IMF On Australia

The IMF has issued a concluding statement following their official visit to Australia. They warn that growth will be modest, more effort is required to contain housing risks – including macroprudential, and a structural reform agenda is required to lift productivity and growth.

Over the past year, Australia’s recovery under the transition from the mining boom has continued despite setbacks. Domestic demand growth has strengthened, and employment growth has picked up markedly since the beginning of the year, most of it in full-time jobs. But labor market slack remains present, and wage growth has remained weak. Beyond wages, stronger retail competition and continued declines in import prices have contributed to inflation outcomes below the mid-point of the Reserve Bank of Australia’s target range of 2 to 3 percent. With stronger terms of trade, the current account deficit has narrowed substantially and the trade balance has moved into surplus, primarily because of higher global prices for coal and iron ore.

Looking forward, conditions are in place for a pick-up in economic growth to above-trend rates. The improved picture reflects a stronger global outlook, recent stronger employment growth, and a stronger contribution from infrastructure investment with positive spillovers to private investment and the rest of the economy, more than offsetting the declining contribution from dwelling investment. Non-mining private business investment should rebound further, while the drag from mining investment should be ending.

The pickup in growth is likely to be modest, while inflation and wages will be slow to rise. Household consumption is expected to be held back by low real wage growth, given labor market slack and structural change in some sectors. Economic slack is projected to decline gradually. Upward pressure on prices and wages should emerge once the economy has been at full employment, including lower underemployment, for some time.

With stronger momentum in domestic demand and inflation close to the midpoint of the target range not yet secured, continued macroeconomic policy support will remain essential . With a welcome pickup in public investment, the overall fiscal stance is expected to be broadly neutral in 2017 and 2018. With the cash rate at 1.5 percent, monetary policy remains appropriately accommodative. With Australia’s recovery lagging that of other major advanced economies, monetary policy should remain firmly focused on ensuring stronger sustained momentum in domestic demand and inflation.

The Commonwealth government’s budget repair strategy is appropriately anchored by medium-term budget balance targets . The strategy is predicated on a rapid rebound of nominal growth to trend, leading to structural revenue and expenditure improvements. The risk is that with a gradual recovery, the rebound to trend might not be as quick as expected. Australia has the fiscal space to absorb this risk and protect or, if needed, increase the spending envelopes for infrastructure investment, structural reforms supporting trend growth and productivity.

Near-term risks to growth have become more balanced, but large external shocks, including their interaction with the domestic housing market, are an important downside risk. On the positive side, the improved global outlook could lead to a stronger-than-expected recovery, underpinned by a larger pickup in non-mining business investment. On the downside, there is the risk of unexpectedly tighter global financial conditions flowing through to domestic financial conditions in Australia while the economy is still recovering. Australia is also particularly exposed to downside risk from China through its trade links in commodities and services. Domestically, growth in consumer spending could weaken if improvements in household incomes turn out to be more gradual than expected, or if a cooling housing market and high debt to income ratios discourage further declines in household saving rates.

Managing Housing Imbalances and Financial Sector Risks

The housing market is expected to cool, but imbalances—lower housing affordability and household debt vulnerabilities—are unlikely to be corrected soon. In the absence of a major shock to the economy, the cooling is expected to be driven mainly by the building completion rate catching up with demand in the major eastern capital regions. But given continued strong population growth and foreign buyer interest, demand growth for housing is expected to remain robust, and, in the absence of a large inventory of vacant properties, prices should stabilize, rather than fall significantly. Declines in household debt-to-income ratios would thus need to be driven by strong nominal income growth and amortization.

The Commonwealth and States have appropriately used a multi-pronged approach to address increasing housing market imbalances and related systemic risks to banks.

Prudential policies by the Australian Prudential Regulation Authority (APRA) have lowered the risks to the banking sector from their large exposure to the housing market in a low-interest rate environment, primarily through a sequential tightening of required underwriting standards. The latest round involved tighter standards on the origination of interest-only loans, and reinforced a cap on lending growth to investors. On the demand side, some States have helped qualified first-time homebuyers to enter the market, including through grants and exemption from stamp duty. In addition, the Commonwealth is assisting those buyers to build savings more quickly for a home deposit via the superannuation system.

Supply-side policies will be most effective in achieving housing affordability in the longer term. The housing supply response is being strengthened through a variety of measures at the State and Commonwealth levels, increasing the supply of developable land and the efficiency of its use. including higher housing densification. These include ramping up infrastructure spending and reforms to planning and zoning. These steps have appropriately been complemented by measures to provide for increases in the supply of affordable housing targeted to lower- and middle-income households.

Supply-side policies could also help in raising productivity and trend growth. Ensuring longer-term affordability in housing, and location cost more broadly, could lower risks that businesses and people are not able to move to the urban areas where they would be most productive because of agglomeration and other network externalities. This, in turn, would also help lower risks to longer-term growth.

These policy efforts should be complemented by tax reform . Housing-related tax settings can also play a role in strengthening supply and efficient use of land and, in the longer term, should limit potential distortions they might introduce in the demand for property. The State stamp duty tax regimes are inefficient—they have narrow tax bases, and discourage mobility and transactions in existing properties that could have more productive alternative uses. It should be replaced with a systematic land tax regime applying to all residential and commercial properties. As demonstrated by the recent reform in the Australian Capital Territory, the transition can be gradual, which helps to avoid a disruptive impact on State revenues. Cash flow problems for low-income homeowners can be addressed through deferment options.

