Global Macro Trends June 202414.3InsightsOpportunity KnocksMid-Year Outlook for 2024 Contents 3 Introduction 11 What Is Changing or Being Amplified?14 Six Areas Where We Differ From Consensus 17 Asset Allocation and Key Themes 17 Picks and Pans 23 Buying Complexity,Selling Simplicity in the Equity Markets 24 Collateral-Based Cash Flows 25 Productivity 26 Security of Everything 26 Intra-Asia 27 Intersection of AI and Energy Supply 28 Demographic Challenges to Retirement Security 29 Global/Regional Economic Forecasts 30 U.S.36 Europe 40 China 43 Japan 46 Capital Markets 46 S&P 500 48 Global Interest Rates 49 U.S.Interest Rates 51 Europe Interest Rates 52 Oil 54 Frequently Asked Questions 54 Where do you see relative value in Credit?55 Do you still believe in a higher resting heart rate for inflation?59 How are you thinking about the U.S.election,including impacts on fiscal policy and the Treasury market?61 What is the outlook for U.S.consumer spending?64 How are you thinking about expected returns and portfolio construction going forward?67 EM:Do you still favor EM Debt over EM Equities?69 Key ConclusionsHenry H.McVeyHead of Global Macro&Asset Allocation,CIO of KKR Balance S David McNellis Frances Lim Aidan Corcoran Changchun Hua Paula Campbell Roberts Racim Allouani Kristopher Novell Brian Leung Rebecca Ramsey Tony Buckley Bola Okunade Rachel Li Thibaud Monmirel Yifan Zhao Ezra Max Miguel Montoya Asim Ali Patrick Holt Patrycja Koszykowska Koontze Jang Allen Liu Insights|Volume 14.3 3Opportunity KnocksMid-Year Outlook for 2024Despite intensifying political uncertainty,heightened geopolitical tensions,and volatile commodity prices,we continue to see compelling investment opportunities across the global macro landscape.Accelerating AI demand for electricity,reorientation of global supply chains,improving labor productivity,and retirement security all represent important macro themes behind which to invest.We also remain really encouraged by the technical backdrop,as net issuance of Equities and Credit remains well below trend.However,it is definitely not business as usual in the world of macro and asset allocation,as our Regime Change thesis requires a different approach to portfolio management.To build upon this view,we have done more analysis to underscore the value of adding more non-traditional assets to ones portfolio.Indeed,unlike in the past,todays volatility in portfolios is being driven by stock-bond correlation,not by single asset volatility.Importantly,most of todays CIOs have not invested in this type of environment.In terms of areas to lean in,we think that the current vintage will be a strong one for Private Equity,especially opportunities linked to value creation by operational improvement and/or corporate carve-outs.Meanwhile,we continue to pound the table on many parts of Real Assets,including Real Estate Credit,Infrastructure,and Asset-Based Finance.Finally,we see a lot of potential in Opportunistic Credit and Capital Solutions.On the risk side,we believe higher rates especially if productivity should tail off are a more challenging scenario than lower rates and slower earnings.We are also keeping an eye on employment trends.Our bottom line:Opportunity Knocks,as we still think the current economic cycle has further to run,a backdrop that should accrue to the benefit of long-term investors,especially ones who have dry powder to lean into the inevitable periodic dislocations that are likely to occur during a Regime Change.A pessimist complains about the noise when opportunity knocks.Oscar Wilde,Irish poet and playwrightInsights|Volume 14.3 4We are often asked,especially heading into the second half of 2024,if we still believe that the glass is half full for global allocators when it comes to deployment opportunities,particularly in an environment of heightened complexity,sticky inflation,and higher for longer interest rates.(See Glass Half Full Outlook for 2024).With an uncertain presidential election around the corner in the United States,and many other important elections taking place across the world,there is certainly a lot to consider.On the more cautious side,equity markets are now nicely higher,and credit spreads are now sharply tighter since late December 2023 when we laid out our thesis that investors might regret looking at the glass as half empty.In fact,our KKR proprietary market-implied default model suggests HY spreads are pricing in about a two percent default rate today,compared with about three percent at the beginning of the year and a historical average of 5.7%.Exhibit 1:Equity Markets Have Withstood Substantial Volatility to Enjoy Glass Half Full Returns and Then Some in the 1H2415.6.9.1.7%Nikkei 225NasdaqS&P 500Euro StoxxEquity Performance Across Regions,YTD PerformanceData as at June 7,2024.Source:Bloomberg.Indeed,unlike in the past,todays volatility in portfolios is being driven by stock-bond correlation,not by single asset volatility.Exhibit 2:While Investors Have Also Gotten More Optimistic About the Outlook for Credit,High Yield in ParticularOct-0214.7%Jun-070.8%Oct-1111.2b-1611.0%Mar-2014.8%Jul-226.7%0%2%4%6%890199419982002 2006 2010201420182022 2026U.S.High Yield Implied Default Rate,%Implied Default RateAvg(5.7%)May-241.8ta as at May 24,2024.Source:Bloomberg.Exhibit 3:Risk Assets Have Responded Favorably to the Idea That There Will Be Fewer Tightenings and More EasingsSep-0668%Mar-2112%Oct-2284%0 0Pp 032004200520062007200820092010201120122013201420152016201720182019202020212022202320242025Consensus Forecast:%of Global Central BanksHiking RatesHiking rates is defined as an increase in rates over the past three months.Data for U.S.,JP,CN,AU,CA,E2,NZ,NO,SE,GB,JP,CH,IN,ID,KR,PH,TW,TH,VN,BR,CL,ZA,TR,IL,CZ,HU,PL.Data as at May 31,2024.Source:Bloomberg,KKR Global Macro&Asset Allocation analysis.Insights|Volume 14.3 5Exhibit 4:Overall,Our Models Still Favor Credit,But Now Only at the MarginApr-241.0%1.1% 1stdev-1stdev-3%-2%-1%0%1%2%3 102012201420162018202020222024Relative Value:Equities vs.Credit,Internal Rate ofReturn for Equities vs.HY YTWU.S.Equity vs.U.S.HY CreditPost-GFC AveragePrefer U.S.HY CreditPrefer U.S.EquityData as at May 24,2024.Source:Bloomberg.However,perhaps more important for long-term investors,there are a lot of political and social crosscurrents that are increasingly bleeding their way into markets.Not surprisingly,the introduction of social media into our political process has created more discord.This type of disruption is like other post-industrial revolutions where technological change ushered in periods of social and political unrest.As our colleague Ken Mehlman explains,just as the invention of the printing press around 1440 introduced years of political,religious,social,and scientific disruption,the combination of the Internet and social media is a Gutenberg 2 moment that has produced and portends similar disturbances.At the same time,complicated issues around immigration and inequality are also driving tense debates across the Western world that increasingly seem to push the left and right further apart.See Section IV,question#3 for a full discussion,but the upcoming U.S.presidential election only increases our conviction that policy from either a Trump or a Biden administration is likely to maintain an inflationary bent(which further heightens discord),given the threat of tariffs and the need for security spending,contributing to an increasing normalization of wider than usual deficits.Finally,great power rivalries around the globe have intensified notably in recent quarters.As such,investors should expect more barriers to trade and capital flows in the coming years under almost all scenarios.Key to our collective thinking is that the intensifying focus on homeland economics is a post-COVID,post-Ukraine global phenomenon that is likely to continue almost regardless of electoral outcomes in most countries.Exhibit 5:After Two Years of Being in Late Cycle and Contraction,Our Proprietary KKR Cycle Indicator Is About to Move Into Its Early Cycle PhaseApr-24-0.31-3.0-2.5-2.0-1.5-1.0-0.50.00.51.01.5199019921994199619982000200220042006200820102012201420162018202020222024KKR Cycle Indicator(1990-Present,Z-Score)ContractionEarly CycleMid CycleLate CycleData as at April 30,2024.Source:Bloomberg,KKR Global Macro&Asset Allocation analysis.Exhibit 6:We Think Earnings Growth Is Set to Broaden Beyond Mega Cap Technology and Become More Balanced in Coming Quarters,Driven by Positive Operating Leverage and Margin Growth in Other Sectors-15%-5%5%5EU%S&P 500 EPS Growth Disagregation2022(1Q-4Q)2023(1Q-4Q)2024(1Qe-4Qe)DeceleratingMega-CapTech EPSAcceleratingEPS across restof S&P 500 Data as at April 30,2024.Source:Bloomberg,KKR Global Macro&Asset Allocation analysis.Insights|Volume 14.3 6Exhibit 7:Long Periods of Equity Outperformance Have Been Driven by Productivity and/or Central Bank Intervention.Productivity vs.Equity MarketsLabor Productivity,%QoQ,SAARS&P 500 Average Annual ReturnAverage U.S.Budget Deficit as a%of Nominal GDPAverage Fed Balance Sheet as a%of Nominal GDPHigh Productivity Period1960s3.3%8.4%-1.0%5.490s-2000s3.1%8.8%-0.8%6.0%Low Produc-tivity Period1970s1.0%-0.9%-2.3%6.4 10s1.0.8%-4.8 .9%All Periods1958-20182.1%7.20%-2.6%8.3%Today4Q22-1Q242.2%8.5%-5.7).8%Note:1960s and 90s-00s are the high productivity growth(3%)periods,referring to 1958-1968 and 1995-2005,respectively.1970s and 2010s are the low productivity growth(6%Vintage IRR vs.5Y S&P Total ReturnCapital Markets Liquidity(IPO High Yield Bond Leveraged Loan Issuance)as a%of GDPPrivate Equity Outperformance Across LiquidityRegimes,1997-2023Capital MarketsLiquidity Is Currentlyat 2.3%of GDP,WhichSuggests Strong PE PerformancePE returns from Preqin on a 5-year forward returns from 1997 2019 basis.Data as at December 31,2023.Source:Preqin,Bank of America,Bloomberg,KKR Global Macro&Asset Allocation analysis.Insights|Volume 14.3 8Against this unique macroeconomic backdrop,however,we continue to argue that as investors we are experiencing a Regime Change.There remain four pillars to our original thesis:ongoing fiscal stimulus,heightened geopolitics,a messy energy transition,and stickier wages(driven largely by a shortage of skilled workers).If we are right,then global allocators and macro investors need to view their portfolios through a different lens.In particular,we think that more diversification across asset classes as well as less dependence on global sovereign bonds is warranted,especially given correlations between stocks and bonds have turned decidedly positive(Exhibit 14).Exhibit 13:While Inflation Should Continue to Cool,We Dont Think It Will Return to Previous Levels.As a Result,We Maintain Our Regime Change ThesisInflationHighGrowthLowHighLow20212024-20252010-20162017-20192022-2023Low and High Growth and Inflation RegimesData as at June 14,2024.Source:KKR Global Macro&Asset Allocation analysis.So,where do we land as we look ahead to the second half of the year and into 2025 and beyond?Most importantly,we retain our optimistic viewpoint for the following four reasons:1.We think that we have entered a structurally higher level of productivity in the United States,a backdrop that we believe will benefit capital markets globally.We were not around for the 1960s,but the surge in productivity that followed tech investment in the 1990s is likely an apt parallel,we believe.Importantly,this increase in productivity will at least partially offset some of our concerns about wider deficits in the near-term.As we detail below in Section II,we are also raising our long-term run rate for U.S.GDP to two percent from 1.5%,signaling a structural improvement in growth that we believe warrants investor attention.2.We think that central banks,especially the Bank of Japan and the U.S.Federal Reserve,have adopted policies that are actually not that restrictive from a historical perspective.For one thing,the Fed and other central banks steady states for balance sheets are still plump relative to history(Exhibit 15).If we are right that U.S.real rates peak at two percent in the coming quarters and decline below one percent over time(note:we forecast one Fed cut in 2024 and an additional four in 2025),then this Fed tightening cycle will have been a fairly mild one by historical standards.One can see this in Exhibit 16,which shows that,if our forecasts are correct,the real fed funds rate will not spend a very long time in truly restrictive territory this cycle(i.e.,at or above the level of potential GDP growth).Exhibit 14:Despite Inflation Falling on a Cyclical Basis,the New Positive Relationship Between Stocks and Bonds Remains Strong0%1%2%3%4%5%6%7%8%9%-40%-20%0 0b-20Apr-20Jun-20Aug-20Oct-20Dec-20Feb-21Apr-21Jun-21Aug-21Oct-21Dec-21Feb-22Apr-22Jun-22Aug-22Oct-22Dec-22Feb-23Apr-23Jun-23Aug-23Oct-23Dec-23Feb-24U.S.Stock-Bond Correlation and U.S.CPI,%Rolling 24 Months Stock-Bond Correlation(LHS)CPI YoY inflationData as at March 31,2024.Source:Bloomberg,KKR GBR analysis.Insights|Volume 14.3 9Exhibit 15:Despite Record Tightening at the Front End,Central Bank Balance Sheets Will Remain Plump With AssetsDec-1836%Sep-2155c-2342c-2438c-2536 %05EPU 122013201420152016201720182019202020212022202320242025G4 Central Bank Balance Sheets as%of GDP,Dollar-WeightedG4=Federal Reserve,the ECB,the Bank of England,and the Bank of Japan.Data as at September 30,2023.Source:Haver Analytics,national central banks and statistical agencies,KKR Global Macro&Asset Allocation analysis.Exhibit 16:We Think The Fed Will Bring Real Rates to Two Percent This Cycle,But No Higher-1%0%1%2%3%4%5%6%1Q232Q233Q234Q231Q242Q243Q244Q241Q252Q253Q254Q251Q262Q263Q264Q26GMAA Base Case:Real RatesFed FundsCore CPIReal RateTwo-Percent ThresholdData as at June 12,2024.Source:Bloomberg,KKR Global Macro&Asset Allocation analysis.Exhibit 17:Annual Spending on the U.S.Debt Service Burden Is Now More Than Spending on National Defense or Medicare,and More Than the U.S.Spends on Veterans,Education,and Transportation Combined$514$498$463Net InterestNational DefenseMedicareOverall Spending,US$BillionsData as at April 30,2024.Source:CBO.Traditional Macro Relationships Are No Longer Behaving the Same as in the Past1Japan is experiencing inflation,while China has disinflationary headwinds.2U.S.Treasuries and the Japanese yen are no longer the risk-off assets of choice.They are,in fact,driving much of the volatility in the capital markets during periods of uncertainty.3European growth is coming from the periphery,not the core,this cycle.4The interest rate easing cycle has started in Europe,not in the U.S.,for the first time.5We have actually raised our long-term forecast for U.S.GDP growth,despite an inverted yield curve and a low savings rate.In the past,these two macro variables were recession signals.6It is the government,not the consumer or corporates,that is most leveraged this cycle.At the same time,we think that many investors are still actually underweight their target allocations,including holding too much Cash at a time when most central banks have finished raising rates.Insights|Volume 14.3 103.Third,we think that the employment market holds up better this cycle.Some of our optimism is actually driven by demographics,especially given the exit that we have seen of aged 55 workers from the workforce since the onset of COVID.While we do expect immigration in the U.S.to create more slack in some sectors,we think this is a positive development for growth as unemployment from excess supply feels very different from the typical cyclical dynamics of over-hiring and layoffs.Exhibit 18:The U.S.Has Been Able to Grow Its Workforce Through Demographic Growth;Meanwhile,Europe and Japan Have Offset Aging Populations by Improving Participation Rates.Looking Ahead,We Think That Aging Demographics Will Require a Rethink of Both Workforce Participation and Immigration Contributions to Workforce Growth,MillionsU.S.EuropeJapan1Q2010 Workforce153.7159.865.7 Demographics11.3-3.0-3.4 Change in Participation2.714.87.0 Change in Prime-Age Male Participation-0.30.10.0 Change in Prime-Age Female Participation1.33.02.7 Change in 55-64 Participation0.59.62.0 Change in 65 Participation1.22.22.34Q23 Workforce167.8171.569.4Europe data based on the Euro-Area 19 subset of E.U.members.Latest available data as at December 31,2023.Source:U.S.Bureau of Labor Statistics,Eurostat,Japan Statistics Bureau.4.Finally,consistent with our Regime Change thesis,and because we are mostly living in a higher nominal GDP environment,we retain our conviction that a hard landing is not in the cards.The most cyclical areas of the global economy already dipped in 2022-23 and are now improving from below-trend levels.We are becoming more constructive around the potential for cyclical wage dynamics,as well as structural considerations related to technology and automation,to drive higher and faster nominal GDP growth globally.Exhibit 19:Besides China,Most Economies Are Experiencing Higher Nominal GDP This Cycle14.9%1.6%-0.5%3.9%5.7%6.0%3.1%6.5%ChinaEuropeJapanU.S.Annual Nominal GDP Growth, 11-20122022-2024E-9.2% 4.3% 3.6% 2.5 24 are KKR GMAA estimates.Data as at May 31,2024.Source:China National Bureau of Statistics,Statistical Office of the European Union,Cabinet Office of Japan,U.S.Bureau of Economic Analysis,KKR Global Macro&Asset Allocation analysis.Against this unique macroeconomic backdrop,however,we continue to argue that as investors we are experiencing a Regime Change.There remain four pillars to our original thesis:ongoing fiscal stimulus,heightened geopolitics,a messy energy transition,and stickier wages(driven largely by a shortage of skilled workers).Insights|Volume 14.3 11Exhibit 20:Pent-Up Demand in Key Pandemic-Affected Services Sectors Continues to Fuel Above-Average Job Growth in the U.S.-3%-9%-7%-7%-6%-6%-5%-3%-3%-2%-2%-2%0%0%0%3%4%-12%-10%-8%-6%-4%-2%0%2%4%6%AverageLeisure&HospitalitySupport SvcsConstructionMgmtPriv.EducationNondur.Goods MfgFinanceTotalDur.Goods MfgRetail TradeHealthcareGovernmentTransportationInformationWholesale TradeProf.ServicesEmployment vs.Pre-COVID Trend,May-24Pre-COVID trend based on linear extrapolation of 2014-19.Data as at May 31,2024.Source:U.S.Bureau of Economic Affairs,Haver Analytics,KKR Global Macro&Asset Allocation analysis.As our colleague Ken Mehlman explains,just as the invention of the printing press around 1440 introduced years of political,religious,social,and scientific disruption,the combination of the Internet and social media is a Gutenberg 2 moment that has produced and portends similar disturbances.However,while our longer-term thesis remains largely intact,we are constantly refining and evolving our convictions.To this end,we wanted to highlight whats changed since December and why we think adding more ballast to portfolios is warranted,particularly given the optimism being priced by markets during an asynchronous cycle where some sectors are slowing more quickly and inflation remains too sticky.So,as part of the next chapter of our Regime Change framework,we note the following:What Is Changing or Being Amplified Since Our Outlook for 2024?1Increasing Importance of Non-Correlated AssetsAfter two major deep dive surveys across the Family Office and Insurance universes,we have even greater conviction in our thesis around owning more non-correlated assets.Key to our thinking is that,in a world where the efficient frontier for expected returns is now flatter,the importance of diversification increases.As a result,CIOs need more diversifiers in their portfolios so that they do not get whipsawed,especially when short-term performance can be quite volatile.One can see this in Exhibit 27.If we are right,then our insight has significant implications for allocators,particularly CIOs who have embraced long-duration bonds and/or VC on the equity side,or that do not believe in linear deployment.Insights|Volume 14.3 122Portfolio Volatility Is Increasing Because of the Changing Relationship Between Stocks and Bonds,Not an Increase in Single-Asset VolatilityThere is another important influence to consider as well.Specifically,given all the movement around interest rates these days,the changing nature of government bonds in a portfolio,and greater use of concentrated ETFs by market participants(e.g.,40%of the High Yield market is now daily liquidity),the volatility of most benchmarks we track is surging to the upside,which increases the risk that a portfolio allocation change can be made at the wrong time.Some great work by Racim Allouani and Rachel Li suggests that todays heightened portfolio volatility is actually driven more by stock/bond correlation than by a surge in single-asset volatility,which was typically the case pre-COVID.This new reality is a big deal as it adds risk to a typical 60/40 portfolio,and it speaks to our view that we are indeed in a Regime Change when it comes to portfolio construction.3We Are More Focused On the Positive Path of Productivity,Especially in the U.S.Given increasing debt loads amidst larger government deficits,we are now extremely focused on the one catalyst that is best equipped to keep stagflation at bay:Productivity.As we detail in Exhibits 7 and 49,the best decades of equity performance are usually linked to periods of strong productivity gains.Against todays backdrop of stickier wages,we think that strong productivity will be needed to allow corporate margins to hold.Were productivity to slip,we likely would take a more defensive stance on risk assets,a reality that is new to our macro thinking in 2024.4The Mismatch Between Energy Supply and Demand Is More PronouncedThe mismatch between energy demand and energy supply seems even bigger than our previously bullish view.Demand is once again rising on electrification trends for EVs and heat pumps and the explosive growth in energy-intensive users such as data centers,semi fabs,EV battery plants,and steel mills.In the U.S.,for example,overall electricity demand is poised to grow 2.4%annually,compared to essentially zero in prior years.We believe as much as one-third of this growth could come from data centers,and that data centers could account for 7-10%percent of total electricity demand in the next few years,compared to two to three percent at the end of 2023.While demand is increasing,our work shows that most developed market economies dont have the infrastructure in place to meet this need.Moreover,a lot of the power demand is not where the power supply is currently located.We view this current set-up as a major opportunity for investors,especially on the Infrastructure side.5A Broadening of Earnings Growth Across Sectors and GeographiesAs we show in Exhibit 76,we have raised our 2024 and 2025 S&P 500 EPS forecasts to$250 and$270,respectively.What is changing in our data is that corporate earnings growth is set to broaden beyond mega-cap Insights|Volume 14.3 13Tech in coming quarters.We think this shift will represent more balance in the equity markets,and as a result,we are raising our 2024 target to 5,700 from 5,400 previously,which is roughly 10ove the top-down consensus estimate of 5,172.Our 2025 target of 6,130 implies about 13%of upside from todays level of around 5,414.Meanwhile,in Europe,we think the economy is bottoming at a time when most investors are underweight the region.Stronger tourism,rebounding sentiment,and an increase in real wages(at last)will lead to a perkier consumer in the coming quarters.As part of this improvement in growth,the services economy is accelerating nicely.Additionally,the end of quantitative easing breathed life back into,and produced strong returns for,the financial services sector.We expect this trend to continue as valuations normalize.6More Sustained Deficits Amid Election Volatility Reinforces Our Regime Change ThesisRegardless of the electoral outcome,the 2024 U.S.election is likely to further strengthen our Regime Change thesis.Though actual fiscal policy under Biden or Trump is not likely to loosen much given the expiration of some 2017 tax cuts or the imposition of tariffs,we continue to think that under either administration the deficit will stabilize at historically wide levels.As a result,we think Treasury term premium will stabilize at wider levels,too which will make it harder for bonds to rally the way they did in past cycles.That said,there are also several policy proposals that could skew inflationary under a second Trump presidency,including writing stimulus checks for households,deporting undocumented immigrants(which would aggravate labor shortages),cutting off Iranian and Venezuelan oil,and potentially pressing for a more dovish Fed.7The Labor Supply and Demand Mismatch Could Create Unprecedented Demand for Worker RetrainingWe think the U.S.labor force is in the early innings of an inflow of about four million additional potential workers amidst a record surge in immigration.However,our best guess is that limited formal skills training means the overwhelming majority of these workers will be competing to fill a small portion(perhaps about two million)of the 8.1 million open jobs in the U.S.As a result,we think the opportunity set for worker retraining may be as large as it has ever been,in part because there will be a lot of pressure to bring unemployed workers from low-skilled sectors(where we expect more of a labor glut in some cases)into high-skilled jobs left open by COVID-era retirements.So,while we certainly believe in the opportunity set and our glass half full perspective,we do want to acknowledge that we are entering a volatile period in the second half of 2024 at a time when spreads are already very tight.To be sure,we are not signaling a more sustained bearish tilt the way we did in 2022(see Walk,Dont Run).Rather if we could steal a page from our Outlook for 2023:Keep It Simple now is not a time to get over-extended when it comes to leverage or liquidity.The current environment,we believe,is more akin to the Oscar Wilde quote when he says that,“A pessimist complains about the noise when opportunity knocks.”Said differently,if Opportunity Knocks in the form of a capital markets draw-down linked to election uncertainty,then you should have your portfolio in position to answer the door.Dont just be the pessimist,particularly when many of todays macroeconomic headwinds can be overcome through a combination of thoughtful asset allocation and directed thematic investing.Insights|Volume 14.3 14Six Areas Where We Differ From Consensus#1:Bumpy,But Faster GrowthAcross all regions,we are again more bullish on growth than the consensus.In the U.S.,stronger assumptions around both job growth and productivity lead us to raise our 2024 forecast to 2.5%,10 basis points ahead of the consensus,and our 2025 forecast at 2.0%,20 basis points above consensus.More importantly,we have raised our long-term forecast for U.S.structural GDP growth to two percent from 1.5%in the past.In Europe,data surprises are no longer lagging the U.S.as economic momentum turns positive.We are increasing our 2024 GDP growth forecast to 0.8%from 0.5%versus a consensus estimate of 0.7%.For 2025,our growth forecast is 1.4%,the same as consensus.We think growth in China is bottoming and likely in the early recovery stage.Our 2024 forecast is at 5.0%versus 4.7%at the beginning of the year and a consensus of 4.9%,while 2025 is at 4.6%,10 basis points above consensus.In Japan,we forecast 0.6%GDP growth in 2024 and 1.2%in 2025,20 basis points and 10 basis points above consensus,respectively.#2:We Are Not as Worried About a Lower U.S.Savings Rate Signaling an Over-Extended Consumer This CycleWhile we do think U.S.consumer spending will slow in coming quar-ters,we are not seeing the type of imbalances that were observed in the run-up to past recessions.Specifically,although savings rates today are at the lowest levels since the GFC(currently around four percent,versus two to three percent in 2005-2006),we think this simple comparison doesnt account for the increase in the 65 population over the last two decades(17%today versus around 12%prior to the GFC).Personal savings rates become sharply negative once households retire,meaning aging demographics likely explain some of the savings pullback.In fact,our estimates suggest that the neutral savings rate has actually fallen to around 5.6%,down from 9-10%in the mid-2000s,implying that savings rates today are just 100-200 basis points below normal,while the savings rates that prevailed before the GFC were actually 700-800 basis points too low.Therefore,while we do expect some retrenchment,households do not look nearly as overspent as they have in the lead-up to past downturns.#3:Bigger Regional Differences in Interest Rates.In the U.S.,Whats the Rush?In the U.S.,we are above consensus on interest rates this year as part of our higher for longer thesis.We see the Fed cutting rates just once this year,to 5.125%(which puts our forecasts about 25 basis points above market forwards)before falling to 4.125%in 2025(also about 25 basis points above market pricing).For the U.S.10-year,we stick to our forecast of 4.25%for year-end 2024 and four percent for year-end 2025,which remains a bit more hawkish than consensus of 4.2%for 2024 and 3.9%for 2025.In Europe,we have the bund at 2.6%for end-2024(above consensus of 2.2%)and 2.8%in end-2025(also above consensus of 2.2%).We think sustained higher inflation volatility means a return to a longer-term average term premi-um of approximately 50 basis points,leading to a long-term bund yield target of approximately 3.0%.In China,by com-parison,we are actually below consen-sus for the 10-year for both 2024 and 2025 at 2.2%vs.2.4%,and 2.0%vs.2.4%,respectively.Against this backdrop,we think FX volatility will remain elevated and will serve as an important source of information for markets alongside the yield on government bonds.#4:Better EPS,Driven By Higher Margins We believe the cycle has further room to run,with margin expansion(as opposed to multiple re-rating)powering the next leg of the recovery.Our 2024 S&P 500 price target of 5,700 remains 10ove the top-down consensus estimate of 5,172.For 2025,our target of 6,130 implies about 13%of upside from todays level of around 5,414.For 2024 and 2025 EPS,our targets are$250 and$270,versus the top-down consensus of$240 and$253,respectively.Our framework linking real GDP growth and unit labor costs to operating margins points to 20-30 basis points of margin expansion this year and next so long as labor productivity stays supportive.#5:Oil$80 is the New$60We expect oil prices to settle in the mid-$70-80s range in 2024 amid slower global demand and better global supply.Longer term,though,we still think$80 is the new$60.As such,our longer-term forecasts remain well above futures,which continue to embed prices falling to the mid-$60-70s in 2025 and beyond.#6:Where Could We Be Wrong?Our base view is that there is an asymmetric risk for the economy and markets if rates go higher versus lower.We still see six percent short rates as somewhat of a tipping point,given this level limits operating cash flow for most levered entities as well as encourages more deposit flight from traditional financial intermediaries.Also,because policymakers did not remove as much stimulus from the markets this cycle,we continue to caution that the currency markets could be a source of unexpected stress for investors to consider in their portfolios.Finally,an extreme spike in unemployment,which is not our base case(as we think unem-ployment stays lower this cycle)would likely be unsettling for both our thesis and the markets,we believe.Insights|Volume 14.3 15What does all this mean from a macro and asset allocation standpoint?In the classic 1975 Steven Spielberg film Jaws,Chief Brody,played by Roy Scheider,proclaims after internalizing the size and power of the shark “youre gonna need a bigger boat”to Captain Quint,who was played by Robert Shaw.Brodys important epiphany was that traditional shark-catching techniques were no longer effective,and as a result,a different approach was warranted.Like Chief Brody,this is how we view asset and security selection in the current macro landscape:another approach is warranted.This viewpoint,since the onset of COVID,served as the backbone of our now well-established Regime Change thesis.As we look ahead,we still have high conviction in this framework,and if anything,we now think that the longer-term implications of our prior work may be even more profound than we had previously understood.We do not make these comments lightly,and to this end,we think that there are several key action items for portfolio managers and CIOs to consider.They are as follows:1.First,we remain of the mindset that a Regime Change(Exhibits 13 and 14)has occurred that requires a different type of portfolio,including more collateral-based cash flows,more upfront yield,and more linkage to the higher nominal GDP environment in which we are operating(Exhibit 19).Importantly,it also means that safe haven assets like government bonds and traditional currency hedges like JPY wont work as well this cycle.If there is good news,it is that our own internal work is showing that wages,which we view as a proxy for sticky services inflation,are moderating from peak levels,though KKRs portfolio company CEOs still see a higher resting heart rate for wages and inflation this cycle.2.Second,given flatter expected returns than in the past,we now think more focus on diversification is warranted.As we detail in Exhibit 21,the five-year forward median return across asset classes we forecast is 80 basis points lower than what we saw over the last five years.That said,we also see more ways to win in this cycle across a wider swath of asset classes.This viewpoint is in direct conflict with what worked before COVID,when concentrating ones assets in long-duration equities(e.g.,VC)and fixed income(e.g.,long-duration Investment Grade Debt)easily bested the benefits of constructing a more diversified portfolio.If we are right then CIOs,similar to what we learned from our proprietary insurance survey,should broaden their exposure and own more non-traditional assets that are less correlated.In addition,allocators will likely need to be more opportunistic to deploy when asset classes,regions and/or sectors periodically fall out of favor.Exhibit 21:Given Flatter Returns,We Think a More Diversified Portfolio Will Perform Better in the Future1.9-0.30.55.45.815.810.912.87.511.110.66.615.73.95.05.36.36.56.66.76.87.37.98.48.812.0Cash(USD)GlobalAg10Yr USTU.S.HYLoansS&P500STOXX600 EuropeMSCIJapanDirectLendingS&P600PrivateInfraPrivateReal EstatePrivateEquityPrivate Market Expected Returns,%Last Five YearsNext Five YearsData as at April 30,2024.Source:Bloomberg,BofA,Cambridge Associates,Green Street,KKR Global Macro&Asset Allocation analysis.Insights|Volume 14.3 16Exhibit 22:The Recent Heightened Portfolio Volatility Is More Correlation Driven Than Single-Asset Volatility Driven.This Backdrop Means That CIOs Need to Find More Assets That Bring Down Overall Portfolio Variance1.13%1.06%-0.22%0.30%0.91%1.36%Avg.2000-2022Avg.202360/40 Portfolio Variance Decomposition Rolling 3-YearSingle-asset VarianceStock/Bond CovariancePortfolio VarianceData as at December 5,2023.Source:Bloomberg,BofA,Cambridge Associates,Green Street,KKR Global Macro&Asset Allocation analysis.3.Third,in our new regime framework,we expect heightened volatility around the fundamental relationship between stocks and bond assets,which have become more correlated.As a result,traditional benchmarks are likely to demonstrate more volatility than in the past.Somewhat ironically,our colleague Chris Sheldon likens the current state of affairs in the global capital markets to self-inflicted wounds,as investors desire for greater liquidity increases volatility given so much of the fixed income market is actually now in equity linked,daily liquidity credit vehicles.One can see this in Exhibit 22,which shows that the increase in stock/bond covariance is leading to higher overall portfolio variance.Importantly,this outcome is occurring despite single asset variance actually declining.Our bottom line:Allocators should consider a shift towards assets that help overcome this increasing correlation between stocks and bonds.Greater communication with boards and end constituents is also likely becoming more important.Otherwise,there is now heightened risk that boards encourage CIOs and their teams to tamp down on certain single asset class allocations at precisely the wrong time,which ultimately could further dent cumulative performance in a world where the investment community is already starting with lower expected forward returns.Our bottom line:Allocators should consider a shift towards assets that help overcome this increasing correlation between stocks and bonds.Greater communication with boards and end constituents is also likely becoming more important.Otherwise,there is now heightened risk that boards encourage CIOs and their teams to tamp down on certain single asset class allocations at precisely the wrong time,which ultimately could further dent cumulative performance in a world where the investment community is already starting with lower expected forward returns.Insights|Volume 14.3 17SECTION IAsset Allocation and Key ThemesPicks and PansAgainst the current macroeconomic setting,we offer our updated Picks and Pans for investors to consider:Public Company Buyouts of Themselves(NEW)We are seeing a growing number of public companies that are essentially taking themselves private through better capital allocation,including aggressive buyback programs.A good example,we believe,is the home building sector.We are also seeing this type of corporate reform behavior in the U.S.home improvement sector as well as in parts of the industrial and energy sectors.In our view,many executives in this area are de-emphasizing the cyclical components of their businesses to create more sustainable companies with greater visibility of earnings and returns.As a result,we think that not only solid buyback activity but also a lower cost of capital could drive valuations materially higher at many of these companies than the consensus now thinks.Exhibit 23:Europe Has Historically Done More Dividends and Fewer Buybacks,But That Is Changing0501001502002010201120122013201420152016201720182019202020212022202320242025Euro Stoxx 600 ex-Financials Gross Buybacks,Billions and GS EstimatesData as at April 24,2024.Source:Goldman Sachs.We are of the view that all-in yields are likely near peak levels,as cooling inflation will give the Fed more conviction on interest rate cuts and easing financial conditions.Insights|Volume 14.3 18Exhibit 24:U.S.Buybacks Have Been Driven by Solid Earnings Growth and Tech Stocks,Contributing Mightily to the Lack of Supply89297802004006008001,0002010201120122013201420152016201720182019202020212022202320242025S&P 500 Annual Gross Buybacks,US$BillionsData as at March 31,2024.Source:S&P,Haver Analytics,KKR Global Macro&Asset Allocation analysis.CLO Liabilities(NEW)We are of the view that all-in yields are likely near peak levels,as cooling inflation will give the Fed more conviction on interest rate cuts and easing financial conditions.While we still like Loans,our preference is to play this idea through higher-quality CLO tranches,as diversification benefits and credit enhancement matter more in an environment where idiosyncratic risks are elevated(particularly when it comes to refinancing).We also think that CLOs fit into our higher for longer thesis on rates relative to pre-COVID.Biotechnology(NEW)We think the recent drawdown in biotech stocks is likely overstated when one compares it to how the rest of the equity market has performed.Just consider that the Nasdaq biotech index is down about 19%from its 2021 peaks,while the S&P 500 has actually climbed about 19%over the same period.Nonetheless,we continue to think biotech remains one of the most compelling secular growth stories in the market,backed by aging populations,increased technological investment,and the fact that a lot of weaker startups have struggled to raise capital/IPO in recent years.Our bottom line:We are turning more bullish on the sector,particularly when one accounts for the fact that valuations in price-to-book terms are now hovering near the lowest levels since the GFC.USD EM Corporate Debt(NEW)While we remain bullish on the growth trajectory for emerging markets,we continue to think that EM Public Equity markets may not be the best way to play this theme,as they are often overweight state-backed enterprises that do not prioritize returning profits to shareholders.By contrast,we like opportunities in the private markets to work alongside local partners to align with key growth themes,as well as opportunities in the public debt markets(particularly as EM default rates are often lower than those for U.S.corporates).At present,we especially like the relative value opportunities in EM Debt to lend to some of the same quasi-governmental enterprises that drag on EM index returns,as these companies carry more protection than typical corporates while offering excess spread relative to their inherent risk.Short Duration European Credit(NEW)Not only does European HY screen cheap to U.S.HY on a spread basis,but we believe historical levels suggest there is more opportunity for high quality senior secured assets to tighten relative to the U.S.Importantly,European HY maturities tend to be shorter,and against this backdrop,we expect fully 35-40%of European HY to mature by the end of 2026.Taken together with ECB rate cuts,this reality offers near-term takeout opportunities for bonds that still have convexity.Moreover,in many instances across Europe,we think that there is some compelling convexity that remains,particularly for any issuers that will try to use future rate cuts as an opportunity to address existing short-term debt.Insights|Volume 14.3 19Exhibit 25:Fully 35-40%of Euro HY Is Maturing by the End of 2026.We See This Refinancing Opportunity as Significant 0%5 %0-11-22-33-44-55-66-77-10 10-30European vs.U.S.HY Maturity,YearsUS HYEU HYData as at April 30,2024.Source:Bloomberg.Japan(REPEAT)We continue to remain constructive on the investing environment in Japan and believe that an economic reawakening is in progress.We see a transition underway in the coming years from the post-COVID,pent-up,demand-driven recovery to a second phase,fueled by real income growth.Capital expenditures remain elevated,which is critical to boosting productivity to offset not only the increase in wages but also the price increases in food and oil.We take comfort that corporate reforms,especially around listed companies,continue to gain momentum under Prime Minister Kishida.We also still see opportunities in corporate carve-outs and significant value in direct public to privates,as we believe the opportunity for operational value creation is meaningful.That said,we do expect the yen to remain weaker for longer and highly volatile,likely only strengthening once the Fed begins its easing campaign.Against this backdrop,we think sound hedging and portfolio construction is only becoming more important.365 Day Lending,Including Fund Financing(REPEAT)If we are right that the Fed cuts rates more gradually than markets expect,then the carry offered by the front end of the curve is going to be an important driver of performance in 2024.We are particularly interested in term subscription lines as an opportunity to receive above-market compensation for exposure to high-quality counterparties in a space where regional banks have pulled back on new lending.Today,a sub-line with less than a 365-day maturity generally yields SOFR 200-250 basis points,which we think could be attractive as a Cash plus surrogate with low default potential.Importantly,this opportunity screens well from a cyclical risk standpoint,as banks are beginning to move back into this market which could tighten pricing in the next few quarters.U.S.Leveraged Loans Refinancing Wave(NEW)Similar to what we are saying about European High Yield,we think the wave of refinancing for leveraged loans will continue,driving better total returns for discounted Leveraged Loans nearing maturity.All told,year-to-date through May,U.S.Leveraged Loan issuance stood at$550 billion,of which fully$198 billion(36%)was driven by refinancing activity.We look for this theme to continue in coming quarters as spreads across risk assets have continued to compress.As our colleague Chris Sheldons recent credit letter suggests,sponsors and issuers are looking to reprice and refinance existing debt,which will continue to provide tailwinds for the asset class and will likely drive spread compression absent new M&A.Insights|Volume 14.3 20Exhibit 26:We Believe Reinsurance Capital Solutions Can in Certain Situations Provide Meaningful Diversification,Reduced Volatility,and Enhanced PerformanceAssetModel Portfolio(Weighting or Ratio)Alternative 1Alternative 2Alternative 3Alternative 4Equities60UUP%Bonds40550%Insurance Assets0%5%5 %Annualized Return5.4%6.3%5.8%6.6%7.9%Volatility13.2.9.3.0.8%Return Risk Ratio0.41x0.48x0.47x0.55x0.73xDifference in Basis PointsModel Portfolio(Weighting or Ratio)Alternative 1Alternative 2Alternative 3Alternative 4Annualized Return5.4% 90 39 129 257Volatility13.2%-27-92-120-239Return Risk Ratio0.41x 0.08x 0.06x 0.15x 0.33xEquities:MSCI ACWI Gross Total Return USD Index;Bonds:Bloomberg Global-Aggregate Total Return Index;Alternative Portfolio:Reinsurance transactions.Data from 1Q18 to 1Q24.Source:KKR GBR analysis.Reinsurance Capital Solutions(NEW)A continuing refrain we heard from our recent survey work was the growing desire to own longer duration,compounding-oriented assets with tax-efficient attributes,especially for family offices/high net worth investors.Importantly,we believe participating in reinsurance transactions(or what we call insurance as an asset class)can be an effective complement to yield-oriented asset classes such as Private Credit and/or Asset-Based Finance.At the same time,the high return on capital attributes of this asset class also enable allocators to play offense with their portfolios.The market potential for insurance as an asset class is quite sizeable,as we increasingly see that a growing number of insurers are looking for partners to reinsure block transactions,or actually exit lines of business.Beyond stable returns and solid yield characteristics,the asset classs low correlation to other more traditional fixed income products is quite compelling if our bigger boat thesis is accurate.Exhibit 27:Which Is In Line With Our Diversification Thesis for Portfolio Construction Model PortfolioAlt 1Alt 2Alt 3Alt 4-2%0%2%4%6%8%5 %Annualized ReturnVolatilityVarious Reinsurance Transaction Portfolios Volatilityand Annualized Return vs.a Traditional 60/40Equities:MSCI ACWI Gross Total Return USD Index;Bonds:Bloomberg Global-Aggregate Total Return Index;Alternative Portfolio:Reinsurance transactions.Data from 1Q18 to 1Q24.Source:KKR GBR analysis.Insights|Volume 14.3 21 Out Year Oil Prices(REPEAT)We expect oil prices to moderate to the mid$70-80 range amid slower global demand and better global supply next year.Longer term,we still think$80 is the new$60.Shale is still the key source of longer-term global supply growth,and producers continue to demonstrate a disinclination to grow supply unless prices center at least around$80.This forecast remains well above futures,which continue to embed prices falling to$60-70 in 2025 and beyond.Exhibit 28:If We Are Correct That Shale Producers Are Now Focused On Generating Attractive FCF and ROEs,We Think Around$80 Is the Long-term Price Level Required to Achieve Those Aspirations201220132014201520162017201820192020202120222023-40%-30%-20%-10%0 00405060708090100110Avg.WTI Oil Px(US$/Barrel)Median ROE of Oily E&Ps*WTI around$80 has beenrequired to generate asustainable 10% ROEMemo:2012-2023Avg.WTI$/bbl:$69Oily E&P ROE:5%Median ROE of Oily E&Ps vs.Avg.WTI Price*Median of COP,EOG,PXD,OXY,FANG,APA,PDCE,MGY,MUR,DEN,CIVI,CRC,SM,CDEV,TALO.Data as at December 31,2023.Source:Bloomberg.Opportunistic Credit(REPEAT)This Pick has multiple threads to it.For starters,we see significant value in opportunistic liquid Credit vehicles that can nimbly toggle allocations across High Yield,Levered Loans,and Structured Credit as well as between sectors and themes,particularly as a repricing of spreads and the risk-free rate create select pockets of relative value.We also think that wider dispersions within Credit asset classes,often driven by indiscriminate ETF buying and/or selling,are creating substantial opportunities that were not available in the past.At the same time,we are seeing some really attractive relative valuation in the bucket we call Capital Solutions Credit to fund acquisitions and/or major capital expenditures including domestic re-shoring initiatives.In particular,it definitely feels to us like there is an upward kink in the efficient frontier that is providing investors in products like Convertible Bonds and Preferred Securities the ability to enjoy some attractive equity upside participation but also retain some downside protection at limited additional costs.Finally,Asia Credit also remains an area of growing interest from investors,as this more nascent market faces less competition from more traditional players.Worker Retraining(NEW)The latest CBO figures imply that total U.S.immigration may be roughly 5.5 million people higher over 2023-2027 than previously expected(or more than double what the CBOs previous forecasts for run-rate immigration had assumed).While that should help alleviate labor scarci-ty,given there are some 8.1 million open jobs in the U.S.,the bad news is that the majority of new workers will be qualified for only about two million of these open posi-tions.Thus,we think there is a massive economic op-portunity to invest in better worker training that can help move many workers into higher-skill job openings across manufacturing,logistics,nursing,etc.,that have been left open as a result of baby boomer retirements or growing needs.Against this backdrop,a rethinking in approach may be warranted.Areas where we see opportunity could include:1)shifting job requirements from a credentials first model to a skills first model.Importantly,we believe this will optimize ROI in education and training and also lead to more employable people;2)reliance on certificates to confirm training of people in areas of specific need and employment relevance;3)a skills first model that allows workers and employers to understand skills adjacency,fa-cilitating the upskilling of existing workers whose jobs have some overlap with or even all of,the skills needed;and 4)expansion of hybrid platform models that provide online credentialing paired with personalized coaching.Insights|Volume 14.3 22Exhibit 29:U.S.Worker Turnover Rates Are Much Higher Than Those in Other Developed Countries1Q245.1%2.8%1.72345678Mar-06Mar-07Mar-08Mar-09Mar-10Mar-11Mar-12Mar-13Mar-14Mar-15Mar-16Mar-17Mar-18Mar-19Mar-20Mar-21Mar-22Mar-23Mar-24Quarterly Job Vacancy Rates by Country,%U.S.EurozoneJapanData as at March 31,2024.Source:U.S.Bureau of Labor Statistics,Eurostat,Bank of Japan,Haver Analytics.Exhibit 30:The U.S.Spends Less On Worker Retraining Than 31 Out of 32 OECD Countries Studied0.01%0.10%0.14%0.14%0.16%0.63%0.66%0.72%0.74%0.77%0.90%1.00%1.01%1.27%2.05%MexicoUnited StatesJapanLatviaIsraelGermanyLuxembourgBelgiumAustriaNetherlandsHungaryFinlandFranceSwedenDenmarkPublic Expenditures on Assistance and Retraining forUnemployed Workers in Top Developed Economiesas a%of GDPBottom FiveTop TenOf the 32 countries included in thedata,the U.S.spends nearly the lowestpercentage,second only to MexicoData as at December 31,2022.Source:U.S.Department of Commerce.Multifamily Real Estate(New)For some time now,we have been advocating an overweight to Real Estate Credit.We now see good value on the equity side,too.Key to our thinking:U.S.rental vacancies are at their lowest levels in about 40 years(except for the pandemic),while run-rate household formation will likely run at a higher rate than rental units can be delivered given the pullback in building starts.Importantly,we think the recent surge in U.S.immigration will only add to these imbalances,as it could potentially double the number of households formed over the next three years.Finally,we think market technicals are becoming more bullish,too,including signs that cap rates have now started to peak(as more transactions are taking place between buyers and sellers)as well as tighter spreads for RE lending(including the CMBS market).So,while we are not yet ready to run when it comes to RE allocations,we think owning some existing multifamily in strategic geographies could be quite fortuitous,particularly in cases where replacement costs are near or above asset values.Fade Fed Rate Cuts When the Market Gets Euphoric(REPEAT)If we are right that we are in a higher nominal GDP environment with increased levels of productivity,then the neutral rate for Fed Funds likely stays higher this cycle.As such,we do not share the consensus view of two or so rate cuts this year.Rather,we stick to our view that inflation is on a cooler path but will not return to the Feds target range of two percent.Therefore,we would use periods of dovish euphoria to hedge out interest rate risks(like the opportunity set that was presented to investors during the banking crisis of 2023).Insights|Volume 14.3 23 Low-Cost Consumer Discretionary(REPEAT)As we have written before,younger and lower-income U.S.consumers have been the most exposed to inflation this cycle,which is weighing on available spending.Moreover,a lot of inflation today is in must-have categories like food,housing,etc.,which is taking wallet share from discretionary spending on nice-to-have budget items like restaurants or recreational goods.Finally,we think the composition of low-income demand is likely shifting away from categories like fast-casual dining as a surge in immigration leads to more competition for both employment and low-cost housing.Against this backdrop,although the consumer in aggregate has mostly recovered from the inflation shock of 2022,we remain cautious about the outlook for nonessential spending among this cohort.FX Risks(NEW)We think the asynchronous experiences of major world economies around inflation and growth will create more volatility in both interest rates and currencies,particularly in cases where countries face tradeoffs between the long-term effects of higher bond yields on budgets versus the impact of weaker currencies on trade balances.To see this,one can consider the divergent experiences of the U.S.and Japan in recent years:U.S.bonds have become quite cheap,while its currency has strengthened sharply.Japanese bonds remain expensive,which should help government deficits,but its currency is at 30-year lows.There are also crosscurrents from geopolitics,including reserve balances and FX interventions,to consider.Our bottom line:betting on currency returns is likely a poor risk/reward for most investors right now,which is why we prefer FX hedge benefits for USD investors to potential currency upside in most cases.Key ThemesWe also think that leaning into themes that serve as foils to todays uncertain landscape is critical.To this end,we are enthusiastic about the following investment trends:1Buying Complexity,Selling Simplicity in the Equity Markets While we still favor simplicity in Credit markets,we are seeing some interesting opportunities around complexity in the Equity markets.In addition to direct public-to-private transactions,we believe that corporate carve-outs are amongst the most attractive ways to find devalued and underappreciated companies in bifurcated markets markets that too often seem to eschew complexity in favor of simplicity at almost all costs.In particular,we still believe the opportunity set to acquire high-quality carve-outs across PE,Infrastructure,and Energy remains outsized in todays markets.In our view,it would not be unreasonable,for example,to expect corporate carve-outs in large markets like the U.S.and Japan to account for a third or more of total deal volume during the next 12-24 months.Importantly,prices for these types of transactions tend to be much more attractive than regular way private-to-private transactions,and the operational upside has also generally been more significant than regular way Private Equity transactions.Insights|Volume 14.3 24Exhibit 31:The Industrials Sector Is Becoming Much More Fragmented536 14 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024Top 10 Largest Industrials as a%of S&P Industrials byMarket CapData as at May 31,2024.Source:Factset,Melius Research.Exhibit 32:We Expect Divestments in Japans Corporate Carve-Out Arena to Continue3,3681,217SubsidiariesAffiliatesTop Five Select Japan Conglomerates Number of Subsidiaries and AffiliatesSubsidiaries refer to subsidiaries with consolidated financial statements.Affiliates refer to unconsolidated subsidiaries.Data as at March 31,2022.Source:Company disclosures,KKR Global Macro&Asset Allocation analysis.Just consider that the projected increase in AI electricity demand is roughly equivalent to adding 24 million homes(or 16%of total housing stock)to the grid.2 Collateral-Based Cash FlowsOur research continues to show that many individual and institutional investors are still underweight Real Assets,especially Infrastructure and Energy,at a time when the need for inflation protection in portfolios remains high.Moreover,if we are right about the AI-electricity demand that we are forecasting,then the opportunity set to own growthier Infrastructure assets,especially around data centers,logistics,etc.,is quite compelling,we believe.Just consider that the projected increase in AI electricity demand is roughly equivalent to adding 24 million homes(or 16%of total housing stock)to the grid.Finally,as we show below,the benefits of using Real Assets,especially Infrastructure,Real Estate Credit,Asset-Based Finance,and certain commodity investments,to increase portfolio diversification dovetail nicely with our current macro view about the need to find more diversifiers in ones portfolios.One can see this in Exhibits 33 and 34,respectively.Exhibit 33:We Think More CIOs May Need to Focus on the Diversification Benefits of Non-Traditional Asset Classes,Particularly InfrastructureAsset Class Correlations,Quarterly,Using Last 12 Months Total Return From 2012-2023 IGRMBSCMBSPublic EquitiesStructured CreditPrivate EquityPrivate CreditRE EquityInfraIG100%RMBS920%CMBS960%Public Equities50(D0%Structured Credit35%64p0%Private Equity29(I0%Private Credit7%-17%5xuv0%RE Equity-20%-19%-173RU0%Infra-3%-19%-6F!cUT0ta as at September 30,2023.Source:Cambridge Associates,JP Morgan,Bloomberg,KKR Global Macro&Asset Allocation analysis.Insights|Volume 14.3 25Meanwhile,within Credit,we favor Real Estate Credit and Asset-Based Finance as a play on our Regime Change thesis.Even with inflation cooling and the Fed approaching an easing campaign,we still think higher for longer will remain in play.As a result,we see a potential upward re-rating of structured products that are being used to finance Real Assets such as houses,aircraft,renewable power assets,and warehouses.Importantly,these products also have a degree of inflation linkage,given they are backed by hard assets that tend to rise in value with consumer prices,and they often have floating coupons that may benefit lenders during periods of higher rates.3 Productivity We continue to believe that corporations will need to focus on automation and productivity to offset skills mismatches and labor shortages in certain instances.In our view,many of the most influential technological trends,including automation and digitalization that were in place before the pandemic have now only accelerated,especially on the industrial side of the economy.We think that the recent uplifts in productivity are not anomalies but instead are closely linked to a resurgence in capital investment that began around 2014.To date,the most advanced efforts have been heavily concentrated in the manufacturing industry,which in the United States accounts for less than 10%of total employment but nearly 90%of all robot installations.However,the playbook is starting to shift,as the aging population makes it harder to fill junior roles in service industries;we believe this trend will only accelerate as automation increases in fields like retail,leisure and hospitality,and healthcare.We are also very bullish on trends in worker retraining.Using data and educational techniques to improve student/employee skills to better match the demand by corporations for labor will be a mega-theme,we believe.No doubt,automation and productivity are emerging as some of the most compelling mega-themes this cycle,in our view,and at times have accounted for about 20-25%of our deal teams PE activity since the pandemic.Exhibit 34:Regime Change:We Think That There Is a Need to Shift Ones Asset Allocation Mix Towards More Investments Linked to Nominal GDP60/40PortfolioAlts Enhanced40/30/300%1%2%3%4%5%6%7%8%9%0%5 Year Historical Average Annual Returns 20 Year Historical Annual Volatility20 Year Average Annual Returns and Volatility of RealAssets and 60/40 PortfoliosEfficient Frontier w/Traditional AssetsEfficient Frontier w/Traditional&Private Real AssetsEfficient frontier calculated using quarterly total returns over the last 20 years ending in March 2023.Traditional asset efficient frontier constructed using the MSCI World Index for Global Equities,the Bloomberg Global Aggregate Treasury Index for Global Government Bonds,the iShares TIPS Bond ETF for TIPS,and the Bloomberg Global Aggregate Corporate Index and Bloomberg Global High Yield Index for Global IG and HY Corporates.Efficient frontier with traditional and Private Real Assets uses all of those indices,plus the MSCI U.S.REIT Index for Global REITS,Commodities proxied using the S&P GSCI Spot Index,Global Private Infrastructure is proxied using the Burgiss Global Infrastructure Index,Private Real Estate proxied using the Burgiss Global Real Estate Index,and the Giliberto Levy Commercial Mortgage Index for Private Real Estate Debt.Data as at March 31,2023.Source:Bloomberg,Burgiss,Giliberto Levy,KKR Global Macro,Balance Sheet&Risk analysis.We are also very bullish on trends in worker retraining.Using data and educational techniques to improve student/employee skills to better match the demand by corporations for labor will be a mega-theme,we believe.Insights|Volume 14.3 26Exhibit 35:Overall,Higher Wages Should Lead to Productivity Growth Over Time,Particularly for Skilled Positions-4%-2%0%2%4%6%8%0.5%1.5%2.5%3.5%4.5%Labor Productivity,2-year lagWage inflation,Y/y%Wage Inflation vs.Labor Productivity inU.S.Manufacturing,ta as at April 30,2024.Source:U.S.Bureau of Economic Analysis,U.S.Bureau of Labor Statistics,KKR Global Macro&Asset Allocation analysis.4Security of Everything We remain the maximum bullish on this theme.Against a background of rising geopolitical tensions,cyberattacks,and shifting global supply chains,CEOs around the world tell us that they want to know that they have resiliency when it comes to key inputs such as energy,data,transportation,and pharmaceuticals.In particular,we think that regulators and executives in the financial services industry feel strongly that cyber protection spending should accelerate more meaningfully,especially after the 2023 hack of the Treasury market.This theme also ties into rising temperatures around the world.Companies will need to ensure the security of storage,power,and transportation,and with government spending initiatives/tax incentives like the Inflation Reduction Act(IRA)in the U.S.,a lot more government support will be targeted at the intersection of climate and supply chains.We also think that the defense industry will continue to benefit mightily from this theme.5 Intra-AsiaMultiple trips to Asia since the onset of COVID confirmed for us that a meaningful transition is occurring:Asia is becoming more Asia-centric,with increased trade within the region rather than simply with developed markets in the West.Already,the share of Asian trade with regional partners(versus with the West)has increased massively to 58%in 2021 from 46%in 1990.We believe that more market share gains are likely,particularly when one considers that intra-Europe trade stood at 69%in 2021.All told,we think that intra-Asian trade could hit 65-70%in the next five to seven years.Key areas on which we are focused include transportation assets,subsea cables,security,data/data centers,and energy transmission.Importantly,local banks are taking more of the local market share as part of this build-out.Before the Global Financial Crisis,Western financial firms accounted for two-thirds of the regions overseas lending.Today,by comparison,local Asian banks,led by China,Japan,and Singaporean entities,account for more than half.We also see more countries in the region participating in and robustly benefiting from the Asia global growth engine.Frances Lim believes that India and Southeast Asia in particular stand to benefit from the ongoing changes.In addition to favorable demographics,more multinational companies are expanding their footprints beyond China,which remains an important influence too.This building of resiliency into supply chains has led to opportunities in data centers,logistics,and lower-cost manufacturing in the region.Insights|Volume 14.3 276 Intersection of AI and Energy SupplyIn recent months we spent a substantial amount of time with internal and external constituents digging into whether we have the power supply to handle all the bullish demand sentiment we are now seeing.Our conclusion is that the constraint is on the supply side,not on the demand side,and that this mismatch will be one of the biggest investment stories over the next few years across North America,Europe,and Asia.All told,our best estimate is that power demand in the U.S.will increase at a CAGR of 2.0-2.5%over the next five years,compared to zero for the past five years.As this growth accelerates,data centers alone are expected to account for 7-10%of total energy demand by 2029,compared to two to three percent today.If we are right,then billions of dollars will be required across natural gas,renewables,transmission,and other forms of infrastructure.As part of our thesis,we expect energy efficiency,including cooling procedures,to become a significant area of growth.A recent trip to Spain in early June to drill down on this topic not only reinforced our conviction about the growing demand side of the equation,but also the emerging bottleneck in production that will need to be met in Europe through more supply of renewables as well as additional grid upgrades.All