Global economic prospects

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Global economic prospects Jan Friederich,
Senior Economist November 2005
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Oil prices and the world economy
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Sharp rise in oil prices
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Oil prices driven by world demand

• Short-term factors
• Commodities as speculative assets boosted by
  strong global liquidity.
• Hurricanes had short impact, particularly on
  refined oil.
• Supply factors
• Middle East politics will remain concern, as
  dependence on Middle East set to increase.
• Some strengthening of investment in exploration
  after earlier slump also strengthening
  investment in refinery capacity.
• Demand factors
• Strong growth of world economy has reduced spare
  production capacity.
• Shift of focus of world demand growth to less
  energy-efficient countries (China, India).
• Dampened by increasing importance of natural gas.

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Surprisingly weak economic impact

• Demand driven
• Rise in oil prices offset by still strong global
  economy - itself driving force for oil prices.
• Expansionary monetary policy
• Oil price rise (without second round effects)
  allows monetary policy to remain expansionary for
  longer.
• History
• Important to remember that past oil recessions
  started before oil price shocks.
• Declining IMF estimates of oil price rise impact
  on US growth
• 2000 rise by US5 lowers growth by 0.3 pp.
• 2005 rise by US30 to US80 lowers growth by 0.8
  pp.
• Determinants of impact
• Dependence on oil imports, tightness of labour
  markets (second-round effects?), liquidity
  constraints.

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The US external imbalance Risk of a crisis
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US foreign debt still contained
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Current account deficit has risen
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Not whether but when and how

• Adjustment need is indisputable!
• Theory With declining marginal returns to
  capital, limited returns to scale, richest
  economy should not be net importer of capital.
• Trajectory With 5 of GDP current account
  deficit, 5 nominal GDP growth, external debt
  will converge to 105 of GDP.
• Experience Few developed economies have been
  able to sustain deficit of more than 5 for
  significant amount of time.
• Expertise Volcker (alarmist), Institute for
  International Economics, IMF, OECD, many others.

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Beware of new paradigms

• Explaining the inexplicable?
• Reaction cycle following emergence of imbalances
  
• Bewilderment, scepticism, attempts to explain as
  structural shift, spreading belief but economists
  continue to warn, adjustment of imbalances and
  tears.
• Examples
• Japanese real estate bubble, New Economy bubble,
  Euro at less than US0.85/EUR in 2001, US c/a
  deficit?
• Lessons
• Economic fundamentals will ultimately assert
  themselves.
• Economics gives little guidance on when this will
  happen, but there are plenty of potential
  triggers.

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Smooth or drastic adjustment

• Asian intervention
• Continued Asian intervention might smoothen
  process fear of capital losses but some key
  currencies (euro) are free.
• Savings glut (Bernanke)
• Emerging markets have turned to being capital
  exporter.
• But unlikely to last and no obvious reason why
  adjustment should be drastic or smooth.
• Dollars special status
• US liabilities in dollars so debt servicing no
  concern but sharp depreciation amounts to
  effective debt default!
• Size of US borrowing relative to world savings
  also destabilising.

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Europe and Japan For ever weak?
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Euro-Japan GDP growth lags behind
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Reasons for euro weakness

• Germany
• Weakened by adjustment following reunification.
• Italy
• Serious problems of competitiveness.
• Structural
• Enterprise conditions weaker than in US hiring
  and firing, business start-up etc gradual
  improvement but temporary negative impact.
• Cyclical
• US went through strong cyclical phase euro area
  had weak period (current account).
• Ageing
• Labour force effect pension savings.

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Japan Sun is rising again?

• Japans lost years
• Depressed by hangover following equity/property
  boom in late 80s early 90s.
• Years of deflation and slowest growth in OECD.
• Recovery on its way
• Domestic recovery this year more resilient than
  expected this year, helped by good job creation.
• Healthy private investment following successful
  balance sheet restructuring.
• Prospects have improved
• LDP majority, fresh mandate for Koizumi boost
  reforms.
• Banks of done their homework on consolidation.
• But Labour force decline will be drag on growth.

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China and India Worlds new work houses
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China outperforms strong region
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Chinese growth boosted by trade

• Catch-up effect
• China starts from low-base, so can increase
  productivity but adopting technologies of
  leaders.
• Trade openness
• High openness to trade for a poor country its
  size (Exports are 38 of GDP, 15 in India, 10
  in US, 38 in Germany).
• World Trade Organisation membership in 2001 end
  of Multi-fiber Agreement in 2004.
• Low wages
• Very low labour costs boost competitiveness.
• US1 per hour, US US22.7, India US0.9, Germany
  US32.9, Sri Lanka US0.3).
• Strong investment
• Foreign direct investment for exports and market
  size.
• Heavy investment is boosting productivity.

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Extremely high Chinese investment
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Concern over over-investment

• Mitigating factors
• Statistical distortions (eg inclusion of land
  purchases).
• Low capital stock - high potential for
  investment.
• State control can direct income to investment, as
  long as state remains in control this can be
  continued.
• Concerns
• Rising over-capacity resulting from
  over-investment would further increase high level
  of non-performing loans (15.6 for state-owned
  commercial banks).
• Substantial part of investment goes into real
  estate-with uncertain financial viability.
• Ultimately need to stop excessive investment, but
  difficult with blunt macroeconomic instruments of
  Chinese authorities.

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Chinas regime change

• Bang or whimper?
• Change Basket, 2.1 adjustment, daily
  fluctuation band against dollar by /-0.3, 2.1
  adjustment.
• Impact Change looks small but in principle
  raises possibility for huge change (/-100 per
  year).
• Forecast Continued substantial intervention and
  only gradual adjustment, though big move
  possible.
• Impact Appreciation might raise competitiveness
  of other Asians no impact on trade Asia/OECD as
  wage differences remain huge.

RmbUS
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Indian growth

• Positive factors
• Low-starting position - allowing for convergence
  effect.
• Low capital stock - high potential for
  investment.
• English language competence - key for foreign
  companies.
• Services outsourcing - still small number but
  relevant.
• Population growth will boost supply side (75-110
  new workers over next decade).
• Democratic system avoids systemic instability.
• Global integration may start acceleration of
  trend.
• Negative factors
• Despite structural reforms in 1990s, structural
  problems remain serious (labour market rigidity).
• Infrastructure remains insufficient, even
  compared with China.

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Looking for the long-term
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Importance of emerging markets to rise
of global GDP
14 more
14 less
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Key changes by 2030

• Economic mass shifts to Asia
• Away from Europe
• Emerging world becomes more important
• But not the most important
• Emerging world remains more dynamic
• Demography and productivity
• Star performers catch up with the developed
  world?
• In volume of overall production yes
• In value per capita no

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Conclusion
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Conclusion

• Oil prices will remain high - but impact so far
  limited.
• US current account deficit is unsustainable and
  risk of crisis is substantial.
• Euro area growth is depressed by both structural
  and cyclical factors, and some recovery is
  likely.
• Japan is recovering from lost decade, though
  demographic problems will be major burden.
• China has grown strongly, boosted by several
  fundamental strength, though investment boom
  causes problem.
• India has substantial opportunities, currently
  still checked by regulatory problems.
• In long term, economic might will shift to Asia,
  away particularly from Europe.

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