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Assessment of Macroeconomic and Monetary Developments- Third Quarter Review 2005-06

Developments in the Global Economy

Global growth appears to have improved in the third quarter (Q3) of 2005. The firming up of global economic activity during the third quarter of 2005 and its broadening ambit suggests that the global growth could reach a level higher than the average for the period 1990-2004. For 2006, the International Monetary Fund (IMF) has projected world growth at 4.3 per cent with advanced economies growing by 2.7 per cent and emerging market and other developing economies growing by 6.1 per cent.

In the US, real GDP rose by 3.7 per cent in Q3 on a year-on-year basis on the strength of business spending, with consumer confidence regaining much of the ground lost after the August hurricanes. The merchandise trade deficit has improved to US $ 64.2 billion in November. The US current account deficit narrowed in the third quarter to 6.2 per cent of GDP. The easy financing of the current account deficit reflected sustained foreign appetite for US assets. In the euro area, a recovery seems to be setting in with real GDP up by 1.2 to 1.6 per cent in 2005. Conditions for emerging out of deflation steadily improved in Japan with real GDP growth rising to 2.9 per cent in Q3, driven mainly by domestic demand and supported by a rise in bank lending. Industrial production also rose by 1.4 per cent in November, increasing for the fourth month in a row, combined with signs of higher employment. Growth in Q3 remained robust in the developing countries led by China (9.4 per cent), Hong Kong (8.2 per cent) and India (8.0 per cent). In Russia and Latin America, too, growth has been buoyant, except for Brazil where real GDP fell in Q3 by 2.8 per cent. High oil prices, domestic capacity constraints and some building up of inflationary pressures continue to be seen as factors restraining growth for most developing countries.

With the moderation in international crude prices since September, consumer price inflation in the advanced economies has fallen in the fourth quarter of 2005. In the US, consumer prices dipped by 0.1 per cent in December, leaving inflation for 2005 at 3.4 per cent. In the euro area too, inflation edged down to 2.4 per cent in November from 2.5 per cent in the previous month. Deflation continued in Japan with overall consumer prices falling by 0.8 per cent in November, the biggest drop in three years. In major industrial countries, inflation appears to have been contained and spillovers of oil prices into wage increases have been moderate. By and large, price stability has been maintained in these countries in the face of the oil shock although asset prices, especially house prices, remain a cause for concern in terms of potential inflationary pressures and the repercussions on consumer spending and financial sector balance sheets. On the other hand, inflation has risen in major emerging market economies. Besides elevated levels of oil prices, tight non-oil commodity markets have imposed price pressures.

Future spikes in crude oil prices continue to carry the major risk to prospects of global growth and stability. While demand generally drove oil prices up in 2004, the price increases in 2005 were also the result of supply disruptions, inadequate investment as well as the reduction in world oil spare capacity which fell to its lowest level in over three decades. World oil prices have climbed throughout 2005 despite somewhat slower demand growth in both China and the United States. Declines in petroleum product prices (especially petrol and diesel) during October-November due to mild weather in the northern hemisphere and ongoing hurricane recovery efforts in the US have been followed by some firming up of prices since December due to geopolitical factors. The average price of the Indian basket of international crude varieties (comprising Brent and Dubai Fateh) ruled at around US $ 60.0 per barrel in October-January 20, 3.8 per cent lower than in the preceding quarter but 41.5 per cent higher than a year ago.

The international pass-through of oil prices to domestic retail prices has been varied across countries. While domestic retail prices (including tax) of petrol in December 2005 increased on a year-on-year basis by 22.5 per cent (in US dollar terms) in Canada and 16.9 per cent in the US, they declined by 4.9 per cent in Japan and Italy. Similarly, diesel prices increased by 23.5 per cent in Canada and 20.5 per cent in the US while they declined by 4.5 per cent in France. Comparatively, India’s domestic retail prices of petrol and diesel (average of four metros) increased by 14.6 per cent and 13.0 per cent, respectively, by January, 2006. While international crude prices have risen by 69.0 per cent between March 2004 and December 2005, domestic prices of petrol and diesel have increased by 34.0 per cent during this period; price of LPG increased by 16.4 per cent but there has been no increase in the price of kerosene. Since the tax component in retail prices varies from country to country, it is more appropriate to compare the position net of the tax component. The retail prices, net of taxes, of petrol and diesel have increased across the board in the developed world. While the increase in petrol prices ranged between 32.0 per cent in Canada, 21.1 per cent in the US and 1.1 per cent in Japan, that of diesel prices was between 29.0 per cent in Canada, 25.9 per cent in the US and 3.3 per cent in France. Prices for crude oil, petroleum products and natural gas are projected to remain high through 2006 because of continuing tightness in international supplies and increasing demand. According to the World Bank, a supply shock that reduces oil deliveries by 2 million barrels per day could push prices up to above US $ 90 per barrel, reducing global growth by 1.0 per cent and the growth of large low-income economies by 1.7 per cent.

