World Economic Outlook 2007

WORLD ECONOMIC OUTLOOK

October 2007

Globalization and Inequality

International Monetary Fund

World Economic and Financial Surveys

©2007 International Monetary Fund

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iii

CONTENTS

Assumptions and Conventions viii

Preface x

Foreword xi

Executive Summary xiv

Chapter 1. Global Prospects and Policies 1

Strong Global Growth Is Being Confronted by Turbulent Financial Conditions 1

The Baseline Outlook Has Been Marked Down Moderately—And Downside Risks

Have Intensifi ed 5

Living with Heavy Foreign Exchange Infl ows 28

Sustaining Robust Growth 31

Policy Challenges 33

Appendix 1.1. Developments in Commodity Markets 40

Appendix 1.2. Climate Change: Economic Impact and Policy Responses 53

References 66

Chapter 2. Country and Regional Perspectives 69

United States and Canada: Uncertainties About the U.S. Outlook Have Risen 69

Western Europe: How Resilient Is the Recovery? 76

Industrial Asia: Defl ation Is Not Yet Decisively Beaten in Japan 80

Emerging Asia: Successfully Managing Strong Foreign Exchange Infl ows 83

Latin America—Responding to Surging Foreign Exchange Infl ows 86

Emerging Europe: Brisk Activity, Rising Imbalances 89

Commonwealth of Independent States: Tensions Between Infl ation and Exchange

Rate Objectives 92

Sub-Saharan Africa—Benefi ting from Globalization 95

Middle East: Balancing Cyclical and Long-Term Considerations in Fiscal Policy 100

References 103

Chapter 3. Managing Large Capital Infl ows 105

Two Waves of Large Capital Infl ows to Emerging Markets 107

Identifying Episodes of Large Capital Infl ows 110

Policy Responses to Large Capital Infl ows 111

Linking Macroeconomic Outcomes and Policy Responses 120

Conclusions 125

Appendix 3.1. Event Analysis and Policy Indices: Methodologies and Data 127

References 131

CONTENTS

iv

Chapter 4. Globalization and Inequality 135

Recent Trends in Inequality and Globalization 137

What Is the Impact of Globalization on Inequality? 141

An Empirical Investigation of Globalization and Inequality 150

Conclusions and Policy Implications 158

Appendix 4.1. Data Sources and Methods 160

References 166

Chapter 5. The Changing Dynamics of the Global Business Cycle 171

Global Business Cycles: A Historical Perspective 172

Has the World Economy Become More Stable? 175

What Is Driving the Moderation of the Global Business Cycle? 180

Conclusions 189

Appendix 5.1. Data and Methods 189

References 195

Annex: IMF Executive Board Discussion of the Outlook, September 2007 199

Statistical Appendix 203

Assumptions 203

What’s New 206

Data and Conventions 206

Classifi cation of Countries 208

General Features and Composition of Groups in the World Economic Outlook

Classifi cation 210

List of Tables 214

Output (Tables A1–A4) 215

Infl ation (Tables A5–A7) 223

Financial Policies (Table A8) 229

Foreign Trade (Table A9) 230

Current Account Transactions (Tables A10–A12) 232

Balance of Payments and External Financing (Tables A13–A15) 238

Flow of Funds (Table A16) 242

Medium-Term Baseline Scenario (Table A17) 246

World Economic Outlook and Staff Studies for the World Economic Outlook, Selected Topics 247