told,our best estimate is that power demand in the U.S.will increase at a CAGR of 2.0-2.5%over the next five years.Exhibit 36:By 2030,Data Centers Could Account for 4.5%of Global Energy Power Generation 0.0%0.5%1.0%1.5%2.0%2.5%3.0%3.5%4.0%4.5%5.000100015002000250020102015202020252030Global Data Center Power Usage Per Year,TWhBase Case:Data Center Power Usuage,LHSAccelerated Case:Data Center Power Usage,LHSBase Case:%of Global Power Generation,RHSData as at March 31,2024.Source:SemiAnalysis.Exhibit 37:Hyperscalers,Which Are the Biggest and Fastest Growing Part of the Market,Require More Energy,Racks,and Cooling Systems010203040506020232024202520262027Rack Density,KW/RackEnterprise and Colocation Data CentersHyperscale Data CentersData as at March 31,2024.Source:JLL.Insights|Volume 14.3 287 Demographic Challenges to Retirement SecurityWhile we believe productivity is in the early stages of an upcycle,we also remain cautious that productivity growth will not be enough to offset the negative impact of a rapidly aging global labor force.Recall that the dependency ratio,or the ratio of the 65 population relative to the working-age population,rose from 18%in 1990 to 30%in 2020 and is expected to rise to 37%by the end of the decade.Said differently,the working-age population is peaking in many parts of the world,while the base of older workers they need to support is growing rapidly.Increased fertility efforts will be required.This challenging demographic landscape will also further incentivize governments and corporations to encourage more domestic savings,including annuities and other tax-deferred savings vehicles in the developed markets.In the emerging markets like India,by comparison,we expect the government to introduce new programs that help shift individuals out of gold and real estate into more traditional capital markets savings vehicles.Exhibit 38:Wealth and Retirement Savings Are Now Greatly Skewed Towards Older Demographics.We Think These Types of Imbalances Will Capture the Interest of Governments Regarding Retirement Security Household Assets by Age Group,US$Trillions and%of TotalAssets,US$TrillionsAs a%of Total AssetsAge202320012023200155 and Older$114$2669Q-54$37$19227%Under 40$15$69ta as at December 31,2023.Source:Federal Reserve.At the same time,existing savings will need to be restructured and/or reorganized,we believe.For starters,just consider that the sizeable wave of retirements experienced in the U.S.and other economies in recent years was linked to financial security that elderly workers enjoyed from rising housing prices,especially post COVID.However,elevated housing prices,combined with structural housing shortages in developed markets,mean that workers will increasingly need to seek alternative vehicles for wealth accumulation going forward.All told,in the U.S.for example,the percentage of total assets owned by the aged 55 age cohort has grown from 51%in 2001 to 69%in 2023 driven in part by a 4x increase in Real Estate assets during that time.One can see this in Exhibit 38.In our view,homeowners will now need to diversify their holdings to create more balanced retirement plans.At the same time non-homeowners,many of whom have had to dedicate more of their current income to cover rental costs,will need to find ways to create catch-up savings,given that they have not benefitted from the home asset price appreciation.In our view,neither task(i.e.,diversification of assets by homeowners as well as much needed catch-up savings for non-homeowners)will be that easy to accomplish without utilization of more professional advice and government incentives.Our final point on retirement security is that we think there will be a blurring between national security and economic security.Simply stated,we expect a greater number of politicians to encourage citizens to keep their savings at home.Indeed,a recent speech by President Macron,for example,identified that Europe is challenged by not having an integrated financial system to ensure that savings are funding innovation and private investment on the continent.Rather,he cited an estimate of 300 billion flowing to U.S.Treasuries,which in his view helped fuel American,rather than European,growth.This vocal viewpoint frankly did not come as a total surprise to us,as to some degree,many political leaders want to lower their cost of capital and reduce dependence on foreign flows,especially in countries that run large deficits.As such,we have seen a notable increase in tax-deferred savings accounts that in addition to the demographic headwinds that countries face help limit some of the anxiety around running large deficits and/or depending on other countries to fund their growth.Insights|Volume 14.3 29SECTION IIGlobal/Regional Economic ForecastsAfter convening our mid-year GBR IC,we left thinking as a team that global growth was actually sturdier than we had originally forecasted.This stronger for longer viewpoint is consistent with some of the work done by Dave McNellis showing that the risk of a recession was overblown.In fact,most recessions he and the team studied were caused by inventory de-stocking and major slowdowns in housing neither of which we see in the cards for 2024(Exhibit 44).Meanwhile,as we detail below,two recent trips to Europe with Aidan Corcoran made us feel better that the region is showing a cyclical upswing in both corporate profit and GDP growth.Finally,within Asia,it also feels a little better than when we did our last update.However,given all the uncertainty in the world,we do continue to create scenario analyses in conjunction with our deal teams to help ensure that our underwriting remains both dynamic and resilient.Meanwhile,as we show in Exhibit 39,on the inflation front we have inflation in line with consensus in both the U.S.and Europe for 2024.However,for 2025,we are modestly below the consensus across every region except the United States,which would represent one of the first times since COVID that we are forecasting a more dovish message,albeit we still do not see inflation levels trending towards central bank targets.The one major outlier to consensus remains China,which we still see experiencing very low inflation amidst declining nominal GDP.After convening our mid-year GBR IC,as a team we left thinking that global growth was actually sturdier than we had originally forecasted.Exhibit 39:Our Forecasts Reflect the Asynchronous Recovery Happening in the Global Economy2024 Real GDP Growth2024 Inflation2025 Real GDP Growth2025 InflationGMAABloombergGMAABloombergGMAABloombergGMAABloombergNewConsensusNewConsensusNewConsensusNewConsensusU.S.2.5%2.4%3.2%3.2%2.0%1.8%2.5%2.4%Euro Area0.8%0.7%2.4%2.4%1.4%1.4%2.1%2.1%China5.0%4.9%0.6%0.7%4.6%4.5%1.3%1.5%Japan0.6%0.4%2.3%2.4%1.2%1.1%1.7%1.8%Note:KKR GMAA estimates and Bloomberg consensus forecasts.Data as at June 7,2024.Source:Bloomberg,KKR Global Macro&Asset Allocation analysis.Insights|Volume 14.3 30Exhibit 40:Our Probability Weighted GDP Forecasts Still Tilt Towards Higher Growth and Stickier Inflation Over Time KKR GMAA Real GDP Forecast and Probability,%KKR GMAA Inflation Forecast and Probability,seLowHighBaseLowHighU.S.20242.5%1.0%3.5%3.2%2.5%4.0 252.0%0.0%2.5%2.5%2.0%4.0%Euro Area20240.8%0.3%1.2%2.4%2.0%3.0 251.4%0.3%2.0%2.1%1.2%3.0%China20245.0%4.6%5.4%0.6%0.2%1.0 254.6%4.0%5.2%1.3%0.8%1.8%Japan20240.6%0.2%1.0%2.3%1.8%2.8 251.2%0.7%1.7%1.7%1.2%2.2%Note:KKR GMAA estimates.In the U.S.and Europe for 2024 and 2025,we assign a probability of 60%for the base case,20%for the bear case,and 20%for the bull case.In China for 2024 and 2025,we assign a probability of 60%for the base case,25%for the low case,and 15%for the high case.In Japan for 2024 and 2025,we assign a probability of 60%for the base case,20%for the low case,and 20%for the high case.Data as at May 31,2024.Source:KKR Global Macro&Asset Allocation analysis.U.S.GDPForecasts:Our 2024 U.S.GDP moves down slightly to 2.5%from 2.7%previously.As such,we are now 10 basis points above consensus.The biggest driver of our revision is the slowdown were seeing in discretionary goods spending,particularly among lower income consumers.Meanwhile,an important offset is that TMT investment spending is running even stronger than wed had penciled in,with AI-related investment a key driver.For 2025,we see growth moderating towards two percent,although the key cyclical drivers of GDP growth(i.e.,fixed investment and inventories)should remain supportive.Notably,our forecasts are 20 basis points above the consensus for 2025.Importantly,for 2026 and beyond,we are raising our forecast for run-rate GDP growth to two percent(in line with consensus)up from 1.5%previously reflecting stronger tailwinds from labor force growth and productivity gains.We do not make this statement lightly;however,given the gains we are seeing in productivity as well as some much needed growth in the U.S.workforce,we feel comfortable making this more structural change to our forecast.Commentary:Upward U.S.GDP revision trends are now finally flattening out for the first time in a year.Our U.S.outlook has been consistently more optimistic than consensus ever since the regional banking crisis broke out last spring.Key underpinnings of our constructive outlook have been 1)the ongoing pull of labor market demand,particularly in pandemic-affected services industries,2)the continuing drumbeat of long-tailed fiscal support,3)the health of balance sheets,particularly on the consumer side,and 4)the resilience of the most cyclical areas of the economy,including construction and inventories.Importantly,all of these tailwinds remain in place,though now with a bit less strength on the consumer side,as job trends normalize and revenge spending continues to dissipate,particularly at lower incomes.Overall,this U.S.expansion remains one defined by rolling sector cycles.In 2022,the key headwind to growth was in residential construction.In 2023,it was an inventory correction related to supply chain reopenings.In 2024,the new wrinkle is a slowing in consumer discretionary spending(something weve been expecting,which is why our forecast revision really reflects the timing rather than the severity of a consumer spending pullback this cycle).Importantly,however,each of these sector cycles has been offset by strength elsewhere.In 2024,we think the offsets are persistently wide government deficits,AI-related investment and less drag from inventory normalization.Importantly,for 2026 and beyond,we are raising our forecast for run-rate GDP growth to two percent from 1.5%previously.Insights|Volume 14.3 31Exhibit 41:Our Cycle Indicator Is On the Verge of Moving Towards Early Cycle After Being in Late Cycle and Contraction Period for Almost Two YearsKKR Cycle IndicatorHomebuilderSentimentInventory/Sales RatioKKR IndicatorApr-24Earnings RevisionsM&A VolumeYield CurveISM New OrdersConsumerSentimentCredit SpreadsJobless ClaimsKKR Indicator 2Q22Job Quits-3.0-2.5-2.0-1.5-1.0-0.50.00.51.01.52.02.53.0Number of Standard DeviationsAbove/(Below)LT TrendNumber of Standard Deviations Above/Below 6M AgoContractionEarly Cycle RecoveryMid Cycle Expansion Late Cycle SlowdownThe KKR cycle indicator is an equal-weighted average of 10 components spanning the labor market,corporate activity,financial conditions,cyclical activity,and the consumer.Data as at April 30,2024.Source:Bloomberg,KKR Global Macro&Asset Allocation analysis.As we show in Exhibit 41,our proprietary business cycle indicator is sending a similar message that the U.S.economy will continue to move forward at a decent clip.Indeed,we are encouraged by the fact that the majority of components(six out of 10)are improving on a 6-month rate of change basis.To be sure,we still need to see the breadth of components broaden to 70%to officially enter the recovery phase.However,we think this condition is likely to occur in coming quarters as M&A volumes recover alongside better capital markets liquidity,earnings breadth broadens out in 2024,and/or homebuilder sentiment stops getting worse as rates stabilize.Digging into the sizeable consumer segment of the U.S.economy,the setup is certainly less optimistic than it was during the immediate recovery from COVID.In particular,there is no question that savings rates are currently low at around 3.5-4%,which is below the six-plus percent levels that prevailed pre-COVID and close to the pre-GFC lows of about two to three percent.Importantly,though,what is different from the 2005-2006 period is that the U.S.population has gotten much older.Indeed,recall that personal savings rates go negative when consumers retire;given that over 17%of the U.S.population is now at or above 65(versus around 12fore the GFC)we estimate that the neutral savings rate has actually fallen to around 5.6%today,down from 9-10%in the mid-2000s.When we account for these structural factors,a four percent savings rate today(which is about 100-200 basis points below neutral)is a much less downbeat signal for the consumer than a two-to-three percent savings rate was in the run-up to the GFC(which was about 700-800 basis points too low).Our bottom line:while we do expect consumer retrenchment in coming quarters(and think this may feel quite uncomfortable for certain at-risk consumer subsectors)households do not look as overspent as they have during past downturns,particularly if we are right that immigration and labor force growth will provide more of a tailwind for aggregate consumption going forward.Our proprietary business cycle indicator is sending a similar message that the U.S.economy will continue to move forward at a decent clip.Insights|Volume 14.3 32Exhibit 42:Savings Rates Vary Considerably Over the Consumer Lifecycle,Especially as Citizens Age27!%5%-24%-34%GDP)x(Avg.Fed Funds-GDP Delta)Real Fed Funds vs.Potential GDP and UnemploymentData as at December 31,2023.Source:Bloomberg,KKR Global Macro&Asset Allocation analysis.By contrast,the forward curve is about 25 basis points below our forecasts for both years,which we think is too ambitious given how much ground was lost in the Feds disinflation fight in 1Q24.Insights|Volume 14.3 50Meanwhile,we also envision a high case where inflation remains stuck in the mid-three percent range on a multiyear basis,and the Fed responds by pushing real rates above two percent(which would equate to two more interest rate hikes),as well as a bear case where growth and inflation fall sharply in response to a financial accident and the Fed is forced to ease 325 basis points over the next year-and-a-half.Importantly,our base case remains that bond yields are likely to settle in the four percent range over the longer term.Key to our thinking is that the term premium for longer-term U.S.debt i.e.,the extra spread investors demand for holding Treasurys over cash on average has likely increased on a structural basis.One can see this in Exhibits 82 and 83,respectively,which show that a positive stock-bond correlation,a wider deficit,and a lower savings rate have led to structurally higher Treasury yields over time.Given our view for an average short rate in the low-mid three percent range over the next ten years,that term premium should help set a floor for bond yields around four percent,we believe.If there is good news,it is that:1)stock-bond correlations are already elevated;2)deficits are not likely to widen dramatically under the next administration;and 3)savings rates are unlikely to fall further.As a result of all these factors,we do not see bond yields sustaining above the high-four percent range barring a major reset in inflation expectations that we are not currently forecasting.With that said,we expect volatility to remain elevated in this market,given a lack of available market-making capital and the inherent uncertainty as the markets base case toggles between dovish and hawkish rate scenarios.At the same time,from the per-spective of the Feds full em-ployment mandate(i.e.,its de-sire not to overtighten),our base case for a slower decline in core CPI suggests that real rates will not reach the two-percent level until the beginning of 2025.Exhibit 82:Our Term Premium Model Suggests UST Yields Will Reset Structurally Higher Over Time24e70bp25e68bp26e65bp-1.0-0.50.00.51.01.52.02007200820092010201120122013201420152016201720182019202020212022202320242025202610-Year UST Term PremiumActualModelStock-bond correlationand wide deficit keepterm premiumelevated thru 2025Data as at March 31,2024.Source:Bloomberg,KKR Global Macro&Asset Allocation analysis.Exhibit 83:Driven by Negative Stock-Bond Correlation and Persistently Wide Fiscal Deficits0-4120-433225121-4914-2257416920-4316-22553670Stock-BondCorrelationQE/QTRiskPremiumSavingsRateDeficitTreasuryVolTotalContributions to Term Premium Model2015-2019Mar-24Dec-24eData as at March 31,2024.Source:Bloomberg,KKR Global Macro&Asset Allocation analysis.Insights|Volume 14.3 51Europe Interest RatesForecasts:We continue to expect a terminal rate of 2.5%for the ECB,with three cuts in 2024 and three in 2025.While consensus expectations had called for a much earlier start to the cutting cycle at the time of our January forecasts with around seven cuts in 2024,those expectations are now about in line with our own,calling for a 3.3%rate at end-2024(compared to our 3.25%)and 2.8%at end-2025(compared to our 2.5%).Further out the curve,we retain a view that is quite differentiated,as we look for the 10-year bund yield to step up from 2.6%at the end of 2024 to 3.0%by 2026.By comparison,consensus expectations are calling for a 2.2-year yield at the end of both 2024 and 2025.Commentary:We are at a historic turning point in the rates cycle,with the ECB cutting rates from an all-time high deposit rate of 4.0%.While we acknowledge the thick fog of war surrounding the ultimate path of rates,we do take issue with consensus forecasts.Specifically,the consensus call for a return to a negative term premium from the ECBs deposit rate to the 10-year bund at end-2025(2.6%vs.consensus of 2.2%)embeds an overly pessimistic view of the growth and inflation prospects of the Eurozone.By comparison,our forecasts call for a return to a positive term premium(2.5%vs.consensus of 3.0%by end-2025),with a base rate that is also positive in real terms,given our long-term inflation forecast of two percent.We view the upcoming period as part of an overall normalization of economic growth and inflation after almost two decades of dislocation post the GFC,the EZ debt crisis,COVID,and the Russian invasion of Ukraine.Further out the curve,we retain a view that is quite differentiated,as we look for the 10-year bund yield to step up from 2.6%at the end of 2024 to 3.0%by 2026.Exhibit 84:The Delta Between Treasuries and the Bund Has Rapidly Widened Over the Past Year,With Treasuries Now Yielding 200 Basis Points Over the Bund10012014016018020022020202021202220232024U.S.10-Year Treasury Bond vs.German 10-YearBund SpreadData as at April 30,2024.Source:Bloomberg.Exhibit 85:The ECB Is Expected to Increase the Pace of QT,Even as Other Central Banks Have Paused Balance Sheet Reduction 01,0002,0003,0004,0005,0006,0002015201620172018201920202021202220232024ECB Holdings-Asset Purchase Programes,BillionsPSPPCSPPCBPP3ABSPPPEPPTotalPEPP 1.7tnAPP 3.1tn340bn unwound from peakData as at April 30,2024.Source:Bloomberg.Insights|Volume 14.3 52OilForecasts:We continue to forecast that$80 is the new$60 as a midpoint for WTI oil prices in coming years.If we are correct that shale producers are now focused on generating attractive free cash flow and return on equity,we believe that a long-term price level of around$80 is required to achieve those aspirations.This level is above futures pricing of$71 per barrel in 2026 and$68 per barrel in 2027.That said,we do think prices may center closer to the mid-$70s during parts of calendar year 2025(i.e.,somewhat below average relative to an$80 long-term run-rate).The key driver is our expectation that the global supply/demand balance will at times flirt with a modest surplus next year.The combination of ample Americas supply growth(Guyana,Brazil,Canada,etc.)and decelerating global demand(end of COVID recovery boost for jet fuel)would likely leave little room for OPEC to boost production.That would keep the core OPEC spare capacity elevated(at more than five million barrels per day),capping the oil price upside absent renewed flare-ups in the Middle East and/or Russia.We are often asked if a second Trump term would change this dynamic via increasing U.S.production or easing of sanctions on Russia.The problem,from our perspective,is that the levers Trump has available to pull are quite limited.For starters,easing Russian export sanctions would add only modest new supply to the market,as it is already exporting most of what it has available to China and India.Furthermore,the acreage of U.S.federal lands where Trump could ease drilling restrictions is relatively small,and as such,we think the additional capacity would likely not move the needle on supply in the near term.We think,however,that Trump could achieve friendlier relations with the Gulf states than what exists today,but the real potential for this to ease oil prices looks limited.Importantly,fiscal breakevens in the Gulf remain quite high,so we see limited scope vs.todays levels for OPEC to facilitate any structural easing of pricing.The bottom line,from our perspective,is that we respect the fundamental unpredictability of Donald Trumps policy playbook,as well as the imperative he may feel to push prices lower.That said,we currently do not see any obvious magic bullets to immediately lower oil prices.Commentary:In terms of why we hold a differentiated view in the out years for oil,we tend to focus on what we call the four Cs at KKR.They are as follows:Exhibit 86:Our 2024 Average WTI Price Forecast of$85 per Barrel Accounts for Tighter Fundamentals and a Heightened Geopolitical Risk Premium.Our 2025 Forecast of$75 per Barrel Is in Anticipation of OPEC Partially Unwinding Voluntary Cuts Amidst Moderating Global Demand GrowthGMAA Base Case vs.FuturesHigh/Low ScenariosMemo:Dec-23 Forecasts KKR GMAAWTI FuturesKKR GMAA vs FuturesKKR GMAA KKR GMAA KKR GMAAWTI Futures May24May24May24High CaseLow CaseDec23Dec232021a6868N/A6868N/AN/A2022a9595N/A9595N/AN/A2023a7878N/A8575N/AN/A2024e807911256575732025e75741956080682026e807191007080662027e806812100708064Data as at May 28,2024.Prior as of December 7,2023.Forecasts represent full-year average price expectations.Source:Bloomberg,Haver Analytics,KKR Global Macro&Asset Allocation analysis.Insights|Volume 14.3 53 y Shale Consolidation:The Shale supply elasticity to price has been cut in half in recent years,as producers are maintaining capital discipline and prioritizing shareholder return over volume growth.The wave of consolidation by larger players should also reduce pro-cyclical drilling by smaller privates.The drawdown of drilled but uncompleted wells(DUCs)to decade lows,coupled with aging tier-1 acreage,base declines,and plateauing well productivity,should lead to a slower pace of U.S.supply growth going forward.y Production Costs:The PPI for oil and gas drilling is still roughly 20ove pre-COVID levels.The latest Dallas Fed Survey suggests that the breakeven price for U.S.producers has increased to around$65 per barrel(up from about$50 per barrel on average in 2019-21),which raises the floor for oil prices,in our view.y OPEC Control of Incremental Supply:More modest U.S.Shale production leaves OPEC in the drivers seat of incremental global supply.Importantly,core OPEC is now prioritizing price stability over market share in our view,underscored by repeated production cuts in recent years to balance global markets.In addition,Saudi Arabias fiscal breakeven has increased on a structural basis to$90-100 per barrel given the higher pace of spending on Vision 2030 mega-projects,which incentivizes higher oil prices.y Durable Consumption:We think the durability of demand from emerging markets(especially Asia)and petrochemicals can offset declines in gasoline demand from developed markets and China.Overall,we expect non-OECD demand to keep growing through the end of the decade at least.Bottom line:Our thesis that$80 is the new$60 as a midpoint for WTI oil prices keeps us constructive on energy-related businesses going forward.As it relates to natural gas,we also remain optimistic about the medium-term demand outlook.New LNG export capacity remains the key source of demand growth,with current FIDs(Final Investment Decision)pointing to exports roughly doubling to greater than 25 billion cubic feet per day by the end of the decade(from 13 billion cubic feet per day in 2023).Power demand should also be a source of upside going forward,which follows 15-20 years of largely stagnant domestic electricity consumption trends.Industry analysts expect AI-related data center power demand to drive an incremental 3-5 billion cubic feet per day of new natural gas demand by 2030,which is a notable boost to help offset erosion from continued renewables penetration.Exhibit 87:The Global Supply/Demand Balance Has Tightened Consistently Over the Past Few Months0.20.3-0.10.40.0-0.5-0.60.2-0.20.81Q242Q243Q244Q2420242025Global Supply Surplus/Deficit,Consensus Estimates,Millions of Barrels per Day Dec-24Apr-24Note:Consensus includes Evercore,MS,JPM,GS,UBS,Citi,RBC and Piper Sandler.Data as at April 16,2024.Source:Energy Intelligence,KKR Global Macro&Asset Allocation analysis.We continue to forecast that$80 is the new$60 as a midpoint for WTI oil prices in coming years.If we are correct that shale producers are now focused on generating attractive free cash flow and return on equity,we believe that a long-term price level of around$80 is required to achieve those aspirations.This level is above futures pricing of$71 per barrel in 2026 and$68 per barrel in 2027.Insights|Volume 14.3 54SECTION IVFrequently Asked Questions QUESTION NO.1Where do you see relative val-ue in Credit?While we think that relative value opportunities in Credit have become less outsized versus the beginning of the year,we still see several attractive pockets of opportuni-ty across both Public and Private markets.We note the following:y Within Liquid Credit,we see value across the capital structure,but we continue to prefer high-grade CLO liabilities as a way to pick up extra spread without taking on significant credit risk.To review:Our research suggests that senior CLO liabilities typically offer about 10-15%credit enhancement(making the chance of a default quite low based on historical behavior),but a total return in the eight to nine percent range.So,while recent spread tightening makes us a bit less excited about this part of the market from a tactical perspec-tive,we still think there is plenty of value in terms of ab-solute return.Meanwhile,within High Yield we continue to prefer European HY to U.S.HY this cycle.Key to our thinking is that shorter maturities and discounted prices in many instances mean that there is potentially more upside in this market,especially if the refinance wave continues to come earlier than markets are expecting.y In Direct Lending,by comparison,we are now a little more cautious on a cyclical basis,though we agree with the growing number of CIOs who now view this asset class as a permanent allocation in a diversified Credit portfolio.What are we seeing?Competition has continued to heat up,with average terms for a new unitranche continuing to tighten and the illiquidity premium falling to very low levels versus history.At the same time,average leverage has remained flat.As a re-sult,the premium for many new entrants is now getting quite narrow relative to liquid U.S.public loans in many instances.We are also seeing a greater propensity for corporations to use payment-in-kind(PIK)strategies when cash flow gets tight.The good news,however,is that for existing portfolios most of the pressure on margins from inflation and interest coverage now seems to be behind us.Said differently,we are not looking for a huge surge in losses in the Private Credit space,despite what we see as a more competitive positioning in this area of the market.y Against this backdrop,we increasingly view Asset-Based Finance as a potentially more interesting destination for new capital on a relative value basis versus Direct Lend-ing.Banks,feeling the impact of fleeing deposits,higher accruals,and/or more regulatory scrutiny,are now more willing sellers of assets backed by hard collateral,and we continue to think the core/prime consumer should con-tinue to hold up fairly well this cycle.All told this space is definitely one area where we continue to look for oppor-tunities,particularly in cases where one can partner with existing platforms around underwriting and origination.We continue to think the core/prime consumer should continue to hold up fairly well this cycle.Insights|Volume 14.3 55Exhibit 88:We Continue to Favor Asset-Backed Finance,Senior Direct Lending,and Shorter Duration European High YieldUS Senior BSLsUS Junior BSLsEU Senior BSLsUS Corp HYEU Corp HYUS Corp IGEU Corp IGCLO AAACLO BBBCLO BBUS CMBSUS RMBSUS Senior DLEU Senior DLGlobal MezzABF0%5 %0.0%1.5%3.0%4.5%6.0%7.5%9.0.5%Expected Total ReturnCredit Strategies-Expected Near-Term Total Return vs.VolatilityAbove Line:Higher return per unit ofmarket riskPrivatePublicData as at April 30,2024.Source:KKR GBR analysis.Exhibit 89:BB and BBB CLOs,Senior Direct Lending,and European High Yield Screen Well On a Return Over Leverage BasisUS Senior BSLsUS Junior BSLsUS Corp HYEU Corp HYUS Corp IGEU Corp IGCLO AAACLO BBBCLO BBUS Senior DLEU Senior DLGlobal Mezz0%5 %2.0 x3.0 x4.0 x5.0 x6.0 x7.0 x8.0 x9.0 xExpected Total ReturnLeverageCredit Strategies-Expected Near-Term Total Return vs.LeverageAbove Line:Higher return per turn ofcorporate leverage EU Senior BSLsPrivatePublicData as at April 30,2024.Source:KKR GBR analysis.QUESTION NO.2 Do you still believe in a higher resting heart rate for inflation?For a long time,our view has been that inflation would be both higher(on average)and more volatile than what markets got used to in the 2010-2019 period.No doubt,we have maintained our conviction that inflation would cool heading into year-end in the U.S.,as a lot of the worst cyclical imbalances in supply chains,labor markets,and lagged supercore price increases are now behind us or are being resolved.Our view presently is that,while inflation is certainly cooling(and Mays CPI was definitely a step in the right direction),it will not return fully to the Feds two percent target and certainly will not trend below two percent the way it did leading up to COVID.Moreover,our colleagues Dave McNellis and Ezra Max think that both the level and volatility of inflation will likely be higher than in the past,owing to a structural shortage of skilled workers and housing,along with geopolitical tensions and record fiscal stimulus.Importantly,we think that this thesis still holds despite better cyclical inflation in the U.S.We have also been asking ourselves whether the recent surge in the supply of workers and goods or the transition to an older demographic base could change our thinking Insights|Volume 14.3 56on the longer-term resting heart rate for inflation.For our money,the answer is no.Top of mind for us are the following:The recent surge in U.S.immigration will not resolve the U.S.worker shortage,we believe.The CBO recently revised its population forecasts to reflect an additional approximately 5.5 million immigrants over 2023-2027.Our estimates suggest that this surge could translate into about four million additional workers over the same period(Exhibit 90).No doubt,this improvement in supply should help the Feds goal of bringing better balance to the labor market.However,the actual impact on labor availability in most industries may be smaller than the headline figures would suggest.In fact,accounting for legal status and educational/skills training,we estimate that about 90%of this additional workforce(or roughly 3.5 million workers)will only be eligible for employment in traditional immigrant-friendly roles,which account for only around 25%of open U.S.jobs(or about two million out of 8.1 million total job openings).As a result,immigration will do comparatively little to impact worker availability for the 6.1 million higher-skilled roles that remain open in the U.S.econ
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itif.org Why the US Economy Needs More Consolidation,Not Less TRELYSA LONG|MAY 2024 Larger firms are generally more productive because of scale economies,but some U.S.industries still have too high a share of small firms.Policymakers should encourage,not discourage,greater consolidation in these industries.KEY TAKEAWAYS Large firms are generally more efficient than smaller ones.As an indicator of their greaterproductivity,firms with 500 or more employees have higher receipts per worker than dofirms with fewer than 500 employees in 710 of 938 six-digit NAICS industries.Most of the 228 industries in which smaller firms are more productive are those withlittle ability to gain scale economies(e.g.,furniture repair,food trucks,etc.).Consolidation can boost industry-wide productivity by ensuring that more production isconducted by larger firms with higher productivity.Some industries would benefit from greater scale but still have large shares of smallfirms.They include industries in which government policy has significant influence,suchas banking,construction,doctors offices,farming,and telecommunications.Despite the efficiency gains consolidation can bring,state,local,and federal governmentpolicies can discourage greater consolidation.Policymakers need to modify or,if possible,remove these policies.Overall,its time to balance the agenda of seeking more competition with an equallycompelling and not mutually exclusive goal of seeking more consolidation and higherproductivity.INFORMATION TECHNOLOGY&INNOVATION FOUNDATION|MAY 2024 PAGE 2 CONTENTS Key Takeaways.1 Introduction.2 Economies of Scale and Productivity.4 The Role of Consolidation in Improving Efficiency.5 Examining 12 Industries in 5 Sectors.7 Banks.7 Physicians Offices.10 Construction.13 Farming.17 Telecommunications.20 Policy Recommendations.23 Conclusion.24 Endnotes.25 INTRODUCTION Larger firms are the key to productivity growth,as,in most industries,large firms are more productive than their smaller counterparts partly because of what economists term“economies of scale.”In some industries,there seem to be few scale effects.For example,its hard to imagine why a motor vehicle towing company with 5,000 workers would be more efficient than one with only 5.And many industries already have achieved close to optimal scalealthough,of course,technology is constantly changing,which is one reason why companies may want to merge or divest.Yet,there are certain industries that appear to be able to benefit from scale economies but have not adequately done so,in part because government policy either restricts consolidation or rewards fragmentation.Although most policies are well-intentioned,many have an unintended negative impact on firm growth and consolidation.For example,while building codes protect us from faulty infrastructure,the lack of standardization across localities and states means that firms are discouraged from expanding to new areas,as they would have to learn a new set of codes,which would increase their costs.As a result,firms in many industries face barriers to reaching scale economies and greater efficiency.This is concerning because the United States nonfarm business labor productivity growth rate has been below average since 2005,leading to slower economic growth,stagnant wages,and reduced competitiveness.(2020 was an anomaly based on COVID reductions in employment in low productivity industries.)(See figure 1.)Increased consolidation,leading to greater scale economies,could play a role in reversing this trend.INFORMATION TECHNOLOGY&INNOVATION FOUNDATION|MAY 2024 PAGE 3 Figure 1:Year-over-year growth in U.S.labor productivity1 Yet,consolidation is demonized by neo-Brandeisians and other proponents of the“small is beautiful”antitrust school,making it much harder to justify modifying policies that limit consolidation.Indeed,they have all but shunned the very idea that consolidation can be beneficial and,accordingly,the economic consensus that some firms can benefit from greater scaleall in order to support their claim that a small businesses-dominated economy is the ideal one.As Robert Atkinson and Michael Lind have asserted:Neo-Brandeisians go out of their way to deny the very existence of scale economies because they know that this reality,more than any other,undercuts their claim that breaking up big companies would be good for the economy.Matt Stoller at the American Economic Liberties Project and Open Markets Institute,reflects that view when he tweets,“Im increasingly convinced the biggest con in business history is the notion of economies of scale.”2 Troublingly,the Biden administration has subscribed to the view that small firms are the ideal outcome for most industries.In addition to appointing neo-Brandeisians and their allies to top positions at the Federal Trade Commission(FTC)and Department of Justice(DOJ),the administration stated in its Executive Order on Promoting Competition in the American Economy that“the problem of consolidation now spans these sectors and many others”essentially demonizing greater consolidation without considering the benefits it could bring to at least some industries.3 Yet,as the broad economic consensus shows,many industries do benefit from greater scale and consolidation.4 Thus,policymakers subscribing to the“small is beautiful”doctrine need to reconsider how they view industry consolidation.-2%-1%0%1%2%3%4%5941998200220062010201420182022INFORMATION TECHNOLOGY&INNOVATION FOUNDATION|MAY 2024 PAGE 4 Policymakers thus need to promote greater consolidation in industries that benefit from large scale economies and that have not yet achieved such scale.The best way to do that is to modify or,if possible,remove government regulationsat the local,state,and federal levelsthat disincentivize consolidation or promote fragmentation.This is necessary because doing so would allow efficient firms to stay in the market and grow while encouraging the less efficient ones to either merge or exit the market,boosting an industrys productivity.As a starting point,the Biden administration should follow up on its prior executive order on competition with a new one,such as an“Executive Order on Removing Barriers to Consolidation in the American Economy”that would do at least two things.First,such an order would call for regulatory size neutrality to minimize bias toward firms of a specific size.Second,it would examine industries and policies with the goal of eliminating policies and regulations that keep industries too fragmented.This report shows 1)that larger firms in the economy are generally more efficient due to scale economies,2)how consolidation can help smaller firms maximize economies of scale,and 3)how 12 industries in 5 sectors(banking,doctors offices,construction,farming,and telecommunications)face barriers to consolidation because of government regulations.For each of the five sectors,it suggests what governments can do to enable market-based consolidation.ECONOMIES OF SCALE AND PRODUCTIVITY The vast majority of industries in the economy enjoy scale economies for two reasons.The first is that most industries have not insignificant fixed costs that do not grow as output increases(a fact that is particularly true in the high technology markets that drive innovation).Firms producing a small output volume will face higher average costs because there are fewer units of output to spread out fixed costs.However,as output increases,the average cost of a unit of output goes down because fixed costs remain stable despite costs growing with revenues.For instance,it can be cheaper per unit of output to produce 100,000 items than 100 because specialized machines can be introduced.Second,every additional unit of production usually declines in cost as workers gain experience.These cost declines continue until the firm reaches an efficient scale wherein greater efficiencies are outweighed by rising inefficiencies from size(such as greater coordination costs).5 The efficient scale varies by industry for a number of reasons,so it is difficult for governments to determine the“proper limit.However,larger firms are generally more efficient than smaller ones in the vast majority of industries throughout the economy.In an analysis of large firms with over 500 employees from 938 six-digit NAICS industries,we found that the receipts per worker are higher than the industry average for 710 industries.6 In comparison,the remaining 228 industries have receipts per worker that are less than the industry average,although some of this could be a result of their charging lower prices.7 These 228 industries with lower receipts per worker than the average tend to be industries wherein massive scale is unnecessary to achieve the lowest costs.For example,large nail salons(NAICS:812113)have receipts per worker of$40,854 compared with the industry average of$64,131.8 Nail salons have few fixed costs and little returns from scale,meaning that their average costs will only decline by a minuscule amount after serving a number of customers.In fact,the marginal cost of serving an additional customer may increase if a nail salon becomes too large for idiosyncratic reasons,such as nail technicians getting in the way of one another.In other words,some industries are efficient with small firms partly because they do not need large outputs with many workers in order to maximize scale economies.INFORMATION TECHNOLOGY&INNOVATION FOUNDATION|MAY 2024 PAGE 5 But most industries likely need large outputs to maximize scale economies.In 2017,the receipt of large firms in the average industry was 21.7 percent higher than the average firm in the economy,or$353,619,compared with the average firms$290,617.9 Small firms receipts per worker were 24 percent lower than that of the average firm.10(See figure 2.)Figure 2:Average receipts per employee across 938 six-digit NAICS industries11 THE ROLE OF CONSOLIDATION IN IMPROVING EFFICIENCY Consolidation is key to firms in industries with a high minimum efficient scale as a way to maximize efficiency.The process is as follows:First,consolidation in the form of mergers and acquisitions(M&A)or an increase in market share from one firm to another allows firms to become larger.As a result of their growth in size,these firms acquire a larger share of the market and can benefit from greater economies of scale to lower marginal production costs(or increased economies of scope or the elimination of double marginalization in conglomerate or vertical transactions).12 Finally,as these firms continue to grow,they will eventually reach a point where their unit costs to produce an additional unit of goods can no longer decrease.13 At that point,the firm has maxed out any efficiency gains from increasing scale.In sum,consolidation helps firms maximize their efficiency from scale economies by becoming larger.(See figure 3.)$0$50,000$100,000$150,000$200,000$250,000$300,000$350,000$400,000Small firmsLarge firmsAll firmsINFORMATION TECHNOLOGY&INNOVATION FOUNDATION|MAY 2024 PAGE 6 Figure 3:The process of increasing efficiency through consolidation When consolidation increases a firms efficiency by achieving significant scale,it ceteris paribus increases the industrys efficiency in partial equilibrium.This is why M&A is generally beneficial to firms and industries.When firms merge or acquire another firm,they can leverage scale economies and reduce costs through synergies,such as by combining their core knowledge.14 For example,two stores need separate accounting,advertising,and purchasing services,but if these two stores combine,they can use a single set of services and workers to serve two customers,thereby reducing the overall costs of selling a unit of goods.Moreover,if these two stores have special processes that make their individual processes efficient,they can also share this know-how,further increasing the merged stores efficiency.As a result,a merger creates incentives to reduce costs for firms and,additionally,improve the quality of a firms service or goods.15 There is an added reason to focus on this issue and that is the role of information and communications technology(ICT).Research has shown that adoption of ICT is a key driver of firm productivity.However,as a recent study by the U.S.Census Bureau shows,ICT adoption is positively correlated with firm size.16 For example,10 times more large firms adopted artificial intelligence(AI)than did small firms in 2020.One reason for this is there are often somewhat high fixed costs relative to marginal costs for information technology(IT)and software,and therefore the economics of adoption work better for larger firms.As firm efficiency increases from greater M&A,an industrys productivity will ceteris paribus also rise.This is because M&A redistributes resources between firms so that the more efficient,acquiring firm will be able to reduce costs,charge lower prices,and create competitive pressures in the market that drive out less-efficient firms.Indeed,a study by Joel David finds that M&A increases output by about 14 percent,and 9 of those percent result from improved productivity distribution of firms.17 Demirer and Karaduman corroborated this with a study on power plants,which concludes that“high productivity firms buy underperforming assets from low-productivity firms and make the acquired assets almost as productive as their existing assets after acquisition.”18 In other words,M&A,or consolidation,increases efficiency at the firm level and,ultimately,at the industry level.M&As or capturing others market share allows firms to growGreater market share lowers production costs through economies of scaleUnit costs decrease until firms reach maximum efficiencyINFORMATION TECHNOLOGY&INNOVATION FOUNDATION|MAY 2024 PAGE 7 EXAMINING 12 INDUSTRIES IN 5 SECTORS In the following five sectorsbanking,doctors offices,construction,farming,and telecommunicationslarge firms are more productive because of scale economies,despite the fact that government regulations have kept or are keeping the industries in these sectors fragmented.This is why the average firm size for the 11 industries in these sectors is below 500 employees,or what the Small Business Administration describes as a“small business.”19(See figure 4.)The average farm size,measured using gross cash farm income(GCFI),was$207,756,or what the United States Department of Agriculture(USDA)would consider a small farm.20 Figure 4:Average number of employees in studied sectors21 As a result of the small average firm size,we explore these five sectors as case studies in the following subsections.Each of the five subsections will provide evidence that 1)an industry benefits from scale economies,2)larger firms are more productive,3)government regulations disincentivize consolidation,and as a result,4)how the industry still has a high share of small firms.Banks Larger banks are generally more efficient than small ones because of scale economies.Studies have found that the larger a bank grows,the greater its efficiency gains from scale economies.Indeed,studies by McAllister and McManus,Ferrier and Lovell,and Hunter and Timme have found that banks with over$1 billion in assets could still benefit from scale economies.22 Further corroborating this finding,banks with over$1 trillion in assets were found to still have increasing returns to scale,meaning that they could still grow larger and benefit from scale economies.23 In contrast,small banks with less than$100 million in assets are found to have substantial scale inefficiencies.24 In other words,banks benefit from large scale economies.050100150200250300350400Commercial bankingWired telecommunications carriersWireless telecommunications carriersIndustrial building constructionAll other telecommunicationsPhysicians officesCommercial and institutional buildingNew multifamily housing constructionNew housing for-sale buildersNew single-family housing constructionResidential remodelersINFORMATION TECHNOLOGY&INNOVATION FOUNDATION|MAY 2024 PAGE 8 This helps explain data for 2017 showing that the average large commercial bank with more than 500 employees had a receipt per employee of$302,358,which was 2.6 percent higher than the industry average of$294,594.25 In comparison,small commercial banks with less than 500 employees had a receipt per employee of$263,435,which was 10.6 percent lower than the industry average.26(See figure 5.)Figure 5:Commercial banking receipts per employee27 Despite large banks greater productivity,government regulations have historically kept banks small by preventing consolidation.As early as the 19th century,states and the federal government already had a series of unit banking laws that prevented branch banking in order to protect small,local banks from competition and consolidation.At the state level,some states permitted their banks to operate branches within their headquartered state or within the same cities.28 Yet,other states were much more restrictive and forced their banks to operate out of a single building.29 At the national level,banks could only operate within a single building from 1863 to 1927.30 As a result,these unit banking laws kept banks relatively small since they could only grow to a limited size and reach a limited share of the market,given the restriction on their location.Although the McFadden Act of 1927 promoted the growth of national banks,allowing them to operate branches as long as they complied with state laws,the banking industry was still fragmented because,at best,each banks growth was still limited to the size of its state.Indeed,Robert Atkinson and Michael Lind asserted that these protectionist policies for small banks resulted in an industry with“thousands of tiny,undercapitalized unit banks owned by members of the local gentry”while other nations industry comprised“a financial system dominated by a few national banks.”31 As a result,while other nations branch banking policies eliminated bank runs in the early 20th century,the United States continued to face bank panics exacerbated by unit banking laws until the late 20th century,when the interstate banking laws were passed.32$0$50,000$100,000$150,000$200,000$250,000$300,000$350,000Small firmsLarge firmsAll firmsINFORMATION TECHNOLOGY&INNOVATION FOUNDATION|MAY 2024 PAGE 9 Moreover,the act also raised wages in the financial industry.33 In other words,government regulations have historically undermined growth and consolidation in banking that could have led to scale economies benefits,fewer bank panics,and higher wages.Yet,despite the consequences of historic unit banking laws,policymakers still insist on keeping banks small through regulation that discourages consolidation.In July 2021,the Biden administration signaled in its Executive Order on Promoting Competition that the administration plans on increasing scrutiny of bank mergers,writing,“To ensure Americans have choices among financial institutions and to guard against excessive market power,the Attorney General,is encouraged to adopt a plan for the revitalization of merger oversight under the Bak Merger Act.”34 In response to the order,DOJ has“recently indicated it would take a more granular,wide-ranging approach to bank merger reviews amid increased antitrust scrutiny.”35 Rallying behind these detrimental policies,neo-Brandeisian antitrust critics have warned,“The total number of banks in America has fallen by some 60 percent since 1981,even as the population has grown substantially,”implying that large banks are gaining more monopoly power.36 Truth be told,however,C4 and C8 concentration ratiosthe four or eight firms with the highest market sharefor commercial banks are declining:From 2002 to 2012,the C4 and C8 concentration ratios for commercial banks fell from 29.5 to 25.6 and from 41.0 to 35.8,respectively.37 To be sure,it is one thing for one of the top-four banks in the United States to acquire another bank,which may or may not have competitive implications.But having 500 small and regional banks get bought up by larger banks is unlikely to reduce competition.38 Unfortunately,government regulations continue to impede the process of consolidation that encourages banks to maximize economies of scale.Indeed,these government regulations are partly why the industry still has a large share of small firms despite larger firms greater efficiency.In 2017,only 5.6 percent of commercial banks(281)were large,while the remaining 94.4 percent(4,735)were small.39(See figure 6.)Figure 6:Small and large firms shares of the commercial banking industry40 Small firms 94.4%Large firms5.6%5,016FirmsINFORMATION TECHNOLOGY&INNOVATION FOUNDATION|MAY 2024 PAGE 10 With so many small banks,the United States has more banks per capita than most other nations.As Robert Atkinson and Michael Lind wrote:But because most other nations never had American-style unit banking laws,they have always had significantly fewer banks per capita.In 1998 Japan had just 170 banks,or one bank for every 747,000 people.Canada,widely viewed as having the safest banking system in the world,had one bank for every 1.16 million residents.The United States has one bank for every 58,000 people.And in 1999,the share of deposits and assets of the five largest US banks was just 27 percent,compared to 77 percent in Canada,70 percent in France and 57.8 percent in Switzerland.41 To encourage greater efficiency,the Biden administration should modify its executive order to encourage more bank acquisitions rather than discourage them.In the modified executive order,the administration should encourage the FTC and the DOJ Antitrust Division to review mergers between small and regional banksnot including mergers by the largest four or five largest banks nationallywith a focus on how efficiency gains can potentially outweigh the increases in concentration.Doing so would allow the banking industry in the United States to benefit from increasing returns to scale.As Robert Atkinson and Michael Lind asserted:But even with the number of banks falling by more than half in the last few decades bank economies of scale have still not been exhausted and the United States still suffers from too many banks.As the Federal Reserve has found,even the largest banks face increasing returns to scale The Fed found,Our results suggest that capping banks size would incur opportunity costs in terms of foregone advantages from IRS Other studies have found similar results.42 In other words,when the administration encourages greater bank consolidation,it will also encourage greater bank efficiency because banks will become larger and benefit from increasing returns to scale.Physicians Offices Larger doctors offices are generally more efficient than small ones because of scale economies.To best serve their patients,doctors offices must adopt new technologies and medical treatments.However,the cost of implementing these new methods is often high,meaning doctors offices face high fixed costs to obtain the tools needed to treat patients.As a result,a larger doctors office can serve more patients to spread out its fixed costs and lower its average cost.43 Indeed,case studies of 14 small primary care practices find that only some of these practices could cover the$44,000-per-doctor cost of electronic health record software after 2.5 years,suggesting that small doctors offices do not have the scale to implement even the most basic efficiency-enhancing technologies.44 This is why Baker,Bundorf,and Royalty concluded that multispecialty group practices are more likely than single specialty groups(which tend to be smaller)to benefit from scale economies.45 For example,One Medical,a large national practice group recently purchased by Amazon,has its own in-office laboratories for blood work and related analysis.The data is in accord.In 2017,large physicians offices had a receipt per worker of$204,931 compared with average small firms receipts per employee of$190,182.46 In other words,large INFORMATION TECHNOLOGY&INNOVATION FOUNDATION|MAY 2024 PAGE 11 firms were 4.6 percent more productive than the average while small firms were 3 percent less productive.(See Figure 7.)Figure 7:Receipts per employee in physicians offices(not including mental health specialists)47 Despite the benefits that doctors offices can gain from scale,government regulations at the federal and state level have historically been an impediment to the growth of doctors offices.For example,in 1964,New York adopted the Certificate of Need(CON)law,restricting the construction of new hospitals under the assumption that the restriction of capital expenditures could reduce the high cost of health care.48 As the American Hospital Association lobbied for more states to also adopt similar regulations,the federal government passed a mandate in 1974 to have all states implement a CON program as part of the National Health Planning and Resources Development Act.49 As a result,all states,except Louisiana,had a CON law by 1980.50 This meant that hospitals and any other health care facilities included in these regulations faced the burden of having to apply for,and then the possibility of being denied,whenever they considered expanding their facilities.In other words,these CON laws prevented growth and consolidation by raising the cost of growth,thereby limiting doctors offices efficiency gains from scale.Although the federal government repealed its mandate in 1986 because the law didnt lower health care costs,35 states still had CON laws as of 2020.51 These laws continue to prevent growth and consolidation in the physicians offices industry,reducing their benefits from scale economies.Indeed,Maureen Ohlhausen,former commissioner of the FTC,wrote that“CON laws actively restrict new entry and expansion.They displace free market competition with regulation and tend to help incumbent firms amass or defend dominant market positions.”52 In other words,these regulations protect small incumbent firms that are unwilling to grow and compete fairly$0$50,000$100,000$150,000$200,000$250,000Small firmsLarge firmsAll firmsINFORMATION TECHNOLOGY&INNOVATION FOUNDATION|MAY 2024 PAGE 12 while simultaneously disincentivizing others from consolidating and becoming more efficient from scale economies and embracing more patient-friendly information technology systems.In addition to the CON laws,state governments have continued to impose other regulations that stifle consolidation in the industry.In the last year,states have passed laws that increased the burden for merging parties in the healthcare industry.For example,New York recently passed a law that requires health care entities to give a 30-day notice before closing a deal,while Maine repealed a law that exempted certain health providers mergers from antitrust laws.53 Additionally,consolidation in the industry could also slow in California next year when all M&A deals have to be reviewed and approved by the Office of Health Care Affordability.54 Indeed,the National Academy for State Health Policy has advocated for more of these legislations with its Model Act for State Oversight of Proposed Health Care Mergers,which calls for greater scrutiny of health care mergers through state regulation.55 As such,consolidation in the industry is already slow and will likely continue to be slow in the future,hurting firms ability to achieve scale and greater efficiency.Despite the benefits that doctors offices can gain from scale,government regulations at the federal and state level have historically been an impediment to the growth of doctors offices.Indeed,CON laws and other regulations that stifle consolidation still exist because proponents of the antimonopolist tradition continue to assert that policymakers should protect small firms from competitionwhen they should really be encouraging them to grow and competedespite reduced efficiency.As a result,consolidation in the doctors offices and physician groups industry more generally is demonized even if it can bring efficiency gains.For example,a New York Times article asserts that“the absorption of doctors practices is part of a vast,accelerating consolidation of medical care,leaving patients in the hands of a shrinking number of giant companies or hospital groups.”56 Meanwhile,Senator Elizabeth Warren(D-MA)asserted that she has a fear“that the acquisition of thousands of independent providers by a few massive health care mega-conglomerates could reduce competition on a local or national basis,hurting patients and increasing health care costs.”57 This combination of state regulations and paranoia among policymakers is partly why the industry still has a large share of small firms despite the higher productivity of large firms.In 2017,large firms comprised only 0.6 percent of physicians offices(not including mental health specialists).There were 919 such offices.The remaining 99.4 percent of physicians offices were small(160,367 offices).58(See figure 8.)INFORMATION TECHNOLOGY&INNOVATION FOUNDATION|MAY 2024 PAGE 13 Figure 8:Small and large firms shares of physicians offices(not including mental health specialists)59 To encourage greater efficiency,state governments should take two steps to encourage greater consolidation in the doctors offices industry.First,they should repeal CON laws if their state still has one in existence.This would encourage doctors offices to consolidate and grow larger without higher costs or fear of repercussions from this law that specifically prohibits firm expansion without extensive review.Second,the state governments should conduct a broad review of their state regulations and compile a list of all regulations relevant to physician groups in order to find those that create a barrier to consolidation and firm growth,and then modify those regulations so that they continue to serve their purpose without impeding consolidation.In addition,some regulations that have the sole purpose of impeding consolidation,such as those pertaining to M&A approvals,should be modified to focus on balancing efficiency gains with competitive effects.Construction Larger construction firms are also generally more efficient because of scale economies.Construction projects are often complex,face uncertainty,and require high levels of coordination between multiple actors,such as architects,designers,manufacturers,and other contractors.60 As a result,the most efficient construction firms have to adopt technologies that increase collaboration and coordination in the project value chain.61 For instance,Swissroc,a Swiss construction firm,adopted a single centralized platform for its workflows that resulted in higher-quality buildings,more referrals,and a 300 percent increase in revenue.Yet,adopting these technologies means high fixed costs for firms.62 As a result,larger construction firms are better positioned to manage risk and adopt new technologies to funnel the projects along at greater efficiency because they can spread out the costs among more projects.Accordingly,there are strong incentives for M&A in construction,including their post-merger sales being higher than their combined sales as individual firms.63 Small firms99.4%Large firms0.61,286Firms160,367(99.4%)INFORMATION TECHNOLOGY&INNOVATION FOUNDATION|MAY 2024 PAGE 14 Indeed,the data supports this.In 2017,large construction firms with over 500 employees were 4 to 148 percent more productive than the industry average.64 Small construction firms were 2 to 25 percent less productive than their respective industrys average.65 For instance,the large firms in the commercial and institutional building construction industry were 38 percent more productive than the industry average,with its receipts per employee at$1.03 million compared with the industry average of$744,462.66 Yet,the small firms in this industry were 10 percent less productive than the industry average,with a receipt per employee of$672,831.67(See figure 9.)Figure 9:Construction receipts per employee68 Despite the greater efficiency of larger firms,the construction industry has historically been and continues to be extremely fragmented because of the extensive unstandardized local and state regulations that have been imposed.Indeed,as early as the 1800s,U.S.cities began establishing regulations that would affect how the construction industry would operate.For example,the California Real Estate Inspection Association notes that larger U.S.cities implemented building codes as early as the 1800s,with New Orleans establishing a law in 1865 that required public property inspections.69 By the 1880s,a myriad of local jurisdictions had also implemented their own versions of exit requirements,plumbing regulations,and hoist and elevator regulations.70 As such,the idiosyncratic nature of these early regulations likely discouraged early construction firms from growing into other jurisdictions,disincentivizing growth and consolidation.By the 1980s,these unstandardized regulations affected every aspect of the construction industry.State and local jurisdictions had implemented such an extensive range of regulations that construction firms had to navigate regulations on aesthetics,demolition,environmental protection,explosives,liability,material and equipment acceptance,and wages,among others.71 This meant that construction firms that wished to expand now faced high entry barriers because they had to 1)familiarize themselves with a wide range of regulations that impacted the industry$0.0M$0.5M$1.0M$1.5M$2.0M$2.5MNew housing for-sale buildersNew multifamily housing constructionCommercial and institutional buildingNew single-family housing constructionIndustrial buildingResidential remodelersSmall firmsLarge firmsAll firmsINFORMATION TECHNOLOGY&INNOVATION FOUNDATION|MAY 2024 PAGE 15 and 2)navigate the differences between these regulations from one jurisdiction to another.As such,construction firms faced higher costs when operating in more than one jurisdiction,disincentivizing them from consolidating and growing.Indeed,this is why construction industry expert Barry LePatner wrote in his book that“everyone associated with the process of purchasing land and building on it over the last twenty-five years know that regulation has grown exponentially there is little double that the current system of government regulation is repressive enough to impede U.S.productivity growth.”72 These unstandardized regulations still place burdens on construction firms seeking to expand.For example,at the local level,construction firms have to abide by local building codes,which vary greatly by local jurisdiction.These include permits,approvals,safety and worksite controls,and public sector mandates for lowest price rules,among other regulations.73 As a result of these unstandardized local regulations,construction firms are hesitant to consolidate or groweven only slightly to the next local jurisdictionbecause they face higher risks working in a jurisdiction where they are unfamiliar with the regulations.In fact,even a uniform building code can have different interpretations depending on the area.For example,Richard Mettler of the Home Builder Association of Phoenix asserted that the one local building code governing the greater Pheonix area isnt even uniform because the officials in Pheonix have a different interpretation of the code than do those in Tempe or Mesa.74 Despite the greater efficiency of larger firms,the construction industry has historically been and continues to be extremely fragmented because of the extensive unstandardized local and state regulations that have been imposed.Assuming that a construction firm wants to expand across state lines,unstandardized state regulations become the next barrier they have to overcome.For example,mechanics lien laws a legal tool that enables contractors,subcontractors,and suppliers to recover compensation for unpaid construction work or for materials they have suppliedvary by states.For instance,the mechanics lien law in Alaska asks for construction firms to prove that an owner consented to a firms services;yet,other states do not mention who has the burden of proof in the regulation.75 These variations mean that construction firms will have to familiarize themselves with the lien law for each state they operate in or hire a professional to help.In other words,they will either have to face the opportunity cost of time to understand each new regulation or the cost of hiring a professional.In either case,the cost of operating in multiple states increases the cost for construction firms,disincentivizing them from consolidating or growing.As such,local and state governments should work to standardize the regulations imposed on the construction industry to encourage consolidation.These recommendations are not new.MIT professor Kelly Burnham called for“national acceptance of a standard building code for plumbing”as early as 1959.76 Others have suggested that the standardization of building codes would reduce costs.Yet,despite these calls and evidence that greater consolidation can benefit the industry,regulations are still highly fragmented across local and state jurisdictions.This is partly why a participant at an Information Technology and Innovation Foundation(ITIF)event asserted that the construction industry is“Americas sole remaining mom and pop industry that wastes at least$120 billion each year”due to its inefficiencies.77 INFORMATION TECHNOLOGY&INNOVATION FOUNDATION|MAY 2024 PAGE 16 This is supported by the data.The construction industry has a large share of smaller,less-efficient firms.In 2017,the six construction industries under the 2-digit NAICS construction sector had between 0.1 and 2.2 percent of large firms in their industry,meaning that a vast majority of firms were still small and had not reached scale economies.78 For example,the new single-family housing construction industry had 49,215 firms,but only 34 had more than 500 employees.