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Global economy projected to improve by late 2001

by Chakravarthi Raghavan

Geneva, 12 July 2001 - The United Nations said Thursday that while there has been a “significant decline” in growth and global output and trade, “the probability of a global recession is not high and the situation should improve by late 2001.”

In making this projection in the Chapter one of its World Economic and Social Survey 2001 (WESS-2001), the UN warns that there is however still a “major risk”, that of a “deeper and longer slowdown than anticipated in the US,” with larger spillovers to the rest of the world through sharp adjustments in its current-account deficit.

The survey projects its assessment of a possible improvement by late 2001 on the expectation of a ‘V’ shaped US recovery, the consequences of this not proving correct and US undergoing a ‘U’ shaped recovery, and about the imbalances in the US economy - large trade and current account deficits, its foreign debt of about 80% relative to its tradable GDP.

However, like other projections and estimations, there is no analysis of what could happen if the US does indeed have a ‘V’ shaped recovery, while the EU and Japan continue as they are: with the kind of trade and current account imbalances (as also low domestic savings, corporate bankruptcies, and now unemployment), such a US recovery without others having a robust growth, would surely create a financial crisis in the US.

Economists of the UN system, with some exceptions, seem chary of talking about this, lest it become a self- fulfilling prophesy. This may be understandable, but ignoring these elements whose origins can and ought to be traced back to misguided liberalization policies of the last two decades, creating unregulated and unrestrained markets, and powerless governments and states, could have far more serious consequences.

And with political leaders looking only at opinion polls and the next few weeks or months, the world could find itself in a dangerous situation where solutions based on the ‘cyclical’ views of the market economy, or the WTO Director-General Mike Moore’s slogan of a new trade round and IMF/World Bank calls for further liberalisation by developing countries, would be as effective as King Canute on the seashore ordering the waves to stop.

The WESS says that from a 4% growth in 2000, world GDP is expected to slow down to 2.5% in 2001 (as against a earlier initial UN forecasts of 3.5 percent).  Expansion of international trade is expected to decelerate even more markedly to 5.5% from the 12% in 2000, but slight improvements are anticipated for 2002 - with GDP rising by 3%and trade by 6.5 percent.

“While there are a number of further downside risks, the probability of a global recession is not considered to be high,” says the UN. “The policy responses in major developed economies since the beginning of 2001, including reduction in interest rates and fiscal stimuli, have produced cautious optimism that the slowdown will end by late 2001.”

The UN also argues that since inflation worldwide is benign, and fiscal position in many major economies has improved, there is room for further policy stimulus if the situation deteriorates more than anticipated.

In addition to arresting growing spillovers from a slowdown as promptly as possible, policy-makers also have to address the risks posed by the large external imbalances among nations that have accumulated over the past decade.

“And there is a need for further reform of the global trading system and the international financial architecture in order to facilitate development by securing less volatile and more balanced world economic growth in the long run.”

Discussing the factors contributing to the slowdown, the WESS concludes that: * due to the sharper-than-desired slowdown, most developed countries have eased their monetary policies, but as interest rate reductions take at least six months to affect the economy, there are unlikely to be any signs of recovery before the second half of 2001;

·        the decline in equity markets is adversely affecting consumption and investment;

·        information and communication technologies (ICT) will continue to be a driving force for the global economy in the medium to longer run, but the duration of the current adjustment and consolidation in the ICT sector in major developed economies is unknown; and

In a part of the chapter, ‘Uncertainties and downside risks’, the survey says that its projection of the outlook is based on the expectation of a ‘V-shaped’ recovery in the US - in the same way that the slowdown took hold very quickly and then intensified rapidly - it is expected that there will be a correspondingly rapid acceleration in growth starting in the second half of 2002, allowing for a return of global economic growth to its long-run pace of about 3% in 2002.

However, says the WESS, there are substantial uncertainties and several downside risks that might lead to a less attractive outcome.

The biggest risk is of a deeper and longer slowdown than anticipated in the US, with larger spillovers to the rest of the world through sharp adjustments in the current account deficit. European economies would then be unlikely to maintain the forecast degree of buoyancy, while it would be more difficult for Japan to address its lingering structural problems. At the same time, external constraints would confine the room for stimulating domestic demand in the majority of developing countries and the transition economies.

Collectively, these would have wider repercussions on the economic growth in the near term for the world as a whole, but especially for many developing countries.

The WESS says that the large trade and current account deficits of the US continue to pose a major risk. It has reached 4.5% of GDP in 2000, aggravating concerns about its sustainability and the consequences of any drastic reversal.  While there are no clear indications of what level of current account deficit is sustainable, experience suggests that a reversal of current account of developed countries stars when the external deficit reaches about 5% of GDP. And the nature of the reversal is a combination of slowing domestic economic growth and a significant depreciation of the exchange rate.

The sustainability of US trade and current account deficit depends to a large extent on ability of private and public sectors to continue borrowing abroad.  The total US foreign debt, in terms of its net foreign investment position is about 20% of GDP - well below the 40-50 percent ratio reached by several developed countries in the 1990s. However, trade only accounts for 25% of US output, and its exports of goods and services less than 12% of GDP.

As a result, the US foreign debt is about 80% of its tradable GDP, and about double that figure in terms of its export earnings. These magnitudes suggest that the external deficits may not be as sustainable as other indicators might suggest, and may need to be compressed in the near future - achieved either through cuts in domestic absorption, notably investment, or a rise in domestic savings.

The adjustment could be a smooth process or an abrupt revival, involving a sharp devaluation of the dollar with respect to major currencies and a market reduction or even reversal of capital flows.

On the basis of simulations using the LINK modelling system, the WESS says that if the adjustment is effected mainly by correcting the private sector’s savings-investment imbalance (by reductions in US domestic absorption), such a compression over 2001-2002 would have a significant deflationary effects not only on the US and developed countries, but also on many developing countries - with the economies of Latin America, and South and East Asia disproportionately adversely affected.

The simulations suggest that a larger part of rebalancing the private-sector savings-investment gap in the US would be accomplished by cutting investment and the smaller part by raising the savings rate - the worst case scenario considered plausible. But even this would involve only a 15% depreciation of the effective exchange rate for the dollar. The adverse consequences of a larger depreciation of the dollar against major currencies or of a possible turmoil in financial markets, would be considerably greater.

Through international linkages, the US adjustment would have a significant deflationary impact on the global economy. Total world trade would shrink considerably, trade surpluses of the EU and Japan would be cut sharply, and the combined trade balances of developing countries would deteriorate substantially.

The outcome would be a decline in global growth of about 1.7 percentage points from the baseline over two years - or a loss of output of some $600 billions.

The reduction in investment that this involves not only implies a decline in domestic demand in the period, but also resulting in a smaller capital stock over the longer-run - an adjustment that would lower output and income growth in the long run, as well as in the short-run. – SUNS4935

The above article first appeared in the South-North Development Monitor (SUNS) of which Chakravarthi Raghavan is the Chief Editor.

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