Global economic prospects

Jan Friederich, Senior Economist

December 2005

Oil prices and the world economy

Sharp rise in oil prices

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1970 1973 1976 1979 1983 1986 1989 1992 1996 1999 2002

WTI in current US$ WTI in 3Q2005 US$

Surprisingly weak economic impact

Demand driven:

• Rise in oil prices offset by still strong global economy - itself driving force for oil prices.

Expansionary monetary policy:

• Oil price rise (without second round effects) allows monetary policy to remain expansionary for longer.

History:

• Important to remember that past “oil recessions” started before oil price shocks.

Determinants of impact on different countries:

• Dependence on oil imports, tightness of labour markets (second-round effects?), liquidity constraints.

The US external imbalance Risk of a crisis

Adjustment need is indisputable!Theory: With declining marginal returns to capital, limited returns

to scale, richest economy should not be net importer of capital, but now emerging markets are lenders (savings glut)!

Debt levels: With 5% of GDP current account deficit, 5% nominal GDP growth, external debt will converge to 105% of GDP; US liabilities in dollars so debt servicing no concern; but sharp depreciation amounts to effective debt default.

Emerging market motivation: Emerging markets lending reflects adjustment after Asian crisis (reserve build-up), high oil price, development strategy but inflation risks put up limits.

Experience: Few developed economies have been able to sustain deficit of more than 5% for significant amount of time.

Expertise: Volcker (alarmist), Institute for International Economics, IMF, OECD, many others.

Not whether but when and how

US foreign debt still contained

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Net foreign assets (% of GDP, 2003)

China

Strong but vulnerable

Chinese growth boosted by trade

Catch-up effect: China starts from low-base, so can increase productivity but adopting technologies of leaders.

Trade openness: High openness to trade for a poor country its size (Exports are 38% of GDP, 15% in India, 10% in US, 38% in Germany); World Trade Organisation membership in 2001; end of Multi-fiber Agreement in 2004.

Low wages: Very low labour costs boost competitiveness. US$1 per hour, US: US$22.7, India US$0.9, Germany US$32.9, Sri Lanka US$0.3).

Risks from excessive investment: Rising over-capacity resulting from over-investment would further increase high level of non-performing loans (15.6% for state-owned commercial banks). Substantial part of investment goes into real estate-with uncertain financial viability.

Extremely high Chinese investment

India Japan

China

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Gross fixed investment as % of GDP in Asia (2004)

Europe and Japan

For ever weak?

Some rays of hope

Euro area: • Structural problems: Enterprise conditions weaker than in

US; hiring and firing, business start-up etc; gradual improvement but temporary negative impact; ageing big

concern. • Cyclical problems: Weakness partly cyclical (reunification),

effects gradually being absorbed.

Japan: Sun rising again?• Domestic recovery this year more resilient than expected,

helped by good job creation.

• Healthy private investment following successful balance sheet restructuring.

• LDP majority, fresh mandate for Koizumi boost reforms.

• But: Labour force decline will be drag on growth.

Conclusion

Global picture

Relief: Oil impact weaker than thought.

Concern: US external imbalance remains threat.

Challenge: Emergence of China (and India), with rapid growth but also big imbalances.

Hope: Western Europe and Japan are recovering from long weakness.