World Recovery Is on Track
World growth will recover this year, pulled along by a strengthening U.S. economy. After widespread weakness in 2001, worsened by the tech-sector downturn and the aftershocks of Sept.11, economies around the globe will post improved economic numbers. Gross world product, the broadest measure of global economic activity, will pick up from its 1.4 percent in 2001 to 1.8 percent in 2002, accelerating to 3.2 percent in 2003.
The global business cycle was broadly synchronized in 2001, with most regions experiencing a slowdown or outright recession. A trade boom that had powered world exports ahead 12 percent in 2000 — much of it in computer and information technology (IT) products — became a trade bust in 2001, when exports fell 1 percent globally. U.S. economic weakness spread through lower import demand, particularly to the technology-oriented East Asian economies. In part the slowdown was policy-related, with demand restrained by interest-rate increases engineered by the Federal Reserve and other central banks to cool inflationary concerns. The bursting of the IT bubble and a sharp investment pullback brought growth to a standstill in many countries.
The United States and Economic Expansion.
The pivotal role of the U.S. in the 2001 recession will swing around this year, with respectable U.S. growth supporting gradual global recovery. Economic conditions are improving fastest here, as evidenced by the unexpectedly strong rise in real gross domestic product (GDP) in the first quarter. Although consumer confidence fell back slightly in April and the unemployment rate edged up, U.S. consumers continue to be upbeat about the future and to ratify that optimism at checkout counters. The drag from inventory correction appears to be ending, so that the outlook for increased production is much improved.
The federal government has supported U.S. recovery in a significant way. The Bush tax cuts, while posing potential long-run financing concerns, kicked in at just the right time to provide needed support for disposable income. Government spending is adding directly to demand, posting the biggest increase in expenditure since the Vietnam War, as the U.S. ramps up the battle against terrorism. For 2002 as a whole, we expect GDP to expand by 2.4 percent, and 3.4 percent by 2003.
While the U.S. economy appears poised for growth this year, it is not clear how robust this recovery will be. Business investment will have to improve in order for the expansion to become well established; so far, weak profitability is holding back investment plans. At the same time, consumers’ ability to continue spending at a rapid rate is questionable. In the short term, continuing high unemployment and the stock market malaise will restrain spending. Down the road, high existing debt levels may become a bigger problem. Normally, a severe downturn is accompanied by a reduction in debt levels; the mildness of the 2001 slowdown means these painful, but necessary, adjustments have been slower to occur.
Europe will Follow.
Western Europe was slow to follow the U.S. into last year’s downturn and will take longer to experience recovery. There is considerable difference across countries in the severity of the business cycle. Growth has held up the best in Britain, which has shared with the U.S. resilient consumer spending and a significant fiscal injection. Germany, Europe’s biggest economy, has fallen harder, and will likely grow less than 1 percent in 2002. France is somewhere in the middle, and should expand by 1.5 percent this year. In relative terms, the biggest fall has been in Ireland, whose New Economy industries propelled it to 11.5 percent growth in 2000, slowing to 5.1 percent in 2001 and an expected 3.1 percent this year.
Eastern Europe has weathered the global downturn well, in part because of its much smaller degree of trade linkages with the rest of the world. Every state of the former Soviet Union grew at a better than 4 percent rate last year, a vast improvement from the decline and stagnation of the mid-1990s. There are reasons to hope that moderately good performance can be sustained, because Russian structural reforms appear to be making some headway. Last year, income tax reform in Russia created a 50 percent rise in revenues by introducing lower flat tax rates. Employment reform and business deregulation is also occurring. The Eastern European countries with closer ties to Europe have seen dramatic gains in export market shares, as they make good on their promise to serve as low-cost production centers for Western European countries. Of course, these trade ties have also exposed countries like Hungary, Poland and Slovakia to more of the European downturn.
East Asian economies are more specialized in computer and information-technology production than any others, so these countries have suffered some of the worst pain during the global IT downturn. The ratio of electronic production to GDP is 40 percent for Singapore, 60 percent for Malaysia and 30 percent for the Philippines. For the Asian region as a whole, manufacturing exports, which had boomed 21 percent in 2000, fell 7 percent in 2001, resulting in large-scale production and investment declines. Both Taiwan and Hong Kong contracted by 2 percent last year, and growth rates plunged in the other East Asian economies.
There is good news in the air, though. Semiconductor orders have begun to pick up, exports have turned the corner and consumer demand is firming throughout non-Japan East Asia. Output has turned the corner in all countries, although it remains behind year-earlier levels in Hong Kong and Singapore. The less-than-robust pickup in world trade will delay full recovery in 2002, and the Asian region is expected to grow 4.5 percent in 2002, strengthening to 5.4 percent in 2003.
A combination of global, regional, and domestic factors could limit the strength of East Asia’s recovery. Areas of concern include the possibility of growth softening in the U.S., ongoing economic uncertainties in Japan and the relative newness of political stability across much of Southeast Asia. There is also a general concern that financial-sector problems have not yet been adequately addressed, exposing a large vulnerability to potential external financial shocks. Luckily, there has been no significant contagion to the region — so far — by the financial crisis devastating Argentina.
