The outlook for the international economy

The world economy grew strongly in the second half of 2003, supported by expansionary monetary and fiscal policies. The durability of the economic recovery has been aided by the broadening of growth, with strong growth in the US and East Asia, a firming recovery in Japan, and modest growth in Europe.

World economic growth is expected to be brisk throughout 2004, resulting in above trend growth for the year as a whole. Monetary and fiscal policies are likely to remain broadly expansionary across a wide group of economies. As the world recovery proceeds, policy stimulus is likely to be reduced with economic growth expected to ease accordingly in 2005. Despite a rise in oil and commodity prices, inflationary pressures are generally low reflecting continued excess capacity, with competitive pricing in domestic and world markets.

The world economy grew by 3.9 per cent in 2003 in year-average terms. World GDP is expected to grow by 4½ per cent in 2004, easing to 4¼ per cent in 2005. Growth in Australia’s major trading partners is expected to be 4¾ per cent in 2004, before easing back to 4 per cent in 2005.

Chart 1: World GDP growth^(a)

1. World GDP growth rates are calculated using GDP weights based on purchasing power parity.

Source: National statistical publications, International Monetary Fund (IMF) and Treasury.

The risks around the near-term outlook are balanced. An upside risk to the outlook is that the momentum building across large parts of the world economy could generate a more vigorous recovery than is currently envisaged. There were a number of upside surprises to growth over the latter half of 2003 and it could be the case that analysts have been slow to adjust their expectations as the world economy has recovered. Further, there is a substantial amount of policy stimulus in the pipeline that has the potential to stimulate growth more than anticipated.

Weighing against upside risks are downside risks emanating from geopolitical tensions, current account and fiscal imbalances, and high and volatile oil prices. Recent increases in oil prices reflect strong demand, particularly from China and the rest of East Asia. Increases in oil prices also reflect geopolitical tensions in the Middle East, a desire by the Organization of the Petroleum Exporting Countries (OPEC) to cut production, oil supply disruptions in Venezuela, and low private sector oil stocks, particularly in the US. For some countries, such as those in the euro area, the rise in oil prices has been offset by currency appreciation against the US dollar. However, high oil prices still pose a risk to world growth, with the current drivers of world demand, the US and East Asia, being the regions most negatively affected by higher US dollar oil prices.

The path of adjustment of current account and fiscal imbalances is a key risk to the medium-term outlook. Policy settings in the US and parts of East Asia are highly expansionary and unbalanced world growth has led to large global imbalances. The orderly depreciation of the US dollar and strengthening of domestic demand in East Asia should assist in partly correcting external imbalances. However, this partial adjustment needs to be set against the strong likelihood of imbalances persisting, with ongoing weakness in the euro area and structural impediments to growth in both the euro area and Japan. While the near-term risk of a disorderly adjustment process may have diminished somewhat, risks remain with the possibility of a sharp adjustment to the US dollar and US interest rates if foreign official capital inflows into the US were to be reduced. That said, it is likely that major Asian central banks have provided short-term support to global activity through their purchase of US Government bonds as part of their exchange rate management policies, though there are medium-term costs to these policies that will need to be addressed.

As the world recovery proceeds, interest rates around the world will rise from historical lows as monetary policy becomes less stimulatory. There is also the likelihood that unsustainable fiscal positions will contribute to an increase in global interest rates. Such a scenario would affect not only those countries in which fiscal positions need to be addressed, such as the US, but also emerging market and developing countries. This latter group is at risk of experiencing higher levels of interest rates, and higher spreads against US interest rates, as the recent reduction in risk premia are re-evaluated. An increase in global interest rates could have a large impact on the balance sheets of both the public and private sectors in emerging market and developing countries.

Lack of progress on multilateral trade negotiations and the recent increase in protectionist sentiment in some countries and regions also present a risk to longer-term growth prospects through constraints to increased trade and economic integration. Improving economic conditions, with favourable implications for labour markets in industrialised countries, may act as a countervailing influence. However, the potential for world and domestic imbalances to exacerbate concerns is likely to persist.

