The outlook for the international economy
The world economy grew by 5.4 per cent in 2006, the fastest growth rate recorded in over 30 years, and slightly faster than the 5¼ per cent expected in the Mid-Year Economic and Fiscal Outlook 2006-07. While the United States economy slowed over the second half of 2006, Japan, India, China, and the euro area grew more strongly than expected.
The strong performance of the world economy occurred despite increases in official interest rates and high oil prices throughout much of the year. World growth continued to be underpinned by favourable financial market conditions and strong corporate balance sheets.
The world economy is expected to continue to expand strongly, and grow by 5 per cent in both 2007 and 2008 (Chart 1). Following growth of 4.8 per cent in 2006, Australia's major trading partners are expected to grow by 4½ per cent in 2007 and 2008 (Table 2).
Chart 1: World GDP growth(a)
- World GDP growth rates are calculated using GDP weights based on purchasing power parity.
Source: International Monetary Fund (IMF) and Treasury.
The United States is forecast to grow by 2¼ per cent in 2007, due to the lagged effects of tighter monetary policy and the downturn in the housing market. In 2008, a gradual recovery in the housing sector is expected to support a return to growth of around 3 per cent.
The housing downturn is likely to weigh on consumption growth over 2007. However, it remains unlikely that the housing market will cause a significant slowdown in other parts of the economy, with the momentum in employment and wage growth helping to offset the impact of the slowing housing market on consumption. Business investment is expected to remain firm over 2007, reflecting strong corporate profitability and high capacity utilisation rates.
While core inflation remains slightly elevated, it is expected to continue to moderate as a result of the slowdown in economic growth. Reflecting this, financial markets have priced in the possibility of a cut in official rates in the second half of 2007.
Table 2: International GDP growth forecasts(a)
- World, OECD and euro area growth rates are calculated using GDP weights based on purchasing power parity. Calculations for major trading partners and other East Asia use export trade weights.
- Euro area numbers are working-day adjusted.
- Production-based measures of GDP.
- 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 (ASEAN-4), which constitutes Indonesia, Malaysia, the Philippines and Thailand.
Source: National statistical publications, IMF and Treasury.
Japan's economic expansion continued in 2006, with GDP growing by 2.2 per cent. Growth is expected to moderate slightly to 2 per cent in 2007, with a gradual pick-up in private consumption growth partially offsetting a moderation in the pace of business investment and export growth. Consumer spending is expected to be supported by tighter labour market conditions and improved wage growth.
While core inflation was positive in through-the-year terms in the second half of 2006, uncertainty remains over whether Japan has fully emerged from its prolonged period of deflation. In February 2007, the Bank of Japan raised the target policy rate by 25 basis points to 0.5 per cent, but is expected to adopt a cautious approach to further tightening, with monetary conditions likely to remain accommodative for some time.
In 2006, China recorded its fourth straight year of double-digit growth, with GDP expanding by 10.7 per cent. Growth is expected to remain strong at 10½ per cent in 2007. Investment should remain the primary driver of growth, which is also likely to be supported by strengthening private consumption and a solid, although lessening, contribution from net exports.
Despite the introduction of monetary and administrative measures to moderate investment growth, investment is expected to remain relatively high. Investment growth will be underpinned by strong fundamentals, including: high rates of national saving; urbanisation, which is generating strong demand for new infrastructure; the continued availability of a large pool of low cost labour for firms to draw upon; and strong profit growth.
Growth in the rest of East Asia accelerated in 2006, with GDP expanding by 5.6 per cent, supported by strong growth in exports and consumption. Growth is forecast to ease to 5 per cent in 2007, in part reflecting moderating external demand, and economic prospects across the region are expected to diverge. In particular, growth in the NIEs is expected to moderate, reflecting softer private consumption, while the ASEAN-4 economies are likely to continue growing strongly due to strengthening domestic demand.
The Indian economy continued to grow strongly, with GDP expanding by 9.1 per cent in 2006, supported by strong domestic demand (Box 1). Concerns around rising inflation and strong credit growth, however, have led Indian authorities to tighten monetary conditions through a combination of higher interest rates and increased cash reserve ratios for financial institutions. As a result, India's growth rate is expected to moderate slightly to 8¼ per cent in 2007.
The euro area grew by 2.8 per cent in 2006, its highest rate of expansion since 2000. The strong result was underpinned by increased investment spending and robust export growth. An improving labour market supported consumer spending.