(See figure 10.)Figure 10:Small firms share of construction industries79 First,to encourage greater efficiency,the federal government could publish a standardized set guidelines on 1)the type of regulations the industry should have and 2)how to set regulations for the construction industry so that it encourages greater consolidation.Although the federal government cannot limit state regulations,it can encourage greater cohesiveness in regulations across states so that construction firms face fewer barriers when consolidating and expanding across state lines.Furthermore,setting guidelines on how to set regulations so that it encourages consolidation can also be an indirect way to prevent future state regulations from impeding firm growth.Second,state governments can also encourage greater consolidation by implementing a standard set of regulations for the industry that effectively preempt local regulations.This will ensure that firms face fewer costs and barriers when expanding across local jurisdictions because they will only have to understand a standardized state regulation rather than multiple varying sets from each local jurisdiction.With fewer barriers,firms will be encouraged to consolidate and grow,increasing their efficiency.100.9.7.5.9.8%0 0%Residential remodelersNew single-family housingNew housing for-sale buildersCommercial and institutional buildingNew multifamily housingIndustrial buildingSmall firmsLarge firmsINFORMATION TECHNOLOGY&INNOVATION FOUNDATION|MAY 2024 PAGE 17 Farming Notwithstanding the sentimental views toward small,family farms,larger farms are generally more efficient than their smaller counterparts partly because of scale economies.According to Purdue University,53 percent of costs(land,machinery,and labor)in agricultural production are fixed.80 As a result,large farms producing more yields benefit from increasing returns to scale as a higher output reduces the average cost of production.In fact,a study of the heartland and Northern Crescent states finds that scale economies are the driving factor for farm efficiency and competitiveness in the economy.81 Simply put,larger farms are generally more efficient.Accordingly,a study by MacDonald,Hoppe,and Newton concludes that a full-time employee at a large farm generates annual sales of$212,766 compared with$36,630 for a small farm producing less output.82 This is compared with the average farms annual sales of$102,145 per full-time employee.83(See figure 11.)Figure 11:Farm receipts per full-time employee84 Despite the greater efficiency of larger farms,government intervention in the form of farm subsidies has historically disincentivized consolidation in the industry.The original intent of these subsidies was to help cash-strapped farmers during the Great Depression.During the height of the Great Depression,President Roosevelt passed the Agricultural Adjustment Act(AAA)as part of the New Deal to curtail the output of crops and livestock in order to stabilize farmers income amid the production of excess crops and low prices.85 Yet,these interventions continued after the Great Depression even though they could no longer be economically justified.According to the Minneapolis Federal Reserve Bank,the AAA was not repealed after the Great Depression but instead became a permanent price adjuster for six basic commodities so that their levels were“relative to the general prices levels in the 1910-1914 period”even during$0$50,000$100,000$150,000$200,000$250,000Small farms(Sales$1M)All farmsINFORMATION TECHNOLOGY&INNOVATION FOUNDATION|MAY 2024 PAGE 18 periods when farm incomes were strong.86 In addition to the AAA,the government continued adding other farming subsidiessuch as supply controlsthat fixed prices for farmers over the next few decades.As a result,farmers no longer had to worry about competing or becoming more efficient in the economy because the government subsidies would essentially guarantee price and revenue to farmers with no strings attached.Indeed,the Private Enterprise Research Center at Texas A&M University concluded that farm subsidies are inefficient because they incentivize farmers to make decisions that will get them the most subsidies rather than“fetch the best price on the open market.”87 In other words,government subsidies disincentivized farms from consolidating,reaching scale economies,and growing more efficient than they were during this period.Today,government subsidy programs continue to disincentivize farms from consolidating and becoming more efficient.Indeed,the U.S.Department of Agriculture spends about$30 billion a year on farm subsidies,which include crop insurance programs,agricultural risk coverages,price-loss coverages,and ad hoc and disaster aid relief,among others.88 Although some support programs are reasonable,such as the conservation program,numerous other programs are just a form of government intervention that impedes the process of competition while disincentivizing growth and efficiency when resources are handed out without any strings attached.For example,the crop insurance program is a farm subsidy program that covers over 100 crops,paying out billions of dollars a year to farmers when their crop yields or revenue is reduced.89 Moreover,most farmers do not have to pay the insurance premium to enroll in this program:The government subsidizes nearly 62 percent of premiums.90 As such,farms have little incentive to consolidate and adopt specialized equipment that will help manage risks and reduce costs because the government removes risks and guarantees revenue with its subsidies.Despite the greater efficiency of larger farms,government intervention in the form of farm subsidies has historically disincentivized consolidation in the industry.The crop insurance program is just one of many government subsidy programs that disincentivize farms from consolidating to increase efficiency.The Price Loss Coverage program and the Agricultural Risk Coverage program are two other programs that also guarantee price and revenue to farmers.91 Both programs make payments to producers when market prices or revenues fall below a certain level.92 Similar to the AAA and other subsidy programs in the 20th century,these two programs disincentivize growth and efficiency because farmers no longer have to compete based on who can offer the lowest price to consumers to gain revenue.93 Instead,they just have to focus on how to obtain the most subsidy from the government.94 As such,instead of finding ways to grow and become more efficient,farms are figuring out how to shift from growing wheat to corn because corn is more likely to fetch higher subsidies in a given year.As a result,government subsidies are one of the reasons the industry still has so many smaller,less-efficient farms.In 2021,the U.S.Department of Agriculture found that 51 percent of all farms had sales less than$10,000 and only 7.4 percent had sales of over$500,000.95(See figure 12.)INFORMATION TECHNOLOGY&INNOVATION FOUNDATION|MAY 2024 PAGE 19 Figure 12:Farming market shares96 To be sure,many of these smaller farms depend on subsidies for income.A USDA technical paper finds that many small and medium-sized farms receive some program benefits from the government,with only one in four able to sell enough to cover their costs.97 The government payments tend to be greater than sales for the smallest farms,and 90 percent of their sales and government payments are derived from government subsidies.98 Indeed,controlling for size,small farms,defined by USDA as those with less than$100,000 in GCFI,received$0.29 per dollar of sales while large farms(more than$1 million in GCFI)only received$0.02 cents.99(See figure 13.)In other words,government subsidies disincentivize growth and consolidation because large farms generally get less than small farms when their size is controlled for.0 0Pp0%Small farms(Sales$500K)INFORMATION TECHNOLOGY&INNOVATION FOUNDATION|MAY 2024 PAGE 20 Figure 13:Government subsidies per dollar of sales100 To encourage greater efficiency,the federal government should not eliminate subsidies for revenue because they ensure a stable food system.Instead,they should tie subsidies to farm efficiency gains or farms efforts to improve their efficiency.In other words,the government should first establish a productivity measure for farms and then establish a new set of policies that only provide subsidies to farms that have experienced productivity gains in the preceding five years(five years because it will likely take time for efforts to increase efficiency to show in productivity measures).Alternatively,the government can also tie subsidies to a farms efforts to increase its efficiency,such as by adopting specialized equipment.Moreover,the government should also establish regulations that prevent farms from manipulating the types of crops produced in order to receive higher subsidies.As a result of these policies,the government will encourage farms to consolidate as they search for ways to increase their efficiency without endangering the stability of the food system.Telecommunications Larger telecommunications firms are also generally more efficient than smaller ones because of scale economies.Telephone and Internet service providers(ISPs)pay extremely high up-front costs,face limited materials and labor forces,and see a return on investment tied directly to the number of customers in a particular area.The provision of telecom and broadband services is also highly complex,technical work that requires considerable investments in infrastructure and development.101 Because a large number of potential customers is needed to recoup even the up-front costs of a project,small telecom providers are generally quite easily priced out of the market,or need heavy,ongoing government subsidies to survive.Large firms have easier access to the massive up-front funds needed,entrenched institutional knowledge that can help them$0.00$0.05$0.10$0.15$0.20$0.25$0.30Small farms(GCFI$100K)Small farms($100K to$249,999)Mid-sized farms($250K to$499,999)Mid-sized farms($500K to$999,999)Large farms(GCFI$1M)INFORMATION TECHNOLOGY&INNOVATION FOUNDATION|MAY 2024 PAGE 21 avoid pricey mistakes,and widespread existing broadband networks and customer bases that are more cost-effectively expanded than built anew.The data is in accord.For wired telecommunications carriers,wireless telecommunications carriers(except satellite),and all other telecommunications industries,large firms range from 3 to 46 percent more productive than their respective industrys average.By contrast,small firms are 31 to 61 percent less productive than their respective industrys average.102 For example,the large firms in the wireless telecommunications carriers industry are 7 percent more productive than the industry average,with receipts per employee of$916,985 compared with the industry average of$854,583.103 This is compared with the small firms receipts per employee of$331,056,or 61 percent less efficient than the industry average.104(See figure 14.)Figure 14:Telecommunications industries receipts per employee Despite the greater efficiency of larger telecom firms,government policies discourage consolidation in the telecommunications industry.This is because some government subsidy programs that enable telecom services in high-cost areas are biased toward smaller providers.For instance,the High Cost Loop support program under the High Cost Fund is biased toward smaller providers.Indeed,historically,the subsidy was based on a formula that only provided support to the telecom companies whose costs were a specified percentage above the national average.As a result,if two companies merge and achieve scale economies,they risk losing this subsidy because their cost to provide service may no longer exceed the national average by the designated percentage.Thus,this means that the telecom companies receiving this subsidy has every incentive to shun growth and consolidation that could result in lower costs and greater efficiency.$0$200,000$400,000$600,000$800,000$1,000,000All othersWireless carriers(except satellite)Wired carriersSmall firmsLarge firmsAll firmsINFORMATION TECHNOLOGY&INNOVATION FOUNDATION|MAY 2024 PAGE 22 Although a vast proportion of telecom companies that once received this subsidy have moved over to the more cost-efficient Alternative Connect America Model(ACAM)of support,some companies are still receiving the High Cost Loop support.However,the continuation of High Cost Loop support as an option for telecom providers is concerning because the subsidy still uses the same formula that caused inefficiencies in the past.According to the Universal Service Administrative Co.,the subsidy is still only available to rural companies whose costs to provide service exceeds 115 percent of the national average cost per line.105 In other words,telecom companies face the risk of losing support if their costs suddenly fell below 115 percent of the national average.As a result,companies still receiving this subsidy have no incentive to consolidate,achieve scale economies,and reduce costs.Indeed,the bias toward small firms in subsidies is partly why the three different telecom industries still have a large share of small firms.In 2017,these industries had 1.3 percent to 3 percent of large firms with more than 500 employees,meaning all three industries still have a vast majority of firms that have yet to maximize scale economies.106 For example,the wired telecommunications industry has only 100 large firms but 3,264 small firms,meaning large firms only make up 3 percent of all firms.107 This means that growth in size of the 3,264 small ones can lead to greater efficiency from scale economies.(See figure 15.)Figure 15:Small firms share of telecommunications industries108 In sum,subsidy programs are undoubtedly necessary to close the digital divide,but the method of subsidy distribution needs to be revamped to encourage greater consolidation in the industry.The best way to do so is to eliminate the High Cost Loop support program and move the remaining telecom companies still receiving this subsidy to the ACAM of support.This is because the provision of subsidy through the ACAM model does not hinge on a firms cost,meaning that 98.7.6.0%0 0%Wireless carriers(except satellite)All othersWired carriersSmall firmsLarge firmsINFORMATION TECHNOLOGY&INNOVATION FOUNDATION|MAY 2024 PAGE 23 two telecom companies looking to merge for efficiency gain can do so without losing subsidies.As such,moving the remaining firms to the ACAM model could only result in efficiency gains as smaller telecom companies choose to consolidate in order to maximize their scale economies.In the case that the telecom companies still receiving the High Cost Loop support resist the move to the ACAM model,an alternative solution would be that the formula for the provision of High Cost Loop support is modified so that it is not based on whether a provider has high costs.Regardless of the solution pursued,the main goal is to ensure that firms seeking to consolidate and become more efficient can do so without losing subsidies.POLICY RECOMMENDATIONS At the broadest level,policymakers should focus on developing policies and programs that encourage small firms to grow,merge based on scale economy benefits,and compete rather than rely solely on government assistance programs for survival.Going beyond that,policymakers should be focused on ensuring that current government policies and programs do not disincentivize greater consolidation in industries characterized by high minimum efficient scale.For instance,the 12 industries in 5 sectors studied all benefit from scale economies,and that is why the large firms in these industries are generally more productive than their smaller counterparts.Yet,these industries still have many small firms,some of which are the result of market conditions,but others are from government policy distortion.Policymakers should encourage an increase in firm size for these and related sectors through greater consolidation from M&A or the loss of market shares from one firm to another.This means policymakers should modify or remove the local,state,or federal government regulations that discourage consolidation in these industries.The Biden administration should draft a new executive order on competition that explicitly looks for instances when government policies keep firms in particular industries too small and unproductive.The goal of the order should be to eliminate regulations that keep these industries fragmented.The administration should also create an interagency body to examine whether an industry benefits from large scale economies and,if so,whether the regulations in that industry are discouraging consolidation.It would also have the task of recommending ways to modify or,if possible,remove existing regulations that discourage consolidation without harming those that the regulations are meant to protect(e.g.,standardizing building codes rather than eliminating them).The Biden administration should draft a new executive order on competition that explicitly looks for instances when government policies keep firms in particular industries too small and unproductive.Finally,FTC and DOJ should not modify their merger guidelines and premerger notification rules.This is because their recent decision to change the merger guidelines,premerger notification rules,and Premerger Notification and Report Form will discourage consolidation for industries with high minimum efficient scale.First,the merger guidelines will discourage consolidation because they no longer acknowledge that mergers can increase efficiencies.This means mergers will face more scrutiny and denials even if their efficiencies balance out anticompetitive effects.109 Second,the modifications to the premerger notification rules and form will increase the burden that firms face when filing merger notifications with the new,extended lists of documents that INFORMATION TECHNOLOGY&INNOVATION FOUNDATION|MAY 2024 PAGE 24 were not previously required.110 These changes will decrease the value firms place on M&A,reducing their incentive to consolidate.As such,the amendments in these two federal regulations are also government distortions that need to be modified in order to promote greater consolidation and efficiency in industries wherein large firms are more efficient,but small firms are still too many.CONCLUSION In a majority of industries in the U.S.economy,larger firms are generally more productive than their smaller counterparts partly because of scale economies.One way firms within these industries can achieve this greater scale and efficiency is through consolidation.This is because consolidation,often through mergers between rivals,increases firms sizes through growth.As such,a growth in average firm size and efficiency can also increase an industrys productivity.To be sure,antitrust policy is important to ensure that scale benefits are not outweighed by anticompetitive incentives to raise prices,reduce output,or diminish innovation.Yet,government regulations at the local,state,and federal levels in industries with large scale economies often unnecessarily discourage consolidation even when the industry still have a large share of small firms.As such,policymakers need to ensure that policiesincluding antitrust,regulation,tax,and subsidiesat all levels of government are size neutral.Given that many regulations still disincentive growth and consolidation,the first step for policymakers is to modify or,if possible,remove these regulations in industries characterized by large scale economies.This is critical because the economy is made up of both large and small firms that need different levels of scale economies to thrive:The U.S.economy needs both dry cleaners and semiconductor fabrication plants,but expecting a semiconductor plant to have only five employees,much like a dry cleaner would,to produce millions of chips would be unreasonableand it goes without saying that having 1,000 employees to dry clean clothes for a local neighborhood would be just as unreasonable.Regulations should not disincentivize consolidation or growth,but rather incentivize firms to grow to as big or as small as they need in order to be efficient,including through M&A.In so doing,size-neutral regulations would help the U.S.economy because all firms would have incentives to grow to an efficient scale.As such,this could be the first step to reversing the United States declining productivity growth since 2005.Also,when firms maximize their efficiencies from scale economies,they are also in a better place when competing in the global market against foreign competitors.If policymakers want a productive,growing economy that can compete globally,they need to remove regulations that demonize consolidation and larger firms.INFORMATION TECHNOLOGY&INNOVATION FOUNDATION|MAY 2024 PAGE 25 Acknowledgments The author would like to thank Robert Atkinson,Joseph Coniglio,Joe Kane,Lilla Kiss,and Jessica Dine for their feedback and assistance on this report.Any errors and omissions are the authors alone.About the Author Trelysa Long is a policy analyst for antitrust policy with ITIFs Schumpeter Project on Competition Policy.She was previously an economic policy intern with the U.S.Chamber of Commerce.She earned her bachelors degree in economics and political science from the University of California,Irvine.About ITIF The Information Technology and Innovation Foundation(ITIF)is an independent 501(c)(3)nonprofit,nonpartisan research and educational institute that has been recognized repeatedly as the worlds leading think tank for science and technology policy.Its mission is to formulate,evaluate,and promote policy solutions that accelerate innovation and boost productivity to spur growth,opportunity,and progress.For more information,visit itif.org/about.ENDNOTES 1.U.S.Bureau of Labor Statistics,Labor Productivity and Cost Measures for Major Sectors(labor productivity change from previous year for nonfarm business sector),accessed November 2,2023,https:/www.bls.gov/productivity/tables/.2.Robert D.Atkinson and Michael Lind,Big is Beautiful(Massachusetts:The MIT Press,2018).3.“Executive Order on Promoting Competition in the American Economy,”The White House,July 9,2021,https:/www.whitehouse.gov/briefing-room/presidential-actions/2021/07/09/executive-order-on-promoting-competition-in-the-american-economy/.4.Maureen Ohlhausen and Taylor Owings,“Evidence of Efficiencies in Consummated Mergers,”U.S.Chamber of Commerce,June 1,2023,https:/ Davut,“The Minimum Efficient Scale:A Note on Terminology,”https:/dergipark.org.tr/tr/download/article-file/36306.6.U.S.Census Bureau,Statistics of U.S.Businesses(U.S.&states,6-digit NAICS),accessed November 9,2023,https:/www.census.gov/data/tables/2017/econ/susb/2017-susb-annual.html.7.Ibid.8.Ibid.9.Ibid.10.Ibid.11.Ibid.12.T.R.Bishnoi and Sofia Devi,“Cost Efficiency and productivity,”in Banking Reforms in India,edited by Philip Molyneux(Bangor:Palgrave Macmillan,2017),121-163,https:/ TECHNOLOGY&INNOVATION FOUNDATION|MAY 2024 PAGE 26 14.Markus Berger-de Leon et al.,“Buy and scale:how incumbents can use M&A to grow new businesses,”McKinsey and Digital,December 21,2022,https:/ Farrell and Carl Shapiro,“Scale Economies and Synergies in Horizontal Merger Analysis”(working paper,University of California,Berkeley Competition Policy Center,October 2000),https:/escholarship.org/uc/item/8v1500b8;https:/www.journals.uchicago.edu/doi/10.1086/704069.16.Nikolas Zolas et al.,“Advanced Technologies Adoption and Use by U.S.Firms:Evidence from the Annual Business Survey”(working paper at the Center for Economic Studies,December 2020),https:/www2.census.gov/ces/wp/2020/CES-WP-20-40.pdf.17.Joel David,“The Aggregate Implications of Mergers and Acquisitions,”The Review of Economic Studies 88,no.4(2012),https:/ Demirer and Omer Karaduman,“Do Mergers and Acquisitions Improve Efficiency:Evidence from Power Plants”October 27,2022,https:/www.ftc.gov/system/files/ftc_gov/pdf/demirerkaraduman.pdf.19.Small Business Administration,“Frequently Asked Questions,”March 2023,https:/advocacy.sba.gov/wp-content/uploads/2023/03/Frequently-Asked-Questions-About-Small-Business-March-2023-508c.pdf.20.United States Department of Agriculture,Agricultural Resource management Survey(ARMS)(gross cash farm income for all farms),accessed January 20,2023,https:/www.census.gov/data/tables/2021/econ/susb/2021-susb-annual.html.21.U.S.Census Bureau,Statistics of U.S.Businesses 2021(U.S.&states,6-digit NAICS),accessed January 22,2024,https:/www.census.gov/data/tables/2021/econ/susb/2021-susb-annual.html.22.Robert DeYoung and Gary Whalen,“Banking Industry Consolidation:Efficiency issues”(working paper,Jerome Levy Economics Institute Working Paper No.110,1998),https:/ Mester,“Scale Economies in banking and Financial Regulatory Reform,”Federal Reserve Bank of Minneapolis,September 1,2010,https:/www.minneapolisfed.org/article/2010/scale-economies-in-banking-and-financial-regulatory-reform.24.Allen Berger,William Hunter,and Stephen Timme,“The efficiency of financial institutions:A review and preview of research past,present,and future,”Journal of Banking and Finance 17,no.2-3(1993),https:/ Bureau,Statistics of U.S.Businesses(U.S.&states,6-digit NAICS),accessed November 9,2023,https:/www.census.gov/data/tables/2017/econ/susb/2017-susb-annual.html.26.Ibid.27.Ibid.28.“McFadden Act of 1927,”Federal Reserve History,November 22,2013,https:/www.federalreservehistory.org/essays/mcfadden-act.29.Ibid.30.Ibid.31.Atkinson and Lind,Big is Beautiful.32.Ibid.33.Ahmet Ali Taskin and First Yaman,“The effect of branching deregulation on finance wage premium”(FAU Discussion Papers in Economics,August 2023),https:/www.econstor.eu/bitstream/10419/280992/1/1876291222.pdf.INFORMATION TECHNOLOGY&INNOVATION FOUNDATION|MAY 2024 PAGE 27 34.White House,Executive Order on Promoting Competition in the American Economy,July 9,2021,https:/www.whitehouse.gov/briefing-room/presidential-actions/2021/07/09/executive-order-on-promoting-competition-in-the-american-economy/.35.“U.S.Bank M&A to Remain Stalled Until Regulatory,Valuation Headwinds Abate,”Fitch Ratings,July 17,2023,https:/ Lynn,“Antitrust:A Missing Key to Prosperity,opportunity,and Democracy,”Desmos,October 2013,https:/ and Lind,Big is Beautiful.38.James Fontanella-Khan,Ortenca Aliaj,and Rob Armstrong,“M&T Bank to buy Peoples United Financial in$7.6bn deal,”Financial Times,February 22,2021,https:/ Bureau,Statistics of U.S.Businesses(U.S.&states,6-digit NAICS),accessed November 9,2023,https:/www.census.gov/data/tables/2017/econ/susb/2017-susb-annual.html.40.Ibid.41.Atkinson and Lind,Big is Beautiful.42.Ibid.43.Laurence Baker,M.Kate Bundorf,and Anne Beeson Royalty,“The Effects of Multispecialty Group Practice on Healthcare Spending and Use”(working paper,NBER,June 2019),https:/www.nber.org/system/files/working_papers/w25915/w25915.pdf.44.Robert Miller et al.,“The Value of Electronic health Records in Solo or Small Group Practices,”Health Affairs 24,no.5(2005),https:/www.healthaffairs.org/doi/10.1377/hlthaff.24.5.1127.45.Baker,Bundorf,and Beeson Royalty,“The Effects of Multispecialty Group Practice on Healthcare Spending and Use.”46.U.S.Census Bureau,Statistics of U.S.Businesses(U.S.&states,6-digit NAICS),accessed November 9,2023,https:/www.census.gov/data/tables/2017/econ/susb/2017-susb-annual.html.47.Ibid.48.Maureen Ohlhausen,“Certificate of Need Laws:A Prescription for Higher Costs,”Antitrust 30,no.1(Fall 2015),https:/www.ftc.gov/system/files/documents/public_statements/896453/1512fall15-ohlhausenc.pdf.49.Jessica Harris,“Certificate of need Laws:A Brief History,”Cardinal Institute for West Virginia Policy,https:/ of Need Laws:A Prescription for Higher Costs”;Adney Rakotoniaina and Johanna Butler,“50-State Scan of State Certificate-of-Need Programs,”National Academy for State Health Policy,May 22,2020,https:/nashp.org/state-tracker/50-state-scan-of-state-certificate-of-need-programs/.51.Ohlhausen,“Certificate of Need Laws:A Prescription for Higher Costs.”52.Ibid.53.Arielle Dreher,“States look to crack down on health care merger,”Axios,June 26,2023,https:/ Tool for States to Address Health Care Consolidation:Improved Oversight of Health Care Provider Mergers,”National Academy for State Health Policy,November 12,2021,https:/nashp.org/a-tool-for-states-to-address-health-care-consolidation-improved-oversight-of-health-care-provider-mergers/.INFORMATION TECHNOLOGY&INNOVATION FOUNDATION|MAY 2024 PAGE 28 56.Reed Abelson,“Corporate Giants Buy Up Primary Care Practices at Rapid Pace,”The New York Times,May 8,2023,https:/ Condon,“Corporate giants ramp up primary care deals,”Hospital CFO Report,May 8,2023,https:/ Bureau,Statistics of U.S.Businesses(U.S.&states,6-digit NAICS),accessed November 9,2023,https:/www.census.gov/data/tables/2017/econ/susb/2017-susb-annual.html.59.Ibid.60.Maria Joo Ribeirinho et al.,“The Next Normal in Construction,”McKinsey&Company,June 2020,https:/ Projects and Infrastructure/Our Insights/The next normal in construction/The-next-normal-in-construction.pdf.61.Ibid.62.Tooey Courtemanche,“Why efficiency in construction is a global issue,”Independent,October 6,2021,https:/www.independent.co.uk/news/business/business-reporter/efficiency-construction-global-issue-b1929129.html.63.Santiago Castagnino et al.,“How to Nail M&A in Engineering and Construction,”BCG,December 19,2019,https:/ Bureau,Statistics of U.S.Businesses(U.S.&states,6-digit NAICS),accessed November 9,2023,https:/www.census.gov/data/tables/2017/econ/susb/2017-susb-annual.html.65.Ibid.66.Ibid.67.Ibid.68.Ibid.69.“The Development of Our Building Codes,”California Real Estate Inspection Association,https:/www.creia.org/the-development-of-our-building-codes.70.Ibid.71.Barry LePatner,Broken Buildings,Busted Budgets:How to Fix Americas Trillion-Dollar Construction(Chicago and London:The University of Chicago Press,2007).72.Ibid.73.Ribeirinho et al.,“The Next Normal in Construction.”74.LePatner,Broken Buildings,Busted Budgets:How to Fix Americas Trillion-Dollar Construction.75.“Chapter 19-50 State Summary Mechanics Lien Law,”Fullerton and Knowles,2019,https:/ Buildings,Busted Budgets:How to Fix Americas Trillion-Dollar Construction.77.“How IT Can Help Fix Americas Ailing Construction Industry”(ITIF,January 2008),https:/itif.org/events/2008/01/24/how-it-can-help-fix-americas-ailing-construction-industry/.78.U.S.Census Bureau,Statistics of U.S.Businesses(U.S.&states,6-digit NAICS),accessed November 9,2023,https:/www.census.gov/data/tables/2017/econ/susb/2017-susb-annual.html.79.Ibid.INFORMATION TECHNOLOGY&INNOVATION FOUNDATION|MAY 2024 PAGE 29 80.“Its Not Just About Costs Per Acre,Even in Tight Times,”Purdue University,April 6,2015,https:/ag.purdue.edu/commercialag/home/resource/2015/04/its-not-just-about-costs-per-acre-even-in-tight-times/.81.Catherine Paul et al.,“Scale Economies and Efficiency in U.S.Agriculture:Are Traditional Farms History?”Journal of Productivity Analysis 22(2004),https:/ MacDonald,Robert Hoppe,and Doris Newton,“Three Decades of Consolidation in U.S.Agriculture”(technical paper,United States Department of Agriculture Economic Research Service,March 2018),https:/www.ers.usda.gov/webdocs/publications/88057/eib-189.pdf.83.Ibid.84.Ibid.85.Edward Lotterman,“Farm Bills and Farmers:the effects of subsidies over time,”Federal Reserve Bank of Minneapolis,December 1,1996,https:/www.minneapolisfed.org/article/1996/farm-bills-and-farmers-the-effects-of-subsidies-over-time.86.Ibid.87.Dennis Jansen,Liqun Liu,and Andrew Rettenmaier,“U.S.Farm Subsidies:A Prime Example of Crony Capitalism,”Private Enterprise Research Center,July 29,2021,https:/perc.tamu.edu/PERC-Blog/PERC-Blog/U-S-Farm-Subsidies-A-Prime-Example-of-Crony-Capita.88.Chris Edwards,“Cutting Federal Farm Subsidies”(Cato Institute,August 2023),https:/www.cato.org/briefing-paper/cutting-federal-farm-subsidies#types-farm-subsidy.89.Anne Schechinger,“One-third of all crop insurance subsidies flow to massive insurance companies and agents,not farmers,”EWG,July 12,2023,https:/www.ewg.org/research/one-third-all-crop-insurance-subsidies-flow-massive-insurance-companies-and-agents-not;Chris Edwards,“Farm Bill 2023:Crop Insurance Subsidies”(Cato Institute,July 2023),https:/www.cato.org/blog/farm-bill-2023-crop-insurance-subsidies.90.Ibid.91.Congressional Budget Office,“USDA Farm Programs”(Washington,D.C.:May 2023),https:/www.cbo.gov/system/files/2023-05/51317-2023-05-usda_0.pdf.92.Ibid.93.Jansen,Liu,and Rettenmaier,“U.S.Farm Subsidies:A Prime Example of Crony Capitalism.”94.Ibid.95.United States Department of Agriculture,Farm and Land in Farms 2021 Summary(Washington,D.C.:February 2022),https:/www.nass.usda.gov/Publications/Todays_Reports/reports/fnlo0222.pdf.96.Ibid.97.“Food and Agricultural Policy:Taking Stock for the New Century”(technical paper,U.S.Department of Agriculture,2001),https:/ntrl.ntis.gov/NTRL/dashboard/searchResults/titleDetail/PB2002105128.xhtml.98.Michael Duffy,“Economies of Size in Production Agriculture,”Journal of Hunger and Environmental 4,no.3-4(2009),https:/www.ncbi.nlm.nih.gov/pmc/articles/PMC3489134/#R1.99.Authors calculations.United States Department of Agriculture,Agricultural Resource Management Survey(ARMS)(government payments and crop sales),accessed January 17,2024,https:/www.ers.usda.gov/data-products/arms-farm-financial-and-crop-production-practices/.100.Ibid.INFORMATION TECHNOLOGY&INNOVATION FOUNDATION|MAY 2024 PAGE 30 101.“Economics of Broadband Networks:An overview,”NTIA,March 2022,https:/broadbandusa.ntia.doc.gov/sites/default/files/2022-03/Economics of Broadband Networks PDF.pdf.102.U.S.Census Bureau,Statistics of U.S.Businesses(U.S.&states,6-digit NAICS),accessed November 9,2023,https:/www.census.gov/data/tables/2017/econ/susb/2017-susb-annual.html.103.Ibid.104.Ibid.105.“High Cost Loop,”Universal Service Administrative Co.,https:/www.usac.org/high-cost/funds/legacy-funds/high-cost-loop/.106.U.S.Census Bureau,Statistics of U.S.Businesses(U.S.&states,6-digit NAICS),accessed November 9,2023,https:/www.census.gov/data/tables/2017/econ/susb/2017-susb-annual.html.107.Ibid.108.Ibid.109.Ted Bolema,“Decoding the 2023 FTC and DOJ Merger Guidelines:Insights into Shifting Antitrust Enforcement”(Mercatus Center,February 2024),https:/www.mercatus.org/research/policy-briefs/decoding-2023-ftc-and-doj-merger-guidelines-insights-shifting-antitrust.110.Harry Robins et al.,“New HSR Form Will Transform the U.S.Merger Review Process,”Morgan Lewis,June 30,2023,https:/
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WORLD ECONOMIC OUTLOOK2024OCTINTERNATIONAL MONETARY FUNDPolicy Pivot,Rising ThreatsWORLD ECONOMIC OUTLOOK2024OCTPolicy Pivot,Rising ThreatsINTERNATIONAL MONETARY FUND2024 International Monetary FundCover and Design:IMF CSF Creative Solutions DivisionComposition:Absolute Service,Inc.Cataloging-in-Publication DataIMF LibraryNames:International Monetary Fund.Title:World economic outlook(International Monetary Fund)Other titles:WEO|Occasional paper(International Monetary Fund)|World economic and financial surveys.Description:Washington,DC:International Monetary Fund,1980-|Semiannual|Some issues also have thematic titles.|Began with issue for May 1980.|1981-1984:Occasional paper/International Monetary Fund,0251-6365|1986-:World economic and financial surveys,0256-6877.Identifiers:ISSN 0256-6877(print)|ISSN 1564-5215(online)Subjects:LCSH:Economic developmentPeriodicals.|International economic relationsPeriodicals.|Debts,ExternalPeriodicals.|Balance of paymentsPeriodicals.|International financePeriodicals.|Economic forecastingPeriodicals.Classification:LCC HC10.W79HC10.80 ISBN 979-8-40028-115-0(English Paper)979-8-40028-317-8(English ePub)979-8-40028-313-0(English Web PDF)Disclaimer:The World Economic Outlook(WEO)is a survey by the IMF staff pub-lished twice a year,in the spring and fall.The WEO is prepared by the IMF staff and has benefited from comments and suggestions by Executive Directors following their discussion of the report on October 8,2024.The views expressed in this publication are those of the IMF staff and do not necessarily represent the views of the IMFs Executive Directors or their national authorities.Recommended citation:International Monetary Fund.2024.World Economic Outlook:Policy Pivot,Rising Threats.Washington,DC.October.Publication orders may be placed online,by fax,or through the mail:International Monetary Fund,Publication ServicesP.O.Box 92780,Washington,DC 20090,USATel.:(202)623-7430 Fax:(202)623-7201E-mail:publicationsIMF.orgbookstore.IMF.orgelibrary.IMF.orgErrataNovember 4,2024This web version of the WEO has been updated to reflect the following changes to the version published online on October 22,2024:-On page 8,1st column,last paragraph(Fiscal policy assumptions):“6.1 percent”was corrected to“6.0 percent”and“134 percent”was corrected to“131.7 percent.”-On page 9,1st column,first paragraph(Fiscal policy assumptions):“47.4 percent”was corrected to“45.8 percent”and“54.8 percent”was corrected to“53.2 percent.”International Monetary Fund|October 2024iiiAssumptions and Conventions viiFurther Information ixData xPreface xiForeword xiiExecutive Summary xivChapter 1.Global Prospects and Policies 1Uncertainty Seeping through as Policies Shift 1The Outlook:Stable yet UnderwhelmingBrace for Uncertain Times 6Risks to the Outlook:Tilted to the Downside 15Policy Priorities:From Restoring Price Stability to Rebuilding Buffers 18Box 1.1.The Global Automotive Industry and the Shift to Electric Vehicles 22Box 1.2.Risk Assessment Surrounding the World Economic Outlooks Baseline Projections 24Commodity Special Feature:Market Developments and the Inflationary Effects of Metal Supply Shocks 28References 39Chapter 2.The Great Tightening:Insights from the Recent Inflation Episode 41Introduction 41What Happened?Dissecting Inflation Dynamics 43The Monetary Policy Reaction 48Lessons for Monetary Policy:A Model-Based Analysis 51Summary and Policy Implications 55Box 2.1.The Role of Central Bank Balance Sheet Policies 58Box 2.2.The Role of Price-Suppressing Policies 60References 62Chapter 3.Understanding the Social Acceptability of Structural Reforms 65Introduction 65Social Acceptability of Reforms:A Primer 68The Challenge of Implementing Structural Reforms:Key Facts 68Attitudes toward Reforms:Evidence from Surveys 71Tools and Strategies for Sustainably Advancing Reform Agendas:Lessons from 11 Country Cases 76Conclusions and Policy Implications 78Box 3.1.Policies to Facilitate the Integration of Ukrainian Refugees into the European Labor Market:Early Evidence 80References 81CONTENTSWORLD ECONOMIC OUTLOOK:POLICy PIvOT,RIsINg ThREaTsivInternational Monetary Fund|October 2024Statistical Appendix 85Assumptions 85Whats New 85Data and Conventions 86Country Notes 87Classification of Economies 89General Features and Composition of Groups in the World Economic Outlook Classification 89Table A.Classification by World Economic Outlook Groups and Their Shares in Aggregate GDP,Exports of Goods and Services,and Population,2023 91Table B.Advanced Economies by Subgroup 92Table C.European Union 92Table D.Emerging Market and Developing Economies by Region and Main Source of Export Earnings 93Table E.Emerging Market and Developing Economies by Region,Net External Position,Heavily Indebted Poor Countries,and Per Capita Income Classification 94Table F.Economies with Exceptional Reporting Periods 96Table G.Key Data Documentation 97Box A1.Economic Policy Assumptions underlying the Projections for Selected Economies 107Box A2.Revised World Economic Outlook Purchasing-Power-Parity Weights 111List of Tables 114Output(Tables A1A4)115Inflation(Tables A5A7)122Financial Policies(Table A8)127Foreign Trade(Table A9)128Current Account Transactions(Tables A10A12)130Balance of Payments and External Financing(Table A13)137Flow of Funds(Table A14)141Medium-Term Baseline Scenario(Table A15)144World Economic Outlook Selected Topics 145IMF Executive Board Discussion of the Outlook,October 2024 155TablesTable 1.1.Overview of the World Economic Outlook Projections 10Table 1.2.Overview of the World Economic Outlook Projections at Market Exchange Rate Weights 12Annex Table 1.1.1.European Economies:Real GDP,Consumer Prices,Current Account Balance,and Unemployment 33Annex Table 1.1.2.Asian and Pacific Economies:Real GDP,Consumer Prices,Current Account Balance,and Unemployment 34Annex Table 1.1.3.Western Hemisphere Economies:Real GDP,Consumer Prices,Current Account Balance,and Unemployment 35Annex Table 1.1.4.Middle East and Central Asia Economies:Real GDP,Consumer Prices,Current Account Balance,and Unemployment 36Annex Table 1.1.5.Sub-Saharan African Economies:Real GDP,Consumer Prices,Current Account Balance,and Unemployment 37Annex Table 1.1.6.Summary of World Real per Capita Output 38Table 3.1.Hypotheses to Boost Policy Support 73Table 3.2.Historical Employment Protection Legislation Reform Episodes 76CONTENTsvInternational Monetary Fund|October 2024CONTENTsTable A2.1.Changes in World GDP Shares from Purchasing-Power-Parity Revisions 112Table A2.2.Revisions to Real GDP Growth of World Economic Outlook Aggregates 113Online TablesStatistical AppendixTable B1.Advanced Economies:Unemployment,Employment,and Real GDP per CapitaTable B2.Emerging Market and Developing Economies:Real GDPTable B3.Advanced Economies:Hourly Earnings,Productivity,and Unit Labor Costs in ManufacturingTable B4.Emerging Market and Developing Economies:Consumer PricesTable B5.Summary of Fiscal and Financial IndicatorsTable B6.Advanced Economies:General and Central Government Net Lending/Borrowing and General Government Net Lending/Borrowing Excluding Social Security SchemesTable B7.Advanced Economies:General Government Structural BalancesTable B8.Emerging Market and Developing Economies:General Government Net Lending/Borrowing and Overall Fiscal BalanceTable B9.Emerging Market and Developing Economies:General Government Net Lending/BorrowingTable B10.Selected Advanced Economies:Exchange RatesTable B11.Emerging Market and Developing Economies:Broad Money AggregatesTable B12.Advanced Economies:Export Volumes,Import Volumes,and Terms of Trade in Goods and ServicesTable B13.Emerging Market and Developing Economies by Region:Total Trade in GoodsTable B14.Emerging Market and Developing Economies by Source of Export Earnings:Total Trade in GoodsTable B15.Summary of Current Account TransactionsTable B16.Emerging Market and Developing Economies:Summary of External Debt and Debt ServiceTable B17.Emerging Market and Developing Economies by Region:External Debt by MaturityTable B18.Emerging Market and Developing Economies by Analytical Criteria:External Debt by MaturityTable B19.Emerging Market and Developing Economies:Ratio of External Debt to GDPTable B20.Emerging Market and Developing Economies:Debt-Service RatiosTable B21.Emerging Market and Developing Economies,Medium-Term Baseline Scenario:Selected Economic IndicatorsFiguresFigure 1.1.Growth and Inflation Revisions 2Figure 1.2.Inflation Surprises and Importance of Food in CPI 2Figure 1.3.Recent Inflation Developments 3Figure 1.4.Labor Market Developments 3Figure 1.5.Monetary Transmission 4Figure 1.6.Fiscal Policy Stance 5Figure 1.7.Pressure on Emerging Markets 6Figure 1.8.Globalization and Trade Fragmentation 6Figure 1.9.Trade Fragmentation:Cold War and Now 7Figure 1.10.Continued Rotation to Services 7Figure 1.11.Global Assumptions 8Figure 1.12.Growth Outlook 9Figure 1.13.Inflation Outlook 14Figure 1.14.Medium-Term Outlook 14WORLD ECONOMIC OUTLOOK:POLICy PIvOT,RIsINg ThREaTsviInternational Monetary Fund|October 2024Figure 1.15.Current Account and International Investment Positions 15Figure 1.16.Inflation Surprises and Changes in Inflation Expectations 16Figure 1.17.Social Unrest Levels 17Figure 1.18.Required Fiscal Consolidation 19Figure 1.19.Government Spending Composition and Future Income Growth 20Figure 1.1.1.Productivity and Global Value Chains in the Automotive Sector 22Figure 1.1.2.Global Share of Electric Vehicles 23Figure 1.2.1.Forecast Uncertainty around Global Growth and Inflation Projections 24Figure 1.2.2.Impact of Scenario A on GDP and Headline Inflation 26Figure 1.2.3.Impact of Scenario B on GDP and Headline Inflation 27Figure 1.SF.1.Commodity Market Developments 28Figure 1.SF.2.Consumption of Copper and Oil 30Figure 1.SF.3.Intermediate Input Expenditure Share of Metals and Oil in Gross Output in the United States 30Figure 1.SF.4.Countries Input-Output Network Exposure to Metals and Oils 31Figure 1.SF.5.Impulse Responses 32Figure 2.1.Cross-Country Inflation Dynamics 42Figure 2.2.Movements in Sectoral Price Dispersion 43Figure 2.3.Sectoral Characteristics and Inflation Dynamics 44Figure 2.4.Energy Price Pass-Through into CPI Inflation 45Figure 2.5.Sectoral Inflation and Price Flexibility 45Figure 2.6.Evolution of Phillips Curves 46Figure 2.7.Inflation Drivers in the United States,Other Advanced Economies,and Emerging Markets 47Figure 2.8.Monetary Policy Tightening 48Figure 2.9.Comparison of Inflation Episodes 49Figure 2.10.Monetary Policy Transmission to CPI during Tightening Episodes 50Figure 2.11.Phillips Curve under Different Constraints 51Figure 2.12.Impacts of Supply Constraints and Commodity Sector Shocks 52Figure 2.13.Counterfactual Monetary Policy 54Figure 2.14.Role of Coordinated Monetary Policy 54Figure 2.15.Alternative Policy Rules 55Figure 2.1.1.Central Bank Balance Sheets 58Figure 2.1.2.Estimated Impact of Monetary Policy and LSAP Tightening 59Figure 2.2.1.Discretionary Inflation Stabilization Policies during the Pandemic 60Figure 2.2.2.Euro Area Actual and Counterfactual Energy Price Levels 60Figure 3.1.Structural Reforms:Uneven Convergence amid Public Resistance 66Figure 3.2.Reform Episodes by Implementation Outcome 69Figure 3.3.Strategies for Building Consensus for Reform 70Figure 3.4.Relative Importance of Reform Strategies for Predicting Reform Implementation 71Figure 3.5.Drivers of Reform Support 72Figure 3.6.Effect of Information Strategies on Reform Support 74Figure 3.7.Reasons for Nonsupport and the Role of Compensatory and Complementary Measures 75International Monetary Fund|October 2024viiA number of assumptions have been adopted for the projections presented in the World Economic Outlook(WEO).It has been assumed that real effective exchange rates remained constant at their average levels during July 30,2024August 27,2024,except for those for the currencies participating in the European exchange rate mech-anism II,which are assumed to have remained constant in nominal terms relative to the euro;that established policies of national authorities will be maintained(for specific assumptions about fiscal and monetary policies for selected economies,see Box A1 in the Statistical Appendix);that the average price of oil will be$81.29 a barrel in 2024 and$72.84 a barrel in 2025;that the three-month government bond yield for the United States will average 5.4 percent in 2024 and 3.9 percent in 2025,that for the euro area will average 3.5 percent in 2024 and 2.8 per-cent in 2025,and that for Japan will average 0.1 percent in 2024 and 0.5 percent in 2025;and that the 10-year government bond yield for the United States will average 4.1 percent in 2024 and 3.5 percent in 2025,that for the euro area will average 2.4 percent in 2024 and 2.5 percent in 2025,and that for Japan will average 1.0 percent in 2024 and 1.3 percent in 2025.These are,of course,working hypotheses rather than forecasts,and the uncertain-ties surrounding them add to the margin of error that would,in any event,be involved in the projections.The estimates and projections are based on statistical information available through October 7,2024,but may not reflect the latest published data in all cases.For the date of the last data update for each economy,please refer to the notes provided in the online WEO database.The following conventions are used throughout the WEO:.to indicate that data are not available or not applicable;between years or months(for example,202324 or JanuaryJune)to indicate the years or months covered,including the beginning and ending years or months;and /between years or months(for example,2023/24)to indicate a fiscal or financial year.“Billion”means a thousand million;“trillion”means a thousand billion.“Basis points”refers to hundredths of 1 percentage point(for example,25 basis points are equivalent to of 1 percentage point).Data refer to calendar years,except in the case of a few countries that use fiscal years.Please refer to Table F in the Statistical Appendix,which lists the economies with exceptional reporting periods for national accounts and government finance data.For some countries,the figures for 2023 and earlier are based on estimates rather than actual outturns.Please refer to Table G in the Statistical Appendix,which lists the latest actual outturns for the indicators in the national accounts,prices,government finance,and balance of payments for each country.What is new in this publication:Following the recent release of the 2021 survey by the World Bank Groups International Comparison Pro-gram for new purchasing-power-parity benchmarks,the WEOs estimates of purchasing-power-parity weights and GDP valued at purchasing power parity have been updated.For more details,see Box A2 in the Statistical Appendix.For Bangladesh,fiscal year estimates of real GDP and purchasing-power-parity GDP are now used in country group aggregates.For Zimbabwe,the authorities have recently redenominated their national accounts statistics following the introduction on April 5,2024 of a new national currency,the Zimbabwe gold,replacing the Zimbabwe dollar.The use of the Zimbabwe dollar ceased on April 30,2024.ASSUMPTIONS AND CONVENTIONSWORLD ECONOMIC OUTLOOK:POLICy PIvOT,RIsINg ThREaTsviiiInternational Monetary Fund|October 2024In the tables and figures,the following conventions apply:Tables and figures in this report that list their source as“IMF staff calculations”or“IMF staff estimates”draw on data from the WEO database.When countries are not listed alphabetically,they are ordered on the basis of economic size.Minor discrepancies between sums of constituent figures and totals shown reflect rounding.Composite data are provided for various groups of countries organized according to economic characteristics or region.Unless noted otherwise,country group composites represent calculations based on 90 percent or more of the weighted group data.The boundaries,colors,denominations,and any other information shown on maps do not imply,on the part of the IMF,any judgment on the legal status of any territory or any endorsement or acceptance of such boundaries.As used in this report,the terms“country”and“economy”do not in all cases refer to a territorial entity that is a state as understood by international law and practice.As used here,the term also covers some territorial entities that are not states but for which statistical data are maintained on a separate and independent basis.International Monetary Fund|October 2024ixCorrections and RevisionsThe data and analysis appearing in the World Economic Outlook(WEO)are compiled by the IMF staff at the time of publication.Every effort is made to ensure their timeliness,accuracy,and completeness.When errors are discovered,corrections and revisions are incorporated into the digital editions available from the IMF website and on the IMF eLibrary(see below).All substantive changes are listed in the online table of contents.Print and Digital EditionsPrintPrint copies of this WEO can be ordered from the IMF bookstore at imfbk.st/551243.DigitalMultiple digital editions of the WEO,including ePub,enhanced PDF,and HTML,are available on the IMF eLibrary at eLibrary.IMF.org/WEO.Download a free PDF of the report and data sets for each of the charts therein from the IMF website at www.IMF.org/publications/weo or scan the QR code below to access the WEO web page directly:Copyright and ReuseInformation on the terms and conditions for reusing the contents of this publication are at www.imf.org/external/terms.htm.FURTHER INFORMATIONInternational Monetary Fund|October 2024xThis version of the World Economic Outlook(WEO)is available in full through the IMF eLibrary(www.elibrary.imf.org)and the IMF website(www.imf.org).Accompanying the publication on the IMF website is a larger com-pilation of data from the WEO database than is included in the report itself,including files containing the series most frequently requested by readers.These files may be downloaded for use in a variety of software packages.The data appearing in the WEO are compiled by the IMF staff at the time of the WEO exercises.The histor-ical data and projections are based on the information gathered by the IMF country desk officers in the context of their missions to IMF member countries and through their ongoing analysis of the evolving situation in each country.Historical data are updated on a continual basis as more information becomes available,and structural breaks in data are often adjusted to produce smooth series with the use of splicing and other techniques.IMF staff estimates continue to serve as proxies for historical series when complete information is unavailable.As a result,WEO data can differ from those in other sources with official data,including the IMFs International Financial Statistics.The WEO data and metadata provided are“as is”and“as available,”and every effort is made to ensure their timeliness,accuracy,and completeness,but these cannot be guaranteed.When errors are discovered,there is a concerted effort to correct them as appropriate and feasible.Corrections and revisions made after publication are incorporated into the electronic editions available from the IMF eLibrary(www.elibrary.imf.org)and on the IMF website(www.imf.org).All substantive changes are listed in detail in the online tables of contents.For details on the terms and conditions for usage of the WEO database,please refer to the IMF Copyright and Usage website(www.imf.org/external/terms.htm).Inquiries about the content of the WEO and the WEO database should be sent by mail or online forum(telephone inquiries cannot be accepted):World Economic Studies DivisionResearch DepartmentInternational Monetary Fund700 19th Street,NWWashington,DC 20431,USAOnline Forum:www.imf.org/weoforumDATAInternational Monetary Fund|October 2024xiThe analysis and projections contained in the World Economic Outlook are integral elements of the IMFs surveillance of economic developments and policies in its member countries,of developments in international financial markets,and of the global economic system.The survey of prospects and policies is the product of a comprehensive interdepartmental review of world economic developments,which draws primarily on information the IMF staff gathers through its consultations with member countries.These consultations are carried out in particular by the IMFs area departmentsnamely,the African Department,Asia and Pacific Department,European Department,Middle East and Central Asia Department,and Western Hemisphere Departmenttogether with the Strategy,Policy,and Review Department;the Monetary and Capital Markets Department;and the Fiscal Affairs Department.The analysis in this report was coordinated in the Research Department under the general direction of Pierre-Olivier Gourinchas,Economic Counsellor and Director of Research.The project was directed by Petya Koeva Brooks,Deputy Director,Research Department,and Jean Marc Natal,Deputy Division Chief,Research Department.The primary contributors to this report are Silvia Albrizio,Jorge Alvarez,Hippolyte Balima,Emine Boz,Damien Capelle,Pragyan Deb,Bertrand Gruss,Eric Huang,Thomas Kroen,Toh Kuan,Colombe Ladreit,Alberto Musso,Diaa Noureldin,Galip Kemal Ozhan,Nicholas Sander,Yu Shi,Sebastian Wende,and Sihwan Yang.Other contributors include Maryam Abdou,Hites Ahir,Gavin Asdorian,Tohid Atashbar,Jared Bebee,Christian Bogmans,Benjamin Carton,Francesca Caselli,Yaniv Cohen,Allan Dizioli,Wenchuan Dong,Angela Espiritu,Rebecca Eyassu,Pedro de Barros Gagliardi,Ganchimeg Ganpurev,Ziyan Han,Alexander Kia Howe,Chris Jackson,Gene Kindberg-Hanlon,Eduard Laurito,Jungjin Lee,Weili Lin,Barry Liu,Jorge Miranda-Pinto,Joseph Moussa,Dirk Muir,Cynthia Nyanchama Nyakeri,Emory Oakes,Pablo Vega Olivares,Maximiliano Jerez Osses,Andrea Pescatori,Clarita Phillips,Naissa Pierre,Rafael Portillo,Shrihari Ramachandra,Nirav Shedge,Arash Sheikholeslam,Martin Stuermer,Nicholas Tong,Roc Walker,Xueliang Wang,Isaac Warren,Evgenia Weaver,Philippe Wingender,Yarou Xu,Max Yarmolinsky,Jiaqi Zhao,Canran Zheng,Dian Zhi,and Liangliang Zhu.Gemma Rose Diaz from the Communications Department led the editorial team for the report,with production and editorial support from Michael Harrup and additional assistance from Lucy Scott Morales,James Unwin,Grauel Group,and Absolute Service,Inc.Elad Meshulam,Mishri Someshwar,and John Michael Burkhardt from IMF Creative Lab assisted with the design of the surveys used in Chapter 3.Gabriele Ciminelli,Davide Furceri,Daisuke Fukuzawa,Ergys Islamaj,and Duong Trung Le provided updated estimates of selected IMF Structural Reform Database series used in Chapter 3.Tatiana Goriainova and Sylvie Poirot from CSF Library provided data licensing services and support.The analysis has benefited from comments and suggestions by staff members from other IMF departments,as well as by Executive Directors following their discussion of the report on October 8,2024.However,estimates,projections,and policy considerations are those of the IMF staff and should not be attributed to Executive Directors or to their national authorities.PREFACEInternational Monetary Fund|October 2024xiiThe Global Battle against Inflation Is Almost Won;A Policy Triple Pivot Is Now NeededThe global battle against inflation has largely been won,even though price pressures persist in some countries.After peaking at 9.4 percent year over year in the third quarter of 2022,headline inflation rates are now projected to reach 3.5 percent by the end of 2025,below the average level of 3.6 percent between 2000 and 2019.Moreover,despite a sharp and synchronized tight-ening of monetary policy around the world,the global economy has remained unusually resilient throughout the disinflationary process,avoiding a global recession.Growth is projected to hold steady at 3.2 percent in 2024 and 2025,even though a few countries,espe-cially low-income developing countries,have seen sizable downside growth revisions,often as a result of increased conflicts.While the global decline in inflation is a major mile-stone,downside risks are rising and now dominate the outlook:an escalation in regional conflicts,monetary policy remaining tight for too long,a possible resur-gence of financial market volatility with adverse effects on sovereign debt markets(see October 2024 Global Financial Stability Report),a deeper growth slowdown in China,and the continued ratcheting up of protec-tionist policies.What accounts for the decline in inflation?As Chapter 2 of this report argues,the surge and sub-sequent decline in global inflation reflects a unique combination of shocks:broad supply disruptions coupled with strong demand pressures in the wake of the pandemic,followed by sharp spikes in commodity prices caused by the war in Ukraine.These shocks led to an upward shift and a steepening of the relationship between activity and inflation,the Phillips curve.As supply disruptions eased and monetary policy tight-ening started to constrain demand,normalization in labor markets allowed inflation to decline rapidly with-out a major slowdown in activity.Clearly,much of the disinflation can be attributed to the unwinding of the shocks themselves,followed by improvements in labor supply,often linked to immigration.But monetary policy played an important role too by helping to keep inflation expectations anchored,avoiding deleterious wage-price spirals and a repeat of the disastrous infla-tion experience of the 1970s.The return of inflation to near central bank targets paves the way for a much-needed policy triple pivot.The firston monetary policyhas started.Since June,major central banks in advanced economies have started to cut their policy rates,moving their policy stance toward neutral.This will support activity at a time when many advanced economies labor markets are showing signs of weakness,with rising unemploy-ment rates.It will also help ward off the downside risks.The change in global monetary conditions is easing the pressure on emerging market economies,with their currencies strengthening against the US dollar and financial conditions improving.This will help reduce imported inflation pressures,allowing these countries to pursue more easily their own disinflation path.However,vigilance remains key.Inflation in services remains too elevated,almost twice as high as before the pandemic.Some emerging market economies are facing a resurgence of inflationary pressures,some-times because of elevated food prices.Furthermore,we have now entered a world dominated by supply disruptionsfrom climate,health,and geopolitics.It is always harder for monetary policy to maintain price stability when faced with such shocks,which simultaneously increase prices and reduce output.Finally,while inflation expectations have remained well anchored this time around,it may be harder next time,as workers and firms will be more vigilant in protect-ing their standards of living and profits going forward.The second pivot is on fiscal policy.Fiscal space is also a cornerstone of financial stability.After years of loose fiscal policy,it is now time to stabilize debt dynamics and rebuild much-needed fiscal buffers.While the decline in policy rates provides some fiscal relief by lowering funding costs,this will not be FOREWORDFOREWORDxiiiInternational Monetary Fund|October 2024sufficient,especially as long-term real interest rates are much above prepandemic levels.In many coun-tries,primary balances,the difference between fiscal revenues and public expenditures net of debt service,need to improve.For some countries,like the United States and China,debt dynamics are not stabilized under current fiscal plans(see October 2024 Fiscal Monitor).In many others,while early fiscal plans showed promise after the pandemic and cost-of-living crises,there are increasing signs of slippage.The path is narrow:unduly delaying adjustment increases the risk of disorderly market-imposed adjustments,while an excessively sharp turn toward fiscal consolidation would be self-defeating and hurt economic activity.Success requires staying the course by implementing gradual and credible multiyear adjustments without delay,where consolidation is necessary.The more credible and disciplined the fiscal adjustment,the more monetary policy will be able to play a supporting role.But the willingness and ability to deliver disciplined and credible adjustments have been lacking.The third pivotand the hardestis on structural reforms.Much more needs to be done to improve growth prospects and lift productivity,as this is the only way we can address the many challenges we face:rebuilding fiscal buffers,aging and declining populations in many parts of the world,young and growing populations in Africa in search of opportunity,tackling the climate transition,increasing resilience,and improving the lives of the most vulnerable,within and across countries.Unfortunately,medium-term global growth remains lackluster,at 3.1 percent.While much of this reflects Chinas weaker outlook,medi-um-term prospects in other