Disclaimer: The following article is based on a lecture by Professor Pierre-Olivier Gourinchas, Economic Counsellor of the International Monetary Fund, at the Lee Kuan Yew School of Public Policy on 1 February 2023, chaired by Professor Danny Quah, Dean and Li Ka Shing Professor in Economics, Lee Kuan Yew School of Public Policy. It should be noted that the IMF has since launched its latest edition of the World Economic Outlook (WEO) on 11 April 2023, which includes updated projections and policy recommendations here.
Professor Pierre-Olivier Gourinchas, Economic Counsellor and Director of the Research Department, International Monetary Fund (IMF), said it's always a "delicate exercise" to anticipate when we reach a turning point. But he made a convincing argument for just that at his recent public lecture held at the Lee Kuan Yew School of Public Policy.
Prof Gourinchas discussed the developments shaping the global economic outlook and the IMF’s latest growth and inflation forecasts at the lecture, chaired by Professor Danny Quah, Dean and Li Ka Shing Professor in Economics, Lee Kuan Yew School of Public Policy.
According to Prof Gourinchas, the global economy could be reaching a turning point, with growth projected to bottom out in 2023 and then gradually improve. The IMF projects global growth of about 2.9 per cent for 2023, with advanced economies bottoming out and starting to grow and inflation decreasing. While there are risks associated with any forecasting exercise, the outlook is somewhat more optimistic than it was in October 2021, due to resilience in many parts of the world.
Resilience
One key factor in this resilience has been households' ability to maintain spending despite rising inflation. Businesses, too, have been able to maintain levels of investment thanks in part to accumulated buffers and excess savings from pandemic support.
Moreover, labour markets are tight in many parts of the world, with unemployment rates at historical lows. Even in the face of supply chain disruptions, such as the "pretty dramatic" recent energy crisis caused by the interruption of Russian gas flows to Europe, many European countries have been able to handle the crisis with the help of government support.
While there are still risks to the baseline scenario, there are also ways in which the global economy could surprise on the upside. The IMF noted that the speed at which disinflation is happening without a corresponding increase in unemployment rates suggests that we may be on a steep part of the supply curve. Faster disinflation could occur without significant job losses.
Yet the fight against inflation is not over, as core inflation remains well above central bank targets in many countries. As a result, the IMF’s recommendation is for monetary policy to remain in a conservative and tightening mode.
China’s economy reopens
Prof Gourinchas drew attention to the "big news" that the Chinese economy has reopened. "I think it's fair to say that transition happened faster than one had anticipated and in a slightly less controlled way."
While this may create some instability in the short term, it also paves the way for a rapid rebound in economic activity and mobility as COVID-19 abates. This reopening is expected to power the global economy, particularly in Asia, where China and India together account for 50 per cent of global growth.
Prof Quah spurred a discussion about the risk factors in China’s growth. He highlighted challenges that China has to deal with, such as the uncertainty still surrounding COVID policies, the real estate asset pricing situation and worry about its green transition when it remains carbon-intensive.
Prof Gourinchas said that the Chinese economic model up until recently has been fuelled by an export-based model. Although the Chinese authorities have wanted to pivot to a domestic engine of growth and the property sector was an attempt to do this, it is not delivering sustained growth.
He noted, “The question here is what is the growth model that China is going to have in the next 10, 15, 20 years? […] If it's not going to be built on engaging in the global economy and still being an export-driven part of the trade matrix, then can it be done by relying on domestic engines of growth?”
“One is to be concerned about the ability to sustain high levels of productivity growth going forward.”
Monetary policy tightens
There has been a synchronised tightening of monetary policy in response to inflation pressure, which will limit how much growth can be achieved this year and into next year. This tightening takes time to work its way into activity and prices, but it happens faster when all central banks are tightening at the same time. This has already affected commodities markets, with energy prices being lower due to decreased global demand.