On paper, China appears to have been almost unaffected by the global slowdown, posting a 7.3 percent growth rate last year. In part, this reflects the relatively small dependence of China on external trade. But there has been growing concern in international circles that China’s national account statistics may be flawed. Other measures of economic activity, such as energy consumption, have failed to show the strong growth reported in GDP figures; in fact, energy demand has actually fallen. There are other challenges ahead for China. In particular, the Chinese government has used fiscal spending to support economic growth fairly continuously since the 1997 Asian financial crisis, something that cannot be sustained over the long run. And China’s accession to the World Trade Organization means that rising imports may be more of a drag on aggregate demand than in the past.
The unexpected standout performers over the past several years have been the countries of South Asia. India managed greater than 5 percent growth in 2000 and 2001, with similar performance in Bangladesh. Pakistan slowed to 3.3 percent. Both private consumption and investment have contributed to demand, and a slowing of population growth is finally permitting significant growth in per capita income. Improvements in education and human capital development have allowed India to become a world center for back office services, call centers and software development.
While South Asia still faces enormous growth challenges, including a relatively poor investment climate and stifling regulatory barriers, the significance of the recent improvements cannot be overstated, and may indicate that the region has joined China in moving half the world’s population steadily away from poverty.
Argentina’s currency collapse captured headlines around the world during the past year, and the crisis in that country will continue to undermine economic conditions for the region.
Argentina’s economy is expected to contract 10 percent this year, and no clear recovery plan is in sight. The good news is that, unlike 1994 and 1997, there has not been a widespread contagion to other countries’ financial markets. The markets appear to have largely anticipated Argentina’s meltdown and to have identified it with country-specific risks. Other developing economies have maintained fairly good interest-rate spreads.
Nevertheless, Latin America continues to share some common problems that will limit growth in coming years, including weak capital inflows, growing foreign indebtedness, stubborn income inequality that limits consumption growth and an end to one-time gains associated with privatization. Venezuela suffers an uncertain political future, which will lead to little growth in 2002. Excluding Argentina, Latin America will expand by about 1.7 percent this year; the number is closer to 0.2 percent, when Argentina is thrown into the mix. Mexico will grow nearly 2 percent this year, accelerating to better than 4 percent in 2003.
Japan was hit hard by the global economic slowdown, plunging into its third recession in a decade. The fall in activity has been driven by domestic and external developments.
Externally, the global slowdown led by the slump in the IT sector induced a slowdown in exports. Domestically, consumer spending slumped as the all-important household sector continued to suffer from anemic income growth and job insecurity, and structural problems remained. Business investment weakened dramatically late in the year as the global slowdown gained speed.
While consumer and corporate sentiment remain weak, there are some preliminary indications that Japan’s battered economy may be bottoming out. Unemployment has started to decline in recent months, while industrial production has reversed its 11-month slide. Production should firm somewhat in coming months as external demand from the recovering U.S. and East Asian economies increases and inventory adjustments begin to wind down.
It is unclear whether a revival of external demand will be sufficient to provide a sustainable recovery. Weakness in private demand and endemic structural problems will continue to bog down Japan’s economy. Consumer prices have fallen for three consecutive years, undermining corporate profits, slashing property values and stock portfolios, increasing real debt burdens and delaying spending. On the structural side, a smothering $300 billion layer of bad debt remains a significant impediment to sustainable recovery.
The Koizumi administration has committed itself to ending deflationary pressure and reforming the bank sector. Actions include the disposal of nonperforming loans, the resolution of excess indebtedness and regulatory reforms. The effectiveness of these reforms remains to be seen.
Policymakers have very limited room for monetary and fiscal maneuvering to back up their plans. Interest rates are near zero, and attempts by the Bank of Japan to expand credit have so far remained ineffective, because a very weak bank-lending environment offsets much of the impact of injected bank reserves. The government continued to fund 35 percent of its spending with borrowing in 2001 and has the highest debt burden among major industrialized economies. The apparent impotence of domestic macro policy raises the possibility that significant yen depreciation may be needed to revive external demand. Japanese output is expected to fall about 1 percent in 2002, as the pronounced weakness in private demand seen in 2001 continues, even as external demand gradually revives.Driving on One Cylinder.
The world economy finds itself once again dependent on a strong U.S. expansion to lead the way to global recovery. Dependence on the U.S. is not a new phenomenon, and interestingly it may actually be intensifying. As world production becomes increasingly fragmented, more and more countries become reliant on trade and investment linkages with the U.S. and exposed to the vagaries of consumer appetites in the world’s biggest market.
The world may just luck out. Recovery in the U.S. is now on track, and world trade will begin to make gains as the year progresses. No sharp global snap-back is expected, however. In 2000, the world economy was riding a high-tech bubble, which has burst, and we will not rapidly reclaim those heights. Of course the U.S. consumer may be more robust than currently expected, so that trade-led recovery in Mexico, Europe and East Asia could exceed current projections.
There are some old and some new risks before us. Among familiar perils is stock market weakness that could undermine all-important consumption spending. U.S. current account deficits continue in the 4 percent to 5 percent of GDP range, a level that poses the risk of a sharp dollar sell-off that could disrupt world trade and financial flows. Recent depreciation of the dollar has been orderly, but the resulting erosion of foreign competitiveness may impede recovery in Japan and other countries. The most difficult risk to evaluate is the potential for political turmoil in the Middle East to spill over into sharply higher oil prices. This could precipitate a sharp slowdown for the oil-dependent global economy. If these risks can be managed, the world seems poised for a return to moderate economic growth in the coming year.
For more on the UHERO forecast, go to www2.Hawaii.edu/~uhero/