regions,such as Latin America and the European Union,have also deterio-rated.The recently published Draghi report offers a clear-eyed assessment of the diminished prospects in the regionand the associated challenges.Faced with increased external competition and struc-tural weaknesses in manufacturing and productivity,many countries are implementing industrial and trade policy measures to protect their workers and industries.While these measures can sometimes boost investment and activity in the short runespecially when they rely on debt-financed subsidiesthey often lead to retaliation,are unlikely to deliver sustained improve-ments in standards of living at home or abroad,and should be firmly resisted when they do not carefully address well-identified market failures or national secu-rity concerns.Instead,economic growth must come from ambitious domestic reforms that boost technol-ogy and innovation,improve competition and resource allocation,further economic integration,and stimulate productive private investment.Yet while structural reforms are as urgent as ever,they often face significant social resistance.Chapter 3 of this report explores the factors that shape the social acceptability of reforms,one of the prerequisites for their eventual success.A clear message emerges from the chapter:better communication can only go so far.Instead,building trust between the government and its peoplea two-way process throughout the policy designand the inclusion of proper compensatory measures to mitigate distributional effects are essential features.This is an important lesson that should also resonate when thinking about ways to further improve international cooperation and bolster our multilateral efforts to address common challenges as we celebrate the 80th anniversary of the Bretton Woods institutions.Pierre-Olivier Gourinchas Economic CounsellorInternational Monetary Fund|October 2024xivGlobal growth is expected to remain stable yet underwhelming.At 3.2 percent in 2024 and 2025,the growth projection is virtually unchanged from those in both the July 2024 World Economic Outlook Update and the April 2024 World Economic Outlook.However,notable revisions have taken place beneath the surface,with upgrades to the forecast for the United States offsetting downgrades to those for other advanced economiesin particular,the largest European countries.Likewise,in emerging market and developing economies,disruptions to production and shipping of commoditiesespecially oilconflicts,civil unrest,and extreme weather events have led to downward revisions to the outlook for the Middle East and Central Asia and that for sub-Saharan Africa.These have been compensated for by upgrades to the forecast for emerging Asia,where surging demand for semiconductors and electronics,driven by significant investments in artificial intelligence,has bolstered growth.The latest forecast for global growth five years from nowat 3.1 percentremains mediocre compared with the prepandemic average.Persistent structural headwindssuch as population aging and weak productivityare holding back potential growth in many economies.Cyclical imbalances have eased since the beginning of the year,leading to a better alignment of economic activity with potential output in major economies.This adjustment is bringing inflation rates across coun-tries closer together and on balance has contributed to lower global inflation.Global headline inflation is expected to fall from an annual average of 6.7 percent in 2023 to 5.8 percent in 2024 and 4.3 percent in 2025,with advanced economies returning to their inflation targets sooner than emerging market and developing economies.As global disinflation continues to progress,broadly in line with the baseline,bumps on the road to price stability are still possible.Goods prices have stabilized,but services price inflation remains elevated in many regions,pointing to the importance of understanding sectoral dynamics and of calibrating monetary policy accordingly,as discussed in Chapter 2.Risks to the global outlook are tilted to the down-side amid elevated policy uncertainty.Sudden erup-tions in financial market volatilityas experienced in early Augustcould tighten financial conditions and weigh on investment and growth,especially in developing economies in which large near-term exter-nal financing needs may trigger capital outflows and debt distress.Further disruptions to the disinflation process,potentially triggered by new spikes in com-modity prices amid persistent geopolitical tensions,could prevent central banks from easing monetary policy,which would pose significant challenges to fiscal policy and financial stability.Deeper-or longer-than-expected contraction in Chinas property sector,especially if it leads to financial instability,could weaken consumer sentiment and generate neg-ative global spillovers given Chinas large footprint in global trade.An intensification of protectionist pol-icies would exacerbate trade tensions,reduce market efficiency,and further disrupt supply chains.Rising social tensions could prompt social unrest,hurting consumer and investor confidence and potentially delaying the passage and implementation of necessary structural reforms.As cyclical imbalances in the global economy wane,near-term policy priorities should be carefully calibrated to ensure a smooth landing.In many countries,shifting gears on fiscal policy is urgently needed to ensure that public debt is on a sustain-able path and to rebuild fiscal buffers;the pace of adjustment should be tailored to country-specific circumstances.Structural reforms are necessary to lift medium-term growth prospects,but support for the most vulnerable should be maintained.Chapter 3 discusses strategies to enhance the social acceptability of these reformsa crucial prerequisite for successful implementation.Multilateral cooperation is needed more than ever to accelerate the green transition and to support debt-restructuring efforts.Mitigating the risks of geoeconomic fragmentation and strengthen-ing rules-based multilateral frameworks are essential to ensure that all economies can reap the benefits of future growth.EXECUTIVE SUMMARYInternational Monetary Fund|October 20241Uncertainty Seeping through as Policies ShiftThe past four years have put the resilience of the global economy to the test.A once-in-a-century pan-demic,eruption of geopolitical conflicts,and extreme weather events have disrupted supply chains,caused energy and food crises,and prompted governments to take unprecedented actions to protect lives and livelihoods.The global economy has demonstrated resilience overall,but this masks uneven performance across regions and lingering fragilities.The negative supply shocks to the global econ-omy since 2020 have had lasting effects on output and inflation,with varied impacts across individual countries and country groups.The sharpest contrasts are between advanced and developing economies.Whereas the former have caught up with activity and inflation projected before the pandemic,the latter are showing more permanent scars(see the October 2023 World Economic Outlook),with large output short-falls and persistent inflation(Figure 1.1).They also remain more vulnerable to the types of commodity price surges that followed Russias invasion of Ukraine(Figure 1.2;October 2023 and April 2024 World Economic Outlook).Since the beginning of the year,signs have emerged that cyclical imbalances are being gradually resorbed,with economic activity in major economies better aligned with their potential.These developments may have helped bring inflation rates across countries closer together,but the momentum in global disinfla-tion appears to have slowed in the first half of the year(July 2024 World Economic Outlook Update).Goods prices have stabilized,and some are declining,but services price inflation remains high in many coun-tries,partly reflecting rapid wage increases,as pay is still catching up with the inflation surge of 202122.This has forced some central banks to delay their pol-icy-easing plans(Chapter 2),putting public finances under more pressure,especially in countries where debt-servicing costs are already high and refinancing needs significant.Now,as before,the global outlook will be shaped largely by fiscal and monetary choices,their interna-tional spillovers,the intensity of geoeconomic frag-mentation forces,and the ability of governments to implement long-overdue structural reforms.With infla-tion approaching central bank targets and governments striving to manage debt dynamics,the policy mix is expected to shift from monetary to fiscal tightening as monetary policy rates are brought down,closer to their natural levels.How fast such rotations occur in individual countries will have consequences for capital flows and exchange rates.The level of uncertainty surrounding the outlook is high.Newly elected governments(about half of the world population has gone or will go to the polls in 2024)could introduce significant shifts in trade and fiscal policy(Box 1.2).Moreover,the return of finan-cial market volatility over the summer has stirred old fears about hidden vulnerabilities.This has heightened anxiety over the appropriate monetary policy stanceespecially in countries where inflation is persistent and signs of slowdown are emerging.Further intensification of geopolitical rifts could weigh on trade,investment,and the free flow of ideas.This could affect long-term growth,threaten the resilience of supply chains,and cre-ate difficult trade-offs for central banks.On the upside,governments could succeed in building the necessary consensus around overdue and difficult-to-pass struc-tural reforms(Chapter 3),which would boost growth and enhance fiscal sustainability and financial stability.Steady Disinflation,yet Bumps in the Road Still PossibleIn many advanced economies,disinflation has come at a relatively low cost to employment,thanks partly to offsetting supply developments.These included a faster-than-expected decline in energy prices and a surprising rebound in labor supply,bolstered by substantial immigration flows that helped cool labor markets(April 2024 World Economic Outlook).Moreover,temporary sectoral bottlenecks during CHAPTERCHAPTERGLOBAL PROSPECTS AND POLICIES1WORLD ECONOMIC OUTLOOK:POLICY PIVOT,RISING THREATS2International Monetary Fund|October 2024and after the pandemic led to a steepening of the Phillips curve and implied a small sacrifice ratio(the slack required to decrease inflation).As explained in Chapter 2,a temporarily steeper Philips curve helps explain both the rapid surge in inflation and theso farrelatively painless disinflation(Figure 1.3,panel 1).Since the beginning of 2024,signs that cyclical imbalances are being gradually resorbed have helped bring inflation rates across countries closer together(Figure 1.3,panel 2).Disinflation has continued broadly as expected but did show signs of slowing in the first half of the year,suggesting potential bumps on the road to price stability(July 2024 World Economic Outlook Update).The persistence in core inflation has been driven primarily by services price inflation.At 4.2 percent,core services price inflation is about 50 percent higher than before the pandemic in major advanced and emerging market economies(excluding the US).This contrasts with core goods price inflation,which has declined all the way to zero(Figure 1.3,panel 3).Recent increases in shipping rates,especially for routes to and from China,have put upward pres-sure on goods prices.However,this source of upward pressure has been mitigated so far by declining prices for exports from China(Figure 1.3,panel 4).Stubbornness in services price inflation partly reflects higher nominal wage growth relative to prepandemic trends.Even as labor market pressure has started to ease(Figure 1.4,panel 2),wage negotiators have continued to aim for sizable raises to counter the cost-of-living squeeze felt after the 202122 inflation surge(Figure 1.4,panel 1).That nominal wage growth continues to run higher after the inflation surge is consistent with past inflationary episodeswhen real wages catch up to their equilibrium level determined by labor productivityand does not necessarily risk a wage-price spiral(see Chapter 2 of the October 2022 World Economic Outlook).With output gaps expected to close,and assuming no disruptions to labor supply in advanced economies,wage growth is expected to moderate.Whether recent increases translate into further persistence in core infla-tion will depend on(1)the impact of recent real wage increases on unit labor costs,which itself depends on labor productivity,and(2)the willingness of firms to absorb increased unit labor costs in their profit margins.These two factors seem to be working differently in the largest two advanced economies but should still allow disinflation to continue.In the United States,wage growth has reflected productivity gains lately,keeping unit labor costs contained.In the euro area,recent wage increases have exceeded productivity,raising unit labor costs(Figure 1.4,panel 3).However,European firms should be able to absorb those costs,given large increases in profit shares in recent years(Figure 1.4,panel 4).AEsEMMIEsLIDCsFigure 1.1.Growth and Inflation Revisions(Percentage points,relative to January 2020 WEO Update)520051015Infation rateCumulative GDP growthSource:IMF staff calculations.Note:X-axis reports latest estimates for cumulative GDP growth from 2020 to 2024 in deviation from January 2020 WEO Update forecast.Y-axis reports latest estimates for inflation rate in 2024 in deviation from January 2020 WEO Update forecast.AEs=advanced economies;EMMIEs=emerging market and middle-income economies;LIDCs=low-income developing countries;WEO=World Economic Outlook.40302010020301040AEsEMMIEsLIDCsFigure 1.2.Inflation Surprises and Importance of Food in CPI(Percent)20100020406080Average annual CPI infation,202024(deviation from Jan.2020 WEO Update)020406080Food and non-alcoholic beverages weight in CPISource:IMF staff calculations.Note:The solid line denotes linear regression.AEs=advanced economies;CPI=consumer price index;EMMIEs=emerging market and middle-income economies;LIDCs=low-income developing countries;WEO=World Economic Outlook.CHAPTER 1 GLOBAL PROSPECTS AND POLICIES3International Monetary Fund|October 2024Core goodsCore services,excluding USUS core servicesCompositeLos Angeles to ShanghaiRotterdam to New YorkRotterdam to ShanghaiShanghai to New YorkShanghai to RotterdamChina export prices(right scale)Figure 1.3.Recent Infation Developments1.Sacrifice Ratio for Inflation(Change in output gap fora change in inflation)0.03.00.51.01.52.02.51990:Q494:Q12000:Q102:Q208:Q309:Q322:Q424:Q12.Headline Inflation Distribution(Percent,year over year)2019:Q124:Q220:Q121:Q122:Q123:Q110505 10 15 20 25 303.Sticky Inflation Driven by Services(Percent,three month over three month,annualized)21002468201519 averagesJan.19Jan.20Jan.21Jan.22Jan.23Jan.24Aug.24Jan.20184.Rising Shipping Costs(US$per 40 ft.container;index,2010=100,right scale)020,0005,00010,00015,0001001801201401601517192123242013Sources:Haver Analytics;Organisation for Economic Co-operation and Development;and IMF staff calculations.Note:In panel 1,sample includes 37 advanced economies.Panel 2 shows the density distribution of headline inflation developments across 32 advanced economies and 13 emerging market and developing economies.The vertical line indicates the 2019:Q1 median.In panel 3,the two aggregates are the purchasing-power-parity-weighted averages.Sample includes 11 advanced economies and 9 emerging market and developing economies that account for approximately 55 percent of 2021 world output at purchasing-power-parity weights.EA union wageUS ECIPosted wage(major AEs)2019:Q4PeakLatestJapanUnited KingdomEuro areaUnited StatesLabor shareProfit shareOther input shareFigure 1.4.Labor Market Developments1.Wage Growth(Percent,year over year)06123452019:Q120:Q121:Q122:Q123:Q124:Q22.Vacancy to Unemployment(Ratio)0.02.50.51.01.52.0JPNUSAGBRDEUEACANAUSKORFRA3.Unit Labor Costs(Percent,year over year)203010010202017:Q118:Q119:Q120:Q121:Q122:Q123:Q124:Q24.Inflation and Profit Shares(Percent,annualized)US2022201019202021202324:Q1Euro area2022201019202021202324:Q11012345678Sources:Eurostat;Haver Analytics;US Bureau of Economic Analysis;and IMF staff calculations.Note:In panel 4,US decomposition uses data on factor shares from the nonfinancial corporate sector only.Euro area decomposition is based on whole-economy data.Data labels in the figure use International Organization for Standardization(ISO)country codes.AEs=advanced economies;EA=euro area;ECI=Employment Cost Index.WORLD ECONOMIC OUTLOOK:POLICY PIVOT,RISING THREATS4International Monetary Fund|October 2024Policy Mix:Tight Monetary,Loose Fiscal PoliciesEconomic developments over the past four years have had a lot to do with how individual countries have deployed fiscal and monetary policies since the pandemic.Following an initial period of easing,monetary policy has tightened significantly,with central banks in many emerging markets starting earlier than major central banks in advanced economies(Chapter 2).Most central banks stopped increasing nominal policy rates in the first half of 2023.But real rates continued to rise as inflation expectations started to decline(Figure 1.5,panel 1),tightening the monetary policy stance further.Real policy rates are currently above estimates of the natural rates and thus are acting to cool down economic activity and bring inflation back to target.Higher policy rates have led to higher mortgage and bank lending rates,a sign that the first leg of monetary transmission has worked as expected.The pass-through to market rates has been gradual but seems to have fin-ished.The increase in borrowing costs has in turn held back private credit growth and investment,moderating aggregate demand(Figure 1.5,panels 2 and 3).The contrast with fiscal policy is striking.Despite a strong rebound in activity in 2022 and generalized inflationary pressures,fiscal policy has remained looser.Some slippage with respect to consolidation plans is evident(see the October 2024 Fiscal Monitor),except in low-income developing countries,where limited fiscal space has constrained their ability to tackle energy and food crises(Figure 1.6,panel 1).From 2022 to 2024,monetary policy tightened significantly in most coun-tries,but fiscal policy lagged and even eased in many instances(Figure 1.6,panel 2),complicating the task of central banks in their effort to rein in inflation and delaying the necessary rebuilding of fiscal buffers.Tight monetary policy combined with relatively loose fiscal policy,particularly relevant in the United States,may be one of the key factors that has led to dollar appreciation in 2024.This is expected to change.With public-debt-servic-ing costs on an upward trend in emerging market and developing economies and a recent jump in the United States(Figure 1.6,panel 3),the baseline assumes a rotation of the policy mix.Necessary fiscal consoli-dation in many economies is expected to slow down growth and calls for looser monetary policy,which should in turn help governments trim deficits more easily(see“Policy Priorities:From Restoring Price Stability to Rebuilding Buffers”).United StatesEuro areaChinaOther AEsOther EMDEsPolicy rateCash deposit rateMortgage rateEuro area:Change in credit to residentsUS:Change in credit from all commercial banksFigure 1.5.Monetary Transmission1.Real Policy Rate Paths in Major Economies(Percent)6642024Jan.2020Jan.21Jan.22Jan.23Jan.24Jan.25Jan.26Dec.262.Median Bank Lending and Deposit Rates across Advanced Economies(Percent)012345678Jan.2019Jan.20Jan.21Jan.22Jan.23Jan.24Jul.243.Real Credit Growth(Percent change,month over month)0.80.40.00.40.81.21.6Jun.2021Jun.22Jun.23Jun.24ProjectionsSources:Bank for International Settlements;Consensus Economics;European Central Bank;Federal Reserve Board;Haver Analytics;and IMF staff calculations.Note:In panel 1,the gray area denotes discretionary tightening periods(nominal rate hikes,excluding China),and the blue area denotes nondiscretionary tightening periods(nominal rate pauses,excluding China).Sample includes 16 AEs and 65 EMDEs.“Other”aggregates are medians.Real rates are calculated by subtracting 12-month-ahead inflation expectations,computed based on Consensus Forecast surveys of professional forecasters,from nominal policy rates.The 12-month-ahead inflation expectations are constructed as the weighted sum of forecasts for the current and subsequent calendar years(see Buono and Formai 2018).Projections for United States and euro area real rates are based on market-implied policy rates and inflation swaps for expected inflation.Panel 2 includes Australia,Canada,Japan,New Zealand,the United Kingdom,and the United States.In panel 3,credit growth is deflated by GDP deflator.AEs=advanced economies;EMDEs=emerging market and developing economies.CHAPTER 1 GLOBAL PROSPECTS AND POLICIES5International Monetary Fund|October 2024Returning Financial Market VolatilityIn the first week of August,global financial mar-kets experienced significant turbulence,interrupt-ing a steady and rapid ascent of equity markets.Weaker-than-expected jobs data raised concerns about a potential recession in the United States,leading to a stock market correction.This,combined with the Bank of Japans decision to hike interest rates,resulted in a rapid unwinding of Japanese-yen-funded carry trades,which amplified the equity market correction(see Box 1.3 of the October 2024 Global Financial Stability Report and Box 1.4 of the April 2023 Global Financial Stability Report).Markets have rapidly stabilized.The Chicago Board Options Exchange Volatility(VIX)Index,after having surged to its highest point since 2020,has returned to its historical average.However,vulnerabilities that contrib-uted to the recent increase in market volatility persist.These include the disconnect between economic uncer-tainty and market volatility(see Chapter 1 of the October 2024 Global Financial Stability Report)and overstretched equity valuations,particularly in the technology sector.Revised market expectations regarding US mone-tary policy have aligned the outlook for rate cuts there more closely with those for other advanced economies,halting the appreciation of the US dollar against the currencies of major advanced economies.However,depreciation pressures remain high in emerging market and developing economies(Figure 1.7,panel 1).Many of these economies,which began hiking interest rates earlier,have also started easing earlier,leading to a nar-rowing of differentials between their policy rates and that of the United States.For some emerging market and developing econ-omies faced with large short-term external financing needsoften a significant share of their buffer of net international reservessovereign borrowing spreads have increased since April,posing an additional challenge(Figure 1.7,panel 2).Although few of these economies are in debt distressdefined as having spreads greater than 1,000 basis pointsheavy reliance on short-term external financing reveals vulnerabilities to sudden currency swings.Rising Geopolitical Tensions but Limited Impact on Global Trade So FarDespite ongoing geopolitical tensions,global trade volume as a share of world GDP has not deterio-rated.However,signs of geoeconomic fragmentation Projected consolidationActual consolidationAEs excluding USEMMIEsLIDCsUSCHNUSAINDRUSJPNDEUBRAIDNFRAGBRITAMEXKORCANAUSZAF1.Fiscal Slippage(Percentage points;2024 minus 2022 primary balance)Source:IMF staff calculations.Note:In panel 1,the projected and actual consolidations are from January 2022 WEO Update and October 2024 WEO,respectively;the panel uses the primary balance to broaden the country coverage.In panel 2,the primary balance refers to the general government structural primary balance in percent of potential GDP,and G20 economies are presented,except for Argentina,Saudi Arabia,and Trkiye,owing to lack of data availability.In panel 3,the projections are based on the October 2024 WEO.Data labels in the figure use International Organization for Standardization(ISO)country codes.AEs=advanced economies;EMMIEs=emerging market and middle-income economies;LIDCs=low-income developing countries;WEO=World Economic Outlook.Figure 1.6.Fiscal Policy Stance2.Monetary-Fiscal Policy Mix(Percentage points)3.General Government Interest Payments(Percent of general government revenues)332101241604812020481216Change in structural primary balance,202224Latest real policy ratesWorldAEsexcludingeuro areaEuroareaEMMIEsChinaLIDCs20081012141618202224262942 02468101214WORLD ECONOMIC OUTLOOK:POLICY PIVOT,RISING THREATS6International Monetary Fund|October 2024have started to emerge,with increasingly more trade occurring within geopolitical blocs rather than between them(Figure 1.8).Specifically,when the averages for the periods 2017 to 2022 and 2022 to the first quarter of 2024 are compared,goods trade growth is observed to have declined by approximately 2 percentage points more between geopolitically distant blocs than within blocs.A more fragmented global trade landscape could emerge if geopolitical tensions continue to develop in a way similar to that during the Cold War(Figure 1.9).Although fragmentation,if it goes hand in hand with an increase in intrabloc trade,may not necessarily imply rapid deglobalization(Gopinath and others 2024),it could reduce the resilience of global supply chains,increase funding costs,disrupt cross-border capital flows(see Chapter 3 of the April 2023 Global Financial Stability Report)and lower market efficiency,slow the transfer of knowledge between advanced and emerging market and developing economies(hamper-ing income convergence),increase costs and risks for businesses,and induce a larger economic cost for the green transition(Box 1.1).The Outlook:Stable yet UnderwhelmingBrace for Uncertain TimesThere has been little change in the global growth outlook since the April 2024 World Economic Outlook.Following the postpandemic rebound,the global projection for GDP growth has been hovering at about 3 percent,both in the short and the medium term.Weak growth extends beyond the disinflation period,suggesting that potential growth has been durably affected(see Chapter 3 of the April 2024 World Eco-nomic Outlook).Jan.2Apr.16Apr.16 to dateCumulativeTURARGBOLSLVEGYCMRGHAKENMOZTUNBLRGEOFigure 1.7.Pressure on Emerging Markets1.Exchange Rate Depreciation versus US Dollar(Percent appreciation from January to September 20,2024)8020706050403020100102.Short-Term External Financing Needs and Sovereign Spreads(Basis points)5004,50005001,0001,5002,0002,5003,0003,5004,000Sources:Haver Analytics;and IMF staff calculations.Note:In panel 1,percentage appreciation is computed as the difference in log exchange rates.In panel 2,fitted regression line is y=19.5 4.47x,with a slope t-statistic equal to 2.51.The regression is weighted by purchasing-power-parity GDP.The sample excludes EMDE oil exporters.Data labels in the figure use International Organization for Standardization(ISO)country codes.EMDE=emerging market and developing economy.MYSZAFPOLIDNROUDZACHNPHLINDHUNPERCHLCOLBRAMEXTUREGYNGAETHSovereign spreadsShort-term external fnancing needs,2025(percent of net international reserves)050100150200250300350400Goods tradeTotal tradeFigure 1.8.Globalization and Trade Fragmentation1.Global Trade Development and Outlook(Percent of GDP)2070304050602.Changes in Goods Trade Growth(Percentage points;difference in trade growth before and after war)625432101Sources:Gopinath and others 2024;and IMF staff calculations.Note:In panel 1,“trade”is defined as the sum of exports and imports.Global tradeand GDP for percentage calculation are in current US dollars.Dashed portions ofgraph lines indicate October 2024 World Economic Outlook forecasts.In panel 2,change is calculated as the average trade growth during 2022:Q224:Q1 minus theaverage trade growth during 2017:Q122:Q1 within and between blocs.For thecurrent period,bloc definition is based on a hypothetical Western bloc centered onthe US and Europe and a hypothetical Eastern bloc centered on China and Russia.Bilateral quarterly growth rates are computed as the differences in log bilateraltrade,which are then aggregated using bilateral nominal trade as weights.19808590952000051015202529Globalfnancialcrisis Between blocsWithin blocsCHAPTER 1 GLOBAL PROSPECTS AND POLICIES7International Monetary Fund|October 2024The picture is far from monolithic,however,and important sectoral and regional shifts underpin the stable global outlook that has emerged since the April 2024 World Economic Outlook.Relative to prepandemic trends,goods prices remain elevated compared with those for services,a lingering effect of the pandemic and its aftermath,which saw strong demand for goods alongside supply constraints(Figure 1.10,panel 1).Consequently,behind stable growth figures,a global shift from goods to ser-vices consumption is underway.This rebalancing is tending to boost activity in the services sector in advanced and emerging markets but is dampening manufacturing.Manufacturing production is also increasingly shifting toward emerging market econ-omiesin particular,China and Indiaas advanced economies lose competitiveness(Figure 1.10,panel 2).Global AssumptionsBefore regional developments are discussed,it is important to review the key assumptions about com-modity prices and fiscal and monetary policy on which the baseline projection is predicated.With acknowledgment of exceptional policy uncer-tainty associated with newly elected governments in 2024(in 64 countries representing about half of the global population),the baseline projection is flanked with two alternative scenarios,which lay out the main implications for growth and inflation of shifts in trade and fiscal policy.The scenarios are meant to be Since Russias invasion of Ukraine(February 2022)Cold War(initial year:1947)Figure 1.9.Trade Fragmentation:Cold War and Now(Percentage points)1.51.01.00.50.00.5Trade semi-elasticity for fowsbetween blocs04812162024283236Number of quarters since the start of the episode1.50.51.00.50.0Trade semi-elasticity for fows withnonaligned countries04812162024283236Number of quarters since the start of the episode1.Trade between Blocs2.Trade with Nonaligned Countries Sources:Gopinath and others 2024;and IMF staff calculations.Note:The figure plots the change in global trade between blocs(panel 1)and with nonaligned countries(panel 2)during the Cold War(blue line,with t0=1947)and since Russias invasion of Ukraine(red line,with t0=2021:Q4).For each episode,the figure plots the semi-elasticity of trade for flows,estimated using a difference-in-differences approach,with bilateral goods trade values on the y-axis,with importer-exporter,importer-year,and exporter-year fixed effects controlled for,and the associated 90 percent confidence bands.The missing category is trade within blocs.The Cold War results are obtained using yearly data from 1920 to 1990excluding the World War II years(193945),and with 1947 as an excluded yearand the bloc definition based on Gokmen(2017).The results for the most recent period are based on quarterly trade data from 2017:Q1 to 2024:Q1(with 2021:Q4 as an excluded quarter),with the wider bloc definition based on the ideal point distance(a measure based on voting patterns in the United Nations General Assembly computed by Bailey,Strezhnev,and Voeten 2017).United StatesEuro areaDeveloped markets:ManufacturingEmerging markets:ManufacturingDeveloped markets:ServicesEmerging markets:ServicesFigure 1.10.Continued Rotation to Services1.Relative Price of Core Goods versus Core Services(Core-goods-to-services ratio)80110859095100105Jan.2015Jan.17Jan.19Jan.21Jan.23Jul.242.Recent PMI trends(Index,50 =expansion)356040455055Jan.2022Jul.22Jan.23Jul.23Jan.24Aug.24Sources:Haver Analytics;and IMF staff calculations.Note:Solid lines denote GDP growth from the October 2024 World Economic Outlook,and dashed lines denote GDP growth forecasts from the April 2024 World Economic Outlook,respectively.PMI=purchasing managers index.WORLD ECONOMIC OUTLOOK:POLICY PIVOT,RISING THREATS8International Monetary Fund|October 2024illustrative but are quantitatively plausible alternatives around the baseline(Box 1.2).Commodity price assumptions:Oil prices are expected to rise by 0.9 percent in 2024 to about$81 a barrel as production cuts by OPEC (Organization of the Petroleum Exporting Countries plus selected nonmember countries,including Russia),sustained global oil demand growth,and geopolitical ten-sions in the Middle East offset strong non-OPEC supply growth.Overall,however,prices for fuel commodities are projected to fall on average by 3.8 percentowing to declines in prices of natural gas(by 16.4 percent)and coal(by 18.0 percent)as they come off their 2022 peaksbut less rapidly than assumed in April(Figure 1.11,panel 1).Food prices are expected to decline by 5.2 percent in 2024 and by a further 4.5 percent in 2025 as global grain produc-tion is forecast to reach record highs in 202425.Monetary policy assumptions:Compared with that in April 2024,the anticipated trajectory of policy rates for major central banks in advanced economies has shifted.In the euro area,100 basis points of cuts are expected in 2024 and 50 basis points in 2025,bringing the policy rate to 2.5 percent by June 2025.In the United States,the Federal Reserve pivoted to cutting rates in September,starting with a 50 basis point drop.The federal funds rate is pro-jected to reach its long-term equilibrium of 2.9 per-cent in the third quarter of 2026,almost a year earlier than what was expected in April.In Japan,however,policy rate projections have been revised upward(since the April 2024 World Economic Outlook),reflecting the Bank of Japans rate hike in July.The policy rate is projected to continue to rise gradually over the medium term toward a neutral setting of about 1.5 percent,consistent with keeping inflation and inflation expectations anchored at the Bank of Japans 2 percent target.Fiscal policy assumptions:Governments in advanced economies are on average expected to tighten their fiscal policy stances in both 2024 and 2025,halv-ing primary deficits by 2029.However,contrasts between the euro area and the United States are important.In the baseline,the US fiscal deficit is only marginally trimmed down,remaining at about 6.0 percent in 2029,with about half of this reflect-ing interest rate expenses.Under current policies,the US public debt is not stabilized,reaching almost 131.7 percent of GDP in 2029.In the euro area,on the other hand,the debt-to-GDP ratio is expected to have stabilized already at about 88 percent in 2024,although with some cross-country differ-ences.Large contrasts are apparent in the emerging market and developing economies country group as well.Whereas fiscal stances are expected to remain relatively loose on average in emerging markets,fiscal consolidation is ongoing among developing economies.Over the past few years,many low-income countries have either lost market access or EnergyFoodUnited StatesEuro areaJapanFigure 1.11.Global Assumptions1.Energy and Food Prices (Index,2022:Q4=100)50120607080901001102022:Q423:Q424:Q425:Q42.Monetary Policy Projections (Percent,quarterly average)01123456724:Q125:Q126:Q127:Q128:Q129:Q129:Q42023:Q13.Fiscal Policy Projections (Percentage points;change in fiscal balance)1.00.50.00.51.02023242526Advanced economiesEmerging market anddeveloping economies2023242526Source:IMF staff calculations.Note:In panels 1 and 2,solid lines denote projections from the October 2024 World Economic Outlook and dashed lines from the April 2024 World Economic Outlook.Also,the dotted line in panel 1 denotes projections from October 2023 World Economic Outlook.In panel 3,the fiscal balance used is the general government structural primary balance,which is the cyclically adjusted primary balance corrected for a broader range of noncyclical factors such as changes in asset and commodity prices.CHAPTER 1 GLOBAL PROSPECTS AND POLICIES9International Monetary Fund|October 2024been forced to drastically scale back deficits because higher interest rates have pushed up borrowing costs(see Chapter 1 of the October 2024 Global Financial Stability Report).Forced consolidation is expected to bring down their debt-to-GDP ratios to 45.8 percent in 2029 from 53.2 percent in 2024,a reduction of about 1.5 percent of GDP every year.Baseline Outlook:Stable Growth amid Continuing DisinflationGlobal growth is expected to remain broadly flatdecelerating from 3.3 percent in 2023 to 3.1 percent by 2029and is largely unchanged from World Economic Outlook forecasts in April 2024 and October 2023(Tables 1.1 and 1.2;Figure 1.12).1 Under the surface,however,offsetting revisions have brought major econ-omies closer together as cyclical forces wane and GDP moves closer to potential.As inflation recedes,policy rates are expected to follow suit,preventing undue increases in real interest rates.Interest rates are expected to gradually descend toward their natural levels:the lev-els of risk-free real interest rates compatible with output at potential and inflation at target.Although global revisions to the forecast since April have been minimal,offsetting shifts at the country group level reflect recent shocks and policies,most notably in emerging market and developing econo-mies.Cuts in production and shipping of commodities(oil in particular),conflicts,and civil unrest have led to downward revisions to the regional outlooks for the Middle East and Central Asia and for sub-Saharan Africa.At the same time,surging demand for semi-conductors and electronics,driven by significant investment in artificial intelligence,has fueled stronger growth in emerging Asia.Growth Outlook:Major Economies Draw Closer TogetherFollowing a reopening rebound in 2022,growth in advanced economies markedly slowed in 2023 and is projected to remain steady,oscillating between 1.7 and 1.8 percent until 2029.This apparent stability conceals differing country dynamics as various cycli-cal forces unwind and economic activity gets back in 1For the global and regional aggregates,this World Economic Outlook report uses the newly revised purchasing-power-parity GDP weights based on the latest release from the International Compari-son Program;see the Statistical Appendix for details.line with potential.In the United States,growth is expected to decelerate,with output reaching potential from above by 2029.In the United Kingdom and the euro area,on the other hand,activity is projected to accelerate,closing the output gap from below.In Japan,where the output gap is already closed,GDP is expected to grow in line with potential.In the United States,projected growth for 2024 has been revised upward to 2.8 percent,which is 0.2 percentage point higher than the July forecast,on account of stronger outturns in consumption and nonresidential investment.The resilience of con-sumption is largely the result of robust increases in real wages(especially among lower-income house-holds)and wealth effects.Growth is anticipated to slow to 2.2 percent in 2025 as fiscal policy is gradually tightened and a cooling labor market slows consumption.With GDP growth lower than potential,the output gap is expected to start closing in 2025.In the euro area,growth seems to have reached its lowest point in 2023.A touch weaker than projected in April and July 2024,GDP growth is WorldAdvanced economiesEmerging market and developing economiesUnited StatesEuro areaJapanKoreaChinaIndiaBrazilMexicoFigure 1.12.Growth Outlook1.Growth Outlook(Percent;dashes=April 2024,dots=October 2023)20232425262.Cyclical Forces Waning and Output Gaps Closing(Percent)32101232023242526272829Source:IMF staff calculations.Note:In panel 1,solid lines denote GDP growth from the October 2024 World EconomicOutlook,and dashed and dotted lines denote GDP growth forecasts from the April 2024World Economic Outlook and the October 2023 World Economic Outlook,respectively.0123456WORLD ECONOMIC OUTLOOK:POLICY PIVOT,RISING THREATS10International Monetary Fund|October 2024Table 1.1.Overview of the World Economic Outlook Projections(Percent change,unless noted otherwise)ProjectionsDifference from July 2024 WEO Update1Difference from April 2024 WEO12023202420252024202520242025World Output3.33.23.20.00.10.00.0Advanced Economies1.71.81.80.10.00.10.0United States 2.92.82.20.20.30.10.3Euro Area0.40.81.20.10.30.00.3Germany0.30.00.80.20.50.20.5France1.11.11.10.20.20.40.3Italy0.70.70.80.00.10.00.1Spain2.72.92.10.50.01.00.0Japan 1.70.31.10.40.10.60.1United Kingdom0.31.11.50.40.00.60.0Canada1.21.32.40.00.00.10.1Other Advanced Economies21.82.12.20.10.00.10.2Emerging Market and Developing Economies4.44.24.20.00.10.10.0Emerging and Developing Asia5.75.35.00.10.10.10.1China5.24.84.50.20.00.20.4India38.27.06.50.00.00.20.0Emerging and Developing Europe3.33.22.20.00.30.10.6Russia3.63.61.30.40.20.40.5Latin America and the Caribbean 2.22.12.50.30.20.20.0Brazil2.93.02.20.90.20.80.1Mexico3.21.51.30.70.30.90.1Middle East and Central Asia2.12.43.90.00.00.40.3Saudi Arabia0.81.54.60.20.11.11.4Sub-Saharan Africa 3.63.64.20.10.10.20.1Nigeria2.92.93.20.20.20.40.2South Africa0.71.11.50.20.30.20.3MemorandumWorld Growth Based on Market Exchange Rates2.82.72.80.00.00.00.1European Union0.61.11.60.10.20.00.2ASEAN-544.04.54.50.10.10.10.0Middle East and North Africa1.92.14.00.10.10.60.2Emerging Market and Middle-Income Economies4.44.24.20.10.00.10.1Low-Income Developing Countries4.14.04.70.20.40.50.4World Trade Volume(goods and services)0.83.13.40.00.00.10.1ImportsAdvanced Economies0.72.12.40.30.30.10.4Emerging Market and Developing Economies3.04.64.90.40.10.30.8ExportsAdvanced Economies1.02.52.70.10.20.00.2Emerging Market and Developing Economies0.64.64.60.40.50.90.7Commodity Prices(US dollars)Oil516.40.910.40.14.43.44.1Nonfuel(average based on world commodity import weights)5.72.90.22.11.82.80.2World Consumer Prices66.75.84.30.10.10.10.2Advanced Economies74.62.62.00.10.10.00.1Emerging Market and Developing Economies68.17.95.90.10.00.30.2Source:IMF staff estimates.Note:Real effective exchange rates are assumed to remain constant at the levels prevailing during July 30,2024August 27,2024.Economies are listed on the basis of economic size.The aggregated quarterly data are seasonally adjusted.WEO=World Economic Outlook.1 Difference based on rounded figures for the current,July 2024 WEO Update,and April 2024 WEO forecasts.Global and regional growth figures are based on new purchasing-power-parity weights derived from the recently released 2021 International Comparison Program survey(see Box A2)and are not comparable to the figures reported in the July 2024 WEO Update or the April 2024 WEO.2 Excludes the Group of Seven(Canada,France,Germany,Italy,Japan,United Kingdom,United States)and euro area countries.3 For India,data and forecasts are presented on a fiscal year basis,and GDP from 2011 onward is based on GDP at market prices with fiscal year 2011/12 as a base year.4 Indonesia,Malaysia,the Philippines,Singapore,and Thailand.5 Simple average of prices of UK Brent,Dubai Fateh,and West Texas Intermediate crude oil.The average price of oil in US dollars a barrel was$80.59 in 2023;the assumed price,based on futures markets,is$81.29 in 2024 and$72.84 in 2025.6 Excludes Venezuela.See the country-specific note for Venezuela in the“Country Notes”section of the Statistical Appendix.CHAPTER 1 GLOBAL PROSPECTS AND POLICIES11International Monetary Fund|October 2024Table 1.1.Overview of the World Economic Outlook Projections(continued)(Percent change,unless noted otherwise)Q4 over Q48ProjectionsDifference from July 2024 WEO Update1Difference from April 2024 WEO12023202420252024202520242025World Output3.43.33.10.10.20.10.0Advanced Economies1.71.91.70.20.10.10.0United States 3.22.51.90.50.10.40.1Euro Area0.21.21.30.30.20.20.1Germany0.20.31.30.50.40.40.5France1.30.71.50.10.00.40.0Italy0.31.00.60.50.70.30.0Spain2.32.92.00.60.11.00.1Japan 0.91.80.20.20.10.10.3United Kingdom0.32.11.10.60.50.60.2Canada1.02.32.10.10.10.50.2Other Advanced Economies22.01.82.60.10.20.30.0Emerging Market and Developing Economies4.74.44.30.10.10.10.2Emerging and Developing Asia5.95.45.00.10.00.30.3China5.44.54.70.10.20.10.6India37.86.76.50.20.00.30.1Emerging and Developing Europe4.32.32.70.10.70.90.1Russia4.82.41.20.60.50.20.0Latin America and the Caribbean 1.32.12.90.30.30.00.3Brazil2.23.52.20.60.20.50.7Mexico2.31.31.41.70.30.60.4Middle East and Central Asia.Saudi Arabia4.32.14.60.50.31.01.3Sub-Saharan Africa.Nigeria3.23.53.70.21.00.01.2South Africa1.31.71.00.40.10.40.2Memorandum World Growth Based on Market Exchange Rates2.82.82.60.10.20.10.0European Union0.51.61.40.10.40.00.3ASEAN-544.26.33.00.80.21.20.1Middle East and North Africa.Emerging Market and Middle-Income Economies4.74.44.30.10.10.10.2Low-Income Developing Countries.Commodity Prices(US dollars)Oil54.47.34.94.90.81.30.6Nonfuel(average based on world commodity import weights)0.23.80.53.90.03.00.1World Consumer Prices65.75.33.50.10.00.10.1Advanced Economies73.22.32.00.20.00.10.0Emerging Market and Developing Economies67.87.74.70.10.10.10.17 The assumed inflation rates for 2024 and 2025,respectively,are as follows:2.4 percent and 2.0 percent for the euro area,2.2 percent and 2.0 percent for Japan,and 3.0 percent and 1.9 percent for the United States.8 For world output,the quarterly estimates and projections account for approximately 90 percent of annual world output at purchasing-power-parity weights.For emerging market and developing economies,the quarterly estimates and projections account for approximately 85 percent of annual emerging market and developing economies output at purchasing-power-parity weights.WORLD ECONOMIC OUTLOOK:POLICY PIVOT,RISING THREATS12International Monetary Fund|October 2024expected to pick up to a modest 0.8 percent in 2024 as a result of better export performance,in partic-ular of goods.In 2025,growth is projected to rise further to 1.2 percent,helped by stronger domestic demand.Rising real wages are expected to boost consumption,and a gradual loosening of monetary policy is expected to support investment.Persistent weakness in manufacturing weighs on growth for countries such as Germany and Italy.However,whereas Italys domestic demand is expected to ben-efit from the European Unionfinanced National Recovery and Resilience Plan,Germany is experi-encing strain from fiscal consolidation and a sharp decline in real estate prices.Offsetting dynamics are also at play among other advanced economies.Growth is expected to deceler-ate in Japan in 2024,with the slowdown reflecting temporary supply disruptions and fading of one-off factors that boosted activity in 2023,such as the surge in tourism.With respect to April,growth is revised downward,by 0.6 percentage point,to 0.3 percent for 2024,reflecting a temporary supply disruption in the car industry and the base effect of historical data revisions.An acceleration to 1.1 is predicted in 2025,with growth boosted by private consumption as real wage growth strengthens.In the United Kingdom,in contrast,growth is projected to have accelerated to 1.1 percent in 2024 and is expected to continue doing so to 1.5 percent in 2025 as falling inflation and interest rates stimulate domestic demand.Growth Outlook:Emerging Markets Get Support from AsiaIn a manner similar to that for advanced economies,the growth outlook for emerging market and devel-oping economies is remarkably stable for the next two years,hovering at about 4.2 percent and steadying at 3.9 percent by 2029.And just as in advanced econo-mies,offsetting dynamics are occurring between coun-try groups.Compared with that in April,growth in emerging market and developing economies is revised upward by 0.1 percentage point for 2024,reflecting upgrades for Asia(China and India)that more than offset downgrades for sub-Saharan Africa and for the Middle East and Central Asia(Table 1.1).Emerging Asias strong growth is expected to subside,from 5.7 percent in 2023 to 5.0 percent in 2025.This reflects a sustained slowdown in the regions two largest countries.In India,the outlook is for GDP growth to moderate from 8.2 percent in 2023 to 7 percent in 2024 and 6.5 percent in 2025,because pent-up demand accumulated during the pandemic has been exhausted,as the economy reconnects with its potential.In China,the slow-down is projected to be more gradual.Despite persisting weakness in the real estate sector and low consumer confidence,growth is projected to have slowed only marginally to 4.8 percent in 2024,largely thanks to better-than-expected net exports.Compared with that in April,the forecast has been revised upward by 0.2 percentage point in 2024 and Table 1.2.Overview of the World Economic Outlook Projections at Market Exchange Rate Weights(Percent change)ProjectionsDifference from July 2024 WEO Update1Difference from April 2024 WEO12023202420252024202520242025World Output2.82.72.80.00.00.00.1Advanced Economies1.81.81.80.10.00.00.0Emerging Market and Developing Economies4.34.04.10.10.00.00.1Emerging and Developing Asia5.55.14.80.10.10.10.2Emerging and Developing Europe3.13.12.30.10.30.00.5Latin America and the Caribbean 2.21.92.40.20.20.00.1Middle East and Central Asia1.52.14.00.10.00.50.3Sub-Saharan Africa 3.43.44.10.20.10.20.1MemorandumEuropean Union0.51.01.50.00.10.10.2Middle East and North Africa1.31.84.00.30.00.70.3Emerging Market and Middle-Income Economies4.34.04.00.10.10.00.1Low-Income Developing Countries4.13.84.80.30.40.60.3Source:IMF staff estimates.Note:The aggregate growth rates are calculated as a weighted average,in which a moving average of nominal GDP in US dollars for the preceding three years is used as the weight.WEO=World Economic Outlook.1 Difference based on rounded figures for the current,July 2024 WEO Update,and April 2024 WEO forecasts.CHAPTER 1 GLOBAL PROSPECTS AND POLICIES13International Monetary Fund|October 20240.4 percentage point in 2025.Recent policy mea-sures may provide upside risk to near-term growth.In contrast,growth in the Middle East and Cen-tral Asia is projected to pick up from an estimated 2.1 percent in 2023 to 3.9 percent in 2025,as the effect on the region of temporary disruptions to oil production and shipping are assumed to fade away.Compared with that in April,the projection has been revised downward by 0.4 percentage point for 2024,mainly the result of the extension of oil pro-duction cuts in Saudi Arabia and ongoing conflict in Sudan taking a large toll.In sub-Saharan Africa,GDP growth is similarly pro-jected to increase,from an estimated 3.6 percent in 2023 to 4.2 percent in 2025,as the adverse impacts of prior weather shocks abate and supply constraints gradually ease.Compared with that in April,the regional forecast is revised downward by 0.2 per-centage point for 2024 and upward by 0.1 percent-age point for 2025.Besides the ongoing conflict that has led to a 26 percent contraction of the South Sudanese economy,the revision reflects slower growth in Nigeria,amid weaker-than-expected activ-ity in the first half of the year.In Latin America and the Caribbean,growth is projected to decline from 2.2 percent in 2023 to 2.1 percent in 2024 before rebounding to 2.5 per-cent in 2025.In Brazil,growth is projected at 3.0 percent in 2024 and 2.2 percent in 2025.This is an upward revision of 0.9 percentage point for 2024,compared with July 2024 World Economic Outlook Update projections,owing to stronger private consumption and investment in the first half of the year from a tight labor market,government transfers,and smaller-than-anticipated disruptions from floods.However,with the still-restrictive mon-etary policy and the expected cooling of the labor market,growth is expected to moderate in 2025.In Mexico,growth is projected at 1.5 percent in 2024,reflecting weakening domestic demand on the back of monetary policy tightening,before slowing further to 1.3 percent in 2025 on a tighter fiscal stance.Overall,offsetting revisions leave the regional growth forecast broadly unchanged since April.Growth in emerging and developing Europe is projected to remain steady at 3.2 percent in 2024 but to ease significantly to 2.2 percent in 2025.The moderation reflects a sharp slowdown in Russia from 3.6 percent in 2023 to 1.3 percent in 2025 as private consumption and investment slow amid reduced tightness in the labor market and slower wage growth.In Trkiye,growth is expected to slow from 5.1 percent in 2023 to 2.7 percent in 2025,with the slowdown driven by the shift to monetary and fiscal policy tightening since mid-2023.Inflation Outlook:Gradual Decline to TargetAlthough bumps on the path to price stability are still possible,global headline inflation is projected to decrease further,from an average of 6.7 percent in 2023 to 5.8 percent in 2024 and 4.3 percent in 2025 in the baseline.Disinflation is expected to be faster in advanced economieswith a decline of 2 percentage points from 2023 to 2024 and a stabilization at about 2 percent in 2025than in emerging market and developing economies,in which inflation is projected to decline from 8.1 percent in 2023 to 7.9 percent in 2024 and then fall at a faster pace in 2025 to 5.9 percent.There is a great deal of variation across emerging market economies,however,which is evident in the difference between median and average inflation(Figure 1.13,panel 1).Inflation in emerging Asia is projected to be on par with that in advanced econ-omies,at 2.1 percent in 2024 and 2.7 percent in 2025,in part thanks to early monetary tightening and price controls in many countries in the region.In contrast,inflation forecasts for emerging and develop-ing Europe,the Middle East and North Africa,and sub-Saharan Africa remain in double-digit territory on account of large outliers amid pass-through of past cur-rency depreciation and administrative price adjustment(Egypt)and underperformance in agriculture(Ethi-opia).For most countries in Latin America and the Caribbean,inflation rates have dropped significantly from their peaks and continue to be on a downward trend.However,large countries in the region have experienced upward revisions since the April 2024 World Economic Outlook that reflect a mix of(1)robust wage growth preventing faster disinflation in the services sector(Brazil,Mexico),(2)weather events(Colombia),and(3)hikes in regulated electricity tariffs(Chile).The decline in global inflation in 2024 and 2025 reflects a broad-based decrease in core inflation,unlike the situation in 2023,when headline infla-tion fell mainly because of lower fuel prices.Core inflation is expected to drop by 1.3 percentage points in 2024,following a 0.1 percentage point WORLD ECONOMIC OUTLOOK:POLICY PIVOT,RISING THREATS14International Monetary Fund|October 2024decrease in 2023,with advanced economies leading this decline.Factors contributing to lower core infla-tion include the delayed effect of tight monetary policies as well as diminishing pass-through effects from earlier declines in prices,especially in those for energy.Overall,returning inflation to target is expected to take until 2025 in most cases.Although the pace of disinflation for the median economy has been faster than expected in October 2023,the dispersion across economies is now expected to be larger.Comparison of official inflation targets with the latest forecasts for a representative group of inflation-targeting advanced and emerging market economies suggests that annual average inflation will exceed targets(or the midpoints of target ranges)in more than three-quarters of these economies in 2025(Figure 1.13,panel 2).But a great deal of this reflects annual carryover effects from 2024.Infla-tion is expected to decline steadily on a sequential basis,and by the end of 2025,most economies are expected to be either at target or within a stones throw of it.Medium-Term Outlook:A Low-Growth Regime Setting InAbsent a strong drive for structural reforms,output growth is expected to remain weak over the medium term(see Chapter 3 of the April 2024 World Economic Outlook).Although monetary policy is expected to return to a neutral stance by 2025 in the worlds largest econo-mies,growth in most economies is expected to remain feeble over the medium term.For many advanced and emerging market economies,the five-year-ahead forecast is weaker than the one-year-ahead forecast(Figure 1.14),suggesting that persistent headwinds to growth will remain prevalent over the medium term.Structural challenges such as population aging,weak investment,and historically low total factor productivity growth are still holding back global growth.The five-year-ahead forecast for global growth stands at 3.1 percent,indicating continued medio-cre medium-term prospects relative to prepandemic forecasts.Compared with those in April 2024,medi-um-term growth prospects for advanced economies are unchanged.Although investment is expected to AEs medianAEs averageEMDEs medianEMDEs averageOct.2023 WEOApr.2024 WEOOct.2024 WEOFigure 1.13.Inflation Outlook0122468102.Inflation Outlook(Percentage points;deviation from inflation target)1.Inflation in AEs and EMDEs(Percent)462024Sources:Central bank websites;Haver Analytics;and IMF staff calculations.Note:In panel 1,the averages are calculated using purchasing-power-parity GDPs as weights.Panel 2 shows the distribution(box-whisker plot)from each WEO report.The blocks in the middle of the boxes are the medians,and the upper(lower)limits of the boxes are the third(first)quartile.The whiskers show the maximum and minimum within a boundary of 1.5 times the interquartile range from upper and lower quartiles,respectively.AEs=advanced economies;EMDEs=emerging market and developing economies;WEO=World Economic Outlook.2920181920212223242526272820242526LIDCsAEsEMMIEsFigure 1.14.Medium-Term Outlook(Percent)0246810Five-year-ahead forecast(2029 growth)0246810One-year-ahead forecast(2025 growth)45-degree lineSource:IMF staff calculations.Note:Bubble size reflects size of the economy using 2024 GDP in purchasing-power-parity international dollars.Data labels in the figure use International Organization for Standardization(ISO)country codes.AEs=advanced economies;EMMIEs=emerging market and middle-income economies;LIDCs=low-income developing countries.USAJPNDEUGBRFRACHNINDIDNRUSBRABGDNGAETHUZBCHAPTER 1 GLOBAL PROSPECTS AND POLICIES15International Monetary Fund|October 2024pick up and productivity growth is also expected to see some normalization,the continued demographic drag is likely to produce an offsetting effect.Cerdeiro,Hong,and Kammer(2024)discuss underlying drivers of recent productivity divergence between the United States and euro area economies that may continue to define medium-term growth trends in these economies.For emerging market and developing economies,medium-term growth prospects have not improved compared with those in the April 2024 World Eco-nomic Outlook and are still much weaker than they were in prepandemic projections.This partly reflects prolonged scarring from the shocks of the past few years,especially for low-income developing countries.It also reflects a slower pace of structural reforms,which is holding back productivity growth.Projected slowdowns in the largest emerging market and developing economies imply a longer path to close the income gaps between poor and rich countries.Having growth stuck in low gear could also further exacerbate income inequality within economies.IMF staff analysis suggests that periods of low economic growth lasting four years or more tend to widen income inequality within countries,because sluggish job creation and wage growthas well as weaker fiscal positions preventing redistributiontend to affect low-income earners disproportionately(IMF 2024).Trade Growth Historically Low,yet in Line with Output GrowthGlobal trade is expected to continue to grow in line with GDP,reaching an average of 3 per-cent growth annually in 2024 and 2025,following a period of near stagnation in 2023.Despite an increase in cross-border restrictions affecting trade between geopolitically distant blocs,the global trade-to-GDP ratio is expected to remain stable.Intrabloc trade and trade with third countries have been com-pensating forces so far.Meanwhile,global current account balancesthe sums of absolute surpluses and deficitsare expected to continue to decline from their 2022 peaks(Figure 1.15).As reported in the IMFs 2024 External Sector Report,the significant moderation of current account balances in 2023 toward prepandemic levels reflected a reversal of large current account surpluses in commodity-exporting countries,continued economic recovery from the pandemic,and a slowdown in global goods trade during 2023.Over the medium term,global balances are expected to narrow gradually as commodity prices decline.Creditor and debtor stock positions reached historically elevated levels in 2022,with the increases reflecting widening current account balances.They are expected to moderate slightly over the medium term as current account balances gradually narrow.In some economies,gross external liabilities remain large from a historical perspective and pose risks of external stress.Risks to the Outlook:Tilted to the DownsideThe most prominent risks and uncertainties surrounding the outlook are now discussed.A mod-el-based analysis that quantifies risks to the global outlook and plausible scenariosincluding shifts in trade and fiscal policiesis presented in Box 1.2.European creditorsEuropean debtorsChinaUnited StatesJapanOthersOil exportersDiscrepancyFigure 1.15.Current Account and International InvestmentPositions(Percent of global GDP)1.Global Current Account Balance2.Global International Investment PositionSource:IMF staff calculations.Note:European creditors are Austria,Belgium,Denmark,Finland,Germany,Luxembourg,The Netherlands,Norway,Slovenia,Sweden,and Switzerland;European debtors are Cyprus,Greece,Ireland,Italy,Portugal,and Spain;oil exporters are Algeria,Azerbaijan,Iran,Kazakhstan,Kuwait,Nigeria,Oman,Qatar,Russia,Saudi Arabia,the United Arab Emirates,and Venezuela.3210123200507091113151719212325272920050709111315171921232527293020100102030WORLD ECONOMIC OUTLOOK:POLICY PIVOT,RISING THREATS16International Monetary Fund|October 2024Downside RisksSince the July 2024 World Economic Outlook Update,adverse risks have gained more prominence.Monetary policy tightening bites more than intended.Although policy rates are projected to normalize,an unanticipated back-loaded strengthening of the transmission of earlier rate increases could lead to a faster-than-anticipated deceleration in near-term growth and rising unemployment.Though the impact on growth is unlikely to be persistent given concurrent policy easing,a rapid weakening of activity could also work its way adversely through consumer and business sentiment.This would place a stronger drag on household spending and prompt businesses to dial back their investment plans,either(or both)of which could create a negative feedback loop to growth.In such circumstances,however,lower energy prices would cushion some of the neg-ative effects on growth as lower demand would push oil prices down.Financial markets reprice as a result of monetary policy reassessments.The global economy is at the last mile of disinflation,which may present greater challenges to monetary policy than expected if the cost of reducing inflation in terms of unem-ployment(the sacrifice ratio)is closer to prepan-demic estimates than suggested by recent evidence(Figure 1.3,panel 1).If underlying inflation proves more persistent than expected,consumers may adjust their near-term inflation expectations(Figure 1.16),forcing central banks to adjust the path of monetary policy normalization.This would weaken consumer and business confidence,lead to market repricing and tighter financial condi-tions,and slow economic recovery.Given existing vulnerabilities(see Chapter 1 of the October 2024 Global Financial Stability Report),financial market turbulence could resurge,prompting sizable price corrections.Contagion effects are possible and could increase risks to financial stability by,among other things,triggering sovereign debt stress in emerging markets.Sovereign debt stress intensifies in emerging market and developing economies.Although spreads have eased since peaking in July 2022,some emerging market and developing economies are still vulnerable to a repricing of risk.This could further increase their sovereign spreads and push them into debt dis-tress.Countries with large external financing needs and a low buffer of international reserves will be most affected,as many are already subject to large sovereign borrowing spreads(Figure 1.7,panel 2).With little room to maneuver on fiscal policy,forcing a front-loaded fiscal consolidation could precipitate an economic downturn amid a fragile recovery.Low-income countries will be particularly at risk given their limited fiscal space and the need to maintain expenditure on programs supporting the most vulnerable.Chinas property sector contracts more deeply than expected.Conditions for the real estate market could worsen,with further price corrections taking place amid a contraction in sales and investment.The experiences of Japan in the 1990s and the United States in 2008 suggest that a further price correction is a plausible downside risk if the crisis is not adequately addressed.Further price drops could dent consumer confidence(which is already at his-toric lows)even more,further weakening household consumption.This could cause domestic demand to falter,with negative spillovers to both advanced and emerging market economies given Chinas rising footprint in global trade(see Chapter 4 of the April 2024 World Economic Outlook).One year aheadThree years aheadFigure 1.16.Inflation Surprises and Changes in Inflation Expectations(Percentage points)432101234Infation expectations changes4321012345Infation surprisesSources:Federal Reserve Bank of New York,Survey of Consumer Expectations;and IMF staff calculations.Note:The figure covers the period January 2020 to May 2024.Dashed lines show fitted values.Inflation surprises are measured as the difference between actual year-over-year inflation and one-year(three-year)inflation expectations from one(three)years prior.Changes in inflation expectations are measured as the changes in one-year(three-year)inflation expectations relative to one(three)years prior.CHAPTER 1 GLOBAL PROSPECTS AND POLICIES17International Monetary Fund|October 2024Government stimulus to counter weakness in domestic demand would place further strain on public finances.Subsidies in certain sectors,if targeted to boost exports,could exacerbate trade tensions with Chinas trading partners.Renewed spikes in commodity prices arise as a result of climate shocks,regional conflicts,or broader geopolitical tensions.Intensification of regional conflicts,especially given the wider span of con-flict in the Middle East,or the war in Ukraine,could further disrupt trade,leading to sustained increases in food,energy,and other commodity prices.Commodity price volatility may result in higher inflation,especially for commodity-import-ing countries,and restrict central banks room to maneuver.Extreme heat and prolonged droughts amid record high temperatures worldwide could also have an impact on harvests,adding to pres-sures on food prices and food security.Low-in-come countries are likely to be disproportionately affected,since food and energy costs take up a large part of household expenditures there.Countries ratchet up protectionist policies.A broad-based retreat from a rules-based global trading sys-tem is prompting many countries to take unilateral actions.Not only would an intensification of protec-tionist policies exacerbate global trade tensions and disrupt global supply chains,but it could also weigh down medium-term growth prospects by limiting positive spillovers from innovation and technology transfer,which fueled growth in emerging market and developing economies as globalization took off.Social unrest resumes.Reports of social unrestincluding protests,riots,and major demonstra-tionshave picked up in some regions,although globally they remain fewer in number than the recent peak in late 2019 to early 2020(Figure 1.17).However,a resurgence of social turmoil,poten-tially driven by higher inflation,higher taxes,and associated loss of purchasing power;spillovers from conflicts;and rising inequality,could slow economic growth,particularly in countries with more lim-ited scope to cushion the impact through policies(Hadzi-Vaskov,Pienknagura,and Ricci 2023).Social unrest could also complicate the passage and implementation of necessary reforms.Chapter 3 emphasizes the crucial role of social consensus in achieving successful and sustainable implementation of structural reforms.Upside RisksMore favorable outcomes for global growth than in the baseline forecast are also plausible:Stronger recovery in investment in advanced economies:Public investment in advanced economies could accelerate to meet various pressing policy objectives,from the green transition to upgrading infrastructure and boosting investment in science and technology.This type of investment could also crowd in the private sector,increasing private investment,and lead to a higher-than-projected recovery in global demand and trade.Higher aggregate demand could be inflationary,although the pressure could be mitigated by the extent to which these investments enhance supply-side capacity(see Chapter 3 of the October 2022 World Economic Outlook).It also depends on how these investments are financed:fiscal slippage in advanced economies could further slow the pace at which central banks can bring inflation to target.Stronger momentum of structural reforms:Many advanced and emerging market economies may accelerate structural reform efforts to prevent pro-ductivity and potential growth from further lagging those of their more productive peers.Faster imple-mentation of macro-critical structural reforms to SSAEURAllWHME and CAAPACFigure 1.17.Social Unrest Levels(Percent of economies experiencing major social unrest)07123456Jan.2018Jan.19Jan.20Jan.21Jan.22Jan.23Jan.24Jun.24Sources:Barrett and others 2022;and IMF staff calculations.Note:The figure shows the share of economies within a world region experiencing major events of social unrest(including protests,riots,and major demonstrations)in the preceding 12 months.All=all economies;APAC=Asia and Pacific;EUR=Europe;ME and CA=Middle East and Central Asia;SSA=sub-Saharan Africa;WH=Western Hemisphere.WORL