The financing of the large current account deficit of the US is increasingly becoming a cause for concern. Government saving has fallen in the US and Japan and household financial saving has virtually disappeared in countries with housing booms. On the counterpart side, many emerging markets, particularly in Asia, have run current account surpluses resulting in build-up of international reserves. The US current account deficit is projected by the OECD to exceed 7.0 per cent of GDP in 2007 with substantial surpluses elsewhere. Such a configuration could increase the probability of a disorderly unwinding of macro imbalances and disruptive movements in major currencies.

Within the mounting global imbalances, oil exporting countries are currently running large current account surpluses, repaying debt, as in the case of Russia, and building up assets. Oil exporting countries have been actively using their export revenue to buy financial assets in various countries. Thus, the rise in oil prices has represented a sizeable redistribution of income from oil consumers to oil producers which could have an impact on global demand and the future course of unwinding of global imbalances.

The prospect of a faster pace of monetary tightening contributed to a sharp drop in equity prices around the world in early October. Equity markets rebounded strongly since November, boosted by signs of still robust growth in the US as well as announcements of mergers, share buybacks and dividend increases. Japan outperformed most other equity markets throughout this period. Upward revisions in policy rates had a surprisingly muted impact on the prices of emerging market assets. Emerging markets benefited from record inflows of foreign portfolio investment in 2005. As concerns about slowing US growth eased, emerging markets bounced back strongly from their late October lows. By late November, equity and bond prices had returned to their end-September highs and had generally reached record levels by early January 2006. Equity markets have, however, weakened overseas thereafter mainly on account of renewed firmness in global crude oil prices. Corporate credit default swap rates and bond spreads remained more or less unchanged in October although they have widened significantly since November. While long-term interest rates rose in many markets in September and October, they retreated slightly in November, and at the end of December it was still unclear whether the recent rise in yields would prove as ephemeral as previous increases. The increase in longer-term yields mainly reflected upward revisions to interest rate expectations over the near term. Further, the potential for rising energy costs to add to inflationary pressures was a key focus of investors’ attention. The rise in implied volatility also reflected growing uncertainty about the economic outlook. During December 27-30, 2005 yields on 10-year US Treasuries fell briefly below those on two-year notes for the first time since December 2000, inverting in intra-day trading and signalling expectations that interest rates could fall in future that is generally associated with weak growth. This inversion came as analysts were finally anticipating an end to the current tightening cycle and a lower long-term risk premium than in the past. In January 2006, however, the spread has turned positive again. The US dollar appreciated by 3.5 per cent in trade-weighted terms during 2005 and a similar trend continued in January 2006.

Of the major central banks, the US Federal Reserve has raised its policy rate by 25 basis points each on thirteen occasions from 1.0 per cent in June 2004 to 4.25 per cent by December 2005 while recently providing indications of nearing the end of the cycle of measured rise in the policy rate. The Bank of England has kept its repo rate unchanged at 4.50 per cent since August 2005 in response to slowing domestic growth. The European Central Bank (ECB) has raised its policy rate by 25 basis points in response to rising inflationary expectations, after holding it unchanged at 2.0 per cent since June 2003. Monetary policy has been tightened in several economies in emerging Asia, primarily in response to higher fuel prices and to the measured pace of policy tightening in the US. Bank Indonesia raised its policy rate by 50 basis points to 12.75 per cent on December 6, 2005 which was the tenth successive increase during the year. In Thailand, the 14-day repurchase rate was increased for the seventh time since January 2005 from 2.00 per cent to 4.25 per cent on January 18, 2006. Monetary authorities in Singapore and Hong Kong raised their policy rates by 187 basis points and 200 basis points, respectively, during the year up to December. In Malaysia, the policy rate was hiked to 3.0 per cent in end-November, 2005. In emerging market economies in general, the direction of policy change has been towards either tightening or withdrawal of the accommodative stance.

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