2.3 Global Developments
The world economy continues to perform strongly and the balance of global growth amongst the major economies has become more even. The recent slowing in the US economy has being offset by firmer growth in the euro area and Japan; growth in China and other emerging economies remains consistently robust. The global economic outlook for the remainder of this year and 2007 looks positive despite the backdrop of rising inflationary pressure and tightening monetary policy. The International Monetary Fund ( IMF) 38 has revised upwards its projections of global GDP growth for this year, up 0.3 percentage points to 5.1 per cent, and next, up 0.2 percentage points to 4.9 per cent.
2.3.1 Euro Area
The euro area's economic recovery gathered pace in 2006 Q2 before falling back slightly in Q3. Eurostat's 'flash' estimate reports that in 2006 Q2 real GDP increased 1 per cent quarter-on-quarter, the highest quarterly GDP growth seen in the euro area for six years, but slowed in Q3 to 0.5 per cent quarter-on-quarter (see Chart 2.8, below). This development appears to match up with the European Central Bank's ( ECB) forecast of a slight slowdown in growth in 2007 compared to 2006. The ECB expects euro area GDP growth for 2006 to lie within the range 2.2 to 2.8 per cent, but to decelerate in 2007 to between 1.7 and 2.7 per cent.
Chart 2.8: Euro area GDP Growth
Source: Eurostat
Box 2.2: Ireland's Economic Performance |
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Ireland's economic transformation over the past thirty years has been dramatic. When it joined the European Community ( EC) in 1973, Ireland was one of the poorest member countries with per capita GDP at 60 per cent of the EU average. However, by 2005, Ireland had become the one of the most prosperous EU states with per capita GDP at 137.5 per cent of the EU-25 average - the second highest in the EU, behind only Luxembourg. This turnaround has been achieved through high GDP growth rates: between 1996 and 2000, Ireland's average annual rate of growth was 9.7 per cent, before slowing during in the period 2001-2005 to an annual average of 5.2 per cent. The Irish economy continues to grow robustly by the standards of other industrialised countries and at a rate significantly above that of the UK, as illustrated in Chart 2.9 below. Chart 2.9: GDP Growth for Ireland & the UK
Source: Eurostat and Office for National Statistics The Irish economy has changed from one heavily reliant on agriculture, to a highly skilled, diversified economy with strengths in IT, electronics and financial services. It is also a very open economy with exports equal to 80 per cent of GDP. Over the transition period the economy benefited from a combination of EU subsidies, high inflows of foreign direct investment (particularly from the US) and, more recently, an upsurge in net migration. Foreign-owned firms have been attracted to Ireland by a variety of factors including relatively low corporate taxes, a highly educated workforce, and the openness of the economy. Much of this investment has come into the high-tech and financial services industries. Overseas companies now account for a quarter of Ireland's GDP and 80 per cent of its exports (Industrial Development Agency, Ireland). Due to the high proportion of foreign ownership of companies based in Ireland, a more accurate measure of Ireland's domestic wealth is GNP rather than GDP, as it takes account of the incomes that flow out of the country in the form of remitted profits. Indeed, Irish GNP is lower than GDP by approximately 18 per cent. Domestic demand, rather than external demand, has been the main driver of recent economic growth. An appreciating euro, especially against the US dollar, has been eroding competitiveness in the economy and causing exports to fall. A further risk to the economy is the large increases in house prices seen in the economy over recent years, fuelled by rising incomes. Improvements in labour market performance have also been crucial to the Irish economy's success. There have been large improvements with the unemployment rate falling from 16.2 per cent in 1988 to 4.3 per cent in 2005 and productivity rising. Furthermore, the labour force has been expanding due to an increase in participation among women and through high levels of migration into the country. This expansion of the labour force has helped to moderate wage and consumer inflation during the Irish economy's rapid expansion. However, recently inflation has picked up due to rising labour costs and oil prices. |
Signs of the emerging euro area recovery in 2006 Q2 were broadly based across both services and industrial production and in Q3 the slowdown was also seen across all sectors. Within services, both trade, repairs, hotels & restaurants, transport & communication and financial, real estate, renting & business activities showed robust growth in 2006 Q2, at 1.3 per cent and 1.0 per cent respectively. The respective growth rates for Q3 were 0.7 per cent and 0.5 per cent. Public administration by contrast grew at a slower pace of 0.3 per cent in both Q2 and Q3. Industrial production (excluding construction) grew by 0.9 per cent in Q3 following growth of 1.2 per cent in Q2, up on the rates seen in recent years.
Within the euro area there remains a substantial degree of dispersion in GDP growth rates. In 2005, annual GDP growth in Greece, Ireland, Spain and Luxembourg, as well as most of the new member states, was above 3 per cent; in comparison, the economies of Germany, Italy and Portugal each grew by less than 1 per cent. The latest figures for 2006 Q3 show the German economy growing more strongly with year-on-year growth of 2.8 per cent, which may in part reflect higher consumer demand associated with Germany's hosting of the FIFA World Cup.