Boxes

1.1 Who Is Harmed by the Surge in Food Prices? 12

1.2 Macroeconomic Implications of Recent Financial Market Turmoil: Patterns from

Previous Episodes 16

1.3 Multilateral Consultation on Global Imbalances 24

1.4 What Is Global Liquidity? 34

1.5 Refi nery Bottlenecks 46

1.6 Making the Most of Biofuels 48

1.7 The Discounting Debate 60

CONTENTS

v

1.8 Taxes Versus Quantities Under Uncertainty (Weitzman, 1974) 63

1.9 Experience with Emissions Trading in the European Union 64

2.1 What Risks Do Housing Markets Pose for Global Growth? 72

2.2 Labor Market Reforms in the Euro Area and the Wage-Unemployment Trade-Off 79

2.3 Managing the Macroeconomic Consequences of Large and Volatile Aid Flows 98

3.1 Can Capital Controls Work? 113

4.1 Measuring Inequality: Conceptual, Methodological, and Measurement Issues 144

4.2 What Do Country Studies of the Impact of Globalization on Inequality Tell Us?

Examples from Mexico, China, and India 146

5.1 Major Economies and Fluctuations in Global Growth 181

5.2 Improved Macroeconomic Performance—Good Luck or Good Policies? 186

5.3 New Business Cycle Indices for Latin America: A Historical Reconstruction 193

A1. Economic Policy Assumptions Underlying the Projections for Selected

Economies 204

Tables

1.1 Overview of the World Economic Outlook Projections 8

1.2 Global Oil Demand by Region 43

2.1 Advanced Economies: Real GDP, Consumer Prices, and Unemployment 70

2.2 Advanced Economies: Current Account Positions 71

2.3 Selected Asian Countries: Real GDP, Consumer Prices, and Current

Account Balance 84

2.4 Selected Western Hemisphere Countries: Real GDP, Consumer Prices, and

Current Account Balance 86

2.5 Emerging Europe: Real GDP, Consumer Prices, and Current Account Balance 89

2.6 Commonwealth of Independent States: Real GDP, Consumer Prices, and

Current Account Balance 93

2.7 Selected African Countries: Real GDP, Consumer Prices, and Current

Account Balance 96

2.8 Selected Middle Eastern Countries: Real GDP, Consumer Prices, and Current

Account Balance 101

3.1 Episodes of Large Net Private Capital Infl ows—Summary Statistics 111

3.2 Post-Infl ow GDP Growth Regressions 122

3.3 Real Exchange Rate Regressions 124

3.4 List of Net Private Capital Infl ow Episodes 128

4.1 Determinants of the Gini Coeffi cient, Full Sample 152

4.2 Estimation of the Benchmark Model Using Quintiles’ Income Shares, Full Sample 158

4.3 Determinants of the Gini Coeffi cient, Regional Heterogeneity 164

5.1 Cross-Sectional Regressions 185

5.2 Panel and Probit Regressions 185

Figures

1.1 Global Indicators 1

1.2 Global Infl ation 2

1.3 Developments in Mature Credit Markets 3

1.4 Mature Financial Market Indicators 4

CONTENTS

vi

1.5 Emerging Market Financial Conditions 5

1.6 External Developments in Selected Advanced Economies 6

1.7 External Developments in Emerging Market and Developing Countries 7

1.8 Global Outlook 9

1.9 Current and Forward-Looking Indicators 10

1.10 Risks to the Global Outlook 11

1.11 Measures of the Output Gap and Capacity Pressures 21

1.12 Productivity and Labor Cost Developments in Selected Advanced Economies 22

1.13 Current Account Balances and Net Foreign Assets 23

1.14 Simulated Effect of a Financial Disturbance on the Global Economy 27

1.15 Private Capital Flows to Emerging Markets 28

1.16 Current and Capital Account Flows to Selected Emerging Market and

Developing Countries 29

1.17 Perspectives on Global Growth 31

1.18 Commodity Price Indices 40

1.19 Crude Oil and Gasoline Prices 41

1.20 Developments in Oil Consumption and Production 42

1.21 Inventories and OPEC Production 44

1.22 Oil Futures Prices, and Selected Energy and Metals Prices 45

1.23 Sources of Demand and Prices of Selected Fuel-Related Food Items 52

1.24 Greenhouse Gas Emissions by Region 54

1.25 Actual and Projected Fuel-Related Carbon Emissions Under “Business-as-Usual” 55

1.26 Time Profi le of Aggregate Damages from Climate Change 57

1.27 Mean per Capita GDP Losses at Different Levels of Warming 58