Table 2: International GDP growth forecasts^(a)(b)

1. Percentage change on previous year.
2. Growth rates for world and the euro area are calculated using GDP weights based on purchasing power parity, while growth rates for major trading partners and non-Japan East Asia are calculated using export trade weights.
3. Non-Japan East Asia comprises Korea, Singapore, Taiwan, Hong Kong, China, Indonesia, Malaysia, Thailand and the Philippines.

Source: National statistical publications, IMF and Treasury.

The US economy grew strongly over the second half of 2003 and into 2004. Growth broadened to include a strengthening recovery in business investment and exports, with continued support from consumption. The rebound in business investment over the second half of 2003 was predominantly driven by investment in equipment and software, especially ICT goods. Consumption, particularly of durable goods, was supported by strong growth in disposable incomes, wealth, and a high level of mortgage refinancing triggered by low interest rates. Disposable incomes were boosted by tax rebates, while increases in wealth reflected rising house prices and stronger stock markets.

The near-term outlook for the US economy is for continued strong growth, although not at the rapid pace of late 2003. Investment is expected to be the key driver of growth with productivity, profitability and business confidence all remaining strong. The low cost of capital and the need to replace existing capital equipment should provide further support to investment over 2004. Until recently there were concerns about weak employment growth. These concerns have been reduced somewhat with the release of recent data, which showed a strong rise in employment in the first quarter of 2004.

Despite recent increases in oil and commodity prices, US inflation remains low owing to continued excess capacity in the labour market, strong domestic competitive pressures and little imported inflation. As the recovery continues, monetary policy settings are likely to become less accommodative, as is already reflected in market interest rates. Reflecting these policy settings, US economic growth is expected to remain strong in 2005, but ease gradually as monetary and fiscal stimuli are reduced.

The US current account deficit remains around record high levels, while the size and likely persistence of the fiscal deficit continues to raise concerns about the medium-term outlook for US and world growth. The depreciation of the US dollar will assist in reducing the current account deficit, but in the near term the US current account will likely remain financed by foreign official capital inflows, which heightens US and global vulnerability to shocks and policy changes. A significant strengthening of domestic demand in the rest of the world, combined with a rebalancing of saving and investment within the US, is required before imbalances are likely to be substantially reduced.

The Japanese economy improved markedly over 2003, growing more strongly than expected in the second half of the year. Although concerns about the quality of national accounts data persist, GDP is estimated to have grown by 2.7 per cent in 2003. Growth was driven primarily by exports and business investment, which in turn were driven by external demand and healthier corporate balance sheets. Importantly for the sustainability of the recovery in Japan, consumption also began to contribute to growth.

The ‘quantitative easing’ monetary policy strategy adopted by the Bank of Japan appears to be having an impact with deflation and deflation expectations easing somewhat. Together with an increase in both consumer and business confidence and growth in disposable incomes, there are positive signs that domestic demand will strengthen in 2004. Improved corporate sector profitability and stronger share prices should support business investment.

Despite the more positive outlook for the Japanese economy, there remain significant structural weaknesses that continue to hamper economic growth. Partly reflecting these concerns and the likely impact of the appreciation of the yen, economic growth is expected to slow in 2005. Looking beyond this, Japan faces significant demographic challenges from a rapidly ageing population. The pressure this will place on the fiscal position is exacerbated by the high levels of government debt. With the Japanese workforce declining, GDP growth will need to come from productivity growth, underlining the urgency of action needed to address structural impediments to growth.

Economies in non-Japan East Asia grew strongly in the second half of 2003. The impact of the SARS epidemic was short but sharp, while avian flu had very little impact on economic growth. The rebound in US growth, particularly the strength of investment in ICT, coupled with very strong growth in China, contributed significantly to export growth across the rest of East Asia. Domestic demand is showing signs of strengthening in the more industrialised East Asian economies, while the developing economies of the region are also growing briskly.

