copyright © 2005 global insight, inc. high oil prices and the falling dollar: how big of a threat...

Copyright © 2005 Global Insight, Inc.

High Oil Prices and the Falling Dollar: How Big of a Threat to the US and

Global Economies?

Nariman Behravesh

Chief Economist

Atlanta Spring Outlook Seminar

May 25, 2005

Copyright © 2005 Global Insight, Inc. 2 5/2005

Outline of the Presentation

A mature and vulnerable expansion

The oil price outlook — over $50 a barrel for a while

The Global Insight world outlook

How big of a threat is a much weaker US dollar?


A Mature and Vulnerable Expansion

The question is not whether the global economy is slowing down, but how much

High oil prices are exacerbating both the growth and current account imbalances

US consumer spending is losing steam, Chinese energy demand is decelerating, and a few countries (Germany, Italy, and Japan) are, once again, flirting with recession


A Mature and Vulnerable Expansion (Cont.)

Good news: Profits are strong, even in the sluggish economies

Good news: Inflation and interest rates are still low

Is there a “surplus” of savings — if not, why are long-term interest rates so low?

There is no shortage of risks Even higher oil prices Lopsided growth Bubbles High debt levels Protectionism


0

1

2

3

4

5

1986 1989 1992 1995 1998 2001 2004 2007 2010

(Percent change, real GDP)

World Growth Peaked in 2004


-2

0

2

4

6

8

NAFTA OtherAmericas

WesternEurope

EmergingEurope

Japan OtherAsia

MiddleEast

Africa

2003 2004 2005 2006 2007


Growth Is Very Uneven Across the World


The Oil Price Outlook — Over $50 a Barrel For a While


Despite an Improving Crude Market Balance, There Are Many Factors Holding Prices High

Factors keeping the price of crude oil high: Demand growth continues

Particularly demand for the light products Non-OPEC supplies continue to disappoint Continuing problems in Iraq; the on-going saga

in Russia Incremental OPEC supplies are heavy Global refining capacity to produce light products

from heavy crudes is limited


0.0

0.5

1.0

1.5

2.0

2.5

3.0

1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

The Strongest Oil Demand Growth in Over 20 Years…

(Annual percent change, millions of barrels per day)

Source: OECD


0.0

0.5

1.0

1.5

2.0

2.5

3.0

Nov-03 Jan-04 Mar-04 May-04 Jul-04 Sep-04 Nov-04

…Which Was Seriously Underestimated in Advance

(Successive IEA estimates of demand growth in 2004 vs. 2003, millions b/d)

Source: OECD


But Diminishing OPEC Spare Capacity Became the Greatest Concern

(Millions of barrels per day)

Source: OECD

0

1

2

3

4

5

6

7

Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05

23

24

25

26

27

28

29

30

Spare capacity (Left scale) Production (Right scale)


15

20

25

30

35

40

45

50

55

2000 2001 2002 2003 2004 2005 2006 2007 2008

WTI Brent

All Point to Higher Crude Prices in the Short Term

(US dollars per barrel)


Why the World Seems Immune to High Oil Prices

A demand-driven increase in oil prices is much less problematic than a supply disruption (e.g., embargo, revolution, or war)

The industrialized economies use roughly half as much energy per unit of output than in the early 1980s

Adjusted for inflation, oil and gasoline prices are much lower than in the early 1980s

The US, UK, and Norway still produce much of the oil they consume

Many emerging markets continue to heavily subsidize energy consumption — and many, especially China, use energy very inefficiently

Nevertheless, the Eurozone and Japan have been hurt more than most, despite greater energy efficiency and rising currencies

“Tipping point”? Around $70 to $80 per barrel


$80 Oil Scenario

Such a “crisis” scenario would be triggered by a supply disruption (e.g. a terrorist attack on Saudi oil facilities, further disruption of Iraqi supplies, more strikes by oil workers in Venezuela, continued rebel activity in Nigeria, more troubles with Yukos, etc.)

The disruption could last as long as two quarters

World growth would be cut by as much as 1.0%.