Labour market conditions in the euro area have improved with reductions in the unemployment rate and increases in the rate of employment. The unemployment rate fell continuously from a peak of 8.9 per cent in mid-2004 to 7.7 per cent in October 2006. This is the first time it has fallen below 8 per cent since 2001. The unemployment level has fallen by 1.5 million since mid-2004 to 11.4 million in October 2006. However, the unemployment rate remains above the rates in the UK, US and Japan.
Euro area employment continues to gradually strengthen with the most recent quarterly growth rate accelerating from 0.3 per cent in 2006 Q1 to 0.4 per cent in Q2. The sectoral breakdown for 2006 Q2 shows that employment in the service sector was up by 0.5 per cent, and in the industrial sector there was job growth of 0.2 per cent. Within the industrial sector, production employment (excluding construction) was unchanged, following successive declines throughout 2005, while employment in construction grew by 0.7 per cent.
The labour market of the euro area remains fairly loose and wage inflation has been fairly muted: in 2006 Q2, the annual rate of change in compensation per employee was 2.1 per cent. As a result, the largest component of GDP, consumer spending, has shown moderate growth so far in 2006, growing by 0.7 per cent in 2006 Q1, 0.3 per cent in Q2 and 0.6 per cent in Q3. Survey evidence points to an improvement over the year in consumer confidence as a result of expected improvements in the general economic situation and lower unemployment. These positive factors are expected to bring about improvements in consumer spending during the remainder of the year.
A concern for the euro area is its low labour productivity growth compared with the US. The euro area lags the US in labour productivity growth across several sectors including manufacturing, financial services and retail sectors. In addition, the euro area does not appear to be catching up: in 2005, labour productivity increased by 0.7 per cent in the euro area compared with growth of 2.3 per cent in the US. The IMF39 suggests labour market reforms need to be put in place to increase labour productivity growth in the euro area.
Business confidence in the euro area is high: the European Commission's economic sentiment index, a measure of business and consumer confidence, has been on an upward trend since mid-2005, alongside improvements in most key economic indicators. This combined with strong external demand, low interest rates and higher profitability has appeared to feed through into higher business investment growth in 2006 Q2. Amongst the domestic components of aggregate demand, investment (gross fixed capital formation) showed the most robust growth in Q2 with quarterly growth of 2.3 per cent, though this slowed in Q3 to 0.8 per cent. This compares to combined growth in the second half of 2005 (Q3 plus Q4) of 2.0 per cent. Within investment, in the first half of 2006 (Q1 plus Q2) non construction investment, made up of investment in capital equipment, grew by 2.0 per cent and construction investment grew by 2.5 per cent.
During the economic downturn in 2001-2003, the fiscal position of many euro area countries worsened as governments tried to fight off recession. In 2005, Germany, Greece, Italy, Portugal and France were all subject to excessive debt procedures under the Stability and Growth Pact for having budget deficits at or above 3 per cent of GDP. In 2006, this situation is expected to continue, albeit with some moderate improvement as a result of increased taxation revenue. The deficit for the euro area as a whole has been falling: the average government deficit decreased from 2.8 per cent in 2004 to 2.4 per cent in 2005, and it is projected to fall again, albeit moderately, in 2006. However, some organisations including the IMF and the OECD have commented on the slow decline in government deficits given that the euro area is currently in the upturn of its economic cycle. Fiscal consolidation is especially important for Europe since the expected ageing population of the euro area will in future create additional demands for spending on health-care and pensions.
Strong external demand in 2006 Q1, particularly from the US, meant that export orders for the euro area were robust. Exports grew by 3.8 per cent compared to import growth of 2.8 per cent in Q1 and so net exports had a positive effect on GDP growth. A slowdown in foreign demand led to export growth in 2006 Q2 falling to 1.1 per cent. Import growth also fell to 1.1 per cent, so the contribution of net exports to GDP in Q2 was approximately neutral. The decline in imports is partly due to slower growth in oil prices in Q2 and also due to the high import intensity of exports, i.e. exports are import intensive in production and so when exports fall, less imports are required for production. In Q3 exports picked up slightly with 1.7 per cent growth and but the growth in imports was stronger at 2.1 per cent growth making the contribution of net exports to GDP in Q3 negative.
The euro area moved from a position of current account surplus in 2005 to deficit in 2006. As at August 2006, the euro area's twelve-month cumulative current account was in deficit by â'¬39.6 billion, 0.5 per cent of GDP. The move into deficit has been caused by the sharp increase in oil prices over the year. The exchange rate of the euro with other major currencies was largely stable in the first half of 2006 but in recent months the exchange rate has depreciated against the dollar.
