Global Economic Conditions and Prospects
After a solid and broad-based growth for three consecutive years, world economic growth has moderated notably at the beginning of 2007. As indicated in the United Nation’s World Economic Situation and Prospects 2007 (WESP), the growth of world gross product (WGP) is expected to slow to a pace of 3.2 per cent for 2007, down from 3.8 per cent in 2006.
The economy of the United States of America will be the primary drag, as its growth is forecast to soften to a rate of 2.2 per cent in 2007, on the back of a substantial correction in housing market. The most recent meltdown in sub-prime mortgage markets, with delinquency rates climbing sharply, has heightened the risks for a possible longer and further weakening of the US housing sector. Meanwhile, the weakening of business capital spending and a downward trending of productivity growth may signal an even broader weakness in the world’s largest economy.
Growth in Europe and Japan appears to remain strong by the standards of those economies, but potential output growth is too limited for these other major economies to take over as alternative engines of global growth. Growth in Western Europe greatly exceeded expectations in the past year, as GDP in the euro area grew by 2.7 per cent, the fastest since 2000, and rates outside the euro area were also strong. This good performance has been anchored by domestic demand, particularly investment expenditure, but exports remain a key factor for the growth of the major economies in the area. The slowdown in the US is expected to induce a slight deceleration of European growth in 2007..Japan has sustained an expansion since 2003 at an average rate of 2.5 per cent, but its growth is also expected to weaken in 2007.
The UN expects that, among the economies in transition, the Commonwealth of Independent States (CIS) will sustain another year of robust growth in 2007 on the assumption of firm prices for oil, gas, and metals. Strength in domestic demand will likely continue in 2007, owing to rising real incomes throughout the region and strong pick-up in investments, especially in the resource-rich economies. Growth in South-Eastern Europe is expected to experience a modest deceleration, partly guided by economic policy measures to curb the booming domestic demand.
Among developing countries, sustained high growth in China and India has engendered more endogenous momentum for the growth of the group, through increasing South-South trade and financial linkages. This is reflected in, among other things, continued strong demand for and higher prices of energy and primary commodities. Commodity-exporting countries benefit from this, as shown by the continued strong performance in most African and Latin American countries.
More encouraging is the economic growth performance of the Least Developed Countries (LDCs), remarkably strong over the past few years, averaging nearly 7 percent per year. Their growth is expected to moderate slightly in 2007. This is good news for their potential to achieve the MDGs. It should be noted, however, that the performance of this group of countries has been quite diverse, with some countries lagging significantly behind.
Notwithstanding the improvement in their domestic economic conditions and stronger performance of their external sector, most developing countries remain highly vulnerable to a slowdown in the major developed economies and to volatility of international commodity and financial markets. The increased volatility in the prices of oil and some metal commodities as observed since mid-2006 should be a vivid warning for countries with a heavy dependence on primary commodity exports. While a large sell-off in the equity markets of many emerging economies in February 2007, which rippled to developed markets as well, was followed by a swift recovery, it serves as a reminder of the risky nature of these markets.
The prices of oil have been highly volatile. Tight worldwide oil production and refinery capacity, coupled with a solid global oil demand, has been the fundamental factor behind the upward trend in oil prices, while geopolitical tensions are among the major factors driving volatility. Oil prices are expected to remain high at about $60 per barrel on average in 2007.
Although high oil prices have thus far not significantly affected global economic growth as a whole, distributional effects across countries have been conspicuous. Oil-exporting countries have obviously benefited. While some oil-importing developing countries have seen strong non-oil commodity prices compensate for higher oil bills, many others have been negatively affected by persistently high oil prices.
The growth of the volume of world merchandise trade has been robust, increasing at a pace of approximately 10 per cent over the past year. The strength of global trade was broad-based. Asian economies continued to lead the dynamism in global trade, with exports of China and India increasing by about 20 percent in real terms. Also, many developing countries in Africa and Latin America managed to expand their exports at double-digit rates. Oil-exporting countries continued to experience large increases in export revenues. Exports of the major developed countries were also robust, driven by global demand for capital goods. In the outlook for 2007, growth of global trade is expected to moderate to about 8 per cent for the year.
