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Asian Development Outlook 2006 Update : 1. Developing Asia and the world
Prospects for the world economy, 2006 and 2007
Table 1.3.1 shows the revised baseline assumptions for the international economy for 2006 and 2007. These provide the basis for the projections made in the country chapters of Part 2, and for the revisions to estimates of growth, inflation, and the current account of the balance of payments for all countries shown in the statistical appendix. United States 
Inflation has clearly edged up, with sustained high oil and commodity prices feeding into both consumer prices and production costs. Headline consumer price inflation accelerated to 4.1% in July, up from 3.4% in December 2005. Core inflation, which excludes food and energy, also moved higher at 2.7%, well above the "comfort zone" of 1-2%. After 17 consecutive rises that brought the policy rate to 5.25% at its late-June meeting, the Federal Reserve in early August took a pause in its 2-year tightening campaign. Even with a slowing economy, strong inflationary pressures remain and it is uncertain whether the Federal Reserve is entirely finished with its rate hikes. The US trade and fiscal deficits continue to cause concern. The trade deficit in goods and services (seasonally adjusted) in January-June 2006 was up by nearly 13%, running at an annual rate of $768 billion and putting the country on track to recording its fifth straight record deficit. Petroleum accounted for about 85% of the increase in the total deficit in the first half. The fiscal situation, however, has improved with better than expected tax receipts. The fiscal deficit, exclusive of the surplus income on the social security trust fund, is projected to fall to 3.3% of GDP in 2006, down from 4.0% in 2005, despite increased spending in the aftermath of Hurricane Katrina and supplementary defense expenditures. For 2007, the fiscal deficit is forecast to widen to 3.4% of GDP by the Congressional Budget Office. The baseline projection for US real GDP growth is 3.3% for 2006, slowing to 2.8% in 2007. The projected deceleration reflects a rebalancing in demand components as a result of moderating private demand and receding policy accommodation. A softening of increases in housing prices and a related decline in residential investment and construction activity will continue to curb both private consumption and investment. The projection is based on the assumption that the Federal Reserve will raise the policy rate by another 25 basis points before the rate plateaus. Despite the strengthening downside risks, and rising concerns that the housing market could unravel and trigger weaker demand, US growth fundamentals remain generally positive. Japan
The Japanese economy continues a moderate expansion based on broadening domestic demand. Second-quarter GDP growth came in at 0.8%, after 2.7% in the first (Figure 1.3.3). Although second-quarter performance was rather flat, this was largely due to a reduction in public spending. Private domestic demand continues to firm up on the back of buoyant business investment and robust consumer spending. Profits are up. Business investment rose by 11.1% in the first half of 2006 from the previous year as the release of demand, pent up since the collapse of the bubble in the late 1990s, continues. Increases in wage income and stronger labor market improvements have boosted consumer confidence. However, improvements in the labor market are relatively less pronounced than gains in corporate profits and business investment, illustrating the corporate sector's cautious approach to hiring during this expansion. While exports grew robustly through the first half of 2006, the contribution of net exports to GDP growth turned negative in the second quarter, reflecting a surge in imports. With core inflation (i.e., excluding fresh food) reaching 0.6% in June, consumer price inflation settled firmly in positive territory for the second consecutive quarter. And with higher input costs potentially squeezing profits, the corporate sector is likely to pass through some of these costs to final consumers. In witness to improving labor markets, consumers seem more ready to accept higher prices. Against this background, the Bank of Japan made a historic move in July, lifting its "zero rate" policy by 25 basis points. Given the strength of domestic demand, another rate increase appears to be in store before the end of 2006. Inflation will remain modest as consumer spending moderates next year, and as the Bank of Japan takes only very cautious steps in the normalization process. 
Japan is set to enjoy a healthy economic expansion over the projection period. Real GDP is expected to grow at 2.8% and 2.4% in 2006 and 2007, respectively. Private domestic demand will continue to drive growth. Although public spending will contract, furthering fiscal consolidation, private domestic demand is sufficiently strong to sustain the growth momentum in 2007. However, a weakening in external demand (some yen strengthening is expected) could spoil this scenario, since the durability of an upswing in business investment without external demand support is yet to be tested. Euro zone
The euro zone economy grew by 3.6% (quarter on quarter, seasonally adjusted annualized rate) in the second quarter of 2006, up from 3.2% in the first (Figure 1.3.4). Indeed, almost all major euro zone economies but Italy were stronger in the second quarter than the first, indicating a generally harmonious recovery across the zone. The second-quarter acceleration reflected strengthening domestic demand, including a recovery of gross fixed capital formation. Industrial production has accelerated in major euro zone economies since the beginning of 2006. Robust business activity has exerted a positive influence on the labor market, and unemployment rates have trended down, to below 8% by June. Reflecting improving labor market conditions, consumer spending is making slow, steady progress. European Union surveys indicate a marked improvement in the business climate and consumer confidence (Figure 1.3.5). Despite an expected drag from the external sector in the second half of the year, a broadening of domestic demand in the euro zone suggests that a moderate expansion will continue for the remainder of this year at least. With oil prices stubbornly high, the European Central Bank is expected to continue raising its policy rate, and is likely to make further rate increases before year-end. Although prices, especially core inflation, remain under control, production input costs are steadily rising. GDP growth in the euro zone economy is forecast at 2.3% in 2006. A combination of moderating exports and tightening fiscal policy is expected to bring down growth to 1.8% in 2007. If fully implemented, the planned fiscal consolidation in major euro zone economies will restrain consumption spending. In Germany, a 3 percentage point increase in value-added tax will take effect in January, and the health insurance contribution is to be increased as part of health care reforms. Italy announced a substantial budget cut in 2007 to bring the deficit to below 3% of GDP (which is the ceiling set by the stability and growth pact). France has also proposed a cut in fiscal outlays. With high oil prices, higher interest rates, and the prospect of a stronger euro, growth is unlikely to come from further external support. Aggressive fiscal tightening-though seen necessary to curb perpetual fiscal deficits-could damage the still-fragile economic expansion. World trade and commodity prices
After the pickup in the second half of last year, the volume of exports grew at an accelerated pace into the first quarter of 2006, pacing vigorous industrial production worldwide. Momentum has eased since, reflecting a moderation of economic activities in major industrial countries; trade expansion is largely sustained by industrial activities in developing regions, particularly Asia. The PRC continues to set new records in industrial production and exports, contributing nearly 2 percentage points to growth in world trade in 2005. Given the strong start to 2006, world trade, measured in terms of the export volume, is projected to grow at about 11% this year, softening to about 8% next year as the pace of global economic expansion slackens a little. 