The European Central Bank ( ECB) operates a ceiling for euro area inflation of 2 per cent. Between November 2005 and August 2006, annual consumer price inflation fluctuated between 2.2 per cent and 2.5 per cent. This run of above-target results is largely due to high energy prices; wage inflation by contrast has remained moderate (i.e. between 1.6 per cent and 2.1 per cent between 2005 Q3 and 2006 Q2). Since last December the ECB has raised interest rates by 1.25 per cent to 3.50 per cent in order to dampen nascent inflationary pressure. Recent monthly inflation has been lower, at 1.6 per cent in October 2006, due to falling oil prices since August. However, underlying inflationary pressures remain and the ECB's projections for inflation are for it to rise again in the coming months.
2.3.2 United States
The growth performance of the US economy has been very positive in recent times. Following growth of 3.9 per cent in 2004 and 3.2 per cent in 2005, the IMF expects USGDP growth to accelerate this year to 3.4 per cent. Growth in 2006 Q1 was very strong, at an annualised rate of 5.6 per cent; however, in Q2 growth slowed to an annual rate of 2.6 per cent, and in Q3 it slowed further to 2.2 per cent. The economy's expansion rate is expected by the IMF to ease in the remainder of 2006 and into 2007, with annual GDP growth settling next year close to its 20-year average at 2.9 per cent. This slowdown is expected to be driven by weaker domestic demand, in particular slower growth in private consumption and residential investment spending.
Private consumption expenditure, which makes up around 70 per cent of US expenditure-based GDP, has been strong in recent years and has contributed to robust growth in GDP. Consumer spending has been well-supported over the period by a combination of positive underlying factors including high employment, low inflation (supported by subdued import prices), low real interest rates and rising house prices. The sharp rise in house prices over the last decade has increased households' wealth and helped provide consumers with the confidence to borrow and consume more (see discussion in Box 2.3).
However, there are signs that the conditions underlying consumer demand are becoming less supportive. The housing market has slowed sharply this year and this, combined with high oil prices and higher interest rates, has dented consumer confidence and households' disposable income. These factors look set to trigger a slowdown in US consumption growth.
The personal savings rate declined to a negative 0.4 per cent of disposable income in 2005, falling further to minus 1.3 per cent in Q3. A negative personal savings rate means that households' spending is greater than households' disposable income and must therefore be financed by running down existing savings or by increased borrowing. In Q3, personal saving was negative to the tune of $121 billion.
The index of consumer sentiment weakened in October and again in November, reflecting consumers' expectations of slower growth. The annualised growth rate in private consumption in Q2 was 2.6 per cent, down from 4.8 per cent in the previous quarter. In Q3, annualised consumption growth regained some momentum as it increased to 2.9 per cent.
The US labour market has performed well over the last year with employment rising and unemployment falling. Employment in November stood at 145.6 million, up just over 2.5 million from the previous year. Unemployment rates have fallen slightly from an average of 5.1 per cent in 2005 to a range of 4.4 to 4.8 per cent in 2006 with the latest figure for November at 4.5 per cent. Productivity growth increased fairly robustly in the first half of 2006 at an annual rate of 2.7 per cent in both Q1 and Q2, but slowed to 1.5 per cent annual growth in Q3. Unit labour costs rose at a rate of 3.6 per cent in 2006 Q1 year-on-year, then slowed to 3.0 per cent and 2.8 per cent in Q2 and Q3 respectively. This rise was due to growth in wages exceeding growth in productivity and may lead to increases in inflation as firms pass the extra costs onto consumers.
Inflationary pressure increased in the first half of the year as the US economy encountered higher energy prices and emerging capacity constraints, but decreased sharply in the autumn. In 2005, consumer prices climbed at their fastest annual rate since 2000 (at 3.4 per cent) and the monthly inflation readings for 2006 only dipped below this level in September and October. The October inflation rate was 1.3 per cent, substantially below the August rate of 3.8 per cent, due to falling energy prices.
The October figure was within the range of 1 to 2 per cent that the Federal Open Market Committee Chairman Ben Bernanke defines as price stability. The Open Market Committee raised the federal funds rate by 25 basis points to 5.25 per cent at its June meeting but has since left rates unchanged. The statement accompanying the decision to hold rates constant in October indicated that the Committee had weighed the upside risks from rising core inflation and increased capacity utilisation with the downside risks of the slowing housing market.