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Critical Minerals and the Future of the U.S.Economy FEBRUARY 2025An edited volume by the Critical Minerals Security ProgramEDITORSGracelin BaskaranDuncan WoodCONTRIBUTORSMorgan Bazilian Rohitesh DhawanFrank FannonAlexandra HelfgottAdam JohnsonJoseph MajkutChris MichienziJane NakanoMeredith SchwartzSeaver WangKellee WickerGregory WischerMatthew D.ZolnowskiCritical Minerals and the Future of the U.S.Economy FEBRUARY 2025An edited volume by the Critical Minerals Security ProgramEDITORSGracelin BaskaranDuncan WoodCONTRIBUTORSMorgan Bazilian Rohitesh DhawanFrank FannonAlexandra HelfgottAdam JohnsonJoseph MajkutChris MichienziJane NakanoMeredith SchwartzSeaver WangKellee WickerGregory WischerMatthew D.ZolnowskiIIcritical minerals and the future of the u.s.economy /gracelin baskaran and duncan woodABOUT CSISThe Center for Strategic and International Studies(CSIS)is a bipartisan,nonprofit policy research organization dedicated to advancing practical ideas to address the worlds greatest challenges.Thomas J.Pritzker was named chairman of the CSIS Board of Trustees in 2015,succeeding former U.S.senator Sam Nunn(D-GA).Founded in 1962,CSIS is led by John J.Hamre,who has served as president and chief executive officer since 2000.CSISs purpose is to define the future of national security.We are guided by a distinct set of valuesnonpartisanship,independent thought,innovative thinking,cross-disciplinary scholarship,integrity and professionalism,and talent development.CSISs values work in concert toward the goal of making real-world impact.CSIS scholars bring their policy expertise,judgment,and robust networks to their research,analysis,and recommendations.We organize conferences,publish,lecture,and make media appearances that aim to increase the knowledge,awareness,and salience of policy issues with relevant stakeholders and the interested public.CSIS has impact when our research helps to inform the decisionmaking of key policymakers and the thinking of key influencers.We work toward a vision of a safer and more prosperous world.CSIS does not take specific policy positions;accordingly,all views expressed herein should be understood to be solely those of the author(s).2025 by the Center for Strategic and International Studies.All rights reserved.Center for Strategic&International Studies1616 Rhode Island Avenue,NWWashington,DC 20036202-887-0200|www.csis.orgIIIcritical minerals and the future of the u.s.economy /gracelin baskaran and duncan woodBLOOMSBURY ACADEMICBloomsbury Publishing Inc,1385 Broadway,New York,NY 10018,USABloomsbury Publishing Plc,50 Bedford Square,London,WC1B 3DP,UKBloomsbury Publishing Ireland,29 Earlsfort Terrace,Dublin 2,D02 AY28,IrelandBLOOMSBURY,BLOOMSBURY ACADEMIC and the Diana logo are trademarks of Bloomsbury Publishing Plc.First published in the United States of America,2025Copyright Center for Strategic and International Studies,2025Cover design:Leena MarteCover image Adimas/Adobe StockAll rights reserved.No part of this publication may be:i)reproduced or transmitted in any form,electronic or mechanical,including photocopying,recording or by means of any information storage or retrieval system without prior permission in writing from the publishers;or ii)used or reproduced in any way for the training,development or operation of artificial intelligence(AI)technologies,including generative AI technologies.The rights holders expressly reserve this publication from the text and data mining exception as per Article 4(3)of the Digital Single Market Directive(EU)2019/790.Bloomsbury Publishing Inc does not have any control over,or responsibility for,any third-party websites referred to or in this book.All internet addresses given in this book were correct at the time of going to press.The author and publisher regret any inconvenience caused if addresses have changed or sites have ceased to exist,but can accept no responsibility for any such changes.ISBN:PB:979-8-7651-9836-0ePub:979-8-7651-9837-7ePDF:979-8-7651-9838-4Printed and bound in the United States of AmericaFor product safety related questions contact .To find out more about our authors and books visit and sign up for our newsletters.IVcritical minerals and the future of the u.s.economy /gracelin baskaran and duncan woodACKNOWLEDGMENTSThe editors hope that this volumes findings,analysis,and policy recommendations will help inform the efforts of the U.S.presidential administration and Congress to build the secure and resilient minerals supply chains essential for U.S.national,economic,and energy security.The editors would like to thank the authors and a series of individuals for their valuable contributions to this project.They would like to thank Meredith Schwartz for her exceptional editorial support and Caroline Smutny for her administrative support.The editors would also like to thank Alex Kisling in the CSIS External Relations department;Phillip Meylan,Hunter Hallman,Kelsey Hartman,and Madison Bruno on the CSIS Publications team for their thoughtful feedback during the publication process;and Leena Marte and Will Taylor in the CSIS Dracopoulos iDeas Lab for bringing this to life for digital and print publication.This volume is made possible through general support to CSIS and the Critical Minerals Security Program.No direct sponsorship contributed to this book.We are grateful to our donors,whose generosity made this important and timely undertaking possible.Vcritical minerals and the future of the u.s.economy /gracelin baskaran and duncan woodCONTENTS1|Introduction 1SECTION 1Crucial Industries Rely on Critical Minerals to Remain Competitive 102|Powering Technology:Critical Minerals for the Semiconductor Industry 113|Securing the Nation:Mineral Needs for the Defense Industrial Base 174|Driving Innovation:Critical Minerals and the Automotive Industry 255|Fueling the Transition:The Role of Critical Minerals in Renewable Energy 34SECTION 2Progress Under the Biden Administration:Important but Incomplete 396|An Evaluation of the Inflation Reduction Act 407|An Evaluation of the CHIPS and Science Act 508|An Evaluation of the Defense Production Act 569|An Evaluation of the Minerals Security Partnership 65SECTION 3Addressing Challenges and Outstanding Questions in theCritical Minerals Industry 7110|Modernizing Mine Permitting in the United States 7211|Closing the Midstream Gap in U.S.Critical Minerals Supply Chains 8312|A Strategy for Minerals Diplomacy in Emerging Markets 9013|Mining the Deep Sea:A New Minerals Frontier 10114|Pursuing Responsible Mining for a Brighter Future 10915|A Comprehensive U.S.Critical Minerals Plan 11616|Conclusion 124About the Editors 132About the Contributors 133Endnotes 134 1critical minerals and the future of the u.s.economy /gracelin baskaran and duncan woodCHAPTER 1IntroductionBy Gracelin Baskaran introduction /gracelin baskaranYuichiro Chino via Getty Images2introduction /gracelin baskaranMining is an inextricable part of the American story.What starts as rock in the ground goes on to become the inputs that build Americas homes and buildings,transportation systems,energy generation and transmission,defense systems,and technological capabilities.Mining is the foundation that allowed the United States to be a military leader,providing the minerals needed to manufacture tanks,missiles,fighter jets and warships.It is the reason computers,phones,and iPads exist.Mining is the reason we have energy and can turn on lights every morning.Today,the United States is 100 percent import reliant for 12 of the 50 minerals identified as critical by the U.S.Geological Survey(USGS)and over 50 percent import reliant for another 29.China is the top producer for 29 of these critical minerals.1 This dominance is the result of decades of minerals-centered domestic industrial strategy and foreign policy.China has repeatedly shown its willingness to weaponize these minerals.Over the last two years,China has rolled out export restrictions,including complete bans,on antimony,gallium,germanium.2 Furthermore,China has a stranglehold on minerals processing,refining between 40 and 90 percent of the worlds supply of rare earth elements,graphite,lithium,cobalt,and copper.Reducing reliance on China and creating resilient mineral supply chains is one of the most bipartisan priorities in Washington,D.C.This is demonstrated by the efforts of the last two administrations.In 2017,President Donald Trump issued Executive Order 13817,intending to improve the management of critical minerals needed for economic prosperity and energy security.In 2021,President Joe Biden issued Executive Order 14017,which led to a review of U.S.critical minerals and material supply chain vulnerabilities.The assessment released by the Biden administration discovered that the overreliance on adversarial countries posed a threat to national and economic security.3Geopolitical tension and war have motivated the advancement of critical minerals policies for nearly a century.At the start of World War II,the United States adopted the Strategic and Critical Materials Stockpiling Act of 1939.4 In his letter to Congress,President Franklin D.Roosevelt noted both that commercial stocks of vital raw resources in the United States were low and that“In the event of unlimited warfare on sea and in the air,possession of a reserve of these essential supplies might prove of vital importance.”5 By 1942,non-essential gold mining was restricted by the U.S.government so that it could free up mining companies capacity to focus on more critical minerals needed for the war effort.6 Less Figure 1:Share of Top Three Producing Countries in Mining of Selected Minerals,2022Rare earthsGraphiteLithiumCobaltNickelCopper0102030405060708090100United StatesRussiaChinaAustraliaChileDemocratic Republic of CongoIndonesiaPhilippinesMozambiquePeruMadagascar2019 top 3 sharePercentageSource:This is a work derived by CSIS from IEA material and CSIS is solely liable and responsible for this derived work.The derived work is not endorsed by the IEA in any manner.3Source:This is a work derived by CSIS from IEA material and CSIS is solely liable and responsible for this derived work.The derived work is not endorsed by the IEA in any manner.Figure 2:Share of Top Three Processing Countries of Selected Minerals,2022Rare earthsGraphiteLithiumCobaltNickelCopper0102030405060708090100ChinaRussiaChileIndonesiaJapanFinlandCanadaArgentinaMalaysiaEstonia2019 top 3 sharePercentageintroduction /gracelin baskaranthan a decade later,the Defense Production Act of 1950 was passed in response to the Korean War and provided authority for allocations to source strategic minerals needed to manufacture defense technologies.7 While conflict and uncertainty have been the biggest drivers of advancing policies to build secure minerals supply chains,demand for minerals has largely been driven by industrialization,technological advancements,decarbonization,and economic growth.For example,in 1975,the United States required that catalytical convertors be installed into automobiles to reduce emissions.These catalytic convertors drove the long-term demand of platinum group metals and have single-handedly made American air cleaner and more breathable,reducing harmful exhaust gases from automobiles by over 90 percent.8 Copper is another example.It is a necessary material for many of the advanced technologies that are essential to the modern global economy,including in infrastructure,clean energy,electronics,and automotives,and copper wires connect electrical grids,integrated circuits,and telecommunications systems.In order to meet net-zero carbon emissions by 2050,annual copper supply would need to double by 2035.9 The artificial intelligence(AI)industry is putting additional pressure on copper demand.The data centers that process AI applications could demand up to 200,000 metric tons of copper per year between 2025 and 2028,adding another 2.6 million metric tons to the copper deficit in 2030.10 Copper reached its highest ever price$11,000 per metric tonon the London Stock Exchange in 2024.11As technologies advance and become cleaner,and as demand for them grows,the mineral needs of the U.S.economy intensify.The competitiveness of the U.S.domestic automotive,energy,technology,and defense industries will be key to determining the United States standing as an economic powerhouse and global superpower in the decades ahead.The United States will need to strengthen both its mission clarity and its execution.At present,the U.S.government has yet to agree on a single critical minerals list.Because copper is not on the USGS list,it has been ineligible for investment incentives from the Inflation Reduction Act(IRA).Additionally,there is no centralized agency or department to coordinate mining activities or execute 4Accordingly,the first part of this book delves into the mineral needs of four key industries to U.S.economic competitiveness:semiconductors,defense,automobiles,and renewable energy.SemiconductorsSemiconductors are foundational to virtually every part of modern life,powering technologies that drive innovation,connectivity,and efficiency.They are used in smartphones,computers,military applications,medical devices,and automotives.Semiconductors are mineral intensivesmall but essential quantities of gallium,germanium,palladium,silicon,arsenic,titanium,and other elements are needed to produce the array of semiconductors required for such diverse applications.The production of these resources is largely concentrated in foreign adversaries,exposing a severe national security risk.USGShas estimatedthat just a 30 percent supply disruption of gallium could cause a$602 billion decline in U.S.economic output,amounting to a 2.1 percent loss of gross domestic product(GDP)a significant economic impact.13 Semiconductor supply chains will not be secure until the necessary mineral supply chains are secured.In Chapter 2,Gracelin Baskaran and Meredith Schwartz assess the minerals needs of the semiconductor industry and provide recommendations on developing appropriate incentives and leveraging research and development.Defense IndustryMinerals are the bedrock of the defense industry.They are used in a wide array of defense applications,including military weapons systems,ammunition,and aerospace technologies.China is rapidly investing in munitions and advanced weapons systems,acquiring new systems roughly five to six times more quickly than the United States.14 While China is operating with a wartime mindset to enhance military readiness,the United States has maintained a peacetime approach.Even before new restrictions,the U.S.defense industrial base struggled with insufficient capacity and surge capability to meet production demands for defense technologies,many of which are highly minerals intensive.Restrictions on critical mineral supplies will further widen the gap,enabling China to advance its capabilities more effectively than the United States.In Chapter 3,Matt Zolnowski describes Department a strategy.There are 15 government departments and agencies working on critical minerals,including the Departments of the Interior,Commerce,Energy,Defense,State,Labor,Homeland Security,Treasury,Agriculture,and Education;the Export-Import Bank;the U.S.International Development Finance Corporation;the U.S.Agency for International Development;the Environmental Protection Agency;and the National Aeronautics and Space Administration(NASA).12 The Bureau of Mines,which was initially opened in 1910 to coordinate all mining activities,was closed in 1996 and never reopened.Most of these departments and agencies are working on their own critical minerals efforts,with little interagency collaboration.Ultimately,strengthening coordination within the U.S.government must be a priority.This book has three sections.Section 1 provides an evaluation of the critical minerals needs of four vital industriessemiconductors,defense,electric vehicles,and renewable energyand provides recommendations for strengthening the resilience of these supply chains.Section 2 evaluates key Biden-era initiatives related to minerals supply chainsthe IRA,CHIPS and Science Act,Defense Production Act,and the Minerals Security Partnershipand provides recommendations for reforming.The final section provides an analysis of key issuesdomestic permitting,building midstream processing capacity,commercial diplomacy for minerals,deep sea mining,responsible mining,and government coordinationand provides concrete recommendations for how the United States can strengthen its performance in these areas to be a competitive and credible global leader.SECTION 1CRUCIAL INDUSTRIES RELY ON CRITICAL MINERALS TO REMAIN COMPETITIVESafeguarding the supply chains for advanced technologies in strategic industries is an economic and national security imperative.Policymakers now face the immense task of fortifying supplies of everything from lithium and graphite for advanced battery chemistries to tungsten and rare earth elements for the next generation of warfighting technologies.introduction /gracelin baskaran5six-fold increase.Therefore,the domestic auto industry now faces the daunting task of sourcing minerals from reliable and responsible partners amid a shifting policy landscape and swiftly evolving battery technologies.In Chapter 4,Duncan Wood and Alexandra Helfgott look at EV trends in the United States,assess the battery landscape,and examine how the United States should provide support to sustain an innovative and competitive domestic EV industry.Renewable EnergyRenewable energy technologies will be key to unlocking new,cleaner sources of energy.In the United States,wind and solar together provide 15 percent of electricity generation,with both sectors poised for substantial growth.In 2023,there was$248 billion in clean energy investments.This is over a three-fold increase from 2018.17 Today,the renewable energy industry employs 8 million people in the United States.18 Southern states have been the biggest beneficiaries of clean energy investments,receiving of Defense(DOD)actions to mitigate critical minerals vulnerabilities and advises how the department can update war-planning assumptions and stockpiling programs to prepare for a future crisis.Electric VehiclesElectric vehicles(EVs)are a major driver of innovation in the auto industry and are shaping the future of mobility.While the EV industry is important for the clean energy transition,it is also of vital importance to the U.S.economy.Domestic automakers began the commercial production of hybrid EVs in 1997.15 They have spent decades investing in the development of the EV industry.EV investments in the United States over the last nine years reached$199 billion and created 201,900 EV-related jobs.By June 2024,automotive manufacturing jobs reached their highest levels since 1990.16 EVs require significant quantities of minerals.While a traditional internal combustion engine(ICE)requires an average of 32 kg of critical minerals,an EV needs an average of 210 kgover a Figure 3:U.S.Import Reliance on China by Mineral Type(as Percent of Consumption)TungstenMagnesiumGermaniumNickelBauxiteZincCobaltTitaniumTantalumManganeseGraphiteGalliumArsenic0102030405060708090100Rare EarthsChina is Primary Import Source China is Secondary or Tertiary Import Source China is Not a Significant Import Source PercentageSource:USGSintroduction /gracelin baskaran6industrial base,and initiated the Department of States Mineral Security Partnership to further international cooperation.These policy measures have been impactful in stimulating private sector investment as well as changing the narrative in policy circles around what qualifies as a strategic industry and what the role of government should be in securing supply chains.But these policy measures also have some significant gaps when it comes to the upstream mining and minerals industries.The new administration will be tasked with determining how these initiatives under the Biden administration can be modified,improved,and strengthened to better fit the mining industrys needs.Inflation Reduction ActThe IRA is the Biden administrations flagship climate initiative,providing unprecedented levels of government incentives in the form of tax credits,grants,and loan guarantees for the clean energy industry.The bill includes provisions designed to address the entire circular clean energy supply chain,from the production of lithium and graphite to the manufacturing of EV batteries and wind turbines to the recycling and recovery of materials from end-use technologies.While the IRA has driven unprecedented investment in clean energy supply chains,sourcing critical minerals remains a critical limitation.In Chapter 6,Gracelin Baskaran and Meredith Schwartz score the IRA on how well it has achieved its objectives thus far and give recommendations as to how the minerals-related provisions may be altered and expanded upon to better meet the needs of industry and national security.CHIPS and Science ActThe CHIPS Act,signed into law in August 2022,was an amalgamation of a number of legislative efforts to address both a rising China and the United States desire to firm up access to semiconductors following the pandemic supply chain shock that froze consumer access to a wide range of products.Although this bill addressed a wide range of science and technology areas relevant to U.S.competitiveness,it did not prioritize securing American access to critical minerals.As a result,the CHIPS Acts focus on critical minerals$428 billion between the first quarter of 2018 and second quarter of 2024,followed by Western states($327 billion),Midwestern states($149 billion),and Northeastern states($90 billion).19 While this renewable energy buildout promises greater energy security,lower costs,and reduced emissions,it will depend heavily on secure mineral supplies.Wind farms and utility-scale solar facilities require far more mineral inputs than conventional power plants.Both technologies rely on critical minerals for their advanced electronics and components.In Chapter 5,Joseph Majkut highlights two materials especially imperiled due to rising demand and a lack of supply chain diversificationrare earth elements and polysiliconwhich are essential for wind and solar power,respectively.China currently dominates the supply chains for both.SECTION 2PROGRESS UNDER THE BIDEN ADMINISTRATIONImportant but IncompleteIn recent years,Washington has come to the realization that crucial U.S.industries and technologies are reliant on supply chains that are heavily concentrated in foreign adversaries,namely China.Advanced semiconductors designed in the United States are being manufactured and packaged in Taiwan.American automakers are producing EVs using Chinese battery chemistries.Domestically produced solar panels are made with Chinese solar cells and polysilicon.Over the course of decades and with the assistance of state-led industrial policies and billions of dollars in subsidies,China has grown to dominate the manufacturing sector for the cutting-edge technologies that the modern economy relies on.The risk this poses to U.S.national and economic security is untenable.To that end,diversifying supply chains and boosting American manufacturing and ingenuity was a central objective of the Biden administration.To achieve these goals,President Biden enacted major pieces of legislation like the IRA and the CHIPS and Science Act,invoked the DODs Defense Production Act to boost the introduction /gracelin baskaran7endures in a new administration.In Chapter 9,Jane Nakano suggests several modifications to the MSP that could accord more dynamism and long-term durability.SECTION 3ADDRESSING CHALLENGES AND OUTSTANDING QUESTIONS IN THE CRITICAL MINERALS INDUSTRY The minerals industry faces a number of unique challenges that policymakers must address in the coming years if they wish to substantially shift mineral supply chains and improve U.S.industrys access to non-Chinese mineral sources.The third part of this volume delves into some of the biggest issues and questions facing the industry,from how to expedite the domestic mine permitting process to whether deep sea mining is the future of minerals extraction.Domestic PermittingMining is the first step in the critical minerals supply chain,yet permitting a mine is a major hurdle in domestic critical mineral production that has yet to be overcome.On average,it takes 29 years to build a mine in the United States,the second-longest time in the world.Obtaining permission to operate a mine in the United States today involves securing federal,state,and local permits.A project can require up to 30 permits,many of which are duplicative.20 Policymakers on both sides of the aisle are calling for a modernized permitting system that facilitates the development of domestic mining projects.In Chapter 10,Morgan Bazilian and Gregory Wischer review the history of permitting policy in the United States and provide actionable policy solutions to streamline the process.Building Processing and Refining CapacityIn the next stage of mineral production,also known as the midstream,mined mineral ore must be processed and refined into the high-purity metals and materials used in end products.This stage of the supply chain is where China truly dominates.The dependence on access is minor,with the majority of funding going toward research and development for chip innovation,workforce development programs,and,above all,attracting investment in semiconductor fabrication,assembly,testing,and advanced packaging.Congress needs to act to explicitly address minerals relevant to semiconductor production,as they have for minerals used for EVs and clean tech.In Chapter 7,Kellee Wicker analyzes the impacts and shortcomings of the CHIPS Act and provides recommendations for strengthening the legislation.Defense Production ActThe Biden administration also invoked the Defense Production Act(DPA)of 1950 to secure critical minerals for the defense industrial base.The DPA authorizes the president to ensure the availability of U.S.and Canadian industry for U.S.defense,essential civilian,and homeland security requirements.DPA Title III,Expansion of Productive Capacity and Supply,includes incentives for the DOD to develop,maintain,modernize,and expand production capacity or critical technologies.DPA Title III funds cannot be used if other funding(e.g.,private investment or funding from other agencies)can be secured.Given the private sectors reluctance to make investments in critical minerals projects due to market price volatility for these materials,the DPA has proven to be a vital financing mechanism.In Chapter 8,Christine Michienzi details how the DPA has been used so far to support the critical minerals industry in the United States and Canada and gives recommendations as to how the new administration can best leverage the program.Minerals Security PartnershipThe Minerals Security Partnership(MSP)is a multilateral State Department initiative uniquely focused on minerals security.Since its inception in 2022,the MSP has mobilized a coalition of market-led democracies,primarily Western developed nations,with India as the only developing nation with membership.By 2024,the MSP supported nearly 30 minerals projects around the world and has brought additional mineral-rich countries to the table in the MSP Forum.But many unknowns and questions still remain as to how efficacious the MSP is and how it introduction /gracelin baskaran8finalized.Still,China continues to make strides in developing the necessary technologies and exploration licenses to capture deep sea resources first.In Chapter 13,Seaver Wang provides insight into the status of the deep sea mining industry and the opportunity to change the calculus around mineral supply chains by expanding tax incentives to cover minerals mined from the sea,strengthening support to seafloor minerals research to improve environmental management approaches,and providing financing to strategic demonstration projects.Responsible MiningMining is an industry with a complicated,and often negative,reputation due to all-too-frequent incidents of environmental degradation,human rights violations,social unrest,and devastating workplace accidents.Therefore,responsible mining standards are a nonnegotiable to ensure that U.S.and allied mines operate under best practices.As a major consumer and increasingly important producer of mined materials,the United States has a critical role in promoting responsible mining practices.In Chapter 14,Rohitesh Dhawan offers insight into how permitting reform can be done in a way that promotes responsible mining practices and advantages projects that follow high standards,how responsible mining standards can be used as a criterion for public procurement of metals or metal-based products,and how green premiums can be leveraged to financially incentivize responsible mining.A Comprehensive U.S.Strategy for Minerals SecurityMinerals policy has shifted quite significantly since 2010.The Obama,Trump,and Biden administrations all approached the critical minerals challenge based on their respective times and the policy tools at their disposal.America has learned much from these experiences.Reflecting on those experiences,Frank Fannon provides a suite of recommendations in Chapter 15 for the new administration to retake the commanding heights of the new economy:developing a single point of accountability to oversee and coordinate the administrations multiple lines of minerals policy efforts,reforming financing tools such as the DFC and Export-Import Bank(EXIM),undertaking permitting reform,and eliminating provisions that allow firms with any Chinese ownership from receiving taxpayer subsidies.Successful action will Chinese processing creates strategic vulnerabilities,exposing the United States to potential supply disruptions due to geopolitical tensions,export restrictions,and price manipulations.To reduce these risks and bolster national security,it is essential to enhance U.S.midstream processing capabilities.In Chapter 11,Adam Johnson explains the importance of building domestic mineral processing capacity and provides recommendations on developing the workforce,leveraging strategic reserves,and streamlining permitting to accelerate the development of midstream capabilities.International EngagementOver the past 30 years,China has emerged as a key player in mineral supply chains through strategic international engagement.Although it produces only 10 percent of the worlds lithium,cobalt,nickel,and copper,China imports sufficient quantities to process 65 to 90 percent of the global supply of these metals.This dominance is the result of years of industrial planning and foreign policy initiatives from Beijing.Given the United States limited domestic reservesincluding less than 1 percent of the worlds reserves of commodities such as cobalt,nickel,and graphite,and less than 2 percent of manganese and rare earth elementsit must develop a strategy to reduce its dependence and enhance its mineral supply security.In Chapter 12,Gracelin Baskaran provides a novel framework for determining which international partners to prioritize and gives recommendations for how policymakers should engage in commercial diplomacy.These efforts should prioritize financing minerals security needs,leveraging soft power through infrastructure development and geological mapping,and developing carrots and sticks to drive market-based activity aligned to U.S.government interests.Deep Sea MiningWhile todays EVs and semiconductors are manufactured with minerals from land-based mines,this may not always be the case.Minerals that are found in nodules at the depths of the ocean,including manganese,nickel,copper,and cobalt,offer immense untapped resource potential.However,the environmental impacts of extraction from these sources remain largely unknown,and a set of international regulations has yet to be introduction /gracelin baskaran9require an“all-of-the-above”approach.Looking AheadThe mission we undertook in compiling this book was to provide a comprehensive analysis of the indispensable role critical minerals play in the modern economys most strategic industries,and to more fully understand and address the vulnerabilities the United States faces in securing the minerals upon which it so clearly depends.Furthermore,this volume is rich in policy proposals for the new administration,laying out a path forward for the most pressing challenges facing the critical minerals supply chain,from extraction to processing and refining to end use.These challenges are real and profound and require urgent attentionbut as the chapters in this book demonstrate,they are not insurmountable.introduction /gracelin baskaranSECTION 1Crucial Industries Rely on Critical Minerals to Remain Competitive11powering technology/gracelin baskaran and meredith schwartzCHAPTER 2Powering TechnologyCritical Minerals for the Semiconductor IndustryBy Gracelin Baskaran and Meredith Schwartz Narumon Bowonkitwanchai via Getty Images12produced no arsenic,no gallium,less than 2 percent of the worlds refined germanium,3 percent of its silicon,and less than 1 percent of its titanium.27 The concentration of global critical minerals supply chains in the hands of adversaries presents a major security challenge for Western chipmakers.The chance of prolonged and widespread supply disruptions for semiconductor minerals is high,as China has already demonstrated its ability to restrict the flow of key minerals in the global economy.In July 2023,China announced export restrictions on gallium and germanium.28 A year and a half later,China cut off the United States from Chinese gallium and germanium entirely through complete export bans on these materials targeted specifically at the United States.29 The semiconductor industry is too central to U.S.economic and national security to allow such an evident vulnerability in its supply chain.To truly secure the Western semiconductor industry,policymakers should address mineral supply chain vulnerabilities,not just vulnerabilities in downstream chip manufacturing.THE IMPORTANCE OF MINERALS TO ADVANCE SEMICONDUCTOR TECHNOLOGY The critical minerals necessary for semiconductor production hold the key to furthering innovation in the industry.A concept commonly known as Moores Law stipulates that the density of a semiconductor(i.e.,the number of transistors that can fit on a 1-square-inch microchip)will continue to rise every year,equating to more computing power,higher speed,and more complex applications.30 For decades,silicon has been the wafer material of choice for most semiconductors due to its abundance in nature and thermal stability,making it a cheaper choice well suited to the early electronics industry.However,silicon alone may be close to reaching the physical limits of Moores Law.31 Rather,gallium and germanium are essential additions and alternatives to unlocking more advanced chipmaking.Gallium and germanium have certain advantages over silicon that make them ideal materials for increasingly Semiconductors are the fundamental building blocks of modern technology,necessary for everything from smartphones and laptops to communications and energy-storage systems to military and aerospace applications.21 These integrated circuits are called“semiconductors”due to being partial conductors,a unique property that enables them to control the flow of electrons by acting as both conductors and insulators.22 Therefore,semiconductors rely on small but essential quantities of specific minerals with these properties to function.Silicon,gallium,and germanium are the most common semiconductor materials used to form wafers,with different chip applications calling for different materials.23 However,a myriad of other critical minerals come into play during the manufacturing stages and doping processin which additional metals are introduced to slightly alter the chips conductivityto create just one integrated circuit.24 Palladium,arsenic,iridium,titanium,copper,and cobalt are just some of the additional minerals that are necessary for semiconductor plating,wiring,doping,and packaging during production.25 The critical minerals most central to semiconductor production have high-risk supply chains largely concentrated in China.China produces 98 percent of the worlds refined gallium and controls 68 percent of refined germanium production,79 percent of the worlds silicon,40 percent of its arsenic trioxide,and 67 percent of its titanium.26 The United States,meanwhile,is reliant on imports to access the materials needed for high-performance semiconductors.In 2022,the United States The success of the Western semiconductor industry depends on reliable access to the critical minerals that are responsible for continuous advancements in the industry.powering technology/gracelin baskaran and meredith schwartz1375 percent of the worlds bauxite due to its leading aluminum industry.38 This access to feedstock has also positioned China well to lead in germanium and gallium recovery.Aided by government subsidies,Chinese firms were able to flood the market with mineral oversupply in the 2010s.39 As prices dropped,Western competitors could not remain economically viable,allowing China to emerge as the world leader in semiconductor minerals.40 In contrast,the United States has small bauxite reserves of 20 million tons(less than 1 percent of global totals)and limited zinc reserves of 76.6 million tons(3 percent of global totals).41 The country currently has limited mining activity and produces only small amounts of germanium from zinc deposits in Alaska and smelting operations in Tennessee.Some new domestic projects may be in the works:In 2023,Dutch company Nyrstar announced a$150 million investment to expand its existing zinc operations in Tennessee to add a gallium and germanium processing facility.42 However,the project has yet to secure investor funding,and the company has faced market challenges that led it to temporarily suspend zinc mining operations in October 2023.43 In the near term,domestic investments will evidently not be enough to secure gallium and germanium supply chains.U.S.allies and strategic partners will be key to sourcing bauxite and zinc and producing gallium and germanium.For example,although Australia is the top producer of bauxite and home to the largest zinc reserves in the world,it lacks midstream processing capacity,leading it to send over 50 percent of its zinc exports and 97 percent of its bauxite exports to China.44 And Peru,a U.S.free trade partner with the largest zinc smelting plant in Latin America,currently produces no germanium or gallium.45 Australia and Peru hold vast potential for alternative gallium and germanium sourcing for the semiconductor industry,but without investment by Western firms into midstream processing and refining,these resources will remain untapped.THE CHIPS AND SCIENCE ACTBut What About the Critical Minerals?In the spring of 2020,at the peak of the Covid-19 pandemic,the United States experienced firsthand how debilitating semiconductor shortages can be.An estimated 169 sectors and consumer advanced semiconductors.Germaniums high electron mobility allows it to conduct electrons nearly three times faster than silicon,translating into faster device performance.32 Semiconductors with germanium channels,known as complementary metaloxide semiconductor(CMOS)circuits,are used today for quantum computers.Gallium similarly offers greater conductive potential for higher power density and energy efficiency.33 High-performance chips made with gallium nitride(GaN)and gallium arsenide(GaAs)are used in advanced defense applications from satellite communications to missile detection systems.Production of GaN chips is expected to grow more than 25 percent annually through 2030,with defense applications driving this increase.34Gallium and germanium are indispensable materials for the future of the semiconductor industry.But with current supply chain challenges and no U.S.sourcing alternatives,these materials are increasingly difficult to obtain.The next generation of chipmaking requires policymakers to devise and execute a critical minerals strategy that ensures the industry will have a reliable supply of needed materials.MINERAL SOURCING CHALLENGESGallium and germanium are especially rare in the Earths crust,at only 19.0 and 1.6 parts per million(ppm),respectively.Copper,in comparison,is estimated at 60 parts per million.35 These concentrations of minerals are too widely dispersed to be recovered directly from the Earth.Rather,the only economically viable way to source gallium and germanium is to recover them as byproducts from the mining and processing of other minerals.Gallium is sourced from bauxite ores through aluminum smelting,and germanium is primarily recovered from zinc smelting.Even so,less than 10 percent of the gallium in bauxite and 5 percent of the germanium in zinc can be recovered.36 These materials must then go through a complex refining process to produce gallium and germanium at the needed purity levels of over 99.99 percent.37 China has several advantages in gallium and germanium sourcing.The country has rich zinc deposits and imports powering technology/gracelin baskaran and meredith schwartz14justified the escalation of the tech war by claiming that such measures were necessary for national security.Meanwhile,the Western semiconductor industry was paying the price.In August and September 2023,China exported no refined gallium and only 1 kg of refined germanium,compared to nearly 8,000 kg and 6,900 kg,respectively,in the preceding July.52 In total,Chinas gallium exports for 2023 were over 50 percent lower than exports for 2022;as of February 2024,gallium exports had yet to return to pre-restriction levels,and it remains unclear when Chinas exports will return to their previous peaks.53 Continued restrictions and the implementation of gallium and germanium export bans in January 2025 will have a significant effect on the U.S.economy.The U.S.Geological Survey(USGS)has estimated that a disruption to just 30 percent of gallium supply could cause a$602 billion drop in U.S.economic output,equivalent to 2.1 percent of gross domestic product.54Prices for these materials have risen markedly over the past year.In April 2024,gallium prices were at their highest level since 2011.Assessed prices for gallium have nearly doubled since the restrictions were imposed,and germanium prices have also climbed over 70 percent,to$2,280 per kilogram.55 China has demonstrated its ability to control the materials market for semiconductors and has only tightened U.S.access to these materials with newly implemented exported bans.Continued and additional bottlenecks in critical minerals supply present an ongoing threat to the resilience of the U.S.semiconductor industry.RECOMMENDATIONSCreating Better Policy for Semiconductor Mineral Supply Chains The CHIPS and Science Act,as well as the current policy focus on downstream chip manufacturing,will not be enough to secure semiconductor supply chains.As long as China controls critical minerals supply chains,the U.S.semiconductor industry will be vulnerable to export restrictions,bottlenecks,and price volatility.One policy recommendation that is frequently cited as a solution to shortages of base metals is to revamp lines were impacted by semiconductor supply disruptions,including the electronic,automotive,communications,and healthcare industries.As a result,Western firms faced lower production volumes,the cancellation of new product lines,and delayed breakthroughs in technologies such as artificial intelligence(AI)and the Internet of Things(IoT).46 Policymakers realized just how fragile current semiconductor supply chains are,due to a highly complex and specialized production process largely concentrated in Asia.In August 2022,President Joe Biden signed the Creating Helpful Incentives to Produce Semiconductors(CHIPS)and Science Act into law,with the goal of strengthening U.S.semiconductor manufacturing and supply chains.This act included over$280 billion in support for advanced chip manufacturing,packaging,and workforce development.47 To address the supply chain vulnerabilities experienced during the pandemic,the bill focused on onshoring downstream capabilities,including by developing fabrication facilities for legacy chips used in communications and defense applications.48 The legislation also introduced significant government grant funding,which has been awarded to companies such as Intel and Micron to enable them to build and expand their chip-manufacturing capacity.49 However,the CHIPS Act overlooked a major national security vulnerability in semiconductor supply chains:critical minerals.The bill did not include any provisions to incentivize the diversification of critical minerals supply chains for semiconductors.EXPORT RESTRICTIONS HIGHLIGHT SUPPLY CHAIN VULNERABILITIESThe United States quickly realized just how big an oversight the exclusion of critical minerals from the CHIPS Act was.On August 1,2023,Chinese export restrictions on gallium and germanium went into effect in retaliation for Washington banning exports of advanced semiconductor technologies to China.50 Due to the restrictions,gallium and germanium exporters in China are now required to apply for an export license for each shipment of material,providing the government with details on the overseas buyer and end use.51 Beijing powering technology/gracelin baskaran and meredith schwartz15that addresses upstream critical minerals mining and midstream processing and refining.Just as the CHIPS and Science Act focused on incentives to boost domestic semiconductor manufacturing and the Inflation Reduction Act(IRA)incentivized investments in EV and clean energy technologies,an upstream and midstream critical minerals incentives package would ensure that U.S.fabs manufacturing the next generation of semiconductor technologies have reliable access to the critical minerals they need.With billions of dollars being invested in chips foundry facilities,their success hinges on access to needed input materials.61 Ensuring the security of the critical minerals supply chain is common-sense policy that supports the ambitious industrial goals of the CHIPS and Science Act and IRA.This package should include investment and production tax credits such as those covered in Sections 48C and 45X of the IRA.Such incentives programs would encourage companies to make the necessary investments in critical minerals recovery and refining facilities amid uncertain and volatile market conditions.Midstream projects like Nyrstars gallium and germanium recovery plant are struggling to secure financing in the face of steep competition from Chinese firms that have a history of pricing out Western competitors.62 Federal tax credit programs signal to the private sector that the government is supportive of the industry and offer an additional cash incentive boost to projects that may otherwise stall.These incentives should apply to both domestic projects as well as ones in strategic allied countries that have high potential for gallium and germanium production,such as Australia and Peru.An incentives package should also include grant funding similar to the large dollar amounts currently being awarded by the CHIPS Program Office within the Department of Commerce for onshoring semiconductor fabs.The U.S.government can incentivize mining companies to make significant investments in gallium and germanium recovery and refining facilities and infrastructure by alleviating some of the capital burden.Just as semiconductor manufacturing facilities require an immense amount of capital,standing up domestic gallium and germanium mining,processing,government stockpiling efforts through the National Defense Stockpile under the Strategic and Critical Materials Stock Piling Act of 1939.The United States currently stockpiles no gallium and only about 14,000 kg of germanium,or half of the countrys annual consumption.56 However,stockpiling semiconductor metals to address critical minerals supply chain vulnerabilities will be challenging due to their price volatility and the small quantities needed for the industry(relative to the electric vehicle industry,for example,which requires significant quantities of base metals).57 In addition,gallium has a shelf life of only around one year due to its low melting point.58 Stockpiling efforts are therefore not the best solution to addressing supply chain concerns.Instead,the United States should consider the following actions:Invest in building the technological know-how for gallium and germanium refining.Refining these minerals to needed purity levels of over 99.99 percent for the semiconductor industry requires specific technology,infrastructure,and expertise,all of which are currently lacking.The United States has only one company that refines high-purity gallium and one operation for germanium.59 A research and development laboratory could boost innovation to increase processing capacity and produce minerals in a more cost-effective way.The Department of Energy already funds laboratories focused on critical minerals for electric vehicles(EVs)and clean energy,but there is less focus on semiconductor minerals such as gallium and germanium.For example,the Critical Minerals Innovation Hub at the Ames National Laboratory in Iowa and the Minerals to Materials Supply Chain Research Facility(METALLIC)network bring together the expertise of several leading national laboratories to find solutions to critical minerals supply challenges for clean energy industries.60 The Department of Commerce should fund similar initiatives focused on minerals for the semiconductor industry.National laboratories can help develop the capabilities,technologies,and skills needed to produce refined semiconductor minerals at scale.Put together a comprehensive incentives package powering technology/gracelin baskaran and meredith schwartz16and refining infrastructure will require massive investment.These projects are not only essential to boosting supply chain security for the high-tech industries downstream that depend on critical minerals,but they will also create jobs,onshore manufacturing capacity and niche skills,and help revitalize mining communities that have been economically left behind.CONCLUSIONThe success of the Western semiconductor industry depends on reliable access to the critical minerals that are responsible for continuous advancements in the industry.The CHIPS and Science Act of 2022 sought to build a domestic ecosystem for a thriving semiconductor industry that is invulnerable to the supply chain risks of the past.But this strategy was incomplete,as there has been no U.S.policy to date addressing the mineral needs of chips manufacturers.As China imposes mineral export restrictions and squeezes supply,policymakers can no longer afford to overlook mineral security.A comprehensive incentives package is needed to build research and development institutions and boost the upstream and midstream capacity needed to onshore and friend-shore gallium and germanium production.powering technology/gracelin baskaran and meredith schwartz17securing the nation /matthew d.zolnowskiCHAPTER 3Securing the NationMineral Needs for the Defense Industrial BaseBy Matthew D.ZolnowskiAnton Petrus via Getty Images18assumptions about the conflicts in which the DOD may be called to fight.Though defense planners historically focused on protracted conflict,the DOD has drifted toward a more optimistic policy baseline:a single-year conflict followed by a multiyear reconstitution period.Even under this more optimistic baseline,the DOD has identified significant supply deficits to defense requirements during a national emergency scenario,covering 69 materials and valued at$2.41 billion.63 In addition to the large-scale industry investments previously noted,these findings have prompted the DOD to embark on wide-ranging reforms to its critical minerals stockpiling law,as well as to tighten procurement restrictions to reduce reliance on adversarial nations for critical minerals.Though the DOD has made significant strides in modernizing statutory authorities and deploying an array of programs to address its critical minerals needs,many of its planning processes related to requirements generation and industrial mobilization remain rooted in the immediate postCold War period.Maintaining the positive progress to date,while reviewing and updating those policies and programs that have not kept pace,should be the DODs next area of focus.THE SPECTRUM OF MILITARY ACTIVITIES REQUIREMENTS GENERATIONThe spectrum of activities undertaken by the U.S.Armed Forces is vast.They conduct military-to-military diplomacy,peacekeeping operations,and potential combat operations,ranging from raids by special operations forces to the deployment of a multinational force for large-scale conventional war.Amid this extreme variability,the DOD has developed a structured process to collect critical minerals data and evaluate which minerals are necessary for both essential civilian and defense industries across a range of scenarios.The DOD has made no public report of its critical minerals needs since 2015,but the results of its assessments are disseminated across the U.S.government every two years.64As the furthest upstream tier of defense supply chains,critical minerals support virtually all Department of Defense(DOD)activities and platforms,whether through indirect consumption,such as a rare earth catalyst for petroleum refining,or direct consumption,such as aluminum and titanium parts in an aircraft.In some cases,the critical minerals supporting a defense system are indistinguishable from those used in civilian products;in others,critical minerals are converted into military-unique formulations that enable a weapon systems cutting-edge performance.However,this critical minerals consumption pattern is a constant for all military organizations throughout human historywhether using bombs and bullets,shot and pike,or sling and stone.Therefore,incorporation into a weapon system is not,by itself,sufficient reason for critical minerals to be deemed essential to national defense.This type of usage certainly would not justify the DODs deployment of over$1 billion since 2019 under the Defense Production Act(DPA)of 1950 and other authorities to expand domestic and allied production of critical minerals.With this contradiction in mind,this chapter aims to describe the process by which the DOD determines whether a critical mineral rises to the level of a national defense requirement,as well as how the DOD and industry are addressing such needs.In its simplest form,the DODs assessment of the“criticality”of a critical mineral is directly connected to the National Defense Strategy and its policy The defense industrial base is at risk of critical minerals shortages in an emergency,with industrial mobilization doctrine and program execution mired in a peace dividend posture.securing the nation /matthew d.zolnowski19demonstrated by multi-decade counterinsurgency campaignsand that an industrial base specialized toward a small,highly sophisticated fighting force will struggle to grow in a protracted conflict.In the“long war”argument,important factors such as where and how U.S.Armed Forces may fight remain highly uncertain.Ultimately,this uncertainty drives hedging behavior,using stockpiles to mitigate demand for conflict surge items or minerals until new wartime production can come online.From the initial promulgation of the Strategic and Critical Materials Stock Piling Act,the combination of World War II and Korean War experiences led U.S.government planners to favor a“long war”planning construct.A five-year war scenario drove the creation of large NDS inventories and broad industrial mobilization activities under the DPA.As the Cold War progressed,subsequent administrations embraced more optimistic war-planning and economic policy judgments,each driving the U.S.government toward smaller critical minerals stockpiles and industrial preparedness efforts.67The“short war”planning construct adopted at the end of the Cold War remains the DODs baseline for critical minerals requirements generation todaya one-year conflict,followed by three years to reconstitute the U.S.Armed Forces.68 Based on these results,the DOD has implemented an array of critical minerals mitigation programs,principally focused on aerospace,operational energy,and armor needs(see Table 1).69Notwithstanding the breadth of critical minerals mitigation programs underway,the unclassified summary of the“base case”results from the Strategic and Critical Materials 2023 Report on Stockpile Requirements identifies ongoing critical minerals requirements in a national emergency.This recent DOD study identified shortfalls to defense requirements for 69 materials,valued at$2.41 billion,and shortfalls to essential civilian demand for 24 materials,valued at approximately$12.21 billion.70More simply,these results suggest that substantial portions of the DODs“short war”critical minerals needs remain unaddressed.At a high level,this process begins with the collection of economic and technical data related to critical minerals markets.This data is integrated by the Defense Logistics Agency(DLA)Strategic Materials,the administrator of the National Defense Stockpile(NDS),for analysis through a series of economic models.These models project the anticipated supply and demand of critical minerals over a given period,after which supply and demand are perturbed.These perturbations are driven by policy judgments related to the execution of a military conflict scenario used for DOD budgetary and planning purposesunderpinned by the National Defense Strategy.The elements described in this scenario include the following:the duration of the conflict the military force deployed combat losses military,industrial,and essential civilian demand shipping losses the availability of foreign supply domestic industrial mobilization civilian austerity measures65Each of these elements is highly subjective,and historically these parameters have been hotly debated between defense planners concerned about a protracted war and those who expect conventional wars involving the U.S.Armed Forces to end quickly.66In its Cold War iteration,advocates of a“short war”planning construct argued that a potential conflict between the United States and the Soviet Union would be extraordinarily violent in its initial phases or might rapidly escalate to the nuclear level.In its contemporary iteration,advocates note the overwhelming conventional advantage of the U.S.Armed Forces over most threatsably demonstrated in the First Gulf Warsuggesting conflicts involving U.S.conventional forces are likely to be very short.In either case,industrial preparedness and stockpiling of any kind would be unnecessary,as the conflict may end before these efforts could impact its outcome.In contrast,the legacy“long war”proponents argue that an asymmetry of conventional military power is an unreliable indicator of conflict durationably securing the nation /matthew d.zolnowski20have remained on autopilot since the end of the Cold War,the industrial base mitigation tool kitand the DOD doctrine governing ithas remained largely unchanged.More specifically,JP 4-05 is almost word-for-word identical from 1995 to the present,and shortcomings in doctrine and practice have yet to be addressed.ContractingDPA Title I requires a U.S.company,and any of its suppliers,to prioritize fulfilling a DOD order over any commercial one.The DOD estimates that it issues approximately 300,000 DPA Title I-rated contracts annually.72 The DOD can also request that DPA Title I ratings be applied to foreign sources,contingent upon local laws and the execution of a“Security of Supply Agreement”with the host government.73 Theoretically,the flowdown of DPA Title I ratings throughout the supply chain should provide the DOD with both traceability and the first“call”on any critical minerals necessary for defense procurement.Despite the“paper”strength of DPA Title I,this authority has significant limitations in practice,all of which would hamper the DODs ability to direct critical minerals supplies to national needs in an emergency.GOVERNMENT AND INDUSTRY MITIGATION TOOLS Given the massive gap between current industrial base capabilities and postulated DOD requirements,the DOD pulls multiple levers to address day-to-day and future planning for critical minerals supply chain risk mitigation.Many of these levers are described in Joint Publication 4-05:Joint Mobilization Planning(JP 4-05),and in its most recent iteration,the principal industrial mobilization tools listed by the DOD include the following lines of effort:actively employ DPA Title I to prioritize DOD contracts or allocate scarce materials to defense contracts expand military production and supporting sectors(e.g.,workforce development)draw upon Canadian industrial capacity to supplement U.S.production obtain other allied weapons production support obtain waivers or exemptions from U.S.environmental laws to facilitate the above71However,just as planning assumptions for NDS functions Table 1:Critical Minerals Mitigation ProgramsMineralSample Use CaseAluminumAerospace alloys(lightweighting),armorAntimonyAmmunition,fire retardantsBerylliumAerospace alloys(lightweighting,non-sparking)BoronArmorCobaltBatteries,aerospace alloys(engines)GermaniumSpace-based solar cellsGraphiteBatteriesLithiumBatteriesMagnesiumAerospace alloys(lightweight)ManganeseBatteriesNickelBatteriesNiobiumAerospace alloys(engines),shipbuilding steelSteelArmorTinElectronicsTitaniumAerospace alloys(structural and engines)TungstenAmmunition,cutting implementsRare earth elementsControl and actuation systems,ceramic materialsSource:Authors analysis of awards under Catalog of Federal Domestic Assistance(CFDA)12.777 Defense Production Act Title III,retrieved from USASpending.gov.securing the nation /matthew d.zolnowski21rule,”only one of the four covered critical minerals may utilize domestic recycled feedstock.77 StockpilingSurprisingly,stockpiling is hardly mentioned in JP 4-05.The limited references include one-off statements that(1)DPA Title I can compel delivery to stockpile contracts;(2)stockpiles should exist;(3)stockpiles should be released once mobilization begins;and(4)stockpiles should be rebuilt once the mobilization period ends.No other analysis or discussion of stockpile planning or management appears.Though this brevity is refreshing,it also highlights a significant gap between DOD doctrine and NDS planning.As previously noted,NDS planning is driven by a short-war requirement,plus a long-term reconstitution phase.However,DOD doctrine calls for rapid in-crisis stockpile releases,with an indeterminate reconstitution phase.Put another way,the NDS stockpile sizing construct focuses on replacement once the fight is over,while Joint Staff doctrine wants to buy time during the emergency until other industrial base expansion programs come online.Although the