Countries with weak growth momentum (e.g. Germany and Japan) would likely be pushed back into recession

China would experience a “soft landing”


Real GDP Growth

United States

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

2005 2006 2007 2008 2009 2005 2006 2007 2008 2009 2005 2006 2007 2008 2009

$80 Oil Scenario Baseline

(Percent)

Germany France

Source: Global Insight Global Scenario Model


Real GDP Growth

Japan

0.0

1.5

3.0

4.5

6.0

7.5

9.0

2005 2006 2007 2008 2009 2005 2006 2007 2008 2009

$80 Oil Scenario Baseline

(Percent)China



The Global Insight World Outlook


The United States — Strong and Resilient


The Remarkable Resilience of the US Economy to Shocks

Record high oil prices? Growth has barely slowed

Iraq war? Post-war growth was the highest since the late 1990s

Corporate scandals? US companies have the strongest financial balances in decades

Terrorist attacks? The US economy barely missed a beat

The biggest stock market crash since the 1930s? The ensuing downturn was the mildest on record

Too little saving and too much debt? The US consumer hasn’t noticed

A sharply lower dollar, rising inflation, and a large budget deficit? The bond market isn’t that worried — yet


Good Luck, Good Policies, or Something More?

Good luck A low inflation and low interest rate environment help

Good policies Aggressive use of fiscal and monetary policies has been a

plus for the US — unlike the Eurozone and Japan

Something more Deregulation and greater reliance on market-based

solutions have helped the US to become more flexible Part of a Schumpeter/Kondratiev “long-wave” expansion?

Too good to be true? Dark side: Growing current account deficit and the risk of

higher inflation and interest rates Bright side: US fundamentals are still strong and a “hard

landing” is a low-likelihood scenario


The US Economy Is Slowing

-1.5

0.0

1.5

3.0

4.5

6.0

7.5

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

3.5

4.0

4.5

5.0

5.5

6.0

6.5(Real GDP growth, annual percent change, 2000 dollars)


(Payroll employment, percent change, annual rate)

Employment Gains Have Disappointed

-3

-2

-1

0

1

2

3

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007


1

2

3

4

5

6

1999 2000 2001 2002 2003 2004 2005 2006

(Percent change from a year earlier)

Productivity Growth Has Been Spectacular…


45

46

47

48

49

50

1999 2000 2001 2002 2003 2004 2005 2006

6.5

7.5

8.5

9.5

10.5

11.5

Wages and Salaries Economic Profits

(Percent of GDP)

…Good News For Profits, But Not For Wages


The Personal Saving Rate Is Close to Zero

-1

0

1

2

3

4

5

1998 1999 2000 2001 2002 2003 2004 2005

(Personal savings rate, percent of disposable income)


House Prices Have Risen Sharply Relative to Wages…

80

90

100

110

120

1972 1976 1980 1984 1988 1992 1996 2000 2004

Existing Home Prices/Hourly Labor Compensation

(2000=100)


…Though Low Interest Rates Mean That Homes Are Still “Affordable”

0.6

0.8

1.0

1.2

1.4

1.6

1972 1976 1980 1984 1988 1992 1996 2000 2004

Affordability Index for Existing Single-Family Home

A higher index means homes are more affordable


1.0

1.5

2.0

2.5

3.0

3.5

1999 2000 2001 2002 2003 2004 2005 2006 2007

All-Urban CPI Core CPI


Core Inflation Has Risen


0

2

4

6

8

1999 2000 2001 2002 2003 2004 2005 2006 2007

Federal Funds 10-Year Treasury Yield

(Percent)

The Fed Has More Work to Do


8

10

12

14

16

18

20

1971 1976 1981 1986 1991 1996 2001 2006

0.8

1.1

1.4

1.7

2.0

2.3

2.6

Light Vehicle Sales (Left scale) Housing Starts (Right scale)

(Millions)

But There’s No Room for Surges in Demand for Cars or Houses

(Millions)