Box 2.3: US Housing Market |
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The performance of the US housing market has been buoyant since the Millennium (see Chart 2.10), gaining support from a combination of low real rates of interest and innovations in the mortgage market that have facilitated higher borrowing. This house price appreciation has in turn been positively associated with gains in output, employment and demand in the US economy. Chart 2.10: US House Price Inflation 
Source: Office of Federal Housing Enterprise Oversight Higher house prices have bolstered households' stock of wealth and provided consumers with the confidence to spend a greater proportion of their current income (the US personal savings rate has declined sharply in recent years and turned negative in 2005). According to NIESR1 research, the rise in US house prices witnessed over the last eight years has added _ of a per cent a year to US consumption growth. Rising house prices have also given a spur to activity associated with residential construction - both investment and employment. Housing investment increased by 8.6 per cent in real terms in 2005, following growth 9.9 per cent and 8.4 per cent in the preceding two years. Employment linked to residential housing (including building, finance, and sales) accounts for nearly 6 million payroll jobs or 4¼ of total payroll jobs in the US. US house price growth has retreated substantially from its peak according to the latest figures. Data on aggregate house prices produced by the Office of Federal Housing Enterprise Oversight ( OHFEO) show that house price growth was 0.9 per cent in 2006 Q3 - the lowest rate of appreciation since 1998 Q2. According to the OFHEO, the decline in the quarterly rate over the past year is the sharpest since the beginning of their house price index in 1975. Real residential investment decreased at an annual rate of 18 per cent in Q3, subtracting a substantial 1.2 percentage points from annualised GDP growth in Q3. This marked turnaround in the housing market has prompted fears of a wider slowdown in the US economy, with potential knock-on effects for the world economy more generally. Economic analysis of the connection between house prices and GDP growth conducted by the IMF (World Economic Outlook, April 2006) indicates that a decline in the real rate of appreciation from 10 per cent to zero could reduce US economic growth by up to 2 percentage points after one year. 1 National Institute Economic Review, NIESR, October 2006 |
Investment expenditure, which accumulated rapidly in 2004 and 2005, is expected to slow to a pace more in line with its long-run average (around 4 per cent) this year and next 40. Gross fixed capital formation accounts for approximately 16.5 per cent of USGDP, split between non-residential investment (10-11 per cent) and residential investment (6 per cent). As previously discussed in Box 2.3 above, residential investment contracted in each of the first three quarters of 2006 in response to the weakening housing market and tighter monetary policy. Non-residential investment, which over the past three years has risen strongly, is expected to be adversely affected by deteriorating corporate profitability caused by high energy prices and rising unit labour costs. Between Q1 and Q2, annualised growth of non-residential investment fell from 13.7 per cent to 4.4 per cent, but recovered to an annual rate 10.0 per cent in Q3.
Exports rose faster than imports in 2005, rising 6.8 per cent compared to imports growth of 6.1 per cent, and a similar pattern was repeated in early 2006. Export growth was particularly strong in Q1, at 14 per cent, before slowing to 6.2 per cent and 6.3 per cent in Q2 and Q3. Import growth was also buoyant in Q1 at 9.1 per cent but slowed sharply to 1.4 per cent in Q2, before rebounding to 5.3 per cent in Q3. However, despite the difference in growth rates, the level of import sales was much higher than export sales: in the first half of 2006 total imports hit $1.4 trillion, 40 per cent higher than exports at $1.0 trillion. The latest data for October 2006 show that the US trade deficit increased $58.9 billion to a level 9.3 per cent higher than the year before. A sizable proportion of this increase can be explained by the increase in world oil prices. The trade deficit with China, the country to whom the US is most in deficit, increased $24.4 billion in October to a cumulative total of $190.1 billion (January to October). A depreciation of the US dollar exchange rate would make US exports more competitive and imports more expensive; however, for this to substantially improve the trade account the depreciation would have to be substantial.
The trade deficit in goods and services contributed to the US's current account deficit, along with income transfers between US and the rest of the world. In 2006 Q2, the current account deficit increased by $5.2 billion to $218.4 billion, which is equal to 6.6 per cent of GDP (see Chart 2.11). This means that the US economy is consuming more than it produces with the difference being financed by large capital inflows (i.e. foreign savings). This point follows on from the negative personal savings in the US discussed above. If national saving were higher, the US would not need such high capital inflows and the deficit would be smaller. However, foreign investors continue to be willing to finance this deficit so interest rates remain moderate and so far there has been only limited pressure on the dollar.
Chart 2.11: US Current Account
Source: Sources: Ecowin and OECD
The federal budget deficit reached a peak in 2004 of $521 billion, 4.5 per cent of GDP. This was due to a combination of strong demands on government spending from national defence and reconstruction following Hurricane Katrina last August and personal tax cuts. However, because of exceptionally strong tax receipts, for the second consecutive year, the federal budget deficit is expected to shrink. In 2006, it is expected to fall to $248 billion, 1.9 per cent of GDP, meeting the government's target of halving the deficit from its peak in 2004 three years ahead of schedule.