1.28 Greenhouse Gas Emission Paths Consistent with Alternative Concentration Targets 59

1.29 Greenhouse Gas Emissions, Kyoto Targets, and Predicted Emissions 66

2.1 United States: Indicators of Investment 69

2.2 Western Europe: What Is the Outlook for Infl ation? 78

2.3 Japan: Defl ation Still Not Decisively Beaten 81

2.4 Emerging Asia: Managing Strong Foreign Exchange Infl ows 85

2.5 Latin America—Capital Infl ows Are Complicating Macroeconomic Management 87

2.6 Emerging Europe: Rapid Credit Growth Is Fueling Domestic Demand 90

2.7 Commonwealth of Independent States: Dealing with Capital Infl ows 94

2.8 Sub-Saharan Africa—Benefi ting from Globalization 97

2.9 Middle East: How Are Oil Revenues Used? 102

3.1 Net Private Capital Infl ows to Emerging Markets 105

3.2 Gross Private Flows, Current Account Balance, and Reserve Accumulation 107

3.3 Current Account Balance, Private Capital Infl ows, and Reserve Accumulation

by Region 108

3.4 Net FDI and Non-FDI Infl ows 109

3.5 Characteristics of Episodes of Large Net Private Capital Infl ows 110

3.6 Exchange Market Pressure Index 117

3.7 Evolution of Policy Indicators 118

3.8 Policy Indicators in the Episodes of Large Net Private Capital Infl ows 119

3.9 Selected Macroeconomic Variables: Averages During, Before, and

After Episodes of Large Net Private Capital Infl ows 120

3.10 Post-Infl ow GDP Growth, Selected Macroeconomic Variables, and Policy Indicators 121

CONTENTS

vii

3.11 Real Effective Exchange Rate Appreciation and Policy Responses When

Infl ation Accelerates 123

3.12 Regional Dimension 125

3.13 Resistance to Exchange Market Pressures and Duration of Capital Infl ow Episodes 126

3.14 Fiscal Policy and Balance of Payments Pressures 127

3.15 Mexico: Identifi cation of Large Net Private Capital Infl ow Episodes 129

4.1 Trade Globalization 137

4.2 Financial Globalization 138

4.3 Cross-Country Trends in Inequality 140

4.4 Income Shares by Quintile 141

4.5 Per Capita Income by Quintile 142

4.6 Per Capita Income by Quintile in Selected Countries 143

4.7 Inequality Versus Globalization: Selected Countries 150

4.8 Information and Communications Technology (ICT) Capital, Private Credit,

Education, and Sectoral Employment Shares 151

4.9 Explaining Gini Coeffi cient Changes 153

4.10 Decomposition of Globalization Effects on Inequality 154

4.11 Inequality Versus Exports in Agriculture 155

4.12 Foreign Direct Investment Stock by Sector 156

4.13 Inequality and Technology, 1981–2003 157

4.14 Explaining the Change in Income Share of Top and Bottom Quintiles 159

4.15 Inequality, Import Share from Developing Countries, Inward Debt, and

Outward Foreign Direct Investment (FDI), 1981–2003 165

5.1 World Growth Has Been Strong and Stable 172

5.2 Expansions in Historical Perspective 173

5.3 Recessions in Historical Perspective 174

5.4 Volatility of Growth in the Main World Regions 176

5.5 Decomposition of Changes in World Output Volatility by Region 177

5.6 Decomposition of Changes in World Output Volatility by Expenditure Component 178

5.7 Decomposition of Changes in U.S. Output Volatility 179

5.8 Volatility Patterns in Rapidly Growing Economies 180

5.9 Some Determinants of Differences in Business Cycle Characteristics 184

5.10 Contribution to Outcome Differences 188

A number of assumptions have been adopted for the projections presented in the World Economic

Outlook. It has been assumed that real effective exchange rates will remain constant at their average

levels during August 22–September 19, 2007, except for the currencies participating in the European

exchange rate mechanism II (ERM II), which are assumed to remain constant in nominal terms

relative to the euro; that established policies of national authorities will be maintained (for specifi c

assumptions about fi scal and monetary policies in industrial countries, see Box A1); that the average

price of oil will be $68.52 a barrel in 2007 and $75.00 a barrel in 2008, and remain unchanged in real

terms over the medium term; that the six-month London interbank offered rate (LIBOR) on U.S.

