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p. 3 of 8 BACK | NEXT I. Developing Asia and the world Developing Asia: Economic highlights of 2004 and prospects for 2005-2007 Prospects for the world economy in 2005-2007 World trade and commodity prices Financial market developments Risks to the outlook, and challenges for developing Asia II. Developing Asia: Subregional trends and prospects III. Promoting competition for long-term development

Asian Development Outlook 2005 Publication Highlights : I. Developing Asia and the world

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Prospects for the world economy in 2005–2007

The economies of major industrial countries are projected to continue a moderate expansion in 2005, following heady growth of 3.5% in 2004. However, a strong and synchronized recovery in these countries between the latter half of 2003 and the first quarter of 2004 gave way to uneven growth over the course of 2004, which is expected to continue widening the growth gap between major industrial economies in the near term (Figure 1.1). With projected growth in the US again outpacing that in the other major industrial economies, the ongoing problem of large external imbalances of the US economy will likely remain unresolved, casting a shadow over the medium-term sustainability of the current rebound. Reflecting such concerns, the dollar declined sharply against the Japanese yen and the euro in the fourth quarter of 2004.

The US is poised to continue further expansion, whereas Japan and the euro zone have been experiencing an extended setback since the second quarter of 2004. Taking a hard hit from high oil prices and slowing external demand, some large economies—notably Germany, Italy, and Japan—slumped in the second half of 2004. However, economic fundamentals remain relatively sound even in these countries, on the grounds of stronger corporate balance sheets and healthy profits. Business investment has been on the rise, even as export growth has eased. In addition, business surveys point to an improving outlook in industrial production through 2005.

Meanwhile, a broadening of the recovery continues in the US, on the back of robust private consumption and business capital spending. With prospects of a continued benign outlook for some major economies—namely the PRC and the US—exports should start lending help again in Japan and the euro zone over the rest of 2005, although the rate of export growth will be lower than the previous peak.

Nevertheless, the widening growth gap entails a significant medium-term risk to the outlook, while sustained high oil prices compound the difficulties for major industrial countries to maintain both internal and external balances. Despite the level of oil prices, core inflation in these economies remained largely under control in 2004. Behind such remarkably subdued inflationary developments lie slow, but accelerating, generation of employment in this economic recovery as well as slackness in most economies. However, excess supply in the labor market in the US is dissipating, with relatively healthy job creation seen in 2004 as a whole.

At the same time, strong US domestic expenditures are deepening the trade deficit, adding downward pressure on the dollar, while exacerbating inflationary conditions in the medium term. Inflationary risks are tilted up with higher labor and nonlabor costs as well as softening productivity growth in the US. These could lead, later in 2005, to interest rates being considerably higher than currently expected, limiting further expansion in the US economy in the medium term. Against this backdrop, sluggish domestic demand in Japan and the euro zone poses a considerable downside risk. As the rest of the world economy, particularly Japan and the euro zone, still relies heavily on exports for growth, a sharp slowdown in US demand could lead to a worldwide slowdown.

Overall, the economies of industrial countries are projected to grow at 2.5% in 2005 and 2006 (Table 1.2 above), lower than the robust performance of 3.5% last year, but still considerably higher than the average growth rate during the 1990s. Nevertheless, there are signs that a gradual deceleration in the economic growth of these countries is likely to continue. With a number of downside risks weighing on the medium-term outlook, growth in major industrial countries will slow to 2.4% in 2007.

United States

The US economy continues its healthy expansion on the back of a strong upturn in fixed investment and robust private consumption (Figure 1.2). GDP growth registered a remarkable 4.4% in 2004, up from 3.0% in the previous year. Private consumption expenditure remained a major contributor to the increase in GDP, rising by 3.8% from 2003. The rebound in private domestic investment, aided by a strong pickup in business capital spending since the latter half of 2003, also continued to provide growth impetus. However, renewed vibrancy in exports during the second half of 2003 and the first half of 2004 has waned amid the extended slowdown in the other major industrial countries since midyear, giving rise to the concern that external imbalances in the US economy may further deepen, at least in the near term.

