- International Monetary Fund. Research Dept.
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- April 2006
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World economic outlook (International Monetary Fund)
World economic outlook: a survey by the staff of the International Monetary Fund.—1980–—Washington, D.C.: The Fund, 1980-
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Assumptions And Conventions
A number of assumptions have been adopted for the projections presented in the World Economic Outlook. It has been assumed that real effective exchange rates will remain constant at their average levels during July 5-August 2, 2006, except for the currencies participating in the European exchange rate mechanism II (ERM II), which are assumed to remain constant in nominal terms relative to the euro; that established policies of national authorities will be maintained (for specific assumptions about fiscal and monetary policies in industrial countries, see Box A1); that the average price of oil will be $69.20 a barrel in 2006 and $75.50 a barrel in 2007, and remain unchanged in real terms over the medium term; that the six-month London interbank offered rate (LIBOR) on U.S. dollar deposits will average 5.4 percent in 2006 and 5.5 percent in 2007; that the three-month euro deposits rate will average 3.1 percent in 2006 and 3.7 percent in 2007; and that the six-month Japanese yen deposit rate will yield an average of 0.5 percent in 2006 and of 1.1 percent in 2007. These are, of course, working hypotheses rather than forecasts, and the uncertainties surrounding them add to the margin of error that would in any event be involved in the projections. The estimates and projections are based on statistical information available through end-August 2006.
The following conventions have been used throughout the World Economic Outlook:
… to indicate that data are not available or not applicable;
– to indicate that the figure is zero or negligible;
– between years or months (for example, 2004–05 or January-June) to indicate the years or months covered, including the beginning and ending years or months;
∕ between years or months (for example, 2004/05) to indicate a fiscal or financial year.
“Billion” means a thousand million; “trillion” means a thousand billion.
“Basis points” refer to hundredths of 1 percentage point (for example, 25 basis points are equivalent to ¼ of 1 percent point).
In figures and tables, shaded areas indicate IMF staff projections.
Minor discrepancies between sums of constituent figures and totals shown are due to rounding.
As used in this report, the term “country” does not in all cases refer to a territorial entity that is a state as understood by international law and practice. As used here, the term also covers some territorial entities that are not states but for which statistical data are maintained on a separate and independent basis.
Further Information and Data
This report on the World Economic Outlookis available in full on the IMF’s Internet site, www.imf.org. Accompanying it on the website is a larger compilation of data from the WEO database than in the report itself, consisting of files containing the series most frequently requested by readers. These files may be downloaded for use in a variety of software packages.
Inquiries about the content of the World Economic Outlookand the WEO database should be sent by mail, electronic mail, or telefax (telephone inquiries cannot be accepted) to:
World Economic Studies Division
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The analysis and projections contained in the World Economic Outlook are integral elements of the IMF’s surveillance of economic developments and policies in its member countries, of developments in international financial markets, and of the global economic system. The survey of prospects and policies is the product of a comprehensive interdepartmental review of world economic developments, which draws primarily on information the IMF staff gathers through its consultations with member countries. These consultations are carried out in particular by the IMF’s area departments together with the Policy Development and Review Department, the International Capital Markets Department, the Monetary and Financial Systems Department, and the Fiscal Affairs Department.
The analysis in this report has been coordinated in the Research Department under the general direction of Raghuram Rajan, Economic Counsellor and Director of Research. The project has been directed by Charles Collyns, Deputy Director of the Research Department, and Tim Callen, Division Chief, Research Department.
The primary contributors to this report are Thomas Helbling, Subir Lall, Kalpana Kochhar, S. Hossein Samiei, Roberto Cardarelli, Florence Jaumotte, Toh Kuan, Valerie Mercer-Blackman, Hélène Poirson, Martin Sommer, Nikola Spatafora, Irina Tytell, and Johannes Wiegand. To-Nhu Dao, Christian de Guzman, Stephanie Denis, Nese Erbil, Angela Espiritu, Patrick Hettinger, Bennett Sutton, and Ercument Tulun provided research assistance. Mahnaz Hemmati, Laurent Meister, and Casper Meyer managed the database and the computer systems. Sylvia Brescia, Celia Burns, and Jemille Colon were responsible for word processing. Other contributors include Ricardo Adrogue, Sergei Antoshin, Bas Bakker, Dan Citrin, Gianni De Nicolo, Roberto García-Saltos, Christopher Gilbert, David Hauner, George Kapetanios, Manmohan Kumar, Michael Kumhof, Luc Laeven, Doug Laxton, Ross Levine, Papa N’Diaye, Christopher Otrok, Arvind Subramanian, Stephen Tokarick, Thierry Tressel, Kenichi Ueda, and Khuong Vu. Jeff Hayden of the External Relations Department edited the manuscript and coordinated the production of the publication.