Box 2.4: World Stock Market Performance |
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Stock markets across the world have recovered in the past few months after experiencing a period of decline in the middle part of 2006 (see Chart 2.12). The FTSE Index of UK equities, for example, reached its highest closing position in 5 years in November, though this was still some way below heights reached during the dot-com bubble in 1999. The performance of the FTSE Index and the Dow Jones ( US industrial shares) has been particularly positive over the last year, whilst the NASDAQ ( US electronically traded shares) and Nikkei 225 (Japanese shares) indices experienced more significant declines during the summer, and have since only recovered to around their level at the start of the year. Chart 2.12: Performance of World Stock Market Indices, 2006 
Source: HM Treasury, Pocket Databank The dip in equity prices around the middle part of the year can largely be attributed to spiralling oil prices, unrest in the Middle-East and fears of the US economy suffering a slowdown, or even a recession. The downturn was most dramatic for the Nikkei index, which lost 13 per cent of its value. The subsequent recovery largely reflects the emergence of lower oil prices, improving corporate profits and a high volume of mergers and acquisitions. As the chart above shows, the FTSE Index has been relatively stable in comparison with the other indices. This reflects the greater relative weight of oil companies, particularly BP and Royal Dutch Shell, in the index. Their presence had the effect of supporting the index in early 2006, when oil prices were high, and acting as a slight drag in the more recent months when falling oil prices have reduced expected returns in the sector, but increased them in other sectors. The sectors that have been particularly influential in driving the recent worldwide increase in equity prices are mining, financial services and utilities. The outlook for the future is clouded by uncertainty. Many analysts believe that equities are likely to continue to appreciate over the next year. There are, however, downside risks to this outlook, particularly if oil prices were to resume the upward trend seen in the first half of 2006, or if there are further increases in interest rates to combat emerging inflation. |
2.3.3 Japan
Japan's economic recovery is deepening and the economy appears, after seven years of falling prices, to have finally moved out of deflation. In the first half of 2006, annualised GDP growth was 3.4 per cent; this follows growth of 2.6 per cent in 2005. The latest GDP data for 2006 Q3 were weaker than expected, with the quarter-on-quarter rate of growth revised downwards to 0.2 per cent due to a decline in domestic demand. Nevertheless, according to IMF forecasts 41, the Japanese economy will grow by 2.7 per cent this year and by 2.1 per cent in 2007.
Japan has experienced annual deflation in every year since 1999. Recently, however, inflationary pressures have increased and since May Japan has recorded positive monthly inflation, signalling a potential end to Japan's entrenched deflation. The turnaround in consumer prices has been led by increases in producer prices inflation in response to higher energy and raw material prices. As a result of these developments, in mid-July the Bank of Japan raised official interest rates to 0.25 per cent. Interest rates had been held at zero since early 2001, while for much of the time the Bank of Japan injected extra liquidity into the banking system.
Since 2005, domestic demand has been the principal driver of growth in the Japanese economy. Much of this domestic impetus has come from business investment, while consumer spending has strengthened more gradually and government consumption has remained subdued. Business investment contributed 0.9 percentage points to GDP growth in 2005 and is expected to add 1.2 percentage points in 2006, facilitated by rising corporate profitability (up 10 per cent in the year to Q2 2006), an improvement in corporate balance sheets and firmer bank lending. The Tankan survey for September reported positive business conditions across both manufacturing and services and showed the capacity utilisation ratio at its highest level since 1991. Total investment accounts for a relatively large percentage of Japanese GDP at 23.2 per cent in 2005 (see Chart 2.13) compared with the UK level of 16.8 per cent, and investment growth according IMF forecasts is set to remain strong at 5.5 per cent in 2006 and 3.9 per cent in 2007.
The momentum behind consumer demand has increased since 2003, but rates of growth continue to trail those for the economy overall. Private consumption expenditure expanded 2.1 per cent last year, up from 1.9 per cent in 2004, and it is expected to maintain this level of moderately strong growth this year and next. IMF projections suggest that consumer demand will increase by 1.9 per cent and 2.0 per cent in 2006 and 2007. The strengthening of consumer demand potentially reflects several factors such as the gradual ending of deflation and improvements in the labour market. In June 2006, the ratio of jobs to applicants rose to 1.08, its highest level since mid-1992, signalling tightening labour market conditions. The latest Tankan survey also reported the emergence of labour shortages, especially in the non-manufacturing sector. Against this backdrop of higher employment and increased labour scarcity, total compensation of employees rose 2.2 per cent in the first half of the year - the strongest rise since 1997. Unemployment, which has ranged between 4 and 5 per cent since January 2004, was 4.2 per cent in September.
Japan's export trade continues to perform strongly, aided by the weak yen. Exports increased by 2.5 per cent in Q3, up from 0.9 per cent growth in Q2, while imports declined by 0.5 per cent, down from growth of 1.8 per cent in Q2. In September, Japan's trade surplus rose by almost 7 per cent to 1 trillion yen (£4.5 billion); while exports are rising, so too are the value of imports due to high oil prices. Japan also runs a large current account surplus and this is set to average 3.7 per cent in 2006-2007.
Japan's net government debt stands at around 90 per cent of GDP and is among the highest of the industrialised countries. One of the Japanese government's key concerns is to reduce this over the medium term. The government's aim is to have its primary budget balance, which excludes debt servicing, in surplus by 2011-2012. To achieve this they plan to cut government spending rather than raise additional taxation.
