The first releases of post-Katrina economic data suggest that the growth rate of the US economy was not
seriously affected by the hurricanes. Nonfarm payrolls declined by 35,000 in September and the unemployment
rate rose to 5.1% but this labour report was less negative than expected - indeed the trend of employment was
improving prior to September. The Institute for Supply Management manufacturing index for September was
also encouraging and it appears that economic growth in the third quarter was similar to the second quarter
result of 3.3%. The growth outlook for the winter quarters is, nonetheless, less optimistic as households will have
to cope with much higher bills for home heating and transportation. The size of the adjustment in spending
patterns will depend on the severity of the winter and preliminary weather forecasts suggest lower than normal
temperatures for this season. Growth in the final quarter of 2005 is expected to fall to about 2.5% whilst the
growth of Federal spending and other reconstruction expenditures should gradually restore momentum in the
first quarter of next year. By the second quarter it seems likely that US domestic demand will be showing strong
signs of growth and this prospect – together with the upward trend in inflation – is a cause for concern. The
minutes of the September 20 meeting of the Federal Open Markets Committee noted that the declining margin
of spare capacity in the economy and the higher energy prices might lead to higher rates of core inflation in
2006 than had previously been expected. The clear message from this meeting and various speeches from
regional Federal Presidents was that there is still a substantial amount of monetary tightening ahead. Market
participants are beginning to take seriously the chance that short term interest rates may need to rise to 5% by
mid-2006 – setting the stage for a rather sharp reversal in consumer confidence in the second half of the
year.
Such higher interest rates might have a disproportionate effect on personal consumption and economic activity if
there is sharp adjustment in house prices next year. Estimates of housing affordability in some US regions have
already reached the levels of the previous housing boom in 1989. Indicators of new home sales and lower trends
in real estate lending suggest that the market may not be able to resist further rises in interest rates. The impact
of lower house prices on household spending is hard to estimate. Recent estimates suggest that a large
proportion of the rise in spending in 2004 and 2005 has been financed by “mortgage equity withdrawal” as
households have taken advantage of the rise in house prices to justify higher levels of debt. The impact on
spending in 2006-2007 of a sharp reduction in this source of financing could be as much as $200 billion which
would lower GDP growth by about 1%. The level of the stockmarket is also vulnerable to a tighter monetary
policy and any adjustment here would put further pressure on consumer spending despite the improving trends in
income and employment.
The main external risk to economic stability remains the outlook for the US dollar. The currency has been
supported by strong economic growth in 2005 and the continued rise in US interest rates. Nevertheless the trade
balance has continued to deteriorate and the $59 billion deficit for August confirms this trend. A further problem
for the dollar is that the rise in the oil price has tended to reduce the foreign currency reserves of Asian countries
to the benefit of oil exporters. Asian governments have been prepared to support the dollar in order to preserve
export market shares but the authorities in oil exporting countries may prefer a more diversified mix of foreign
currency assets – especially if the European economy improves next year as expected.
Japan
Following the very good performance of the Japanese economy in the first half of this year the economic
indicators for the third quarter were disappointing. In the first half of 2005 the economy grew at an annualized
rate of 4.5% as a result of strong growth in domestic demand but consumer confidence has softened in the third
quarter amid rising energy prices. Despite the continued rise in workers’ income in the quarter it seems that
GDP growth will fall to 1-2% as a result of lower personal spending. Indicators of corporate sentiment were also
below expectations and the September Tankan report from the Bank of Japan noted slightly disappointing
results for large companies in both manufacturing and non-manufacturing. Corporate profits have been affected
by the rise in energy costs which has reduced price margins but companies will continue to invest.
Businesses expect to increase capital spending by 6.8% in this financial year with a particular improvement
coming from small companies. This third quarter pause in growth is expected to be a temporary setback as
Japanese fundamentals remain on track. In particular overseas demand is expected to make a positive
contribution to fourth quarter growth. August exports showed year-on-year growth of 9% boosted by a surge in
exports to China and a global improvement in demand for IT products.
Whilst second half growth may not match the excellent first half performance, the continued expansion together
with the rise in the oil price should increase the rate of inflation in Japan before the end of the year. The October
monthly assessment of the Bank of Japan was in line with the consensus expectation of growth in domestic and
external demand and a stabilization of prices before the end of the year. In the first quarter of 2006 the Bank may
respond to these developments with a change to monetary policy – indeed a recent statement by the Governor
commented that the path towards a change in policy has already been set. At present monetary policy attempts
to control the size of the monetary aggregates in Japan but a movement towards interest rate targeting is likely
next year. Later in 2006 this may imply some tightening in policy but at least in the first half of next year interest
rates will be close to zero in nominal terms and negative in real terms – this will add some further stimulus to
economic growth.
Despite the revival of domestic demand the economy would suffer from any downward adjustment in the US or
Chinese economies in 2006 and this remains a major risk factor for the Japanese economy. Higher oil prices
have increased material costs and thus reduced profit margins but the ongoing impact on this energy-efficient
economy will be limited unless there is a further surge. According to the consensus forecast, the Japanese yen
may strengthen towards ¥100 during 2006 which would further mitigate the impact of higher oil prices on the
economy.