The analysis has benefited from comments and suggestions by staff from other IMF departments, as well as by Executive Directors following their discussion of the report on August 22 and 23, 2006. However, both projections and policy considerations are those of the IMF staff and should not be attributed to Executive Directors or to their national authorities.
The World Economic Outlook is truly a joint product, primarily with inputs from the Research Department of the International Monetary Fund, but also from the staff of a number of other departments. I thank Charles Collyns, David Robinson (who was with us during the important initial phase of this Outlook), Tim Callen, members of the World Economic Studies Division, and all the IMF staff from other divisions and departments who worked together to bring this World Economic Outlook to you.
The world economy continues to be strong, with a third year of significantly-above-trend growth. Growth continues to become more balanced with the United States slowing and the euro area picking up, while Japan’s growth is moderating toward trend. A key element to the strong world performance is the extraordinary growth of emerging markets and developing countries.
Much has rightly been made of the strong productivity growth of the U.S. economy over the last decade or so, which has contributed to this purple patch for the world. Far less has been made of the equally impressive productivity growth in emerging markets and developing countries. In Chapter 3, we examine the sources of labor productivity growth in Asia (the primary source of growth in output per capita), and compare it with other regions of the world. Asian labor productivity growth has benefited not just from fast accumulation of physical and human capital but also significant total factor productivity (TFP) growth—growth that typically comes from technological progress and from using the factors of production more efficiently. Indeed, in both China and India, TFP growth exceeds the contribution of physical or human capital accumulation. This extraordinary change has been made possible through an enabling environment that has fostered the development of efficient manufacturing (and in the case of India, services), while encouraging some movement of labor out of low-productivity agriculture.
Given the still high share of employment in agriculture in China, India, and the ASEAN countries, and provided the policy environment continues to be enabling, growth will continue to come from the shift out of agriculture. Given that a substantial population will still be employed in agriculture in the poorer Asian economies for some time, an important objective of policy should be to improve agricultural productivity. Equally important for the richer countries is to improve productivity in the service sector, especially because services will constitute an increasingly important fraction of their economies. For a number of Asian economies, a critical element of any policy mix to improve agricultural and service sector productivity will be opening up these sectors to foreign entry and competition.
Productivity growth, especially when unexpected, has a number of valuable benefits. Other things equal, it reduces unit labor costs, and increases the potential growth rate of the economy. Thus it helps keep inflation under check. It also helps offset the investment and growth consequences of adverse supply shocks. That the world economy has remained robust in recent years despite higher oil and commodities prices is due, in no small part, to the enabling policies that allowed economies to continuously improve productivity.
Robust global growth over the last few years has brought some new policy challenges. For one, unexpectedly high demand for some non-oil commodities may have generated enormous revenues for some commodity producers temporarily, but conditions will change as supply catches up. As Chapter 5 suggests, prospects for non-oil commodities, especially metals, may be different from oil in that there is more likely to be a robust supply response as investment increases to meet the unexpectedly higher demand. Our model, as well as futures prices, suggests that metals prices are likely to decline in the future. Non-oil-commodity-dependent economies should anticipate this risk by being cautious on raising expenditures that are hard to reverse, such as public sector salaries, and instead focus on expenditures that help build diversified productive capacity for the future.
Another risk is that some market-led processes may overshoot when times are good. For instance, widespread productivity growth may have played a role in the emergence of global current account imbalances. The strong productivity growth in the United States, as is well known, certainly made the United States an attractive place to invest in, drawing in capital and producing a counterpart current account deficit in the late 1990s. In addition though, as Chapter 4 suggests, the United States’ sophisticated arm’s length financial system made it easier for consumers to borrow against future incomes and consume immediately, augmenting the size of the current account deficit. Indeed, the expectation of higher future incomes coupled with accommodative monetary policy and low interest rates may have fueled the U.S. housing boom, which boosted consumption even more as the financial system allowed borrowing against collateral.