requirements generation process for stockpiling and overall doctrine have remained static,the underlying Stockpiling Act has not.The DOD requested significant reforms to this law for the FY 2023 National Defense Authorization Act(NDAA),and Congress has proceeded to implement these changes across the FY 2023 and FY 2024 NDAAs.Among other elements,this reform aims to infuse private sector best practices into stockpile management while removing statutory barriers to more efficient government operations by:consolidating multiple DOD critical minerals policy oversight boards into a new“Strategic and Critical Materials Board of Directors”authorizing multiyear procurements and general acquisition of shortfall materials authorizing off-take agreements from DPA Title III industrial base investment projects supporting feasibility studies for new critical minerals projects expanding the scope of potential NDS research project applicants to include U.S.allies78For example,DPA Title I ratings only apply to U.S.companies and,by request,select U.S.allies.Any nation outside this circlean adversary or otherwiseis under no obligation to support the DODs needs.As indicated by the volume of DPA Title I ratings,contracting and the incorporation of critical minerals sourcing requirements into such contracts is the most common tool for managing supply chain risk.Two of the most well-known critical minerals sourcing regulations are(1)the“specialty metals clause,”the colloquialism for a 1973 rule requiring the purchase of aerospace alloys and steel from U.S.or allied sources,and(2)the“sensitive materials rule,”a 2019 rule that prohibits the purchase of refractory metals and rare earth permanent magnets from China,Russia,North Korea,and Iran.74Historically,defense contractors have been at odds with the metals and mining sector over these procurement rules.Broadly,the domestic metals and mining sector tends to favor rules that may drive defense spending toward their facilities,which may be more costly than foreign ones.Defense contractors,on the other hand,tend to oppose rules that may complicate subcontract management and compliance costs.Particularly when a subcontractor principally serves the commercial market,DOD-unique critical minerals sourcing rules may deter participation in defense contracts.Whenever Congress has required the DOD to implement a new critical minerals sourcing rule,the timeline for implementation has been lengthy and subject to intense advocacy campaigns.For example,reaching a final rule on the“specialty metals clause”was the subject of ongoing regulatory and legislative advocacy for almost a decade.75 A similar battle is currently underway over the“sensitive materials rule.”76These two rulesthe“specialty metals clause”and the“sensitive materials rule”also highlight the well-intentioned but often inefficient promulgation of new critical minerals sourcing mandates.For example,samarium-cobalt permanent magnets are covered under both the“specialty metals clause”and the“sensitive materials rule,”but since the DODs implementation of the newer“sensitive materials rule”is executed on a contract-by-contract basis,ensuring contract compliance is highly complex and costly.Similarly,recycling is an important source of domestic production of critical minerals,but under the“sensitive materials securing the nation /matthew d.zolnowski22projects funded by the Industrial Base Fund(i.e.,the Innovation Capability and Modernization(ICAM)program),feasibility or commercial scaling projects funded by the Defense Production Act Fund,and various military servicespecific organic industrial base funds.81Historically,industry has expressed its frustration with the DODs inability to bridge the“Valley of Death,”where the DOD supports early-stage development of an innovative technology or product but cannot transition it to procurement by a program of record.This frustration has also been directed toward the aforementioned industrial base investment programs.However,the DOD has several recent case studies in the critical minerals sector that provide reason for optimism,with multiple companies successfully transitioning from early-stage research to commercial-scale production with or through the DOD(see Table 2).In alignment with JP 4-05,the DOD also has awarded defense industrial base investment funds to Canadian companies,who have been considered a“domestic Prior to these changes,the Stockpiling Act had remained largely untouched since 1979,and the DOD is only beginning to implement many of these reforms.79 On the other hand,though the NDS is authorized to carry out these new functions,new funding has slowed to a trickle.After a significant one-time appropriation of$125.0 million in FY 2022 and$93.5 million in FY 2023,FY 2024 funding collapsed to only$7.6 million.These funding increments are wholly insufficient to meet the shortfall requirements for defense($2.41 billion)and essential civilian needs($12.21 billion)in a national emergency.80 Industrial Base Investment ProgramsPivoting to industrial base investment,the DOD offers an array of programs to foster the development of new critical minerals production technologies,sources of supply,and end use items for the military services.Among these are Small Business Innovation Research(SBIR)programs,basic research and qualification projects funded by the NDS,pilot or prototype demonstration Table 2:Critical Minerals Transition ProgramsCompanyDevelopment ProgramScaling ProgramRare Earth Salts Separations&Refining LLC DLA:($8.4 million)Rapid Innovation Fund demonstration DLA:($0.2 million)basic R&D study DPA Title III:($4.2 million)terbium recycling programMP Materials Corp.ICAM:($0.6 million)heavy rare earth demonstration ICAM:($35.0 million)heavy rare earth scalingLynas USA,LLC ICAM:($0.6 million)heavy rare earth demonstration ICAM:($258.2 million)heavy rare earth scalingNoveon Magnetics Inc.DLA/SBIR:($1.0 million)magnet recycling and production demonstration DLA/SBIR:($1.6 million)qualifying magnets for Excalibur,Peregrine,JDAM,and Small Diameter Bomb DPA Title III:($0.8 million)magnet inventory demonstration DPA Title III:($28.8 million)magnet productionGraphite One(Alaska)Inc.DPA Title III:($37.3 million)feasibility study Department of Energy,Loan Program Office:($201 million)direct loan applicationPerpetua Resources Idaho Inc.DPA Title III:($59.2 million)feasibility study Army/DLA:($15.7 million)qualification study Export-Import Bank:($1.8 billion)direct loan letter of interestTalon Nickel(USA)LLC DPA Title III:($20.6 million)nickel resource development Department of Energy,Manufacturing and Energy Supply Chains:($114.8 million)nickel processingSource:Authors analysis of awards posted at FPDS-NG and USASpending.gov and press releases by the DOD and company awardees.securing the nation /matthew d.zolnowski23antimony project in Idaho and South32s zinc-manganese project in Arizona.89 Given the limited dataset,it is not possible to determine whether inclusion on the FAST-41 dashboard provides a meaningful benefit to project development or whether other factorssuch as a U.S.government award from the DOD or another agencyare more decisive.RECOMMENDATIONSFirst,the Joint Staff and DOD critical minerals programs need to update their war planning assumptions.Senior DOD leadership,civilian and military,has clearly stated that the DOD must begin to prepare for a protracted conflict,but this view has not been reflected in the warfighting scenarios that the NDS uses for requirements generation.90 Without needed updates to war planning,DOD base budget requests will continue to grossly underestimate critical minerals needs.Therefore,the Joint Staff should develop a war-planning scenario suitable for NDS planning to reflect DOD policy and generate more realistic estimates of defense requirements for critical minerals.Second,the Joint Staff and DOD industrial investment and stockpiling programs should realign doctrine and program execution.The industrial base management sections of the mobilization doctrine generated by the Joint Chiefs of Staff,JP 4-05,have not changed since 1995.The document does not reflect lessons learned from(a)industrial base expansion efforts to respond to the Covid-19 pandemic or provide military assistance to Ukraine,(b)related medical or war reserve inventory distribution challenges,or(c)the management of DPA Title I allocations of scarce materials to the domestic market.91 Moreover,the objectives established in the current doctrine(i.e.,provide in-crisis response)are not matched by the NDS requirements generation process(i.e.,provide for reconstitution of forces).Therefore,the Joint Staff and civilian components of the DOD responsible for industrial mobilization should update JP 4-05 or develop new doctrine to reflect how the department is likely to respond to a mobilization event.Third,the DOD should stabilize funding for critical minerals in the base budget.The DOD has made significant progress in supporting the upstream supply source”since 1992.82 Additionally,Congress amended the DPA to expand the scope of eligible foreign allies to include the United Kingdom and Australia.83 Though a handful of Canadian firms have received DPA Title III awards,the legislative change for the United Kingdom and Australia is sufficiently recent that no such companies have received a DPA Title III award to date.84Notwithstanding this apparent success in supporting critical minerals development through the Trump and Biden administrations,70 percent of DOD funding for critical minerals projects$778 million of$1.1 billionhas been derived from supplemental appropriations.85 In other words,Congress is the principal driver behind the DODs investments in critical minerals,not the DODs bottom-up requirements generation and budgetary process.To that end,recent DOD budget requests suggest that critical minerals investment funding will fall to approximately$30 million per year.86 Based on recent DPA Title III awards for critical minerals,this level of funding is sufficient to execute perhaps one or two“feasibility study”projects per year.Waivers or Expediency Under Other Domestic LawsWith respect to other authorities to waive domestic laws or otherwise expedite critical minerals projects,the DOD does not appear to have pursued or received authorization under extant pathways for regulatory relief in U.S.environmental laws.These include,for example,national security or paramount interest pathways under the Endangered Species Act and the Clean Air Act.87 However,additional information on DOD recommendations regarding U.S.environmental laws may be forthcoming through the FY 2025 NDAA.88 Namely,the U.S.House of Representatives included a requirement for the DOD to report on the impact of the National Environmental Policy Act on the largest defense industrial base projects.Environmental regulation aside,the DOD also does not appear to have actively pursued or promoted other nonregulatory pathways to streamline permitting activities for its projectscritical minerals or otherwise.Of note,only two DOD industrial base investment projects are included on the FAST-41 Covered Projects Dashboard:Perpetua Resources securing the nation /matthew d.zolnowski24in defense or essential civilian industry needs in a postulated wartime scenario.However simple that question may be,the answer is highly susceptible to subjective policy judgments,which flow directly from the DODs National Defense Strategy.Over the past seven decades,U.S.defense policy has trended toward a more optimistic appraisal of the availability of foreign sources and the severity of a conflict involving the U.S.Armed Forces.This pendulum is now swinging in the opposite direction,with a greater focus on protracted conflict.DOD planning and posture are beginning to change for the better,particularly for rare earth elements and battery minerals.However,the preponderance of the DODs efforts is funded by out-of-cycle supplemental appropriations acts.Critical minerals have not yet become a mainstay of the departments base budget,nor has DOD doctrine and program execution materially evolved from its immediate postCold War posture.On balance,the DOD and defense industry have notched major accomplishments to secure their supply chain for critical minerals.Fully addressing this challenge,though,is a marathon,not a sprint,and the work of the DOD,Congress,and industry in this realm has only just begun.chain across numerous minerals.Though these efforts only began in earnest in 2019,DOD prime contractors and major subcontractors are already integrating new domestic sources into DOD programs of record.92 However,most of this success is being carried by one-off supplemental appropriations acts,which do not provide predictability to industry or the DOD for investment planning.Therefore,the congressional defense committees should continue to provide discrete program increases or“functional transfers”for critical minerals projects within industrial mobilization programs,such as the Defense Production Act Fund,the Industrial Base Fund,and the National Defense Stockpile Transaction Fund.Fourth,the DOD should streamline critical minerals sourcing rules.Given rising concerns related to the United States reliance on adversarial sources,Congress continues to legislate mandates for the DOD to restrict sources of supply for critical minerals and end-use items containing critical minerals.In some cases,the same mineral is covered under multiple sourcing rules simultaneously,with nonsensical exception structures.93 This constantly shifting regulatory regime places a significant cost burden on all tiers of the defense industrial base,with the compliance burden especially acute at the prime contract level,given that noncompliance occurs many tiers removed from the prime contractor.Therefore,the DODs Office of Defense Pricing,Contracting,and Acquisition Policy should undertake an acquisition reform study focused on critical minerals sourcing.At a minimum,this study should identify the extant Defense Federal Acquisition Regulation Supplement rules and their underlying legislation for critical minerals products,describe these rules use and exception structures,and then develop a streamlining legislative proposal for Congress.As appropriate,this proposal also should include requests for funding to support the development of military specifications,standards,or other industry-led initiatives to validate sub-tier supplier compliance.CONCLUSIONAs explored in this chapter,the central question regarding the“criticality”of a critical mineral to national defense is whether the DOD finds a classified shortfall securing the nation /matthew d.zolnowski25CHAPTER 4Driving InnovationCritical Minerals and the Automotive IndustryBy Duncan Wood and Alexandra Helfgottake1150 via Adobe Stockdriving innovation /duncan wood and alexandra helfgott26driving innovation /duncan wood and alexandra helfgottMoreover,the uncertainty currently affecting the EV industry in the United States has a knock-on effect on the global market for critical minerals,particularly regarding U.S.and allied countries investments in the critical minerals supply chain.This chapter will examine the drivers of growing demand for EVs,the knock-on effects on demand for critical minerals,and the challenges facing the supply chain.It will also highlight the importance of innovation in the EV battery sector to reduce the industrys vulnerability to interruptions and shortcomings in the critical minerals supply chain.A combined approach of reducing demand for critical minerals through innovation,boosting domestic supply of those minerals,and working closely with allies to secure U.S.supply chains will provide certainty and stability for the market,protecting U.S.investments,jobs,and competitiveness.THE IMPORTANCE OF THE AUTOMOTIVE MARKET IN THE UNITED STATES AND NORTH AMERICAThe auto industry is a cornerstone of North American trade,accounting for 22 percent of total trade under the United States-Mexico-Canada Agreement(USMCA).94 It supports a staggering 42.2 million jobs across the region,both directly and indirectly.95 In the United States,the industry directly employs 9.7 million people and supports an additional 11 million indirect jobs,highlighting its critical role in the nations economy.96 In Mexico,the sector provides 1 million direct jobs and contributes to 20 million indirect positions,underscoring its importance in driving economic development.97 Canada,while smaller in scale,still benefits significantly,with 500,000 jobs tied to the industry.98 This interconnected workforce demonstrates the auto sectors immense economic impact and its role as a vital driver of prosperity across North America.In 2023,North America produced approximately 3.6 million EVs,and the industry created over 200,000 direct EV-related jobs across manufacturing,battery production,and infrastructure development.99 It is The development of the electric vehicle(EV)industry has been the single biggest driver of critical minerals demand growtha trend that is expected to continue for years to come.This demand growth has been fueled by government incentives at both the national and subnational levels globally.However,given the inherently international nature of the EV supply chain,U.S.EV manufacturers are concerned about disruptions stemming from rising geopolitical tensions.The EV industrywhich has mobilized significant investment and created nearly 100,000 jobs in recent yearswill require uninterrupted access to the materials needed to produce batteries and motors.As the Trump administration takes office,the future of the EV industry is clouded by uncertainty,with serious questions regarding the outlook for existing consumer and production incentives.The proximity of Tesla CEO Elon Musk to U.S.president Donald Trump may influence this decision,but more important will be the rationale for continued support in the context of economic security,strategic competition with China,and U.S.jobs.It is clear that U.S.automakers are already committed to the transition to EVs and hybrid vehicles,having invested billions of dollars over the past four years in building gigafactories across the United States and the rest of North America.Uncertainty for the sector also stems from shifts in consumer preferences and interest rates,technological advancements in battery chemistries,and a slower-than-expected expansion of the charging network.The single biggest determinant for key minerals such as lithium,graphite,cobalt,nickel,and manganese is consumer demand for EVs themselves.27processed in these countries will increase from 40 percent in 2023 to 80 percent by 2027.105 Starting in 2025,batteries utilizing critical minerals mined or processed by foreign entities of concern(primarily referring to Chinese-owned firms)will not be eligible for the tax credit.The other portion of the EV credit applies to vehicles with batteries manufactured or assembled in North America,with the percentage of components manufactured in the region set to increase over timefrom 50 percent in 2023 to 100 percent by 2029.106 The inclusion of this requirement in the IRA underscores the regions importance in the auto industry and emphasizes the critical role of regional integration in strengthening the industry.Recent TrendsSince the passage of the IRA,the United States has seen considerable growth in EV sales,reaching 7.9 percent of total sales in 2023.107 Driven largely by these incentives,sales of EVs have risen significantly in recent years in the United States.Despite a slow year in 2023,sales of EVs in the United States have rebounded rapidly in 2024.In the third quarter of 2024,EV sales increased by 11 percent year-on-year,while EVs as a share of all automotive sales in Q3 reached 8.9 percent.108 The EV industry will soon account for a tenth of all auto sales in the United States.However,progress has been far from linear.According to the U.S.Energy Information Administration,sales of hybrid,plug-in hybrid,and battery electric vehicles(BEVs)grew to over 16 percent of total new light-duty vehicle sales in the United States in 2023.109 In the first part of 2024,however,EV sales declined,with nearly a 1 percent decrease in hybrids,plug-in hybrids,and BEVs sold in the first quarter of 2024 compared to the fourth quarter of the previous year.110 This decrease in demand for EVs in 2023 and 2024 has pushed automakers to rethink their strategies,particularly as hybrid vehicles gain more traction.Despite the fact that sales of EVs have risen significantly in the United States,these figures are disappointing compared to global numbers.In China,BEVs are projected to account for 50 percent of all light vehicle sales by the end of 2024an impressive total with far-reaching implications for the global important to note that much of this production relies on cross-border,tariff-free trade under the USMCA.Growing DemandThe single biggest determinant of demand for key minerals such as lithium,graphite,cobalt,nickel,and manganese is consumer demand for EVs themselves.This demand has grown substantially in recent years,with EV sales reaching nearly 14 million cars globally in 2023.100 The International Energy Agency(IEA)estimates that global demand for critical minerals driven by EV production was under 2 million metric tons in 2020 but is projected to exceed 30 million metric tons by 2030,representing approximately 75 percent of the minerals required for clean technology(cleantech).By 2050,EV demand alone is expected to account for over 130 million metric tons,or roughly 90 percent of the total mineral demand for cleantech.However,this growth is mostly concentrated in the United States,Europe,and Chinacountries where the use of personal vehicles is more commonthough EV sales in Southeast Asia and Brazil are picking up speed,largely due to government subsidies and the availability of low-priced Chinese EVs.101 In the United States,major decisions by auto companies to produce more EVs,or even shift to 100 percent EV production,have begun to fundamentally alter the market.General Motors 2021 announcement of plans to transition to 100 percent EV production by 2035 marked a watershed moment for the domestic industry.102 President Joe Bidens goal of having 50 percent of auto sales be electric by 2030 was another signal to the market that demand will grow significantly.103 However,the major factor driving the EV market in recent years has been the Inflation Reduction Act(IRA).The IRA,which is discussed in detail in Chapter 6,provided important tax credits for new EV sales.Section 30D of the IRA includes a$7,500 tax credit specifically for light-duty EVs for individuals earning less than$150,000 or families earning less than$300,000.104 Half of the tax credit is allocated for batteries manufactured with materials mined in the United States or countries with which the United States has a free trade agreement.Notably,materials recycled within North America are also eligible.The percentage of the value of critical minerals mined or driving innovation /duncan wood and alexandra helfgott28important for investors and policymakers to understand that progress will involve leaps forward and some steps back before a more widespread shift to EVs occurs.THE EV SUPPLY CHAINThe first phase of the EV battery supply chain,often referred to as the upstream portion of the supply chain,is raw mineral extraction.This phase is arguably one of the most important,as it forms the fundamental basis of the EV battery.The list of critical minerals essential for EV battery manufacturing is extensive and includes manganese,graphite(and graphene),lithium,nickel,and cobalt,among others.The midstream phase of the EV battery supply chain entails the processing and refining of raw materials.This typically requires high-heat or chemical-based treatments to transform the raw materials into what will eventually be cathode and anode active battery materials.Rare earth metalsa group of 17 elementsare used in various clean energy technologies for their oil and critical minerals markets.According to the Alliance for Automotive Innovation,Chinese EV manufacturing is comparable to the entire output of the U.S.auto industry.111 The story of EV sales in Europe is less straightforward.After rapid growth in 2021 and 2022,2023 saw a slowdown in global EV sales due to rising inflation and the end of government subsidies,particularly in Europe.This was most notable in Germany,where sales dropped by 37 percent in July 2024 following the governments termination of EV subsidies.112 Registrations for hybrid vehicles in Europe reached 24 percent in July 2024,while EV registrations were just 13.6 percentnearly a full percentage point lower than during the same time period the previous year.113 The slowdown in Europe continued throughout the first half of 2024,but EV sales saw an increase in the third quarter.What these statistics show is that linear development of the EV industry is not guaranteed.Although numbers continue to rise,much work remains to drive consumer demand and ensure the industrys sustainability in the United States.While long-term growth is expected,it is Source:Monica Abboud,“U.S.share of electric and hybrid vehicle sales increased in the second quarter of 2024,”U.S.Energy Information Administration,August 26,2024,https:/www.eia.gov/todayinenergy/detail.php?id=62924.Figure 1:Quarterly U.S.Light-Duty Vehicle(LDV)Sales by Powertrain,January 2014June 2024driving innovation /duncan wood and alexandra helfgott29Larger electric car models have a significant impact on battery supply chains and critical mineral demand.In 2023,the sales-weighted average battery electric SUV in Europe had a battery almost twice as large as the one in the average small electric car,with a proportionate impact on critical mineral needs.If all electric SUVs sold in 2023 had instead been medium-sized cars,around 60 GWh of battery equivalent could have been avoided globally,with limited impact on range.Accounting for the different chemistries used in China,Europe,and the United States,this would be equivalent to almost 6,000 tonnes of lithium,30,000 tonnes of nickel,almost 7,000 tonnes of cobalt,and over 8,000 tonnes of manganese.117According to the IEA,copper,cobalt,nickel,lithium,rare earth elements,and aluminum are the minerals in highest demand.118 Demand for these critical minerals is projected to grow fourfold under the IEAs Sustainable Development Scenario by 2040.119 However,this projection is subject to three key external factors:evolving technology,the development and implementation of governments clean energy policies,and the demand for EVs.120 All three factors are currently experiencing a high degree of uncertainty.The two-way connection between the EV market and critical minerals prices is exemplified by the recent collapse in lithium prices,which has impacted the competitiveness of EVs in automotive markets.After peaking at over$79,637 per ton in December 2022driven by soaring demand for EVslithium prices fell to less than$11,000 per ton by September 2024.121 This decline was caused by several factors,including high interest rates,a weak Chinese economy,and market manipulation.Additionally,new resources coming into production globally and lower-than-expected EV sales following the initial surge in the United States,China,and Europe were significant contributors.Stagnating EV sales in 2023 had a profound and rapid impact on the lithium market.For instance,earlier in 2024,Ganfeng Lithium Group reported a net loss of$107 million and announced plans to limit capacity expansions as a“glut of supply overwhelmed slower-than-expected demand growth from electric-vehicle makers,drivingspot carbonateprices to a three-year low.”122“permanent magnetic properties.”114 In the specific case of EVs,they are primarily used in magnets for EV motors and as catalysts for battery fuel cells.Critical minerals processing tends to be regionally concentrated,and it is more common than not for extraction and refining to occur at separate facilities.The third stage in the EV battery supply chain,the downstream phase,involves assembling battery cells into modules,which include battery management systems,electronics,and sensors.These modules are then packaged and sold to automakers,although some manufacturers produce and install their own battery packs.The final process in the EV battery supply chain is reuse and recycling.Reuse entails“disassembly of the pack,testing module/cells,and repackaging.”115 Pyrometallurgy,hydrometallurgy,and direct recycling are currently the three most viable options for lithium-ion battery recycling,though new technological advances are emerging.Both reuse and recycling are logistically challengingnot only from an economic and regulatory standpoint but also in terms of the basic logistics of transporting the batteries.Moreover,the manufacturer-specific nature of the batteries adds to the cost of recycling.EV DEMAND AND THE CRITICAL MINERALS SUPPLY CHAINIt is abundantly clear that the shift from traditional internal combustion engine(ICE)vehicles to EVs will require significantly increased quantities of critical minerals for EV production.Whereas a traditional ICE vehicle uses an estimated 34 kg of critical minerals,an EV uses approximately 200 kg,primarily for the electric motor and battery.116 However,this is likely to change over time as battery size,battery chemistry,modularity,and consumer preferences continue to change.While larger battery sizes may increase mineral demand,shifts in battery chemistry will impact the mix and proportions of metals required in those batteries.The IEA makes the important point that the percentage of electric sport utility vehicles(SUVs)being sold has a significant impact on the critical minerals supply chain:driving innovation /duncan wood and alexandra helfgott30charging network.Persistent consumer concerns about locating charging stations,charging speeds,and the maintenance and distribution of these stations are often grouped under the term“range anxiety.”However,as EV ranges improve with advances in battery technologies,it may be more accurate to discuss charging convenience.Potential EV buyers in urban areas face unique challenges regarding access to charging infrastructure.For example,availability in their neighborhoodsor,more specifically,in apartment buildingsmay be limited.Drivers who lack garages and rely on street parking face even greater concerns about convenience.The Biden administrations National Electric Vehicle Infrastructure program allocated$7.5 billion to the construction of 30,000 charging ports across the United States,with a particular focus on Alternative Fuel Corridors.These funds are intended to be distributed through state governments.However,as of November 12,2024,only 102 charging ports at 25 charging stations in nine states had been opened.128 Several factors have contributed to this slow rollout,but a significant portion of the total fundingaround$4 billionhas already been committed to the states.Consequently,the buildout will accelerate over the next few years,as these funds cannot easily be rescinded by the federal government.THE ROLE OF TECHNOLOGICAL INNOVATIONInnovation in battery chemistry and design is likely to play a crucial role in shaping the demand for critical minerals in the EV industry.While the internal combustion engine evolved slowly over the past 150 years,the EV industry is seeing rapid,profound,and unparalleled advances in battery chemistry,design,and efficiency.Mineral demand for EV batteries depends on the cathode and anode chemistries of the batteries but is ultimately influenced by evolving technologies that have the potential to alter the mineral composition of EV batteries.For example,an NMC(nickel manganese cobalt oxide)battery uses half as much nickel as an NCA(nickel cobalt aluminum oxide)battery but requires Some experts predict that the current oversupply of lithium will last until 2027.123 In the interim,there is hope that new extractionand,more importantly,processingprojects will come into operation around the world,particularly in the United States and U.S.-friendly countries.The difficulty in estimating demand projections is further exacerbated by governments evolving approaches to clean energy policy development and implementation.For example,changes in administrations in the United States and a potential move away from the incentives outlined in the IRA will play a significant role in determining short-term demand.Other factors influencing future EV demand include local-and state-level incentives and regulations.Just as the IRAs clean vehicle tax credits boosted demand for EVs after 2022,Californias rapid shift toward an EV-friendly regulatory framework and higher gasoline prices had a similar effect.While California has the best-known incentives,many other states have followed suit.124 Consumer financing innovations also have the potential to incentivize higher EV sales and end-of-life recycling.In the United States,the IRA succeeded in driving new financing from auto firms such as Hyundai,whose vehicles were not eligible for IRA tax credits.In response,Hyundai implemented its own financing mechanisms to match the value of these credits.At the industry level,there is room for even greater innovation.For example,a recent paper on the cobalt supply chain proposed a“lease-to-recycle”model for batteries to drive EV adoption and enhance the potential for recycling battery metals.125 Private sector funding for EVs and battery facilities has significantly shaped the industrys development in the United States.Between 2018 and 2024,the private sector has announced investments of$90 billion in battery facilities and$33 billion in EV facilities.126 Notably,states with Republican governors have been more successful in securing this funding,with the southern region of the United States receiving over$68 billion in regional investments.In comparison,the Northeast received just$300 million,while the West Coast garnered$13.3 billionwell below the Souths total.127 One additional factor influencing the demand for critical minerals for EVs is the buildout of the driving innovation /duncan wood and alexandra helfgott31density and improved safety by replacing liquid electrolytes with solid materials.The development of solid-state technology will reduce the need for cobalt and nickel but continue reliance on lithium and possibly new solid electrolytes,like lithium metal.b.Graphene-Based Batteries:A technology still in development,graphene batteries involve the integration of graphene into the cathode and anode to significantly improve energy density,charging speeds,and battery life.Often considered a“wonder material”due to its lightweight nature and superior performance in various applications,graphenes high conductivity allows for faster charge transfer,and its durability supports longer-lasting batteries,making it a promising material for future EV battery advancements.A shift to this technology would increase demand for graphite and graphene,the latter being essentially the building block for graphite.c.Sodium-Ion(Na )Batteries:An emerging alternative to Li-ion batteries,Na batteries use sodium instead of lithium as the primary charge carrier.They can be cheaper and more sustainable than lithium(due to the natural abundance of sodium),but they have lower energy density.Na batteries have potential applications in stationary energy storage and some EVs.Growth in their use would reduce dependence on lithium.d.Lithium-Sulfur(Li-S)Batteries:This emerging subset of lithium-ion chemistries has the potential for very high energy density but faces issues with durability and lifespan.Li-S batteries have a higher energy density than traditional Li-ion batteries and rely on sulfur,which is abundant and inexpensive,instead of nickel and cobalt.132Battery design is also an important factor.Currently,EV batteries are relatively standardized across the industry.However,experts anticipate that future developments will introduce modular designs,enabling customers to tailor their batteries to meet specific needs,such as prioritizing extended range or enhanced performance.133 eight times more cobalt.LFP(lithium iron phosphate)batteries,by contrast,require 50 percent more copper than NMC batteries but do not use nickel,cobalt,or manganese.129 NMC batteries typically last around 2,000 cyclesa battery cycle is the process of a battery being fully charged and then discharged
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Global Development Policy CenterChina-Latin America and the Caribbean Economic Bulletin 2024 EDITIONJULY 2024Global Development Policy CenterREBECCA RAY,ZARA C.ALBRIGHT,ENRIQUE DUSSEL PETERSZara C.Albright is a Global China Pre-doctoral Research Fellow at the Boston University Global Development Policy Center and a Ph.D.student in the Political Science department at Boston University,where she studies global development and political economy,specifically in Latin Americas relationship with China.Her current work examines the politics of Chinas large infrastructure investments and related loans,exploring the incentives and tradeoffs facing policymakers in Latin America.Rebecca Ray is a Senior Academic Researcher at the Boston University Global Development Policy Center.She holds a PhD in Economics from the University of Massachusetts-Amherst and an MA in International Development from the Elliott School of International Affairs at the George Washington University.Since 2013,she has focused her work on the nexus of international development finance,particularly Chinas role in reshaping the global financial landscape and on sustainable development,primarily in Latin America.Enrique Dussel Peters is a Professor at the Graduate School of Economics at Universidad Nacional Autnoma de Mxico(UNAM),and is the Coordinator of the Center for Chinese-Mexican Studies(Cechimex)of the School of Economics at UNAM and of the Academic Network of Latin America and the Caribbean on China(Red ALCChina).He holds a PhD in Economics from the University of Notre Dame.Cover:Rio de Janeiro,Brazil.Photo by Sbastien Goldberg via Unsplash.Suggested Citation:Ray,Rebecca,Zara C.Albright and Enrique Dussel Peters.2024.“China-Latin America and the Caribbean Economic Bulletin,2024 Edition.”Boston University Global Development Policy Center.Acknowledgments:This research benefitted greatly from helpful comments by Diego Morro Paredes.China-Latin America and the Caribbean Economic Bulletin|2024 Edition 3CONTENTSEXECUTIVE SUMMARY 4INTRODUCTION 7SETTING THE AGENDA:LAC PRESIDENTIAL VISITS AND AGREEMENTS IN CHINA 8TRENDS IN THE LAC-CHINA ECONOMIC RELATIONSHIP 12TRENDS IN CHINA-LAC MERCHANDISE TRADE 15TRENDS IN CHINESE OUTBOUND FOREIGN DIRECT INVESTMENT IN LAC 21TRENDS IN CHINESE INFRASTRUCTURE IN LAC 27DEVELOPMENT FINANCE AND DEBT 30FUTURE PROSPECTS 33REFERENCES 374 China-Latin America and the Caribbean Economic Bulletin|2024 EditionEXECUTIVE SUMMARYIn 2024,Latin American and Caribbean(LAC)governments took intentional steps forward in their relationships with China,with frequent visits to discuss the important emerging sectors,such as telecommunications and renewable energy supply chains.While lower-technology mineral and agricultural commodities continue to dominate LAC exports to China,Chinese firms operating in LAC have shown a broader array of interests,including automotive manufacturing in Mexico,energy in South America and transportation throughout LAC.These are among the findings of the China-Latin America and the Caribbean Economic Bulletin,2024 Edition.This report provides analysts and observers a reference to the ever-changing landscape of China-LAC economic relations,a landscape where data is not always readily accessible.Key findings:A record eight LAC presidents visited China in 2023,after just one visit in 2022 and none in 2021 or 2020.Major topics covered in these presidential agendas included cooperation in renewable energy and transition minerals,telecommunications,and trade agreements regarding traditional export commodities,such as beef and petroleum.LAC exports to China rose to approximately$208 billion in 2023,while Chinese exports to LAC fell to approximately$242 billion amidst slower Chinese exports overall.As a result,LAC saw its merchandise trade deficit with China shrink to approximately$33 billion,or 0.5 percent of regional GDP.LAC minerals exports to China declined in 2022 amidst lagging Chilean copper output,but that trend partially reversed in 2023.China now accounts for 34 percent of LACs mineral exports.For the first time since China became a major trading partner with LAC,beef entered the ranks of the top five regional exports to China in 2023.This change is due in part to falling prices of refined copper(the traditional fifth largest LAC-China export)but also to rising beef trade,which has doubled in volume in the last five years.Transition minerals continue to play a growing role in the LAC-China relationship.LAC-China exports now account for approximately half of global trade in the unprocessed forms of two major transition minerals:lithium carbonate and copper ores and concentrates.While raw commodities continue to dominate LAC-China exports,the same is not universally true for Chinese investment in LAC.New(“greenfield”)Chinese investment projects in Mexico,Central America and the Caribbean have been predominantly concentrated in manufacturing(particularly automotive)sectors for the last 12 years.This trend continued in 2023 with Solarever investing$1 billion and Ningbo Xusheng Group investing$350 million in electric vehicle and vehicle part manufacturing in Mexico.Minerals continue to play an important role in Chinese investment in South America,where Chengxin Lithium Group and Zijin Mining Group invested$823 million and$600 million in Argentinas lithium sector,respectively.China-Latin America and the Caribbean Economic Bulletin|2024 Edition 5 Chinese investment through mergers and acquisitions(M&As)in LAC were concentrated in energy sectors in 2023,with State Grid Corporation purchasing Enel Peru for$2.9 billion and PowerChina purchasing Brazils Pontoon(and its Cear solar plant)for$360 million.New to the 2024 China-Latin America and the Caribbean Economic Bulletin is consideration of trends in infrastructure contracts:trade in services for building or operating public infrastructure projects.Over the last four years,the most important sector for Chinese infrastructure in LAC has been transportation,particularly in long-distance cargo rail and urban light rail.Chinese development finance to LAC consisted of just$1.3 billion in new commitments in 2023,comprised of two loans from the China Development Bank to its Brazilian counterpart,Banco Nacional de Desenvolvimento Econmico e Social(BNDES).Public and publicly guaranteed(PPG)debt to China is concentrated in a few countries.Suriname,the LAC country with the greatest PPG debt stock to China,owed 14.6 percent of GDP to China in 2022.From 2024-2028,its PPG debt service payments to China are expected to amount to 2.5 percent of exports.However,no country in LAC including Suriname owes Chinese creditors more than it owes other major creditor categories,including bondholders,Paris Club creditors,multilateral development banks(MDBs)or other creditors.Thus,any significant debt restructuring negotiations with countries facing unsustainable debt burdens will need to include significant participation of all creditor classes.LAC-China exports have been relatively buoyed in recent years thanks to rising global commodity prices.However,those elevated prices are not expected to remain high.Thus,over the next few years,LAC is likely to see a rebound in its trade deficit with China unless it sees significant progress in diversification or significant increases in the volume of its commodity exports.As Chinese firms have gained experience operating in LAC,they have relied less on the intermediation of Chinese development finance institutions and instead opted for direct investment or direct provision of infrastructure contracts.Thus,it is unlikely for develop-ment finance to rebound to the levels of its peak years,2009-2015.However,this shift is a sign of the maturation,rather than the weakening,of the China-LAC relationship.The shifts highlighted here toward electric vehicles,rail transportation,renewable energy,transition minerals and agricultural commodities together present mixed prospects for regional sustainable development.While electric vehicles and urban rail play a crucial role in decarbonizing transportation,beef and soy supply chains are drivers of deforestation and the loss of carbon sinks.Transition mineral extraction and renewable energy provision can play positive or negative roles in local sustainable development depending on their design and policy environment.Thus,the growth in government-to-government communication(including the record number of presidential visits to China)is an important precursor to ensuring that the China-LAC economic relationship is a“win-win”for both sides.6 China-Latin America and the Caribbean Economic Bulletin|2024 EditionBuenos Aires,Argentina.Photo by Nestor Barbitta via Unsplash.China-Latin America and the Caribbean Economic Bulletin|2024 Edition 7INTRODUCTIONIn 2024,Latin American and Caribbean(LAC)governments took intentional steps forward in their relationships with China,with frequent visits to discuss the important emerging sectors,such as telecommunications and renewable energy supply chains.While lower-technology mineral and agricultural commodities continue to dominate LAC exports to China,Chinese firms operating in LAC have shown a broader array of interests,including automotive manufacturing in Mexico,energy in South America and transportation throughout LAC.These are among the findings of the China-Latin America and the Caribbean Economic Bulletin,2024 Edition.This report provides analysts and observers a reference to the ever-changing landscape of China-LAC economic relations,a landscape where data is not always readily accessible.This brief introduction is followed by a section describing the record number of LAC presidential visits to China and the economic themes that were most important in these trips and which set the tone for the relationship,particularly telecommunications,commodity exports,infrastructure and renewable energy supply chains.Next,the bulletin provides a comparison of the trends in trade,investment,infrastructure contracts and development finance.Rather than growing in tandem,China-LAC trade,investment and infrastructure have all continued to grow rapidly while Chinese development finance in LAC has receded dramatically.This shift may reflect a maturing of the relationship,as Chinese firms are more likely to work directly in the region rather than requiring the intermediation of Chinese development finance institutions(DFIs).The bulletin then gives a detailed description of trends in each avenue individually:trade,investment,infrastructure and development finance,with emphasis on remaining debt to China from the past decade of borrowing.Finally,the bulletin concludes with discussions of future prospects,including the continued strength of infrastructure and investment,and the implications of these shifts for sustainable development in LAC.8 China-Latin America and the Caribbean Economic Bulletin|2024 EditionSETTING THE AGENDA:LAC PRESIDENTIAL VISITS AND AGREEMENTS IN CHINARecent editions of the China-Latin America and the Caribbean Economic Bulletin(China-LAC Economic Bulletin)have explored the investment,trade and finance goals of LAC countries in their relations with China.In 2023,more LAC presidents made official visits to China than in any previous year,as highlighted in Figure 1,providing a unique opportunity to assess the regional and country-level agendas with China.The presidents of Argentina,Brazil,Chile,Colombia,Guyana,Honduras,Uruguay and Venezuela highlighted a combination of traditional cooperation on infrastructure projects and primary products exports and emerging partnerships in renewable energy and sustainable development.In addition to several cabinet-level ministers and undersecretaries,most visits also included extensive private sector business delegations seeking investment and export opportunities.Figure 1:LAC Presidential Visits to China,2010-202320102011201220132014201520162017201820192020202120222023ARGCHLGUYBOLBRACOLCRICUBBOLMEXSURURYVENMEXCHLARGCRIECUVEN(1)ARGBRAMEXPERURYARGBRACHLMEXPANBOLDOMECUSLVVENBRACOLSLVSURECUARGBRACHLCOLGUYHONURYVENVEN(2)Source:Author compilation.Note:ARG:Argentina;BOL:Bolivia;BRA:Brazil;CHL:Chile;COL:Colombia;CRI:Costa Rica;CUB:Cuba;DOM:Dominican Republic;ECU:Ecuador;GUY:Guyana;MEX:Mexico;PAN:Panama;PER:Peru;SLV:El Salvador;SUR:Suriname;URY:Uruguay;VEN:VenezuelaChina-Latin America and the Caribbean Economic Bulletin|2024 Edition 9LACs economic relationship with China has historically been dominated by two aspects:exports of primary commodities,chiefly agricultural and mining products,and financing for major infrastructure projects,particularly in the energy and transportation sectors.The 2023 presidential visits demonstrated the continued importance of these areas.Brazil,Chile,Colombia,Honduras,Uruguay and Venezuela all signed new phytosanitary protocols for exports of meat,fruit and other foodstuffs.These exports may be bolstered by new or potential free trade agreements(FTAs)with Ecuador,Honduras,Nicaragua and Uruguay,drawing praise from agro-exporting industries and criticism over concerns for environmental degradation and further re-primarization,or return to concentration in low-technology commodity production(Associated Press 2024,Invima 2023,Embajada de Colombia en China 2023,Kaieteur News 2023a,b,MRE 2023,Poder Popular 2024,Presidencia de Uruguay 2023c,Reuters 2023,Xinhua 2023).Telecommunications were also on the agenda during all of LACs presidential visits,with Huawei figuring prominently in these discussions.Presidents Alberto Fernndez(of Argentina),Luiz Incio Lula da Silva(of Brazil),Mohamed Irfaan Ali(of Guyana)and Xiomara Castro(of Honduras)all visited Huaweis research and development center in Shanghai(Casa Rosada 2023b,Kaieteur News 2023,Planalto 2023b,Poder Popular 2024).Chile signed a memorandum of understanding(MOU)with Huawei for cooperation on digital literacy.Argentina,Chile,Colombia and Guyana all courted Chinese investors for their information and communications technology(ICT)sectors.Colombia,Uruguay and Venezuela signed MOUs to collaborate on communications and media projects.LAC countries are taking advantage of Chinese companies expertise in this sector and the relatively low costs they offer for telecommunications infrastructure and technologies.Table 1 illustrates the main agenda items discussed on these visits in order of how many presidents addressed them on their visits.Table 1:Agendas of LAC Presidential Visits to China,2023Agenda itemARGBRACHLCOLGUYHONURYVENTotalTelecommunications8Commodity exports6Infrastructure5Renewable energy,transition minerals5Diplomacy4Green development3BRI Forum2Source:Author compilation.Although specific projects were not announced,infrastructure finance was on the agenda for Argentina,Colombia,Guyana,Honduras and Venezuela(Kaieteur News 2023).For Honduras,financing for the next phase of the Patuca Hydropower project could add to the complex,with earlier stages having been built by Power Construction Corporation of China(PowerChina).In line with Chinas evolving conception of the Belt and Road Initiative(BRI)and its overseas financing commitments,LAC countries are unlikely to see major loans from 10 China-Latin America and the Caribbean Economic Bulletin|2024 EditionChina for infrastructure projects like those of the previous decade(Ray 2023).However,new forms of infrastructure cooperation are possible,especially for renewable energy or telecommunications,two emerging priority areas in China-LAC relations.The involvement of Chinese contractors in urban light rail projects may also reflect an expansion of the Green BRI concept,the implications of which are explored in depth by scholars including Guo,Gallagher and Zhang(2023)and Albright et al(2023).In recent years,Chinese companies have won contracts for sections of Santiago,Chiles Metro Line 7 and Bogot,Colombias Metro Line 1,and the contract for Monterrey,Mexicos metro system(Dussel Peters 2024b).These projects aim to reduce urban congestion and improve sustainable transportation options in some of the regions largest cities.Chinese companies success in these open and competitive bidding processes without accompanying financing from the China Development Bank(CDB)or Export-Import Bank of China(CHEXIM)indicates a continued evolution of Chinas contributions to LACs infrastructure.In more recent years,sustainability and renewable energy supply chains have taken on greater importance in the China-LAC relationship,a trend that was highly visible during 2023s presidential visits.All eight presidents discussed or signed agreements related to renewable energy and sustainable development.Argentina and Chile both emphasized investments in lithium extraction and production of value-added products,such as cathodes and batteries.Brazil,Colombia and Uruguay signed MOUs related to green and sustainable development,including for joint cooperation on green hydrogen projects.Guyana emphasized its desire to play a role in energy security,and China agreed to assist Venezuela with water conservation efforts.Hondurass Patuca hydropower project is an example of a shifting focus towards renewable energy in Chinas overseas energy cooperation.These developments demonstrate the convergence of LACs and Chinas interests to support the energy transition and confront climate change.The rest of this section details each presidents specific agenda and priority areas.In the first of the 2023 presidential visits to China,Brazilian President Lulas April visit included nine cabinet ministers and five provincial governors and aimed to revitalize Brazil-China relations as part of Brazils more activist foreign policy agenda under President Lula(Planalto 2023a).The president also attended the inauguration of former President Dilma Rousseff as the head of the New Development Bank(NDB)and emphasized the growing role of the BRICS countries in the global economy(Prazeres 2023).Key agenda items for this visit were the resumption of Brazilian beef exports to China,an agreement to construct a sixth satellite and a potential peace plan for Russias war in Ukraine(Boadle 2023,Planalto 2023a).Three months after Honduras established diplomatic relations with the Peoples Republic of China in March 2023,President Castro visited China in June where she signed 22 agreements aiming to boost economic opportunities between the two countries(Presidencia de Honduras 2023b).In addition to an MOU joining the BRI,Honduras and China established a joint Trade and Investment Council(Presidencia de Honduras 2023a).Two major agenda items were also the negotiation of an FTA and potential investment for the next phase of the Patuca hydropower project(Cao and Lee 2023;Mistreanu 2023).Negotiations for an FTA began in July 2023,and in February 2024,Honduras and China signed an Early Harvest agreement for tariff-free shrimp exports;the government of Honduras anticipates conclusion of the FTA negotiations in 2024(Poder Popular 2024).China-Latin America and the Caribbean Economic Bulletin|2024 Edition 11In July,President Irfaan Ali of Guyana visited China with an agenda emphasizing Guyanas potential as a partner for China in food security,climate change cooperation and renewable energy(iNews 2023).Guyana has borrowed heavily from China in the past to complete major infrastructure projects,including the Demerara River Crossing and Cheddi Jagan airport expansion project(Kaieteur 2023a,Myers and Ray 2024).Building on this history,the two countries signed an MOU to create an Investment and Economic Cooperation Working Group focused on infrastructure,agriculture,health,energy and education(MFA 2023).In his visit to China in September,Venezuelan President Nicols Maduro and Chinese leader Xi Jinping upgraded the bilateral relationship between Venezuela and China to an All Weather Partnership,making Venezuela the first LAC country to be accorded this status(Xinhua 2023).The joint declaration also highlighted the conclusion of negotiations on a reciprocal investment agreement.Among the 31 additional agreements,the two countries agreed to cooperation in trade,education,tourism,science and technology,health and aerospace development(TeleSUR 2023).Maduro also announced the agendas for later visits of Venezuelan officials to China seeking investments in technology,petroleum development and agricultural projects(Infobae 2023).Argentine President Fernndezs October visit coincided with the Third Belt and Road Forum for International Cooperation,and the headline announcement from this visit was the extension of Argentinas central bank swap line to$6.5 billion(Casa Rosada 2023a,Fernndez 2023).The leaders also announced nearly$10 billion in planned infrastructure financing,to supplement the previously announced$14 billion alongside Argentinas adhesion to the BRI in 2022.Lithium investment and renewable energy were also high on President Fernndezs agenda.He met with five mining companies Gotion Argentina,PowerChina,CST Mining,Tsingshan and Tibet Summit Resources to discuss existing and potential investments in lithium extraction and processing and battery production(Casa Rosada 2023b).After a campaign characterized by strong political rhetoric criticizing China,the election of President Javier Milei in December 2023 led to an initial cooling of the bilateral relationship between Argentina and China.Since January 2024,however,there have been signs that pragmatism may prevail for both sides.Argentinas Minister of Foreign Affairs Mondino travelled to China in April 2024,and China approved a yearlong extension of the$5 billion swap line in June 2024(BRCA 2024,MRECIC 2024).President Gabriel Boric of Chile attended the Third Belt and Road Forum for International Cooperation in October,continuing the tradition of Chilean presidents attending these forums.During the visit,the seven government authorities travelling with the president signed 13 agreements ranging from agriculture and aquaculture to education and digital literacy(MSGG 2023).President Boric also attended the opening ceremony of ChileWeek,Chiles annual export and investment promotion event in China.The agenda was dominated by cooperation for the energy transition,lithium investments and telecommunications,(Urdinez and Montt 2023)and during the visit,President Boric announced China Yongqing Technology Co.Ltd.as the second company selected under CORFOs lithium value-added tender(MEFT 2023).The$233 million investment will construct a lithium cathode production plant in Antofagasta and allow Yongqing to access preferential prices from Chilean lithium producer Sociedad Qumica y Minera(SQM).Colombian President Gustavo Petro visited China just after the Belt and Road Forum,and though the two countries discussed infrastructure cooperation,particularly the Bogot metro 12 China-Latin America and the Caribbean Economic Bulletin|2024 Editionproject,they did not sign an MOU for Colombia to join the BRI(Rodrguez 2023,Myers 2023).During the visit,12 agreements were signed,including phytosanitary protocols for exports of Colombian beef and quinoa,the former of which had been under negotiation for nearly a decade(Cancillera 2023;Invima 2023).Alongside other agreements in trade,ecological development,the digital economy,agriculture,science,education and culture,Colombia and China also established a Strategic Partnership(Embajada de Colombia 2023;Declaracin Conjunta 2023).Uruguayan President Luis Lacalle Pous visit in November featured the signing of 24 agreements,including one elevating the bilateral relationship to a Comprehensive Strategic Partnership(Presidencia de Uruguay 2023a).The two leaders also discussed progress on the negotiation of a potential FTA,covered in last years edition of the China-LAC Economic Bulletin(Albright,Ray and Liu 2023,Presidencia de Uruguay in El Pas 2023).Eight other government officials travelled with President Lacalle Pou to China(Presidencia de Uruguay 2023b).The other agreements included easing trade through updated phytosanitary protocols for beef,sheep and goat meats,citrus fruits,and live seafood exports(El Pas 2023).The two countries also signed MOUs on green development and energy cooperation.TRENDS IN THE LAC-CHINA ECONOMIC RELATIONSHIPThe China-LAC Economic Bulletin has been tracing this economic relationship for over a decade.In that time,the relative importance of trade with China and Chinese development finance,infrastructure and outbound foreign direct investment(OFDI)have shifted significantly,as Figure 2 shows.Figure 2 traces the importance of each of these pathways as a share of the LAC economy.It does so in four-year periods,ending with the 2020-2023 period,to reflect the significant changes in the global economy after the outbreak of the COVID-19 pandemic and subsequent economic turbulence.Figure 2A follows the rising importance of merchandise trade with China.LACs exports to China have roughly doubled as a share of LAC gross domestic product(GDP)in the last decade,while Chinas exports to LAC have risen by 70 percent1.Figure 2B extends the analysis to Chinese development finance,OFDI and infrastructure provision in LAC.These categories of activity have not grown in tandem but instead demonstrate a significant shift away from development finance and toward Chinese firms direct provision of infrastructure in LAC.Chinese firms infrastructure provision in LAC has more than tripled as a share of LAC GDP over this period,while development finance has fallen dramatically.Chinese OFDI in LAC has grown at a more moderate pace,rising by about one-third in importance.This shift from sovereign finance to direct provision of services may reflect a maturation of the China-LAC relationship.As Akhtar et al(2023)note,the levels and types of firm risk exposure differ greatly among these various approaches to project development.While sovereign finance carries repayment risk,direct infrastructure provision also carries project risks and equity investments carry risks all along the project lifecycle.Thus,as Chinese firms gain experience operating in the region,they have taken on more project risk and relied less on the intermediation of development finance institutions(DFIs),shifting toward contracting directly 1Except where otherwise specified,trade data is measured as reported by the exporting partner rather than the importing partner(for example,Chinas exports to LAC rather than LACs imports from China).This choice highlights the value of the merchandise itself by excluding the costs of shipping and insurance,which are paid by importers and which can vary significantly with fuel costs.China-Latin America and the Caribbean Economic Bulletin|2024 Edition 13for infrastructure projects and taking on equity stakes through FDI.Each of the pathways of economic interaction shown in Figure 2 merchandise trade,development finance,OFDI and infrastructure provision is described in turn in the sections that follow.Figure 2:China-LAC Economic Activity Relative to LAC GDP,2012-20232A.China-LAC Merchandise Trade Relative to LAC GDP,2012-20232.2%2.8%4.1%1.6%2.1%3.2%0.0%1.0%2.0%3.0%4.0%5.0 10-20142015-20192020-2023Percent of LAC GDPChina-LAC exportsLAC-China exports2B.Chinese development finance,infrastructure contracts and OFDI in LAC,2012-20240.21%0.14%0.01%0.05%0.06%0.10%0.06%0.13%0.16%0.00%0.05%0.10%0.15%0.20%0.25 10-20142015-20192020-2023Percent of LAC GDPChinese development finance in LACChinese outbound FDI in LACChinese infrastructure contracts in LACSource:Author calculation from Dussel Peters(2024a,b),IMF(2024),Myers and Ray(2024),UN DESA(2024).14 China-Latin America and the Caribbean Economic Bulletin|2024 EditionBogota,Colombia.Photo by Random Institute via Unsplash.China-Latin America and the Caribbean Economic Bulletin|2024 Edition 15TRENDS IN CHINA-LAC MERCHANDISE TRADEAdvances in Trade AgreementsThe 2023 China-LAC Economic Bulletin outlined the state of several new and ongoing negotiations for FTAs between China and LAC countries(Albright,Ray and Liu 2023).Over 2023,important advances occurred in the FTAs with Ecuador and Nicaragua.Ecuador and China had previously concluded formal negotiations in December 2022,and the agreement was officially signed by both countries in May 2023.In February 2024,Ecuadors National Assembly approved the FTA,paving the way for its entry into force later this year(AP 2024).The agreement allows 99.6 percent of Ecuadorian exports to enter China without tariffs immediately or within 10 years,and it excludes a number of Chinese products in sensitive sectors,chiefly textiles and clothing(MPCEIP 2023).Outstanding questions remain about the potential environmental effects of the agreement,which may lead to increased deforestation and overfishing to meet new demand for agricultural and aquaculture products(AP 2024).Negotiations between Nicaragua and China began in July 2022 and after a year of negotiations,the agreement was signed in August 2023 and entered into force on January 1,2024(Xinhua 2024).Within 10 years,91 percent of Nicaraguan products will enter China with zero tariffs;many of these products are commodities and foodstuffs,such as meats,seafood and wood(VOA 2024).This agreement had been a priority for Nicaragua and comes two years after it re-established diplomatic relations with China in December 2021.These are the first new FTAs between China and LAC countries to enter into force since Costa Rica and Chinas FTA did so in 2011.This brings the total of LAC countries with FTAs with China to five;Colombia,Panama and Uruguay still have ongoing or stalled negotiation processes.On his visit to China,Uruguays President Lacalle Pou discussed the potential agreement with his counterpart,where the two leaders agreed to continue working towards an agreement(Presidencia de Uruguay in El Pas 2023).Trends in Trade FlowsOverall,Chinas exports to LAC declined in 2023 in a reflection of the countrys overall falling exports for the year,the first time since 2016 that China experienced declining exports(Tan 2024).This led to a contraction in the LAC regions overall merchandise trade deficit with China,to 0.5 percent of GDP,as Figure 3 shows.16 China-Latin America and the Caribbean Economic Bulletin|2024 EditionFigure 3:LAC Merchandise Trade Balance with China,2003-20230.7%1.7%2.3%3.0%3.7%0.6%1.0%1.6%2.5%3.2%-0.1%-0.7%-0.7%-0.4%-0.5%-2%-1%0%1%2%3%4%5 032008201320182023(est)Percent of LAC GDPChinas exports to LACLAC exports to ChinaBalanceSource:Author calculation from IMF(2024),UN Comtrade(2024).Due in parts to the dip in Chinas exports,most major LAC economies saw improving national trade balances with China,as Figure 4 shows.The exception to this pattern is Chile,which has the largest trade surplus with China among major LAC economies,but which saw a significant dip in its trade surplus in 2023,of over 0.5 percent of GDP.This decrease was largely due to a declining copper output for the year,which hit a 15-year low,a trend attributed by observers to water shortages and delays associated with new projects as the country considered potential constitutional changes(Azzopardi 2024,Cambero 2024).Figure 4:National Merchandise Trade Balances with China,2003-2023-6%-4%-2%0%2%4%6 032008201320182023(est)Percent of GDPArgentinaColombiaBrazilMexicoChilePeruLACSource:Author calculation from IMF(2024),UN Comtrade(2024).China-Latin America and the Caribbean Economic Bulletin|2024 Edition 17In fact,Chiles falling copper exports to China are not an isolated anomaly.As Figure 5 shows,LAC-China mineral exports began declining in 2022 in dollar value,amidst significant drops in the world prices of two major LAC-China mineral exports:iron(which saw a 25 percent drop in 2022)and copper(which had its own 5 percent drop).Figure 5 disaggregates LAC-China exports by sector,clearly showing the recent volatility in the value of minerals trade.Figure 5:LAC-China Exports by Sector,2003-20230.5%0.9%1.4%1.7%0.3%0.4%0.6%1.0%1.2%0.2%0.1%0.1%0.2%0.3%0.0%0.5%1.0%1.5%2.0 032008201320182023Percent of LAC GDPExtractionAgricultureManufacturingSource:Author calculation from IMF(2024),UN DESA(2024),UN Trade and Development(2024).In contrast,exports of petroleum oil from LAC to non-China trading partners surged,particularly from newly tapped deposits in Guyana,as well as traditional exporters Brazil and Mexico(Parraga 2023).As a result,Chinas share of LAC mineral exports fell from a record of 34 percent in 2020 to 33 percent in 2021 and to 25 percent in 2022,before rebounding to 34 percent in 2023.Figure 6 shows the resulting volatility in Chinas share of LAC extractive exports.Figure 6:Chinas Share of LAC Exports by Sector,2003-20234%64%7!