Meanwhile, a weakening in the dollar, together with sustained high oil prices, continues to exert upward pressure on the import bill. A visible reduction in net exports was the primary reason for the deceleration in GDP growth in the fourth quarter: GDP growth fell from a seasonally adjusted annualized rate (saar) of 4.0% in the third quarter to 3.8% in the fourth.

Business activity remains buoyant. Industrial production was 4.2% higher in December 2004 than in December 2003, pushing capacity utilization to 79.1% at year-end, or over 2 percentage points higher than 12 months earlier. The January Institute for Supply Management (ISM) survey suggests healthy expansion in both manufacturing and nonmanufacturing, with the ISM composite purchasing managers index for manufacturing and the ISM nonmanufacturing index reading 56.4% and 59.2%, respectively. (A reading above 50% indicates that business activity generally is expanding.) In spite of slowing exports, manufacturers’ new orders and shipments continue to post decent gains on resilient domestic demand. This ongoing demand-side pressure should sustain sound production through 2005.

Strong sales and production have bolstered corporate profits, which grew by an estimated 12.8% year on year in 2004 despite hurricane damage in the third quarter. Solid profit gains as well as a brighter business outlook in 2004 paved the way for a sharp rebound in corporate spending. Fixed investment rose by 10.0% year on year, buoyed by increased spending on equipment and software. Following several years of conservative corporate spending, the release of pent-up demand turned out to be enduring. Many firms took advantage of still-favorable tax and financing conditions to replace obsolete computers, software, machinery, and other types of business equipment. However, as interest rates rise further and profit growth slows, the pace of business spending on equipment and software will likely moderate in the latter half of 2005. Enhanced corporate discipline in the aftermath of the high-tech boom of the late 1990s will also keep inventory building under control, restraining excessive capital spending. Residential construction peaked in the second quarter of 2004 and is expected to continue stabilizing with a cooling in the housing market over the rest of 2005.

The labor market is making slow, but steady, progress. Nonfarm payroll employment gained a total of 2.2 million during 2004, lowering the overall unemployment rate to an average of 5.5% in 2004 from 6.0% in 2003. Reflecting the improvement in the job market, hourly compensation in the business sector increased by 4.2% in the fourth quarter (saar) following a 3.8% rise in the previous quarter. Higher compensation has underpinned a strong turnaround in private consumption since the latter half of 2004, while continuing wage increases are expected to exert upward pressure on inflation in 2005. Meanwhile, the household financial position is poised to improve on rising incomes, heralding an orderly consolidation in household balance sheets in the coming years. Personal saving as a share of disposable income appears to have bottomed out, though it remained low at 1.6% in the fourth quarter, while growth in consumer credits outstanding shows signs of stabilization.

Strong domestic demand is being slowly translated into price increases. The consumer price index (CPI)—which measures headline inflation—rose by 3.3% in 2004. The price deflator for private consumption expenditure less food and energy—the basis for a preferred measure of core inflation by the Federal Reserve (the Fed)—edged up by 1.5% over the same period. Although core inflation remains in check and high oil prices have been primarily responsible for headline inflation, there are signs that inflationary risks are inclined upward. With the labor market gradually closing the demand gap, unit labor costs in the nonfarm business sector rose at 2.3% (saar) in the fourth quarter, after a 1.6% increase in the third (Figure 1.3). High productivity growth, which has been a basis for the sound expansion of output without putting undue pressure on inflation, is also reaching a plateau. Fourth quarter labor productivity grew by only 0.8% (saar) in the nonfarm business sector, down from 1.8% growth in the third.

Inflation will be a key variable to watch in the US economy over the forecast period. First, the cyclical demand pressure on overall wages and price levels will likely increase, as the economy continues to work off the slack in the labor market. While wage gains were relatively muted, benefits picked up rather sharply in 2004, pointing to a tightening in the labor market. Second, the downward trend of the dollar is expected to persist, with significant external imbalances weighing on its strength, pushing up import prices. Third, sustained high prices in energy and nonenergy commodities will likely eventually feed into final sales prices. Increasing labor and nonlabor costs, along with slowing productivity growth, suggest dwindling profit margins, which may induce many companies to pass on such increased costs to customers.