Even though emerging markets have experienced strong productivity growth in recent years, many did not have financial systems that could translate this into either higher investment or higher consumption. Their rising incomes were therefore channeled into net savings that helped finance the United States’ dissaving. The ability to run current account imbalances therefore has allowed the world to grow faster than it would otherwise have. This is a good thing but it has limits. It is important, therefore, that we bring imbalances down in stable times so that we have room to expand them when future needs arise—this is just prudent countercyclical global policy.
Prudence is especially important when the times are changing. Revisions to U.S. data suggest that productivity growth was not so high as earlier believed. Furthermore, productivity growth has been declining as the expansion matures, and unit labor costs have been accelerating. With tight labor market conditions (including in other industrial countries), and high capacity utilization, inflationary pressures are on the rise. Even as liquidity is being withdrawn, the Federal Reserve has to assess not just how much the economy will slow because of prior rate increases (and their effects via the housing market) and higher energy prices, but also what the potential growth of the economy truly is. It also has to pay attention to the narrowing global output gap. There are risks of both excessive tightening as well as overly gradual tightening.
While growth in the rest of the world is likely to pick up some of the slack of a slowing U.S. economy, it is hard to estimate precisely how much of that momentum is independent of U.S. growth because the world has become so much more closely integrated over the last few years. Our baseline is that world growth will continue to be strong, but that forecast is surrounded by significant risks to the downside.
Policymakers should recognize that some of their country’s performance is not just because of their own skills at the helm but because of spillovers from the robust global economy, as well as the benign financial conditions. The emerging protectionism not just in trade, but increasingly in preventing cross-border acquisitions and foreign direct investment, can interrupt the process of global productivity growth that has been so critical to the robust health of the world in recent years. This is why country authorities should strive hard, not just to revive the Doha Round, but even to make it more ambitious. They should work together to sustain the smooth flow of goods, capital, and ideas across borders, not least through the various mechanisms proposed by the IMF’s Managing Director in his Medium-Term Strategy to invigorate the quality of the multilateral dialogue. Finally, wherever possible, they should ensure that public policy does not exacerbate imbalances created by the private sector, as well as avoid creating uncertainties where none existed before. Prudent, predictable policy, in this environment of increasing uncertainty, is the need of the hour.
Economic Counsellor and Director, Research Department
Global Economic Environment
The global expansion remained buoyant in the first half of 2006, with activity in most regions meeting or exceeding expectations (Chapter 1). Growth was particularly strong in the United States in the first quarter of 2006, although it has slowed subsequently. The expansion gathered momentum in the euro area, and continued in Japan. Emerging markets have grown rapidly, especially China, and low-income countries have also maintained an impressive growth performance, helped by strong commodity prices.
At the same time, there are signs that inflationary pressures are edging up in some countries as sustained high rates of growth have absorbed spare capacity. Headline inflation in a number of advanced economies has for some time been above central bank comfort zones, pushed up by rising oil prices, but there are now signs of increases in core inflation and inflation expectations, most notably in the United States. In Japan, there is increasing evidence that deflation has finally ended.
Oil and metals prices have hit new highs. Prices have been supported by tight spare capacity in global markets against the background of buoyant GDP growth, and in the case of oil, rising geopolitical tensions in the Middle East and risks to production in some other large producers (notably Nigeria). Futures markets suggest that oil prices will remain elevated for the foreseeable future.
Major central banks have responded by tightening monetary policy. The U.S. Federal Reserve continued to raise interest rates through June, although pausing in August; the European Central Bank has raised interest rates further in recent months; and the Bank of Japan ended its zero interest rate policy in July. The U.S. dollar has weakened against the euro, and to a lesser extent the yen, while long-term interest rates have firmed.
