Table 1: International GDP growth forecasts(a)
Initial expectations for the US sub-prime crisis were that its economic impact would be limited to a short stagnation in the US and a very mild slowdown in the global economy. This viewpoint was based on the belief that co-operation between the Fed and other central banks - mainly European - would be able to contain the financial market stress and shelter the real economy from any negative effects.
While the global economy has remained relatively resilient in spite of worsening conditions in US credit markets, in the last few months financial market stresses have intensified and risk becoming self-reinforcing. At the same time, the economic slowdown in the US and abroad is gathering pace, placing strains on corporate and household balance sheets, and increasing the risk of a global credit crunch.
As these events have continued to unfold it now appears likely that the global economy will slow more significantly than previously anticipated. As a result, world growth is forecast to slow from 4.9 per cent in 2007 to 3¾ per cent in 2008, before staging a slight recovery in 2009 (see Table 1 and Chart 1).
Chart 1: World GDP growth
Source: IMF and Treasury.
Inflation has continued to rise, with headline and core measures exceeding comfort levels in many economies. This reflects a combination of higher energy and food prices and limited spare capacity. However, as the pace of growth eases, we expect lower energy prices and the emergence of spare capacity in some economies to curb inflation pressures later in the year.
After growing strongly in the middle of last year, the US economy ended 2007 on a soft note. Since then, the economic environment has worsened, becoming particularly unfavourable for consumers. Declining employment, an energy-driven rebound in inflation, falling house and equity prices and a substantial tightening in lending conditions will all combine to dampen consumption. As a result, we now expect the US to experience a mild recession in 2008.
Emerging economies have been broadly resilient, so far, although some slowing of growth in export and industrial production has been evident. Growth has been broad based across Latin America, Africa, emerging Europe, and developing Asia. In 2008 and 2009, rising household consumption, strong infrastructure investment, high commodity prices and capital inflows are expected to continue to provide support to the expansion in emerging economies.
Moreover, strong fiscal positions in most countries and the accumulation of large foreign exchange reserves will provide governments with a buffer to counter any protracted slowdown in the external environment. Nevertheless, with a deteriorating outlook for the US the growth outlook for emerging economies has been revised down slightly.
The Chinese economy posted another stellar performance for 2007, recording its fastest rate of growth in over a decade. Urbanisation and infrastructure development have continued to drive this rapid expansion, and has fuelled a boom in energy and raw materials prices which has also benefited major commodity-exporting emerging economies.
The risks to the global outlook are substantial and have increased. The current turmoil in global financial markets is becoming more than just a problem of liquidity in key funding markets. It is increasingly a reflection of deep-seated balance sheet fragilities amongst some of the world’s major financial institutions, and its effects are likely to be broader, deeper and more protracted than was previously anticipated.
The virtual collapse of US investment bank Bear Stearns in March, and the opening of additional emergency funding mechanisms by the Fed, has highlighted the potential for current market disruptions to morph into a systemic financial crisis. Had Bear Stearns been forced to declare outright bankruptcy, the effect on broader financial markets would have been significant and far reaching.
The Fed has demonstrated that it is alert to the seriousness of the situation by taking a series of extraordinary policy actions to address liquidity shortages in key funding markets and to maintain financial system stability. Expanding its emergency lending facilities to include investment banks as well as commercial banks should help to limit the potential for another investment bank to suffer a liquidity crisis of the type that led to the Bear Stearns situation.
Nevertheless, it is likely that further policy actions will be needed over the near term. As underlying economic conditions in the US weaken - perhaps substantially - a wider deterioration in credit quality beyond subprime mortgages is expected.
This will put added pressure on the capital and funding positions of systemically important financial institutions, and will further restrain their ability (and willingness) to extend credit to households and businesses.
Moreover, there is the potential for this contraction in credit to become self-reinforcing, leading to a more severe and protracted deterioration in US economic conditions. If such a scenario were to materialise the implications for world economic growth would be significant.
To date, the large emerging economies of Asia and Latin America have been only modestly affected by developments in advanced economy financial markets. In fact, there is potential for increasing concerns about asset quality in advanced economies to foster - not depress - capital flows to these emerging economies as investors look for new opportunities, fuelling greater-than-expected credit growth and domestic demand in these economies.
Growth risks related to inflation and the oil market have intensified, despite the slowing growth outlook. World oil prices have remained well elevated, reaching record highs in nominal and real terms in mid-March 2008. These increases can be attributed to a larger than expected fall in global crude oil inventories, weakness in the US dollar, and a range of adverse geopolitical pressures. Oil market fundamentals remain tight, and with the risk for potential supply disruptions, there is a risk that oil prices could increase further, unless there is a significant softening in demand from emerging countries.
Food prices, a significant contributor to inflation in many emerging economies, are also expected to remain high this year. Grain prices have sustained strong gains in recent months, driven by poor harvests and rising consumption. While forecasts for more favourable seasonal conditions in most producer countries will be beneficial to this year’s production, increased use of grain in bio-fuels may counteract some of the downward price impacts from this supply response.
