The state of the global economy

Speech by Mr Agustín Carstens, General Manager of the BIS, at the BNP Paribas 2021 Global Official Institutions Conference, Basel, 9 June 2021.

Introduction

Thank you for the invitation to speak today. After last year's event was unfortunately cancelled, I am glad that we can all be here, even if only virtually. And I look forward to the time, hopefully not too far in the future, when we can hold events like this in person again.

My comments today will be in two parts. First, I will describe how I see the progress of the global economic recovery so far. The short summary is that economic conditions are better than expected, in some jurisdictions extraordinarily so, but at the same time highly uneven. Second, I will highlight two features of the recovery that need to be addressed, to give it a solid foundation for the medium term. The first is the lack of progress on tackling the long-term consequences of the pandemic, most notably for sectoral reallocation. The second is the weakness in corporate balance sheets. We will provide more detail on these issues in our Annual Economic Report, to be published later this month.

The state of the global economy is mixed.

• To be sure, we are in a much better place than we thought we would be a year ago.
• If you had told me back then that we would now be nearly 12 months into an expansion, with consumer spending in the major economies roaring back in the second half of last year, corporate bankruptcies at multi-decade lows, global goods trade at pre-pandemic levels and several highly effective vaccines in production, I would have described that as an unrealistically rosy outcome.
• But the recovery is uneven and incomplete. It could hardly be otherwise given that the pandemic is far from over. Indeed, rather than a single global recovery, it is better to think of three distinct recoveries being under way.

The first recovery is taking place in countries where the effects of the pandemic on economic conditions are rapidly receding.

• I am thinking here particularly of the two big engines of the world economy – China and the United States – which are in the midst of rapid expansions. Most forecasters project that GDP in these countries will have more or less caught up to their pre-pandemic trajectories by the end of the year. The United States may even exceed it.
• Pleasingly, we do not seem to be witnessing a repeat of the sluggish recovery from the Great Financial Crisis.
• It is early days yet. One shouldn't overstate the positives – output and labour market conditions are still well below their pre-pandemic trends. There is no guarantee that growth momentum will persist. But these countries seem to be on the right trajectory.

The second recovery is taking place in countries where growth momentum slowed around the turn of the year, but prospects for the rest of 2021 remain favourable.

• The clearest example is here in Europe, where second and third infection waves have hit hard.
• Even so, lockdowns haven't curbed economic activity as much as they did last year. We don't have a lot of hard data yet, but in recent months the previously strong correlation between measures of mobility and timely activity indicators, such as PMIs, has weakened considerably. Except for sectors directly affected by lockdowns, conditions have remained firm.
• And, as vaccination programmes ramp up, growth momentum has already started to return and seems likely to pick up further in the second half of the year.

The third recovery is taking place in many emerging market economies (EMEs). Progress varies by country and region, but the overall story is much less positive.

• It is in these countries that the pandemic is furthest from being over. Many have experienced multiple infection waves. And vaccination is making slow progress as EMEs have received only a fraction of the vaccines distributed to advanced economies.
• Indeed, I think we need to accept that vaccines will not end the pandemic by themselves. We need to learn to live with the virus. This means complementing vaccines with better treatments and more targeted prevention measures. Without these, prospects are bleak for containing the virus, and hence of kicking off a robust recovery in emerging markets.
• Besides experiencing larger outbreaks of the virus, most EMEs are benefiting much less from policy stimulus than AEs. Indeed, after exhausting much of their available policy space over the past year, just maintaining the current degree of policy accommodation could be a challenge.

Even the strengthening recovery in advanced economies is a double-edged sword for EMEs.

• To be sure some countries will benefit from increased export demand coming from the very strong recoveries in China and the United States – Mexico being an obvious example. Commodity exporters are also gaining from higher commodity prices.
• But there are forces that are pushing the other way. Rising food prices and, in some countries, depreciating exchange rates are stoking inflation. In a number of these countries, central banks have already raised interest rates to combat these pressures. Others may follow. More generally, it could be hard for EME policymakers to maintain accommodative policy stances should global financial conditions tighten materially. But tighter policy will make economic recovery even more difficult.

The extent of any financial tightening will depend to a significant degree on how much inflation rises in the major advanced economies.