Euro-zone
Most surveys and forward-looking indicators suggest that the Euro-zone economy achieved higher growth in the
third quarter. Business sentiment in the zone has not been badly affected by the higher energy prices – in fact
the EU Commission survey released at the end of September is consistent with an improving trend, after the
deterioration seen in the second quarter. The EU composite indicator improved to 98.6 in September from 97.8
in August, its fourth consecutive increase. All business sectors showed progress with the greatest upward
momentum in the manufacturing sector. Consumers, however, remain depressed which seems surprising
considering the upward move of Euro-zone retail sales in August. The volume of retail trade rose by 2% in
comparison to 2004 and by 0.9% in comparison to July. The explanation may be that the improvement was
concentrated in France with little progress in other larger economies. Even in Spain retail sales fell below year
ago levels. Altogether recent production, retail sales and labour market data indicate progress in the third
quarter although similar expectations have been followed by disappointing performance on many previous
occasions. Most of the momentum for better industrial performance is coming from higher overseas demand.
The euro has been weak in 2005 and the strong performance of the US, Japanese and Middle Eastern
economies should ensure continued growth in exports for the remainder of this year.
Companies may be optimistic for the final quarter of this year but household budgets will struggle to cope with
rising prices. Headline inflation has risen visibly since the summer and the combination of high oil prices and the
weaker euro suggests further pressure on real incomes. The first estimate of inflation for September showed an
increase to 2.5% year-on-year, following 2.2% in August. This was the highest inflation rate for 16 months and
may explain the concern expressed by the ECB after the October Council meeting. Most notably the Bank now
exercises “strong vigilance” with regard to the upside risks for price stability. Some market commentators have
brought forward their forecast of a rise in Euro-zone interest rates to the end of this year.
The Euro-zone is unlikely to achieve a rapid recovery next year. Expectations of further structural reform in
Europe’s largest economy were dented by the result of the German general election. After weeks of discussion
a coalition of the two largest parties is the final outcome. The new Chancellor of Germany will be Mrs. Angela
Merkel of the conservative CDU party but the major ministries will be divided between the two parties –
complicating the process of labour market and employment cost reform. In so far as higher export growth does
boost economic activity over the next quarters, the ECB may well decide to raise interest rates in the first quarter
of 2006. Such an increase might restrain domestic demand later in 2006 by which time European exports may
be affected by a slowdown in North American and Asian economies.
Former Soviet Union
In the second quarter of the year Russian GDP rose by 6.1%, following a 5.1% rise in the first quarter. The trade
sector grew most rapidly, followed by the transport and communication sector. Mining and manufacturing
continued to lag. Mining output rose by only 2.1% whilst manufacturing activity was only 1.3% above the level of
2004. Overall industrial production rose by 4% in the first half of the year. This rate of growth was maintained in
July and August although in these two months mining activity was scarcely above the level of 2004. Despite the
less impressive performance of Russian output in 2005, high oil and commodity prices have boosted the main
financial aggregates. Higher oil prices have had a dramatic effect in boosting the value of the Stabilization Fund
which benefits from oil export revenues at prices above $20/bl. In the first eight months of this year the fund rose
to $29 billion but a further sharp rise to $53 billion is expected by the end of the year. The surplus on
merchandise trade reached $140 billion in the first three quarters – pushing the overall current account to a
surplus of $98 billion. The fiscal position also continues to improve and the surplus reached an all-time high of
10.2% of GDP in the year to August. Although higher pension and wage payments may increase spending
somewhat in the fourth quarter, the continued high oil price should produce an overall surplus of at least 8% of
GDP for 2005.
This strong surplus is likely to create pressure for fiscal relaxation next year and real government spending may
increase by at least 12%. Inflationary pressures will remain for the foreseeable future and, for the first time since
1999, the rate of inflation is expected to show no significant reduction. The Bank of Russia is committed to
pursuing inflation targeting in 2006 – however the target will need to be reconciled with a limit to real exchange
rate appreciation. The rather poor performance of the Russian manufacturing sector this year highlights the need
to consider the loss of competitiveness if the rouble were allowed to appreciate further. In September the rouble
appreciated by 1% against the Bank’s basket and for 2005 as a whole the rouble will appreciate in real terms by
about 10%. The progress of the economy was recognized by the Moody’s rating service which has placed
Russia’s credit ratings under review for a possible upgrade. Despite the positive contribution of oil and resource
revenues to the economy, the agency will consider the effect on government finances of a possible downturn in
commodity prices in 2006 and the inflationary consequences of the higher state spending planned for
2006-2007 as the Duma and Presidential elections approach.
