Document Index Budget Paper 1 Budget Statement 2

Part II: The Outlook for the International Economy

The severe recession in Japan and the weakness in the East Asian crisis economies detracted significantly from world economic growth in 1998, with growth slowing from 3¼ per cent in 1997 to 1¾ per cent in 1998. Robust growth in the United States economy and solid economic growth in Europe has supported world growth.

Growth in the United States and Europe is expected to be weaker in 1999 and significant contractions are expected in several emerging market economies, in particular Brazil and Russia. Offsetting these are the expected improvement in the troubled economies of East Asia and a moderation in the rate of economic contraction in Japan. On balance, world economic growth should be maintained at its current pace of around 1¾ per cent.

World economic growth is expected to strengthen to around 2½ per cent in 2000, with an anticipated pick-up in growth in the European Union, further improvement in East Asia and recovery in Latin America and Eastern Europe. While growth in the United States could continue to exceed expectations, there remains considerable uncertainty surrounding the outlook for Japan and the strength of recovery in the crisis-affected emerging markets.

Chart 1: Percentage Point Contributions to World Growth Rates^(a)

1. European Union, Non-Japan East Asia, Rest of World and World GDP growth rates are calculated using GDP weights based on market exchange rates.
2. Germany, France, Italy, the United Kingdom, Belgium, Netherlands, Greece, Denmark, Sweden, Luxembourg, Austria, Spain, Portugal, Finland and Ireland.
3. Korea, Singapore, Taiwan, Hong Kong, China, Indonesia, Malaysia, Thailand and the Philippines.

Source: Various national statistical publications, IMF and Treasury.

Table 2: GDP Growth Rates for Selected Countries and Groupings^(a)

1. European Union, Non-Japan East Asia, OECD and World GDP growth rates are calculated using GDP weights based on market exchange rates.
   
2. The United States, Japan, Germany, France, Italy, the United Kingdom, Canada, Australia, Austria, Belgium, Czech Republic, Denmark, Finland, Greece, Hungary, Iceland, Ireland, Korea, Luxembourg, Mexico, the Netherlands, New Zealand, Norway, Poland, Portugal, Spain, Sweden, Switzerland and Turkey.
   
3. Treasury estimates for European Union, OECD and World.
   Source: Various national statistical publications, IMF and Treasury.

The United States economy continued to grow strongly in 1998 and into 1999 -- its ninth year of continuous economic expansion -- providing considerable support to world growth.

In recent years, above-trend economic growth has reflected particularly robust growth in both consumption and investment. This has been supported by strong employment growth, rising real wages, large gains in the value of equity holdings, significant falls in interest rates and high levels of consumer confidence. Household consumption growth has exceeded income growth as conventionally measured (ie excluding capital gains and losses). Inflation and inflation expectations remain subdued, having fallen significantly in recent years despite strong employment growth and very low rates of unemployment.

The continuation of strong economic growth and subdued inflation probably reflects, in some part, a structural improvement in productivity growth flowing from increased competition in product and labour markets, and substantial investment in new technology. However, this low-inflation growth has also been aided by several positive supply-side developments. These include, in particular, the significant declines in world commodity prices -- especially energy prices -- and in import prices more generally that have resulted from a weakening in world growth and a strengthening US currency.

The relative strength of the US economy has also attracted large amounts of international capital from less stable markets. This inflow has helped to push down domestic bond yields, boost equity prices and increase investment. However, the associated fall in net exports has impacted significantly on manufacturing output.

The outlook for 1999 and 2000 is for growth to moderate towards a more sustainable rate, with a waning in recent positive supply-side developments expected to provide some direct constraint to growth. Investment should slow with a weaker overall profit outlook, lower capacity utilisation rates and the ongoing impact on industrial production of a strong currency and external weakness. Consumption spending should ease as a result of an expected slowing in employment growth and in the rate of wealth accumulation.

However, US economic growth may continue to exceed expectations. Much of the strength of investment has been in information technology which may distort traditional capacity utilisation measures. If so, investment growth may continue to be strong notwithstanding apparently low capacity utilisation. In the first quarter of 1999, consumption and investment growth has maintained the momentum of 1998 and the stock market has continued to post significant gains supported by indications of continued strong profit performance. That said, there is limited scope for further falls in unemployment and, with some abatement in the factors that have helped offset inflation, the continuation of current growth rates is likely to increase inflationary pressures. In addition, the rapid growth in equity prices in recent years poses concerns about the effects of a possible significant and sustained correction.

Further, while the maintenance of open and competitive markets has helped to cushion the negative impact of external weakness on the US economy, there is a risk that further deterioration in the current account deficit in 1999, as is expected, may give increased voice to protectionist sentiment within the United States.

Growth in the European Union maintained the momentum of 1997 into the first half of 1998, with some moderation occurring in the second half of the year. While there was continuing strength in France and the smaller euro economies, weaker growth became evident in Germany, Italy and the United Kingdom. The manufacturing sectors suffered as a result of weakness in the East Asian region and weak business confidence in general, but domestic demand strengthened considerably on the back of productivity increases that boosted household income, along with high levels of consumer confidence and reductions in interest rates.