dollar deposits will average 5.2 percent in 2007 and 4.4 percent in 2008; that the three-month euro

deposits rate will average 4.0 percent in 2007 and 4.1 percent in 2008; and that the six-month Japanese

yen deposit rate will yield an average of 0.9 percent in 2007 and of 1.1 percent in 2008. These are, of

course, working hypotheses rather than forecasts, and the uncertainties surrounding them add to the

margin of error that would in any event be involved in the projections. The estimates and projections

are based on statistical information available through end-September 2007.

The following conventions have been used throughout the World Economic Outlook:

. . . to indicate that data are not available or not applicable;

— to indicate that the fi gure is zero or negligible;

– between years or months (for example, 2005–06 or January–June) to indicate the years or

months covered, including the beginning and ending years or months;

/ between years or months (for example, 2005/06) to indicate a fi scal or fi nancial year.

“Billion” means a thousand million; “trillion” means a thousand billion.

“Basis points” refer to hundredths of 1 percentage point (for example, 25 basis points are equivalent

to ¼ of 1 percent point).

In fi gures and tables, shaded areas indicate IMF staff projections.

Minor discrepancies between sums of constituent fi gures and totals shown are due to rounding.

As used in this report, the term “country” does not in all cases refer to a territorial entity that is a

state as understood by international law and practice. As used here, the term also covers some territo￾rial entities that are not states but for which statistical data are maintained on a separate and indepen￾dent basis.

ASSUMPTIONS AND CONVENTIONS

viii

This report on the World Economic Outlook is available in full on the IMF’s Internet site, www.imf.org.

Accompanying it on the website is a larger compilation of data from the WEO database than in the

report itself, consisting of fi les containing the series most frequently requested by readers. These fi les

may be downloaded for use in a variety of software packages.

The following changes have been made to streamline the Statistical Appendix of the World Economic

Outlook. Starting with this issue, the printed version of the World Economic Outlook will carry only Part A

Tables in the Statistical Appendix section.

Part A contains Tables 1, 2, 3, 6, 7, 8, 11, 20, 25, 26, 31, 35, 43, and 44 from the previous issues of

the World Economic Outlook; Tables 1.2 and 1.3, which used to be in the main text of the report; and a

new table on private capital fl ows. Tables in Part A present summary data for both advanced economies

and emerging market and developing countries in the categories of Output, Infl ation, Financial Poli￾cies, Foreign Trade, Current Account Transactions, Balance of Payments and External Financing, Flow

of Funds, and Medium-Term Baseline Scenario.

Part B of the Statistical Appendix contains the remaining tables. The complete Statistical Appendix,

which includes both Part A and Part B Tables, will be available only via the Internet at www.imf.org/

external/pubs/ft/weo/2007/02/index.htm.

Inquiries about the content of the World Economic Outlook and the WEO database should be sent by

mail, electronic mail, or telefax (telephone inquiries cannot be accepted) to:

World Economic Studies Division

Research Department

International Monetary Fund

700 19th Street, N.W.

Washington, D.C. 20431, U.S.A.

E-mail: [email protected] Telefax: (202) 623-6343

FURTHER INFORMATION AND DATA

ix

x

The analysis and projections contained in the World Economic Outlook are integral elements of the

IMF’s surveillance of economic developments and policies in its member countries, of developments

in international fi nancial markets, and of the global economic system. The survey of prospects and

policies is the product of a comprehensive interdepartmental review of world economic developments,

which draws primarily on information the IMF staff gathers through its consultations with member

countries. These consultations are carried out in particular by the IMF’s area departments together

with the Policy Development and Review Department, the Monetary and Capital Markets Department,

and the Fiscal Affairs Department.

The analysis in this report has been coordinated in the Research Department under the general

direction of Simon Johnson, Economic Counsellor and Director of Research. The project has been

directed by Charles Collyns, Deputy Director of the Research Department, and Tim Callen, Division

Chief, Research Department.

