IMF's Gopinath: "Central Banks will go all the way, it will be challenging to prevent a hard landing"

"At the end of the month we will publish a new forecast for the global economy and we expect to update it downwards. This comes after two downward updates we published since the beginning of the year. There is clearly a new atmosphere, where a significant part of the risks we feared and mentioned three months ago have materialized. That's why we defined the forecast as gloomy," said Prof. Gita Gopinath, First Deputy Managing Director of the International Monetary Fund (IMF), the world's most important international economic organization, in an exclusive interview with Calcalist.

In the midst of a global economic storm, one of the most influential economists today, who previously served as the IMF's Chief Economist, explains why we may be witnessing further deterioration in global growth ("if there is a shortage of electricity in Europe because of the war"); How much she fears the consequences of rising interest rates ("We are in a sensitive period in terms of financial conditions. The numbers are reminiscent of the 2008 crisis"); How close the Fed's policy is to that of 1980 ("this is not really a Volcker-style policy") referring to the Fed Chairman in the 1980s, Paul Volcker, who fought inflation by aggressively raising interest rates from 10% to about 20% within two years.

Gita Gopinath, First Deputy Managing Director of the International Monetary Fund.

Unlike her friend, World Bank Chief Economist Carmen Reinhart, Gopinath believes that this time around the central banks will go all the way ("otherwise they will pay a heavy price for losing credibility"); And what about the hard landing scenario? ("There are conflicting signs, but it is becoming more and more challenging to prevent a recession").

The latest document released by the IMF Director General from the G20 summit in Bali is very disturbing. Why such pessimism?

"Since April, when the last forecast was published, inflation has become a bigger problem in most countries around the world. Therefore, for the sake of curbing it, monetary tightening, i.e. the raising of interest rates, has been much faster than we previously expected. 75% of central banks have already raised interest rates over the past year. We are in the midst of a global cycle of interest rate hikes."

How much of this pessimism is related to the war in Ukraine?

"Another risk we emphasized at the time was the deepening of sanctions, and counter-reactions to those sanctions, on exports of Russian energy products, especially to Europe. Russian gas exports to Europe today stand at only 40% of what they were in 2021. This decline has far-reaching consequences not only in Eastern European countries but also for the German economy, for example.”

The third factor that influenced the pessimism of the forecast and which could not be fully estimated in April, is the impact of the lockdowns in China due to new Covid variants, Gopinath says. The new data revealed that the impact was severe. "The problem is that unfortunately, there are a few more risks on the horizon."

What are those additional risks?

"The first, is a further tightening of sanctions and a further decline in the arrival of Russian gas in Europe to the point where we are witnessing a real shortage of gas - something we have not seen so far. This is a very big problem."

Gopinath, the first and only woman to become the IMF's Chief Economist, earning her the title of 'the breaker of glass ceilings', explains that another risk is the continued tightening of financial conditions - higher financing costs and interest rates and more difficult access to financing - as seen in the last two or three months.

"Developed economies are struggling however, it is clear that emerging markets are having a harder time coping with the new reality, not to mention poorer countries where the situation is even more difficult. We are in a very sensitive era in terms of financial conditions, and they may get much worse in the near future. This will increase the cost of living while hurting the purchasing power of households around the world, which could lead to growth in the rate of economic slowdown we are currently witnessing. And of course, we must not forget that the pandemic is still here, and there may be additional lockdowns such as the one in China."

You are touching on one of the most sensitive issues during this period, which the IMF Managing Director has defined as "a new era of record debt with rising interest rates." How dangerous is this event?

"The way to curb inflation is by tightening financial conditions. Meaning, a necessary consequence of the current policy is an increase in financing and credit costs.

"Loans are getting more expensive for everyone: households, companies and governments are striving to cut spending. That's how it works. The question is how serious of an issue this will become. We already see that about a third of emerging market governments pay 10% interest on their loans, as reflected in the yields on their government bonds today."

Gopinath notes that "among the poorer countries, about 60% are in a state of financial distress or fear of distress. These numbers are very close to what we saw in the global financial crisis in 2008-2009. Of course, there is high heterogeneity: those who raised credit over a long-term will be in a better position. Those who have raised in foreign currency are in a more problematic situation. However, countries need to be prepared for increases in financing and credit costs.”

The problem is not the exclusive domain of emerging markets. We can see what is happening in the Eurozone.

"We are seeing an increase in yield gaps; however, we have not yet reached alarming levels. As we enter a turbulent financial period of sharp tightening in financial terms, it would be very reasonable for the European Central Bank - ECB, to think about how they deal with the phenomenon. It's a good sign that the ECB has already commented on the issue and clarified that it has indeed come out with a policy tool that will address the issue. However, it is important to remember that central banks need to address gaps when they are the result of external financial shocks. We do not want the ECB to start intervening when the reason for the opening of these gaps is related to structural issues stemming from fundamental factors of those economies."

Gopinath is hinting at an excessive or irresponsible increase in deficit or debt, for example. "In these cases the government of that country must adjust its macroeconomic policy and use that adjustment to close the gaps. In the case of turbulent markets, central banks do have a role, otherwise there is no justification."