Prudential reform efforts on lifting banks’ mortgage asset quality are appropriately complemented by reforms refining the capital adequacy framework. In combination with higher capital adequacy and liquidity requirements, tighter mortgage underwriting standards have strengthened banks’ resilience to housing market shocks. APRA is in the process of further refining the capital adequacy framework. In July 2017, it clarified the capital requirements for Australian banks’ to “be unquestionably strong,” as suggested by the 2014 Financial Sector Inquiry. It is also preparing regulations to address the systemic risk from banks’ concentrated exposure to residential mortgages through capital requirements.

Fostering Long-Term Growth Opportunities

Reforms could lift productivity growth . The decline in trend output growth in Australia over the past decade or so was driven mainly by lower labor force growth and lower rates of capital accumulation, both developments reflecting corrections after the mining investment boom which are likely to have run their course. Average productivity growth has picked up recently, primarily because of the transition to higher capital stock utilization in the mining sector. Nevertheless, productivity growth could be lifted by reforms.

There is scope to expand infrastructure spending beyond the recent increase in the fiscal envelope. According to some international metrics, Australia has a notable infrastructure gap compared with many other advanced economies. While the recent boost has helped to narrow the gap, it might not be enough to close it. Further increases in investment have the potential to improve physical and digital interconnectivity, both internally and with Australia’s trading partners, thereby contributing to higher growth.

Fostering innovation, research and workforce skills upgrades, would complement the productivity effects from more infrastructure.

  • Australia’s research and development (R&D) share of GDP lags other OECD members. But the relatively small scale National Innovation and Science Agenda (NISA) is only funded through FY2018/19. A clear implementation of the upcoming 2030 Strategic Plan for the Australian Innovation, Science and Research System by defining the scope and funding of policy instruments would help strengthen the reach and magnitude from its possible positive productivity externalities.
  • Flexible labor markets have contributed to relatively smooth adjustment after the end of the mining boom. But with continued structural change and higher under- or unemployment in some age and skill cohorts, defining a longer-term envelope for active labor market policies for workforce re-education and skill upgrades can help raise human capital and labor force participation, such as the levy proposed to maintain the new Skilling Australians Fund.

Productivity and inclusion could also be supported with a broad tax reform package . The Commonwealth government has implemented a reform by lowering the corporate income tax rate for SMEs, with the goal of broadening it to all firms at an even lower rate. A more comprehensive tax reform has the potential to increase efficiency of the tax system, increase investment and labor demand, and reduce inequality. This would entail lowering taxes on income from mobile factors of production (capital and labor) and increasing reliance on taxes on immobile factors of production (land) and indirect taxes on consumption, undertaken in a revenue neutral way. Such a reform would complement the switch to a broad-based tax on land instead of stamp duties already discussed.

Reconsidering broad tax reforms. Concerns about the regressive nature of higher taxes on consumption at a time of low wage growth could be addressed by broadening the base, reducing generous tax concessions (some of which are not means-tested or are limited), and revising the design of the income tax reform. Two developments could encourage reconsideration of tax reform. First, significant corporate income tax reductions in other large advanced economies, which would have capital flow implications of potential concern for Australia. Second, the ongoing Horizontal Fiscal Equalisation Review by the Productivity Commission is reopening consideration of the distribution of GST revenues, which could allow for a broader package for agreement between the Commonwealth and the States.

The proposed areas of reform suggested above could draw further measures from the recent work by the Productivity Commission. In its inaugural 5-Year Productivity Review, the Commission has proposed structural reforms in health, education, urban development, and regulatory aspects of market efficiency. These proposals could define new policy parameters, which could also increase certainty about policy directions for business investment decisions. These would also build upon the recently enacted legislative agenda of the Competition Policy Review (the Harper report) at the Commonwealth level. At the State level, there are still further agreements needed to fulfill the Harper report’s implementation.

 

A Concluding Statement describes the preliminary findings of IMF staff at the end of an official staff visit (or ‘mission’), in most cases to a member country. Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF’s Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, or as part of other staff monitoring of economic developments.

The authorities have consented to the publication of this statement. The views expressed in this statement are those of the IMF staff and do not necessarily represent the views of the IMF’s Executive Board. Based on the preliminary findings of this mission, staff will prepare a report that, subject to management approval, will be presented to the IMF Executive Board for discussion and decision.

Is The Global Banking Network Really De-globalising?

An IMF working paper “The Global Banking Network in the Aftermath of the Crisis: Is There Evidence of De-globalization?” released today, shows that contrary to popular belief, the Global Banking Network has not shrunk since the GFC in the simple way often thought. Using complex and innovative modelling, they conclude that the banking world in some ways is connected more deeply, and with greater complexity than before. This means that players in one location could be impacted more severely by events in other geographies. They conclude that the hidden dynamics of the global banking network after the crisis suggest that the assertion that cross-border lending has shrunk globally seems to miss out significant details. They refrain from assessing the risk impact of this observation.

However, we conclude, like our digital world, global banking is more financially networked than ever, suggesting that risks could be propagated widely and in unexpected directions.

The global financial crisis in 2008-09 underscores the unique role of financial interconnectedness in transmitting and propagating adverse shocks. Previous literature stresses the significance of network structure in generating contagion,  lays out detailed mechanisms of contagion through balance-sheet effects, is followed by a large body of theoretical and empirical research on interbank markets, mostly within a single country or region, that focuses on modeling banks’ behavior in response to shocks in the financial system. Cross-border implications of the banking network, however, are mostly ignored due to scarcity of data and rich country-level heterogeneity that may lower the explanatory power of a unified framework.