Corporate Cash Flow Is at Record Levels

7

8

9

10

11

12

1970 1974 1978 1982 1986 1990 1994 1998 2002 2006

(Net corporate cash flow, percent of GDP)


-10

0

10

20

30

40

Structures Computers Software Communic.Equipment

OtherEquipment

2003 2004 2005 2006 2007

(Percent change, 2000 dollars)

Business Investment Has Accelerated — But Pace of Growth Will Probably Ease in 2005


US Federal Budget: Receipts Are Out of Line with Historical Experience

16

18

20

22

24

1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007

Receipts Outlays

(Percent of GDP)


Nondefense Discretionary Spending Is Less than 20% of the Federal Budget

Medicare13% Medicaid

8%

Other mandatory

12%

Net Interest7%Defense plus

HLS21%

Nondef. discr. (ex-HLS)

18%

Social security21%

Federal budget spending shares, FY2004(HLS = homeland security)


-12

-8

-4

0

4

8

12

16

1998 1999 2000 2001 2002 2003 2004 2005 2006

Real US Exports Real US Imports


Will Export Growth Reaccelerate?


Why Didn’t the Eurozone Participate in the 2004 Boom?


Why Didn’t the Eurozone Participate in the 2004 Boom?

Very weak domestic demand growth is the most serious problem in the Eurozone

Fiscal and monetary policies are too tight given cyclical weakness and an appreciating currency

Large Eurozone companies are doing well by outsourcing and investing overseas

By some measures, financial vulnerability is greater in the Eurozone than the US

High oil prices have also hurt the Eurozone more than the US or the UK

A strong euro has not prevented some economies (e.g., Germany) from enjoying export-led growth


-1

0

1

2

3

4

France Germany Italy Spain UnitedKingdom

Sweden

2003 2004 2005 2006 2007

(Percent change)

Real GDP Growth Remains Below Trend in the Eurozone


(Dollars per euro)

The Euro Will Appreciate Further

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1999 2000 2001 2002 2003 2004 2005 2006


Real Effective Exchange Rate of the Euro 1990–2005

80

85

90

95

100

105

110

115

120

1990 1992 1994 1996 1998 2000 2002 2004

CPI PPI


The World’s Growth Imbalance

-1

0

1

2

3

4

5

2001 2002 2003 2004 2001 2002 2003 2004 2001 2002 2003 2004

Real GDP Growth Net Export Contribution Potential GDP Growth

(Percent)

United States Germany Japan


Japan — Growth Relapse


Slow and Uneven Progress in Japan

Japan’s economy is slowly beginning to recover from yet another recession in mid-2004 — exports, consumer spending, and business investment will show modest growth in 2005

Conditions have improved since the late 1990s — Japan’s financial sector is healthier, corporate profits are strong, and labor mobility is improving

There is a dichotomy between large, profitable multinational firms and struggling small- and medium-sized firms

The yen will continue to appreciate

Deflation will end in 2006 — maybe

Japan’s population will peak in 2007, then gradually decline


Japan’s Economy Is Back to Trend Growth


-2

0

2

4

6

8

1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008


(Yen per U.S. dollar)

The Dollar Will Keep Depreciating Against the Yen

50

70

90

110

130

150

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006


Asia — Still the Star Performer


Asia-Pacific: Still the Star Performer

China’s high-powered growth will gradually cool as the government curbs excessive state investment

India is rapidly developing its computer software, biotech, and business and financial services industries

South Korea is slow to recover from a consumer credit bubble — exports, the engine of growth, are now decelerating

Hong Kong, Singapore, Taiwan, and Indonesia are seeing an acceleration in business investment

Australia’s expansion will moderate in response to rising debt, a housing price bubble, and higher interest rates


Real GDP Growth in Asian Economies

(Percent change)

0

2

4

6

8

10

China Hong Kong Taiwan India Australia

2003 2004 2005 2006 2007


(Percent change)

Real GDP Growth in Asian Economies (Cont.)