The external financing costs for emerging market economies remain low. The spreads in the Emerging Markets Bond Index (EMBI) reached all-time lows in 2006, and have remained low despite the market turmoil of February 2007. Also, the benchmark interest rates underlying the external financing costs for emerging market economies have remained moderate. Such favourable external financing conditions may not be sustainable, as the current-account deficit of the United States may eventually induce higher benchmark interest rates.
Private capital flows to developing countries were strong, particularly foreign direct investment (FDI). Developing countries like China and India, as well as the major oil-exporters, have also become important foreign investors themselves.
On balance, however, poor countries continue to transfer more resources to rich countries than they receive. Net outward transfers by developing countries reached $658 billion in 2006 and those by economies in transition $125 billion. This trend of poor countries financing rich countries has continued for a decade, raising questions about its sustainability. The building-up of official reserves has been a key mechanism through which these net financial transfers have occurred. Developing countries now own well over $3 trillion in foreign-exchange reserves, with China alone holding more than $1 trillion.
There are a number of uncertainties and downside risks that may make the outlook for the global economy more gloomy. Two of them are elaborated here: the housing sector and global imbalances.
The possibility of a more severe downturn in housing markets represents a significant downside risk to the economic outlook. A number of economies have witnessed substantial appreciation of house prices over the past decade, and the associated wealth effects have contributed to solid economic growth rates. A reversal of the process will negatively affect the world economy.
A substantial correction in the housing market of the United States has already been undergoing for about a year. Sales of both new and existing homes had fallen near 20 percent below their peak levels, homebuilders cut construction sharply, and the inventory of unsold homes has more than doubled the normal level. Meanwhile, the pace of house-price appreciation has slowed markedly, with median prices of houses nation-wide starting to decline moderately. The slump in the housing sector has led to an estimated loss of GDP by more than one percentage point over the past year, with residential investment dropping by about 20 per cent.
So far the weakness has been contained within the housing sector, but the turmoil in sub-prime mortgage markets as manifested at the beginning of 2007 has heightened the risks of a spread of the weakness to the economy at large. As delinquency rates among sub-prime borrowers surged to an all-time high, lenders are facing substantial losses and are tightening the terms in the sub-prime mortgage markets. Although prime mortgage markets have remained calm and the general credit conditions remain healthy, more financial repercussion could show up should house prices fall further.
The prospects for the housing market remain uncertain. While the United Nations’ baseline forecast assumes a mild adjustment in the housing market, and hence a moderate slowdown in the US economy, an alternative, more pessimistic scenario, shows that a more severe decline in housing prices in the United States would not only reduce its own growth to a pace below 1 per cent in 2007, but also reduce economic growth in the rest of the world by more than one percentage point.
Current-account imbalances across countries have widened further during 2006. The deficit of the United States rose to above $800 billion. The current account of the developed economies as a whole shows a deficit of more than $600 billion, despite sizeable surpluses in Germany and Japan. Most developing regions are running surpluses, with the surplus in the group of oil-exporting countries increasing the most in 2006, to about $500 billion. The surplus in developing Asia remains above $200 billion, concentrated almost exclusively in China. Latin America has managed to run a surplus for an unprecedented period of four consecutive years, although most of the surplus generation has been concentrated in a few countries. Also, Africa as a region is now in surplus. The surplus in the CIS group has surpassed $100 billion, mainly on account of the Russian Federation.
In the baseline outlook for 2007, the global imbalances are expected to narrow slightly. With the economic growth in the United States expected to moderate more than that of other major economies, its current-account deficit is expected to narrow in 2007, but only by a small margin. As a result of the chronic current-account deficit, the indebtedness of the United States has deepened. This is undermining the sustainability of the current constellation of global imbalances.
The risk for a sharp depreciation of the dollar in association with an adjustment of the large US current-account deficit has increased. Since 2002, the trend of a depreciating dollar has been interrupted by periodic rebounds as the differentials in the interest rates and GDP growth rates among the major economies have been in favour of the dollar. But in 2007, these favourable rate-of-return differentials for the dollar are expected to narrow substantially. Since the differentials in growth rates and interest rates across major economies regions are expected to bring an unfavourable change of the United States dollar vis-à-vis other major currencies, a self-fulfilling sell-off of the dollar in foreign exchange market could trigger a steep fall of this currency, which could in turn upset financial markets and cause an abrupt adjustment of global imbalances.