The sharp fall in global cross-border banking claims after the crisis has been persistent, either measured in Bank for International Settlements (BIS) Locational Banking Statistics (LBS) or BIS Consolidated Banking Statistics (CBS). This persistent aggregate decline in cross-border banking claims has been considered evidence of financial deglobalization. In this paper, we consider the validity of the financial de-globalization argument by studying the evolution of the global banking network before, during and after the crisis, with a particular focus on the aftermath of the crisis. Instead of trying to establish the role of the network in propagating the crisis at a global level, we take the role of the global banking network as given and seek to investigate the impact of the crisis on the network. In this context, our key contributions to the literature are twofold: (i) we measure and map the global banking network using a model-free and data driven approach; and (ii) we analyze the evolution of the network using network analysis tools, including some novel applications, that are relevant given the  characteristics of the global banking network and the available data.

The foremost challenge in constructing the global banking network is to map and identify an accurate and comprehensive network structure using the available data on cross-border banking flows. Researchers face a tradeoff between data coverage and frequency. High frequency data, such as banks’ daily transactions, often contain a limited number of banks within a country, while datasets with a good coverage of global lending mainly report country-level aggregate statistics, and are updated infrequently. This challenge is further complicated by the difficulty in identifying the composition, sources and destinations of bank flows, primarily due to the use of offshore financial centers as important financial intermediaries. Not only are global banks able to conduct cross-border lending via entities in their headquarters and offshore financial centers, but also they can lend domestically through subsidiaries and/or branches within the border of the borrower countries. BIS International Banking Statistics (IBS), through its two datasets (LBS and CBS), offer the best available data to map the international bank lending activity across countries. This is especially the case of the CBS dataset, which consolidates gross claims of each international banking group on borrowers in a particular country, aggregating those claims following the nationality of the parent banks. This nationality-based nature of CBS is an advantage over LBS, which follows a residency-based principle, and thus obscures the linkages between the borrower country and the parent bank institution, when lending originates in affiliates located in third countries (e.g., off-shores financial centers). A disadvantage of using CBS is that it registers the full claims of the affiliates, independent of how those assets were funded (e.g., a claim of a foreign affiliate that is fully funded with local domestic depositors is still counted as a claim from the country of the parent bank on the borrower country where the affiliate is located). In order to avoid this overstatement of financial linkages, which are large in the case of emerging countries as shown in the next section, we combine BIS CBS data with bank level data, taking into account the claims of foreign affiliates and the local deposit funding used by subsidiaries and branches.

We use the improved measure of cross-border banking linkages to  onstruct a sequence of global banking networks, and apply tools from network theory to analyze the evolution of economic and structural properties of the network. We take a step further to incorporate this important discussion into our choice of metrics to identify important players and trace the structural evolution of the global banking network. We provide an in-depth discussion of network measure choice based on the structural context of a core-periphery, asymmetric and unbalanced network structure and in the economic context of characterizing banking flows at the country level.

We introduce measures of node importance that capture  distinct aspects of global banking linkages. In particular, we use recursively defined Katz-Bonacich centrality and authority/hub measure to characterize country importance based on its connection to and dependence on other important countries, as well as a novel application of modularity in order to capture the regional fragmentation of the network. The flexibility of our network configuration allows us to use a small number of network metrics to reveal distinct aspects of network structure and node importance.

We find that the overall shrinkage of cross-border bank lending after the crisis, which has been the key argument behind the claims on financial de-globalization, is also reflected in the average number of links and their strength in the global banking network.

However, rich details on the evolution of the network suggest that this argument is overly simplified.

While connections within traditional major global lenders (banks in France, Germany, Japan, UK, and US) became sparser, many non-reporting countries located at the periphery of the network are more connected, mainly due to the rise of non-major global lenders out of Europe. Measured in metrics of node importance, these lenders have been steadily climbing up the rank, resulting in a corresponding decline of European lenders in status and borrowers’ decreasing dependence on traditional lending countries. Moreover, we find substantial evidence indicating increasing level of regionalization of the global banking network. Even though post-crisis retrenchment of major global and non-major European banks’ operation in the aggregate was just partially offset by the rest of the BIS reporting countries’ regional expansion, their targeted expansions have increased regional interlinkages through both direct cross-border and affiliates’ lending. More formally, using network modularity as a novel application to assess the quality of network cluster structure based on region divisions, we find that this measure increases after the crisis, thus indicating, from the perspective of network theory, that some form of regionalization characterizes the post-crisis dynamics of the global banking network. Finally, we also confirm this regionalization process through a regression analysis of the evolution of cross-border lending. After controlling by geographical distance and trade relationships as well as lender and borrower characteristics, we find a statistically significant increase in cross-border lending when both borrower and lender belong to the same region, especially in the case of peripheral lenders during the post-crisis period.

We show that without proper adjustment, country-level banking statistics suffer from multiple data issues that distort the actual role of each country in cross-border lending, and increase the difficulty of accurately detecting key players in the network. We find evidence confirming the overall shrinkage in the scale of cross-border bank lending using a variety of network analysis tools. Moreover, these methods capture rich dynamics that occur inside the global banking network and are not captured by traditional aggregate indicators.