0

2

4

6

8

10

Indonesia S. Korea Malaysia Philippines Singapore Thailand

2003 2004 2005 2006 2007


China’s Macroeconomic “Malaria” — Deflationary Overheating and

the Currency Peg


Reform Bottleneck — Growth and Inflation Both Declining

-5

0

5

10

15

20

25

1980 1983 1986 1989 1992 1995 1998 2001 2004

Real GDP GDP Deflator


2nd Round of ReformBegan

Tienanmen Incident Disruption

1997-2004 avg.GDP=8.3%PGDP=0.8%

1980-1996 avg.GDP=10.1%PGDP=7.4%


Despite Overheating, Deflationary Forces Remain Strong

-4

0

4

8

12

16

Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05

CPI CPI Food CPI Non-foodSource: Global Insight


Most Frequently Suggested Exchange Rate Policy Options to China

1. Revalue the renminbi

2. Widen the renminbi trading band and keep capital controls in place

3. Free float the currency and open the capital account

4. Repeg the renminbi to a trade-weighted basket of currencies

5. Adopt a managed float system and keep capital control

6. Maintain the currency peg, while offering an outlet for foreign exchange earnings and finding ways to relieve appreciation pressures


Arguments Against Each Option

Option 1 – Revalue: How much? Too large hurts exports, too small not credible

Option 2 – Widen band: Same as option 1

Option 3 – Free float: Excessive FX volatility, and risking banking sector collapse

Option 4 – Bskt peg: USD main vehicle currency for trade — basket peg eliminates ability to hedge exchange rate risks

Option 5 – Mng float: Similar to option 4

Option 6 – Keep peg: Trilemma. Encourages speculation. Imports US monetary policy


Renminbi Policy Outlook

The first four options are not viable given China’s macro conditions

The last two policy options are the least costly, with the peg option maintaining a modest edge

But given Beijing’s desire to gradually liberalize the capital account, the balance between the two options could soon reach a tipping point

Therefore, Beijing is likely to keep the peg for another few years and then switch to a managed float


China: The Long-Term Promise and Pitfalls

China’s high growth rate is sustainable given its large population, still low levels of productivity, and high saving rate

China could have grown even faster if it had used its capital more efficiently

China’s open model of development is particularly well suited to the 21st century

The road ahead could still be very bumpyProblems with state-owned companies and banksRegional disparities and social tensionsTaiwan


Other Emerging Markets Enjoying The Ride


Other Emerging Regions Enjoying the Ride

The world recovery and strong commodity prices have boosted growth prospects in emerging markets

However, high oil prices are hurting some countries

Lower risk premiums are helping to attract capital again

Countries with currencies linked to the US dollar have benefited from the its depreciation over the past two years

Sources of vulnerability: Weaker commodities prices US consumer retrenchment Chinese hard landing Even higher oil prices


Other Emerging Markets Are Growing

0

2

4

6

8

Central Europe &the Balkans

Commonwealth ofIndependent

States

Middle East &Africa

Latin America &Caribbean

2003 2004 2005 2006 2007



How Big of a Threat Is a Much Weaker Dollar?


Global Imbalances: Myths, Realities, and Risks

The tendency to label the US as “profligate” misses the point

Public and private sector debt levels in most developed countries are high, saving rates have fallen and house prices have skyrocketed

If high debt levels lead to current account deficits, why are Japan and Germany running surpluses?

High savings, current account surpluses, and strong currencies don’t always translate into strong growth

Both the US budget and current account deficits are manageable problems


Global Imbalances: Myths, Realities, and Risks (Cont.)