The primary contributors to this report are Roberto Cardarelli, Kevin Cheng, Selim Elekdag,

Florence Jaumotte, Ben Jones, Michael Keen, Ayhan Kose, Toh Kuan, Subir Lall, Valerie Mercer￾Blackman, John Norregaard, Chris Papageorgiou, Hossein Samiei, Alasdair Scott, Martin Sommer,

Nikola Spatafora, Jon Strand, Natalia Tamirisa, and Petia Topalova. Sergei Antoshin, Gavin Asdorian,

To-Nhu Dao, Stephanie Denis, Nese Erbil, Angela Espiritu, Patrick Hettinger, Susana Mursula,

Murad Omoev, Allen Stack, Bennett Sutton, and Ercument Tulun provided research assistance.

Mahnaz Hemmati, Laurent Meister, and Emory Oakes managed the database and the computer

systems. Sylvia Brescia, Celia Burns, Jemille Colon, and Sheila Tomilloso Igcasenza were responsible

for word processing. Other contributors include Andrew Benito, Luis Catão, Gianni De Nicolò,

Hamid Faruqee, Thomas Helbling, Michael Kumhof, Tim Lane, Douglas Laxton, Gian-Maria Milesi-Fer

retti, Emil Stavrev, Thierry Tressel, and Johannes Wiegand. External consultants include Nancy Birdsall,

Menzie Chin, Gordon Hanson, Massimiliano Marcellino, and Carlos Végh. Archana Kumar of the

External Relations Department edited the manuscript and coordinated the production of the

publication.

The analysis has benefi ted from comments and suggestions by staff from other IMF departments, as

well as by Executive Directors following their discussion of the report on September 17 and 24, 2007.

However, both projections and policy considerations are those of the IMF staff and should not be

attributed to Executive Directors or to their national authorities.

PREFACE

Throughout a turbulent summer, the World Economic

Outlook team at the IMF has worked hard to stay

ahead of developments, to refi ne our analytical work,

and to keep our forecasts up to date. Led by Charles

Collyns and Tim Callen, the World Economic Studies

division has worked closely with other IMF staff to pro￾duce a WEO that is close to current developments while

providing some much-needed longer-term perspective.

We hope that it will help you both understand what has

happened in the past few months as well as refl ect on

what might be in store for the next 15 months.

The world economy has entered an uncer￾tain and potentially diffi cult period. The

fi nancial turmoil of August and Septem￾ber threatens to derail what has been an excel￾lent half-decade of global growth. The problems

in credit markets have been severe, and while

the fi rst phase is now over, we are still waiting to

see exactly how the consequences will play out.

Still, the situation at present is one with

threats rather than actual major negative out￾comes on macroeconomic aggregates. At this

point, we expect global growth to slow in 2008,

but remain at a buoyant pace. Growth in the

United States is expected to remain subdued.

Problems in the housing sector are more intense

than previously expected, and the disruption

of credit is likely to have further impact. We

expect some slowing in Japan, where the second

quarter was disappointing, and in Europe, where

banks were involved to a surprising degree with

instruments and vehicles exposed to the U.S.

subprime sector.

The good news is that emerging market and

developing countries weathered the recent

fi nancial storm and are providing the basis

for strong global growth in 2008. For the fi rst

time, China and India are making the largest

country-level contributions to world growth (in

purchasing-power-parity terms; see the fi gure).

China is also making the largest contribution at

FOREWORD

0

5

10

15

20

25

30

35

0

5

10

15

20

25

30

35

Emerging Markets Now the Major Engine of Global Growth

(Percent of world growth)

2006

2007

Contributions to Real GDP Growth

Source: IMF staff calculations.

Based on PPP Weights

China India United

States

Euro

area

Russia Japan Brazil

Based on Market Weights

United China India

States

Euro

area

Japan United Russia

Kingdom

2006

2007

xi

FOREWORD

market prices. More generally, emerging market

and developing countries are reaping the bene￾fi ts of careful macroeconomic management over

the past decade. While there are some potential

vulnerabilities, and there is no room for compla￾cency going forward, emerging markets should

remain strong in the foreseeable future.

