World Economic Outlook April 2009

1. World Economic Outlook April 2009

2. Chapter IIIFrom Recession to Recovery: How Soon and How Strong? By Prakash Kannan, Alasdair Scott and Marco Terrones

3. Motivating background • Global economy is experiencing deepest downturn in post-WWII period • 15 advanced economies currently in recession • Global growth projected to decline by 1.3% in 2009 • Rare combination of financial crisis in advanced economies with a globally-synchronized recession.

4. Key Questions Are recessions and recoveries associated with financial crises different from others? What are the main features of globally synchronized recessions? Can countercyclical policies help shorten recessions and strengthen recoveries?

5. “ For historians each event is unique. Economics, however, maintains that forces in society and nature behave in repetitive ways. History is particular; economics is general.” - Charles Kindleberger (Manias, Panics and Crashes)

6. Findings Recessions associated with financial crises are severe and recoveries from such recessions are typically slow. These features become more pronounced if, in addition, the recession is global. Countercyclical policies are helpful in ending recessions and strengthening recoveries.

7. Outline • Recessions and Recoveries • Recessions associated with financial crises • Globally synchronized recessions • Countercyclical Policies • Current Recessions in Perspective

8. 1. Recessions and Recoveries

9. Business cycle dating • Adopt “classical” approach to dating business cycles • Bry-Boschan (1971), Harding and Pagan (2002) • Defines cycles on output levels rather than deviations from trend • Advantages: Replicable on a cross-country dimension Disadvantages: Narrow measure of activity • For the U.S., method generally dates cycles similarly to NBER, but with notable exceptions

10. Identifying nature of recession • Two stages to associating recession with financial crisis: • Using dating by Reinhart-Rogoff (2008), Kaminsky-Reinhart (1999) • Associate recession with financial crisis if start date before or in early part of a recession. • Highly-synchronized recessions defined as period where 50% or more of sample in recession.

11. Data and summary statistics • Quarterly data for 21 advanced economies during the 1960:1-2008:4 period. • Excluding the current recessions, there were 122 recessions. Of which: • 15 were associated with financial crises • 37 were globally synchronized (1975, 1980 and 1992). • 6 were both associated with financial crises and globally synchronized.

12. Features of recessions and recoveries across types of recessions Recessions Recoveries

13. Financial crisis recessions are long and severe with weak recoveries(Median = 100 at t = 0; peak in output level at t = 0) Mean time to trough in output for financial crises Financial Crises All other recessions Mean time to trough in output for all other recessions Output Private Consumption Trade Balance (share of GDP; difference from level at t = 0) Credit

14. Differential role of exports in recovery(Median = 100 at t = 0; peak in output at t = 0) Highly Synchronized Recessions Financial Crises

15. 2. Countercyclical monetary and fiscal policies

16. Measuring discretionary fiscal and monetary policies • Fiscal policy measured by • Government consumption (cyclically-adjusted) • Primary balance (cyclically-adjusted) • Monetary policy measured by deviations of nominal and real interest rates from a policy rule • All policies are measured as peak-to-trough changes

17. Questions and methodologies • Do policies help shorten the duration of recessions? • Do policies help strengthen recovery? • Duration analysis used to address first question and linear regression analysis (with country fixed effects) used for second question.

18. Fiscal stimulus is effective in financial crises (Probability of remaining in a recession beyond a certain number of quarters) Financial crises Financial crises with high fiscal response Full sample

19. Appropriate policies can shorten recession duration • Fiscal policy has a significant impact in reducing the duration of a recession associated with financial crises. • No significant difference in effectiveness of monetary policy during these episodes. • However, across all recessions, monetary policy is effective in shortening the duration of a recession. No robust results found for fiscal policy.

20. Expansionary policies are associated with stronger recoveries • Linear regression with country fixed effects: • Dependent variable: Cumulative growth rate one-year after trough of recession. • Explanatory variables: Duration of recession, amplitude of recessions and peak-to-trough changes in policy measures. • A 1 standard deviation increase in government consumption is associated with an increase in the cumulative growth rate during recovery of about 0.8 percent. • Equivalent number for monetary policy is about 0.4 percent.

21. Level of public debt reduces the effectiveness of fiscal policy • Aggressive use of discretionary fiscal policy raises concern about fiscal sustainability. • Include public debt to GDP ratio in regression: level and interaction • Results suggest that fiscal policy loses its effectiveness at high levels of public debt

22. 3. Current Recessions in Perspective

23. Current Recessions Likely to Be Severe … (Median log differences from one year earlier unless otherwise noted; peak in output level at t = 0; quarters on x-axis) Current U.S. recession Median of all other current recessions 50 percent interval of previous recessions Unemployment Rate (median percentage point difference from one year earlier) Output Private Consumption Residential Investment

24. …but, countercyclical policies have been aggressive (Median log differences from one year earlier unless otherwise noted; peak in output level at t = 0; quarters on x-axis) Current U.S. recession Median of all other current recessions 50 percent interval of previous recessions Nominal Interest Rate (median percentage point difference from one year earlier) Government Consumption

25. Policy Message The current recessions are likely to be long-lasting and severe with weak recoveries. Usual deleveraging that happens after a financial crisis compounded with weak external demand due to global synchronization. Monetary and fiscal policies can help reduce the duration of the current recessions, and strengthen economic recovery.