With inflationary pressures building, US interest rates could move significantly higher in 2005. Unlike 2004 when the Fed started raising interest rates from a historically low base of 1.0%, the US economy will begin to feel tightening effects as the Fed continues its rate increases this year. As of March 2005, the Federal Funds rate stood at 2.75%, pushing real interest rates back into positive territory. Meanwhile, the financial positions of both the public and household sectors in the US have yet to improve significantly. The large fiscal deficit aside, the household sector remains considerably indebted. In 2004, the increase in Federal Funds rate notwithstanding, long-term interest rates did not move much, keeping under control the cost of borrowing for the household sector as well as for long-term business investment. However, this could change significantly this year, given the inflationary pressures and the forces of global rebalancing.

Nevertheless, growth momentum still favors the US economy. The baseline GDP projection is 3.7% for 2005. Business surveys point to continued expansion across a broad swathe of business activities, while demand-side pressure will continue to support corporate spending and hiring. As the economy moves toward its potential, higher wages will ensue, slowing further expansion. In spite of significant downside risks arising from inflation, the weakening dollar, higher interest rates, and the global adjustment forces, the relatively controlled pace of job creation and remarkably subdued inflation so far suggest that growth will likely remain healthy at 3.4% in 2006, subsequently moderating toward 3.1% in 2007, nearer its long-term potential.

Japan

The Japanese economy fell into another mild recession after posting encouraging growth of 6.0% (saar) in the first quarter of 2004, followed by 2 consecutive quarters of contraction (Figure 1.4). The exceptional growth witnessed from the second quarter of 2003 to the first quarter of 2004 failed to last, as exports—the major engine of growth during the latest recovery—faltered amid slowing global expansion, a cyclical downturn of the global information technology sector, and rising oil prices. A broadening of the recovery as strong exports helped lift business and consumption spending was also cut short before such a domestic demand recovery could become self-sustainable. Both business and consumer confidence fell, reflecting the lack of growth momentum (Figure 1.5). Future growth prospects are heavily influenced by underlying structural difficulties, which are compounded by the burden of an aging demographic profile.

GDP growth was 2.7% for 2004 as a whole, drawing largely on the exceptional performance of the first quarter. However, softening demand (both external and internal) put a heavy drag on growth in subsequent quarters. Export growth slowed sharply to 2.6% (saar) in the third quarter, although somewhat improving to 4.9% in the fourth, from first and second quarter growth rates of 20.2% and 14.8%, respectively. Meanwhile, high global oil and raw material prices kept import costs up, as a result of which the contribution of net exports to growth turned negative in the last 2 quarters.

A tentative recovery in domestic demand also petered out. Private consumption rose by 3.0% (saar) in the first quarter, contributing 1.7 percentage points to growth. A gradual improvement in the job market from late 2003, combined with some advance in wages, sent consumer confidence up, boosting household spending until the first quarter of 2004. But the momentum was short lived against the strong headwind of slowing exports and production. Consumer spending has since retrenched, contracting by 0.9% (saar) and 1.0% in the last 2 quarters, consecutively. To make matters worse, a deterioration in the business environment is quickly translating into falling wages and household income. Total cash earnings of employees plunged in December, clouding the prospect of a consumption recovery in the first half of 2005.

Private investment demand was also hit, with gross fixed capital formation growth in the private sector falling from a peak of 13.4% (saar) in the second quarter to 0.3% in the third. However, private investment demand remains a relatively positive spot on the grounds of strong profit gains in the corporate sector and a recovering real estate market since 2003. Final quarter growth in private gross fixed capital formation ended slightly higher at 0.8% (saar) on the back of resilient private residential investment, contributing 0.2 percentage point to GDP growth. Moderately improving machinery orders since late 2004 also supported a turnaround in business capital spending, with private nonresidential investment posting growth of 0.2% (saar) in the fourth quarter, recovering from a contraction of 0.4% (saar) in the third. The strength of business investment remains crucial to putting the economy back on the recovery path. Underpinning continued investment recovery through early 2005, Japan’s leading exporters posted strong profit gains even as exports slowed from the second half of 2004. Beneath such resilience lie enhanced operational efficiency and financial stability in the corporate sector, after several years of substantial restructuring efforts.