In terms of global risks, we see most of these

as being on the downside for growth, that is,

unexpected developments are more likely to

push growth down rather than push it up.

Our growth fan chart shows probabilities both

above and below our forecast, based on our

previous forecast errors, but the skewness of

the chart—based on our reading of what could

push the global economy away from our central

forecast—is almost entirely to the downside.

Some of these risks have received consider￾able attention, including those in housing

markets and fi nancial sectors. But some are

more surprising, including the fact that oil

prices remain high and that sharp food price

increases are contributing to infl ation concerns

in emerging market and developing countries.

A key unknown is what will happen in Europe.

Until the events of this summer, Europe was in

the upswing of its cycle, with Germany in par￾ticular emerging as a driver of growth, moving

beyond the long, diffi cult process of reunifi ca￾tion. But the serious disruptions in the market

for interbank liquidity and the diffi culties

experienced by some European banks in recent

months were largely unexpected. Quite how

these developments will affect the real economy

remains to be seen.

I would also stress that the implications for

global imbalances remain uncertain. It seems

likely that the U.S. current account defi cit will

decline relative to GDP, in part because the dol￾lar has depreciated further since the summer—

its value is down more than 20 percent from

its recent peak in 2002. Fortunately, we have in

place a framework for cooperative actions by

the key countries involved with imbalances; this

was a major outcome of the IMF’s Multilateral

Consultation this year. Oil producers continue

to scale up their spending on infrastructure

and investments. China remains determined to

rebalance its demand so as to lower its current

account surplus. Europe and Japan continue

with the process of structural reform, which

should help with restructuring and boost domes￾tic demand. We expect that this framework will

facilitate the gradual decline of imbalances and

reduce risks of disruptive changes in exchange

rates, but this situation requires continued care￾ful attention.

Turning to our analytical chapters, Chapter 3

highlights a major challenge for many emerging

market and developing countries—how to man￾age large capital infl ows. These infl ows slowed

this summer, but recent indications are that they

are again picking up. The chapter assesses what

we can learn from recent episodes of capital

infl ows around the world, and it looks at what

kinds of macroeconomic policies help to ensure

that growth post-infl ows remains strong. It turns

out that intervening in exchange markets, either

with or without sterilization, has not been suc￾cessful in limiting real exchange rate apprecia￾tion or avoiding a deceleration in post-infl ow

growth. What really helps is being careful with

fi scal spending. The lesson here is not that a

country needs to cut spending when there are

infl ows, but rather that it needs to exercise fi scal

restraint. The greater caution of some leading

emerging markets in this regard since the late

1990s is commendable and has defi nitely con￾tributed in part to their resilience today. I hope

other countries will learn the same lesson.

Chapter 4 takes a longer-term perspective

and looks at what has happened to inequal￾ity around the world, particularly during the

recent surge in various forms of globalization.

While we have written extensively, including in

the April 2007 World Economic Outlook, about

the benefi ts of globalization, the fi ndings in

this chapter should be seen as more caution￾ary. In almost all countries, inequality has

increased in recent years. The authors fi nd that

increased trade is not the culprit. Rather, it

seems likely that the spread of new technology

around the world, both in general and through

foreign direct investment, has disproportion￾FOREWORD

xii

FOREWORD

xiii

ately benefi ted people who are better educated.

The implication, of course, is not to try to

prevent the adoption of new technology—such

an approach would be sure to derail growth.

Rather the policy objective should be to provide

the education and other social services (such as

affordable health care, a reasonable-cost pen￾sion system, and so on) to ensure that as many

people as possible can fi nd and keep high￾productivity jobs. It would be unwise to ignore

the issue of growing inequality; globalization is

a key source of rising world prosperity, but more

effective policy actions are needed to make sure

that these benefi ts are well shared.

