Economic ship steady as she goes, A commentary By Raghuram Rajan Economic Counsellor and Director Research Department, IMF

September 23, 2005

A commentary By Raghuram Rajan
Economic Counsellor and Director
Research Department
International Monetary Fund
The Age (Melbourne, Australia)
September 23, 2005

The International Monetary Fund's Raghuram Rajan assesses how world economies are going. They're all right, but he has a few words of warning.

Our central forecast for global growth has remained relatively unchanged since our last World Economic Outlook in April. We project a robust growth rate of 4.3 per cent for this year and next. But several developments concern us. These include the excessive dependence of global demand on consumption, especially in the United States, high asset prices, particularly housing, and the high, volatile price of oil. The risks to our forecasts have increased.

We estimate hurricane Katrina, tragic as the human suffering has been, will reduce growth in the US by only 0.5 percentage points at an annual rate (by the end of the year) that will be partly offset by improvement next year. Put another way, growth this year will be about 0.1 percentage points lower because of Katrina.

Before Katrina, solid growth and booming house prices allowed US consumers to boldly spend. But consumer confidence has fallen. With rising inflation cutting into nominal wages, and rising interest rates slowing house price growth, we expect private consumption growth to slow. We project lower overall growth of 3.5 per cent this year and 3.3 per cent next year for the US.

Europe continues to disappoint. Our gross domestic product projections have drifted down to 1.2 per cent for this year and 1.8 per cent for next. Weak domestic demand continues to be the main problem. Europe's citizens do not seem convinced the bitter medicine of continued structural reforms will cure the stagnation that afflicts much of the continent. Of course, economists can only prescribe, but it takes politicians to persuade. It is a failure of politics that people have not come to see that the more they want to retain the attractive European way of life, the more the way they work will have to change.

The Japanese economy offers more hope, with the first half of this year coming in very strong. Particularly gratifying has been the steady improvement in private consumption. Coupled with buoyant private investment, Japan has been reducing its reliance on exports for growth. We have increased our growth estimate to 2 per cent.

China's economic expansion continues unabated, with growth of 9 per cent and a moderate easing to 8.2 per cent for next year. While China has to increase consumption, it also needs to improve the quality of its investment. Provinces, state-owned corporations and banks need to face a realistic cost of capital so that they invest more carefully.

India has been growing strongly and is basking in the glow of domestic business confidence and growing international interest. To maintain or even accelerate growth, India will need further reforms. But the Government has not built the needed consensus, and even the halting steps towards fiscal consolidation are giving way partially to populist measures. There is a tide, as Shakespeare wrote, which taken at the flood leads on to fortune. India cannot afford to miss the tide.

Growth elsewhere in emerging Asia moderated because of higher oil prices and a correction in the information technology sector, but is expected to pick up again in the second half of this year. Growth in Latin America and emerging Europe is slowing from its strong pace last year. In the Commonwealth of Independent States, growth is more subdued because of sluggish investment and lower oil output. In sub-Saharan Africa, economic performance is still robust, though several non-oil commodity exporters are facing a challenging environment. The Middle East has strong prospects because of higher oil revenue.

Let me now turn to risks. Some have suggested the world has a savings glut. In fact, the world is investing too little. The current situation has its roots in crises over the past decade that were caused by excessive investment, including the Japanese asset bubble, the crises in emerging Asia and Latin America, and the IT bubble. Investment has fallen off sharply since then, with only very cautious recovery.

The policy response to the slowdown in investment has differed considerably across countries. In the industrial countries, accommodative policies such as expansionary budgets and low interest rates have led to consumption or credit-fuelled growth, particularly in the Anglo-Saxon economies. Government savings have fallen, especially in the US and Japan, and household savings have virtually disappeared in some countries with housing booms.

By contrast, the crises were a wake-up call in several emerging market countries. Historically lax policies have been tightened, with some running primary surpluses for the first time, and most bringing down inflation through tight monetary policy. With corporations cautious about investing and governments prudent about spending, exports have led growth. Many emerging markets have run current account surpluses for the first time.

We should celebrate the implicit global policy co-ordination that enabled the world to weather these crises. Rich countries with policy room expanded consumption and were supplied and financed by emerging markets whose governments needed to be more austere. This is not a new world order; it is a temporary and effective response to crises. Now it needs to be reversed.

It is misleading to term this situation a savings glut, for that would imply that countries running current account surpluses should reduce domestic incentives to save. But if the true problem is investment restraint, then a reduction in world savings incentives will generate excessively high real interest rates when the factors holding back investment dissipate.

This is why the world now needs two kinds of transitions. First, consumption has to give way smoothly to investment, as past excess capacity is worked off and as expansionary policies in industrial countries return to normal. Second, to reduce the current account imbalances that have built up, demand has to shift from countries with deficits to countries with surpluses.

There are reasons to worry whether the needed transitions will take place smoothly. First, we need more investment, especially in low-income countries, emerging markets and oil producers. Of course, China is an exception in needing less, not more investment. The easy way to get more investment is a low-quality investment binge led by government or fuelled by easy credit. We know the consequences of that. The harder and correct way is through product, labour and financial market reforms, which will ensure high-quality investment emerges. While some progress has been made here, the good may have been the enemy of the perfect.

Higher oil prices are a clear and present danger. Their limited effect on growth thus far has been, in part, because prices were themselves driven up by unexpectedly strong demand growth. Yet increasingly, it is not news about unexpected demand but news about supply shortfalls and potential future shortages, especially of refined products, that are driving price increases. Moreover, higher oil prices are now adversely affecting confidence, and with economies closer to capacity, may create stronger inflationary pressures. Countries should pass on oil price increases to citizens instead of subsidising them, so that citizens make the right consumption choices. Populism on the energy front is not just harmful to a country but to the world, which faces an aggregate supply constraint. Conservation measures need to be also contemplated.


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