Using a set of centrality measures with meaningful economic interpretations, we delve substantially deeper to capture the interconnectedness faced by each country. While the structural stability of the highly concentrated global banking network is mainly due to the stability of major global lenders, we observe decline in importance for non-major global European lenders and a corresponding rise in the ranks for lenders from other region, comprised of mostly emerging market lenders. The hidden dynamics of the global banking network after the crisis suggest that the assertion that cross-border lending has shrunk globally seems to miss out significant details.

NOTE: IMF Working Papers describe research in progress by the authors and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the authors and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

Assessing China’s Residential Real Estate Market

The IMF just published a working paper examining real estate in China.

After a temporary slowdown in 2014-2015 China’s real estate market rebounded sharply in 2016. As signs of overheating emerged, the government turned to tighten real estate markets through a range of macroprudential and administrative measures. Many empirical studies point out that the house price surge is driven by fundamentals, while others consider the pickup of real estate activity is unsustainable. This paper uses city-level real estate data to estimate the range of overvaluation of real estate markets across city-tiers, and assesses the main risks of a real estate slowdown and its impact on economic growth and financial stability.

Real estate has been a key engine of China’s rapid growth in the past decades. Real estate investment grew rapidly from about 4 percent of GDP in 1997 to the peak of 15 percent of GDP in 2014, with residential investment accounting for over two thirds of the total real estate investment.

Bank lending to the sector makes up 25 percent of total bank loans, about half of all new loans in 2016, and banks’ increasing exposures to real estate, including through property developers and household mortgages, may pose financial stability concerns. Real estate also has strong linkages to upstream and downstream industries (about a quarter of GDP is real-estate related).2 In addition, land sales are a key source of local public finance, accounting for about 30 percent of local government revenue in 2016, while general government net spending financed by land sales is about 9 percent of the headline revenue in 2016. There has been a rapid expansion of government subsidies on social housing, consisting of nearly 6 million apartment units in 2015-2017.

Real estate markets vary significantly in China because of its large economic size, economic and social diversity, and fragmented local government policies. The real estate cycles tend to be more pronounced in top-tier cities in terms of price volatility, but they account for a small fraction of real estate inventory and investment.  Smaller cities constitute over half of residential real estate investment, but the price increase on average was much lower during 2013-16.

Distortions render China’s property market susceptible to both price misalignment and overbuilding. On the supply side, the market is distorted by local governments’ control over land supply and their reliance on land sales to finance spending. On the demand side, the market is prone to overvaluation—housing is attractive as an investment instrument given a history of robust capital gains, high savings, low real deposit interest rates, a lack of alternative financial assets, as well as capital account restrictions.

The government has closely monitored real estate activity given its importance in the economy. Policies are highly decentralized, with local governments (often with local branches of the financial regulators) deciding land sale and infrastructure development, granting construction and sales permits to developers, and setting purchases restrictions. The central government and financial regulators can also affect the housing market through financing conditions and macro-prudential tools for mortgage lending.

If house prices rise further beyond “fundamental” levels and the bubble expands to smaller cities, it would increase the likelihood and costs of a sharp correction, which would weaken growth, undermine financial stability, reduce local government spending room, and spur capital outflows. Empirical analysis suggests that the increasing intensity of macroprudential policies tailored to local conditions is appropriate. The government should expand its toolkit to include additional macroprudential measures and push forward reforms to address the fundamental imbalances in the residential housing market.

Note: IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

IMF Downgrades Australia’s Growth Prospects

The latest IMF forecast is still expecting a growth rate of around 3% in 2018, but they revised down 2017 in the latest Global Financal Stability Report.

Our first half result in 2017 was 1.2%, so the second half is circa 1%, hardly stellar, and the sudden rebound to 3% next year, some might say appears courageous.

They also revised up the unemployment rate, remaining at 5.6%, rather than falling to 5.3% as estimated last time.

This plus slow wage growth highlights the issues underlying the economy.

Financial Stability Improves, But Rising Vulnerabilities Could Put Growth at Risk

From The IMF Blog.

It seems like a paradox. The world’s financial system is getting stronger, thanks to healthy economic growth, buoyant markets, and low interest rates. Yet despite these favorable conditions, dangers in the form of rising financial vulnerabilities are starting to loom. That is why policymakers should act now to keep those vulnerabilities in check.

As we explain in the latest Global Financial Stability Report, the recovery from the global financial crisis isn’t yet complete. Central bankers rightly maintain easy policies to support growth. But this is breeding complacency and allowing a further build-up of financial excesses. Non-financial borrowers are taking advantage of cheap credit to load up on debt. Investors are buying riskier and less liquid assets. If left unattended, these growing vulnerabilities will continue to mount, threatening to derail the economic recovery when shocks occur.

Capital buffers

To be sure, there are reasons for optimism. Low interest rates and rising asset prices are spurring growth. Big, globally systemic banks – so called because the failure of just one of them could shake the financial system – have added $1 trillion to their capital buffers since 2009. Overseas investment into emerging market and low income economies has increased. The global economic upswing is laying hopes for a sustained recovery and allowing central banks to eventually return their monetary policies to normal settings.

So why should policy makers be concerned?

Let’s start with risks in financial markets. Before the crisis, there were $16 trillion in relatively safe, investment-grade bonds yielding more than 4 percent. That has dwindled to just $2 trillion today. There is simply too much money chasing too few high yielding assets. The result is that investors are taking more risks and exposing themselves to bigger losses if markets tumble.