#%2%1%2%2%3%5%9%0%5 %05 032008201320182023Chinas Share of LAC ExportsExtractionAgricultureManufacturingTotal ExportsSource:Author calculation from UN DESA(2024),UN Trade and Development(2024).18 China-Latin America and the Caribbean Economic Bulletin|2024 EditionVulnerability to the type of dramatic volatility shown in Figure 6 is one danger of the high concentration of regional exports to China in a few raw commodities.As mentioned in past editions of the China-LAC Economic Bulletin,more than two-thirds of the regions exports are drawn from just five commodities:unrefined copper,soybeans,unrefined iron,crude petroleum oil and copper.In turn,each of these products comes predominantly from a few major sources.Table 2 shows more detail for each of these five products since 2020.Table 2:LACs Top Exports to China,2020-2023ProductShare of totalMajor SuppliersCopper ores,concentrates18.6%Chile(51%),Peru(33%),Mexico(10%)Soybeans,other oilseeds18.1%Brazil(93%),Argentina(6%)Iron ores,concentrates14.1%Brazil(86%),Peru(7%)Crude petroleum oils10.9%Brazil(81%),Colombia(14%)Copper5.6%Chile(83%),Peru(14%)Total,top 5 products67.2%Source:Author analysis of UN DESA(2024)data.Scholars estimate that LACs“China boom”in commodities occurred roughly between 2002-2011(see for example Ray et al 2017,Dussel Peters and Armony 2015,Wise 2020).But as Figure 7 shows,LACs exports to China in primary products(raw commodities with little to no local value added such as soybeans and crude petroleum oils)continued to accelerate in total value after 2012,even outpacing resource-based products(those with some limited local value added such as soybean oil and refined gasoline).Manufactured exports to China,by contrast,have continued to account for less than one-fourth of one percent of LAC GDP.Figure 7:LAC-China Exports by Technology Level,Percent of LAC GDP,2003-20230.8%1.4%1.6%0.2%0.4%0.7%0.9%1.4%0.2%0.1%0.1%0.1%0.2%0.0%0.5%1.0%1.5%2.0 032008201320182023Percent of LAC GDPPrimary productsResource-based productsManufactured productsSource:Author calculation from IMF(2024),Lall(2010),UN DESA(2024).China-Latin America and the Caribbean Economic Bulletin|2024 Edition 19Two new commodities have been growing particularly quickly among China-LAC exports:beef and lithium.Beef exports rank in sixth place among LAC-China exports for the 2019-2023 period,just behind the top five exports shown in Table 2.In 2023,they rose to fifth place,displacing copper.LAC-China beef exports have doubled in volume in the last five years and roughly quintupled in the last decade,now accounting for over three-fourths of Chinas beef imports.In contrast,lithium is still trading at relatively low levels as a newly important commodity in global trade,but LAC-China lithium exports are growing at an even faster rate than beef:LAC-China lithium carbonate exports have quintupled over just the 2020-2023 period.Figure 8 shows more detail for selected important agricultural LAC-China exports:soybeans and beef.In each case,LAC-China exports expanded dramatically beginning in 2018,when China increased tariffs on agricultural imports from the United States(Bown and Kolb 2024,Mullen 2021).Chinas beef imports from LAC were further bolstered starting in 2018 amidst Chinas struggle with African swine fever,which boosted meat imports(Ma et al 2021,You et al 2021).However,LAC-China exports of both soybeans and beef have remained strong in the last few years,indicating that they are likely to continue to take prominence in the relationship in the years to come.Figure 8:Chinas Imports of Soybeans and Beef,by Source,2003-20238A.Soybeans 8B.Beef,Frozen-20 40 60 80 10020032008201320182023Millions of Metric TonsArgentinaBrazilOther LACOther Regions 00.511.522.5320032008201320182023Millions of Metric TonsArgentinaBrazilUruguayOther LAC Source:Author analysis of UN DESA(2024)data.20 China-Latin America and the Caribbean Economic Bulletin|2024 EditionFigure 9 gives more detail about two important mineral exports:lithium carbonate and copper ores and concentrates.In these cases,LAC comprises not only the majority of Chinas imports but a majority of world trade overall.For this reason,Figure 9 shows total global trade divided into four categories:LAC-China exports,LAC exports to other partners,Chinas imports from other partners and trade among other countries.In each case,LAC-China exports now account for about half of world trade.Note that Figure 9 shows data only through 2022,as South Korea(a major minerals importer)had not yet published data for 2023 as of June 2024.Figure 9:World Trade in Lithium Carbonate and Copper Ores and Concentrates,by Direction9A.Copper Ores and Concentrates 9B.Lithium Carbonate-10 20 30 4020022007201220172022Millions of Metric TonsLAC-ChinaLAC-OtherOther-ChinaOther-Other -50 100 150 200 25020022007201220172022Thousands of Metric TonsLAC-ChinaLAC-OthersOther-ChinaOthers-OthersSource:Author analysis of UN DESA(2024)data.China-Latin America and the Caribbean Economic Bulletin|2024 Edition 21TRENDS IN CHINESE OUTBOUND FOREIGN DIRECT INVESTMENT IN LACPrevious editions of the China-LAC Economic Bulletin have included analyses of Chinese FDI data available through the private databases of FDIMarkets and DeaLogic(Albright,Ray and Liu 2023).The present edition draws from the Red Acadmica ALC-Chinas annual“Monitor of Chinese OFDI in Latin America and the Caribbean”(Dussel Peters 2024b).This choice allows for greater confidence in the resulting analysis,as the Red Acadmica data is manually verified,meaning that it excludes projects that have been announced but never materialized.Furthermore,the Red Acadmica data is recorded chronologically based on when activity begins rather than when investment intentions are initially announced,allowing for a more accurate representation of trends over time.China-LAC OFDI trends are covered in detail in the Red Acadmica China-LAC OFDI Monitor(Dussel Peters 2024b).Nonetheless,several trends merit mention for their contrast with trade.While LAC-China exports are dominated by a few raw or processed commodities,China-LAC OFDI has very different profiles for different parts of the LAC region.For example,Chinese OFDI in South America is overwhelmingly concentrated in energy supply chains(including upstream stages of mining and drilling,as well as downstream stages of power generation and transmission).In contrast,Chinese OFDI in Mexico,Central America and the Caribbean is concentrated in manufacturing,particularly in the automotive sector(Mexicos share outweighs that of Central America and the Caribbean,but the overall trends remain the same across the entire sub-region).Figure 10 shows Chinese new(“greenfield”)OFDI in LAC by sub-region and sector for the last 16 years.Notably,Figure 10 divides time into four-year periods rather than the more typical five-year periods,to allow consideration of the impact of the COVID-19 pandemic and subsequent economic turmoil.Figure 10:New(Greenfield)Chinese FDI in LAC by Sub-region and Sector,2008-202310A:LAC together6.3 1.1 2.3 2.1 1.2 1.2 1.4 2.2 2.2 2.2 3.2 3.0 3.6 5.7 12.1 5.8 14.2 12.5 21.0 05101520252008-20112012-20152016-20192020-2023Billions of USDTOTAL:Energy,minerals and miningAutomotiveOther manufacturingTelecoms and transportOther22 China-Latin America and the Caribbean Economic Bulletin|2024 Edition10B.South America5.80.42.60.90.90.80.82.92.74.712.05.010.48.713.2-5 10 152008-20112012-20152016-20192020-2023Billions of USDTOTAL:Energy,minerals and miningAutomotiveOther manufacturingTelecoms and transportOther10C.Mexico,Central America and the Caribbean0.22.10.70.20.40.62.21.41.92.90.91.00.83.83.87.8024682008-20112012-20152016-20192020-2023Billions of USDTOTAL:Energy,minerals and miningAutomotiveOther manufacturingTelecoms and transportOtherSource:Author analysis of Dussel Peters(2024a)data.The largest category in Figure 10,by far,is Chinese OFDI in the energy,minerals and mining sector in South America.The second largest sector shown in Figure 10 is Chinese automotive manufacturing OFDI in Mexico,Central America and the Caribbean.Chinese automotive investment has garnered international attention in the last few years,particularly since the recent imposition of US tariffs on vehicles manufacturing in China(CRS 2024,Ray 2024).However,as Figure 10 shows,this investment has not increased dramatically recently,but has grown at a relatively steady pace over the last 12 years.Indeed,the sector gained prominence in 2010 with Chery Automotives investment of$400 million in Brazil.By 2015,the automotive industry was the top sector for Chinese greenfield FDI in Mexico,Central America and the Caribbean.In 2023,the largest Chinese greenfield investments in LAC include:Solarevers$1 billion investment in electric vehicle manufacturing in Mexico.Chengxin Lithium Groups$823 million investment in the SDSA lithium project in Argentina.Huaweis$800 million investment in smartphone manufacturing in Brazil.China-Latin America and the Caribbean Economic Bulletin|2024 Edition 23 Zijin Mining Groups$600 million investment in Argentinas Tres Quebradas lithium project.Ningbo Xusheng Groups$350 million investment in a new electric vehicle plant in Mexico.Minerals and Metals Groups(MMGs)investment of$350 million to expand its Las Bambas copper mine in Peru.BYDs investment of$290 million in a lithium cathode factory in Chile.Figure 11 shows the sector distribution among Chinese mergers and acquisitions(M&A)OFDI in LAC.It shows much the same trend as Figure 10,with the exception that automotive manufacturing does not have the same major significance it has among greenfield investments,as M&As are not a common method for automotive OFDI.Instead,the most important sector for Chinese M&A OFDI in Mexico,Central America and the Caribbean has been non-automotive manufacturing.The largest purchase in that sector dates from 2016,when Qingdao Haier,a subsidiary of the Haier Group,purchased GE Appliances from General Electric for$5.4 billion,including its stake in Mexican appliance company Controladora Mabe.In 2023,the largest Chinese M&A investments in LAC include:State Grid Corporation of Chinas purchase of Enel Peru for$2.9 billion.PowerChinas purchase of Brazils Pontoon and its Cear solar plant project for$360 million.Midea Groups joint venture with Carrier in the Brazilian air conditioning manufacturing sector for$122 million.Finally,previous editions of the China-LAC Economic Bulletin have noted the rising prominence of private Chinese enterprises relative to the traditionally important Chinese public-sector investors.Figure 12 shows this trend in more detail.Public-sector Chinese investors still represent the majority of Chinese OFDI in LAC overall,with private firms accounting for approximately 40 percent of all Chinese OFDI in LAC in the last four years.However,Figures 12B and 12C which differentiate between sub-regions of LAC show that private Chinese enterprises have been the driver of Chinese investments in Mexico,Central America and the Caribbean for the last eight years and accounted for approximately three-fourths of this investment in the last four years.24 China-Latin America and the Caribbean Economic Bulletin|2024 EditionFigure 11:Chinese M&A Investment in LAC by Sub-region and Sector,2008-202311A.LAC together5.7 2.2 3.7 8.0 2.6 32.4 16.9 27.8 21.7 37.0 22.7 44.6 25.2 010203040502008-20112012-20152016-20192020-2023Billions of USDTOTAL:Energy,minerals and miningAutomotiveOther manufacturingTelecoms and transportOther11B.South America5.2 2.0 2.3 2.2 2.6 30.316.327.120.334.420.036.223.30102030402008-20112012-20152016-20192020-2023Billions of USDTOTAL:Energy,minerals and miningAutomotiveOther manufacturingTelecoms and transportOther11C.Mexico,Central America and the Caribbean0.5 0.8 1.5 5.9 0.5 2.1 0.5 0.8 1.4 2.6 2.7 8.4 1.9 02468102008-20112012-20152016-20192020-2023Billions of USDTOTAL:Energy,minerals and miningAutomotiveOther manufacturingTelecoms and transportOtherSource:Author analysis of Dussel Peters(2024a)data.China-Latin America and the Caribbean Economic Bulletin|2024 Edition 25Figure 12:China-LAC Investment by Sub-Region and Chinese Firm Ownership,2008-202312A.LAC together 38.7 26.4 35.8 28.1 10.5 21.3 18.2 42.8 36.9 57.2 46.2 02040602008-20112012-20152016-20192020-2023Billions of USD TOTAL:Private sectorPublic sector12B.South America 6.6 11.7 10.9 36.8 23.9 33.2 25.6 39.4 30.4 44.9 36.5 010203040502008-20112012-20152016-20192020-2023Billions of USDTOTAL:Public sectorPrivate sector12C.Mexico,Central America and the Caribbean3.9 9.7 7.3 2.5 2.6 2.5 3.4 6.4 12.2 9.7 024681012142008-20112012-20152016-20192020-2023Billions of USDTOTAL:Public sectorPrivate sectorSource:Author analysis of Dussel Peters(2024a)data.26 China-Latin America and the Caribbean Economic Bulletin|2024 EditionMontevideo,Uruguay.Photo by Drone 5 via Shutterstock.China-Latin America and the Caribbean Economic Bulletin|2024 Edition 27TRENDS IN CHINESE INFRASTRUCTURE IN LACNew to the 2024 edition of the China-LAC Economic Bulletin is consideration of Chinese firms participation in LAC infrastructure contracts,as reflected in the Red Acadmica ALC-Chinas annual“Monitor of Chinese Infrastructure to LAC”(Dussel Peters 2024b).These projects are service contracts to build and/or operate infrastructure projects,separate from FDI projects in which Chinese firms take equity stakes in projects(such as State Grid Corporation of Chinas purchase of Enel Perus energy transmission infrastructure).As highlighted in the annual Monitors of Chinese Infrastructure to LAC(Dussel Peters 2024b),an infrastructure project is understood as a service between a client and a supplier through a contract-usually the result of a bidding process,although the process can be by direct designation in which the ownership belongs to the client.This definition is important in order to distinguish infrastructure contracts from OFDI transactions which do not include a client and a supplier(as they are usually intrafirm decisions),do not include a contract and the ownership is always of the firm.This definition allows for a clear distinction in the registration of OFDI and infrastructure projects.Some projects may also be included as development finance,if the contracts are financed through loans from CDB or CHEXIM.For example,Ecuadors Coca-Codo Sinclair hydropower plant involved both an infrastructure contract(with Sinohydro,a subsidiary of PowerChina)and financing from CHEXIM.Other projects,such as Nicaraguas Punta Huete airport,received lending from Chinese commecial entities(in this case,CAMC Engineering).Still other projects,such as the Puerto Peasco solar power plant in Sonora,Mexico,do not involve Chinese financing,but a Chinese firm is involved as a contractor.Figure 13 shows the resulting infrastructure trends by sector and LAC sub-region.In the last four years,transportation projects have risen to become the most important sector in the China-LAC infrastructure relationship.This is true in South America,as well as the broader LAC region.Transportation projects have mostly included rails,including long-distance cargo routes in Argentina and Brazil,as well as urban passenger rail in Colombia and Mexico.This trend reinforces the pattern discussed regarding China-LAC OFDI:a South American concentration on commodities for export to China and a focus elsewhere in LAC on urban areas,including manufacturing and urban transport.Figure 13:Chinese Infrastructure in LAC by Sub-region and Sector,2008-202313A.LAC together 5.0 2.7 0.9 5.3 9.2 29.1 13.3 4.9 22.1 11.2 14.8 14.1 37.2 46.0 010203040502008-20112012-20152016-20192020-2023Billions of USDTOTAL:EnergyTransportationTelecommunicationsOther28 China-Latin America and the Caribbean Economic Bulletin|2024 Edition13B.South America3.0 0.9 4.1 8.3 20.7 8.3 4.4 19.6 10.1 8.8 11.6 31.6 35.9 0102030402008-20112012-20152016-20192020-2023Billions of USDTOTAL:EnergyTransportationTelecommunicationsOther13C.Mexico,Central America and the Caribbean0.5 0.7 2.1 0.5 0.5 1.0 8.4 5.0 2.5 1.2 6.0 2.5 5.6 10.1 0246810122008-20112012-20152016-20192020-2023Billions of USDTOTAL:EnergyTransportationTelecommunicationsOtherSource:Author analysis of Dussel Peters(2024b)data.Fittingly,the most active Chinese contractors in LAC have been major state-owned entprises in the communications and transportations sectors.Table 3 shows the 10 most active firms in the region.China Communication Construction Company(CCCC)has done the most in the last four years,as well as over the entire 16-year period considered,with over$16 billion in infrastrucure contracts(despite its name,CCCC is mostly active in transportation sector).However,newly active firms such as China Railway Construction Corporation(CRCC)and China National Nuclear Corporation(CNNC)have risen sharply in prominence as rail and nuclear energy projects have been developed.Table 3:Top 10 Providers of Infrastructure Services in LAC,2012-2023(Billions of USD)2012-20152012-20152016-20192020-2023TOTALChina Communication Construction Co.(CCCC)0.61.46.97.416.3Power Construction Corp.of China(PowerChina)4.72.32.54.113.6China-Latin America and the Caribbean Economic Bulletin|2024 Edition 292012-20152012-20152016-20192020-2023TOTALChina Railway Construction Corp.(CRCC)0.10.82.58.111.6China National Petroleum Corp.(CNPC)5.00.03.20.08.2China National Nuclear Corp.(CNNC)0.00.00.07.97.9China National Machinery Industry Corp.(Sinomach)1.64.10.51.27.4China Energy Engineering Group(CEEC)0.80.34.71.57.3State Grid Corp.of China(SGCC)0.00.74.40.05.1CRRC Group Corporation(CRRC)0.00.00.44.54.9Huawei Technologies Co.Ltd.0.00.00.23.03.2Source:Author analysis of Dussel Peters(2024b)data.Note:Projects with multiple Chinese contractors are excluded from this table.In 2023,the largest Chinese infrastructure projects in LAC include:Metro lines and trains in Monterrey,Mexico,provided by China Railway Construction Corporation(CRCC)for$1.2 billion.The second stage of the Puerto Peasco solar plant in Sonora,Mexico,provided by China Energy Engineering Group(CEEC)for$800 million.The Camarai Industrial Park in Bahia,Brazil,provided by BYD for$620 million.The Mesopotanian branch of the Urquiza railway in northern Argentina,provided by CRRC for$550 million.30 China-Latin America and the Caribbean Economic Bulletin|2024 EditionDEVELOPMENT FINANCE AND DEBTAs Chinese firms have gained exerience operating in LAC,they have relied less on Chinas DFIs,CDB and CHEXIM,to initiate and finance new activities.This finding is reflected in the low levels of sovereign finance shown in the 2024 update to the Chinese Loans to Latin America and the Caribbean Database,produced by the Inter-American Dialogue and Boston University Global Development Policy Center(Myers and Ray 2024,Ray and Myers 2024).In 2023,Myers and Ray(2024)note that Chinese DFIs extended just two sovereign loans,both by the CDB to its peer in Brazil,the Banco Nacional de Desenvolvimento Econmico e Social(BNDES).These included an$800 million loan for long-term investments and a$500 million loan for short-term investments,such as trade finance.Figure 14 shows Chinese development finance to LAC from 2005-2023.Whereas Chinese DFIs committed about as much as or more than the World Bank and the Inter-American Development Bank(IDB)from 2009-2016,a rapid decline began in 2017 and has continued since.Figure 14:Chinese Development Finance in LAC,2005-202305101520252005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023Billions of USDChina(CDB CHEXIM)World Bank(IBRD IDA)IDBSource:Myers and Ray 2024.Note:IBRD:International Bank for Reconstruction and Development;IDA:International Development Association.IDB commitments include only sovereign operations.After years of strong sovereign borrowing,it is important to consider the remaining levels of debt to China across the LAC region.Figures 15 and 16 explore various aspects of LAC countries debt to China.Figure 15 maps LAC debt to China in two ways:Figure 15A shows each countrys debt stock as a share of GDP and Figure 15B shows near-term(2024-2028)debt service payments to China as a share of projected exports.Notably,Figures 15 and 16 are limited to countries that report debt through the World Bank International Debt Statistics.Countries may be excluded either because they are higher-income countries(as in the cases of Antigua and Barbuda,the Bahamas,Barbados,Chile,Panama,St.Kitts and Nevis,Trinidad and Tobago,and Uruguay)or for lack of robust public debt data(as in the cases of Cuba,St.Lucia,St.Vincent and the Grenadines,and Venezuela).Venezuelas absence is particularly noteworthy:as Myers and Ray(2024)indicate,Venezuela accounted China-Latin America and the Caribbean Economic Bulletin|2024 Edition 31for nearly half of Chinese development finance commitments in LAC between 2005-2023.Nonetheless,Figures 15 and 16 demonstrate the most robust data available for public and publicly guaranteed(PPG)debt to China in the remainder of the LAC region.Figure 15:LAC External Public and Publicly Guaranteed(PPG)Debt to China 15A.PPG Debt to China,2022 15B.PPG Debt Service to China,2024-2028(Percent of GDP)(Percent of Projected Exports)GeoNames,Microsoft,OpenStreetMap,TomTomPowered by Bing0.5%0.2%0.0%0.0%0.0%3.3%0.0%7.3.6%Percent of GDP3.6%3.6%3.9%(DMA)2.0%(GRD)3.6%(GUY)14.6%(SUR)1.2%GeoNames,Microsoft,OpenStreetMap,TomTomPowered by Bing0.1%0.0%0.0%0.0%0.9%0.8%0.0%1.2%2.5%Percent of Projected Exports1.0%(DMA)0.5%(GRD)0.2%(GUY)2.5%(SUR)1.2%0.6%1.0%Source:Author calculation from Boston University Global Development Policy Center(2024),Ray and Simmons(2024).Note:PPG:Public and publicly guaranteed.Grey territories indicate no available data.Includes PPG debt to commercial creditors.As Figure 15A shows,Suriname stands out among LAC countries as having by far the highest PPG debt to China:14.6 percent of its GDP and over three times higher than any other LAC country with publicly available data.No other LAC country has publicly-reported PPG debt to China exceeding 4 percent of GDP.Five countries Bolivia,Dominica,Ecuador,Guyana and Jamaica all owe China between 3-4 percent of GDP and the remainder of LAC countries owe China less than 2 percent of GDP.Figure 15B explores LAC debt through near-term(2024-2028)repayment burdens.Suriname once again stands out as owing China more than any other LAC country:2.5 percent of projected export revenue over the 2024-2028 period.Ecuador is in a distant second place,owing 1.2 percent of the value of its projected exports to China from 2024-2028.No other country with public data in the region is expected to owe more than approximately 1 percent of its export revenue in debt service payments to China over the next five years.Among the four largest classes of creditors worldwide(bondholders,China,Paris Club and multilateral creditors),China plays a relatively minor role as a LAC creditor.Chinese creditors are not the largest creditors for any LAC country.Figure 16 shows LAC countries external PPG debt to China in comparison to four other creditor classes:bondholders,Paris Club creditors,multilateral development banks(MDBs)and other creditors.Figure 16A compares debt stock 32 China-Latin America and the Caribbean Economic Bulletin|2024 Editionacross creditors,while Figure 16B does the same for debt service.In each case,China plays a relatively minor role overall and in most countries.Figure 16:LAC External PPG Debt,by Creditor Class16A.Exernal PPG Debt Stock,2022(Percent of GDP)15%4%4%4%3%4%60%7 $%5%5%7%2%4%4%3%4%5%H8)5%5!%9%2%5%4%8%5%2%7%5%5dVTQDDC74110)(! %0 0Pp%SURVCTDMAJAMGRDBLZNICSLVECUDOMPRYBOLHNDCOLCRIMEXARGPERGUYGTMHTIBRAPercent of GDPChinaBondholdersParis ClubMDBsOther16B.Exernal PPG Debt Service,2024-2028(Percent of Projected Exports)1%2%1%1%1%1%1%1%8%7%5%4%1%3%2%2%3%3%1%4%1%3%1%1%1%3%1%1%1%2%3%4%4%4%7%8%8%5%9%5%4%5%5%3%3%1%2%2%1%2%1%2%3%1%9%9%9%9%8%8%7%5%5%5%5%5%4%1%0%2%4%6%8%DOMJAMCOLHTISURSLVVCTBOLECUNICHNDDMABLZPRYGTMARGMEXGRDPERBRACRIGUYPercent of Projected ExportsChinaBondholdersParis ClubMDBsOtherSource:Author calculation from Boston University Global Development Policy Center(2024),Ray and Simmons(2024).Note:PPG:Public and publicly guaranteed.Includes PPG debt to commercial creditors.China-Latin America and the Caribbean Economic Bulletin|2024 Edition 33As Figure 16A shows,11 countries owe MDBs more than any other creditor class,eight owe the most to bondholders and one(Brazil)owes the most to Paris Club creditors.Over the next five years,Figure 16B shows that MDBs play an even greater role,with 13 countries owing more in debt service payments to MDBs than any other creditor class.Thus,for LAC countries undergoing debt restructuring,participation of bondholders as well as mutilateral creditors,in addition to China,will be crucial for finding meaningful relief.FUTURE PROSPECTSThis edition of the China-LAC Economic Bulletin has highlighted the rise in Chinese firms participation in infrastructure contracting amidst a dramatic fall in development finance.For its part,Chinese OFDI to LAC has fluctuated strongly in the last decade,growing to represent 10.6 percent of all inbound FDI in LAC from 2020-2023,but falling in absolute terms since the COVID-19 pandemic.Chinese infrastructure projects present stronger growth:with almost$46 billion for the most recent period 2020-2023,Chinese infrastructure projects reflect an important upward tendency.While both OFDI and infrastructure projects are likely to continue to grow in importance,infrastructure shows the strongest growth potential.As Chinese firms become increasingly experienced operating in LAC,they are likely to engage through investment and through infrastructure contracts independent of the intermediation of Chinas DFIs.Thus,development finance is likely to continue to lag in comparison to other forms of economic engagement.In countries with a tradition of expanding infrastructure through FDI,such as Peru,this activity is likely to come through equity investment,such as the$1.8 billion Chancay port,which was developed by China Ocean Shipping Group Company(COSCO)in 2019 and is expected to be inaugurated at the November 2024 Asia-Pacific Economic Cooperation(APEC)summit in Peru(Sihue 2024).In other countries with a tradition of public ownership of infrastructure,such as Nicaragua,this will likely be through government infrastructure contracts,such as the Punta Huete airport,financed through a commercial Chinese firm(CAMC Engineering).Future prospects for commodity tradeFigure 17 shows global prices for the four top LAC-China export commodities since 2011,including forecasts for 2024 and 2025 by the Economist Intelligence Unit(EIU)and the World Bank.All four of the top commodities in the LAC-China export relationship(copper,soybeans,iron and petroleum)lost significant ground in their global prices in the decade after their peak years,but mostly returned to peak levels in 2021 or 2022.However,the recent returns to peak prices are unlikely to stick,as they emerged from supply-chain complications due to the uneven return to economic activity after the initial years of the COVID-19 pandemic,as well as Chiles lull in copper production and Russias war in Ukraine(UN DESA 2023).By 2025,most of these top four commodities with the exception of copper are expected to return to lower price levels.Thus,trade balances are likely to worsen for countries other than the top copper exporters(Chile and Peru),unless increased volumes make up for the difference.34 China-Latin America and the Caribbean Economic Bulletin|2024 EditionFigure 17:Global Prices of Major LAC-China Export Commodities,2011-2025-75%-50%-25%0% 1120122013201420152016201720182019202020212022202320242025Cumulative change from 2011Copper(EIU)Soybeans(EIU)Iron ore(EIU)Crude oil(EIU)Copper(WB)Soybeans(WB)Iron ore(WB)Crude oil(WB)Actual ForecastsSource:Author calculation from EIU(2024a,b)and World Bank(2024).Prospects for future sustainabile development Significant shifts in the China-LAC relationship will shape the prospects of the relationships impact on LACs sustainable development.This is particularly true for the growing importance of a few sectors:automotive manfuacturing(particularly electric vehicles),rail and renewable energy infrastructure,and trade in beef,soy,lithium and copper.Together,these sectors create a mixed portrait of the implications for sustainable development in LAC.Chinese electric vehicle manfuacturers and urban rail builders are undoubtedly contributing to reducing the carbon intensity of transportation in the LAC region.LACs hybrid and electric vehicle market are relatively new but growing quickly,and are expected to more than double by the end of the present decade(Statista 2024).Observers including Myers(2024)and Tobin(2024)note the crucial role that Chinese firms have played in this growth,through both trade and investment.Urban rail is another crucial element in sustainable transit.Monterey,Mexico ranked among the 10 most congested cities in the world in 2022,making the expansion of urban rail crucial for quality of life as well as air quality(INRIX 2023).Renewable energy,as well as its mineral inputs such as lithium and copper,are crucial for reducing global carbon emissions.The local sustainability impacts of these projects on social,environmental and economic fronts depend in large part on their design and governance.Albright et al(2023)explore the policy challenges posed by these nascent supply chains in Latin America,finding that the vast majority of environmental,social,economic and traparency governance needs have yet to be filled either by policy or by academic research to support policy.LAC has made significant strides in recent years,including the ratification of the Regional Agreement on Access to Information,Public Participation and Justice in Environmental Matters in Latin America and the Caribbean(commonly known as the Escaz Agreement)by 16 countries.Nonetheless,building specific policies and procedures to embody these principles will require ongoing attention from national governments(Chinese as well as LAC),civil society and academic researchers(ECLAC 2024).China-Latin America and the Caribbean Economic Bulletin|2024 Edition 35Trade in South American beef and soy is associated with significant environmental and social risks,which will need significant collaboration if they are to be managed successfully.Ermgassen et al(2020b)trace the deforestation risk from Brazils global beef exports and find that Chinas demand carries the greatest exposure to deforestation risk among Brazils trading partners(between 15,900 and 23,000 hectares per year).On soy,the prospects are more positive and point to areas for potential future collaboration to limit environmental risks.Ermgassen et al(2020a)note that the Chinese meat industry has adopted a zero deforestation commitment(ZDC)for its purchases of Brazilian soy and that Chairman Jun Lyu of Chinese agricultural giant COFCO Corporation has called for the expansion of the Soy Moratorium(a voluntary industry agreement to end purchase of soy from the Amazon biome)to also include the Cerrado,the surrounding tropical savannah(Lyu 2019).Such an extension could have a significant impact on the sustainability of the soy industry,as the Cerrado is home to most Brazilian soy production.Across all of these sectors,international collaboration is crucial for ensuring that the China-LAC relationship benefits or at least does not harm local economies and ecosystems.The increase in 2023 LAC presidential visits to China are a positive sign for the strengthening of government-to-government dialogue.Mobilizing those avenues of dialogue for sustainable and inclusive development will remain a crucial agenda item for the coming years,particularly as transition minerals continue to play a growing role in the LAC-China relationship and the global energy transition.36 China-Latin America and the Caribbean Economic Bulletin|2024 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Annual EconomicReportJune 2024Promoting global monetary and financial stabilityISSN 2616-9428 ISBN 978-92-9259-570-8Bank for International Settlements(BIS)www.bis.orgemailbis.orgBISAnnual Economic Report June 2022BISAnnual EconomicJune 2022Report Bank for International Settlements 2024.All rights reserved.Limited extracts may be reproduced or translated provided the source is stated.www.bis.orgemailbis.orgFollow usAnnual EconomicReportJune 2024BISThis publication is available on the BIS website(https:/www.bis.org/publ/arpdf/ar2024e.htm).Bank for International Settlements 2024.All rights reserved.Brief excerpts may be reproduced or translated provided the source is stated.ISSN 2616-9428(print)ISSN 2616-9436(online)ISBN 978-92-9259-772-6(print)ISBN 978-92-9259-771-9(online)BIS Annual Economic Report 2024ContentsSo far,so good .ixIntroduction .ixThe year under review .ixPressure points and risks ahead .xPolicy challenges .xiiThe AI wave .xviI.Laying a robust macro-financial foundation for the future .1The year in retrospect .2On course for a smooth landing .2Sustained disinflation opened the door to a monetary policy pivot .4Box A:China as a disinflationary force .6The financial system positioned for a smooth landing .8Box B:The role of monetary policy in the recent inflation episode .11Pressure points .13Inflation pressure points .13Macro-financial pressure points .14Box C:Commercial real estate risks in the spotlight .17Box D:The challenge of private credit .20Fiscal pressure points .22Productivity pressure points .22Box E:Life insurance companies legacy risks from“low for long”.23Turbulence scenarios and policy implications .26Turbulence scenarios .26Policy implications .28Endnotes .32Technical annex .34References .38II.Monetary policy in the 21st century:lessons learned and challenges ahead .41Introduction .41Monetary policy conduct in the 21st century:a brief review .42Lessons learned .44Central banks can forestall inflation de-anchoring .45Central banks can stabilise the financial system in times of stress .46Prolonged monetary easing runs into limits .49Box A:Are the effects of balance sheet policies(a)symmetric?.52Communication has become more complicated .56Box B:Central bank financial results and their economic implications .57FX intervention and macroprudential policies can enhance stability .60Challenges ahead .62Implications for monetary policy .64iiiBIS Annual Economic Report 2024Robustness .64Realism in ambition.65Box C:The natural rate of interest:a blurry guidepost for monetary policy .66Safety margins .67Nimbleness .68Box D:Central bank balance sheet choices .69Complementary policies .71Conclusion .72Endnotes .74Technical annex .78References .82III.Artificial intelligence and the economy:implications for central banks .91Introduction .91Developments in artificial intelligence .93Box A:Words as vectors:a primer on embeddings .95Box B:A primer on the transformer architecture.98Financial system impact of AI .99Harnessing AI for policy objectives .103Box C:BIS Innovation Hub projects in artificial intelligence .107Box D:Nowcasting with artificial intelligence .108Macroeconomic impact of AI .109Box E:Gen AI and labour productivity:a field experiment on coding .110Toward an action plan for central banks .114Endnotes .117Technical annex .120References .121ivvBIS Annual Economic Report 2024GraphsChapter I1 Evolution of realised and forecasted output growth .22 Several factors sustained economic resilience .33 Inflation receded towards central bank targets .44 Inflation abated as commodities retreated and spending rotation reversed .55 Both supply and demand contributed to disinflation .56 Equity markets rallied as earnings improved .97 Spreads narrowed,market expectations converged to central bank assessments 98 Risk-on phase contrasted with high bond volatility and a stronger dollar .109 Lending standards were tight,loan demand and credit growth were weak .1010 Banks remained resilient and EMEs weathered the tightening cycle well .1211 Two key relative price adjustments are still incomplete .1312 The financial cycle is peaking .1513 Private sectors financial buffers are diminishing .1614 Sharp declines in real estate prices pose risk to outlook .1915 Chinese FX swap markets and riskiest loan segments point to stress .1916 Greater public spending demand with dwindling fiscal space .2217 Productivity has been sluggish as employment underpins economic growth .2518 Productivity growth at a crossroads .2519 Relative price adjustments could slow inflations convergence to target .27Chapter II1 Inflation,growth and monetary policy since 1900 .422 Central bank balance sheet size and composition .433 Crises,FX reserves and macroprudential measures .444 Low-versus high-inflation regimes .465 The role of monetary policy in countering the inflation surge .476 Central bank policies during crises alleviate stress .487 From lender of last resort to market-maker of last resort .498 Weaker traction of monetary policy when interest rates are low .519 The impact of monetary policy on inflation in the US .5110 Side effects of prolonged monetary easing .5511 Projected central bank balance sheet trajectories in AEs .5612 Communication challenges:market reactions,inflation and wider topic range .5913 FX intervention as a quasi-macroprudential tool in EMEs .6114 Macroprudential tightening reduces the likelihood of financial stress .6215 Public debt projections and debt service cost counterfactuals .63Chapter III1 The adoption of AI .922 Decline in correspondent banking has changed the global payments landscape 1003 Households trust in generative AI(gen AI).1024 Machine learning models performance in different monitoring scenarios .1045 Anti-money laundering(AML)in the next generation of correspondent banking 1056 Opportunities from generative AI adoption for cyber security in central banks .1067 AI and productivity .1118 The impact of AI on labour demand and wages .1129 The impact of AI on output and inflation .11310 Challenges in recruitment and retention .115viBIS Annual Economic Report 2024This Report went to press on 21 June 2024 using data available up to 31 May 2024.A technical annex containing detailed explanations for the graphs and tables is included at the end of each chapter.Conventions used in the Annual Economic Reportstd dev standard deviation2 variance$USdollarunlessspecifiedotherwise000 thousandsmn millionbn billion(thousand million)trn trillion(thousand billion)%pts percentage pointsbp basis pointslhs,rhs left-hand scale,right-hand scalepa per annumsa seasonally adjustedsaar seasonally adjusted annual ratemom month on monthyoy year on yearqoq quarter on quarter.not available.not applicable nil or negligibleComponents may not sum to totals because of rounding.The terms“country”and“economy”used in this publication also cover territorial entities that are not states as understood by international law and practice but for which data are separately and independently maintained.The designations used and the presentation of material in this publication do not imply the expression of any opinion whatsoever on the part of the BIS concerning the legal status of any country,area or territory or of its authorities,or concerning the delimitation of its frontiers or boundaries.Names of countries or other territorial entities are used in a shortformwhichisnotnecessarilytheirofficialname.TableChapter III1 Opportunities,challenges and financial stability risks of AI in the financial sector 99viiBIS Annual Economic Report 2024Country codes AE United Arab EmiratesAR ArgentinaAT AustriaAU AustraliaBE BelgiumBR BrazilCA CanadaCH Switzerland CL ChileCN China CO ColombiaCZ Czechia DE GermanyDK Denmark DZ AlgeriaEA euro areaEE Estonia ES SpainFI FinlandFR FranceGB United Kingdom GR GreeceHK Hong Kong SARHR CroatiaHU HungaryID Indonesia IE IrelandIL IsraelIN India IT Italy IS IcelandJP Japan KR KoreaKW KuwaitLT Lithuania LU LuxembourgLV Latvia MA MoroccoMT MaltaMX MexicoMY MalaysiaNL Netherlands NO Norway NZ New Zealand PE PeruPH PhilippinesPL Poland PT PortugalRO RomaniaRU Russia SA Saudi ArabiaSE SwedenSG SingaporeSI Slovenia SK SlovakiaTH ThailandTR TrkiyeTW Chinese TaipeiUS United StatesVN VietnamZA South Africa Currency codesAED UAE dirhamARS Argentine pesoAUD Australian dollarBRL Brazilian realCAD Canadian dollarCHF Swiss francCLP Chilean pesoCNY(RMB)Chinese yuan(renminbi)COP Colombian pesoCZK Czech korunaDKK Danish kroneDZD Algerian dinarEUR euroGBP pound sterlingHKD Hong Kong dollarHUF Hungarian forintIDR Indonesian rupiahILS new shekelINR Indian rupeeJPY Japanese yenKRW Korean wonKWD Kuwaiti dinarMAD Moroccan dirhamMXN Mexican pesoMYR Malaysian ringgitNOK Norwegian kroneNZD New Zealand dollarPEN Peruvian solPHP Philippine pesoPLN Polish zlotyRON Romanian leuRUB Russian roubleSAR Saudi riyalSEK Swedish kronaSGD Singapore dollarTHB Thai bahtTRY Turkish liraUSD US dollarVND Vietnamese dongZAR South African randviiiBIS Annual Economic Report 2024Advanced economies(AEs):Australia,Canada,Denmark,the euro area,Japan,New Zealand,Norway,Sweden,Switzerland,the United Kingdom and the United States.Major AEs(G3):the euro area,Japan and the United States.Other AEs:Australia,Canada,Denmark,New Zealand,Norway,Sweden,Switzerland and the United Kingdom.Emerging market economies(EMEs):Algeria,Argentina,Brazil,Chile,China,Colombia,Czechia,Hong Kong SAR,Hungary,India,Indonesia,Israel,Korea,Kuwait,Malaysia,Mexico,Morocco,Peru,the Philippines,Poland,Romania,Russia,Saudi Arabia,Singapore,South Africa,Thailand,Trkiye,the United Arab Emirates and Vietnam.Global:all AEs and EMEs,as listed.Depending on data availability,country groupings used in graphs and tables may not cover all the countries listed.The grouping is intended solely for analytical convenience and does not represent an assessment of the stage reached by a particular country in the development process.ixBIS Annual Economic Report 2024So far,so goodIntroductionSo far,so good.The world economy appears to be finally leaving behind the legacy of the Covid-19 pandemic and the commodity price shock of the war in Ukraine.The worst fears did not materialise.On balance,globally,inflation is continuing to decline towards targets,economic activity and the financial system have proved remarkably resilient,and both professional forecasters and financial market participants see a smooth landing ahead.This was by no means a given a year ago.It is a great outcome.Still,there is a“but”.Challenges remain.The recent stickiness of inflation in some key jurisdictions reminds us that central banks job is not yet done.Financial vulnerabilities have not gone away.Fragile fiscal positions cast a shadow as far as the eye can see.Subdued productivity growth clouds economic prospects.Beyond the near term,laying a more solid foundation for the future is as difficult as ever.It could not be otherwise:it is an arduous task that requires a long-term view,courage and perseverance.As is customary,this years Annual Economic Report(AER)takes the pulse of the global economy and explores policy challenges.It also devotes particular attention to two issues.Looking back,it reflects on the lessons learned so far from the conduct of monetary policy in the tumultuous first quarter of the 21st century.Looking forward,it examines the opportunities and risks associated with the rise of artificial intelligence(AI).The year under reviewIn the year under review,the global economy made further progress in absorbing the huge and long-lasting dislocations caused by the pandemic and Russias invasion of Ukraine.Inflation has continued to decline from its peak in 2022.Both headline and core inflation kept moving down for much of the period under review.The rotation in the contribution to inflation from goods to services proceeded further,as commodity prices edged down while services price growth proved stickier.By the end of the period,inflation had come down substantially further:monetary policy had delivered(see below).At the same time,although it was more subdued in places,particularly in Asia,it was still hovering above central bank targets across much of the world.There were signs that the decline had become more hesitant in some key jurisdictions,notably the United States.Economic activity held up surprisingly well,indicating that a“normalisation”in both demand and supply had helped disinflation.Employment remained unusually buoyant in relation to output,supporting demand further in the near term.Households again dipped into savings accumulated during the pandemic.The lingering effects of extraordinarily generous fiscal support,and in some cases additional fiscal expansion,boosted activity.Having borrowed at longer maturities and at fixed rates,households and firms were partly shielded from higher interest rates and the burden of debt.The resilience of the financial system and financial market sentiment underpinned activity.There were no renewed serious banking strains la March 2023.And while xBIS Annual Economic Report 2024banks were rather cautious in granting credit,conditions in financial markets remained quite easy.Equity prices rose,with those in the technology sector reaching heady heights,and bond spreads remained quite narrow by historical standards.For much of the period,buoyant investor sentiment reflected eager expectations of an immediate and substantial easing of monetary policy that did not materialise.Against this backdrop,the most intense and synchronised monetary policy tightening in decades gave way to a somewhat more differentiated picture,in line with the growing differences in domestic inflation outlooks.Central banks prepared the ground for easing,for example in the euro area and much of Asia,or made the first cuts,such as in some countries in Latin America,where policy had been tightened ahead of the rest,and in Asia.The Peoples Bank of China eased further in response to weak domestic conditions and given subdued inflation.In Japan,the central bank finally exited the negative interest rate policy era and abandoned yield curve control while retaining an accommodative stance.This more differentiated picture has raised the prospect of larger interest rate differentials and pressures on currencies.In particular,following the latest monthly inflation readings in the United States,financial market participants expect greater divergence in policy rate trajectories,especially between the Federal Reserve and other central banks.This has reinforced a broad-based dollar appreciation,which has been especially marked vis-vis the yen.The appreciation has already elicited policy responses,including in some cases foreign exchange intervention or adjustments in the policy stance.And it has raised broader questions about the impact on capital flows and financial markets.Pressure points and risks aheadLooking ahead,the central scenario painted by professional forecasters and priced in financial markets is a smooth landing.Price stability is restored,economic growth picks up,central banks ease,and the financial system remains strain-free.Compared with past expectations,which were generally that a significant economic slowdown could be required to lower inflation,this is an impressive outcome.That said,risks persist.Some are more near-term,others further out.Some reflect an incomplete adjustment to the pandemic dislocations,others longer-standing weaknesses.To varying degrees,they all stem from the same root cause analysed in previous AERs:the pandemic hit a global economy that,while enjoying low inflation and growing briskly,had been relying for too long on an unsustainable debt-fuelled growth model.Hence worrying signs emerged,such as the historically high levels of private and public debt and the drastically reduced monetary and fiscal policy headroom.Consider several pressure points pertaining to inflation,the macro-financial nexus and real economy factors,respectively.While somewhat arbitrary given the tight interconnections involved,this classification can help organise the discussion.At the heart of the risks to inflation is the partial adjustment of two,closely related,relative prices thrown out of kilter by the pandemic.One is the price of services relative to that of(core)goods;the other is the price of labour(wages)relative to that of goods and services(the price level),ie real wages.The pandemic-induced dislocations interrupted the secular increase in the price of services relative to that of goods.As demand rotated away from services to goods and clashed with inelastic supply,the price of goods rose by much more.And as demand subsequently rebounded strongly after having been first artificially suppressed by public health measures and then turbocharged by economic policies,its rotation back to services failed to re-establish the pre-pandemic relative price relationships even as services became the prime inflation driver.It is possible that the pandemic,and associated aggregate demand stimulus and supply disruptions,has permanently xiBIS Annual Economic Report 2024altered the trend relative price relationship between goods and services.However,it is not clear why this should be the case,to the extent that the trend reflected deep-seated structural forces.These include a growing relative demand for services as incomes rise,slower productivity growth in services than in goods and nominal wage increases that do not compensate for the productivity growth rate differential in the two sectors.If the relative price between goods and services did return to its previous trend,it would raise overall inflation significantly above pre-pandemic rates for some time,unless disinflation in goods proceeded sufficiently fast,with prices growing below those rates.It might be hard for goods prices to grow that slowly in a world in which globalisation tailwinds are waning.The pandemic-induced dislocations also interrupted the secular increase in real wages,as the surprising inflation flare-up eroded purchasing power.Real wages have recovered somewhat since then,but generally languish considerably below the previous trend.The shortfall could add to wage pressures ahead,especially given continued tightness in labour markets and sluggish productivity growth(see below).To the extent that profit margins have benefited from surprise inflation,there should be room for adjustment.But having regained a taste for pricing power during the inflation phase,firms might be tempted to use it again.The two relative price adjustments are closely linked because the services sector is more labour-intensive.This is one reason why services price increases tend to be stickier than those of goods.And it helps to explain why the pass-through from wages to prices is much higher in this sector.These incomplete relative price adjustments could provide fertile ground for other sources of inflationary pressures.Any commodity price spikes linked to,say,geopolitical tensions or the withdrawal of price subsidies would be more likely to trigger second-round effects.And the likelihood is higher following the long phase of above-target inflation,which can encourage and entrench inflation psychology.Macro-financial pressure points reflect the combination of higher interest rates and financial vulnerabilities in private sector balance sheets in the form of high debt and stretched valuations.The current configuration is rather unique.The previous globally synchronised and intense monetary policy tightening took place during the Great Inflation era of the 1970s,when a repressed financial system had not allowed widespread vulnerabilities to develop(see previous AERs).The outcome,so far,has been surprisingly benign,but tougher tests may lie ahead.The significant banking strains in March 2023 stemmed in many cases from the materialisation of interest rate risk alone,as higher interest rates shook valuations without causing borrowers to default.The materialisation of credit risk is still to come;the only question is when and how intense it will be.The lag is typically quite long,and yet it can appear deceptively short as memories fade.There are indications that financial cycles have started to turn.Savings buffers are dwindling.Debts will have to be refinanced.Within this broad picture,specific macro-financial pressure points abound.There are those we know about.Commercial real estate,historically a much more typical source of banking stress than residential real estate,has been on supervisors radar screen for quite some time.The office segment,in particular,has fallen victim to the confluence of post-pandemic structural and cyclical forces.Similarly,the opaque risks in the burgeoning private credit markets have attracted considerable attention.And then there are certainly vulnerabilities we know far less about.They could catch markets by surprise and shake confidence and trust.The intensity of any stress that could emerge will naturally depend on the condition of financial institutions.Banks are now much better capitalised than before the Great Financial Crisis,notably thanks to stronger prudential regulation.Their profits have also benefited from higher interest rates,which have buoyed net interest xiiBIS Annual Economic Report 2024margins.That said,many are still facing longer-term profitability challenges and investor mistrust,as reflected in depressed price-to-book ratios.The more lightly regulated parts of the non-bank financial sector remain a source of concern as stress amplifiers,owing to hidden leverage and liquidity mismatches.Two real economy pressure points stand out:fragile fiscal positions and subdued productivity growth.As assessed in detail in last years AER,fiscal trajectories represent one of the biggest threats to macroeconomic and financial stability in the medium to longer term.Pre-pandemic,the threat was masked by the long phase of exceptionally low interest rates,which had taken the debt service burden to historical lows despite historically high debt-to-GDP ratios.Since then,further broad-based fiscal support has darkened the picture.In some cases,fiscal policy is still adding stimulus to the economy,acting at cross-purposes with monetary policy.Absent consolidation measures,debt ratios are set to climb over time,even in a scenario in which interest rates remain below the growth rate of the economy.And demands on fiscal authorities have been increasing,as the financing needs of the green transition and geopolitical considerations have come on top of the looming burden of ageing populations.Post-pandemic,productivity growth the key to longer-term prosperity has been generally lacklustre compared with previous trends,although the United States is one exception.The lingering impact of the pandemic makes it especially hard to parse the influence of cyclical and structural forces.But gradually slowing productivity growth was a concern even before Covid-19 struck.The wave of technological advances under way,notably AI,could significantly improve the picture.Still,it would be unwise to simply assume it will.Should slow productivity growth continue,it would make the economic and political environment more challenging.It would add to inflationary pressures,reduce the headroom for both monetary and fiscal policy,and,more generally,widen the gap between societys expectations and policymakers capacity to meet them,making any adjustments much harder.Policy challengesThe overarching policy challenge is to complete the job of returning to price stability while at the same time keeping a firm eye on the longer term,thereby laying the foundations for sustainable and balanced growth.This has implications for both policy settings and frameworks in the monetary,prudential,fiscal and structural domains.Near-term policy settingsThe priority for monetary policy is to firmly re-establish price stability.In doing so,the lessons learned from the conduct of policy in the tumultuous years since the turn of the century can be helpful in guiding decisions(see below).This means travelling the last mile of the disinflation with a steady hand,being especially alert to the risk of further significant upward surprises and not hesitating to tighten again if inflation proves to be more stubborn and unresponsive than anticipated.It also means safeguarding the room for policy manoeuvre that central banks have finally regained the only silver lining of the inflation flare-up.For instance,it would be imprudent to cut interest rates significantly based on the view that the“neutral”or“natural”interest rate(r-star)remains as low as it was perceived to be before inflation took hold.We simply know too little about where such a rate might be and what its determinants are.Rather,it would be safer to be guided by actual inflation and to take this opportunity to wean the economy off the low-for-long state that can generate longer-term risks for financial,macroeconomic and,hence,price stability.xiiiBIS Annual Economic Report 2024The prospects of greater divergence in the outlook for interest rates and concomitant pressures on exchange rates and capital flows could raise additional challenges for adjustments in monetary policy settings.Emerging market economies,in particular,are in a better position to address them than in the past,thanks to the build-up of foreign currency reserve buffers and stronger policy frameworks generally.As experience in recent years indicates,this should provide greater room for manoeuvre in the calibration of monetary policy,supported,where appropriate,by judicious use of foreign exchange(FX)intervention.The priority for prudential policy is to strengthen further the resilience of the financial system.There is still a window of opportunity to build up defences for the credit losses that will inevitably materialise at some point.In particular,on the macroprudential side,it would be important to avoid a premature loosening,calibrating the measures with respect to financial cycle conditions.On the microprudential side,tight supervision can temper risk-taking and help ensure adequate provisioning and realistic asset valuations.Should financial stress emerge,supervisors would need to act in concert with monetary and fiscal authorities to manage the strains in an orderly way while allowing monetary policy to focus on re-establishing price stability.The priority for fiscal policy is to consolidate with clear-eyed and firm resolve.This would relieve pressure on inflation,even if in the near term any removal of lingering energy and food subsidies would raise prices a foreseen side effect.More importantly,it would pave the way for the arduous long-term task of ensuring the sustainability of public finances.Longer-term policy frameworksMonetary policy frameworks have faced a series of extraordinary tests since the Great Financial Crisis shattered the deceptive tranquillity of the so-called Great Moderation.And central banks have delivered:they have contained the damage of financial crises;they avoided major shortfalls of inflation from target all the way to the pandemic;and they have put in place a solid basis for a return to price stability following the post-pandemic inflation surge.The years ahead may be no less challenging.Unless fiscal positions are brought under control,the threats to financial and macroeconomic stability will grow.The risk of global fragmentation,the reality of climate change and demographic trends could make the supply of goods and services less elastic and the world more inflation-prone.At the same time,a return of persistent disinflationary pressures cannot be ruled out either,especially if the current wave of technological advances bears fruit.Against this backdrop,Chapter IIs in-depth analysis of the conduct of monetary policy over this long historical phase points to a number of lessons that could inform refinements to existing frameworks.Some of these lessons confirm previous widely held beliefs;others temper previous expectations.Together,they help us to better understand monetary policys strengths and limitations.Five lessons stand out.First,forceful monetary tightening can prevent inflation from transitioning to a high-inflation regime.Arguably,central banks underestimated the extent to which the exceptional and prolonged further easing at the time of the pandemic would contribute to the flare-up in inflation,and could have responded more promptly once inflation surged.But their subsequent vigorous and determined response has so far succeeded in preventing a shift to a high-inflation regime.Second,forceful action can stabilise the financial system at times of stress and prevent the economy from falling into a tailspin,thereby eliminating a major source of deflationary pressures.On such occasions,the deployment of the central bank balance sheet does the heavy lifting,as the central bank is called upon to perform as lender and,increasingly,market-maker of last resort.That said,whenever the solvency xivBIS Annual Economic Report 2024of borrowers,financial or non-financial,is threatened,this requires government backstops.And those interventions,if repeated,can distort risk-taking incentives in the longer term.Hence the importance of strengthening regulation and supervision further.Third,exceptionally strong and prolonged monetary easing has limitations.It exhibits diminishing returns,it cannot by itself fine-tune inflation in a low-inflation regime,and it can generate unwelcome side effects over the long term.These include weakening financial intermediation and inducing resource misallocations,encouraging excessive risk-taking and the build-up of vulnerabilities,and raising economic and political economy challenges for central banks as their balance sheets balloon.These limitations were not fully appreciated at the time the measures were first introduced.Fourth,communication has become more complicated.The multiplicity of instruments makes it difficult to aggregate their effect and to understand which of them are intended to influence the stance,and when.The failure to anticipate the surge in inflation has threatened credibility.More generally,there is a growing“expectations gap”between what central banks are expected to deliver and what they can actually deliver.Finally,the experience of emerging market economies,in particular,has illustrated how the deployment of complementary tools can help to improve the near-term trade-offs that monetary policy faces between price and financial stability.If used judiciously,FX intervention a form of balance sheet policy,but in foreign currency allows the build-up of FX buffers that strengthens resilience and can help to address disruptive swings in global financial conditions and exchange rates.Macroprudential measures,which central banks either control or help set,have been a welcome addition to the toolkit to address financial booms and busts.These lessons highlight the importance of four features that could inform refinements to frameworks:robustness,realism in ambition,safety margins and nimbleness.Together,they can reduce the risk that monetary policy,just as fiscal policy,is relied upon excessively to drive growth the“growth illusion”analysed in detail in last years AER.And they are designed to ensure that monetary policy focuses on maintaining inflation within the region of price stability while safeguarding financial stability.Consider the implications of these considerations for the definition of the inflation objective,for acceptable deviations from targets,for the deployment of the tools,and for the institutional arrangements that support policy,including the role of communication in that context.The operational definition of price stability would need to help hardwire a low-inflation regime while allowing for deviations consistent with central banks ability to control inflation.Ideally,the objective would be low enough so that inflation would not materially influence economic agents behaviour.Adjusting current targets upwards,quite apart from the risk of undermining central banks hard-earned credibility,would not be consistent with this goal and would risk squandering the self-equilibrating properties that inflation exhibits in such a low-inflation regime.When inflation evolves in a low-inflation regime,there is room for greater tolerance than in the past for moderate,even if persistent,shortfalls of inflation from narrowly defined targets.The additional room would take advantage of the self-equilibrating properties of inflation and reduce the side effects of keeping interest rates very low for extended periods.This would allow central banks to better take into account the threats to financial,macroeconomic and price stability that develop over longer horizons and would reduce the risk of losing precious safety margins.At the same time,the self-reinforcing nature