World economy: Groping for growth

The revival of the world economy had been taken for granted since the second-half of 2001; this of course has still not materialised.

Despite the slowdown in business investment, the overextended American consumer has been providing the impetus for growth.

The ongoing World Economic Forum is addressing the issue of global growth. Though forecasting is a humbling experience, economists continue to cherish this experience globally.

This article tries to examine the outlook for the world economy based on developments in G-3, regional growth dynamics and risk factors that may eventually lead to a downward revision of the current fairly optimistic growth forecasts for 2003.

The forecast of 4.0 per cent growth in world GDP for 2003 seems sanguine. The key driving force for global growth comes from developing countries such as India and China, which are expected to grow in excess of 5 per cent.

The US has been the resilient engine driving the world economy, while Germany continues to sputter and Japan has stalled.

The housing boom in the US has mitigated the wealth effect of the sharp drop in equities in March 2000.

Consumption spending has remained robust, though with job losses and a general increase in uncertainty. The Budget deficit is creeping up and more importantly current spending may not be able to stimulate growth on a sustained basis.

The developments in the Euro area depend to a large extent on the economic outlook for Germany. One of the major factors which is constraining economic growth in Germany is the slowdown in construction activity.

After the reunification of Eastern Germany, construction activity boomed and the real estate market is still trying to absorb the ambitious property developments.

The other factors are taxes and social security contributions and structural rigidity of the labour market.

The marginal burden of taxes and levies of 50 per cent or more is quite high and with the generous social benefits, there is no incentive to work. The complex structuring of labour contacts and the difficulties associated with redundancies have reduced the demand for labour in Germany.

In 2002, exports were a major source of growth.

The outlook for 2003 is still uncertain. Business investment seems fragile; consumption activity is not buoyant and government spending will soon be restricted to achieve the 3 per cent deficit and 60 per cent debt level as per the norms in the growth and stability pact.

The recent appreciation of the Euro by 21 per cent approximately on year on year basis may seriously affect exports, which was one of the key drivers of growth last year.

While some have dismissed the threat of deflation in Germany, the sustained weakness in aggregate demand suggests that deflation is still a clear and prevailing danger.

The precipitous drop of over 60 per cent in equity prices since the peak in March 2000, has been borne by financial institutions in Germany especially banks and life insurance companies.

The major risks facing the world economy are the sustainability of US current account deficits, threat of deflation, and the economic implications of the war on Iraq.

The US current account deficit is 4.8 per cent of gross domestic product -- usually a flashing red sign in the case of developing countries that a financial crisis is imminent.

The major component of current account deficit is the trade deficit.

The three major components of the US trade deficit are capital goods and non-industry supplies, consumer goods and autos, and services.

While capital goods and non-industry supplies and services are in surplus, consumer goods and autos are persistently in deficit. The deficit has actually increased from $150 billion in 1995 to about $300 billion in 2001.

Research on US trade dynamics has found that the long run elasticity of US exports of goods and services with respect to foreign national income stood at 0.80.

The long run elasticity of US imports of goods and services with respect to US national income was 1.80.

Though the US economy may grow at a slower pace than the world economy, due to the elasticities, trade deficit and thereby the current account deficit is expected to widen.

The financing of the current account deficit ultimately decides its sustainability.

The accumulation of current account deficits and net foreign capital inflows has made the US net international investment position negative.

In 1991, the net international investment position stood at $269 billion and by 2001 the net international position of the US economy was -- $2 trillion -- approximately 20 per cent of US GDP.

Global investors are probably close to their peak in terms of their holding of US assets in their global portfolio. The US is again with the problem of twin deficits: budget and current account deficit.

Given the sluggishness in the Euro area and Japan, the present depreciation of the dollar will not lead to a dramatic increase in US exports.

The dollar will have to depreciate further to bring the current account to more sustainable levels. The quantum of depreciation and the speed at which it happens is a significant source of risk for global economic growth.

The lack of credible structural reforms in Germany and financial sector reforms in Japan suggest that their dependence on external stimulus for growth will continue and sources of domestic demand remain stunted.

The Asian economies are experiencing robust domestic demand but are not large enough to pull up the world economy.

The threat of global deflation has been hanging like the sword of Damocles on the world economy. Deflation is a result of a sharp fall in aggregate demand.

The only way producers can push consumers to buy goods is by cutting prices on a regular basis.

The decline of consumer prices at the rate of 1 per cent per year in Japan has been one of the major causes for its economic woes.

The trouble with deflation is that it increases the real cost of borrowing, all forms of spending decline and debt deflation wherein the real value of debt increases.

China has been experiencing deflation driven by massive increases in aggregate supply due to productivity gains and decreasing costs.

Chinese exports to industrialised countries have also contributed to the declining prices in these countries.

The war on Iraq will not only lead to an increase in oil prices but also generally rattle financial markets with uncertainty.

Given that Iraq has the second largest known oil reserves in the world, the long- run economic impact of a stable regime in Iraq with massive investments in the oil sector can ensure stable oil prices.

The painful memories of stagflation of the 1970s must alert us to the risks of the current imbalances in the world economy, lest we end up with deflation and stagnation.