Eastern Europe
The Polish economy continued to underperform its regional competitors in the third quarter. Industrial production
in August was weaker than expected – growing by only 4.6% year-on-year. The manufacturing sector remained
the main engine of growth, rising by 5.2%, but overall it seems that Polish GDP grew by perhaps only 3-3.5% in
the quarter. The positive aspect of the subdued growth performance is the very low rate of core inflation which is
below 2%. The Polish general election looks likely to result in a centre-right coalition. The new government is
expected to continue gradual progress towards a lower budget deficit and lower tax rates. The Hungarian
economy is achieving much higher growth but at the cost of higher inflation and a poor fiscal situation. Industrial
production rose by 8.4% in July year-on-year and inflation was 3.6% in August. The main problem facing the
government is the very high budget deficit which is expected to reach 7-8% of GDP this year. The outlook for
2006 is even worse as planned tax cuts and increased spending may push the deficit to over 8% of GDP. It is
now clear that adoption of the euro by 2010 is out of reach. The performance of the Czech economy continues to
impress. GDP growth remains robust – driven mainly by external demand. Industrial production rose strongly in
July and the core rate of inflation remains below 2%. Interest rates are also low and the CNB noted that the
strong currency has helped to mitigate the effects of the third quarter oil price increase. No change in Czech
interest rates is expected until well into next year.
Developing Countries
China officially announced in September that the economy had expanded by 9.5% y-o-y in the first half of the
year, indicating that growth continued over that period at the same rapid rate as was seen in 2004. Investment is
still the primary driver of the economy, although the rise in investment has slowed since the government has
started to restrain certain sectors. Deflation in China is a growing concern, although the high energy cost due to
high oil price has helped to minimize the threat of deflation in China. In addition to China, most indicators point to
a healthy expansion India as well. Recent data confirmed that the economic growth for India in the second
quarter continued at the 8.1% pace seen in the first quarter, despite natural calamities. However, domestic
demand is the worrying factor in most Asian countries as their economic growth is driven by export. The
Brazilian economic growth has been softer during January-June of the current year. Most expectations suggest
that this growth will remain less robust than in 2004 and during the remainder of 2005 and 2006. While in 2004
the recovery was driven by external demand, domestic private-sector demand is expected to be more active in
the coming months and consumer spending will be bolstered by an expansion of credits and higher real
incomes. Investment is expected to be encouraged by the easing of real lending rates. The real GDP
growth rate is anticipated to slow from 5.1% in 2004 to 4.3% this year and inflation is receding, paving the way
for interest rate cuts. Regarding Sub-Saharan Africa’s business environment, a World Bank report, Doing
Business 2006 released in September 2005, is a useful tool in ranking Africa’s business, even though it does
not take political risk into account However, this report ranks a total of 155 countries, 40 of them African, in terms
of the ease of operating, with high scores indicating more a business-friendly environment. Accordingly, African
governments and policy-makers have much to learn from the report, not least that many crucial reforms that
would extensively improve the business climate are simple and cheap to implement. The report underscores the
fact that, although the return on investment in Africa is higher than in many other regions of the world, the risks
are also greater. In general, the growth in the developing countries has been overshadowed by the impact of
high oil prices and natural disasters.
OPEC Member Countries
OPEC Member Countries are expanding rapidly, creating jobs and making up for chronic underinvestment in
infrastructure over the past two decades. For instance, the Algerian government is aiming at creating 2 million
jobs by 2009. The stock markets in the Middle East have seen extraordinary activities. Since 2001, the market
capitalisation of the six stock exchanges in the Middle East — Saudi Arabia, the United Arab Emirates, Qatar,
Kuwait, Oman and Bahrain — has more than tripled, passing the £1,000 bn mark earlier this year. During the
same period trading volumes have risen from about $200 m a day to more than $4 bn. This rise is indicative of
the bottleneck in the region’s booming stock market. Currently there is strong liquidity in Saudi Arabia, the UAE
and Qatar — the region’s three hottest markets. With a wealth of money chasing limited opportunities, stock
prices have been driven up to 30-40 times earnings, peaking in some cases at price-to-earning ratios of
50-80%. Amidst windfall revenues from high oil prices, economic reforms are continuing in OPEC
Member Countries. In Indonesia, the government has raised fuel prices by an average of 126.6% to reduce the
financial burden of fuel subsidies on the state budget. The Saudi authorities are up to establish a secondary
market for government bonds and have demanded greater financial transparency from governmental
departments. Inflation is a growing concern in all OPEC Member Countries. In addition to the fact that demand is
by far exceeding the supply of goods and services, resulting in a price hikes, there are a number of cost- related
factors including the fuel price hike and the rising costs of imported items due to the weaker dollar against other
leading currencies. In September for instance, the UAE’s Central Bank governor expected inflation to be around
6.5% this year. A recent IMF study also estimated that economic growth to be in excess of 10% with inflation
close to 6%.
Oil prices, the US dollar and inflation
Following the dollar weakness of August the currency stabilized in September. The solid performance of the US
economy and expectations of further rises in interest rates supported the dollar – despite the continued high
level of the US trade deficit. The dollar rose by 0.3% against the euro, 0.4% against the yen and was unchanged
versus the Swiss franc. The dollar fell by 0.8% against the British pound. In September the OPEC Reference
Basket was also stable, rising to $57.88/b from $57.82/b in August. In real terms (base July 1990=100), after
accounting for inflation and currency fluctuations, the Basket price rose by 0.1% to $41.29/b from $41.26/b. The
dollar rose by 0.1% as measured by the import-weighted modified Geneva I +US dollar basket.