26. Chapter IVHow Linkages Fuel The Fire:The Transmission of Financial Stress from Advanced Economies to Emerging Economies Prepared by: Ravi Balakrishnan, Stephan Danninger, Selim Elekdag, and Irina Tytell with support from Stephanie Denis and Murad Omoev

27. Unprecedented financial stress in advanced economies… (GDP weighted number of countries with stress index one Stdev above trend) LTCM collapse October 1987 stock market crash Nikkei crash, DBL bankruptcy, and Scandinavian banking crisis US Corporate crisis Dot-com crash U.S. banking stress ERM Crisis Q1: 09

28. …has triggered a decline in capital flows to emerging economies New Issuances in billions of U.S. dollar1 1 Total of equity, syndicated loans, and international bond issuances

29. Questions 1. How severe is the current crisis in emerging economies (EMs)? 2. How strong is the transmission of financial stress from advanced to emerging economies? And what is the role of banking sector stress? 3. Can policies help mitigate stress transmission?

30. Key Findings • Financial stress in EMs has surpassed peaks of Asian crises. • Financial stress transmits strongly and rapidly to EMs • Almost one-for-one response within 1-2 months. • Transmission stronger with closer financial & trade links. • Bank lending linkages main channel in current crisis. • Recovery of capital flows likely to be slow. Past banking sector stress led to protracted declines in capital flows to EMs. • During a global crisis, higher fiscal and current account balances offer little insulation.

31. Outline 1. Financial Stress Index 2. Transmission of Stress 3. Impact on Capital Flows

32. Emerging economies’ have experienced severe exchange market turmoil… Foreign exchange markets Exchange Rates (month-to-month percent change) Foreign Reserves (month-to-month percent change)

33. …and have seen sovereign spreads widen and equity markets fluctuate. JPMorgan EMBI Stripped Spreads (basis points) Stock Index Volatility

34. 1. Financial Stress Index Composite index comprises 5 components: EM-FSI = EMPI (exchange market pressure index) + sovereign spreads + banking β (banking sector β) + stock returns + stock volatility • Components standardized (variance weighted & demeaned) • FSI robust to other weighting schemes (principal components analysis). Also (Illing and Liu 2006) • Data will be made publicly available

35. Synchronized financial stress fluctuations in emerging economies

36. Recent stress above Asian crises’ peaks.Comoves with advanced economy stress. Q1: 09

37. Exchange Market Pressure Equity market profitability Bank beta Equity market volatility Sovereign Spreads (JP Morgan EMBI) Stress in EMs now larger and broader than during past global crises (EM-FSI centered around peaks of widespread advanced economy stress) Past Stress Episodes Current Stress Episodes Quarters Quarters

38. 2. Transmission of Stress

39. Commodity prices Vulnerabilities Global output Economic characteristics Global interest rates Disentangle stress transmission: global or country-specific effects? Financial Stress Emerging Economies Common factors Country-specific factors Financial linkages Trade linkages Advanced Economies Financial Stress

40. Stress transmission:empirical strategy Estimate stress transmission coefficient (βi) and its determinants: EM-FSIit = f (AE-FSIt , Global factorst , Xit ) EM-FSI...... Emerging economy financial stress index AE-FSI….. Advanced economy financial stress index Two approaches • Two-stage approach (Forbes and Chinn 2004) • Annual panel estimation

41. Financial stress transmission to emerging economies: large but varied Country specific βof stress co-movement with advanced economy stress Mean co-movement (ßi)

42. Bank linkages drove transmission in 2008(Western Europe and emerging Europe) Bank Lending Liabilities to Advanced Economy Banks as of 2007 Portfolio Exposure to Advanced Economies as of 2007 (percent of emerging economies’ GDP) Emerging Asia Emerging Europe CIS and Russia Latin America Emerging Asia Emerging Europe CIS and Russia Latin America MENA Africa MENA Africa

43. Financial stress transmission and country vulnerabilities: size of shock matters! • Higher current account and fiscal balances reduce financial stress in EMs • Higher foreign reserves also help • However, lower vulnerabilities provide little insulation against large global shock. Transmission effect dominates. (Note: no analysis of recovery and growth)

44. During global stress good domestic policies offer little insulation Change in Emerging Economies’ Financial Stress, 1997–2008 Emerging economies’ FSI Contributions from: Advanced economies’ FSI Global Factors Openness Current account balance Fiscal balance Foreign reserves Residual 2

45. 3. Impact on Capital Flows

46. Case study: after banking crises capital flows recovers only slowly U.S. banking sector of the 1980s • Capital flows to Latin America Japanese Banking crisis of the 1990s • Capital flows to Emerging Asia Both cases illustrate a long and protracted withdrawal from EMs by the advanced economy banks concerned

47. U.S. banks pulled out relatively more from all EMs after the debt crisis Consolidated Bank Claims on Latin America (percent of destination region’s GDP) Consolidated Bank Claims on Emerging and Other Developing Economies (percent of destination region’s GDP)

48. Japanese banks massively withdrew from East Asia in the late 1990s Japanese Bank Claims on East and Offshore Asia (percent of destination region’s GDP) Advanced Economy Bank Claims on East Asia (percent of destination region’s GDP)

49. Policy Message • Strong and rapid stress transmission AND little protection through strong domestic policies argue for coordinated policy action against global crises. • Avoid second round of deleveraging through multifaceted approach: official support for EMs, clean-up of bank balance sheets in advanced economies, enhanced coordination between home and host supervisors. • Beyond near-term: improve multilateral insurance systems to reduce risks for EMs from global financial integration (e.g. the new IMF FCL).