Divergences in confidence levels are also becoming apparent, with sentiment in the US and the world remaining strong but much weaker in Europe. While Europe has been resilient, there is an expected sharp slowdown in growth.
Three key issues
Prof Gourinchas went on to discuss three issues related to the global economy. The first being geo-economic fragmentation, which has been a significant concern since the Russian invasion of Ukraine. This has caused countries to split along geopolitical lines and has deepened existing cracks in the global economic order. Tensions between the US and China, as well as issues related to reshoring, onshoring and nearshoring, are indicators of this rising issue.
As a multilateral organisation, the IMF is concerned about this dislocation and potential reorganisation around geopolitical lines. The IMF is doing a lot of work to understand the channels through which geo-economic fragmentation can affect international trade, technological diffusion, migration, capital flow and uncertainty. This uncertainty can depress investment, increase volatility and lead to policy mistakes.
"Policy mistakes are especially important when you think about fragmentation because you may have perfectly legitimate decisions that are taken by one country in isolation, but failing to take into account how they will lead to some retaliation and the tit for tat and amplification," said Prof Gourinchas.
The second issue is debt distress for low-income countries, which is a common good that needs to be addressed collectively. However, in a world that is becoming more geopolitically fragmented, there is less scope for reaching agreements across parties that are divided.
Next, Prof Gourinchas moved on to the issue of inflation, which has been a concern in the global economy. He noted that inflation has been driven by a combination of supply-side and demand-side factors, including disruptions to global supply chains, energy prices and pent-up demand due to the pandemic. The IMF is closely monitoring these factors and is committed to helping countries address inflation in a way that supports growth and stability.
Policy recommendations
Prof Gourinchas had a lot to say about how the IMF has looked at the various challenges and tried to come up with policy recommendations, including some that go against conventional wisdom.
For example, how can countries satisfy national security objectives without unravelling the gains that come from an integrated global trade matrix that has generated tremendous productivity gains globally over the last four or five decades?
While many advocate reshoring, nearshoring or friendshoring, the IMF argues that is not the best policy. Why? For one, countries are more concentrated in their own production than one might think. "For all the talk about the global supply chain, it's still the case that a lot of things are produced domestically," said Prof Gourinchas.
Instead of trying to duplicate the manufacture of key items domestically or within a nearby friendly zone, it is better to diversify the supply chain so those key items are not concentrated in one location.
When it comes to monetary policy, the IMF promotes the Integrated Policy Framework (IPF) or in other words, "Mundell-Fleming 2.0."
According to the Mundell-Fleming model, in countries with deep markets and absence of frictions, using only the policy rate and exchange rate flexibility is typically optimal.
In other countries, policy rate and exchange rate flexibility remain useful, but may no longer be optimal if there are significant frictions. In this departure from Mundell-Fleming, there is scope for additional instruments to be used, whether that's foreign exchange intervention or capital controls.
Three use cases for additional tools are as follows. The first is to address destabilising premia in shallow foreign exchange markets. The second is to counter financial stability risks from foreign exchange mismatches. The third is to help prevent de-anchoring of inflation expectations.
The caveat is that no policy tool should be used to substitute for a warranted adjustment of macroeconomic policies.
The final recommendation was on how to set a carbon price high enough to get to net zero without increasing energy prices so high that it causes a supply shock.
The answer, according to the IMF, is to set policy in a gradual and credible way. They said the impact of that climate transition is very modest on output and inflation. The cost is not zero, but it's modest compared to the cost of not dealing with a climate crisis.
But if we wait — or if the process is uncertain or delayed — then those costs become much larger. Because the longer we wait to set carbon prices, the higher they will need to be to have the same effect. That would in turn, require a response by central banks to try to keep price stability and offset some of the price implications coming in.
"So, there is a clear message here as well, which is we are hurting ourselves. If we're delaying, we're hurting ourselves, not just in a climate transition," said Prof Gourinchas.