The US economic outlook has worsened significantly in recent months, with downside risks to growth having increased substantially. Given deteriorating consumer confidence and the extraordinary stress in financial markets, a US recession is now expected. As a result, US GDP growth is now forecast to be ¾ per cent in 2008, down 1 percentage point since December JEFG. In 2009, a modest rebound in growth is expected, with GDP forecast to grow by 1½ per cent.
US domestic demand is likely to contract in early 2008, with outright declines in consumption expected up until the December quarter. Consistent with this, retail sales have declined in real terms
in four of the past five months to February, while consumer sentiment has weakened sharply. Increasing softness in the labour market is also expected to restrain consumption, with private employment having contracted in each of the three months to February. For 2008 as a whole, consumers may face further house and equity price falls, tighter credit conditions and high energy costs.
Moreover, tighter credit conditions and weaker business sentiment are likely to restrain business investment over 2008 and into 2009. In addition, the housing sector is likely to continue to detract from growth until at least early 2009. Nevertheless, net exports are expected to remain solid, with exports boosted by solid trading partner growth and a softer dollar, while weaker domestic demand should restrain imports.
Risks to US growth remain skewed to the downside. A significant concern is the risk of a downward spiral in confidence and activity caused by renewed strains in financial markets and the ongoing housing contraction. Moreover, should households take the opportunity to aggressively increase savings, then growth will also be slower than expected, which could dampen the projected rebound in 2009.
US authorities have acted to support growth. The Federal Reserve has aggressively cut interest rates and taken a series of extraordinary steps to boost liquidity, despite some concerns about inflation risks. The US Administration has announced a fiscal stimulus package (of 1 per cent of GDP), which should bolster household spending and growth in the second half of 2008.
The outlook for the Japanese economy has softened since December JEFG as a result of the weakening external environment. After growing by 2.1 per cent in 2007, growth is expected to ease to 1¼ per cent in 2008, as a gradual pick-up in consumption and recovery in housing investment only partly offset moderating business investment and exports. Growth is expected to pick up to 1½ per cent in 2009 as the global outlook improves.
The outlook for the Chinese economy is for continued strong growth although at a somewhat more moderate rate than previous outcomes. The economy grew by 11.4 per cent in 2007, the fastest rate of growth in 13 years. The forecasts for 2008 and 2009 have been revised down to 9½ per cent. The downward revision reflects a weakening in the export sector due to an expected slowdown in developed economies.
However, with strong investment, and rising incomes, domestic consumption is expected to maintain its rapid growth. Furthermore, the government has ample financial reserves to support domestic growth should the US slowdown have a more serious adverse impact than is currently anticipated.
Nevertheless, a further acceleration in inflation poses a threat to the outlook. Until recently, the increase in inflation has been largely contained to food prices. However, price pressures appear to be more broadly based with core measures now ticking-up.
Notwithstanding a downward revision to our 2008 forecast, the Indian economy is expected to continue to grow at a strong pace of 7½ per cent. The downward revision reflects a greater-than-expected effect of monetary policy tightening, and an anticipated moderation in India’s exports as global growth slows.
The outlook for growth in India in 2009 is for 7¾ per cent. It is expected that as the global economy recovers and domestic consumption picks up, supported by fiscal stimulus in the 2008-09 budget and significant increases to public wages, growth should improve.
The outlook for the rest of East Asia has deteriorated since December JEFG as a result of a weaker external environment. Growth in the rest of East Asia has been revised down by 1 percentage point to 4¼ per cent in 2008. Growth in 2009 has been revised down by ½ of a percentage point to 4¾ per cent.
In the NIEs, growth is forecast to ease to 3¾ per cent in 2008 before accelerating slightly to 4¼ per cent in 2009. The moderation in growth in 2008 largely reflects slowing US demand for the region’s exports. In addition, growth in domestic demand is expected to ease in 2008 in line with weaker export growth.
Growth is also expected to ease in the ASEAN-51economies to 5 per cent in 2008, before picking up to 5½ per cent in 2009. Domestic demand is expected to underpin growth in 2008 as exports moderate in line with weaker global growth. Growth is expected to pick up in 2009 with a modest rebound in exports and solid growth in domestic demand.
Following two consecutive years of strong growth, the euro area is forecast to slow to 1½ per cent in 2008. The outlook reflects weakening domestic demand as well as a less supportive external environment. Risks remain to the downside, with the possibility for further adverse financial market developments and the potential for emerging economies to be more adversely affected by developments in the US.
The outlook for New Zealand has deteriorated in recent months as indications of weakness in the domestic economy have coalesced. Growth is forecast to slow to 1½ per cent in 2008, reflecting ongoing weakness in the housing market, sluggish consumer spending, weak consumer sentiment and the prospect of continued drought. The Reserve Bank of New Zealand is likely to maintain its tight monetary policy stance in the short term to combat inflationary pressures generated by high commodity prices and persistent capacity constraints. Growth is expected to recover to 2¼ per cent in 2009, assisted by monetary easing and fiscal stimulus in the 2008-09 budget.
1 ASEAN-5 consists of Indonesia, Malaysia, the Philippines, Thailand and Vietnam.