The global economic outlook

inSight

20 Jan 2000

The global economic outlook

The outlook for the global economy at the beginning of the Year 2000 is a bright one. But three issues cloud the horizon and threaten financial stability.

Over the past six months investors have understandably become more optimistic - even exuberant - about global economic prospects, as emerging markets join in the upswing that started earlier in the developed economies. There are good reasons for optimism. The US economy continues to surprise observers with a combination of strong growth and subdued inflation. Europe appears to be on a steady, if undramatic, recovery path, with significant declines in unemployment and signs of confidence in future growth prospects. Indicators in Japan, while still mixed, point more convincingly to the beginnings of a sustained recovery than at any time over the past decade. Other Asian economies have surprised forecasters with "V-shaped" recoveries, in contrast to the extended period of stagnation that many were predicting little more than a year ago.

At times such as these it is natural that investors should downplay the inherent risks, just as they tended to play up the doom and gloom during the recent financial crisis. But they would do well to take note of three less encouraging issues that have the potential to affect the performance of markets.

The first of these is the risk of overheating in the industrial economies. Although productive potential has increased substantially as a result of advances in information technology, overall demand, particularly in the US, has been showing tendencies to grow faster than the capacity of the economy to supply the goods and services demanded. Regardless of the pace of technological change, there are limits to the scope for supporting growth through increases in employment beyond the underlying expansion in the labour force, as has been the recent trend. The consequence is a possible re-emergence of inflationary pressures. Knowing reasonably well how the key monetary policy makers in the US think, my guess is that they would not be so concerned about downward adjustments in asset prices as to refrain from pushing up interest rates to an extent adequate to pre-empt this consequence. Again, adjustments in asset prices in the US would be magnified by the potency of international finance, and there could be rapid contagion across markets worldwide.

The second issue is the worsening balance of payments disequilibrium we are seeing in the industrial economies, particularly in the US. We could be looking at a current account deficit in the US this year of over US$400 billion, equivalent to roughly five percent of GDP. Everybody has said that this imbalance cannot last for ever and that sooner or later exchange rate adjustments will be needed. International capital is happy to be funding the US current account deficit and buying into their stretched markets because, relatively speaking, there is a lack of good alternatives. But in the euro zone, with no balance of payments problem and with growth potential also being enhanced by information technology - the new economy of the US spreading to Europe - an alternative is emerging. Sharp exchange rate movements could be a destabilising force for emerging markets, as we have learnt in the past few years.

The third issue is the possibility that the strong economic recovery in Asia will diminish political support for urgent structural reforms. This would mean continued vulnerability among economies in the region to the kind of forces that can be generated - and the punishments that can be meted out - by international finance. The probability of a recurrence of financial turmoil, which has been so damaging to the economic well-being of the region and to investors, is definitely still there.

Once again: investors beware.

Joseph Yam
20 January 2000

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