Washington, DC: For the second day in a row, the International Monetary Fund (IMF) warned that the world economy was in the “danger zone”, and put the onus for action directly on politicians.
Releasing the Global Financial Stability Report (GFSR), officials also cautioned that emerging market economies such as India faced an abrupt reversal of capital flows if foreign portfolio investors perceived that the strong prospects of economic growth were being reversed.
According to it, foreign investor behaviour, particularly of public and private pension funds and insurance firms, had undergone a radical transformation during the crisis, resulting in their withdrawal from risky and illiquid assets.
“The main determinants (of foreign investment sentiment) are strong prospects for domestic economic growth and lower-perceived country risk rather than interest rate differentials,” the report said.
India, among the fastest growing economies in the world, was a recipient of substantial foreign portfolio investments in 2010, but this has since slipped as markets have turned uncertain. Investments by foreign institutional investors in equity amounted to $29.36 billion (Rs 1.4 trillion today) in 2010 and $607.4 million so far this year, according to the Securities and Exchange Board of India.
Implicitly, IMF was signalling that failure to stick with prudent macroeconomic policy, especially fiscal discipline, to guarantee the growth trajectory would potentially influence foreign investor behaviour.
GFSR assesses key risks facing the global financial system and identifies systemic vulnerabilities. Conventionally, it plays the role of an early warning system and recommends policy action to stave off a problem.
On Tuesday, IMF’s biannual World Economic Outlook lowered the global growth forecast to 4% in 2011, down from 4.3% in the last report released in June. It also warned that the world economy was in a “dangerous new phase”.
Addressing the press, Jose Vinals, IMF director of monetary and capital markets, echoed this sentiment, saying: “We’re back in the danger zone.”
According to the report, financial stability risks increased substantially in the past few months of what it believes to be the fourth phase of the crisis that began with the subprime crisis in the US.
It describes the phases as the subprime crisis involving private debt, the systemic banking crisis that spread from the US to Europe, the sovereign debt crisis in the euro zone, and finally the political phase, wherein a political consensus on fiscal consolidation and adjustment has eluded the political class on “both sides of the Atlantic”.
As policy palliatives, it suggests a three-pronged action plan for advanced economies:
a) Improve public balance sheets through a “credible” medium-term fiscal adjustment plan in the US, Europe and Japan.
b) Resolve overstretched US household balance sheets through an aggressive restructuring programme of mortgages, including writing off some of the debts.
c) Immediately fix the banking sector in Europe to absorb the spillovers from riskier sovereigns, through infusion of capital from either public or private sources.
For emerging economies, GFSR has advised the need to “balance current risks to avoid future crises”.
According to it, policymakers need to avoid a further build-up of financial imbalances, where credit growth remains high even though capital flows may have abated in recent months. This is to ready itself ahead of a potential “global shock” that could risk reversing capital flows and a slump in economic growth.
“Our analysis shows the impact on emerging market banks could be substantial and thus warrants a further buildup of capital buffers in the banking system,” it said.