The International Monetary Fund (IMF) has had a dour week. On Tuesday, the IMF released its biannual World Economic Outlook, replete with gross domestic product forecast downgrades and tales of geopolitical risk. Also, the organization's former chief economist, Olivier Blanchard, stressed the dangers of a solvency crisis that could befall Japan at some point.
Of course, the three months since the IMF released its last forecasts have been tumultuous, rife with upheavals in the stock markets, evidence that some central banks are losing control of their economies, China's continued decline and a bitter Brexit battle raging in the United Kingdom. Coupled with worrisome business confidence and investment figures, these developments have led the IMF to lower its 2016 GDP forecasts almost across the board.
And the worse news is that the IMF's list did not include certain risks — although its modeling undoubtedly did. Among these perils are Italy's attempts to cope with its bad loan problem. This week, with encouragement from the Italian government, a 5 billion-euro ($5.6 billion) private fund was created to help support the Italian banking sector. Considering the sector's 200 billion euros in nonperforming loans, this fund may seem like a drop in the bucket, and indeed, it is. But given the structure of Italy's problems, it is an important step nonetheless.
Italy's banking sector comprises a sizable number of small banks along with a few giants. Italy's banks, large and small, share the burden of the nonperforming loans. Danger arose this week when the European Central Bank asked a small bank, Banco Popolare di Vicenza, to recapitalize. A larger bank, Unicredito, would underwrite the move. But the markets failed to invest in Banco Popolare di Vicenza, leaving Unicredito to foot the recapitalization bill. In turn, to cover the cost of Banco Popolare di Vicenza's recapitalization, Unicredito found that it, too, might need to recapitalize. Had it been forced to the markets, and had they also failed to buy shares in the larger bank, a banking crisis could have emerged and brought down the whole house of cards. To avert this disaster, various Italian banks contributed to a newly created fund, to (or “intending to”) dividing the problem among themselves. At the moment, Italy's frailty is such that a 5 billion-euro fund could solve a problem that could otherwise have become systemic.
And then there is the question of inflation. The World Economic Outlook provides a ranking of those most at risk for deflation. First is the euro area, with a 35 percent risk, which may be a conservative estimate since it has already been in negative territory in recent months. Japan follows with a 20 percent risk consistent with currently low levels of inflation and the yen's strength. But the United States, in third place at 10 percent, seems anomalous. Not only is the US inflation rate closer to 1 percent at the moment, but the Federal Reserve's most recent moves have been perhaps more dovish than the US economy requires. The dollar fell steeply after Federal Reserve Board Chair Janet Yellen announced slower increases in interest rates, ostensibly an effort to alleviate pressure on China's yuan. Under such circumstances, the United States would seem to run a greater risk of inflation than deflation and could find itself behind in the tightening cycle that awaits.
Meanwhile, Japan, which has commandeered the headlines in recent weeks as the yen continues to soar against the dollar, is locked in its private torment. As ever more extreme strategies — quantitative easing, negative interest rates — come up short, it seems that the Bank of Japan can do nothing to weaken the yen. And US Treasury Secretary Jack Lew recently made it clear that he would not tolerate direct intervention in the markets by the Bank of Japan.
A weak yen, and the desired inflation it would yield, are central to Abenomics, the great economic experiment Prime Minister Shinzo Abe has undertaken in Japan. Abenomics was designed to stimulate Japanese growth, for which the IMF has just downgraded its forecast by 0.5 percent. In turn, the accelerated growth would help Japan's economy to overcome its enormous debt levels, currently at 230 percent of GDP. Olivier Blanchard alluded to this very debt when he referred to a potential future crisis in Japan. His statement presages a time when the country would depend on foreign investors to buy its debt, leading to major vulnerability when the debt was subsequently sold off and driving bond yields higher.
But the World Economic Outlook recalls other complexities associated with Japan's situation. Although the country may be deep in debt, it also acts as a substantial creditor to the world. By net financial assets, Japan sits above the line in the surplus territory, along with China and emerging Asia, Germany and Northern Europe, and the world's major oil producers. On the other side of the line, debtors include the United States, Southern Europe and the rest of the world. Because Japan issues its debt in its currency, and because its current account surplus continues to bring money into the country, thus sustaining the net financial asset surplus, Japan's gigantic debt levels are deceptive. By all appearances, the Japanese government still has a few levers it can pull before descending into the kind of crisis Blanchard envisions.
The IMF's growth forecasts are far from perfect and have been known to miss the mark wildly. This is not an indictment of the IMF but rather a testament to the delicate nature of real-world financial modeling. The IMF's World Economic Outlook should, therefore, be viewed as an apt guide to the present, but perhaps a less-than-perfect guide to the future. Regardless of its accuracy — the IMF is no worse than other prognosticators — the risks laid out in the World Economic Outlook are real and present substantial concerns for the global economy.