Global economic prospects Jan Friederich, Senior Economist December 2005

Oil prices and the world economy

Sharp rise in oil prices

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. Determinants of impact on different countries: Dependence on oil imports, tightness of labour markets (second-round effects?), liquidity constraints.

The US external imbalance Risk of a crisis

Adjustment need is indisputable! Theory: With declining marginal returns to capital, limited returns to scale, richest economy should not be net importer of capital, but now emerging markets are lenders (savings glut)! Debt levels: With 5% of GDP current account deficit, 5% nominal GDP growth, external debt will converge to 105% of GDP; US liabilities in dollars so debt servicing no concern; but sharp depreciation amounts to effective debt default. Emerging market motivation: Emerging markets lending reflects adjustment after Asian crisis (reserve build-up), high oil price, development strategy but inflation risks put up limits. 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. Not whether but when and how

US foreign debt still contained

China Strong but vulnerable

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 Low wages: Very low labour costs boost competitiveness. US$1 per hour, US: US$22.7, India US$0.9, Germany US$32.9, Sri Lanka US$0.3). Risks from excessive investment: 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.

Extremely high Chinese investment

Europe and Japan For ever weak?

Some rays of hope Euro area: Structural problems: Enterprise conditions weaker than in US; hiring and firing, business start-up etc; gradual improvement but temporary negative impact; ageing big concern. Cyclical problems: Weakness partly cyclical (reunification), effects gradually being absorbed. Japan: Sun rising again? Domestic recovery this year more resilient than expected, helped by good job creation. Healthy private investment following successful balance sheet restructuring. LDP majority, fresh mandate for Koizumi boost reforms. But: Labour force decline will be drag on growth.

Conclusion

Global picture Relief: Oil impact weaker than thought. Concern: US external imbalance remains threat. Challenge: Emergence of China (and India), with rapid growth but also big imbalances. Hope: Western Europe and Japan are recovering from long weakness.