Hamish McRae: Poised on the brink of a downturn, the world needs an action plan to come out of Washington this weekend

A slump in the dollar, a fall in demand from China or a house price crash in Britain – there are many spectres stalking the global economy
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The Independent Online

It is IMF time again – the annual meetings of the International Monetary Fund and World Bank now getting under way in Washington, and this weekend, ahead of the formal meetings, a get-together of the finance ministers of the Group of Seven large economies.

The financial markets will focus on whatever the G7 ministers say or don't say, the obvious issue being the plight of the dollar. Meanwhile, those of us here in the UK are interested by something closer to home: the World Economic Outlook, a report on the global economy by IMF staff that is published before the meetings.

As you may have picked up from the headlines last week, one of the things it warned about was the danger of a house-price crash in the UK. We'll come to that in a moment. First, though, let's consider the dollar, for that too has profound implications for Britons.

Up to now the dollar has been declining steadily but pretty relentlessly, particularly against the euro, to reach a level where it is starting to correct the US current account deficit. American exports are rising much faster than imports, with the effect that the deficit, which reached 7 per cent of GDP, is closing at a rate of between half and one percentage point a year. The adjustment of a key global imbalance is happening. Unfortunately, it may not be fast enough for international investors, who withdrew nearly $70bn (£35bn) of funds from the US during August. The spectre of a dollar slump, as opposed to some modest further decline, looms over the G7.

Of course no one can know whether that will happen. It would not be in the self-interest of the foreign holders of dollar assets to sell suddenly, thereby further depressing the value of their remaining assets. But there is increasing resistance in the US to the way countries such as China and Russia seem likely to try to rebalance their holdings, switching from US Treasury securities to a wider range of assets including equities – and we may hear something of this over the weekend.

What you can see, though, is the potential sequence of events whereby a declining dollar makes imported goods, including oil, more expensive, and this simultaneously slows the US economy still further and limits the ability of the Federal Reserve to boost it by cutting interest rates. A sharper US slowdown would inevitably be bad news for the world economy.

But not quite as bad as it might have been in previous economic cycles. One of the most interesting parts of the World Economic Outlook is a passage on the economic cycle. Its core message is that demand from the rest of the world, and particularly China, is now taking over as the locomotive pulling the world economy along. As you can see from the first graph above, China is generating more incremental demand for the world this year than the US or the eurozone. This is the first time this has happened and will, I think, come to be seen as a turning point in global economic history. It is happening at market exchange rates, not just at purchasing parity rates, so the demand has a real and direct impact on international trade in commodities and other goods.

This then leads to another issue: what will end this cycle? Will it be some fall-off in demand in Asia, maybe led by China, or will it be weaknesses within the developed world?

One such weakness, evident in the US but maybe spreading to Europe, is what has been happening to the price of residential property. The IMF view is that several markets are more overvalued than the US and what is happening there (which, by the way, is getting worse) is likely to happen elsewhere. Britain is one of the most exposed (see the right-hand chart).

In an effort to give the UK housing market a further kick, our new Chancellor of the Exchequer last week called on mortgage lenders to be more restrictive in their criteria for granting loans. That was something they were already doing but Alistair Darling managed to give a slap in the face to the housing market just as it was already cooling fast.

The time to have warned lenders was two or three years ago, when they started to increase the multiples of income on which they lent and rolled out more interest-only loans. That might have curbed Northern Rock's enthusiasm. But whether what a minister says now has much effect is doubtful. What will matter is what happens to the economy and to interest rates.

The latest news on the economy is quite positive. Demand is still strong: figures on Friday show that third-quarter growth was up 0.8 per cent, bringing year-on-year growth up to 3.3 per cent. I suppose what worries me there is that, despite this strong growth, the Government's finances are heading into more of a mess, with the monthly borrowing running way over the original budget target. I am beginning to wonder whether even the revised borrowing target of £38bn will be breached. Pencil in £40bn for government borrowing this financial year and remember you read it here first.

Retail sales are also strong, which will limit the ability of the Bank of England to cut rates, although to be fair, it will also reduce the need for it to do so. The question is whether retail sales remain healthy simply because they lag events in the rest of the economy, and whether they can carry on strongly even in the event of a more serious housing slowdown. My instinct is that they will indeed be strong through the rest of this year and into next, largely because it takes a long time for a slowdown in the housing market to feed through into consumer demand. Growing economies take a long while to come off the boil.

Meanwhile let's see if the Washington meetings come up with any significant action – for example, what sort of statement they make on the dollar and on the freedom of sovereign funds to invest where they like. So far, the world economy has come through what might have been a difficult autumn in remarkably good shape. Maybe that is why we are all feeling a bit twitchy: it's that awkward sense that the present boom is gradually drawing towards its close.

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