The Hindu Business Line : World Economic Outlook April 2005<br>US on notice: Cut spending, fiscal deficit

The latest World Economic Outlook is hard-hitting in pointing out the failures in the economic policies of such superpowers as the US, Europe and Japan. Deploring the widening current account gap of the US, which has a mirror image in the current account surpluses of developing countries like China and India, the WEO prescribes that the US must reduce its massive fiscal deficit even as it cuts consumption. Difficult choices are involved, but the report pins its hopes on leaders who can focus beyond the here and now, says S. Venkitaramanan.

SPRING beckons one to Washington, along with cherry blossoms, central bankers and Finance Ministers, to contemplate the state of the world economy and debate measures to restructure it. This is the time when the World Bank and IMF hold their semi-annual meetings to discuss problems of world development.

The World Economic Outlook (WEO), incorporating the efforts of the various IMF economists — a distinguished lot, by any reckoning — is released in time for the meeting. It is, rightly, the cynosure of all eyes, spelling out as it does the IMF's forecast of economic growth for various countries, commodity prices, monetary policies and, in general, movement of the world's capital flows.

The latest WEO of April 2005 follows in the grand tradition of its predecessors, except that it is more hard-hitting in pointing out the failures in the economic policies of such superpowers as the US, Europe and Japan.

The WEO 2005 points out that the world economy enjoyed one of its strongest years of growth last year. This robust growth is expected to continue this year, albeit at a more moderate pace. The projections of the rate of growth of world output as set out in the WEO are shown in the Table.

The World Economic Outlook has taken into account the likely impact of the rise in oil prices on the growth prospects of the global economy. It is not sanguine about the oil price coming down. It estimates that the pressure of rising demand from growth of the world economy, especially China and India, combined with the limitation on known reserves, will keep the price high.

While economies such as ours (and Indonesia's) are trying to shield the consumers from the effects of high petroleum prices through fiscal subsidies, the trend in advanced economies is to bite the bullet of energy price increases and respond through better conservation measures.

The WEO has some pertinent suggestions for responding to the oil price problem, but they mostly centre on exploring further energy prospects in non-OPEC sources, besides implementing conservation measures. It is significant that the latest oil shock has not had as great an impact on economic output as in the 1970s. This is primarily because the advanced economies have become more efficient in their use of energy per unit of output. This shows the direction other economies have to follow.

The WEO 2005 focusses, most importantly, on the growing global economic imbalance. These primarily relate to the widening current account gap of the US, which has a mirror image in the current account surpluses of developing countries like China and India, besides other developed countries, like the euro area and Japan.

The current account deficit of the US has reached the unsustainable level of nearly 6.7 per cent of GDP. In absolute terms, it runs into around $600 billion a year. The situation is expected to worsen in 2005-06. The latest WEO emphasises that this is primarily the reflection of the US' consumption moving ahead of its savings.

Financial globalisation, in the sense of easier integration of financial markets, has made the bridging of the large current account gaps easier.

Flows of funds from one part of the world to the other have become more flexible. The result is a reversal of the common-sense position which would have expected a large flow of resources from the richer countries to the poorer. The WEO notes that, ironically, it is the poorer countries that contribute resources to the richer nations.

The dollar has depreciated to some extent but not sufficiently against the currencies of the emerging economies. The WEO notes that the depreciation of the dollar has not helped in alleviating the trade deficit or current account deficit of the US. China's and Japan's surpluses continue to rise.

One of the remedies suggested by WEO 2005 follows the standard IMF prescription — namely, moving to floating exchange rates. The fixity of exchange rates leads to the exacerbation of current imbalances, in the IMF's view. So, the suggestion is that countries like China, should float — in effect, revalue — their currencies. Will revaluation help? This is a billion-dollar question. Japan's yen has been floating for years and has appreciated. But its exports have not decreased. Will the same thing happen to China?

The latest news is that the US is threatening to act through tariffs imposed on Chinese imports if the latter does not float its exchange rate and allow the remninbi to appreciate. The US Senate voted earlier this month on a Bill moved by Senator Charles Schimmer that would impose a tariff of 27.5 per cent on all Chinese imports if China does not revalue its currency in the next six months.

This amounts to passing the buck to other countries for failure on the US' part to manage its economy on the right lines. It is bidding goodbye to US protestation of free trade and WTO rules and regulations. The way China goes on to react to Mr Schimmer's amendment will reveal how Chinese policy-makers think in terms of handling their difficult trading partner whom they cannot afford to ignore!

The WEO 2005 minces no words in dealing with what is to be done about reducing the imbalances. It stresses the need for the US to reduce its massive fiscal deficit even as it reduces its consumption. It is obvious that difficult choices are involved. Politicians will find it difficult to take hard decisions as long as the consequences of not doing so are not sharply perceptible. But the WEO states the problem sharply in the following words:

"Despite the near certainty of rising interest rates and the possibility of significantly higher oil prices, economic conditions are still favourable. This is an ideal time to undertake the reforms that are needed to bolster medium-term prospects.

There seems little sense of urgency in political circles because the consequences of imbalance have not been painful as yet and in part because many of these reforms will bear fruit only in the medium term, while in the short-term some of them may be painful.

"Politics is in the short term, however. So, the timing of the pain and gain for such reforms is exactly the opposite of what politicians prefer. Every once in a while, leaders emerge, who rise above ordinary policies and focus beyond the here and now. It is to them that we must rest our hopes for reform."

Stirring words these, which are truly eloquent! But is the principal author, Dr Raghuram Rajan, the Economic Counsellor and Director, Economics Research Department, IMF, really hopeful that Mr George Bush, the current occupant of the White House, will listen to his call for action?

The times are truly out of joint. The current situation in which the world pours in a flood of resources to sustain the US' spending spree is unsustainable over the long run. This is a view shared not only by IMF but by many a distinguished observer of the world economy.

The Economist of April 16-22, 2005 has an interesting quote from Mr Paul Volcker, the redoubtable former Chairman of US Federal Reserve, who was responsible for handling the earlier currency crises of the US and, above all, for slaying the inflation dragon.

Writing in the Washington Post recently, Mr Volcker is reported to have stated: "Circumstances seem to me as dangerous and intractable as any I can remember, and I can remember quite a lot.

What concerns me," he went on to say, "is that there seems to be no willingness or capacity to do anything about it."

Opinions differ, however, whether it is right to panic or to stay calm. What is clear, however, is that interest rates are likely to harden, the US dollar will depreciate, oil prices will rise and there will be a not-too-hard landing of the US economy.

But what it will portend for those countries that are today heavily invested in US paper — bonds or equity — is a different question.

Surely, the pangs of adjustment will be hard, if they are one of the big lenders to the US economy. The harder the dollar falls, so too will their reserves in terms of real value.

The unwinding of the US imbalance will have its undoubtedly harsh impact not only on the US but also on those who have invested in its bonds and equity.

Do we have a way out of the present and pressing danger of the collapse of the US dollar, which is almost a sure thing, however much we may like to wish it away? We have upwards of $100 billion invested in the greenback, if my reading of the RBI's balance sheet is right. The hit will be hard for India to take if the US resolves its problems by devaluing the dollar. And what other alternative does it have?

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