New risks

Then there are rising levels of debt in the world’s biggest economies. Borrowing by governments, households and companies (not including banks) in the so-called Group of 20 exceeds $135 trillion, equivalent to about 235 percent of their combined gross domestic product. Despite low interest rates, debt servicing burdens have risen in several economies. And while borrowing has helped the recovery, it has also created new financial risks. For example, chapter two of the Global Financial Stability Report showed growth in household debt relative to GDP is associated with a greater probability of a banking crisis.

 China

In China, the size, complexity, and pace of credit growth points to elevated financial stability risks. Banking sector assets have risen to 310 percent of GDP, nearly three times the emerging-market average and up from 240 percent at the end of 2012. “Shadow” lending, including wealth management products, remains a big risk for smaller banks. The authorities have taken welcome steps to address these risks, but there is still work to do. Broader reform measures are necessary to reduce the economy’s reliance on rapid credit growth.

Low-income countries have also benefited from easy financial conditions by expanding their access to international bond markets. While borrowing has generally been used to fund infrastructure projects, refinance debt, and repay arrears, it has also been accompanied by an underlying deterioration of debt burdens as measured by the debt service ratio.

Policy implications

Overall, investors are growing complacent about potential shocks that could cause turmoil in markets. These include geopolitical risks, a surge in inflation, and a sudden jump in long-term interest rates. How should policymakers respond? There are several steps they can take:

  • Major central banks can avoid creating market turbulence by thoroughly explaining their plans to gradually unwind crisis-era policies.
  • To discourage riskier lending, financial regulators should deploy so-called “macroprudential” policies, such as limits on loan-to-value ratios for mortgages, for macro critical objectives.
  • Emerging-market and low income countries should take advantage of benign external conditions to reduce vulnerabilities and enhance resilience by enhancing underwriting standards, building capital and liquidity buffers, and increasing reserves.
  • Supervisors should focus more on the business models of banks to ensure sustainable profitability. We estimate that almost one-third of systemically important banks, with $17 trillion in assets, will struggle to achieve the profitability that’s needed to ensure their resilience to shocks.
  • The global regulatory reform agenda should be completed and fully implemented. Global cooperation remains essential.

With the right measures, policy makers can take advantage of these benign times to keep a lid on mounting vulnerabilities and ensure that the global economic expansion remains on track. This is not the time for complacency. The time to act is now. Otherwise, future growth could be at risk.

Global Economic Upswing Creates a Window of Opportunity – IMF

From the IMF Blog.

The global recovery is continuing, and at a faster pace. The picture is very different from early last year, when the world economy faced faltering growth and financial market turbulence. We see an accelerating cyclical upswing boosting Europe, China, Japan, and the United States, as well as emerging Asia.

The latest World Economic Outlook has therefore upgraded its global growth projections to 3.6 percent for this year and 3.7 percent for next—in both cases 0.1 percentage point above our previous forecasts, and well above 2016’s global growth rate of 3.2 percent, which was the lowest since the global financial crisis.

For 2017, most of our upgrade owes to brighter prospects for the advanced economies, whereas for 2018’s positive revision, emerging market and developing economies play a relatively bigger role. Notably, we expect sub-Saharan Africa, where growth in per capita incomes has on average stalled for the past two years, to improve overall in 2018.

The current global acceleration is also notable because it is broad-based—more so than at any time since the start of this decade. This breadth offers a global environment of opportunity for ambitious policies that will support growth and raise economic resilience in the future. Policymakers should seize the moment: the recovery is still incomplete in important respects, and the window for action the current cyclical upswing offers will not be open forever.

Global recovery still incomplete

Why do we say that the recovery is incomplete? It is incomplete in three important ways.

First, the recovery is incomplete within countries. Even as output nears potential in advanced economies, nominal and real wage growth have remained low. This wage sluggishness follows many years during which median real incomes grew much more slowly than incomes at the top, or even stagnated. Drivers of growth including technological advances and trade have had uneven effects, lifting some up but leaving others behind in the face of structural transformation. The resulting higher income and wealth inequalities have helped fuel political disenchantment and skepticism about the gains from globalization, putting recovery at risk.

Second, the recovery is incomplete across countries. While most of the world is sharing in the current upswing, emerging market and low-income commodity exporters, especially energy exporters, continue to face challenges, as do several countries experiencing civil or political unrest, mostly in the Middle East, North and sub-Saharan Africa, and Latin America. Many small states have been struggling. About a quarter of all countries saw negative per capita income growth in 2016, and despite the current upswing, nearly a fifth of them are projected to do the same in 2017.

Finally, the recovery is incomplete over time. The cyclical upswing masks much more subdued longer-run trends of productivity and demographics, even correcting for the arithmetical effect of more slowly growing populations. For advanced economies, per capita output growth is now projected to average only 1.4 percent a year during 2017–22 compared with 2.2 percent a year during 1996–2005. Moreover, we project that fully 43 emerging market and developing economies will grow even less in per capita terms than the advanced economies over the coming five years. These economies are diverging rather than converging, going against the more benign trend of declining inequality between countries due to rapid growth in dynamic emerging markets such as China and India.

Window for action

These gaps in the recovery challenge policymakers to action—action that should take place now, while times are good. Success requires a three-pronged approach in the context of completing and refining the important financial stability reforms undertaken since the global crisis, without weakening them.