We are seeing influential economists, such as Nobel prize winners Paul Krugman and Joseph Stiglitz, who believe that there is no real need for an aggressive process of raising interest rates ‘Paul Volcker’ style.

"I would not say the Fed's policy is following the 'Volcker route’. We are talking about interest rates that are expected to reach 3% - 4%. It is clear that this is a significant increase compared to the last two decades but it is not really 'Volcker’, it is not similar at all. Since we are talking about the 1970s and 1980s, when inflation raised its head, it is worth remembering the main lesson of those days: it is essential that monetary policy be credible in its ability to curb inflation."

Gopinath notes that in the early 1980s, when the Fed saw a slight slowdown in inflation, it stopped raising interest rates, causing inflation to come back even stronger. "I'm sure the Fed understands that it must maintain its credibility and see the mission through to the end by persevering in the current path."

There are economists, such as Prof. Carmen Renihart, who said in an interview with Calcalist a month and a half ago that as soon as they see numbers indicating a recession, Central Banks will panic and stop raising interest rates.

"It would be in stark contrast to what they are declaring now. In the forward-looking guidelines they were very clear about curbing inflation. They stated they will not stop until they make sure it really goes down and that they will follow through to the end. So, at least in this aspect, we have good news.

“According to the latest IMF forecasts published in recent days, the U.S. economy is expected to grow by 1% in 2022 and by 0.6% in 2023, which is why we wrote that there is a 'very narrow path’ to prevent a recession as risks increase. So, the bigger question is, what kind of recession will we be facing."

When asked what a recession looks like, one with a "hard" or "soft" landing, Gopinath said "we are seeing conflicting signs but, it is clear that the situation is becoming increasingly challenging to prevent a recession in world economies given the shocks we are seeing. It's very unclear now as there is great uncertainty. When we look at the situation optimistically, for many countries such as the U.S. and Europe, we are seeing very strong balance sheets and very strong labor markets. That is, in the current atmosphere there are shock absorbers in the systems to help economic activity continue.”

Gopinath clarifies that there is another, important point. "We are coming out of a very unique period, after the reopening of the economies following the pandemic, in which there was record growth. Therefore, we all expect to see moderation in activity, at least in some sectors, and this figure cannot be ignored. By the way, this is what we saw in the U.S. this year - negative growth. Quite a few experts estimate that we will see in the second quarter further decline in growth in the U.S. economy, compared to the previous quarter. On the other hand, if you look at the number of new jobs, it reflects a very healthy and strong labor market."

But in China, the second largest economy in the world which has been the main driver of global growth for the last two decades, the situation seems problematic and there is a fear of a ‘hard’ landing.

"The growth of China's economy has slowed. Compared to April, we are heading for a significant downward update. Growth is not expected for the whole of 2022 but expectations are that China will record negative growth in the second quarter. Private consumption has not recovered. We have always said that the recovery of the Chinese economy should be based on a transition from growth driven by public investment to growth driven by private consumption. This shift has not yet happened. What will happen to China's economy depends on the administration's ability to cope with the new Covid variants and how they will manage lockdowns. And, of course, what will happen with the real estate sector since it is currently very vulnerable. These are the two important factors."

As for the global situation, will the globalization of the last three decades be replaced by the splitting of the world into geopolitical blocks with separate economic-financial-technological systems?

"This risk is real and the war in Ukraine has indeed raised the risk of 'fragmentation' because countries are now preoccupied with issues of national security and that they are safely getting all the necessary inputs they need to function and survive. In a process of fragmentation, inflation, which is already at peak levels, will become a greater challenge. The Covid pandemic, and certainly the war in Ukraine, are pushing countries and companies to strengthen their resilience. By the way, strengthening resilience is not a bad thing in itself. It requires diversification and expansion of the states that are the source of inputs. However, the conclusion from this process must be that they become more dependent on international trade, not less."

Gopinath says the IMF is deeply concerned about the process of fragmentation versus globalization that has borne much fruit, such as increased productivity, improved living standards, especially in weaker economies, and the reduction of poverty. "Of course globalization is not perfect, it needs to be fairer and more equal, for example. But it is very important that we do not go in the opposite direction, and countries will decide, God forbid, to return all production ‘in house’. The fruits of free trade should not be given up.”

We have been seeing a surge in inequality since the pandemic. In a recent report, the Managing Director of the IMF wrote that benefits should be increased and money deposited directly into the accounts of the most financially challenged in society. This is an unusual recommendation for the IMF.

"Inequality harms growth, productivity and social cohesion. We at the Foundation have worked hard on this issue and, in order to address the phenomenon, there are several steps required. The basis is equality of opportunity and, first and foremost, good education. Inequality in education is one of the main causes of inequality. Second, it is important to have a strong social safety net that will ensure that the weakest achieve a basic standard of living. This, too, is done through direct transfers of funds. Another factor is public investment in education, health, infrastructure, and the environment. There should also be a proper tax system in place. That is, one that is broad enough - when the burden falls on a broad, progressive basis that benefits the weak, and is well implemented then tax revenues reach public registers. This is at a national level, but there are also international efforts that need to be promoted like an international corporate tax treaty that ensures that global corporations pay a fair share of the taxes that must be paid. But that is not all, in order to address the issue, it will be necessary to provide funding, liquidity and relief to the weak countries that are in trouble."