Spillovers in interconnected global economy

Since the outbreak of the 2008-2009 global financial crisis, triggered by the US subprime mortgage mess, policy-makers have been preoccupied with the potential risks from shocks in major economies to other economies. Their concerns have raised the urgency of multilateral cooperation to minimize the harmful effects of such shocks on the world economy. Currently, those concerns center on mitigating the potential contagion from the worsening Euro Area crisis.

The International Monetary Fund (IMF), which failed to warn against the US housing bubble and the subsequent global financial crisis, has focused its recent research on spillovers. Its 2011 inaugural spillover reports for the five “systemic” economies, the US, the EA, the UK, China, and Japan, called the S5, as well as the consolidated spillover report, added granularity to its surveillance function, i.e., how the IMF monitors, assesses, and advises on economic and financial policies of its 188 members. The spillover reports enhanced the IMF's flagship multilateral surveillance reports, the World Economic Outlook and Global Financial Stability Report, and the Fiscal Monitor.

Last Thursday, the IMF released the 2012 consolidated spillover report, overshadowed by its Article IV consultation and country reports for the US released on the same day. In preparing the spillover reports the IMF researchers ask policy-makers in each of the S5 economies, as well as several advanced and emerging market economies (EMEs), including Turkey whose main S5 partner is the crisis-ridden EA, to specify confidentially how the policies of their main S5 partners would affect them. Then the researchers quantify these concerns using analytical tools such as econometric simulations. Their results are discussed with each of the S5 as part of their Article IV consultations.

The major conclusions of the 2011 consolidated spillover report were: (1) Short-term policy spillovers are the strongest through financial linkages; (2) Since financial channels dominated the propagation of global shocks and since the US-UK-European financial core was central to the global economy, stronger cooperation and better regulation in the core were critical. (3) The spillovers from China and Japan were mostly through real channels. Although they took longer than financial ones to play out, they could create distortions through global imbalances if their stresses, especially on those countries with chronic current account deficits, were not addressed. As for the individual spillover reports, the US report focused on how looser monetary policy through the Fed's quantitative easing affected other countries, and the China spillover report focused on how the Chinese renminbi appreciation impacted its trading partners.

The major concerns underlying the 2012 consolidated spillover report were: (1) It had become very difficult to get and stay ahead of the chronic Euro Area crisis. (2) The uncertain fiscal policy of the US, facing a “fiscal cliff” (a combination of expenditure cuts and tax hikes) next year, as well as the Fed's unclear monetary policy were creating apprehension about spillovers from the US. Many EME policy-makers were concerned about further US monetary easing that would put upward pressure on the prices of their currencies, assets, and commodities. (3) Slowing domestic growth and external demand from China as well as rising government bond yields in Japan, with the highest sovereign debt to GDP ratio among the S5, were feared widely. (4) Many countries worried about the unintended consequences of some of the post-global financial crisis reforms, such as rising liquidity premia and bond yields resulting from the US Volcker Rule, which prohibits proprietary trading in foreign sovereign debt. These concerns formed the basis of the simulated shocks from the S5 economies and their effects, such as output losses, on the rest of the world.

The 2012 report's major recommendations toward the prevention of those shocks and their harmful spillovers are: (1) The Euro Area must move closer to banking and fiscal unions, and accelerate structural reforms to stimulate growth and increase international competitiveness. (2) The US should avoid falling off the fiscal cliff in 2013 and realize that its financial reforms can have potentially harmful effects on other countries. (3) China should adapt its macro policies to an unexpected global slowdown, rebalancing domestic demand from investment to consumption.

The report concludes that “high asset price correlations, shocks to financial risk premia, and limited policy space all combine to intensify cross-border spillovers” as the global economic outlook deteriorates. But it warns against “a global patchwork of trade and capital flow restrictions,” the antithesis of international cooperation. Although it is too much to expect the IMF's spillover reports, still in their infancy, to strengthen international cooperation, they offer a useful analytical framework for anticipating the potential problems confronting our interconnected global economy.