Hamish McRae: China, oil and higher rates will be the big issues during the next parliament

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What will happen to the world economy during the life of the new parliament - the backdrop against which the next government will have to perform?

What will happen to the world economy during the life of the new parliament - the backdrop against which the next government will have to perform?

Of course we cannot know what the great geo-political forces will whip up: whether, for example, there will be another war involving the UK. Not many people, four years ago, would have predicted a second invasion of Iraq. But if you focus on economics rather than politics there are surely some things that can be said, always bearing in mind politicians can derail economies if they try hard enough.

There are clearly at least three big forces that will dominate the next five years. Top of my list would be the continuing rise of China and India, the increasingly tight oil market and, in the early years, the need to increase world interest rates. We also need to remember there is such a thing as the economic cycle and that the world is some way through the growth phase.

China and India first. We don't have the figures yet but last year, in all probability, China became the world's fourth-largest economy, passing the UK. That calculation is made at actual exchange rates, not purchasing power parity rates. On that basis, China is already the world's second-largest economy after the US, while India would be the fourth, with Japan at number three.

There is always a debate as to which exchange rate matters more. If you are looking at clout in world trade, actual exchange rates matter most because trade is carried out with real money. If you are looking at living standards, purchasing power parity is better because that measures what people can actually buy.

However, on actual exchange rates, by 2009 China will be the world's third-biggest economy, while India will be securely in the top ten. The first graph shows the projections that Goldman Sachs made in its famous BRIC (Brazil, Russia, India, China) study. They won't be precisely right but unless there is some utter catastrophe they will be broadly so.

That is a huge shift of power. From the narrow perspective of the UK, for the first time for about 150 years a developing country will have a larger economy than Britain. As we come to realise this, it will colour the way we think about the world. Some people will be frightened, seeing manufacturing jobs going to China and service industry ones to India. In the US there is considerable political resistance to the growth of Chinese imports and heading that off will be one of the big concerns of the present administration. In Europe there will be new calls for resistance against globalism - much of the support for a "non" vote in the coming referendum on the European Constitution seems to be based on this. But whether you welcome the shift in power as a proper realignment of the world's wealth, or feel threatened by it, something of this scale cannot be ignored.

The second big global change that may take place during the next five years will be that world oil production reaches its peak. The Association for the Study of Peak Oil (ASPO), a network of scientists studying this, calculates that production will peak next year and then fall. Its projections are shown in the second graph.

Now this is not the view of the oil industry, which thinks that peak production will be perhaps a decade away, maybe more, and certainly not next year. But we can test ASPO's prediction in the next five years. If it turns out to be right and production in 2007 is lower than 2006, the world economy will have to start adapting pretty fast. If it is wrong we will still have to adapt but have a bit more time to do so.

Remember too that irrespective of concern about supply, the rise of China and India puts pressure on the demand side of the equation. Given this, a sensible judgement would be that oil will remain quite expensive - and tend to become more so - not just for the next five years but for the foreseeable future. That will be an inevitable drag on global growth.

The third thing that will happen is the end of free money. We are towards the end of a long period when interest rates have been so low that money - for any organisation that can borrow at the best rates - is virtually free. Interest rates here have always been positive but in much of the eurozone and the US they have been below the rate of inflation. The US Federal Reserve is gradually tightening policy, though the European Central Bank - facing very weak conditions in most of the eurozone - has so far failed to do so.

You cannot have free money for long. If you do, you encourage people to invest in crazy projects. When many of these go under, as they inevitably will, the bad debts threaten the banking system. There is a good argument to be made that US policy in particular has stacked up some really bad problems for the future. That is certainly what a lot of bankers think. The trouble is, neither they nor the rest of us know what will burst the bubble and when it will happen. History does suggest, though, that the tightening of US monetary policy has a long way to go - as the third graph would suggest.

That leads to the final point. There is an economic cycle and the world economy is already slowing. A combination of high oil prices and rising interest rates might tip it into recession.

It is hard to know how to judge this one. If you read the headlines in the papers in the UK it seems that we may be heading into one already. Retail sales are very weak, the housing market has stalled and we face higher taxes. I was at the OECD in Paris this week and heard some grade A pessimism about the eurozone's prospects from its chief economist, Jean-Philippe Cotis, who has, by the way, a good track record in predicting such matters. If you want to add to the gloom quotient, note too that the imbalances in the US remain as wide as ever and that China, Japan and the rest of east Asia may not want to carry on lending the US the money to cover its trade and budget deficits.

On the other hand it is equally plausible that these tensions noted above will merely provoke a mid-expansion pause. Growth worldwide will slow sharply this year and inflationary pressures will ease. This will allow interest rate increases to be put on hold and growth will carry on for a while yet.

My instinct, for what it is worth, is that the "pause then grow again" outcome is more likely than the "recession round the corner" one. But it would be mad to ignore the existence of the economic cycle and I would be astounded if there were not some sort of downturn - maybe a serious one - in the next five years. A combination of tough reforms in the Eighties and good economic management by Gordon Brown enabled the UK to come through the last cycle in very good shape.

We are still in not too bad shape when compared with other large developed countries and at least, unlike the countries in the eurozone, we still have control over our interest rates and hence are able to adapt policy to meet shifts in demand. It is only gradually becoming clear how difficult it is proving for the ECB to frame policy to suit the entire region and I fear for the eurozone if the next downswing really bites.

Getting through the next downturn will be more difficult even for Britain, as I think we all intuitively accept. I'm not sure our politicians have grasped this yet, but they will before the next parliament has run its course.

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