Chart 2.13: Investment Expenditure as a Proportion of GDP, 2005
Source: HM Treasury, Pocket Databank, November 2006
2.3.4 China
The Chinese economy, which has recently become the world's fourth largest, continues to grow at around 10 per cent per annum (see Chart 2.14). For this year and next, the IMF expects similar rates of economic expansion to be maintained due primarily to strong export performance and high levels of investment. The key risks to this positive outlook, include the possibility of a reversal of China's current investment boom or a weakening of demand from China's main export markets in the US and Japan.
Investment spending on a huge scale, equivalent to over 40 per cent of China's GDP (see Chart 2.13, above), has been channelled into productive capacity, infrastructure improvements and preparations for the Olympic Games in 2008. The latest figures for October 2006 indicate year-on-year growth of 26.8 per cent, helping to underpin sustained high rates of growth in the Chinese economy. China's investment boom has been facilitated by an abundance of cheap credit, soaring profits and restrictions on access to alternative investment opportunities overseas. The strength of investment growth has, however, prompted fears of over-investment in capacity in certain sectors. These fears have prompted the authorities to increase interest rates and raise commercial banks' reserve requirements in order to curb speculative lending and to prevent an increase in the number of non-performing loans. These changes have the potential to lessen future GDP growth, but commentators 42 have questioned their impact for the reason that retained profits, not just bank loans, have funded a large slice of China's investment boom.
Chart 2.14: Annual GDP Growth (selected economies)
Source: HM Treasury, Pocket Databank, November 2006
China ran a large current account surplus of 7.1 per cent of GDP in 2005 (in US dollar terms, $193.9 billion) largely driven by a surplus on trade in goods and services, which was around US $166 billion. The two largest markets for Chinese exports are the US and Japan, and a slowdown of import demand from these economies would have a substantial dampening effect on China's export sales. According to IMF forecasts, however, the pace of economic growth in both these economies is expected to slow only moderately next year.
The global impact of China's prodigious growth can be seen when we consider that China has become the world's third largest importer. China's economic expansion has placed a huge call on the world's supply of energy and non-fuel commodities. China presently accounts for around a quarter of world demand for aluminium, copper and steel, for example. This demand, in the absence of a significant supply response, has contributed much towards recent higher commodity prices. Current forecasts suggest that import growth will outpace export growth in 2007 and 2008 and this, combined with higher commodity prices, should help to contain China's current account surplus.
Another important factor affecting China's trade is the external exchange value of its currency, the renminbi ( RMB). The RMB is widely thought to be undervalued. The RMB was pegged to the US dollar at a rate of 8.28 per dollar until July 2005 when the exchange rate regime changed to a managed float against a wider basket of currencies. Since then there has been modest appreciation: on 8 December 2006 the exchange rate stood at 7.82 per US dollar. Further appreciation of the RMB would tend to put downward pressure on the current account surplus.
External demand has played a crucial role in China's economic growth so far, however, many commentators, and the Chinese authorities themselves, have suggested that the composition of growth should be shifted towards domestic demand for a more balanced and stable economy. The share of private consumption in GDP remains low by international standards at 40 per cent of GDP in 2005. Nevertheless, private consumption is growing strongly (by 9 per cent in 2005) and is supported by the spread of higher incomes and rising wages.
In the two decades to 2001, the number of Chinese people living in extreme poverty is estimated to have declined by over 400 million. Urban areas are wealthier and have a lower rate of unemployment than rural areas and spending per capita on education, health and social services is higher in urban areas than in rural areas. The Chinese government aims to redress these imbalances and increase expenditure in rural areas. Social infrastructure improvements in both the rural and urban sector may have the potential knock-on effect of reducing the high levels of precautionary saving present in Chinese society and could therefore help to strengthen local economic demand.
2.3.5 Central Europe & the Baltic States
The economic expansion of the EU's new member states 43 ( NMS) continues apace. Strong domestic demand growth, buoyed by capital inflows and credit growth, drove GDP growth in the NMS economies to 5.5 per cent in 2005, much faster than the euro area average of 1.5 per cent 44. Economic performance varied widely among the group, however: the three Baltic economies (Estonia, Latvia and Lithuania) grew by 8.8 per cent on average in 2005, with Latvia leading the way with GDP growth of 10.2 per cent. The three largest economies of the NMS - Poland, Hungary and the Czech Republic - yielded more modest growth in 2005 of 3.4 per cent, 4.1 per cent and 6.1 per cent respectively.
Despite the robust pace of recent growth, per capita GDP in the NMS economies is low compared with most other parts of the EU (see Chart 2.15). Whilst the Prague region scores highly (19 th out of 272 EU regions) in terms of per capita GDP, most regions in the new member states have per capita GDP of less than two thirds of the EU average according to Eurostat.
