Major developments are underway in the world economy. The long-awaited ?global rebalancing? is finally happening. As expected, this has created a number of difficulties in the US economy. The US is likely to have below-trend growth in both 2007 and 2008. It is very likely that the US Fed will cut rates, but this could well accentuate US inflation, creating a stagflationary environment. The US slowdown will, no doubt, exert a drag on the world economy, including India.
For many years, economists warned the world about the difficulties of ?global imbalances?. This had many elements, the main ones among which were: a large US fiscal deficit, a large US current account deficit, a housing bubble in the US, massive reserves accumulation in Asia, an overvalued dollar, a distorted exchange rate and an investment bubble in China. Economists like Martin Feldstein and Ken Rogoff diagnosed deep connections between these apparently unrelated phenomena. For many years, financial markets largely ignored the economists, thinking that business could go on despite these difficulties, while the economists continued to warn that things that can?t go on, don?t. In 2007, it is clear that an unwinding of global imbalances has begun.
Many signs suggest that the long-awaited ?global rebalancing?, which corrects these several pathologies, is now underway. The US has been putting its fiscal house in order, pulling itself back from a deficit of 3.6% in calendar 2004 to 1.2% in 2007?an improvement of 2.4% in three years. The US dollar has crashed dramatically?the Major Currencies Index of the US Fed has dropped by roughly 40% in five years. There has been a sharp collapse in the US housing market. In response to these three developments, the US current account deficit has started to shrink.
These developments, of course, imply substantial difficulties in the US economy. Fiscal consolidation is contractionary. The difficulties in the US housing sector have adversely affected the spending of many households. At the same time, the drop in the US dollar has spurred demand for US exports and has helped to prop the economy. Present projections suggest that the US is likely to have just 2% GDP growth in both 2007 and 2008. This is below the trend US growth rate of 3%. Projections for 2009 are also below 3%.
Under these conditions, it is now very likely that the US Fed will cut rates. However, the headroom for this is limited, given stubborn inflation in the US that is partly accentuated by the dollar depreciation. If the Fed gives in to political pressure, and cuts rates while inflation is worrisome, this could yield the worst of all worlds?stagflation, in which recession and inflation go together. The events of 2007 have demonstrated the difference with the UK and European monetary policy framework, something that Alan Greenspan pointed out in his recent book, where inflation targeting is written into law and the central bank has its hands tied down?when compared with the US framework, where the Fed has discretion over how seriously to focus on inflation, and thus comes under political pressure to favour spurring growth over containing inflation.
The US slowdown will exert a drag on the world economy, including India. While a drop in American imports and a rise in exports is good for the US economy, and helps compensate for the effects of fiscal consolidation coupled with a housing bust, it is only bad news for the world economy. The slowing US economy would imply weakening economic conditions worldwide.
There have been arguments about Asian decoupling, and how the world economy will absorb a US slowdown because China and India are growing well. However, the numbers do not square with this optimistic assessment. China and India are too small to affect the world economy yet. And a US slowdown will adversely affect exports from both. This will have an indirect effect on other Asian countries that supply raw materials to firms in China and India, which go on to export goods and services to the US.
With the US adjustment having commenced, the key question now is about what will happen in China. So far, there has been no progress on the resolution of China?s macroeconomic imbalances. China continues to pursue a faulty exchange rate regime?the yuan is undervalued and is a one-way bet that is attracting massive capital inflows through both legal and illegal means. Asset and food prices are all showing very high inflation. Reserves continue to grow at $50 billion a month or worse. The Chinese government lacks the tools of macroeconomic policy?such as an effective monetary policy?to influence the economy. In a world that is successfully rebalancing, China stands out as a big risk. With a falling consumption ratio, high levels of savings and investment, especially by public sector enterprises, and a 12% current account surplus, the role that China will play in the global rebalancing underway is still a question mark. This is unnerving.
?Ila Patnaik is senior fellow at National Institute of Public Finance and Policy. These are her personal views