Stronger growth is expected to resume in the second half of 1999 and continue into 2000. Investment is expected to pick-up steadily during 1999, supported by accommodative monetary conditions including a weaker euro, high capacity utilisation and a gradual improvement in the external sector as world growth strengthens. Consumption strongly supported growth during 1998 and is expected to do the same in 1999. While the external sector is expected to improve through 1999 it is still likely to detract from growth for the year as a whole. The improvement in the external sector is expected to continue in 2000.

Growth in the past two years has been supported by a shift in the balance of macroeconomic policy settings, with significant easings in monetary conditions and substantial improvement in fiscal positions, made in the move toward European Monetary Union (EMU). The operation of EMU, however, will serve to highlight further the persistent structural impediments to growth in both labour and product markets in Europe. Flexibility in these markets will become more important as governments have relinquished the policy options of nationally-set interest rates and internal exchange rate adjustments and have placed limitations on fiscal policy.

The Japanese economy remains in protracted recession. Substantial fiscal stimulus measures and growth in the external sector have been unable to offset contraction in private domestic demand, which has been adversely affected by significant deterioration in business and consumer confidence, constrained credit availability arising from problems in the banking sector and weak profitability within the corporate sector.

The outlook is for a further contraction in activity in 1999 before stabilising in 2000. Continued weakness in private demand is expected in 1999, influenced by the ongoing removal of excess industrial capacity and increased restructuring within the corporate sector and further deterioration in employment and household income prospects. In addition, the strengthening of the currency since August 1998 should temper the positive contribution that the external sector provided in 1998. While fiscal stimulus is anticipated to provide some support for activity in 1999 and 2000, high levels of public debt will constrain the sustainability of this course of action in the longer term.

Reforms aimed at restructuring the financial sector and improving profitability within the corporate sector will provide a stronger base for economic recovery in the medium term. In the short term, these reforms may have a contractionary impact, although effective progress may also provide some positive impact on business and consumer confidence. While significant reforms are occurring in the banking and broader financial sector, there are still many problems to be resolved. Further reforms are necessary within the corporate sector, the labour market and in the provision of access to Japan's domestic market.

Several emerging market economies, particularly Brazil and Russia, are expected to experience significant contraction in 1999, following severe financial market instability and capital flight experienced over the latter half of 1998 and early 1999. Significant tightening in monetary policy made in response to the instability and significant moves towards fiscal consolidation, particularly in Brazil, are likely to contribute to the deterioration in the outlook for 1999.

These policy measures have been necessary to restore stability and confidence in financial markets and to address underlying structural and fiscal problems that hinder the return to strong sustainable growth. With reform now in progress in a number of these economies, it is anticipated that there will be an improvement in growth in 2000. However, if the implementation of reform in institutional, structural and macroeconomic policies is not ongoing, recovery is likely to be more delayed as confidence deteriorates, which may weaken the expected improvement in world growth in 2000.

The non-Japan East Asian region, in aggregate, contracted over the first half of 1998 --the first recession in at least 30 years -- after averaging annual output growth of around 8 per cent in the preceding decade. Output fell dramatically in Indonesia, Thailand, Malaysia and Korea, while Hong Kong was also heavily affected. The contraction in activity seen in Singapore and the Philippines was less severe, while solid growth was achieved in China and Taiwan, albeit at lower rates than experienced over recent years.

The worst of the economic contraction would appear to have passed, with the region in aggregate likely to experience a gradual improvement in growth rates over the next few years. Since the middle of 1998, activity in China has strengthened on the back of increased infrastructure spending, while output growth has resumed in Korea, Malaysia and Singapore. Taiwan has maintained solid output growth, while activity in Thailand and the Philippines is likely to stabilise over coming months. In Indonesia, progress will be heavily influenced by political and social developments. Increased stability in regional financial markets in the second half of 1998 allowed authorities to adopt more expansionary monetary and fiscal policies which assisted in halting the declines in output. However, large divergences in growth performance are likely to remain and many factors could still derail the recovery.

The outlook for exports will be an important factor affecting the recovery prospects of the East Asian economies. The improvement in competitiveness that many regional countries gained from large currency depreciations during the second half of 1997 has, to a large extent, been maintained and has contributed to an increase in exports to the growth economies of the United States and Europe. However, intra-regional exports have remained weak.

The gradual improvement in regional growth rates over the next few years will be a positive for exports within the region. However, the large trade imbalances building between the East Asian region (including Japan) and the growth economies (particularly the United States) have increased trade tensions and calls for trade restrictions. Continued access to the United States and European markets will be an important factor for the outlook for the region over the next few years.

The value of East Asian exports has also been affected by global over-capacity in several key sectors such as textiles and electronics, and the likelihood is that continuing weak global prices in these sectors will constrain export revenue over 1999.