of transitions from low-to high-inflation regimes underscores the importance of reacting strongly when inflation rises sharply above levels consistent with price stability and threatens to become xvBIS Annual Economic Report 2024entrenched.It is one thing to avoid fine-tuning,leveraging the self-stabilising properties of the low-inflation regime;it is quite another to put the systems self-equilibrating properties to the test.The desirability of operating with safety margins to reduce the vulnerability of the economy puts a premium on the prudent deployment of instruments.This means implementing policies that include as an explicit consideration retaining policy room for manoeuvre over successive business and financial cycles.It means putting a premium on exit strategies from extreme policy settings designed to stabilise the economy and on keeping balance sheets as small and riskless as possible,subject to effectively fulfilling mandates.And it means avoiding overreliance on approaches that may unduly hinder flexibility,such as certain forms of forward guidance,critical dependencies on unobservable and highly model-specific concepts,or frameworks designed for seemingly invariant economic environments.Good monetary policy often requires taking actions that may involve costs in the short run to reap benefits in the longer run.This calls for appropriate supporting communication strategies and institutional arrangements.As regards communication,the toughest and growing challenge is to narrow the“expectations gap”a major source of pressure on the central bank to test the limits of sustainable economic expansions and to pursue mutually inconsistent and overly ambitious objectives.Failing to do so can ultimately undermine the central banks legitimacy and societys trust.As regards institutional arrangements,there is a need to shield the central bank from political economy pressures,be they linked to inflation or the build-up of financial imbalances.Safeguards for central bank independence are essential.They may become even more important in the years ahead.Monetary policy frameworks,however,are only one element of the broader policy setup.Indeed,the trade-offs monetary policy faces can become unmanageable,and sustainable macroeconomic and financial stability remain beyond reach,unless other policies also play a key role in a coherent whole what the BIS has termed a holistic macro-financial stability framework.In the years ahead,further efforts will be needed to strengthen prudential frameworks.In the near term,it is essential to complete the international banking reforms,known as Basel III,in a full,timely and consistent manner.In the longer term,as discussed in more detail in last years AER,it will be important to adjust regulatory and supervisory arrangements in the light of the evolving financial landscape and the lessons drawn from episodes of financial stress,both recent ones and inevitable future ones.An area that requires urgent action is the non-bank financial intermediation sector.Despite many post-Great Financial Crisis initiatives,a systemic stability-oriented(“macroprudential”)regulatory framework has proved beyond reach.Making substantial progress may well require more incisive steps,not least to include financial stability as an explicit objective in the mandate of securities regulators.Fiscal policy frameworks,too,require strengthening.It is imperative that sufficient institutional safeguards be put in place to ensure that fiscal positions are sustainable and that,just like monetary policy,fiscal policy can operate with adequate safety margins.The types of remedy are well known.They all involve constraints that can be embedded in legislation and enforced in a variety of ways,with different degrees of stringency.Ultimately,though,no remedy is workable without the political will to adopt it.And implementing the necessary policy adjustments has arguably become harder since the Great Financial Crisis,as expectations of government support have grown.The same political will is needed to revive the flagging effort to reinvigorate the supply potential of the global economy.Only structural policies can deliver the productivity improvements needed to enable higher sustainable growth.Recognising xviBIS Annual Economic Report 2024this point,in turn,calls for a broad change of mindset to dispel the deeply rooted“growth illusion”at the heart of the debt-fuelled growth model that the world has de facto relied on for too long.The analysis and proposals in this report are intended to promote such a change.The AI waveAmong the structural developments of relevance to central banks,AI figures high on the list.AI has taken the world by storm and has set off a gold rush across the economy,with an unprecedented pace of adoption and investment in the technology.The technology underpinning AI has been in development for decades,but AI has come of age with the ready availability of unstructured data and the computing power that can process it.Machine learning excels at imposing mathematical structure on unstructured data,such as text or images,to allow enormous computing power to process the information.The result is the uncanny versatility of the latest AI applications.They can perform tasks that they were not specifically trained to perform,or need only minimal training to do so;they are“zero-shot learners”or“few-shot learners”.Large language models(LLMs)are trained on the totality of the text and non-text data on the internet,drawing on connections in the data to tackle a wide range of tasks.Such versatility distinguishes the latest AI models from past expert systems that were good for only narrowly defined domains.For these reasons,AI will have a profound impact on daily lives.AI impinges on the job of central banks in two important ways.First,it bears on central banks core activities as stewards of the economy.The versatility of AI models will have far-reaching implications for the economy.In the labour market,AI could displace some workers but could complement the skills of others and introduce altogether new tasks that boost economic activity,innovation and growth.Central banks mandates around monetary and financial stability would be profoundly affected by AI.The impact on inflation will depend on how the balance of supply and demand effects plays out,but widespread adoption of AI could enhance firms ability to adjust prices quickly in response to changing circumstances,affecting inflation dynamics.Financial markets will also be affected,with implications for market dynamics and financial fragility.These issues are rightly of great concern to central banks.AI also affects central banks as users of the technology.The ability to impose mathematical structure on unstructured data makes AI ideally suited to identify patterns that are otherwise obscured.This ability“to find a needle in the haystack”could offer breakthroughs in nowcasting economic activity and in the monitoring of financial systems for the build-up of risks.The“zero-shot”or“few-shot”nature of LLMs also means that they can perform tasks other than simply analysing textual information.LLMs excel at detecting patterns.Just as LLMs are trained by guessing the next word in a sentence using a vast database of textual information,macroeconomic forecasting models can use the same techniques to forecast the next numerical observation from a sea of structured and unstructured data.Many central banks already support their economic analysis with nowcasting models,producing real-time assessments of the economy.Financial market applications by central banks mirror AI tools already in use by private sector institutions in their data analytics,risk management and fraud detection,but AIs potential impact could be of even greater importance for central banks given their influence on the economy.All this said,AI also introduces new challenges.One such challenge is new sources of cyber risk that exploit weaknesses in LLMs to make the model behave in unintended ways,or to reveal sensitive information.By the xviiBIS Annual Economic Report 2024same token,however,AI can be harnessed to strengthen cyber security by uncovering anomalies,trends or correlations that might not be obvious to the naked eye.Most importantly,the new era of AI highlights the importance of data governance.While the underlying mathematics of the latest AI models follow basic principles that would be familiar to earlier generations of computer scientists,their capabilities derive from the combination of vast troves of data and massive computing power that is up to the task of unlocking the insights.The centrality of data demands a rethink of central banks traditional roles as the compilers,users and disseminators of data.Our conventional approach to data favours using existing structured data sets organised around traditional statistical classifications.However,the age of AI will rely increasingly on unstructured data drawn from all walks of life,collected by autonomous AI agents.Data availability and data governance are key enabling factors for central banks use of AI.Both will require investment in technology and in human capital.Above all,the challenges of the age of AI necessitate close cooperation among central banks.Central banks need to come together to foster a“community practice”to share knowledge,data,best practices and AI tools.1BIS Annual Economic Report 2024I.Laying a robust macro-financial foundation for the futureThe global economy appears to be poised for a smooth landing.The sudden post-pandemic burst of inflation was met with the most synchronised and intense monetary policy tightening in a generation.So far,the efforts have borne fruit,defying last years concerns of looming recessions and very sticky inflation.The financial system has proved resilient.The baseline going forward is a gradual convergence of growth rates to their medium-term trends as inflation approaches central bank targets.Still,old risks have not gone away while new ones have come into sight.A number of pressure points could compromise the benign baseline scenario.Inflationary dynamics could re-emerge,spurred by ongoing adjustments of relative prices.Geopolitical events and commodity price increases could complicate the last mile of disinflation.Varying exposure to inflationary pressures could deepen the divergences across jurisdictions,bringing about disorderly adjustment in exchange rates and capital flows.Fiscal policies could boost demand at an inopportune time,while debt sustainability concerns could strain the financial system.Depleted buffers and the cumulative effects of past monetary policy tightening could reach tipping points and prompt a sharp squeeze in private demand.Seemingly dormant,macro-financial imbalances could unwind in a costly way.In this challenging landscape,policies will need to finish the job of guiding the economy back to price stability and set the foundation for durable growth.In doing so,macroeconomic policies will need to keep a firm eye on the longer-term consequences of near-term decisions.Monetary policy will need to stay alert to a re-emergence of inflationary pressures and preserve the regained room for manoeuvre.Fiscal consolidation remains essential to support disinflation and restore debt sustainability.Prudential policy needs to remain vigilant and continue the efforts to strengthen the resilience of the financial system.Structural reform efforts,which have flagged for too long,need to be revived to support higher sustainable growth and a better income distribution.Enhancing growth and resilience through reforms that foster competition,flexibility and innovation will improve economic well-being and ensure the capacity for effective macro-stabilisation policy responses,when the need arises.Key takeaways Following the most synchronised and intense monetary policy tightening in a generation,inflation has declined substantially with little collateral damage so far.The financial system has been largely strain-free since March 2023,and market pricing suggests a smooth landing.That said,a number of pressure points could throw the global economy off track.Inflationary pressures may prove more stubborn than anticipated,growth may stall and long-standing fiscal and macro-financial vulnerabilities may lead to stress.Monetary policy will need to finish the job on disinflation.Fiscal policy will need to consolidate.Prudential policy will need to remain vigilant and continue efforts to enhance resilience.Structural policy will need to set the basis for sustainable growth and prepare the economy for the challenges ahead.2BIS Annual Economic Report 2024This chapter reviews economic and financial conditions over the past year.It then discusses the key pressure points and lays out scenarios for how they might threaten a smooth landing.Finally,it elaborates on the near-and long-term policy challenges.The year in retrospectOn course for a smooth landingThe global economy proved resilient over the past year.Growth surprised to the upside across several major advanced economies(AEs),including the United States and Japan,as well as large emerging market economies(EMEs),such as India,Mexico and Brazil(Graph 1).At 3.2%for 2023,global growth exceeded expectations as of mid-2023,slowing only moderately from 3.5%in 2022.Fears of a global recession proved unfounded.Growth this year is expected to hold up at 3.0%.To date,the smooth-landing trajectory appears intact.Two factors help explain this surprising resilience.First,the labour market remained unusually buoyant in relation to output.Unemployment rates stayed close to pre-pandemic levels,edging up only slowly despite sharp monetary policy tightening.Based on historical relationships,the labour market was generally stronger than would have been predicted by output growth(Graph 2.A).Labour market tightness reflected the continued cyclical uplift from the services-led recovery,which is more labour intensive,and pandemic-related behavioural shifts.1 This,in turn,lent support to household income(purple bars in Graph 2.B)and domestic demand,contributing to more resilient activity.Second,the transmission of monetary policy to the real economy proved smooth and non-disruptive.One reason was the measured pass-through of monetary policy to financial conditions.Buoyant market sentiment kept risk spreads compressed and the financial system remained largely strain-free(see below).Importantly,the pass-through Restricted Evolution of realised and forecasted output growth1 In per cent Graph 1 1 For 2023,the starting point of the arrow shows the forecasted GDP growth for 2023 in June 2023,and the end point shows the realised GDP growth in 2023.For 2024,the starting point of the arrow shows the forecasted GDP growth for 2024 in June 2023,and the end point shows the latest forecast(as of May 2024)for GDP growth for 2024.Sources:IMF;Consensus Economics;BIS.6420Other EMEsBRMXCNINOther AEsGBEAJPUSWorldAEsEMEs23 2423242324UpwardMinimal(0.1%pts)Downward Revisions:Forecast as of June 20233BIS Annual Economic Report 2024from tighter financial conditions to real activity was dampened by robust household and corporate balance sheets.While private debt levels are high,the prominence of fixed-rate loans and the lengthening of loan maturities delayed the impact of higher rates on borrowers(Graph 2.C).More generally,large cash cushions allowed investment to remain robust,while excess savings from the Covid-19 era and the lingering effects of fiscal support,including energy subsidies(yellow bars in Graph 2.B),played a part in sheltering consumption.EMEs were resilient,contrary to some earlier tightening cycles,reaping the benefits of stronger policy frameworks and domestic financial systems.Since the early 2000s,the shift towards inflation targeting and greater exchange rate flexibility,supported by larger reserves,had enhanced central bank credibility,helping to anchor inflation expectations and to reduce the pass-through of changes in the exchange rate to inflation(Chapter II).Stronger prudential regulation and supervision had strengthened the banking systems resilience.Fiscal policy frameworks had also improved somewhat,and many EMEs benefited from a greater market tolerance for government indebtedness,hence the broad stability of sovereign credit ratings despite much higher debt levels for many countries.A substantial reduction in currency mismatch in borrowers balance sheets and the development of domestic-currency bond markets reduced the sensitivity of EME bond spreads to global financial conditions.2 Not all jurisdictions around the world proved equally resilient,however,and differences in growth became more apparent as the year progressed.Growth was remarkably strong in the United States,supported by substantial fiscal spending.Latin American economies,most notably Brazil and Mexico,performed well,also benefiting from proximity to the United States.By contrast,the euro area,the United Kingdom and several small open AEs registered barely positive growth.Economic activity was also typically weaker in central Europe and emerging Asia.Subdued global trade amid a continued manufacturing slump played a role,given some of these economies Several factors sustained economic resilience1 Graph 2A.Labour markets were strongerthan expected given activityB.together with transfers,supporting spendingC.More fixed-rate and long-termcorporate debt than post-GFC2%Cumulative changes since Q4 2019,%1 See technical annex for details.NFC=non-financial corporation.The start(end)of an arrow represents 2010(2023).2Sources:OECD;LSEG Datastream;S&P Capital IQ;national data;BIS.1086420THKRMYIDCLTRUSGBEASGMXPHINBRCHAUCASEActualPredictedAEs:Unemployment rate:EMEs:201001020302023202220212020Real consumption in AEsSavings rate changeConsumption deflatorTransfersNet incomeContributions:AmericaLatinCNAEs OtherJPAsian EMEsITFRDEEAUS756045301510080604020AEsEMEs(%of total NFC debt)Long-term debt Fixed rate debt(%of total NFC debt)CA4BIS Annual Economic Report 2024reliance on exports.The greater impact of rising energy prices,especially in Europe,and smaller fiscal support also played a part.In China,domestic real estate woes continued to beset the economy and weigh on consumer confidence,prompting further policy support for the sector.Activity was held up by strong investment in manufacturing and infrastructure as well as by exports.Sustained disinflation opened the door to a monetary policy pivotGlobal inflation continued to recede from the peak it reached in 2022.Inflation was back to around central bank targets across a range of countries,including several euro area economies(Graph 3).In the United States,the disinflation journey largely followed the forecasted path,notwithstanding the upside surprises in early 2024,and inflation remained a little above target.Most EMEs also saw inflation decline,with a few exceptions,such as Argentina and Trkiye.In both Latin America and Asia,disinflation was broad-based,with Thailand and China even seeing falling prices at one point.Chinas export drive may have acted as a global disinflationary force for importing countries(Box A).The decline in inflation was common for both core and headline,but headline decreased more,especially in AEs.Headline inflation dropped below 3%in AEs and below 4%in EMEs(Graph 4.A).This was in large part due to commodity prices retreating from 2022 peaks,despite elevated geopolitical tensions(red line in Graph 4.B).By early 2024,contributions to inflation from food and energy had largely disappeared in AEs and had dropped significantly in EMEs(yellow bars in Graph 4.A).Among core inflation components,moderation in price growth was more pronounced in(core)goods than in services.Benign supply chain conditions(blue line in Graph 4.B)and a continued rotation of spending from goods back to services(Graph 4.C)supported these patterns.The main inflation driver in AEs became services price growth,a more persistent component historically.Similarly,in EMEs,contributions to inflation from services doubled since 2021 and remained large,while contributions from food,energy and other goods shrank.Restricted Evolution of realised and forecasted output growth1 In per cent Graph 1 1 For 2023,the starting point of the arrow shows the forecasted GDP growth for 2023 in June 2023,and the end point shows the realised GDP growth in 2023.For 2024,the starting point of the arrow shows the forecasted GDP growth for 2024 in June 2023,and the end point shows the latest forecast(as of May 2024)for GDP growth for 2024.Sources:IMF;Consensus Economics;BIS.Inflation receded towards central bank targets Year on year,in per cent Graph 3 1 Headline CPI used for cross-country comparability and may not correspond to the central banks preferred measure.Peak since 2021.Countries are sorted by distance of the latest value of headline inflation relative to the target(midpoint for those with an interval).2 Inflation targets are official point targets,target bands,tolerance ranges or unofficial objectives announced by authorities.3 Monthly headline inflation average for 19902019.Sources:LSEG Datastream;national data;BIS.6420Other EMEsBRMXCNINOther AEsGBEAJPUSWorldAEsEMEs23 2423242324UpwardMinimal(0.1%pts)Downward Revisions:Forecast as of June 202312.510.07.55.02.50.0ROCLMXCZILIDBRPEINCNNOATUSNZNLIEDEGBPTCADKCOSGKRVNPHHUZAMYPLHKTHESBEGRSEAUJPLUFRFICHITAEs EMEs19182617Peak to latest1Target/tolerance interval2Historical average35BIS Annual Economic Report 2024 Restricted Inflation receded towards central bank targets Year-on-year changes,in per cent Graph 3 1 Headline CPI used for cross-country comparability and may not correspond to the central banks preferred measure.Peak since 2021.Countries are sorted by distance of the latest value of headline inflation relative to the target(midpoint for those with an interval).2 Inflation targets are official point targets,target bands,tolerance ranges or unofficial objectives announced by authorities.3 Monthly headline inflation average for 19902019.Sources:OECD;LSEG Datastream;national data;BIS.Inflation abated as commodities retreated and spending rotation reversed Graph 4A.Both headline and core inflation declined1 B.Commodity prices and supply disruptions down from 2022 highs C.Spending started to rotate back to services1,3 yoy,%2 Jan 2018=100 std dev%1 See technical annex for details.Core inflation does not add up to the sum of serv2ices(red bar)and goods(blue bar)because the sum shows the contributions to headline inflation.3 Dashed lines correspond to trend based on 19932019 data.Sources:OECD;LSEG Datastream;Macrobond;national data;BIS.86420201519202120222023Apr 24201519202120222023Apr 24AEsEMEsHeadlineCore2ServicesGoods(excl food and energy)Food and energyContributions to headline:18016014012010080604321012242322212019181716Bloomberg Commodity Index(lhs)Index(rhs)Global Supply Chain Pressure5040302023181308039893USEAOther AEsGoods share of nominal consumption:Restricted Both supply and demand contributed to disinflation1 Graph 5A.Supply and demand contributed to the decline in inflation from peak B.Anchored inflation expectations contributed to disinflation C.Inflation dropped more for cyclically sensitive sectors%pts 1 See technical annex for details.2 The sectors in order of highest to lowest cyclical sensitivity are:transport,housing and utilities,restaurants and hotels,education,food and non-alcoholic beverages,clothing and footwear,furniture,miscellaneous,recreation and culture,health,alcoholic beverages and tobacco,and communications.Sources:Firat and Hao(2023);Federal Reserve Bank of Cleveland;Federal Reserve Bank of New York;Federal Reserve Bank of St Louis;OECD;Bloomberg;LSEG Datastream;BIS.Equity markets rallied as earnings improved Graph 6A.Global stock markets rallied,with the exception of China B.as expected earnings improved2 C.Price-to-earnings ratios for major tech firms remained above norms3 1 Jul 2022=100 3 Jan 2022=100 Ratio a Start of period under review(1 June 2023).1 Shanghai Shenzhen CSI 300 equity index.2 EPS=earnings per share.Current shows latest figures as of 31 May 2024.3 See technical annex for details.Sources:IMF;Bloomberg;LSEG Datastream;LSEG Workspace;BIS.KRIDMXZAJPFRDECAUSGB2101234EMEsAEsTotalDemandSupply%pts105051015202320222021expectationsInflationLagged inflationin the US:Contribution to change in inflation pressuresSupply chainOther 05101520250.80.60.40.20.0USEA Cyclically sensitive sectors(coefficient)2Change in price growth(%pts)6BIS Annual Economic Report 2024Box AChina as a disinflationary forceDeclining prices in China have been delivering a disinflationary impulse to prices elsewhere.Through falling prices for its exports,as well as the impact of weaker domestic demand on commodity prices,developments in China are estimated to have reduced the annual rate of import price increases in other major economies by around 5 percentage points over 2023,on average.It can take time for such downward pressures to be fully reflected in consumer prices given that many of Chinas exports are intermediate goods(such as steel)or capital goods(such as machinery).1 While these direct effects are the focus of this box,indirect effects are also likely to be arising from Chinas role as the marginal producer of many products,which would lead competitors from other countries to also reduce prices.In China,headline consumer price index(CPI)inflation has been close to zero since April 2023(Graph A1.A,red line).While declining food prices are part of the explanation,core inflation has also been weak:the level of core CPI was around the same in early 2024 as two years before.Producer prices have fallen by even more(Graph A1.A,blue line),although declines in producer prices are much more common than in consumer prices.Chinas export prices have also fallen sharply(Graph A1.A,yellow line).Nearly all exporting sectors had seen price drops in 2023,with the steepest ones in labour-intensive sectors such as clothing and miscellaneous manufacturing(Graph A1.B).Not surprisingly,Chinese export volumes have grown significantly(Graph A2.A,yellow line).For iron and steel products,the export volume increased by 9.4%in the year to February 2024 while prices fell 15.7%,and for the automobile sector,the volume increased by 27.7%while prices fell 4.4%.The depreciation of the Chinese yuan against many other currencies further boosted Chinas competitiveness,amplifying the impact of Chinas domestic disinflation on export volumes.Between early 2022 and early 2024,the nominal effective exchange rate fell by about 6%(Graph A2.A,red line).The combination of falling prices and a depreciating currency caused the yuans real value to depreciate by 13%over the same period(Graph A2.A,blue line).Declining prices in China have increasingly translated into lower import prices in other countries.Estimates based on four-quarter changes in export prices within the network of bilateral product-level trading relationships among 12 major countries indicate that,during 2022,Chinas exports added around 2 percentage points to the increase in import prices in its trading partners.2 In contrast,by the third quarter of 2023 their median estimated effect was a 5.8 percentage point reduction,which moderated to 4.1 percentage points the following quarter(Graph A2.B).Looking at individual countries,the effect was stronger where Chinese exports made up a larger share,such as in Australia,Brazil and India.Restricted Sharp declines in real estate prices pose risk to outlook1 Graph 14A.The commercial real estate price bust in the 1990s was costly2 B.A repeat today would disrupt the benign growth outlook C.Stretched residential property valuations could add to risk 1989=100%pts%pts Index(de-meaned)a Commercial property price peak(1989).1 See technical annex for details.2 PNFS=private non-financial sector.Shades show interquartile ranges;lines show medians.Sources:Borio et al(1994);Zhu(2002);OECD;Bloomberg;national data;BIS Chinas prices have weakened Graph A1A.China price indices B.Changes in export prices and quantities by sector2 yoy changes,%1 Three-month moving average.2 The changes are between H1 2023 and H2 2023;the size of the circle reflects the relative magnitude oftotal exports of the sector.Sources:CEIC;Macrobond;BIS.100806040200510152019981994199019861982apricesReal commercial property Lhs:Real GDPBank credit to PNFSproperty prices peak:Rhs,growth rate relative to commercial03691201234 LhsRhsCommercial property pricesCredit growthGDP growthestate shock:Effects of adverse commercial real3020100102030Latest20s10s00s90s80sMedianfrom historical average:House price-to-income ratio deviation Interquartile range 1050510Q1 24Q3 23Q1 23Q3 22CPIPPIExport unit price1Electric&electronicTextilesMetal productsMachinery&transportMisc manufacturingChemicalsRubber&plasticMedicalClothing101520201510505Change in quantity(%)Change in unit price(%)7BIS Annual Economic Report 2024While the effects on CPI are likely to build over time,elasticity estimates from other studies suggest that a 5.8 percentage point decrease in import prices would eventually translate into a 1.5 percentage point lower CPI inflation rate,on average,albeit with significant variation across countries.31 Di Sano et al(2023)suggest that the effect of Chinas lower prices on euro area inflation is relatively limited,decreasing headline inflation by around 0.4 percentage points in the year to June 2023.However,given that 43%of Chinese exports to the European Union are intermediate goods,the impact takes some time to feed through supply chains to inflation.2 This follows the approach in Amiti et al(2024),which provides an estimate of the contribution of each source country to import price inflation in each destination country at each point in time.3 Goldberg and Campa(2010)assess the sensitivity of the CPI to import prices across 21 countries based on input-output tables for around the year 2000.The sensitivity varies from 0.07 for the United States to 0.56 for Ireland,with an average of 0.26.This implies that,on average,a 1%increase in import prices at the border is associated with a 0.26 percentage point rise in the CPI across these countries.Restricted Chinas prices have weakened Graph A1A.China price indices B.Changes in export prices and quantities by sector2 yoy changes,%1 Three-month moving average.2 The changes are between H1 2023 and H2 2023;the size of the circle reflects the relative magnitude oftotal exports of the sector.Sources:CEIC;Macrobond;BIS.Chinas disinflation is translating into lower import prices in other countries Graph A2A.Effective exchange rates and export volumes B.Contribution of China to import price inflation2 yoy changes,%end-2021=100 yoy,%pts NEER=broad nominal effective exchange rate;REER=broad real effective exchange rate.1 Three-month moving average.2 Estimated effect of China on the year-on-year inflation rate of imported goods,following the approach in Amiti et al(2024).The sample consists of AU,BR,CA,CN,DE,ES,GB,IN,IT,JP,MX and US.Sources:United Nations Comtrade;Macrobond;BIS.15105051015115110105100959085Q1 24Q3 23Q1 23Q3 22Q1 22Export volume1Lhs:NEERRhs:REER5051015Q4 23Q3 23Q2 23Q1 23Q4 22Q3 22Q2 22AUINBRJPDEUSMedianOther countriesBoth supply and demand factors played a role in the disinflation process.Distinguishing their respective contributions is difficult,but results from a range of stylised exercises can help shed some light.One exercise,which distinguishes supply and demand based on the relationship between price and quantity changes,points to cross-country differences.3 This analysis suggests that more than half of the decline in inflation from its peak reflects increased supply in the United Kingdom,the United States,South Africa,Indonesia and Korea(Graph 5.A).By contrast,weaker demand appears to have accounted for more of the inflation decline in Canada,France and Mexico.A complementary simple regression exercise provides further insights by breaking down US inflation into the contribution of a wider range of factors(Graph 5.B).According to these estimates,the resolution of supply chain pressures explains a significant portion of the inflation decline since late 2022(blue bars),confirming the importance of supply factors.Monetary policy has also played a key role(see Box B for further discussion).One important channel is by anchoring inflation expectations,following their upward drift during the inflation flare-up(red bars).Expectations of low and stable future inflation influence current spending as 8BIS Annual Economic Report 2024well as the price-and wage-setting decisions of firms and households;anchored expectations therefore limit second-round effects and in turn contribute to the actual decline in inflation in future.Another channel is by restraining demand.Indeed,sectors that are more sensitive to the output gap,such as transportation and food,experienced larger drops in price growth(Graph 5.C).Not captured in these estimates,the globally synchronised tightening has also had an impact by cooling commodity price increases.4After a notable period of synchronisation,divergence eventually emerged in monetary policy stances across countries.With notable progress towards meeting their inflation targets,some central banks reduced policy rates and others signalled easing ahead.Most central banks in Latin America cut rates,after being among the first to tighten.Among AEs,the Swiss National Bank was the first to cut and was followed by Sveriges Riksbank,while the ECB and the Bank of Canada both lowered their policy rates in June.The Federal Reserve kept policy rates constant,reiterating the need for greater confidence in inflation converging to target before considering an easing.Changes in policy rates in Asia were more moderate and varied,partly reflecting lower inflation in the region and greater use of other stabilisation instruments,such as foreign exchange intervention.The Peoples Bank of China eased monetary policy further in response to weak domestic conditions.The Bank of Japan increased the policy rate for the first time since 2007 in response to accumulated evidence that inflation could finally rise to the 2%target on a durable basis.Bank Indonesia raised rates,while several Asian EMEs intervened in foreign exchange markets to mitigate pressure on their currencies linked to interest rate differentials with AEs.The financial system positioned for a smooth landingAgainst this benign macroeconomic backdrop,exuberant financial markets anticipated a smooth landing,in part helped by a lack of major incidents like those in March 2023.The prospects of lower policy rates and resilient growth,alongside improving earnings,propelled equity markets across most AEs and EMEs(Graphs 6.A and 6.B).The rally was particularly strong in technology stocks,which benefited from optimism related to artificial intelligence(AI).Valuation ratios of AI stocks reached lofty heights,above historical norms(Graph 6.C).China was a notable exception to this general picture,as stocks there slumped at the beginning of 2024 before partly recovering.Credit markets also reflected the general risk-on sentiment.Credit spreads of investment grade and high-yield bonds continued their downward trajectory from mid-2022.They started the review period above historical norms but finished it deeply below(Graph 7.A).Despite such narrow spreads,corporate bond issuance remained subdued in both the euro area and the United States.The optimism in financial markets contrasted with more cautious central bank communication.While taking cues from incoming data and policy announcements,market participants anticipated more monetary easing ahead than central banks did for much of the period,especially in the United States.Accordingly,they paid less attention to inflation surprises than the Federal Reserve(Graph 7.B).Still,the perception gap narrowed over time(Graph 7.C),and markets converged to central bank assessments by the second quarter of 2024 amid renewed inflation concerns.On balance,global financial conditions tightened during the review period,despite the risk-on mood.They tightened sharply in the third quarter of 2023 and loosened through end-2023,finishing the review period tighter than where they started and tighter than historical averages(Graph 8.A).Conditions danced to the tune of evolving perceptions of the degree of monetary easing ahead.Uncertainty about the future path of interest rates was high,to the point that bond volatility hovered well above equity volatility a rare occurrence.The gap between the two volatilities 9BIS Annual Economic Report 2024 Restricted Both supply and demand contributed to disinflation1 Graph 5A.Supply and demand contributed to the decline in inflation from peak B.Anchored inflation expectations contributed to disinflation C.Inflation dropped more for cyclically sensitive sectors%pts 1 See technical annex for details.2 The sectors in order of highest to lowest cyclical sensitivity are:transport,housing and utilities,restaurants and hotels,education,food and non-alcoholic beverages,clothing and footwear,furniture,miscellaneous,recreation and culture,health,alcoholic beverages and tobacco,and communications.Sources:Firat and Hao(2023);Federal Reserve Bank of Cleveland;Federal Reserve Bank of New York;Federal Reserve Bank of St Louis;OECD;Bloomberg;LSEG Datastream;BIS.Equity markets rallied as earnings improved Graph 6A.Global stock markets rallied,with the exception of China B.as expected earnings improved2 C.Price-to-earnings ratios for major tech firms remained above norms3 1 Jul 2022=100 3 Jan 2022=100 Ratio a Start of period under review(1 June 2023).1 Shanghai Shenzhen CSI 300 equity index.2 EPS=earnings per share.Current shows latest figures as of 31 May 2024.3 See technical annex for details.Sources:IMF;Bloomberg;LSEG Datastream;LSEG Workspace;BIS.KRIDMXZAJPFRDECAUSGB2101234EMEsAEsTotalDemandSupply%pts105051015202320222021expectationsInflationLagged inflationin the US:Contribution to change in inflation pressuresSupply chainOther 05101520250.80.60.40.20.0USEA Cyclically sensitive sectors(coefficient)2Change in price growth(%pts)1201008060Q2 24Q4 23Q2 23Q4 22aUSAEs excl USCN1EMEs excl CN100908070605040Q2 24Q4 23Q2 23Q4 22Q2 22 S&P 500 MSCI World EURO STOXX 600forecasts:Long-term EPS median:2000current3020100Major techEMEsAEs AEs EMEs Major US tech firmsHistorical:Latest:Restricted Spreads narrowed,market expectations converged to central bank assessments1 Graph 7A.Corporate spreads narrowed2 B.Inflation surprises influenced terminal-rate expectations C.Market expectations converged to that of the central bank bp bp%a Start of period under review(1 June 2023).1 See technical annex for details.2 HY=high-yield;IG=investment grade.Sources:Board of Governors of the Federal Reserve System;Bloomberg;ICE Data Indices;BIS.Banks remained resilient and EMEs weathered the tightening cycle well1 Graph 10A.Bank valuations increased after Silicon Valley Bank collapse B.EMEs weathered the current tightening cycle better than the tightening episodes pre-20002 Ratio a Silicon Valley Bank(SVB)announced capital raising(9 March 2023).1 See technical annex for details.2 Changes relative to the month prior to the first policy rate hike,scaled by the corresponding increase inthe policy rate(except for the policy rate itself).na=not available.Sources:Federal Reserve Bank of St Louis;Bloomberg;EPFR;JPMorgan Chase;LSEG Datastream;national data;BIS.55040025010031023015070202420232022Actual:median:2005currenta US Europe US EuropeHY(lhs):IG(rhs):1.00.50.00.53.53.02.52.01.51.00.5FOMC dot plotFed funds rate futuresJune 2021June 2024:Inflation surprise(%pts)Revision to terminal rate(%pts)5.04.54.03.53.0Q2 24Q1 24Q4 23Q3 23end-2024 fed funds rateFOMC dot plot median for December 24Fed funds rate futures for 1.41.21.00.80.6Q2 24Q1 24Q4 23Q3 23Q2 23Q1 23aUSEAOther AEsEMEsBanks price-to-book ratio:na0.10.142022010010flowsyieldsrateportfolioequitiesspreadgovyieldfundsEMEFX rateEMEEMBIEME10y USTFedLhs Rhs%pts%naUSD bn Episodes in 198090s Current cyclefunds rate:Changes in fed of policy tightening:Changes per 1%pt10BIS Annual Economic Report 2024 Restricted Risk-on phase contrasted with high bond volatility and a stronger dollar1 Graph 8A.Global financial conditions tightened B.Positive gap between bond and equity volatility was historically wide C.Dollar appreciated,especially against the yen Index Index pts Index Q1 2022=100 a Start of period under review(1 June 2023).1 See technical annex for details.Sources:Bloomberg;Goldman Sachs Global Investment Research;LSEG Datastream;BIS.101.25101.00100.75100.50100.25100.00Q2 24Q4 23Q2 23a Financial conditions tightenGoldman Sachs global FCI010203040505040302010024232221201918VXTLTVIX differenceLhs:VXTLTRhs:VIX 1301201101009080202420232022 USD appreciatesaJPY/USDLatin AmericaOther AEsAsian EMEsOther EMEs1510505JPGBEAUSQ1 20240102030JPGBEAUSQ1 2024864202EMEsJPGBEAUSQ1 2024Historical median(200919)financial sector:Bank credit to the private non-11 Restricted Risk-on phase contrasted with high bond volatility and a stronger dollar1 Graph 8A.Global financial conditions tightened B.Positive gap between bond and equity volatility was historically wide C.Dollar appreciated,especially against the yen Index Index pts Index Q1 2022=100 a Start of period under review(1 June 2023).1 See technical annex for details.Sources:Bloomberg;Goldman Sachs Global Investment Research;LSEG Datastream;BIS.Lending standards were tight,loan demand and credit growth were weak Graph 9A.Lending standards tightened B.Loan demand was subdued C.Credit growth was weak%yoy changes,%1 See technical annex for details.Sources:LSEG Datastream;national data;BIS.1510505JPGBEAUSQ1 20240102030JPGBEAUSQ1 2024864202EMEsJPGBEAUSQ1 2024Historical median(200919)financial sector:Bank credit to the private non-11was positive for most of 2023 and 2024 and the widest in 20 years unlike in previous years(Graph 8.B).In contrast to past risk-on episodes,the dollar appreciated(Graph 8.C).Notably,the Japanese yen dropped to record lows against the dollar,on account of interest rate differentials.In contrast to the exuberance in financial markets,bank lending remained cautious.Banks reported tighter lending standards(Graph 9.A)and weaker demand 11BIS Annual Economic Report 2024Box BThe role of monetary policy in the recent inflation episodeInflation has declined considerably following the strongest surge seen in decades.The effects of the robust post-pandemic rebound in aggregate demand,further boosted by fiscal and monetary policies,have faded,while those of the rotation in demand are still under way.Supply chain disruptions and war-induced commodity price shocks have ebbed.But monetary policy has also played an important role.This box examines the impact of monetary policy through the initial burst and subsequent decline of inflation.At the onset of the inflation spike,the stance of monetary policy was extraordinarily accommodative.Indeed,in response to the pandemic,central banks globally cut policy interest rates to historical lows,and some stepped up asset purchases.This came on top of the unusually long period of extraordinarily easy policy that had followed the Great Financial Crisis,given the persistent shortfall of inflation from point targets.While inflation flared up in early 2021,major central banks began to lift rates only one year later,partly due to uncertainty about its persistence after the long period of very subdued price increases(Graph B1.A).With the benefit of hindsight,the exceptional degree of accommodation put in place to support the economy probably contributed to the surprisingly strong rebound in economic activity,increasing the risk of second-round price adjustments.As the full extent of inflationary pressures became apparent,monetary policy responded forcefully to rein in inflation.Central banks raised policy rates to two-decade highs,keeping them there even as inflation began to come off the peak.Central banks also clearly signalled their willingness and determination to act as needed to return inflation to target.These decisive policy actions illustrated central banks commitment to price stability and helped to restrain demand,a key force that had pushed inflation higher.To quantify the role of monetary policy,one approach is to appeal to historical relationships and ask what has been different this time.Focusing on the United States,the exercise uses a time series model to capture the joint evolution of inflation,monetary policy and other key macroeconomic variables,and identifies the effects of monetary policy as those consistent with theory.The exercise then compares the actual outcomes with one where monetary policy would have reacted more promptly to the inflation burst,in line with the past reaction function.The comparison suggests that the initial slow response of monetary policy to inflation did contribute to price pressures.Had monetary policy kept pace with macroeconomic developments,in line with past Monetary policy and inflation Graph B1A.Inflation bursts prompted a delayed but sharp policy tightening1 B.Monetary policy contributed to latest inflation surge and retreat2 C.Decisive policy actions anchored medium-term inflation expectations3%yoy changes,%pts%1 GDP-PPP weighted averages for 10 AEs(AU,CA,DK,EA,GB,JP,NO,NZ,SE and US)and 10 EMEs(CL,CO,IN,KR,MX,MY,PH,TH,TR and ZA).Shaded areas represent persistent inflation periods.2 Simulation based on a Bayesian vector autoregression(BVAR)model of corepersonal consumption expenditures(PCE)inflation,output gap,financial condition index and monetary policy stance index(an optimallyweighted average of policy rate and balance sheet size).Blue line is the counterfactual inflation outcome assuming zero monetary policy shocks,identified through sign restrictions.Methodology based on Mojon et al(forthcoming).3 Median across countries within regions.Other AEs=AU,CA,CH,DK,GB,JP,NO,NZ and SE.Sources:Mojon et al(forthcoming);Congressional Budget Office;Federal Reserve Bank of Chicago;Federal Reserve Bank of St Louis;Consensus Economics;national data;BIS.15105024140494847464Headline inflation(yoy)Policy rates5432102.52.01.51.00.50.00.52322212019Rhs:ActualCounterfactualDifferenceUS core PCE:Lhs:2.752.502.252.001.751.502423222120191817USEAFive-year inflation expectations:EMEsOther AEs 12BIS Annual Economic Report 2024patterns,and tightened earlier,core personal consumption expenditure(PCE)inflation would have been around 1 percentage point lower than the actual peak of 5.6%in early 2022(Graph B1.B).The analysis also indicates that this effect was temporary,as the subsequent swift policy tightening brought the monetary stance in line with past behaviour.Higher interest rates associated with this catch-up in turn contributed importantly to the disinflation observed since mid-2023.The preceding analysis,subject to the usual caveats of any statistical model,does not directly capture a key role played by monetary policy:anchoring economic agents expectations to a low-inflation regime.In a low-inflation environment,such anchoring is relatively trivial because households and businesses pay little attention to inflation.But as inflation rises,it can quickly draw public focus.A strong monetary policy response becomes crucial in pre-empting a transition to a high-inflation regime.Without it,the central banks commitment to price stability could be called into question,resulting in a much higher and more persistent inflation surge(see Chapter II).Indicators of inflation expectations confirm this role.Central banks forceful policy tightening appears to have kept them in check.Although medium-term inflation expectations ticked up in some cases early on,they eventually settled within the pre-pandemic range(Graph B1.C).for credit across major AEs(Graph 9.B).Credit growth was generally subdued in major AEs,except Japan,as well as in EMEs(Graph 9.C).The financial system remained resilient despite the challenges posed by the higher interest rate environment.Some signs of strain did emerge.US regional banks were in the spotlight again,following losses in New York Community Bancorp.And Chinese banks remained under pressure as the problems in the real estate sector continued.That said,the strains were localised and were nothing like those seen in March 2023 among regional banks in the United States or in Europe,where a global systemically important bank,Credit Suisse,had gone under.And any incipient stress was absorbed in an orderly manner.Bank valuations recovered(Graph 10.A),and Restricted Spreads narrowed,market expectations converged to central bank assessments1 Graph 7A.Corporate spreads narrowed2 B.Inflation surprises influenced terminal-rate expectations C.Market expectations converged to that of the central bank bp bp%a Start of period under review(1 June 2023).1 See technical annex for details.2 HY=high-yield;IG=investment grade.Sources:Board of Governors of the Federal Reserve System;Bloomberg;ICE Data Indices;BIS.Banks remained resilient and EMEs weathered the tightening cycle well1 Graph 10A.Bank valuations increased after Silicon Valley Bank collapse B.EMEs weathered the current tightening cycle better than the tightening episodes pre-20002 Ratio a Silicon Valley Bank(SVB)announced capital raising(9 March 2023).1 See technical annex for details.2 Changes relative to the month prior to the first policy rate hike,scaled by the corresponding increase inthe policy rate(except for the policy rate itself).na=not available.Sources:Federal Reserve Bank of St Louis;Bloomberg;EPFR;JPMorgan Chase;LSEG Datastream;national data;BIS.55040025010031023015070202420232022Actual:median:2005currenta US Europe US EuropeHY(lhs):IG(rhs):1.00.50.00.53.53.02.52.01.51.00.5FOMC dot plotFed funds rate futuresJune 2021June 2024:Inflation surprise(%pts)Revision to terminal rate(%pts)5.04.54.03.53.0Q2 24Q1 24Q4 23Q3 23end-2024 fed funds rateFOMC dot plot median for December 24Fed funds rate futures for 1.41.21.00.80.6Q2 24Q1 24Q4 23Q3 23Q2 23Q1 23aUSEAOther AEsEMEsBanks price-to-book ratio:na0.10.142022010010flowsyieldsrateportfolioequitiesspreadgovyieldfundsEMEFX rateEMEEMBIEME10y USTFedLhs Rhs%pts%naUSD bn Episodes in 198090s Current cyclefunds rate:Changes in fed of policy tightening:Changes per 1%pt13BIS Annual Economic Report 2024capital ratios remained stable or improved.Despite one of the most synchronised and fastest tightening cycles in AEs,financial markets in EMEs managed to weather the change very smoothly compared with past episodes(Graph 10.B).Pressure pointsA smooth landing is the central scenario,but several pressure points remain.Four stand out:the underlying inflation trajectory,the macro-financial backdrop,fiscal positions and productivity growth.These pressure points,and their interactions,could compromise the expected benign outcome.Inflation pressure pointsDespite encouraging progress to date,two key and closely related relative price adjustments could stretch out the path towards inflation targets.The first relative price adjustment is that of core goods versus services.The powerful pandemic-induced sectoral shifts in demand interrupted the decades-long entrenched trend of services prices outpacing core goods prices(Graph 11.A).5 The initial plunge in the relative price of services vis-vis core goods has partly unwound following the resolution of supply disruptions and the fall in commodity prices.Indeed,most of the recent disinflation has been driven by goods prices;services inflation has proven more stubborn,and its contribution to overall inflation has increased.Despite the recent unwinding,the relative price of services vis-vis goods remains below the pre-pandemic trend in most economies,and a further adjustment is likely.The price of services vis-vis core goods in EMEs is still well below its 2019 Restricted Two key relative price adjustments are still incomplete1 Graph 11A.The relative price of services vs goods lags pre-pandemic trend B.as do real wages,in both services and manufacturing C.Wage-to-price pass-through is stronger in services than in industry2 Ratio of CPIs,2019=1 Q4 2019=100%1 See technical annex for details.2 Cumulated response at different horizons(in quarters)of producers price indices in the industrial and services sectors to a 1 percentage point increase in hourly wages.Sources:Amatyakul,Igan and Lombardi(2024);Ampudia et al(2024);Eurostat;OECD;LSEG Datastream;national data;BIS.Private sectors financial buffers are diminishing1 Graph 13A.Excess savings are already or close to depleted B.Non-financial companies face debt rollover in the coming years C.Interest rates on household mortgage loans are to reset%of GDP USD trn%1 See technical annex for details.Sources:De Soyres et al(2023);CGFS(2023);Board of Governors of the Federal Reserve System;S&P Capital IQ;national data;BIS.1.051.000.950.900.85242118151209 AEs EMEsActual:Pre-pandemic trend:104102100989624232221201918 Manufacturing ServicesActual:Pre-pandemic trend:100755025025201612840Euro area:Pass-through intervals 90%confidence Industry:Private services:Quarters since increased hourly wages14BIS Annual Economic Report 2024pre-pandemic ratio,while it has just recently crossed it in AEs.In both cases,the relative price remains below the previous trend.Unless the pandemic-induced disruptions have permanently altered preferences or productivity patterns,the upward trend in the relative price would re-establish itself.If lower core goods price growth does not compensate for the shortfall,the upward pressure on inflation could be sizeable(see scenario 1 below).There are signs that are consistent with this risk.Demand for services has been growing more strongly than that for goods in many economies an indication that consumers are reverting to pre-pandemic preferences.Input most notably labour cost pressures also remain more pronounced for services.Admittedly,core goods price growth could slow further,including owing to developments in China(Box A).That said,goods price increases could gather pace at some point,given the indications of greater fragmentation in the global economy.The second relative price adjustment is that of labour versus consumer goods and services,ie real wages.As inflation surged,real wages plummeted across most jurisdictions,and have yet to recover despite robust labour markets(Graph 11.B).The catch-up may take time and be less than complete if workers bargaining power remains as limited as it was before the pandemic.6 Even so,there is a risk that sustained robust conditions in labour markets lead to persistent wage demands in excess of growth in productivity.And since terms of trade effects have largely dissipated,there is no obvious reason why real wages should not catch up.These pressures could remain in the pipeline even after inflation subsides,especially in jurisdictions where wage bargaining is more centralised and staggered.If the purchasing power lost in the recent inflation burst were recouped in the coming years,there could be significant upward pressure on inflation(see scenario 1 below).The risks are related because services are more labour-intensive than goods.This is one reason why price growth in the services sector generally tends to be more persistent.It also helps to explain why the pass-through from wages to prices tends to be higher in that sector.For example,estimates based on the euro area suggest that the pass-through is twice as large in the private services sector than in industrial sectors.Moreover,the lags are significant,about two to three years(Graph 11.C).7 In addition to the incomplete adjustment of relative prices,other pressure points are noteworthy.Rather mechanically,the withdrawal or expiration of support measures could unleash new short-term price increases.In particular,fuel subsidies are still substantially above pre-pandemic levels,highlighting the significant role of fiscal policy in containing living costs.Lifting the subsidies is essential,both from a fiscal sustainability point of view and to avoid medium-term inflationary pressures.But,as was clear from the outset,dismantling them will have short-term costs in terms of inflation and make the disinflation journey bumpier.In addition,further disruptive supply side shocks cannot be ruled out,particularly in the current geopolitical environment.Tensions could flare up and have a significant impact on commodity prices in particular.After a long period of inflation well above target,further shocks would be more likely to threaten a shift to a high-inflation regime,as behaviour adjusts to the recent more inflationary experience.Macro-financial pressure pointsAlthough the financial system has been resilient so far,macro-financial imbalances could unwind and cause headwinds due to historically high levels of debt and debt service costs.As the impact of pandemic-era loan assistance programmes fades,some households and businesses might find themselves in a precarious position.The cumulative effects of policy tightening could then carry momentum.15BIS Annual Economic Report 2024Indeed,particularly in AEs,there are signs that the financial cycle has peaked,as credit indicators and real property prices start returning to their longer-term trends(Graph 12.A).Typically,this is a harbinger of credit losses ahead and weaker economic activity.8 Historically,financial stress tends to show up within two to three years following the first rate hike,as loan impairment ratios rise and economic activity weakens(Graph 12.B,yellow and blue lines,respectively).9 The current cycle is still in very early stages of the post-peak phase(red and purple lines).This historical comparison suggests that it is typical for stress to emerge only with a lag.The risk is higher the longer interest rates stay up,putting pressure on borrowers that need to refinance their debts,especially once the pandemic support that kept defaults artificially low fades.Within this broad picture,several pressure points merit particular attention.First,deteriorating balance sheets in the non-financial sector and dwindling savings buffers could cause domestic demand to falter.Even for those households benefiting from large fiscal support,excess savings have run out or diminished substantially(Graph 13.A).10 As maturity walls are hit(Graphs 13.B and 13.C),the need to roll over debt at higher interest rates could further dent the financial buffers of households and firms.The cumulative effects of past monetary tightening could generate a materially stronger contractionary effect on domestic demand than seen in the last few years.Second,and more specifically,commercial real estate(CRE)is facing both cyclical and structural headwinds(Box C).CRE bankruptcies could impact banks lending capacity and overall financial health.Signs of possible future stress in the sector appeared initially in 2023,with losses on US CRE exposures crystallising in the books of a few US regional banks and banks elsewhere.Major banks have also reportedly started increasing provisions in anticipation of future losses.So far,the banking system has proved resilient,but vulnerabilities could become evident if exposures to CRE are underreported and if prices drop more than expected.The financial cycle is peaking1 Graph 12A.Credit and property price indicators are returning to their longer-term trends B.pointing to possible stress ahead2 std dev%pts%pts a Start of the Asian financial crisis(Q3 1997).Start of the Great Financial Crisis(Q3 2007).b1 See technical annex for details.Lines show medians and shaded areas show interquartile ranges across countries.2Sources:Fitch;national data;BIS.210123202320182013200820031998199319881983abInterquartile rangeMedianAEs:Financial cycle indicator:EMEs:0.90.60.30.00.30.62.50.02.55.07.510.0 20 16 12 8 404 Loan impairment ratio(lhs)GDP(rhs)Current:Past:Quarters around US financial cycle peaks16BIS Annual Economic Report 2024The macro-financial impact of a large CRE correction could be significant.In the 1990s,when CRE prices fell by over 40%in real terms,credit and GDP growth dropped by 12 and 4 percentage points,respectively(Graph 14.A).An econometric estimate of macro-financial responses to CRE price shocks suggests a sharp fall in CRE prices this time could have a similarly material impact on credit and GDP growth(Graph 14.B).While naturally uncertain,these estimates highlight the possible repercussions of a CRE bust.And the impact could be amplified by credit losses or a broader drop in other asset prices.Indeed,the risk of such a drop looms large for the residential segment of real estate markets,where house price valuations continue to be very stretched relative to in the past(Graph 14.C).Third,nonbank financial intermediation merits close monitoring.In particular,private credit and equity markets have grown exponentially in the post-Great Financial Crisis(GFC)years of cheap financing(Box D).11 This has increased their vulnerability to higher interest rates.Despite the recent drop in credit spreads,the gap between those in the riskiest and those in other loan segments has increased(Graph 15.A),highlighting pockets of vulnerability.Opaque valuations and infrequent updates of these valuations might create a lagged reaction of private markets to a potential correction in public markets.A correction in private equity and credit could spark broader financial stress via at least three channels.First,investors might liquidate assets elsewhere,potentially transmitting the shock to other market segments.Insurance companies could be quite vulnerable given their increased exposure to private credit(Box E).Second,firms that tap the market could find themselves squeezed,generating spillovers on their clients and the economy.Third,banks remain exposed to the sector,either directly or indirectly,not least as ultimate providers of liquidity.Finally,a slowdown in the Chinese economy and troubles in its financial sector,particularly related to real estate,could spill over globally.The falling equity market Restricted Two key relative price adjustments are still incomplete1 Graph 11A.The relative price of services vs goods lags pre-pandemic trend B.as do real wages,in both services and manufacturing C.Wage-to-price pass-through is stronger in services than in industry2 Ratio of CPIs,2019=1 Q4 2019=100%1 See technical annex for details.2 Cumulated response at different horizons(in quarters)of producers price indices in the industrial and services sectors to a 1 percentage point increase in hourly wages.Sources:Amatyakul,Igan and Lombardi(2024);Ampudia et al(2024);Eurostat;OECD;LSEG Datastream;national data;BIS.Private sectors financial buffers are diminishing1 Graph 13A.Excess savings are already or close to depleted B.Non-financial companies face debt rollover in the coming years C.Interest rates on household mortgage loans are to reset%of GDP USD trn%1 See technical annex for details.Sources:De Soyres et al(2023);CGFS(2023);Board of Governors of the Federal Reserve System;S&P Capital IQ;national data;BIS.1.051.000.950.900.85242118151209 AEs EMEsActual:Pre-pandemic trend:104102100989624232221201918 Manufacturing ServicesActual:Pre-pandemic trend:100755025025201612840Euro area:Pass-through intervals 90%confidence Industry:Private services:Quarters since increased hourly wages108642022023202220212020USEAGBJPExcess savings since Q1 2020:54321030292827262524USAEs excl USEMEsYear of maturity806040200SANLLUKRAUFRBEGBCANZHKVariable rateUp to 2 yearsFrom 3 to 5 yearsFrom 6 to 10 yearsFor greater than 10 yearsFixed rate:17BIS Annual Economic Report 2024Box CCommercial real estate risks in the spotlightCommercial real estate(CRE)markets are smaller than residential real estate(RRE)markets,yet they present a greater risk to financial stability.Historically,it was losses on CRE,rather than RRE,that often caused financial crises.1 The Covid-19 pandemic generated a structural shift in the demand for CRE,particularly office space.Compounded by a rising interest rate environment,this put downward pressure on prices in the sector,reducing valuations and creating losses for lenders.Such losses have already started generating stress at some banks and other financial intermediaries.These losses are poised to weigh on profits and may cause further strains a risk recognised by authorities in a number of countries.2 The post-pandemic shift in the CRE landscape has affected property values worldwide.Vacancy rates in office CRE have risen in many large cities in the past two years,especially in the United States and China(Graph C1.A).Higher vacancy rates depress rent revenues and put downward pressure on property prices.CRE prices have declined in many countries,particularly in the office sector,with the largest drops in US cities.Declining CRE prices have increased the risk of default and losses at financial intermediaries.Banks non-performing CRE loans rose starting in 2022(Graph C1.B).CRE makes up about 18%of bank loans in the United States,12%in Germany and 10%in the Netherlands countries where non-performing loans(NPLs)have risen sharply.While banks are typically the key lenders,non-bank financial institutions(NBFIs)have been playing a growing role and have seen risks materialise for example in commercial mortgage-backed securities(CMBS)(Graph C1.C).In the United States,the impact on the financial system has not yet led to actual stress,as in past episodes.Vacancy rates are at an all-time high,bank lending standards have tightened,and thus far the decline in market returns for CRE investors has already exceeded that of the 1990 CRE stress(Graph C2.A).Despite this,however,credit to the CRE sector continues to expand,even at a faster pace than overall bank credit(same panel).This may stem in part from the distribution of CRE exposure and losses.While direct exposure to the CRE sector as a whole in the US banking system is largest at small and mid-sized banks,NPLs have thus far risen mainly among Restricted Commercial real estate(CRE)prices are falling,risk is rising Graph C1A.Office prices fall as vacancies rise1 B.CRE NPLs rise2 C.CMBS spreads elevated3%of loans bp 1 Top three cities in each area with largest price drop between Q4 2021 and Q1 2024.2021 vacancy rate approximated by Q1 2022 value forAsia.NPL=non-performing loans.Commercial mortgage-backed securities(CMBS)spreads refer to the difference in yield between23CMBS and a benchmark interest rate.For US,it is the five-year on-the-run AAA CMBS spread over the Secured Overnight Financing Rate(SOFR).For EA,it is the five-year euro CMBS spread over Euribor.Sources:European Banking Authority;BankRegData;Bloomberg;CommercialEdge;JPMorgan Chase;Knight Frank;Macrobond;Statista;BIS.20151050020406080San FranciscoChicagoSeattleSingaporeTokyoShanghaiLondonFrankfurtParisUS:Asia:Europe:2023:Vacancy(lhs):2021:(rhs):Price change642020232
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