Hamish Mcrae: 'BRIC' economies hold the key to building global growth in 2007

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The Independent Online

This is the last of these columns for 2006, hence the seasonal temptation to try to think through the principal economic influences during the coming year. It is an exercise that is useful not because global economic changes follow an annual calendar - they don't - but rather because it is worth standing back from time to time from the daily news flow and thinking about long-term changes in the world economy. A year-end is as good a time as any to do so.

At least three important things happened during 2006: the start of the long-expected decline in the dollar; a return to "normal" interest rates; and India and Russia joining China as fast-growing "BRIC" economies. A word about each, for they form the baseline for the things to look for in 2007.

The fall of the dollar has yet to have any impact on the scale of the US current account deficit, stuck at some 7 per cent of GDP, but it is a necessary precondition for the correction that we all know sooner or later has to happen. As US growth slows during the coming year we may catch sight of the turning point in the current account. Meanwhile the dollar remains vulnerable.

The return to positive real interest rates in the US and euro area has yet to slow the world economy. In fact, last year saw global growth at around 5 per cent, a bit above its long-term trend and pretty astounding given the price of oil. That was the first ever oil shock that seems to have had virtually no impact on growth. Everyone expects some decline in world growth this year, though no collapse.

Besides, even were growth in the US and euro area to shade back more sharply than people expect, global growth will be supported by what is happening in China, India and Russia, the three fastest-growing of the four BRICs. Brazil, the other member of the club, is less significant at the moment.

These three points lead into a discussion of the likely pattern for 2007, with perhaps the best starting point being the likely extent of the slowdown. The first thing to be clear about is it would be quite normal after a year of above-trend growth to have one at or below it. The first graph, from the economic team at Deutsche Bank, shows how actual growth has fluctuated around the trend since the early 1970s, with itself dipping a bit through the 1980s and now recovering. The bank reckons that growth over the next couple of years will come back to trend but not dip below it.

That feels right. This expansion has weaknesses, of which the imbalances noted above are the most troublesome, but equally it does not have the manic feel of the booms of the late 1980s or 1990s. It may sound unscientific but downturns usually occur when everyone is convinced that "this time it is different". There is not much indication of that sentiment yet.

If that is right, the expansion continues through 2007 and into 2008. The main economic forecasts for both years are shown in the other graph. I have taken Goldman Sachs' projections on the grounds that they give a better feeling for the expectations of the financial community than official data. As you can see there is quite a sharp slowdown in the US next year, but growth is still expected to be above 2 per cent. German growth also falls back after an exceptional year: not only have exports continued to flourish but some domestic demand has come forward ahead of the increase in VAT in January. France and the UK are both projected to grow faster next year than this, but thanks to the slower growth in the US, overall growth for the G7 will fall from 2.8 per cent to 2.1 per cent.

Contrast that with the projections for the BRICs, which do fall a little, but merely from 8.9 per cent to 8.5 per cent. China bounds on at close to 10 per cent, India at around 8 per cent, Russia at around 7 per cent. Brazil's growth, at a perfectly creditable 3-4 per cent, seems almost mundane by comparison.

It is not until you reflect on this contrast between the 2 per cent of the present developed world and the 8 per cent of these rapidly developing giants that you appreciate the extent to which the next cycle will be shaped by the latter. That leads to two further questions. To what extent is the growth of the BRICs dependent on the growth of the G7? And is the world economy made more stable or less stable by this rebalancing of economic power?

As far as the first is concerned, next year will be extremely interesting because we will see to what extent the US slowdown affects China. This will not be a stress test, unless the relatively benign projections for the US prove wrong and demand really falls sharply. But it will be the first time since 2001, when the Chinese economy was much smaller, that the country faces weaker demand in its principal export market.

The response of China will help to give some answers to the second question. If you look back at the past 10 years, the developing world has been a source of instability rather than stability. The Asian debt crisis, the Russian default, Latin American monetary woes - all these have imposed shocks that the developed countries have had to cope with. But that was the past. It is plausible that the rapid growth of the BRICs has made them less susceptible to shocks than the slower-growing G7: they might be able, so to speak, to grow their way out of trouble. We won't know the answers to this in 2007, but we will get a better feeling for the future. This is an issue that will become yet more important as the weight of the world economy shifts in the years ahead.

There are, seen from a British perspective, three more immediate issues for 2007. The most obvious is the nature of the US slowdown and the policy response to it. A huge amount depends on the US housing market, and the very latest figures suggest that this will make a "soft landing". That is, there will be no crash, just a plateau. But until we know this for sure, it makes little sense to try to predict the direction of US interest rates. And until we know what happens to interest rates, it is very hard to say much that is sensible about the dollar. Most of us expect the decline to continue, but getting exchange rates right is almost impossible. Reason says there should be a greater decline vis-à-vis Asian currencies than against European ones, but reason does not necessarily rule.

The second immediate issue is whether the euro area recovery will be sustained. So much depends on Germany. The economy has had its most successful year for nearly a decade, but no one can predict the impact of tax increases and more broadly the strains on the coalition government. If Germany continues to come right, the euro area continues to come right.

And then there is us. We get a new prime minister and a new chancellor, and I suppose the question is whether the run of economic good luck continues. Reason says the main difference will be the step change downwards in the growth of public spending. From next year onwards this will no longer provide a net boost to demand as it has for the past seven years. As long as the world economy goes on growing this should not matter, but I wonder whether we realise the extent to which things will feel different when public spending is squeezed.