How Economy recovers from the global financial crisis and sustained growth?

The European and global economies are experiencing the most severe and prolonged financial crisis Since the 1930s. Economic activity decelerated sharply during 2008, especially in the last quarter; it is projected to contract significantly in the EU this year and to recover very moderately and gradually in the course of 2010. Importantly, the economic outlook is surrounded by exceptionally high uncertainty reflecting, among other factors, the low level of consumer and business confidence as well as the ongoing deleveraging of banks and other financial institutions.The economic and financial situation and prospects are characterised by two features: first, a synchronised decline or deceleration in economic activity in all economies which is associated with a collapse in world trade; and, second, growing signs of an adverse feedback loop between the real economy and the financial sector.

These observations have two general implications for economic policy. First, the economy’s recovery requires the simultaneous implementation of macroeconomic policies to stimulate aggregate demand and of measures that will help repair banks’ balance sheets and encourage the provision of credit to the economy. In this way, a potential vicious circle can be prevented. Second, concerted policy efforts in all economies, especially the large ones, are necessary so that world trade can be revitalised and financial capital flows stabilised. This will help support the emerging market economies and global growth. The policy strategies pursued need not be identical across countries and regions and the required size of the economic stimulus and the nature of the other measures taken need not – and should not – be the same, as structural and conjunctural conditions differ. Nevertheless, a similar orientation and consistency is warranted.Since the intensification of the financial crisis in September 2008, central banks and governments globally have acted in a decisive and concerted manner to contain the adverse effect of the financial crisis on the real economy and promote its recovery.Government support for financial institutions in the form of recapitalisations, guarantees on bank debt and, more recently, asset relief schemes, have been significant and the pertinent measures are progressively being implemented. And the fiscal stimulus packages of money area governments are substantial.

The RBI’s monetary policy and provision of liquidity have played a key role in containing the downside risks to price stability, supporting economic activity and stabilising the financial system.Nevertheless, and although bank lending rates have been gradually falling, bank credit standards on new loans have been tightened and credit growth to the private sector has been decelerating. This partly reflects the impact of the decline in economic activity on the demand for bank loans, but it is also a consequence of the ongoing deleveraging process in the banking system and continued stresses in the funding markets.

Governments have supported the banking system through various measures: by injecting new capital, by providing guarantees on new bank debt issuance and, more recently, through asset relief schemes (involving the removal of impaired assets from the banks’ balance sheets or the provision of guarantees to limit the valuation losses of such assets). These measures have succeeded in stabilising the banking system, by reducing systemic risks and strengthening confidence.

A relevant question is whether the tight financing conditions and the continuing stresses on the banking system require further measures by governments and central banks in order to help revive the extension of bank credit to the economy. The answer regarding the need and the nature of potential further measures depends on the causes or determinants of the prevailing financing conditions and on the structure of the financial system. To the extent that (i) financial market stresses, (ii) the deleveraging process, (iii) uncertainty about the economic outlook and about potential further bank losses, and (iv) low confidence impair the functioning of the credit and bank funding markets and the transmission of the effects of monetary policy, “non-standard” measures aimed at reducing funding uncertainty and enhancing the functioning of the credit market and, consequently, the monetary policy transmission mechanism, may represent possible courses of action.

An extensive and impressive amount of work has been undertaken by national authorities and international bodies, under the auspices of the Financial Stability Forum and, more recently, the G20 process. Concrete proposals have been formulated – and others are currently being elaborated – on how to reduce the cyclicality of the financial system through various measures and reforms, including the enhancement of the scope and effectiveness of financial regulation and supervision.

Last, and definitely not least, it is also essential for sustainable growth and prosperity that confidence in the long-term soundness of public finances is maintained. Government deficits and public debts are rising substantially in most countries as a result of the economic downturn, discretionary measures to stimulate the economy, and the funding of the bank support schemes. This is partly inevitable – due to the downturn – and partly necessary – to help stabilise the economy and the financial system – in the short run. But it is also imperative that fiscal policies are designed and implemented in a manner that strikes the right balance between the need to support the economy’s recovery and the need to preserve the confidence in the soundness and sustainability of public finances which is key for the long-term performance of the economy.

The severity and duration of the current economic and financial crisis is partly a consequence of the reduced confidence in the prospects of the economy and the soundness of the financial system. The recovery of the economy also hinges on the restoration of consumer and business confidence that can contribute to the revival of spending and investment, and the return to normality in financial markets and the banking system. The rebuilding of trust will depend on our ability to appropriately combine the policy actions needed to address the immediate challenges with the necessary reforms for establishing an economic, financial and institutional environment that is conducive to sustainable long-term growth.