not corporations or emerging markets. This suggests that the real catalysts may be an oversupply of long-dated government paper and a return of confidence that reduces demand for safe, low return investments.

Second, investors are showing a greater appetite for risk. Equities have surged 39 percent since they hit bottom at the beginning of March. The boost has contributed to stronger consumer balance sheets and has opened the door for banks and non-financial corporations to raise new capital by issuing equities or selling assets.

Third, fiscal stimulus is now beginning to flow into the spending stream. Personal, after-tax income in the United States has grown at a strong 8.3 percent annual rate so far this year, reflecting tax rebates and help from other income-support programs. In China, private consumption rose 11 percent year-over-year in the first quarter, aided by various government stimulus measures.

Fourth, emerging markets have seen a remarkable improvement, benefiting immensely from the easing of the credit crunch and recovering commodity prices. Though several countries in Eastern Europe and the Baltics remain vulnerable to a protracted recession and confidence shifts, many emerging markets have sound fundamentals and are seeing a cessation or even reversal of capital outflows. Steps to recapitalize the International Monetary Fund, establish new credit lines, and engage in currency swaps with central banks in emerging markets have helped, too. The EMBI spread has declined from 695 basis points in early March to 412 basis points as of mid-June and stock markets are up by nearly 40 percent since the start of the year. The receding fear of capital flight has allowed room for counter-cyclical policies.

What did not happen is also important. Despite many new protectionist measures and an increase in anti-dumping initiations, world markets have remained open and trade disputes have remained within the historical norm.
Indications of Stabilization

Thankfully, history’s sharpest recorded drop in production and trade appears to have slowed. Across a large swath of countries, beginning with the United States, manufacturing activity has been declining much less sharply and some Purchasing Manager surveys are pointing to further improvement in the coming months. This, together with easing credit, represents the most tangible sign that massive government interventions are working to stem the tide.

Purchasing Managers Index(PMI)* Industrial Production, 3m/3m saar
Country May-09т % change from 3 months ago % change from a month ago April-09
United States 42.8 0.196 0.067 -16.5
China 53.5 0.181 0.021 8.6
Japan 46.6 0.475 0.126 -48.9
Germany 39.1 0.245 0.105 -34
UK 42.9 0.198 0.086 -19.4(March)
France 42.9 0.058 0.099 -24.7(March)
Canada 53.7 0.488 0.243 -20.9(March)
Russia 45.3 0.116 0.044 -1.6
Brazil 44.8 0.176 0.062 -1.6
India 55.7 0.185 0.045 -1.5(March)
* Below 50 represents a contraction in activity
Т: latest PMI for France, Canada and Brazil is March.
Source: PMI data from Bloomberg L.P., Industrial Production data from World Bank.

Improvement is particularly noticeable in Asia, the region most highly dependent on manufactured exports. Helped by the relative resilience of China and India, a sharp improvement in Japan’s manufacturing output (albeit from extremely low levels), and the beginnings of stabilization of intra-Asian trade, the region will probably register significant positive growth in the current quarter. According to JP Morgan, Japanese GDP will grow by 2.5 percent this quarter, and the rest of Asia will see growth of 6.1 percent.

Given the region’s size and underlying dynamism, an early recovery in Asia would provide a major prop to global recovery. Even in the years before the crisis, Asia accounted for a large share of world growth. The relative soundness of Asian banks and the region’s insulation from financial contagion also suggest that once recovery takes hold in the region, it is likely to be sustained.

It is Too Early to Proclaim a Global Recovery

However, these improvements must be put in context. Global manufacturing activity has reached very great depths and is still declining―albeit more slowly―in many instances. Further, much of the stabilization can be attributed to the need for manufacturers around the world to restock. During the panic in fall 2008, production declined much more quickly than final demand. Once the adjustment in inventories is complete, however, the growth in production will only be sustained if final demand grows. That will depend on the recovery of the highly cyclical housing and automobile markets in the world’s largest economies.

There are already some signs of recovery. In the United States, pending home sales climbed 6.7 percent between March and April, and auto sales rose to an annual rate of 9.9 million units in May, up from an average of 9.5 million in the first four months of the year. However, these increases are also occurring from extremely low levels and are benefiting from the temporary help of various government incentives and income tax cuts.

With unemployment rising sharply (to 9.4 percent in the United States and 9.2 percent in the euro-zone), mortgage rates possibly increasing further, and oil prices headed higher, demand still faces considerable headwinds. Further, the overbuilding of houses and overproduction of automobiles preceding this episode suggest caution in expecting large pent-up demand to manifest itself anytime soon.

These improvements must be put in context. Global manufacturing activity has reached very great depths and is still declining in many instances.

Large declines in European industrial production and German exports also suggest caution. European banks have proved just as vulnerable to the downturn as those in the United States, and Germany and several smaller European economies have been among the hardest hit by the collapse in world trade.

Yet the European policy response, particularly in the areas of bank rescue and monetary policy, has been less aggressive than that of the United States. Large as the long-term benefits of a common currency may prove to be, constraints on euro-zone members as they contend with big asymmetric shocks are evident. Rigidities in European labor, product, and capital markets make the adjustment more difficult than in other regions.

The strains of recession are most likely to lead to new shocks in Europe and along its periphery. These could still come from the failure of other large banks, perhaps associated with a collapse of currency pegs in the Baltics and spillover onto other countries in Eastern Europe. The repeated downgrading of sovereign credit ratings such as that of Ireland, for example, could yet be a harbinger of much bigger problems. The longer the recession persists, the greater these strains are likely to become.

Policies Must Remain Proactive

Under any recovery scenario, the complex game of withdrawing fiscal stimulus and reabsorbing liquidity to avoid inflation is unlikely to unfold smoothly. The uncertainties associated with this process are considerable.

Still, strong stimulus and financial rescue policies must continue. Indeed, policy makers should have contingency plans on hand to step up these efforts in the event of a relapse. Multilateral institutions should also be strengthened; the IMF must be recapitalized, and the WTO needs greater teeth for its surveillance of protectionism.

Beginning to withdraw stimulus now would be an error of historic proportions.

The most acute phase of this crisis may be behind us, but its lessons are still being drawn. This is the time―when panic has receded and while memories are fresh―to move forward on new regulations designed to avoid a repeat. The need to extend the regulatory net so that it covers all systemically important financial firms, including investment banks, hedge funds, and insurance companies, and to improve the transparency of derivatives markets, such as credit default swaps and mortgage-backed securities, is a central lesson of the crisis.

Action on these reforms is bound to be overwhelmingly the province of national political processes and agencies. Nevertheless, the G8, G20, and various international forums can play a crucial role in promoting standards, motivating action at the country level, and reducing the risk of international regulatory competition.

In conclusion, the patient is stable but cannot be taken out of intensive care. Global activity is falling at a slower rate, but it is still falling. Stabilization policies are only just beginning to have their desired effects and the return of confidence is fragile. Beginning to withdraw stimulus now would be an error of historic proportions.