Extracted from World Economic Outlook, IMF, 2007


Global Economic Environment


The global economy expanded vigorously in 2006, growing by5.4 percent. In the United States, the expansion slowed in the face ofheadwinds from a sharp downturn in the housing market, but oil price declines since August have helped to sustain consumer spending. In the Euro area, growthaccelerated to its fastest pace in six years as domestic demand strengthened.In Japan, activity regained traction toward year-end, after a soft patch inmidyear. Among emerging market and developing countries, rapid growth was ledby China and India, while momentum was sustained across other regions ascountries benefited from high commodity prices and continued supportivefinancial conditions. Strong growth and rising oil prices in the first half of2006 raised concerns about inflation, but pressures have moderated with thedecline in oil prices since August. Against the background of strong growth andreduced concerns about inflation, global financial market conditions havegenerally been buoyant.


In foreign exchange markets, the U.S. dollar has weakened,mainly against the Euro and pound sterling. The yen has also depreciated further, in part because prospects for continued low interest rates have encouragedcapital outflows, although it recovered some ground in early 2007. The Chineserenminbi has declined modestly in real effective terms despite a mildacceleration in its rate of appreciation against the dollar. The U.S. current account deficit rose to 6 percent of GDP in 2006, although the non-oil tradedeficit declined as a percent of GDP as exports accelerated. Surpluses in Japan, China, and the Middle Eastern oil-exporting countries increased further.  The majorcentral banks have faced differing policy challenges in recent months. The U.S.Federal Reserve has kept policy rates on hold since June 2006, seeking tobalance risks from a cooling economy and lingering concerns about inflation.The European Central Bank (ECB) and other central banks in Europe havecontinued to remove monetary accommodation.  The Bank of Japan has raisedits policy rate very gradually since exiting its zero interest rate policy inJuly 2006.


Some emerging market countries- including China, India, and Turkey- have also tightened monetary policy.  Advanced economies continued tomake progress in strengthening their fiscal positions in 2006. Budget deficitswere reduced substantially in Germany, Japan, and the United States.  Fiscal gains largely reflected strong growth of tax revenues in thecyclical upswing.


Outlook and Risks


Global growth is expected to moderate to 4.9 percent in 2007and 2008, some percentage point slower than in 2006. In the United States, growth is expected to come down to 2.2 percent this year, from 3.3 percent in 2006,although the economy should gather some momentum during the course of the yearas the drag from the housing sector dissipates.


Growth is also expected to ease in the Euro area, reflectingin part the gradual withdrawal of monetary accommodation and further fiscalconsolidation. In Japan, the expansion is projected to continue at about thesame pace as in 2006.  Emerging market and developing countries areexpected to continue to grow strongly, albeit at a somewhat slower pace than in2006. These economies will continue to draw support from benign globalfinancial conditions and commodity prices that remain high notwithstandingrecent declines. China's growth is projected to remain rapid in 2007 and 2008,albeit a little below the torrid pace in 2006, while Indias economy shouldalso continue to grow rapidly. Commodity-rich countries should continue to prosper. 


Particular uncertainties include the potential for a sharperslowdown in the United States if the housing sector continues to deteriorate;the risk of a retrenchment from risky assets if financial market volatilitywere to rise from historically low levels; the risk that inflation pressures could revive as output gaps continue to close, particularly in the event of anotherspike in oil prices; and the low probability but high cost risk of a disorderlyunwinding of large global imbalances. 


Were the U.S. economy to slow sharply, this would have amore substantial impact on global growth.  From a longer-term perspective,developments that undermined the buoyant productivity performance of recentyears would clearly have an adverse affect on global growth. Strong productivity growth has been supported by a combination of technological progress, anincreasingly open global trading system, rising cross-country capital flows,and more resilient macroeconomic policy frameworks and financial systems. It isessential that these pillars remain in place, and that trends that could posechallenges to continued strong global economic performance-such as populationaging and global warming-are adequately addressed.


 

Can the Productivity Boom Be Sustained?


Recent years have been a remarkable period for the world economy, as global output growth has reached its highest sustained rate since the early 1970s, with strong increases in virtually all regions. Buoyant productivity has made possible healthy growth in profits in combination with rising real wages, has allowed sharp increases in commodity prices to be absorbed without derailing inflation performance, and has contributed to rising asset values that have supported consumption and investment. It is well known that productivity growth accelerated in the United States in the mid-1990s, in substantial part in response to increasing use of new information and communications technology (ICT), but productivity growth has also been strong and increasing in emerging market and developing countries over the same period.


Detailed studies with more precise measures of total factor productivity confirm this trend, particularly for countries and regions that have undergone major structural transformations- notably China, India, and emerging Europe, which have made dramatic progress in opening their economies and advancing market reform. In turn, strong productivity growth has been supported by a combination of technological developments, an increasingly open global trading system, rising cross-country capital flows, and more resilient macroeconomic policy frameworks and financial systems.


The rapid growth of international trade and the introduction of new technologies have allowed the production process to be unbundled, with both manufacturing and services activities being off shored to lower-cost locations in an increasingly global market, thus providing productivity gains both in source and in host countries.