Rising inflation concerns and tighter monetary conditions led to some weakness in advanced-economy equity markets and a series of larger moves in some emerging market asset prices in May-June, although markets have been more stable since July. These moves appear to largely represent corrections after major price run-ups, rather than a fundamental reassessment of economic risks, and seem unlikely to have a major growth impact, although growth in some individual countries may be dampened as their central banks have raised interest rates to calm financial market conditions and head off inflationary pressures.
Global imbalances remain large. Despite an acceleration in export growth, the U.S. current account deficit is expected to near 7 percent of GDP in 2007. Surpluses in oil exporters and a number of Asian countries are expected to stay high, with China’s surplus remaining in excess of 7 percent of GDP.
Outlook and Risks
The forecast for global growth has been marked up to 5.1 percent in 2006 and 4.9 percent in 2007, both ¼ of a percentage point higher than in the April 2006 World Economic Outlook.
Growth in the United States is expected to slow from 3.4 percent in 2006 to 2.9 percent in 2007, amid a cooling housing market. Growth in Japan will also ease as the cycle matures. In the euro area, the recovery is projected to sustain its momentum this year, although growth in Germany will be reduced in 2007 by the planned tax increase. Among emerging markets and developing countries, growth is expected to remain very strong, with the Chinese economy continuing its recent rapid expansion.
The balance of risks to the global outlook is slanted to the downside, with IMF staff estimates suggesting a one in six chance that growth could fall to 3¼ percent or less in 2007. The most notable risks are that inflationary pressures could intensify, requiring monetary policy to be tightened more than currently expected; that oil prices could increase further against the background of limited spare capacity and geopolitical uncertainties; and that the U.S. housing market could cool more rapidly than expected, triggering a more abrupt slowdown of the U.S. economy.
The potential for a disorderly unwinding of global imbalances remains a concern. A smooth, market-led unwinding of these imbalances is the most likely outcome, although investors would need to continue increasing the share of U.S. assets in their portfolios for many years to allow this to happen. The depth and sophistication of U.S. financial markets has facilitated the financing of recent large current account deficits. However, there remains some risk of a disorderly adjustment, which could impose heavy costs on the global economy.
Central banks in advanced economies will need to carefully weigh the relative risks to growth and inflation in the period ahead. The U.S. Federal Reserve faces a difficult situation of rising inflation in a slowing economy, but given the importance of keeping inflation expectations in check, some further policy tightening may still be needed (Chapter 2). In Japan, interest rate increases should be gradual, as there is little danger of an inflationary surge, while the reemergence of deflation would be costly. In the euro area, further increases in interest rates are likely to be needed if the expansion develops as expected, but for now inflation pressures seem broadly contained, and faced with continuing downside risks to growth, policymakers can afford to be cautious in tightening monetary policy further.
In most of the large advanced economies, fiscal consolidation in the face of aging populations remains a huge challenge. Fiscal consolidation is envisaged in many countries in the coming years, but it is neither ambitious enough nor backed up by clearly identified policy measures. Social security systems need to be put on sounder footings, and effective ways found to contain the inexorable rise in health care costs.
Structural reforms to improve the business environment and global competitiveness remain essential to bolster growth prospects. In the euro area, faster progress to advance the Lisbon agenda—particularly more open competition in services, more flexible labor markets, and financial sector reforms—remain key to boost productivity growth and improve job opportunities. In Japan, priorities include public sector reforms, steps to enhance labor market flexibility and financial sector efficiency, and reforms to improve productivity in the services sector.
Chapter 4 examines how differences in financial systems can affect economic cycles in advanced economies. A new index is constructed that characterizes financial systems according to the degree to which transactions are based on long-term relationships between borrowers and lenders or are conducted at “arm’s length.” The chapter finds that while there has been a general trend toward bank disintermediation and a greater role for financial markets, the pace has differed across countries, and there are still important differences in financial systems. The chapter offers some evidence that such differences in financial systems may affect cyclical behavior. Specifically, in more arm’s length systems, households may be able to better smooth consumption in response to changes in income, but their spending may be more sensitive to changes in asset prices. Corporate investment appears to react more smoothly to cyclical downturns in relationship-based systems, but arm’s length systems seem better at reallocating resources in response to structural changes.