Chapter 5 offers hope but also some cau￾tion regarding the longer-term prospects of the

global economy. Looking back as far as possible

with comparable data (which takes us to around

1960), it is clear that the past half-decade has

seen the strongest and most broadly based run

of global growth since the 1960s. This was not a

fl uke, but rather the result of improved frame￾works for both monetary and fi scal policies, as

well as serious institutional improvements in

many middle- and lower-income countries. At

the same time, there was some luck involved—

infl ation has been low, globally, in part because

of low-cost manufactured goods (part of the

globalization process) and because private capi￾tal fl ows have been relatively stable. It would be

unwise to expect that there will not be shocks

going forward, and the chapter makes recom￾mendations that should help ensure that these

shocks do not have major repercussions.

In sum, the main message of this World

Economic Outlook is that, as long as policy fun￾damentals remain strong and institutions are

not undermined, the global economy should

grow rapidly, with the continued involvement

of almost all countries. Events of the past few

months have been a major test of global fi nan￾cial stability, and some unexpected weaknesses

have emerged. As long as those remain con￾tained within a few industrial countries and are

addressed in a timely fashion, the impact on

world growth should be small.

The key, in the years ahead, is to make sure

that emerging market and developing coun￾tries can continue to grow rapidly and without

major disruptions. Macroeconomic stability

is necessary but not suffi cient for economic

growth. We have to continue the process of

trade liberalization, allow capital to fl ow to

more productive opportunities in poorer coun￾tries, and—most important—make sure that

the benefi ts of growth are widely shared across

all countries and by as many people as possible

within countries. We would do well to antici￾pate further serious shocks, both downside and

upside, and to work harder to make sure that

the policies and institutions in place can with￾stand these shocks.

Simon Johnson

Economic Counsellor and Director, Research Department

EXECUTIVE SUMMARY

The global economy grew strongly in the fi rst half

of 2007, although turbulence in fi nancial markets has

clouded prospects. While the 2007 forecast has been

little affected, the baseline projection for 2008 global

growth has been reduced by almost ½ percentage point

relative to the July 2007 World Economic Outlook

Update. This would still leave global growth at a

solid 4¾ percent, supported by generally sound fun￾damentals and strong momentum in emerging market

economies. Risks to the outlook, however, are fi rmly on

the downside, centered around the concern that fi nan￾cial market strains could deepen and trigger a more

pronounced global slowdown. Thus, the immediate

focus of policymakers is to restore more normal fi nan￾cial market conditions and safeguard the expansion.

Additional risks to the outlook include potential infl a￾tion pressures, volatile oil markets, and the impact on

emerging markets of strong foreign exchange infl ows.

At the same time, longer-term issues such as popula￾tion aging, increasing resistance to globalization, and

global warming are a source of concern.

Global Economic Environment

The global economy continued to expand

vigorously in the fi rst half of 2007, with growth

running above 5 percent (Chapter 1). China’s

economy gained further momentum, growing

by 11½ percent, while India and Russia contin￾ued to grow very strongly. These three countries

alone have accounted for one-half of global

growth over the past year. Robust expansions

also continued in other emerging market and

developing countries, including low-income

countries in Africa. Among the advanced econo￾mies, growth in the euro area and Japan slowed

in the second quarter of 2007 after two quarters

of strong gains. In the United States, growth

averaged 2!/4 percent in the fi rst half of 2007 as

the housing downturn continued to apply con￾siderable drag.

Infl ation has been contained in the advanced

economies, but it has risen in many emerging

market and developing countries, refl ecting

higher energy and food prices. In the United

States, core infl ation has gradually eased to

below 2 percent. In the euro area, infl ation has

generally remained below 2 percent this year,

but energy and food price increases contrib￾uted to an uptick in September; while in Japan,

prices have essentially been fl at. Some emerg￾ing market and developing countries have seen

more infl ation pressures, refl ecting strong

growth and the greater weight of rising food

prices in their consumer price indices. The

acceleration in food prices has refl ected pres￾sure from the rising use of corn and other food

items for biofuel production and poor weather

conditions in some countries (Appendix 1.1).

Strong demand has kept oil and other commod￾ity prices high.