The significant downturn in exports took a heavy toll on business activity. Industrial production fell by 0.7% in the fourth quarter (quarter-on-quarter), following a decrease of 0.6% in the third. A marked decline in new orders for high-tech equipment corresponding to the cyclical adjustment in the global information technology sector since mid-2004 was primarily responsible for a slowdown in production. There is a glimmer of hope for a production recovery in 2005, as November and December data for machinery orders in manufacturing and shipments of manufacturing goods show a slight improvement on the mild turnaround of exports in the fourth quarter. This is mainly due to robust growth in the economies of the US and the PRC, Japan’s major trading partners. However, the weak domestic sector is expected to limit the scope for a swift recovery. Together with a gradual rebound in the export sector, though at a more subdued rate, this suggests only a slight recovery in industrial production for 2005.

On a brighter note, deflationary pressures are slowly easing, with year-on-year growth in the corporate goods price index (which measures inflation at the wholesale level) settling firmly into positive territory over the course of 2004. CPI inflation also turned positive for 3 consecutive months (until December 2004), for the first time since 1999. Easing deflationary pressures should help the corporate sector sustain profit margins, in the face of high energy costs and slowing sales, both domestic and foreign. However, further deflation remains a considerable downside risk to the recovery, as both the corporate and consumer price inflation rates retreated slightly between December 2004 and January 2005.

In spite of continued capital spending in the export sector, the near-term outlook remains bleak, with GDP expected to grow at 1.1% in 2005. The lackluster growth projection reflects unfinished business in the reform efforts. While the export sector has aggressively clamped down on excess capacity and has strengthened its financial position on rising global demand, the domestic nonmanufacturing sector—consisting mainly of small and medium enterprises—has made only limited progress in restructuring, thus delaying the recovery process in corporate spending and hiring. Meanwhile, the country’s unfavorable demographic profile and related high pension burden suggest that the weakness in the domestic sector will persist, limiting any significant growth gains. GDP growth is projected to rise to 1.3% in 2006 and 2007, buttressed by a mild improvement in exports.

Euro zone

Euro zone GDP grew by 2.0% in 2004, up from 0.5% in 2003. However, final quarter GDP growth in 2004 slid to 0.6% (saar), much lower than the first quarter’s 3.0%. A continued appreciation of the euro started to weigh on external trade. Export growth subsided to 5.2% (saar) and to 1.9% in the last 2 quarters, consecutively, from an average growth rate of 8.6% in the first half of 2004. Meanwhile, imports further increased following an improvement in the terms of trade as well as a surge in prices of oil and raw materials, turning the contribution of net exports to a negative 2.6 and 0.7 percentage points, respectively, in the third and fourth quarters, a sharp drop from 1.6 percentage points in the first. A recovery in private consumption remains fragile, with growth falling to 0.2% (saar) in the second quarter (although it has improved somewhat since then) from 3.1% in the first. Rising oil prices appear to be curbing consumption spending by eroding household discretionary income, which was already under pressure from anemic job growth (Figure 1.6).

As external demand softened, some of the larger euro zone economies that relied heavily on exports during the latest rebound slumped over the course of 2004. Germany and Italy, the largest and third-largest economies in the zone, contracted by 0.9% and 1.2% (saar), respectively, in the fourth quarter when the euro, already at its highest level since its launch, further appreciated against the dollar. Other countries—notably France and Spain, where domestic demand strengthened noticeably during 2004 thus exhibiting relative resilience as exports slowed—also remain vulnerable to sustained high oil prices in the face of sluggish job creation. Based on a combination of moderating exports and a slack domestic economy, euro zone GDP is projected to slow to 1.6% in 2005.

Despite the lackluster performance in the second half of 2004 and weakened near-term outlook, the euro zone economy will likely continue a modest recovery on the grounds of a gradual strengthening of domestic demand over the medium term. In support of the slow, but steady, economic rebound, business investment continues to firm up. Gross fixed capital formation rose by 3.9% (saar) in the final quarter, continuing its rebound from the third. Following years of subdued investment, the corporate sector appears to be in need of replacing old machinery and equipment. Robust export earnings in the past few years have also significantly improved corporate financial positions, underpinning an upward trend in business capital spending. Rising corporate spending should in turn exert a positive influence on the labor market, thus eventually boosting private consumption. Against this backdrop, GDP is projected to grow at 1.8% in 2006, returning to a long-term average growth rate of 2.1% in 2007.