Needed structural reforms differ across countries, but all have ample room for measures that raise economic resilience along with potential output. Our research has shown that structural reforms are easier to implement when the economy is strong.

For some countries that have returned close to full employment, the time has come to think about gradual fiscal consolidation to reduce swollen public debt levels and build buffers against the next recession. Higher infrastructure and educational spending, which are needed in some countries that do have fiscal space, can have the added benefit of boosting global demand just as consolidation measures elsewhere subtract from it. This multilateral fiscal policy mix can also help reduce excess global imbalances.

Critically important to growth that can be sustained and shared by all is investment in people at all life cycle stages, but especially the young. Better education, training, and retraining can both ease labor market adjustment to long-term economic transformation—from all sources, not only trade—and raise productivity. In the short term, the excessive youth unemployment that afflicts many countries urgently deserves attention. Investing in human capital should also help push labor’s income share upward, contrary to the broad trend of recent decades—but governments should also consider correcting distortions that may have reduced workers’ bargaining power excessively.

In sum, structural and fiscal policy together should promote economic conditions conducive to sustainable and more inclusive real wage growth.

The third policy prong, monetary policy, still has a key role to play. Earlier deflation threats in advanced economies have receded considerably, but inflation has remained puzzlingly low even as unemployment rates have come down. Clear central bank communication and the smooth execution of monetary policy normalization, where and when appropriate, remain crucial. Success will help prevent market turbulence and sudden tightening of financial conditions, which could disrupt the recovery with spillovers to emerging market and developing economies. Those economies, in turn, face diverse monetary policy challenges but should continue where possible to use exchange rate flexibility as a buffer against external shocks, paying due attention to implications for price stability.

Numerous global problems require multilateral action. Priorities for mutually beneficial cooperation include strengthening the global trading system, further improving financial regulation, enhancing the global financial safety net, reducing international tax avoidance, and fighting famine and infectious diseases.  Also crucially important are to mitigate greenhouse gas emissions before they do more irreversible damage, and to help poorer countries—which are not themselves substantial emitters—adapt to climate change.

If the strength of the current upswing makes the moment ideal for domestic reforms, its breadth makes multilateral cooperation opportune. Policymakers should act while the window of opportunity is open.

Rising Household Debt: What It Means for Growth and Stability

From The IMFBlog.

Whilst increased household debt gives an economy a boost in the short term, the IMF has found it creates greater risk 3-5 years later, lifting the potential for a financial crisis, as household struggle to repay.  Given the ultra-high debt levels in Australia, this is an important observation.

Debt greases the wheels of the economy. It allows individuals to make big investments today–like buying a house or going to college – by pledging some of their future earnings.

That’s all fine in theory. But as the global financial crisis showed, rapid growth in household debt – especially mortgages – can be dangerous.

A new IMF study takes a close look at the likely consequences of growth in household debt for different types of economies, as well as steps that policy makers can take to mitigate these consequences and to keep debt within reasonable limits. The overall message: there is a tradeoff between the short-term benefits and the medium-term costs of rising debt, but there is plenty that policymakers can do to ease this tradeoff, according to Chapter Two of the IMF’s October 2017 Global Financial Stability Report.

Given the widespread misery the crisis caused, you might think people have become skittish about borrowing more. Surprisingly, that’s not the case. Since 2008, household debt as a proportion of gross domestic product has grown significantly in a sample of 80 countries. Among advanced economies, the median debt ratio rose to 63 percent last year from 52 percent in 2008. Among emerging economies, it increased to 21 percent from 15 percent.

Reversal of fortune

In the short term, an increase in the ratio of household debt is likely to boost economic growth and employment, our study finds. But in three to five years, those effects are reversed; growth is slower than it would have been otherwise, and the odds of a financial crisis increase. These effects are stronger at the higher levels of debt typical of advanced economies, and weaker at lower levels prevailing in emerging markets.

What’s the reason for the tradeoff? At first, households take on more debt to buy things like new homes and cars. That gives the economy a short-term boost as automakers and home builders hire more workers. But later, highly indebted households may need to cut back on spending to repay their loans. That’s a drag on growth. And as the 2008 crisis demonstrated, a sudden economic shock – such as a decline in home prices–can trigger a spiral of credit defaults that shakes the foundations of the financial system.

More specifically, our study found that a 5 percentage-point increase in the ratio of household debt to GDP over a three-year period forecasts a 1.25 percentage-point decline in inflation-adjusted growth three years in the future. Higher debt is associated with significantly higher unemployment up to four years ahead. And a 1 percentage point increase in debt raises the odds of a future banking crisis by about 1 percentage point. That’s a significant increase, when you consider that the probability of a crisis is 3.5 percent, even without any increase in debt.

The good news is that policy makers have ways to reduce risks. Countries with less external debt and floating exchange rates, and which are financially more developed, are better placed to weather the consequences.

Mitigating risks

Better financial-sector regulations and lower income inequality also help. But this is not the end of the story. Countries can also mitigate the risks by taking measures that moderate the growth of household debt, such as modifying the down payment required to purchase a house or the fraction of a household income that can be devoted to debt repayments. So, good policies, institutions, and regulations make a difference – even in countries with high ratios of household debt to GDP. And countries with poor policies are more vulnerable – even if their initial levels of household debt are low.

