According to estimates by the United Nations, the global economy expanded by 3.8% last year, continuing the strong performance recorded since 2003. Led by China and India, developing countries were prominent among the best performing economies, expanding by 6.5% on average in 2006. But can this apparently benign pattern of global growth be sustained, particularly since growth has been accompanied by ever-widening global financial imbalances?
Average annual growth in the least developed countries, many in Africa, reached almost 7% last year. The world’s largest economy, the United States, expanded by 3.2 %, and growth also recovered in previously sluggish Japan and Europe. These trends are remarkable in light of the shocks from the surge in oil prices, the wars in Afghanistan and Iraq, international terrorism, and the breakdown of multilateral trade negotiations.
Strong economic performance reflects strong domestic demand in the US, owing to low borrowing costs and rising asset prices. This lifted manufactured exports around the world and kept inflation down, which in turn boosted demand for energy and raw materials from the developing world, pushing up commodity prices and benefiting many poor countries. The savings generated in East Asia and the major oil exporters have increased global liquidity, helping to finance the US current account deficit, which has now reached unprecedented levels.
But the outlook for 2007 is for weakening global economic growth. The UN’s World Economic Situation and Prospects 2007 cautions that a weaker housing market will undermine US growth. Consequently, global economic expansion will slow, as no other major country is set to take over as the main engine of growth. With slowing world economic growth, US financing needs could cause a drop in investors’ confidence in the future of US-based assets, precipitating a sharp dollar depreciation.
The UN report observes that national economic policies and existing multilateral settings are not designed to mitigate effectively the risk of a global slowdown or to address global imbalances. In Europe and Japan, for example, monetary and fiscal policies have been tightening in response to domestic concerns, further slowing the world economy.
The build-up of official reserves in East Asia and other developing countries will provide them with extra means to deal with possible external shocks. However, it has also limited the expansion of domestic demand and import growth, exacerbating rather than redressing the global imbalances.
Of course, no single government can bear all the costs of the policies needed to correct today’s global imbalances. But an internationally agreed set of policies could help reduce the risk of weaker growth in the major economies, maintain confidence in the stability of international financial markets, and avoid a hard landing for the dollar. This would require, for instance, stimulating growth in Europe, Asia, and the major oil exporters in order to offset the contractionary effect on the world economy of adjustment in the US, which should include more restrictive fiscal policies, less private consumption, and higher domestic savings to reduce its external deficit.
Exchange rates should be realigned in a coordinated fashion to stimulate exports from deficit countries and import demand from surplus countries. This is not just a matter of revaluing the Chinese currency, as argued by some US policymakers, but requires gradual adjustment of most major currencies against the dollar in conjunction with concerted fiscal and monetary policy adjustments in the rest of the world.
Existing platforms, such as the G-8 summits, are unsuitable to achieve this course of action, mainly because key players from the developing world are not included. The multilateral surveillance mechanisms launched last year by the IMF are a step in the right direction, but only if they become part of an institutionalized multilateral mechanism of surveillance and policy coordination.
To be credible as a mediator of this mechanism, the IMF itself would need reform, including a substantial change of voting power to bring the influence of developing countries in line with the weight they carry nowadays in the global economy. Modest steps in that direction were taken during the IMF meetings in Singapore last September.
Such a new platform should also be used to work towards structural reform of the international monetary system aimed at reducing its excessive reliance on the US dollar as a reserve currency. Such reforms should work towards developing a multilaterally agreed multi-currency reserve system or even, in the longer term, a world currency based on the Special Drawing Rights issued by the IMF.
The mere possibility of an imminent hard landing for the dollar – and with it, for the US and world economy – should be alarming enough to mobilize concerted action. Coordination will surely deliver more satisfactory outcomes than what any one country can achieve on its own.