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THE GLOBAL ECONOMY has been in a sweet spot in recent years, and prospects for 2007 remain favourable. World GDP is on course to post its fourth consecutive year of roughly 5% real growth, the fastest in several decades. Globalization, technological innovation and adoption, and economic reforms are enabling strong growth with sustained low inflation. Combined with abundant liquidity and what are by historical standards low interest rates, this positive macroeconomic backdrop has boosted global asset prices.
Yet there is a lingering sense among policymakers, investors, business executives and average citizens that these good times wont last. Geopolitical risks are an obvious source of concern, with the situation in Iraq continuing to deteriorate and US-Iranian tensions seemingly building. The threat of a spike in oil prices persists, despite the fact that crude costs are well off last years highs. Global warming has moved up the list of pressing issues, although it is unlikely to affect the near-term economic outlook. Some cite lingering global imbalances or the sharp increase in the use of financial derivatives and leverage in recent years as looming risks. Others view historically low costs of corporate credit and narrow emerging market sovereign spreads (versus US treasuries) as signs of dangerous complacency in global capital markets.
But the global economy has proven to be remarkably resilient and capable of handling shocks. The US economy appears to be absorbing the unwinding of its earlier housing boom surprisingly well. Although it is premature to suggest that the housing sector has stabilized, worries about the impact on consumer spending have so far been overblown. China continues to be a source of support for the global economy, and this is unlikely to change soon. More generally, emerging market economies are healthier than at any time in memory. Low inflation and robust corporate finances provide additional strength and flexibility to the global economy. Event risk a crisis in a company, market or country is unavoidable but the risks of widespread contagion that could derail world economic expansion are low.
The benefits of productivity
The current health of the global economy reflects a significant improvement in global productivity growth, which has permitted real incomes to rise, kept a lid on inflation, and boosted corporate profits. This productivity growth, in turn, is the result of continuing changes in the world economy, stemming from globalization, technological innovation and economic reform.
Rapid globalization has been a key driver of productivity growth in recent years. While at the company level globalization involves reorienting production, distribution and managerial functions, at the macroeconomic level it effectively implies increasing cross-border flows of goods, services, capital and labour. These increasing flows enable companies and countries to focus on their comparative advantages.
The US has been on the leading edge of the globalization process among the larger, advanced economies. Accordingly, it has enjoyed sustained, strong productivity growth for more than a decade. The impact of globalization on the US is evident in the dramatic decline in manufacturing employment, the steady rise in the import content of its domestic consumption and the continuing decline in the price of goods (an increasing proportion of which are imported) relative to services.
China has been a major winner from globalization. Its economy has posted strong growth since it was opened up in 1978, but the pace has accelerated since China acceded to the World Trade Organization in 2001. China has become the worlds manufacturing centre, with massive inflows of foreign direct investment enabling it to become the third-largest exporter.
Meanwhile, the emerging economies are reaping the fruits of reforms undertaken after the crises of the 1990s and have paid down foreign debt, built up huge foreign exchange reserves and moved into current account surplus positions.
Strong productivity growth and low inflation have helped smooth out the business cycle, reduce uncertainty and temper interest rate volatility. But their benefits are primarily of a longer-term nature. They dampen, but do not eliminate, cyclical risks that remain key elements of the outlook for the remainder of 2007.
Oil prices providing relief
The sharp drop in crude oil prices in the second half of 2006 could not have come at a better time for the global economy. The decline from a peak of $78 a barrel to the $50 to $60 range has provided substantial relief to the American consumer. It is premature to declare that the US housing sector has stabilized and there are no longer downside risks to household spending. Still, the odds of the hard-landing scenario that many once feared have diminished markedly.
Many in the international community have been predicting the imminent demise of the US consumer for years. These bears argue that the low level of the household saving rate, ever-rising debt-to-income ratios, massive mortgage equity withdrawal in recent years, and a seemingly insatiable appetite for goods and services all spell eventual doom for the US consumer.
Perhaps that is the case but it seems unlikely to happen soon. The US household balance sheet is more liquid and stronger than many believe and, although debt levels and servicing costs are high by historical standards, as long as the job market stays firm there is little danger of a severe consumer retrenchment.
Indeed, the outlook for the US consumer appears to be improving. Aside from the drop in oil prices, employment growth and incomes are holding up well and point to steady spending. With headline inflation now retreating, real spending growth should be decent, ensuring that the US economy grows at a near-trend pace for 2007. The bears on the US economy look likely to be proven wrong again.
China remains a linchpin
Chinas economy has also repeatedly surprised on the upside in recent years. It expanded at an eye-popping 10.7% in 2006, the fastest pace in more than a decade. Growth is too fast for policymakers comfort and they have implemented various measures to clamp down on real estate speculation and investment in metal fabrication industries, and have allowed the renminbi to appreciate more rapidly against the US dollar. But with inflation still low, authorities are loth to take policy risks. Rather they will tinker at the edges to ensure that growth stays strong but is better balanced, both between investment and consumption, and between the coastal and inland regions.
Given Chinas crucial role as a source of downward pressure on global goods prices, worries about inflation risks on the mainland are widespread. There are lots of anecdotal reports about rising wage pressures and labour shortages in the south but there is as yet no sign that they are generating broader-based inflation. Strong nominal wage gains are more than offset by extremely rapid productivity growth, such that unit labour costs are still declining. This is supported by the fact that the prices of US imports from China continue to fall.
Fears that there could be a sharp appreciation of the renminbi or that China might stop buying US treasuries in order the better to diversify its foreign exchange holdings are also misplaced. Chinas paramount policy objective is to maintain rapid growth in order to employ its vast population. A significantly stronger renminbi in the short term is anathema to Chinese policymakers because it could undermine export activity, which is the driver of the economy.
Liquidity, liquidity everywhere
Abundant and cheap liquidity has been among the most prominent features of the global economy since this upswing began in 2001. Households and businesses have benefited from the availability of credit and the resulting rise in asset prices, but many policymakers and investors fear that as a result the global financial system is becoming increasingly vulnerable to a shock.
The debt deflations of the 1930s and in Japan in the 1990s serve as sober reminders of how periods of easy money can produce severe economic crises. In a debt deflation, excess leverage causes a vicious spiral of falling prices and output that feeds upon itself, and policymakers seemingly become powerless to halt it.
But there is little to support the contention that the global financial system is about to implode of its own accord. Financial crises are typically triggered by deteriorating economic conditions that then become contagious and eventually self-reinforcing, and are compounded by policy blunders. Fortunately, the global economy is quite robust and inflation remains low, indicating that central banks can gradually, rather than precipitously, unwind any excessive liquidity in the financial system.
The bottom line is that while there are always risks, and individual countries are vulnerable to shocks or political turmoil, the world economy is in remarkably good shape. Prospects are good for another year of global prosperity.
Peter Perkins is managing editor of Daily Insight at BCA Research, one of the worlds leading independent providers of global investment research. It provides services to investors in more than 80 countries through a range of products, consulting and conferences.Daily Insight at BCA Research, one of the worlds leading independent providers of global investment research. It provides services to investors in more than 80 countries through a range of products, consulting and conferences.
Global political risk map: Courtesy of Reactions magazine
|For historical country risk data please visit the Euromoney Country risk website|