• There has much recent speculation that the global economy could be in for a period of "reflation".
• Over the past few months, signs of cost pressures and supply bottlenecks have become ever more apparent. These have shown up in rising commodity prices, longer delivery times and soaring freight costs. In some jurisdictions, there have been reports of labour shortages and tentative evidence of faster wage growth, albeit from very low levels.
• The higher inflation print that we saw in the United States in April reinforced this perception.
• In my view, it is too soon to conclude that the global economy is set for a sustained period of high inflation, rather than a temporary overshoot of central bank targets.
• Admittedly, the conditions for a rise in inflation seem to be in place, at least in the United States. An enormous fiscal stimulus has been unleashed. At the same time, easing lockdowns are providing an additional boost to demand. And all the while, the lingering effects of the pandemic continue to constrain supply. Given these conditions, it would not be surprising if inflation were to rise above central bank targets for a while.
• At the same time, one should be cautious about reading too much into one or two months' inflation numbers. There were always going to be adjustments as countries exited lockdowns. Indeed, some of the largest recent price increases have been for items like airfares and hotel accommodation, which were heavily affected by the pandemic. These are best viewed as one-off relative price shifts rather than signs of sustained inflationary pressure. Interpretation of the data is also clouded by base effects from comparing economic conditions today with the very depressed ones of 12 months ago. Above all, higher costs can only raise inflation persistently if they keep rising.
• The bigger risk is that even a modest and temporary overshoot of central bank targets could be disruptive if financial markets overreact. If markets come to expect that higher inflation will persist, bond yields could rise and financial conditions tighten.
• This will pose a delicate communication challenge for central banks. On the one hand, they will surely want to lean against a pre-emptive market-driven tightening that threatens to hold back the recovery. On the other hand, being seen to be ready to act to prevent demand from getting too far ahead of capacity is key to ensuring that inflation overshoots are ultimately temporary. Further complicating communication is the difficulty of pinpointing underlying inflation momentum in a rapidly shifting economic landscape.

That is where we stand. I would like to use my remaining time to highlight some challenges to the recovery, even in countries that are reasonably well placed.

• In many countries, the recovery has so far been driven largely by policy stimulus and consumption.
• This is understandable given the nature of the recession. But to ensure a robust expansion over the medium run, business investment needs to step up.
• And, to avoid the economic malaise that followed the GFC, the recovery needs to be accompanied by a sustained rise in productivity growth.

In this regard, I have two concerns. The first is that the real consequences of the pandemic have not been addressed.

• The pandemic is a real shock with real consequences;
• Policy stimulus has held the economic fabric together, limiting the fallout of lockdowns and other containment measures.
• But at some point, the pandemic's legacy has to be tackled. Some changes, such as increased remote work and online shopping, will undoubtedly endure. I also find it hard to believe that people will travel as much for business as they did before. And international tourism will remain in the doldrums for some time, at least to destinations with low vaccination rates and high caseloads.
• Fiscal and monetary stimulus can postpone these developments. But at some point, the economic structure needs to adjust. We cannot avoid the reckoning forever.
• This is not all bad news. When patterns of demand shift some firms will need to close. Some industries will become permanently smaller. At the same time, existing firms in industries experiencing increased demand will need to expand and new ones emerge. What matters is that resources are put to their best use and that reallocation occurs smoothly and with as few costs as possible.

These structural changes will be smoother and less disruptive if businesses are in a position to adjust to the changes in pandemic-induced demand patterns. This brings me to my second concern: that many businesses are in poor financial shape.

• A year ago, we talked of the liquidity phase of the crisis transitioning into the insolvency phase. But the wave of insolvencies that we feared hasn't come to pass. It is not yet clear whether these insolvencies were avoided or merely delayed. But no doubt extensive policy support – debt moratoriums, government guarantees, furlough schemes and the like – not to mention ample credit supply, has done its job and helped firms to weather the storm.
• There is a price to pay for all this. Corporate leverage – already on the rise before the crisis – has increased further. This rise in leverage carries several risks:
  • Highly indebted firms are less likely to invest, delaying reallocation and making the recovery less balanced; and
  • Highly indebted firms may become "zombies", lowering productivity.
• Either or both of these developments would make the recovery less robust, and the sooner they are dealt with the better.

But let me end on a positive note.

• Whatever the challenges that the global economy faces at present, it is in a much better place than seemed likely a year ago.
• The prospects for a solid recovery over the medium term are good.
• Securing that recovery will require the following:
  • Assisting EMEs with their health challenges so that they are not left behind;
  • Taking advantage of the strong recoveries in China and the United States to build global economic momentum elsewhere;

And ensuring that the recovery is built on a solid foundation of business investment and productivity growth, not just stimulus and consumption.