Tuesday, October 08, 2013 2:17 PM / WSJ.com Editors
The International Monetary Fund cut its world growth forecast amid deteriorating emerging market prospects, urging authorities to shore up their economies as the U.S. prepares to exit its easy money policies and wrestles with a budget impasse that threatens to derail the global recovery.
In its sixth consecutive downward revision, the IMF cut its growth forecast for this year by 0.3 percentage point to 2.9% and next year by 0.2 percentage point to 3.6%, compared with the fund's last assessment in July.
"Two recent developments will likely shape the path of the global economy in the near term," the fund said in its latest World Economic Outlook.
First, the pace of the Federal Reserve's exit from its easy-money policies meant to spur growth can make or break growth. If the Fed withdraws its stimulus too fast, it could stall global growth as borrowing costs rise too quickly for many economies and fuel further emerging-market volatility as investors pull out their capital en masse.
Second, "there is strengthening conviction that China will grow more slowly over the medium term than in the recent past," particularly as Beijing has indicated it can live with lower growth as a way to foster healthier long-term expansion of the economy. The fund cut China's 2014 outlook nearly half a percentage point from its last forecast to 7.3%.
But it wasn't just China. Gloomier prospects for emerging markets across the globe drove the IMF's revisions. India's outlook for the year was slashed by 1.8 percentage points to 3.8%, Mexico's 2013 forecast was chopped by more than half to 1.2%, and the fund notched Brazil's growth for next year down 0.7 percentage point to 2.5%.
Emerging-market stocks, bonds and currencies took major hits earlier this year after Fed officials indicated they could soon begin withdrawing the bank's extraordinary stimulus. The promise of rising returns in the U.S. amid waning growth prospects and potential over-investment in emerging markets prompted investors to pull their capital out in droves. Markets have since calmed as the Fed tempered expectations for an earlier exit.
But "contrary to popular impression," the cooling down of emerging markets wasn't solely driven by the Fed's action. Rather, the potential reversal of years of cheap cash exposed areas of financial and economic weakness around the globe, the fund said. And many emerging markets that have hit a peak in expansion are likely to grow at much lower rates on average than the previous decade as competitiveness constraints, infrastructure bottlenecks and slowing investments curb potential economic expansion.
The report sets the stage for talks between global finance ministers and central bankers gathering this week in Washington.
The revisions are also a warning, to both the Fed and emerging market officials.
The Fed will eventually start withdrawing its stimulus, and "in this setting, emerging-market economies may face exchange rate and financial market overshooting as they also cope with weaker economic outlooks and rising domestic vulnerabilities," the fund said.
"Some could even face severe balance of payment disruptions," it said.
Emerging markets should use the small window of time available to get their economic houses in order, said Olivier Blanchard, the IMF's chief economist.
Reforms, such as boosting domestic consumption in China and removing barriers to investment in India and Brazil, "can help ease the adjustment and are becoming more urgent," Mr. Blanchard said. Countries with large budget deficits need to tighten their fiscal belts, and those with high inflation, such as Turkey, must raise interest rates and put in place a more credible monetary policy framework, he said.
To ride out turbulence, emerging markets should allow their currencies to depreciate and be prepared to flood dysfunctional markets with cash reserves. As a last resort, IMF Managing Director Christine Lagarde has said the fund stands ready to bailout countries in need.
At the same time, the Fed must take care in calibrating an exit. If it moves too soon, by cutting its bond purchases before the end of the year, for example, the central bank could stunt growth for years, the IMF said.
The IMF's latest figures assume, however, that U.S. officials quickly resolve the simmering budget standoff between the two major political parties.
That is not assured, however. Washington is in the second week of a government shutdown after lawmakers failed to pass a budget. The longer the stalemate continues, the more it escalates fears the political gridlock will force the U.S. into a default.
The fund cut its forecast for U.S. economic growth next year by 0.2 percentage points to 2.6%.
A short-term shutdown is likely to have a limited impact on the economy, the fund said, but a longer shutdown could be "quite harmful."
"Even more importantly, a failure to promptly raise the debt ceiling, leading to a U.S. selective default, could seriously damage the global economy," the fund said.
Aside from such potential cliff events, the fund said a growing worry is a prolonged period of sluggish global growth.
"The major economies must urgently adopt policies that improve their prospects," the IMF said. "Otherwise, the global economy may well settle into a subdued medium-term growth trajectory," it said.
In addition to prudent U.S. and emerging market policy action, the fund said the euro zone, which should expand by 1% next year after more than a year of recession, needs to move faster in bolstering the currency union with a unified budget and banking union. And Japan must continue its economic restructuring with entitlement reform, one of several actions necessary to avoid losing gains made largely through aggressive monetary policy.
Failure to act on all fronts could cut global growth over the medium term by a quarter, with the economy only expanding by 3% a year instead of 4%, the IMF said.