Crude oil prices have risen to yet another record on renewed geopolitical concerns. The price of benchmark Brent crude again tested levels near $80 per barrel in early August, as fighting in the Middle East escalated. The benchmark price averaged $66 for the first half of 2006, which is already considerably higher than the average of $55 for 2005. Oil prices are expected to stay at over $70 on the basis of near-term futures prices (adjusted for the cost of carry) for the remainder of 2006 (Figure 1.3.6). For the year as a whole, Brent crude is projected to average $69 per barrel. The baseline assumes little change relative to 2006 prices for the average oil price in 2007. Prices of nonenergy commodities have made an impressive run-up since 2002, based on strong metal prices (Figure 1.3.7). Steady and steep increases in metal prices over the past several years accelerated even further into early 2006, in evidence of strong end-user demand as well as their attractiveness as financial investments. Despite having fallen from the highs reached in May, most metal prices remain elevated compared with their start-of-year levels. Prices of agricultural raw materials and food have also firmed up, buttressed by strong demand and higher energy production costs. For 2006, nonenergy commodity prices are expected to rise on average by about 21% according to World Bank estimates. In 2007, prices are expected to decline moderately (about 5%), because overall supply conditions are improving rapidly. 
A modest demand-driven recovery continues in global hightechnology industries. Semiconductor sales grew steadily in the first half of 2006 on a gradual recovery in consumer spending in Japan and the euro zone, with still generally healthy growth in the US and Asia (Figure 1.3.8). Despite some slackening, demand prospects for hightechnology industries remain favorable for 2006 and into 2007 as global demand for consumer electronics, such as wireless communication devices, digital cameras, and MP3 players continues to support a cyclical upswing. However, global competition is becoming fierce; putting downward pressure on the overall prices of information technologyrelated products. Supply-side conditions have also eased, adding to this pressure. Capital flows and marketsEmerging Asian financial markets have rebounded since the mid-May 2006 correction (or dip) following some adjustment in “risk appetite” and global investors’ portfolio positions (Figure 1.3.9). Asian equity markets on average have now regained ground to return to January’s levels. The prospect of sustained high earnings and attractive prices has helped make emerging Asian equity markets a top destination for global investors in recent years. According to the Institute of International Finance, Asia accounted for nearly 60% of net portfolio equity flows to emerging markets in 2005. The resilient growth outlook for Asian economies, even in a slowing global context, suggests continued sizable portfolio equity inflows.
External funding conditions for Asian issuers remain broadly favorable, with sovereign credit spreads staying generally compressed, despite a mild pickup during the brief May sell-off (Figure 1.3.10). Taking advantage of relatively favorable funding conditions, total issuance of equities, bonds, and syndicated loans continued to grow robustly into the first quarter of 2006, following a record-breaking year in 2005 (Figure 1.3.11). Total equity issuance by emerging Asian countries rose sharply in 2005, reflecting the ongoing surge in initial public offerings in the PRC. The issuance of bonds and syndicated loans was also active. However, as rising global interest rates continue to put pressure on the cost of external funding, new issuance of debt securities by Asian entities may ebb over the projection period.
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The pace of US economic activity is slowing. Real GDP grew by 2.9% (quarter on quarter, seasonally adjusted annualized rate) in the second quarter, after registering 5.6% growth in the first quarter (Figure 1.3.1). The relatively sharp deceleration in the second quarter primarily reflected in about equal measure a weakening in consumer spending and in fixed investment expenditure, mainly in equipment and software. Monetary tightening over the past 2 years is apparently taking its toll on housing markets. A cooling in house price inflation appears to be damping consumer activity and confidence, cutting strong consumer spending that has been supported by the wealth effect of rapidly rising property prices (Figure 1.3.2). The increase in private sector nonfarm employment in August, for the fifth month in a row, continued to be smaller than the 150,000 a month regarded as necessary to absorb entrants to the labor force. Lackluster job growth in recent months may also have affected consumer behavior. The softening in house price rises has been generally moderate and, with the rate of unemployment standing at 4.7% in August (a fairly tight rate historically), another sharp deterioration in the household sector appears unlikely, at least for the remainder of 2006. On the corporate front, though first-quarter vigor of equipment and software investment spending has abated, corporate profits remain healthy, suggesting some strengthening of investment in the second half. 
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