Inflationary pressures key risk to global growth

Updated: Oct 31 2007, 06:33am hrs
Excerpt from the RBIs mid-term review of the Annual Policy 2007-08

Developments in the Global Economy

41. Since late July, global financial markets have experienced bouts of turbulence and high volatility with the unfolding of the US sub-prime mortgage crisis. A freezing of credit markets spread rapidly to equity, currency and bond markets with disorderly re-pricing of risk in all segments. The deterioration in sentiment has affected consumer confidence with apprehensions of potential economy-wide effects in the US. Global economic activity, however, appears so far to have been resilient in the face of the heightening of volatility in international financial markets in the third quarter of 2007. Fundamentals remain strong in other large industrial countries as well as in most emerging market economies, especially in Asia which as a region is running current account surpluses with reduced public debt. Nevertheless, the downside risks to the outlook have increased from a few months ago, accentuated by the recent financial market turmoil. Firm inflationary pressures and high and volatile crude prices are other risks to the outlook. Consensus expectations continue to support a broad-based economic expansion for 2007, although heightening of uncertainties is recognised. According to the World Economic Outlook (WEO) of the International Monetary Fund (IMF) released in October 2007, the forecast for global real GDP growth on a purchasing power parity basis has been retained at 5.2 % for 2007 as in the July 2007 update, down from 5.4 % in 2006. The IMF has, however, revised the forecast for 2008 down to 4.8 % in October from 5.2 % in the July 2007 update.

42. In the US, real GDP growth had risen to 3.8 % in the second quarter of 2007 as compared with 2.4 % a year ago, reflecting growth in net exports, commercial structures and inventories, partly offset by a decrease in residential fixed investment. The IMFs October 2007 WEO now expects the US economy to grow at a slower pace of 1.9 % in 2007 and 2008 as against 2.9 % in 2006.

43. Real GDP in the euro area grew by 2.5 % in the second quarter of 2007 on a year-on-year basis as compared with 2.9 % a year ago. Unemployment held steady in August 2007 for the third month running at a record low of 6.9 %. Expansionary economic forces are predicted to prevail in the second half of 2007 in Germany the largest euro area economy with pick-up in domestic demand, production and exports. The October 2007 update of the IMFs WEO has placed average annual real GDP growth of the euro area at 2.5 % in 2007 and 2.1 % in 2008.

44. The Japanese economy grew by 2.3 % in the second quarter of 2007 as compared with 2.1 % a year ago and moderate expansion is likely to continue in the second half of 2007, aided by gains in household spending which offset the decline in corporate outlays. Going ahead, business investment should be an important driver, with high capacity utilisation and profits. In addition, the negative contribution from stock building in recent quarters suggests that inventory accumulation would add to growth. The October 2007 WEO of the IMF has projected real GDP growth in Japan at 2.0 % in 2007 and 1.7 % in 2008.

45. In emerging Asia, economic activity has continued to expand at a sustained pace, especially in the largest economies of the region, despite the existence of a volatile global setting with strengthening commodity prices and abundant liquidity. The Chinese economy grew by 11.5 % in the third quarter of 2007 as compared with 10.6 % a year ago. The deceleration in Chinas economic growth from 11.9 % in the second quarter has been attributed to policy efforts to curb high-polluting, energy-intensive industries as well as monetary tightening policies adopted in the first half, reduction of export rebates and restrictions on processing exports. Inflation accelerated to 6.5 % in August 2007 from 1.3 % a year ago, and moderated only slightly to 6.2 % in September. China is expected to grow by 11.5 % in 2007 and by 10 % in 2008, but inflation may remain at a level higher than the central banks target of 3.0 %. The impact of losses of Chinas financial institutions and the transmission of financial turmoil to Chinas markets seems to be limited.

46. The Peoples Bank of China (PBC) has raised interest rates seven times since April 2006 to 7.29 % and has raised cash reserve requirements eleven times between July 2006 and September 2007. In recent months, the PBC has cut the rebate on VAT taxes and has increased export taxes on some products to discourage the balance of payment surpluses and reduce funds flow to the stock markets which have reached elevated levels. China ran a record US $ 185.7 billion trade surplus in the first nine months of 2007, 69.0 % higher than in the same period last year, which has contributed to the overhang of liquidity in the economy. Chinas foreign exchange reserves reached US $ 1.4 trillion at the end of September 2007, remaining the key driver of domestic liquidity and contributing to asset price pressures.

47. Among other major Asian economies, the Korean economy grew by 5.8 % in the third quarter of 2007, higher than 4.8 % a year ago. Exports continue to post robust growth and domestic demand is showing a steady increase, led by consumption. The upward trend of real estate prices has been blunted by the tightening measures taken by the authorities since 2006. The Korean economy is expected to grow by 4.8 % in 2007, slower than 5.0 % in 2006. Consumer price inflation had accelerated to 2.3 % in September 2007 from 1.7 % in January 2007. The Bank of Korea has taken tightening steps in 2006 and 2007 by raising its policy rate, increasing reserve requirements, cutting the ceiling on aggregate loans to commercial banks for lending to small and medium enterprises and has attempted to curb the steady rise in property prices by restricting mortgage loan issuance to one contract per person, introduction of price ceilings on new houses and disclosure of construction cost of new homes.

48. In the second quarter, the Thai economy has registered a growth of 4.4 %, lower than 5.0 % a year ago. The Bank of Thailand introduced a series of measures to stem strong capital inflows into the economy in 2006 and 2007, although monetary policy setting has eased in the context of the moderation in growth. Growth is projected to slowdown to 4.0 % in 2007 from 5.0 % recorded in 2006, but is expected to recover to 4.5 % in 2008.

49. Inflationary pressures remain a key risk to global growth. In the global foodgrains market, prices have been rising in response to the surging demand for major crops such as corn, soybeans and wheat whose prices have increased by 10 %, 55 % and 51 %, respectively, from a year ago. The rally has swept up prices of other commodities such as barley, sorghum, eggs, cheese, oats, rice, peas, sunflower and lentils. The increase in prices has been also driven up by higher energy and fertiliser prices, low levels of inventories, shortfalls in certain crops mainly caused by weather-related factors such as the ongoing drought in Australia and strong increases in the demand for crops. The latter reflects mainly two new emerging sources of demand, which include US Government incentives that are encouraging businesses to turn corn and soybeans into motor fuel and the growing economies of Asia and Latin America which are enabling their large populations to spend more on food. The price of corn, the main feedstock for ethanol production in the United States, rose at the beginning of the year to ten-year highs. As this encouraged US farmers to increase their corn production, they decreased the supply of other agricultural products, with a subsequent upward impact on the prices of these products in world markets.

54. Crude oil prices, which softened from the July-August 2006 peak of US $ 78 per barrel to around US $ 53 per barrel in January 2007, have rebounded since July 2007 to close at a record level of US $ 91.7 on October 26, 2007 on renewed tension in the Middle East, low US crude stocks, weak US economic data and the easing of the US dollar against other major currencies. Futures prices for crude oil have moved up to US $ 91.86 per barrel. Barring a slowdown in oil demand growth, continued high demand and low surplus capacity leave the crude oil scenario vulnerable to unexpected supply disruptions through 2008.