The global imbalances are global problems requiring global solutions Higher savings in the US Stronger domestic demand growth in Europe

and Japan More currency adjustment in Asia

Risk: Another 30% to 40% drop in the dollar

Reality: The 35% drop in the dollar in the late 1980s did only limited damage


0 30 60 90 120 150

Italy

France

Germany

United States

Canada

United Kingdom

Japan

1991 2003

G7 Household Debt

(Percent of disposable income)

Source: OECD


House Price Inflation

-75 0 75 150 225

Hong KongJapan

GermanySwitzerland

CanadaDenmark

New ZealandBelgium

United StatesItaly

NetherlandsSwedenFrance

AustraliaSpain BritainIreland

South Africa

(Percent increase 1997-2004)

Source: The Economist


Fiscal Balances

-12.5

-10.0

-7.5

-5.0

-2.5

0.0

2.5

1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015

United States Eurpean Union Japan Asia excl. Japan

(Percent of GDP)


0 30 60 90 120 150 180

United Kingdom

United States

Canada

Eurozone

Japan

1991 2004

General Government Gross Financial Liabilities

Source: OECD

(Percent of GDP)


0 100 200 300 400 500 600 700 800

United KingdomSweden

SpainAustralia

ItalyCanada

United StatesNew ZealandNetherlands

FranceGermany

Japan

(Percent)

General Government Debt-to-GDP Ratio in 2050

Source: Standard & Poor


(Percent of GDP)

Current Account Balances

-8

-6

-4

-2

0

2

4

1990 1993 1996 1999 2002 2005 2008 2011 2014

United States European Union Japan Asia exc. Japan


Domestic Demand Growth

(Percent change)

-2

0

2

4

6

8

1985 1987 1989 1991 1993 1995 1997 1999 2001 2003

United States Germany Japan


(US dollar foreign exchange value, FRB broad index, March 1973=100)

The Exchange Rate Has Not Yet Fallen as Far as in the 1980s

80

90

100

110

120

130

1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003


Impact of a Weaker Dollar Versus US Growth on Germany’s Export Growth

-12-8-4048

1216

1985 1987 1989 1991 1993 1995 1997 1999 2001 2003

0.70.80.91.01.11.21.31.4

Germany Export Growth (Left scale, percent change)

US Real GDP Growth (Left scale, percent change)

US Dollar per Euro (Right scale, annual average)


Impact of a Weaker Dollar on US Interest Rates

90110130150170190210230250

1985 1987 1989 1991 1993 1995 1997 1999 2001 2003

34567891011

Yen per US Dollar (Left scale)

US Long Term Interest Rate (Right scale)

(Annual average) (Percent)


US Budget Deficit Reduction Scenario: United States

0

1

2

3

4

2005 2006 2007 2008 2009 2010

0

10

20

30

40

US Budget Deficit Reduction Scenario (Left scale, real GDP growth rate)

Baseline (Left scale, real GDP growth rate)

Current Account Deviation from Baseline (Right scale)

(Real GDP growth rate, percent) (Billions of US dollars)



US Budget Deficit Reduction Scenario: Japan

0.0

0.5

1.0

1.5

2.0

2.5

2005 2006 2007 2008 2009 2010

US Budget Deficit Reduction Scenario Baseline

(Real GDP growth rate, percent)



30% Drop in the Dollar Scenario: United States

0

1

2

3

4

5

2005 2006 2007 2008 2009 2010

-100

0

100

200

300

400

30% Dollar Drop Scenario (Left scale, real GDP growth rate)

Baseline (Left scale, real GDP growth rate)

Current Account Deficit Deviation from Baseline (Right scale)

(Real GDP growth rate, percent) (Billions of US dollars)



30% Drop in the Dollar Scenario: Japan

0.0

0.5

1.0

1.5

2.0

2.5

2005 2006 2007 2008 2009 2010

30% Dollar Drop Scenario Baseline

(Real GDP growth rate, percent)



Bottom Line

Higher oil prices are a bigger threat to the global outlook than a falling dollar

If oil prices rise to $80 per barrel (possible but not likely) then some economies could be pushed into recession

Even in the base case, world growth will be lopsided

A much weaker dollar will reduce domestic demand in the US and boost export growth – if the rest of the world stimulates domestic demand, then the outcome could be positive

The implications for Europe, Asia, and Latin America will depend on how much currencies in these regions appreciate against the dollar and how much stimulus is provided

copyright © 2005 global insight, inc. high oil prices and the falling dollar: how big of a threat...

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