The Disconnect Between Unemployment and Wages

There is an assumption that as employment rates and growth picks up,  the much needed wage growth will follow. We discussed this on ABC’s The Business last week, with HSBC’s Chief Economist who held the view that the RBA won’t lift the cash rate here until wages growth comes through. We were not so sure.

But an interesting piece from the The IMFBlog suggests there are more fundamental forces at work, especially in terms of employment patterns and the rise of part-time work, which suggests that unemployment and wage growth is more disconnected now. We think underemployment is one of the most critical drives of wage stagnation. If this is true, then wages may be lower for longer, which is not good news for those households with heavy debt burdens, especially if rates rise. We release our September analysis of mortgage stress next week. Here is the IMF commentary:

Over the past three years, labor markets in many advanced economies have shown increasing signs of healing from the Great Recession of 2008-09. Yet, despite falling unemployment rates, wage growth has been subdued–raising a vexing question: Why isn’t a higher demand for workers driving up pay?

Our research in the October 2017 World Economic Outlook sheds light on the sources of subdued nominal wage growth in advanced economies since the Great Recession.  Understanding the drivers of the disconnect between unemployment and wages is important not only for macroeconomic policy, but also for prospects of reducing income inequality and enhancing workers’ security.

Job growth picked up, wage growth less so

In many cases, employment growth has picked up and headline unemployment rates are now back to their pre-Great Recession ranges. Still, nominal wage growth remains well below where it was prior to the recession. Sluggish wages may reflect deliberate efforts to slow down wage growth from unsustainably high levels, as was the case with some countries in Europe. But the pattern is more widespread.

There are several factors at play in explaining this pattern, both cyclical and structural – or slow-moving – in nature.

A key cyclical factor is labor market slack – that is, the excess supply of labor beyond the amount that firms would like to employ.

First off, however, it is important to recognize that headline unemployment rates may not be as indicative of labor market slack as they used to be. Hours per worker have continued to decline (extending a trend that began before the Great Recession).

Several countries have also experienced higher rates of involuntary part-time employment (workers employed for less than 30 hours per week who report they would like to work longer) and an increased share of temporary employment contracts These developments in part reflect continued weak demand for labor (itself a reflection of weak final demand for goods and services).

Another key driver of wage growth is the widely-recognized slowdown in trend productivity growth. Sustained weakness in output per hour worked can squeeze business profitability and eventually weigh on wage growth as firms becomes less willing to accommodate fast increases in compensation.

Slower-moving factors

Besides these forces, slower-moving factors such as ongoing automation (proxied by the falling relative price of investment goods) and diminished medium-term growth expectations also appear to hold back wage growth. However, our analysis suggests that automation may not have made a large contribution to subdued wage dynamics following the Great Recession.

The analysis also indicates sizable common global factors behind wage weakness in the aftermath of the Great Recession and especially during 2014–16. In other words, labor market conditions in other countries appear to have a growing effect on wage setting in any given economy. This points to the possible roles of the threat of plant relocation across borders, or an increase in the effective worldwide supply of labor in a context of closer international economic integration.

Putting it all together

The relative roles of labor market slack and productivity growth vary across countries. In economies where unemployment rates are still appreciably above their averages before the Great Recession (such as Italy, Portugal, and Spain), high unemployment can explain about half of the slowdown in nominal wage growth since 2007, with involuntary part-time employment acting as a further drag on wages. Wage growth is therefore unlikely to pick up until slack diminishes meaningfully—an outcome that requires continued accommodative policies to boost aggregate demand.

In economies where unemployment rates are below their averages before the Great Recession (such as Germany, Japan, the United States, and the United Kingdom), slow productivity growth can account for about two-thirds of the slowdown in nominal wage growth since 2007. Even here, however, involuntary part-time employment appears to be weighing on wage growth, suggesting greater slack in the labor market than headline unemployment rates capture. Assessing the true degree of slack in these economies will be important when determining the appropriate pace of exit from accommodative monetary policies.

Broader changes in the labor market

Our research further indicates that sluggish wage growth has occurred in a context of broader changes in the labor market. The increase in involuntary part-time employment itself, for example, is in part explained by cyclically-weak demand.  Accommodative policies that help lift aggregate demand would therefore lower involuntary part-time employment. But it is also associated with slower-moving factors such as automation, diminished medium-term growth expectations, and the growing importance of the service sector.

Some of these developments represent persistent changes in relationships between firms and workers that mirror underlying shifts in the economy – with the emergence of the gig economy and shrinkage of traditional sectors such as manufacturing. Policymakers may therefore need to enhance efforts to address the vulnerabilities that part-time workers face. Examples of possible measures include broadening minimum wage coverage where it does not currently include part-time workers; securing parity with full-time workers by extending pro-rated annual, family, and sick leave; and strengthening secondary and tertiary education to upgrade skills over the longer term.

House of Cards

From The IMFBlog.

In some countries, owning a home is a rite of passage: a symbol of a stable life and a sound investment.

However young adults in the United Kingdom, United States, and Europe have experienced declining home ownership rates.

Our chart of the week, drawn from research by Lisa Dettling and Joanne W. Hsu, senior economists at the US Federal Reserve, in the June issue of Finance & Development magazine , shows that millennial home ownership rates are nearly 10 percent lower than those of their baby boomer and Generation X counterparts of the same age.

For millennials who have purchased a home, net housing wealth—the value of the home, minus mortgage debt—is about the same as that of their baby boomer parents at the same age.

