International economic outlook

At Budget, the world economy was expanding strongly, with the pattern of growth across countries becoming more broadly based. The world economy remained strong over the first half of 2006, with strong activity across most regions. More recently, growth outcomes have begun to diverge. In particular, the US economy has slowed, driven by a downturn in the housing market and the lagged effects of monetary policy tightening. Growth in the euro area and Japan remains strong, with business investment a key driver of domestic demand in these economies. China and India have continued to grow rapidly, and continued economic strength has been a feature in other regions such as Latin America, Central and Eastern Europe, and Africa.

Spare capacity has been steadily absorbed in a number of developed economies, which has led to emerging signs of inflationary pressure. Monetary policy has been tightened in all major advanced economies, including Japan. That said, long-term inflation expectations remain well contained, and have actually fallen recently amid expectations of a moderation in US demand.

The world economic growth forecast for 2006 has been revised to 5¼ per cent, ¼ of a percentage point higher than at Budget, while the 2007 forecast remains unchanged (Table 3). Major trading partner growth is expected to be 4¾ per cent in 2006, an upward revision from Budget of ¼ of a percentage point, while the 2007 forecast remains unchanged. These upward revisions are largely due to higher-than-expected growth in China and the euro area, which more than offset slight downward revisions to the outlook for the US and Japan.

Table 3: International GDP growth forecasts^(a)(b)

1. Percentage change from preceding year.
2. Growth rates for the World and euro area are calculated using GDP weights based on purchasing power parity, while growth rates for major trading partners and other East Asia are calculated using export trade weights.
3. Other East Asia comprises the newly industrialised economies (NIEs), which constitutes Hong Kong, Korea, Singapore and Taiwan, and the Association of Southeast Asian Nations group of four (ASEAN4) which constitutes Indonesia, Malaysia, the Philippines and Thailand.

Source: National statistical publications, IMF and Treasury.

The outlook for the United States economy has deteriorated since Budget, with growth in the June and September quarters being weaker than anticipated. The US economy is expected to grow by 3¼ per cent in 2006, ¼ of a percentage point lower than at Budget, and 2½ per cent in 2007, ¾ of a percentage point lower than at Budget.

A contraction in residential investment is expected to continue to affect US growth into 2007. Moreover, the slowdown in the housing market is expected to result in a moderate slowing in consumption growth. However, overall domestic demand is expected to remain solid, reflecting high employment, firm wage growth and the recent moderation in oil prices. Business investment is expected to remain firm in 2007, with corporate profits currently strong and core capital goods orders remaining robust.

The likelihood of further increases in US interest rates appears to have diminished due to moderating output growth and inflation. However, the labour market remains tight and unit labour costs are rising, and there remains a risk that a continuation of the cyclical downturn in productivity could exacerbate inflation pressures.

In Japan the outlook for economic growth has been revised down since Budget. In part, this reflects weaker‑than‑expected growth in private consumption as a result of low incomes growth and one-off factors, such as unfavourable weather affecting clothing purchases. In addition, real GDP growth in 2005 has been revised down substantially, from 2.7 per cent to 1.9 per cent. Taking these effects together, the Japanese economy is expected to grow by 2 per cent in 2006, one percentage point lower than at Budget. GDP is expected to grow at a similar rate in 2007, with a modest pick-up in private consumption growth offsetting a moderation in the pace of business investment.

The Bank of Japan raised interest rates to 0.25 per cent in July, which was the first increase in almost six years. With recent core inflation outcomes being weaker than expected, further increases in interest rates are expected to occur very gradually.

Growth in the Chinese economy has exceeded expectations since Budget, largely due to a pick-up in investment growth in the first half of the year. The Chinese economy is forecast to grow by 10½ per cent in 2006 and 10 per cent in 2007, an upwards revision of ¾ of a percentage point from Budget in both years.

The pick-up in investment growth has led to renewed concerns about overheating and overinvestment, prompting the Chinese authorities to introduce further monetary and administrative tightening measures from April 2006. These measures have led to investment and GDP growth easing in the second half of 2006. GDP growth is expected to moderate slightly in 2007 but remain strong, with high rates of national saving, widespread urbanisation and the availability of a large pool of low-cost labour continuing to underpin the rapid pace of capital accumulation.

Growth in the rest of East Asia has evolved largely in line with expectations at Budget, with favourable world growth supporting robust demand for the region’s exports and strong employment growth supporting consumption growth. However, growth prospects across the region are likely to diverge in 2007. The ASEAN4 economies are expected to continue growing strongly while growth in the NIEs is expected to moderate. A pick-up in domestic demand in the NIEs is likely to be insufficient to offset weaker demand for the region’s exports particularly from the US.

Expectations for euro area growth in 2006 have improved markedly since Budget, with the 2006 forecast revised up by one percentage point, to 2¾ per cent, reflecting stronger-than-expected business investment. However, growth in 2007 is expected to moderate to around trend growth of 2 per cent, which predominantly reflects the fiscal consolidation packages that have been announced in Germany and Italy, as well as recent monetary policy tightening. The European Central Bank has raised official interest rates by a total of 150 basis points since December 2005.

There are a number of risks associated with the current outlook for the world economy with the balance of these risks tilted to the downside. These include: the potential for the US to slow more than expected; the possibility of higher oil prices; a re-appraisal of financial market risk; and a disorderly unwinding of world saving and investment imbalances.

An unexpectedly sharp slowdown in the US housing sector has emerged as a key risk to the US economy and the near-term world outlook. A sustained downturn in house prices could adversely affect consumption, depending on the extent to which households consolidate their balance sheets, which may precipitate a broader downturn in the US economy. Recent IMF estimates suggest that an unexpected one percentage point decline in US growth could lower world growth by around ½ of a percentage point.

Oil prices are currently around 20 per cent below the August peak of US$77 per barrel. Whilst the fall in prices is likely to provide some relief to consumers it may be short-lived. Supply-side concerns linger, and the spectre of further increases in prices remains a feature of the current market.

An increase in inflation expectations in mid-2006, and associated fears over the potential for more aggressive monetary policy tightening in advanced economies, sparked a sharp sell-off in financial markets. Financial markets have since recovered with recent months marked by a period of relatively low volatility. That said, the world financial system is not immune to adverse economic shocks, and in particular a shock which might lead to a reassessment of credit risk or expose weaknesses in risk management practices.

Whilst an orderly unwinding of world saving and investment imbalances remains the most likely path of adjustment over the medium term, the longer the imbalances continue, the greater is the potential for a sudden adjustment. Recent weakness in the US dollar may provide a tentative indication that the adjustment process is already under way. A disorderly adjustment would involve sudden changes in financial asset prices and exchange rates. A sudden adjustment of this sort could have serious implications for world economic activity.