This process has been supported by important trade liberalization initiatives, including the entry of former Eastern bloc countries in Europe into a free trade zone with the European Union in 1994, Mexicos participation in the North American Free Trade Agreement from 1994, China's entry into the World Trade Organization (WTO) in 2001, and Indias progressive unilateral reduction in trade barriers since the early 1990s.


The shifting production structure has also been supported by the increasing international mobility of capital, especially rising rates of foreign direct investment into emerging market countries, that has not only provided a conduit for financing but also embodied diffusion of new technologies and management skills. Another central feature of the recent past has been that strong productivity growth has been achieved even while investment has remained relatively subdued around the world.


Saving outside the advanced economies has continued to rise, mainly attributable to increasing savings (public and private) in China and higher public savings in oil-producing countries, although plans to boost government spending are now well under way. These investment and saving trends have contributed to the generally supportive global financial environment, with low long-term real interest rates and low volatilities, even as monetary conditions have been tightened. Thus, the U.S. expansion has continued to benefit from robust consumption growth despite the housing downturn, with the resultant widening current account deficit financed without upward pressure on long-term interest rates. Developments in the global financial system have played an important role, including the ability of the United States to generate assets with attractive liquidity and risk management features, as well as the continuing role of the U.S. dollar as an international reserve currency.


What factors could threaten the continuation of this benign combination of trends? There are a number of reasons to think that global productivity growth may decelerate in the period ahead. The recent slowdown in productivity growth in the United States may reflect to some degree a diminishing of the boost from advances in the ICT sector, as well as normal cyclical factors. Most other countries have lagged the United States in reaping the benefits from ICT advances, and therefore should be able to achieve continuing gains. However, doing so will depend in part on sustained reforms to reduce regulatory impediments and increase competition, particularly in service sectors such as wholesale distribution and finance, where the U.S. productivity performance has been very strong. 


A second source of concern is that global productivity growth may receive less support from trade liberalization in the years ahead. The recent revival in the Doha Round of multilateral liberalization is very welcome- a successful conclusion of the round could provide significant efficiency gains, particularly in agricultural sectors.

 

The process of bilateral and regional trade liberalization may continue, but it is not a substitute: such agreements- which already cover around one-third of global trade- are inherently less beneficial than liberalization on a "most favored nation" basis, and can be counterproductive if not well designed. Moreover, there is a serious danger that protectionist forces could rise in the years ahead, reversing some of the gains from an increasingly integrated global economy. Already there are concerns about recent resort to antidumping and "safeguards" actions around the world- and anti-trade measures could intensify in the context of a cyclical downturn and rising unemployment that would give added force to popular concerns about the impact of globalization on the distribution of income, particularly in advanced economies. Chapter 5 discusses how the rapid growth of international trade and the increasingly global labor market, combined with the introduction of new technologies, have produced important gains for income levels in both advanced and developing countries, as well as had an impact on income distribution.


The chapter presents evidence suggesting that recent declines in the share of labor in advanced economies reflect more technological change than increasing competition from a burgeoning global labor force. Nonetheless, more could be done to help those whose jobs may be particularly affected by recent trends in technology and trade, including through better education systems, more flexible labor markets, and welfare systems that cushion the impact of, but do not obstruct, economic change.


Third, global environmental and resource constraints are likely to impose increasing costs. Efforts to date to address the long-term problem of global warming have been limited and partial- few countries are expected to meet the goals for control of carbon emissions over 2008-12 set out in the Kyoto Protocol.


The potential long-term economic consequences of climate change are increasingly recognized, leading to rising interest across countries to take actions to control carbon emissions that would inevitably add to the costs of doing business even while averting much graver long-term consequences. For example, the recent Stern Review on the Economics of Climate Change estimates that it would cost about 1 percent of GDP a year to stabilize carbon dioxide concentrations in the atmosphere, while the consequences of taking no action would be long-term damage of 5 percent or more of global consumption, concentrated in lower-income countries in the tropics.


Beyond such environmental consequences, the marginal costs of energy production are already rising, as easier-to-exploit oil reserves outside a few very large producers are being depleted and a rising share of non‑OPEC production will take place in much more expensive offshore facilities or from low-grade, hard-to-extract deposits such as tar sands.


Fourth, aging populations, especially in advanced economies, pose challenges for maintaining productivity growth. As the share of new entrants to the labor force declines, it will become harder to continually raise the knowledge base, particularly related to the technological frontier, and there are risks of mismatches between specific labor skills and needs. A rising ratio of dependents to working-age population will also impose fiscal strains as pension and health care costs to governments rise.


Achieving fiscal sustainability in the face of these rising costs will require substantial adjustments of the order of 4 percent of GDP in the G-7 countries. In turn, this will put pressure to raise tax rates that will have an efficiency cost. To some degree, more open immigration policies and steps to encourage higher birth rates may help to address such concerns, but they would only be able to partially compensate for aging trends. Slowing productivity would have implications for investment and consumption trends and the unwinding of global imbalances.


Source: AEPC newsletter