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Macroeconomic and Monetary Developments First Quarter Review 2005-06

Developments in the Global Economy

27. Global economic growth is projected by the International Monetary Fund (IMF) to slow down, albeit moderately, to 4.3 per cent in 2005 from 5.1 per cent in 2004. After exceeding the expectations in the first quarter of 2005, recent data suggest that global growth has slowed down in the second quarter of 2005, in part reflecting the rise in oil prices. Divergence in growth is also increasing across the regions. In the current year, the growth performance has been strong in the US, China, and most emerging markets and developing countries but the Euro zone has registered low growth.

28. During the second quarter of 2005, consumer price inflation in the US has increased, but remained stable in the Euro zone, the UK, Japan and other advanced economies. Inflation in other major emerging markets and developing countries, including Latin American countries, has also shown some decline during this quarter. Stabilisation in global prices of metals and minerals seems to have had a moderating impact on inflation. The rise in oil prices has not yet triggered generalised inflationary pressures in contrast to the experience of earlier oil shocks.

29. The global oil economy continues to be characterised by elevated prices and considerable volatility, accentuated by speculative activities. The outlook remains highly uncertain with limited scope for enhanced supplies in the near future taking account of inventories, unutilised capacities and gestation periods for new investments. The geopolitical factors seem to continue to be critical. The outlook for demand remains firm, with fast-growing China as well as India being somewhat low in energy-efficiency, and the persistence of large energy consumption in the US. While the global economy is coping with these uncertainties in a demonstrably better manner than in earlier episodes, the associated problems are getting complex for oil-exporting countries in terms of managing the surpluses and difficult for oil-importing countries like India in terms of effect on prices, output, competitiveness and indeed, disposable incomes.

30. Risks to global growth arise from the imbalances in the current account of the BoP, the fiscal imbalances, hedge fund activity, and the excessive leveraging in some advanced economies. There is even a greater need to keep a vigil on potential bubbles in the asset markets since real estate market valuations have, in the recent past, been supported by low-interest consumer debt. The recent appreciation of the US dollar could delay the adjustment process further and has the potential for accentuating the need for sharper adjustment in future. Significantly, last week China has moved to a managed floating exchange rate regime linked to a basket of currencies, with an initial appreciation of RMB by about 2 per cent against the US dollar.

31. The paradigm shift in exchange rate policy announced by China is bound to have important consequences for the global economy. The extent of revaluation is described as a very modest one, and the policy framework explicitly provides for management of the exchange rate, but the nature, extent and intensity of management is yet to be revealed and in any case likely to evolve gradually. While the direction of change is evident, the pace, the steps and the associated administrative measures by the authorities would have to be watched to determine the impact of these changes on the global economy. Of particular significance would be the ongoing responses of the domestic financial as well as real sectors in China to the new foreign exchange policy. As per current indications, the impact on India is assessed to be marginally positive on trade account, neutral on current account, and somewhat indeterminate on capital flows but is unlikely to be negative for India, though the capital flows could be potentially volatile on the global front.

32. Of the major central banks, the US Fed has raised its policy rate by 25 basis points each on nine occasions from 1.0 per cent in June 2004 to 3.25 per cent by end-June 2005 while providing clear indications for continued rise in the policy rate. While the Bank of England has held its repo rate steady at 4.75 per cent since August 2004, in the July 2005 meeting of the Monetary Policy Committee, four out of nine members preferred a reduction in the repo rate by 25 basis points. The European Central Bank (ECB) has kept its policy rate unchanged at 2.0 per cent since June 2003.

33. The recent months have witnessed unanticipated high volatility in currency markets, a sharp drop in long-term bond yields described as a conundrum, and extraordinary buoyancy in equity markets labelled as paradox. Long-term bond yields have fallen in recent months in mature financial markets, perhaps reflecting moderate growth, expectations of lower inflation, smaller real term premium due to moderation of the business cycle, excess of saving over intended investment, and shift in the preference of institutional investors towards fixed-income instruments. There is a view that global saving is tending to be in excess of global investment opportunities. This may be partly attributable to surpluses generated by oil exporting countries, which incidentally seem to give considerable weight to the US dollar denominated assets typical of oil economy. There are possible implications of such saving-investment imbalances for currency markets, for bond markets and equity markets with a potential for underpricing of risks. It is not impossible that, beneath the apparent stability, there are disequilibria which will get corrected sometime in future, and if the process of correction were to be abrupt, emerging economies may be particularly vulnerable. No doubt, the current macro-policy framework of most emerging economies has imparted noteworthy resilience, but heightened global uncertainties do demand close attention to elements of the recently accentuated disequilibria.

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