Global Economic Prospects: Bright for 2004 but with Questions Thereafter

Led by an upsurge in Asia and in the United States, global economic growth should reach 4¾ percent on a year-over-year basis for 2004-equal to the strongest performance in a generation. Although recovery in Western Europe will continue to lag, most of the rest of the world will participate in the general global upswing, with strong commodity prices aiding a number of developing countries.

For 2005, global growth prospects are somewhat less buoyant, with year-over-year growth of 4 percent projected. This slowdown partly reflects the likelihood of necessary and desirable slowdowns from unsustainably rapid economic expansions in several economies, most notably China. It also reflects some risk that either market reactions or policy adjustments to evidence of economic overheating may begin to precipitate a more serious global economic slowdown by next year. In this regard, the sharp recent rise in world oil prices poses probably the most important near-term risk to global growth, while the possibility of a more general rise of inflationary pressures (and the policy reactions thereto) poses the greater medium-term threat.

The Challenge of Global Imbalances

More generally, while global economic prospects look quite bright through 2004, there are important imbalances in the global economy that raise concerns for the longer term. It is useful to reflect briefly on these concerns before turning to a region-by-region assessment of near-term prospects.

Policy interest rates are exceptionally low in most industrial countries: zero in Japan and Switzerland, 1 percent in the United States, 2 percent in the euro area, and at or near historic lows in the United Kingdom and Canada. Inflation rates also are generally very low in the industrial countries, but, even taking this into account, short-term real interest rates are very low. (Realized short-term real rates went negative during some periods of rapidly rising inflation in the 1970s, but this was an anomaly that is not comparable to the present situation of low anticipated real interest rates.)

The very low level of policy interest rates is an imbalance (relative to normal conditions) that reflects exceptionally easy monetary policies to combat economic weakness. This policy imbalance poses an important challenge for the future conduct of monetary policy. Situations of low policy interest rates and low inflation tend to be associated with unusual inertia in the processes of general price inflation, which makes traditional indicators of rising inflationary pressures less reliable as measures of the need to begin to tighten monetary conditions. Also, these situations tend to be associated with high valuations of equities, real estate, and long-term bonds, which can become fertile ground for large, unsustainable increases in asset prices. In this situation, if monetary policy is tightened too much too soon (perhaps because of worries about unsustainable increases in asset prices), the result can be an unnecessary asset market crunch and economic slowdown, and monetary policy may have relatively little room to ease in order to counteract this outcome.

On the other hand, if monetary policy remains too easy for too long (perhaps because subdued general price inflation gives no clear signal of the need for monetary tightening), then large asset price anomalies may develop before corrective action is taken. The monetary authority would then confront the grim choice of trying to keep an unsustainable asset price bubble alive or trying to combat the collapse of such a bubble without a great deal of room for monetary easing.

A further concern related to the general monetary policy imbalance in the industrial countries is its effect on emerging market economies. Interest rate spreads for emerging market borrowers have contracted substantially and flows of new credit have increased. The boom in emerging market credit has not yet reached the frenzy of the first half of 1997, but it is headed in that direction. Another major series of emerging market financial crises (such as 1997-99) does not seem likely in the near term in view of the very low level of industrial country interest rates and the favorable global economic environment for emerging market countries. By 2005 or 2006, however, either upward movements in industrial country interest rates or deterioration of market perceptions of the economic and financial stability of some emerging market countries could trigger another round of crises.

Another important policy imbalance of global significance is the medium- and long-term fiscal imbalance of most industrial countries. Ratios of government debt to GDP are high in several countries, most notably Japan and Italy. Fiscal deficits are large in Japan and the United States and above the desired ceiling of 3 percent of GDP in Germany and France. Most important, industrial countries generally face enormous fiscal challenges from financing social benefits for aging populations that will materialize during the next two to three decades. These problems imply that, even in the near term, expansionary fiscal policy cannot prudently be used as a significant means for stimulating more rapid growth of aggregate demand in the industrial countries. To the extent that such stimulus may be needed, monetary policy is the prudent tool. But, as just noted, monetary policy does not at present have much remaining capacity to play this role and may not regain this capacity any time soon.