The move toward more arm’s length financial systems that has been under way in most countries over the past decade is set to continue, given technological innovations and the removal of regulatory barriers. Policymakers will need to maximize the benefits from this ongoing change, including by implementing complementary reforms to increase labor market flexibility, improve the portability of employee pension plans, and strengthen bankruptcy procedures. Supervisory and regulatory policies will need to keep up with the increasing sophistication of the financial sector, while macroeconomic policy management will need to adapt to reflect possible changes in cyclical behavior.
Emerging Market and Developing Economies
In emerging market and developing economies, policymakers must adjust to the more challenging global environment by continuing to reduce vulnerabilities and by putting in place reforms that will help sustain the current growth momentum. Recent developments have provided a reminder that emerging market economies remain susceptible to turbulence in global financial markets. Countries at risk include those with still weak public sector balance sheets, large current account deficits, and less well-anchored inflation expectations. In a number of countries in emerging Europe, the increasing reliance on private debt flows to finance large current account deficits is a concern. More also needs to be done in emerging market and developing economies to advance market-oriented reforms, particularly by reducing barriers to competition, to create the climate for vigorous private sector–led growth.
Chapter 3 analyzes Asia’s remarkable growth performance, and focuses on what needs to be done to sustain strong growth in the future. The chapter finds that the favorable policy environment in Asia has been the key to strong total factor productivity growth and rapid accumulation of physical and human capital in the region. Indeed, the importance of establishing a favorable policy environment is the key lesson that late developing countries—both within Asia and in other parts of the world—can learn from the successful early developers such as Japan and the newly industrialized economies (NIEs). Trade liberalization, improved access to education, and steps to promote financial development and encourage entrepreneur-ship would facilitate the ongoing shift of resources out of agriculture and into industry and services. Efforts to boost productivity growth in industry, and particularly the relatively more sheltered services sector, will also pay important dividends. Policies to encourage increased competition in services include removing barriers to entry, encouraging foreign investment, and streamlining regulations.
Chapter 5 examines the outlook for prices of nonfuel commodities. These prices—par-ticularly for metals—have risen sharply in recent years, defraying the losses from higher oil import bills for exporters of these commodities. The chapter finds that price increases have largely been driven by strong demand, particularly from China, as well as supply bottlenecks. In addition, the chapter finds that speculative activity does not seem to have been a significant driver leading commodity price movements, although speculators may have played a role in providing liquidity to markets. Metals prices are expected to come down over the medium term as new production comes on stream to meet rising demand. The key policy message for countries that export commodities—par-ticularly metals—is that they should not assume that high prices will be sustained.
Current revenue windfalls should be saved or invested to support future growth in noncommodity sectors, rather than used to increase spending in areas that will be difficult to reverse later.
Joint policy efforts would help to ensure a smooth reduction of global imbalances. An orderly private sector–led adjustment, involving a rebalancing of demand across countries, with accompanying further depreciation of the U.S. dollar and exchange rate appreciations in many surplus countries (notably in parts of Asia and oil producers), remains the most likely outcome. However, there remains a risk of a more disorderly unwinding that would imply a heavy cost for the global economy. The risks of such a disorderly adjustment would be considerably reduced by sustained policy actions across the major players in the world economy involving steps to boost national saving in the United States, including through fiscal consolidation; greater progress on structural reforms in Europe and Japan; reforms to boost domestic demand in emerging Asia (consumption in China, investment elsewhere) together with greater exchange rate flexibility; and increased spending in oil-producing countries in high-return areas, consistent with absorptive capacity constraints, especially in the Middle East, where the large buildup of investment projects already in train is welcome. Taking a joint, multilateral approach may help to advance implementation by providing assurance that possible risks associated with individual actions would be alleviated by simultaneous policy initiatives elsewhere. The present multilateral consultation by the IMF can contribute to this process.
Efforts are needed to reinvigorate the process of multilateral trade liberalization. The apparent deadlock in the Doha Round is deeply disappointing. Trade liberalization on a nondiscriminatory (most favored nation, or MFN) basis remains the best way to open up new global growth opportunities. The threat of protectionist pressures needs to be firmly resisted.
High and volatile prices in world energy markets remain a major concern that will require sustained efforts from all sides to address. Increased investment is needed to build up adequate production and refining capacity, while appropriate incentives for consumers would encourage improved energy conservation.