Hamish McRae: New economic giants India and China give a twist to the global recovery

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It is a funny time, isn't it, for the world economy?

It is a funny time, isn't it, for the world economy?

In some ways things are all reassuringly normal. The global upswing is picking up pace. The OECD has just upgraded its forecast for developed world growth this year to 3.4 per cent, the fastest for four years. As a result, interest rates are expected to rise as monetary policy leans against the growth to stop things running too fast. We have already had some interest rates increases here. Alan Greenspan, the chairman of the Federal Reserve board, has hinted that the first rise in US rates will come soon.

Dr Greenspan's comment has led to a wobble in the US markets, as they had not fully taken on board the fact that if growth races away far ahead of the natural trend, something has to be done to check it.

Within the eurozone, the expectations have been for interest rate cuts rather than increases, thanks to the fact that growth has not pulled up the economies of Germany and Italy. That is unusual: they ought to be doing better than they are. Nevertheless, insofar as any recovery phase of an economic cycle can be called normal - they all vary a bit - this one does looks pretty typical. As growth becomes embedded, interest rates rise.

The first two graphs, taken from the new Bank of England Inflation Report, show what has happened to short-term rates during the downward swing of the cycle and where rates are "predicted" to go by the markets. The forward lines are not a prediction in the sense that people are asked where they think rates will go. They are rather better than that, in that they show the interest rates available now for longer dated deposits, from which you can deduce where the implicit official rates would be at various dates in the future.

As you can see, the UK is leading the upward swing, but note how the US rates are also expected to move sharply upwards next year, overtaking eurozone rates. Even Japanese rates click up a bit, too.

There are other aspects of the cycle that also appear pretty normal. There has been a big bounce in share prices since the bottom of their cycle, reached in the UK last spring. You frequently get this during the early stages of an economic recovery. It is, after all, the job of the markets to look forward. The present debate in the equity markets is whether profits in the coming year will rise enough to justify the present level of share prices and allow further rises in the months ahead. But again, this is a typical sort of debate that happens at this stage in the cycle.

The central issue is whether companies are now in a "sweet spot" for profits: additional demand has come though but the associated costs of dealing with that demand have yet to rise.

There are however a number of features that make this cycle different. One is the growing importance of the "new" economic giants of China and India. My own quick tally suggests that some 45 per cent of the additional demand that was added to the world economy last year came from non-developed nations. China added about as much demand as the US, while India added as much as continental Europe.

China is exerting its influence on the world economy in two particular ways. On the one hand its booming exports of cheap consumer goods is holding down the price of manufactured products all around the world. It is not just the fact that Chinese goods are relatively very cheap. Fear of Chinese competition is forcing non-Chinese manufacturers to squeeze down their costs too. As a result the price of most goods, throughout the developed world, are either stable or falling.

On the other hand Chinese demand is forcing up the price of raw materials, including oil. The oil price topped $40 a barrel this week for the first time since the first Gulf War. China has now passed Japan as the world's second largest oil consumer. Much of the additional oil demand is for electricity generation. This year alone China is adding as much new generating capacity as the entire installed capacity of the UK.

So thanks largely to China, a twist is taking place. Finished goods prices are falling and raw material prices are rising. That is different to previous cycles, when the price of both would rise more or less in tandem. It is not clear how monetary policies designed to curb inflation, or boost demand, in the rich developed world will be effective when much of the force driving both inflation and demand comes from outside the developed economies.

We do still have home-generated inflation in services, but arguably the entry of India as a place to outsource many such services will start to have a similar deflationary effect, at least in the private sector. India puts less pressure on the world's natural resources, for it tends to under-invest in infrastructure, rather than over-invest in it. Nevertheless as India grows it too will increasingly affect raw material prices.

There are also, within the developed world, features of this cycle that seem abnormal. Take the differential impact of very low interest rates. These have boosted demand in the entire English-speaking world but largely failed to do so on the continent or in Japan. For some reason Americans, Britons and Australians behave differently. Part of the explanation lies in attitudes to home ownership and housing finance, but that does not explain why Germans and Japanese consumers are so loath to borrow money to fund their purchases. Now, as rates go up, you would expect that to have more impact on the "Anglo" nations. But that may take a long time.

The UK housing market provides an intriguing test case of the effectiveness of monetary policy. Rates are rising and will rise more. Everyone knows that. Everyone worries about it, including the OECD in its latest Economic Outlook, published this week. The ratio of house prices to average earnings is the highest on record, higher even that during the 1988 peak. But affordability - the amount that people have to set aside each month to service their mortgages - has not risen nearly as much as it did in 1988 because the general level of interest rates is so much lower now.

But so too in the general level of inflation. The effect of a high interest rate, high inflation environment is to bring forward the burden of debt repayment into the early years of the loan. The third chart, also taken from the Bank's Inflation Report, illustrates this. It assumes that the initial loan of a 25-year repayment mortgage is three times earnings; that earnings go up by 2 per cent a year in real terms and the real interest rate is 2.5 per cent. If inflation averages 7 per cent, the house buyer starts with mortgage payments of nearly 30 per cent of income. But the high inflation whittles away the real value of the loan so that after 15 years the repayments are less than 10 per cent of income. By contrast, with inflation at only 2 per cent, the initial burden is much lower, only 20 per cent of income. That falls, but towards the end of the mortgage, the home-buyer is still paying a much higher proportion of income than in the high-inflation example.

The point here is that if indeed inflation remains low, people who borrow big now will find themselves under a significant debt burden in 10 or more years' time.

This leads to a more general point. In shorthand, in the "Anglo" world personal debts are high; in the continental and Japanese worlds, government debts are high. But all of us, either personally or as taxpayers, have loaded our economies with debt. We are indeed into the upswing of a normal cycle and that is good. But the debt burden will increasingly curb our exuberance in the years ahead and may well mute the next stage of the upswing.