Chart 2.15: GDP Per Capita Relative to EU25 Average - Selected A8 Economies
Source: HM Treasury, Pocket Databank, November 2006
Forecasts from the IMF indicate that NMS growth rates will remain broadly similar this year and next, though the dispersion between the Baltic and the Central European economies will narrow somewhat as growth accelerates in Poland, the Slovak Republic and Slovenia. The anticipated recovery in euro area growth through this year and next will help will to add impetus to the NMS expansion through higher export demand and inward investment.
Domestic demand is a key factor explaining the strength of GDP growth in the NMS. Private consumption, fuelled by rising employment, asset prices and rapid credit growth, has grown strongly in the NMS. For example, in Estonia, private final consumption grew by 14.5 per cent year-on-year to 2006 Q2 compared with the euro area average of 1.5 per cent year-on-year growth. Investment expenditure has also recorded impressive growth, a feature common in emerging economies. Total investment as a percentage of GDP for 2005 in the Czech Republic, Estonia and Hungary, for example, was 24.9 per cent, 31.1 per cent and 23.2 per cent respectively. This compares to 19.8 per cent for the EU-15.
The new member states have been successful, particularly so since 2000, in attracting inflows of foreign capital, both foreign direct investment ( FDI) and debt finance. These inflows have supported growth in exports and employment and reinforced capital formation, but the sheer size of these inflows in recent years has prompted concern for the economic stability of the NMS economies. Examples of the destabilising effect of a sudden reversal of foreign capital inflows, notably the Asian financial crisis of the late 1990s, serve as a warning to the NMS of an over-reliance on mobile foreign finance. In this context, the growing prevalence of short-term debt finance compared to longer term FDI investment has been noted. In 2005, private sector debt accounted for 60 per cent of Emerging Europe's net capital inflows 45.
With such large amounts of short-term debt it is crucial to keep investor confidence in the NMS economies high so as to avoid capital flight, especially with the possibility that this could spill over and spark contagion effects amongst the group. Preparations for entry to the single European currency, including adherence to the Maastricht criteria, should help to embed sound principles of macroeconomic management and bolster investor confidence. Five of the accession states have already entered the Exchange Rate Mechanism ( ERM II) and Slovenia has been accepted to join the single currency in January 2007.
The corollary of rapid growth in domestic demand and credit, substantial capital inflows from abroad and higher assets prices, is apparent in the large current account deficits of the NMS economies. All eight new EU members ran negative current account balances in 2005, ranging from a low of 1.1 per cent of GDP in Slovenia to a high of 12.4 per cent of GDP in Latvia. In the Czech Republic, however, the current account balance improved by almost 4 per cent of GDP between 2004 and 2005 as exports grew by over 11 per cent. According to IMF projections, the current account position of the NMS economies will, on average, remain broadly similar this year and next despite the expectation of strong export growth in many NMS economies in 2006 and 2007.
The fiscal position of the NMS governments varies substantially. Whilst Estonia ran a government surplus in 2005 of 2.3 per cent and Latvia was broadly in balance at 0.1 per cent, all other countries ran deficits. The largest deficit in the region was seen in Hungary which had a deficit in 2005 of 6.5 per cent, an increase of 1.2 percentage points from 2004. Hungary is now running a twin deficit in its current and government accounts and both are forecast to widen in 2006/2007. The Czech Republic and Slovakia also had deficits of over 3 per cent - at 3.6 per cent and 3.1 per cent respectively - in 2005.
2.3.6 Russia
High commodity prices and inflows of capital from abroad have helped to bolster the performance of the Russian economy. In the first half of 2006, GDP grew at an annualised rate of 6.3 per cent following growth of 6.4 per cent in 2005, and economic growth is projected by the IMF to stay around this level in 2006 to 2007. Most recent data for Q3 shows the Russian economy to have grown at 7 per cent year on year.
Domestic demand remains the main driver of growth in the Russian economy. Household consumption grew robustly at a rate of 10.9 per cent in 2005 and is expected to maintain a similar level of growth this year. Investment is also growing at similar rates (10.5 per cent in 2005), supported by high levels of foreign direct investment ( FDI), and fixed investment has picked up from the lows in Q1 to 12.9 per cent year on year growth in Q3. However, there is huge need for investment in new capacity in Russia and so ideally the pace of growth would be higher than this. The share of investment in Russian GDP is relatively low at around 18 per cent (see Chart 2.13, above), well below the 25 per cent or above rates common among emerging economies.
The strong domestic demand is feeding into high rates of inflation. In 2005, the annual inflation rate was 10.9 per cent and in the year to October the inflation rate was 9.2 per cent. The Russian authorities have a target to reduce inflation to 8.5 per cent in 2006, but high oil prices and strong domestic demand are hindering their progress. Allowing the nominal exchange rate to further appreciate would aid in reducing inflation, however, the authorities are wary of this option because of the negative impact it would have on Russia's export trade.