China expanded rapidly in 2003, growing at its highest annual rate since 1996 (Box 1). Output growth was driven by strong investment, particularly in construction and automobiles. Trade has expanded significantly, with vigorous growth in both exports and imports. Rapid money supply and credit growth have raised concerns about the economy overheating and triggered a tightening of policy. A key uncertainty is how effective such tightening will be in reducing strong investment growth and containing inflationary pressures, particularly in the context of its managed exchange rate regime.

The euro area recovery has been hesitant with growth stalling in early 2003, before picking up modestly in late 2003. The improvement in growth was driven by external demand rather than an expansion in domestic demand. The weakness in domestic demand is reflected in the continued low level of consumer confidence. While economic indicators remain mixed, on balance they suggest a continued modest recovery with weakness remaining centred on Germany, which accounts for nearly a third of the output of the single currency zone.

Domestic demand in the euro area remained anaemic despite large fiscal deficits and tax cuts in both Germany and France. In 2004, six euro area countries are expected to breach the 3 per cent of GDP fiscal deficit limit prescribed by the Stability and Growth Pact. Concerns remain about the willingness of euro area governments to tackle their cyclical and persistent structural problems. The pending demographic challenges increase the need for progress on structural reform, particularly while labour movement restrictions from the ten accession countries exist. Europe’s capacity to manage macroeconomic policy will be further tested if the accession countries prematurely adopt the euro.

The United Kingdom (UK) grew more strongly than the euro area in 2003 and growth prospects remain significantly better in 2004. Growth in the UK is likely to be underpinned by continued solid consumption growth supported by growth in real disposable incomes and a record low level of unemployment, together with increases in both house prices and financial wealth.

In the near term, the world economic outlook is positive with upside and downside risks broadly balanced. The medium-term outlook presents more challenges, with the adjustment of large current account and fiscal imbalances and significant policy reforms required in many industrialised countries. There are also risks surrounding the related unwinding of the substantial policy stimulus currently in place.

Box 1: China as a driver of regional growth

China’s economy has grown by a remarkable 9.7 per cent per year on average over the past twenty years. In more recent years China has made an increasingly important contribution to regional growth (Chart A). China’s development as a major regional trading partner has been driven by the opening up of its large markets, its low production cost advantage and East Asian economies seeking out new opportunities. Since mid-2003, the region has exported more to China than to Japan. Chart A: Contributions to East Asian growth Source: IMF and Treasury estimates. Newly Industrialised Economies (NIEs) are Korea, Taiwan, Hong Kong and Singapore. ASEAN-4 are Indonesia, Malaysia, Thailand and the Philippines. China’s emergence is also reinforcing East Asia’s already strong links with developed economies, particularly the US. China’s exports to the US have risen to around 21 per cent of its total exports in 2003, with a considerable portion of these exports including components and semi-finished manufactures from elsewhere in the region.

Despite the considerable momentum in China’s economy there are a number of challenges that need to be addressed to ensure the continuation of strong and stable growth. One challenge is to address possible overheating of the economy. While consumer price inflation has been trending up, it has primarily been driven by food prices, with the prices of many other goods falling. Further, while inflation is likely to edge higher and become more widespread due to producer price pressure, a number of competing factors, such as productivity growth and a large surplus of rural labour, should work together to keep inflation under control. A greater challenge is to address possible overinvestment. Investment as a share of GDP is now well above its previous peak in 1993, with strong investment in steel, cement, aluminium, property and automobiles. Rapid investment has pushed up commodity prices and placed pressure on infrastructure. There is a risk that capital is being allocated inefficiently and directed towards projects that will prove unprofitable, placing further pressure on China’s financial system. China’s policymakers have used a range of measures to rein in money supply and credit growth, including raising banks’ required reserve ratios and discouraging loan growth to certain industries. The degree to which these measures are successful will have a large bearing on China’s near-term growth path and, by implication, the world economy.

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