The other key global imbalance is the massive US current account (and net export) deficit and the corresponding surplus of the rest of the world. While it is plausible to suppose that the United States can continue to attract voluntary net capital inflows sufficient to finance a current account deficit of 2 to 2½ percent of its GDP, continuing deficits of 5 percent of US GDP are not plausible. The global adjustment necessary to reduce the US current account deficit by roughly half involves three essential elements.

First, in order to shift world demand toward US goods and services and away from those of the rest of the world by $250 billion to $300 billion, the real effective foreign exchange value of the US dollar needs to decline from its peak in 2000/01 by roughly 30 percent. Substantial downward corrections of the US dollar against the euro, sterling, and the Canadian and Australian dollars, and lesser correction against the Japanese yen, have now delivered somewhat less than half of the total required correction. Some further depreciation of the US dollar against these (aforementioned) currencies, particularly the Japanese yen, is needed over the next couple of years. However, the key remaining challenge for exchange rate adjustments is securing appreciations in the exchange rates of key emerging market currencies, especially in Asia. The exchange rate of the Chinese yuan has rightly received much recent attention in this regard (and Nicholas Lardy will comment further on this issue). But the issue is much broader. For most of emerging Asia, there has been little or no currency appreciation against the US dollar since 2000/01 (implying effective depreciation of the trade weighted exchange rate), and most of these countries have recently been intervening massively to resist market pressures for appreciation. These policies need to change to allow a broader downward correction of the value of the US dollar.

Second, for the US current account deficit to decline, domestic demand in the United States must grow more slowly, by a corresponding amount, than US output (real GDP). (This is the reverse of the pattern of recent years, when the excess of domestic demand growth over real GDP growth has accounted for the large deterioration in the US current account.) Getting this to happen in the United States, while also keeping US output close to potential, poses some difficulties. If domestic demand growth falls below potential output growth, the improvement in US net exports must step in to keep total demand for US output growing in line with potential. Otherwise, margins of slack will increase in the US economy. On the other hand, if output (and, hence, income) growth matches potential (with the level of output near potential), then there must be something to depress the growth of US domestic demand below the growth of US income. Otherwise, if US net exports are improving (due to the effects of a weaker US dollar and stronger demand growth abroad), then there would be undesirable overheating of the US economy. The necessary depressing force on US demand growth could come from a progressive tightening of US monetary policy. But this would depress domestic demand growth primarily by slowing private investment, thereby slowing the longer-term growth rate of the US economy. The preferable policy solution would be for the reversal of the fiscal expansion of 2001/04 to provide the desired negative impetus to domestic demand.

Third, for the rest of the world, the counterpart of US adjustment must be that domestic demand grows more rapidly than output. The amount of this difference corresponds to the deterioration of the current account in the rest of the world, which must match the improvement in the US current account. (Since the US economy accounts for about one-quarter of world output at market exchange rates, an improvement in US net exports equal to 3 percent of US GDP requires a worsening of net exports in the rest of the world of about 1 percent of GDP.) In recent years, however, the rest of the world has had difficulty generating sufficient demand growth to keep output growing at potential-and has relied on a net contribution of demand from the growing US net export deficit. Thus, securing a boost to demand growth in the rest of the world over the next couple of years poses a challenge, particularly so because, as previously noted, fiscal policy is generally not available to provide much demand stimulus, and monetary policies (at least in industrial countries) are already quite easy. At a minimum, it would appear desirable to keep monetary policies easy to support demand growth, but not so easy as to frustrate the exchange rate adjustments that are also a necessary factor in correcting global payments imbalances.