It remains to be seen if millennials are delaying home purchases or forgoing home ownership all together. New research suggests barriers to financing a home, such as borrowing constraints, are at least partially to blame for falling home ownership rates and rising co-residence rates.

Whether these barriers will ease in the future is unknown. However, a recent study in the UK finds that groups experiencing low home ownership rates at age 30 tend to catch up later in life.

To read more research and find data on housing markets around the world, check out the IMF’s Global Housing Watch .

You can also read more blogs about global house prices and our recent chart of the week on the housing price boom in Norway .

China’s Growth Sustainable Says IMF

The results from the 2017 Article IV consultation with China have been published. The IMF acknowledged that China’s continued strong growth has provided critical support to global demand and they commended the authorities’ ongoing progress in re-balancing the Chinese economy toward services and consumption.

They noted that economic activity had recently firmed and saw this as an opportunity for the authorities to accelerate needed reforms and focus more on the quality and sustainability of growth. They supported the importance of reducing national savings to help prevent domestic and external imbalances and emphasized the need for greater social spending and making the tax system more progressive. Stronger domestic demand helped further reduce China’s external imbalance, though it remains moderately stronger compared to the level consistent with medium-term fundamentals

Amid strong growth, the authorities have pivoted toward tightening measures, reflecting a greater focus on containing financial sector risks.

Debt is now expected to continue to grow as the IMF now assumes that the authorities will broadly maintain current levels of public investment over the medium term and not substantially consolidate the “augmented” deficit, reaching 92 percent of GDP in 2022 on a rising path. Private sector credit is projected to continue increasing over the medium term. Thus, total non-financial sector debt reached about 235 percent of GDP in 2016 and is projected to rise further to over 290 percent of GDP by 2022.

They say downside risks around the baseline have increased. A key consequence of the new baseline is that it envisions China using up valuable fiscal space to support a growth path with slower rebalancing and a higher probability of a sharp adjustment. Thus, if a sharp adjustment were to materialize, China would have lower buffers with which to respond. Such a potential adjustment could be triggered by several risks, including:

  • Funding. A funding shock could come from at least two (related) pressure points. The first is the mostly short-term, “interbank” wholesale market (which includes banks’ claims on each other and on NBFIs). The second is a loss of confidence in short-term asset management products issued by NBFIs, or a run on the WMPs which fund them.
  • Retreat from Cross-Border Integration. Should higher trade barriers be imposed by trading partners, the impact would depend on their coverage and magnitude, how exchange rates respond, and whether China retaliates. For example, an illustrative simulation in the IMF’s Global Integrated Monetary and Fiscal Model suggests that if the U.S. puts a 10-percent tariff on Chinese exports and China allowed its real exchange rate to adjust, real GDP in China would fall by about 1 percentage point in the first year. If China retaliated with similar tariffs on U.S. imports, its GDP would contract further. However, given the complexity of global trade relationships and uncertainty regarding how  exchange rates would adjust, the effect could be larger and more disruptive.
  • Capital Outflows. Pressure on the exchange rate could resume because of a faster-than-expected normalization of U.S. interest rates, much weaker growth in China, or some other shock to confidence. In an extreme scenario, the pressure could lead to renewed large reserve loss and eventually a potential disruptive exchange rate depreciation. However, this risk is likely small in the short run due to the stronger enforcement of CFMs, the prominence of state-owned banks in the foreign exchange market, and ample foreign exchange reserves.

While agreeing on the growth outlook, the authorities disagreed about the associated risks. The authorities agreed that 2017 growth was likely to exceed marginally the 6.5 percent full year target. This implied some deceleration during the course of the year and would result in inflationary pressure remaining contained and a broadly unchanged current account. For the medium term, though the authorities shared the view that their 2020 target of doubling 2010 real GDP would likely be reached, they viewed the debt build-up thus far as manageable and likely to slow further as their reforms take effect. They also explained that their “projected growth targets” were anticipatory and not binding. They underscored that reaching the desired quality of growth was a greater priority than the quantity of growth. The authorities viewed domestic concerns, such as high financial sector leverage, as manageable considering ongoing reforms and Chinese-specific strengths, such as high domestic savings. They saw the external environment as facing many uncertainties, such as an unexpected fall in global demand or a retreat from globalization.

The IMF conclude that:

China continues to transition to a more sustainable growth path and reforms have advanced across a wide domain. Growth slowed to 6.7 percent in 2016 and is projected to remain robust at 6.7 percent this year owing to the momentum from last year’s policy support, strengthening external demand, and progress in domestic reforms. Inflation rose to 2 percent in 2016 and is expected to remain stable at 2 percent in 2017. Important supervisory and regulatory action is being taken against financial sector risks, and corporate debt is growing more slowly, reflecting restructuring initiatives and overcapacity reduction.

Fiscal policy remained expansionary and credit growth remained strong in 2016. Growth momentum will likely decline over the course of the year reflecting recent regulatory measures which have tightened financial conditions and contributed to a declining credit impulse.

The current account surplus fell to 1.7 percent of GDP in 2016, driven by a sharp recovery in goods imports and continued strength in tourism outflows. It is projected to further narrow to 1.4 percent of GDP this year, due primarily to robust domestic demand and a deterioration in terms of trade. Capital outflows have moderated amid tighter enforcement of capital flow management measures and more stable exchange rate expectations. After depreciating 5 percent in real effective terms in 2016, the renminbi has depreciated some 2¾ percent since then and remains broadly in line with fundamentals.