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Strong world growth masks medium-term risks Based on Martin Wolf, ft July 19 2004 This year is now expected to see something close to a perfectly synchronised global economic recovery. According to Consensus Forecasts, US growth should reach 4.5 per cent and Japan - astonishingly - 4.2 per cent. The UK economy is forecast to grow by 3.2 per cent and even the lagging eurozone by 1.7 per cent. The Asia Pacific region (including Japan) is forecast to achieve 5.1 per cent growth, eastern Europe 5.5 per cent and Latin America 4.6 per cent. Leading the pack is China, forecast to achieve 8.7 per cent growth this year. For the world as a whole, Goldman Sachs forecasts output growth this year of 4.8 per cent, up from 3.4 per cent in 2003. Next year, growth is expected to slow, but the consensus remains cheerful. US growth is forecast at 3.8 per cent and the UK's at 2.7 per cent. The eurozone is expected to reach 2 per cent, although Japan's growth is forecast to tumble to 1.8 per cent. A soft landing is forecast for China, with growth falling to 7.7 per cent. Latin America is forecast to grow at 3.7 per cent. The US current account deficit has risen from about 1.5 per cent of gross domestic product to over 5 per cent today. During the recent US slowdown, the current account deficit has, remarkably, continued to rise (see chart). This is the opposite of what one would normally expect and of experience in the early 1990s. A net creditor for most of the 20th century, the US has seen its net liability position move from a rough balance in 1988 to minus 24 per cent last year (see chart). Yet, despite a current account deficit of 4.9 per cent of GDP in 2003, net liabilities to the rest of the world fell as a share of GDP. The tumbling dollar reduced net liabilities by more than the current account deficit increased them. According to the IMF, between the third quarter of 2001 and the fourth quarter of last year, US real domestic demand rose, cumulatively, by 8.9 per cent, while the UK's increased by 6.9 per cent (see chart). Over the same period, Japan's demand rose by just 2.7 per cent and the eurozone's by 2 per cent. Germany's fell by 0.7 per cent. In 2004, according to the Organisation for Economic Co-operation and Development, the Anglosphere (the US, UK and Australia, but not Canada in this case) will run a combined current account deficit of $636bn, with the US deficit alone accounting for $555bn (see chart). No other group of countries is forecast to run significant deficits. Asia's current account surplus was recorded at $322bn. Between February 2002 (when the dollar's overall real exchange rate started to fall) and April 2004, official foreign currency reserves (predominantly in dollars) rose by $1,211bn to $3,277bn (see chart). Seventy-eight per cent of this massive rise was in Asia alone, with Japan and China accounting for 34 per cent and 19 per cent of the overall increase in reserves, respectively. In 2002 and 2003, the increased foreign currency reserves of the Asian countries totalled $718bn. Of this $540bn was generated by the current account surplus, while the other $178bn represented the recycling of Asia's private capital inflow. What do these facts tell us? First, the US has long been exporting demand stimulus to the rest of the world. Second, this new business cycle, with its set off imbalances is taking off where the last one ended. Third, at recent real exchange rates, the US has been able to generate rapid growth of domestic output only with still faster growth in real domestic demand. Fourth, Asian countries have intervened massively to prevent the revaluation of their currencies. Finally, they have, in this way, also made it extremely difficult for the US to shift to greater reliance on foreign demand for its growth. The big question for the years ahead is how far this pattern can be sustained for another entire cycle and, if not, what will replace it. The macroeconomic (im)balances are far from the only medium-term challenge to the expansion. Another is the impact of a second elephant. China is now big enough to have an appreciable effect on the dynamism of the world economy. In the course of the present cycle, its impact is likely to become ever larger. One way in which China will affect the recovery is via instability in the growth of its domestic demand, which has, unlike that of the US, been investment-led. Investment growth peaked at over 40 per cent in the year to the first quarter of 2004. This is slowing and will almost certainly slow further, perhaps to as little as 10 per cent next year. This will, in turn, mean a drastic slowdown in the construction boom. HSBC suggests that the true economic slowdown could be from 12 per cent economic growth this year to 7 per cent in 2005. Yet another way in which China and the rest of Asia affects the world economy is through relative prices. China and India drive down the prices of labour-intensive manufactures and services. Both are also tightening the world market for oil. The big question here is not the balance between existing demand and supply but rather the ability to meet the rising demand that the Asian expansion and US recovery will generate. According to the International Energy Agency, China will generate one-third of global incremental demand for oil between 2002 and 2004 and the rest of Asia another 15 per cent (see chart). North America generates another 26 per cent. Moreover, the 2.9 per cent increase in global demand this year is the highest figure since 1980. As Asian growth continues, the global balance between demand and supply will continue to be tight, unless (or until) a vast increase in investment takes place. With such tight markets, relatively modest disruptions could eaily lead to explosive ju mp s in oil pri ce s, as happened twice in the 1970s. That might, in turn, feed into the inflationary spiral that many observers already fear. The possible combination of unstable growth in global demand with large and rising current account deficits and shocks to oil markets threaten a third danger: protectionism. So far this has been contained. International trade has also recovered strongly from the slowdown. But an outright failure to make progress in the Doha round, a new US administration and geopolitical frictions could threaten the present liberal order.