A major downside risk to this scenario is the slow progress in the labor market to date. Jobless rates in the euro zone are persistently high, at an average of 8.9% in 2004. In Germany, the unemployment rate surged to 12.6% in February 2005, while France reported 10.0% in January 2005. Such a dismal job situation in the euro zone, combined with reductions in unemployment benefits and tighter restrictions on eligibility for benefits that came into effect in January 2005 in Germany, could severely dent the prospects of a recovery in consumer spending over the forecast period. Consumer confidence, which showed a mild recovery in Germany, France, and Italy in early 2005 amid tax cuts and stabilizing oil prices (partly due to the offsetting effect of the strong euro), could also sharply deteriorate as a result of the dim job outlook.

Growth performance remains highly uneven across the euro zone economies, exacerbating the difficulties of harmonizing macroeconomic policies in support of a weak recovery. The dampening effect of continued euro strength notwithstanding, headline inflation remained slightly above the European Central Bank (ECB) target of 2% in 2004 due to sustained high oil prices. Moreover, credit growth has been relatively strong, given the resilient business capital spending and buoyant housing markets in many European economies. While the ECB is likely to maintain the current stance—reasonably accommodative at 2%—for the first half of 2005 in the face of a lagging recovery, a gradual pass-through of higher producer prices could trigger a rate hike later this year, barring any significant slowdown in economic activity. Fiscal policies in many euro zone economies remain largely restrictive, reflecting the target limits of the Stability and Growth Pact (SGP). Although some of the larger countries have introduced tax cuts while pursuing SGP reforms to provide a stimulus to weakening domestic demand, persistently large fiscal deficits and pension burdens limit likely expansionary fiscal spending across the region.

The German economy slowed sharply in the second half of 2004, although it posted decent growth of 1.6% for the year as a whole. The continued appreciation of the euro and a moderating global expansion led to erosion of previous export gains. However, new orders, both domestic and foreign, for manufacturing goods increased in December 2004, by 8.1% and 8.3% respectively, from the previous month, gently brightening the growth outlook for this year. Business surveys also suggested a moderate recovery for industrial production. Nevertheless, a modest turnaround in domestic demand is unlikely to be sufficient to accelerate the economy in the face of moderating foreign demand this year. Ongoing reforms in the labor market, health care, and pensions, although beneficial for long-term growth, will dampen near-term prospects.

In France, the recovery has been more broadly based than Germany and Italy, with domestic demand picking up along with exports. Boosted by income tax cuts, robust consumer spending has been sustained despite the weakness of job growth. The release of pent-up demand in the corporate sector has also lifted business investment. However, a mild cyclical correction is expected this year based on waning fiscal stimulus, continued slack in the labor market, and slowing exports.

The Italian economy ended 2004 on a grim note by shrinking in the final quarter. Exports, which had been the main driver of growth, declined as a result of continued euro appreciation and slowing external demand, while domestic demand stagnated. Meanwhile, the rigidity in the labor market is further eroding Italy’s competitiveness, as well as hampering a consumption recovery. Late in 2004, the Government announced tax cuts for 2005 to support domestic spending. However, without significant reforms in public finances, more measures to curb fiscal spending will be required to keep the government budget deficit from exceeding the SGP limit of 3% of GDP, which leaves the net effect of tax cuts largely ambiguous.

Outside the euro zone, the United Kingdom economy continues to expand on the back of strong consumer spending and business investment. Growth accelerated to 3.0% in 2004, although it will likely moderate to 2.7% in 2005 and 2.6% in 2006. In sharp contrast to the euro zone, past reforms have significantly lifted overall economic efficiency and productivity through enhanced flexibility in both labor and product markets. Productivity gains in turn are reinforcing a pickup in corporate profits, which is passed on to household income and net financial wealth, thus underpinning continued strength in private consumption. However, there are signs that the economy has already reached its potential, pushing labor costs higher, particularly in the buoyant private services sector. Household and corporate liabilities also seem overextended, as reflected in a marked reduction of private savings. Over the forecast period, the pace of private sector spending will soften, which will be partly compensated for by a gradual rise in public spending. Private consumption has already slightly retrenched following stabilization in housing prices coupled with rises in interest rates in the latter half of 2004.

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