Policy Coordination for Global Rebalancing
Existing macroeconomic policy stances in individual economies are not designed to achieve a benign adjustment in the global imbalances. Any unilateral or bilateral attempt to adjust the imbalances will be ineffective and could be counterproductive. An internationally coordinated strategy, in contrast, could help mitigate the contractionary effects of the global rebalancing and buttress confidence in the stability of financial and foreign exchange markets. A concerted stimulus in Europe, Asia, and the major oil-exporting countries could then offset the contractionary effect of adjustment policies conducted by the United States.
The UN in its annual report, the World Economic Situation and Prospects 2007 , has proposed a number of concrete steps that may lead to an effective international consultation mechanism, a step towards international policy coordination. This mechanism would include the IMF as an outside mediator to generate a consensus on such policies. These consultations should further involve all major players, including a fair representation of developing countries. Therefore, existing platforms, such as the Group of 8 (G-8), are unsuitable in this regard.
Apart from working towards coordinated policies, the new consultation mechanism should also work towards more fundamental reforms of the international monetary system which would replace the current constellation under which the dollar acts largely as the dominant reserve currency for the world. The need for international policy coordination is more pressing than ever. Reaching consensus about the necessary adjustments will likely be less painful while the world economy is still growing at a relatively strong pace.
Voice and Participation of Developing Countries
The Monterrey Consensus highlighted the need for decision-making reform in the bodies of global economic governance. The question of strengthening representation of developing countries is now clearly on the agenda of the Bretton Woods institutions. In September 2006, the IMF Board of Governors adopted a resolution on quota and voice reform. The two main goals of the reform are ensuring that the distribution of quotas reflects member countries’ economic weight and role in the global economy and enhancing the voice of low-income countries. There is general agreement that the reform of IMF governance is of utmost importance, for the issue of voice and representation is at the heart of the Fund’s credibility and legitimacy as an international institution overseeing the stability of the global economy.
As a first step, an ad hoc quota increase was approved for China, Mexico, the Republic of Korea, and Turkey, four clearly underrepresented members. A two-year plan of action has been outlined for more fundamental reforms, including an agreement on a simpler and more transparent quota formula that will provide the basis for a second round of ad hoc quota increases and future increases. The resolution also calls for at least a doubling of basic votes for all members and for protecting, at a minimum, the existing voting share of low-income countries as a group. It also calls for the proportion of basic votes in the total voting power to remain constant going forward. Current reform efforts need to address the substantial decline in the share of basic votes prior to this effort, which has fallen from the level of 11 percent, when the IMF was founded, to approximately two percent today.
As an arrangement directed toward mutual assistance and responsibility, the IMF was configured as a cooperative agency. Alleviating the perceived democratic deficit in the allocation of quotas is necessary to rebuild the IMF’s credibility in providing policy advice and undertaking surveillance, in designing and monitoring conditionality, and in the eyes of private markets, whose resources now dwarf those of the IMF. Therefore, it is important that the quota formula incorporate certain basic principles, which respond to these challenges. There should be adequate representation not only for contributors but also for users of the funds. These basic principles should inform the choice of indicators, the manner in which they are measured, and their weights in the formula.
In the formula for voting allocation, the relative weights of different variables will have a major impact on the allocation of quotas. Without prejudging, all four proposed variables (GDP, openness, variability of external accounts, and reserves) need to be re-examined to ensure that they not only accurately reflect the relative economic importance of countries, but also better capture vulnerabilities to the external shocks and the resulting potential need for Fund resources. The choice of actual indicators for these variables is also critical and should be consistent with their measurement in related analytical exercises. In this regard, the use of GDP measured through purchasing power parities (PPP) would be consistent with other practices in comparing the relative economic importance of economies.
Reaching an agreement on quota and voice reform will be challenging, involving conceptual, technical, and political complexities. It will be critical to engage in a wide-ranging consultation process to build a broad consensus.