Growth is expected to remain strong but moderate to 2½ per cent in 2007, largely due to the effects of monetary and fiscal tightening and a lower contribution from net exports. Inflation remains relatively benign, although the European Central Bank has noted that the risks remain on the upside in the medium term.
Despite the positive global economic outlook, a number of risks remain. The main risks are: a sharper‑than‑expected slowing in the United States; heightened inflationary pressures; a substantial increase in oil prices; a re-appraisal of financial market risk by investors; and a disorderly unwinding of global current account imbalances.
A worse-than-expected slowdown in the United States housing sector remains a key risk to the United States economy and the near-term world outlook. To date, the slowing housing market has had limited impact on the wider economy. Moreover, the recent difficulties in the sub-prime mortgage market do not appear to have flowed through to the prime mortgage segment or triggered broader credit problems. Nevertheless, if the housing downturn becomes more severe than currently envisaged, this could flow more broadly through the economy.
Box 1: India's economic emergence | ||
India has emerged as one of the world's fastest growing economies. Over the past quarter‑century, India's economy has grown at an average annual rate of 6 per cent and, more recently, reached rates of around 9 per cent (Chart A). Chart A: India's growth performance
Source: IMF, April 2007. India has grown from being the world's ninth largest economy in 1980 (in purchasing power parity, or PPP, terms) to being the fourth largest today. Over recent years, India has contributed more to world economic growth than the euro area and Japan combined. Based on current trends, India could double its share of world GDP to around 12 per cent by 2030. India nonetheless remains a relatively poor country, and around two-thirds of its labour force continues to be employed in the agricultural sector. In 2006, GDP per capita (in PPP terms) was an estimated US$3,737; about one-tenth of the United States' level and less than half that of China. India's growth has been largely driven by domestic demand, with the services sector playing a leading role. In contrast to many other countries in Asia, India's external sector remains relatively small, with the sum of exports and imports accounting for only 33 per cent of GDP in 2006 (compared with 67 per cent for China). India has the potential to grow rapidly well into the future as it adopts newer technologies and its labour force shifts to more productive sectors. Favourable demographics will also continue to underpin growth. However, in order to achieve its potential, India will need to undertake further structural reforms. India has been Australia's fastest growing export market over the past five years, and is now our seventh largest export destination. In 2005-06, bilateral trade in goods reached $8.6 billion, of which $7.4 billion were exports to India (Chart B). Trade in services amounted to $1.7 billion and was dominated by Australian education exports to India. Chart B: Bilateral merchandise trade
Source: ABS cat. no. 5368.0. |
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As the world's economic expansion has strengthened and broadened, spare capacity has diminished in a number of developed economies prompting monetary authorities to tighten policy. This policy response, and the associated expected moderation in world growth, should help contain inflationary pressures. However, labour markets have continued to tighten in a number of economies, including the United States. Although nominal unit labour costs remain relatively well contained, wage growth could feed into inflationary pressures at some point over the forecast period. If this eventuates, it may prompt higher-than-expected interest rates and result in lower-than-expected global growth.
Following substantial falls in the second half of 2006 and early 2007, West Texas Intermediate oil prices have stabilised in recent months. Nevertheless, spare production and refining capacity remain low, and in such an environment there is a significant risk that adverse geo-political developments could lead to a substantial rise in oil prices. Any such increase would add to global inflationary pressures and lead to weaker growth.
The recent rebound in financial market volatility suggests that some repricing of financial risk is currently underway. Some of the factors that have underpinned favourable financial market conditions in recent years — such as an abundance of global liquidity and improvements in corporate balance sheets — cannot be expected to continue indefinitely. A greater-than-expected pick-up in financial market volatility, and associated increase in risk aversion, could have negative consequences for the global economic outlook.
One of the more striking features of financial markets over the past year has been the strong increase in leveraged buyouts. While corporate default rates remain low and overall corporate balance sheets remain healthy, higher debt levels could cause a more painful adjustment if interest rates were to increase unexpectedly, or if global economic growth were to slow markedly.
The risk of a disorderly unwinding of global current account imbalances appears to have abated somewhat, with growth across the world economy becoming more balanced. While an orderly unwinding remains most likely, the potential for a sudden, disorderly adjustment will remain while large imbalances persist.