Russia is the world's second largest oil exporting nation and so the recent high price of crude oil has boosted government revenues leading to large fiscal surpluses. As a result, the Russian government has loosened its fiscal policy stance and has budgeted to increase government expenditure in 2006 to 17.5 per cent of GDP. Additional public spending will be directed towards, amongst other areas, increasing public sector pay and national priority programmes such as health, education, housing and agriculture. The finance ministry estimates that in 2006 the non-oil fiscal balance, i.e. the balance excluding oil revenues, will be in deficit of 5.2 per cent of GDP. However, there are concerns that the extra spending is not being used to put in place crucial structural reforms that would boost potential GDP growth and reduce the Russian economy's reliance on the oil and gas sectors 46.
Exports grew strongly in the first half of 2006 although this primarily reflects the increases in the price of oil, Russia's main export commodity, rather than increases in export volumes. Indeed in terms of growth in volumes, imports are growing at a faster rate than exports: in 2005 imports grew by 16.2 per cent compared to export growth of 5.6 per cent. However, the increase in export value outweighed the increase in import value to give Russia both a trade balance surplus and a current account surplus: in 2005, Russia's surplus on the current account of the balance of payments was equivalent 10.9 per cent of GDP. The IMF expects this figure to increase to 12.3 per cent of GDP this year before easing to 10.7 per cent in 2007.
2.3.7 India
India has experienced rapid economic growth in recent years, albeit at a slower pace than in China. In 2005, the Indian economy grew by 8.5 per cent and this strong expansion has continued into 2006 with the most recent figures for 2006 Q3 showing year-on-year growth of 9.2 per cent.
In terms of the composition of growth, all sectors have grown over Q3 with the fastest growth seen in services, at 10.9 per cent year-on-year, followed by industry, at 10.3 per cent, and agriculture and allied industries at 1.7 per cent. The service sector remains the principal sector in the Indian economy, accounting for around 60 per cent of total GDP. It has shown double digit growth since 2003/2004. The industrial sector continues to be driven by the manufacturing sub-sector which grew by 11.9 per cent.
All components of domestic demand have been growing strongly. Private consumption grew by 6.6 per cent in 2005 and is forecast to continue to grow at a similar rate over 2006-2008. Indeed, domestic demand has outpaced domestic supply and so the balance has been met by an increase in imports, causing the current account to move into deficit in 2004. This strong demand is contributing to high business confidence which in turn is causing strong growth in investment. Gross fixed capital formation accounts for around 30 per cent of India's GDP and it is growing (see Chart 2.13, above). This is a relatively large share in comparison with the levels found in advanced economies.
Pressures on the Indian government to improve public services and infrastructure have resulted in high government spending and a large fiscal deficit. In the fiscal year 2005/2006 the combined state and central government fiscal deficit stood at 7.5 per cent of GDP and it is budgeted at 6.5 per cent for the year 2006/2007. Concerns about the deficit becoming unsustainable and constraining private sector growth led to legislation being introduced to tackle the problem. The Fiscal Responsibility and Budget Management Act set targets for the reduction of the federal fiscal deficit each year in order to stabilise public debt as a proportion of GDP over the medium term. In order to meet these targets the government aims to reduce spending on non-priority areas and increase the tax base; however, reducing spending is politically difficult when India has such large social spending needs. The target for the federal budget deficit in 2006/2007 is 3.8 per cent of GDP, down from 4.1 per cent in 2005/06.
In terms of India's external trade, both exports and imports are growing at a rapid pace. As mentioned above, India has a current account deficit, however this is due to the strength of internal demand for consumer goods and inputs, including oil, rather than a poor performance by exports. Exports of manufactured goods, including chemicals, engineering and textiles, grew strongly over the period April June 2006 at a year-on-year rate of 15.1 per cent, albeit this is down on 2005's phenomenal rate of 31.5 per cent. Growth of exports of goods and services in 2005 was estimated at 22.4 per cent and whilst growth is projected to fall to 18.4 per cent and 14.6 per cent in 2006 and 2007 respectively, this still represents rapid growth. Imports are expected to grow by 14.0 per cent and 12.1 per cent in 2006 and 2007 but the value of imports will remain higher than exports and so the economy will remain in trade deficit. The current account deficit is projected to be 3.2 per cent in 2006 and to widen to 4.1 per cent in 2007 and 2008. This deficit may cause a slight depreciation in the rupee.
There are strong inflationary pressures in the economy due to the extremely strong demand and in October consumer price inflation was at 7.3 per cent. However, state-controlled oil companies have had to absorb higher oil costs instead of increasing their prices to consumers and so this figure for inflation is artificially low. This policy does not seem sustainable considering India's large demand for oil. In response to elevated inflation and in order to meet its target band for inflation of 5-5.5 per cent, the central bank has gradually tightened monetary policy through interest rate rises.
Looking to the future prospects for the Indian economy, the government is progressing with its reforms in social areas such as health and education and to improve its infrastructure, particularly the power supply to improve on the current state of intermittent power cuts. Furthermore, if the government were to relax its labour laws and allow employment to rise more quickly, the country would be more able to participate in formal manufacturing.