Financial market conditions have become

more volatile. As discussed in the October

2007 Global Financial Stability Report (GFSR),

credit conditions have tightened as increas￾ing concerns about the fallout from strains

in the U.S. subprime mortgage market led to

a spike in yields on securities collateralized

with such loans as well as other higher-risk

securities. Uncertainty about the distribution

of losses and rising concerns about counter￾party risk saw liquidity dry up in segments of

the fi nancial markets. Equity markets initially

retreated, led by falling valuations of fi nancial

institutions, although prices have since recov￾ered, and long-term government bond yields

declined as investors looked for safe havens.

Emerging markets have also been affected,

although by relatively less than in previous

episodes of global fi nancial market turbulence,

and asset prices remain high by historical

standards.

xiv

EXECUTIVE SUMMARY

xv

Prior to the recent turbulence, central banks

around the world were generally tightening

monetary policy to head off nascent infl ation

pressures. In August, however, faced by

mounting market disruptions, major central

banks injected liquidity into money markets to

stabilize short-term interest rates. In September,

the Federal Reserve cut the federal funds rate

by 50 basis points, and fi nancial markets expect

further reductions in the coming months.

Expectations of policy tightening by the Bank of

England, Bank of Japan, and European Central

Bank have been rolled back since the onset of

the fi nancial market turmoil. Among emerging

markets, some central banks also provided

liquidity to ease strains in interbank markets,

but for others the principal challenge remains

to address infl ation concerns.

The major currencies have largely contin￾ued trends observed since early 2006. The

U.S. dollar has continued to weaken, although

its real effective value is still estimated to be

above its medium-term fundamental level. The

euro has appreciated but continues to trade in

a range broadly consistent with fundamentals.

The Japanese yen has rebounded strongly in

recent months but remains undervalued relative

to medium-term fundamentals. The renminbi

has continued to appreciate gradually against

the U.S. dollar and on a real effective basis, but

China’s current account surplus has widened

further and its international reserves have

soared.

Outlook and Risks

In the face of turbulent conditions in fi nan￾cial markets, the baseline projections for global

growth have been marked down moderately

since the July World Economic Outlook Update,

although growth is still expected to continue at

a solid pace. The global economy is projected to

grow by 5.2 percent in 2007 and 4.8 percent in

2008—the latter forecast is 0.4 percentage point

lower than previously expected. The largest

downward revisions to growth are in the United

States, which is now expected to grow at 1.9 per￾cent in 2008; in countries where spillovers from

the United States are likely to be largest; and in

countries where the impact of continuing fi nan￾cial market turmoil is likely to be more acute

(see Chapter 2).

The balance of risks to the baseline growth

outlook is clearly on the downside. While the

underlying fundamentals supporting growth are

sound and the strong momentum in increasingly

important emerging market economies is intact,

downside risks emanating from the fi nancial

markets and domestic demand in the United

States and western Europe have increased.

While the recent repricing of risk and increased

discipline in credit markets could strengthen

the foundations for future expansion, it raises

the near-term risks to growth. The extent of the

impact on growth will depend on how quickly

more normal market liquidity returns and on

the extent of the retrenchment in credit mar￾kets. The IMF staff’s baseline forecast is based

on the assumption that market liquidity is gradu￾ally restored in the coming months and that

the interbank market reverts to more normal

conditions, although wider credit spreads are

expected to persist. Nonetheless, there remains

a distinct possibility that turbulent fi nancial

market conditions could continue for some

time. An extended period of tight credit condi￾tions could have a signifi cant dampening impact

on growth, particularly through the effect on

housing markets in the United States and some

European countries. Countries in emerging

Europe and the Commonwealth of Independent

States region with large current account defi cits

and substantial external fi nancing infl ows would

also be adversely affected if capital infl ows were

to weaken.

Several other risks could also have an impact

on the global outlook. While downside risks

to the outlook from infl ation concerns have

generally been somewhat reduced by recent

developments, oil prices have risen to new highs

and a further spike in prices cannot be ruled

out—refl ecting limited spare production capac￾ity. Risks related to persistent global imbalances

still remain a concern.