The Americas

The United States (which accounts for 22 percent of global GDP on a WEO PPP exchange rate basis) continues to be a key driver of the world economy. The acceleration of US economic growth to a 6 percent annual rate in the second half of 2003 (from 2½ percent in the first half) made a key contribution to the acceleration of similar magnitude in the pace of global growth.

For the first quarter of 2004, it now appears that the US economy grew at about a 4 percent annual rate, and this growth rate is forecast to persist through the fourth quarter of this year. (This implies year-on-year growth of 4½ percent for 2004.) The general rationale for this forecast is that the potential growth rate of the US economy (determined basically by projections of labor force productivity growth) is about 3¼ percent per year. There is a margin of slack in the US economy amounting to 1 to 1½ percent of GDP. Accommodative monetary and fiscal policies should help to erode this margin of slack, leading to actual GDP growth moderately above potential.

More specifically, looking to the main components of US GDP, it may now be expected that real consumer spending will continue to grow but somewhat less rapidly than real GDP-as the extra stimulus from mortgage refinancings and from personal tax cuts begins to wear thin. Real business spending on equipment and software has already accelerated into double digits, and exceptionally strong corporate profits should help to sustain rapid growth in this area. After a large decline, investment in nonresidential structures has probably turned the corner, and a modest positive contribution to GDP growth may be expected from this sector. Moderate gains from inventory investment may also be expected in order to keep inventories better aligned with sales growth. Residential investment should show a modest decline after spectacular growth in 2002 and 2003, but continued low mortgage interest rates and rising household incomes should avert a major decline. The projected growth of the federal deficit suggests that there are some further gains in government purchases. For net exports, the combination of substantial weakening of the foreign exchange value of the dollar (over the past two years) and stronger growth abroad should keep the large negative contribution from net exports from expanding further during 2004.

On the negative side for 2004, the rise in oil and natural gas prices will cut into household real incomes and tend to depress aggregate demand for US output. Were it not for this factor, the forecast for US growth this year (Q4 to Q4) would be 4½ percent-but some allowance must be made for a factor that in the past has appeared to have a substantial influence on the US economy.

For 2005, US real GDP growth is projected to moderate to 3½ percent as the effect of fiscal stimulus wears off and as output nears potential by about end-2005. It is anticipated that the Federal Reserve will raise short-term interest rates, with the federal funds rate rising gradually to 2.5 percent by the fourth quarter of 2005 (in line with current market expectations as reflected in the eurodollar futures market). The presumption here is that there will be some upward move in consumer price inflation (as measured by the PCE index, excluding food and energy) but that this increase will not be enough to take inflation above the Fed's comfort range. Following the present patterns of futures prices for most commodities, including oil, it is expected that crude goods prices will ease in 2005-adding to comfort that general price inflation is not headed rapidly higher. Lower energy prices will also be a positive factor for economic growth.

In foreign exchange markets, the US dollar is projected to continue its recent trend of downward adjustment-as a necessary part of the process of gradually reducing the US trade and current account deficits. This exchange rate adjustment, together with continuing growth in US export markets (and somewhat slower demand growth in the United States), should be sufficient to bring modest improvement to US real net exports in 2005. This improvement, in turn, will be necessary to sustain US real GDP growth in the face of a slackening (of about 1 percent) in the annual rate of real domestic demand growth in the United States.

Of course, several things could go wrong with this benign scenario for the US economy. For example, rising commodity prices and a falling dollar, together with some erosion of slack in the United States, could induce an uncomfortable rise of inflation that might either directly trigger an adverse asset market response or lead to monetary tightening that would induce a sharp economic slowdown. Alternatively, failure of the US government to make any serious effort to curtail its burgeoning budget deficit might at some point unnerve foreign and/or domestic holders of US assets. World oil prices might remain stubbornly high or even spike upward in the event of some further supply disturbance. Or a major terrorist attack or series of such attacks might upset global asset markets and depress consumer and business sentiment.

Barring such accidents, however, it is reasonable to project that the US economy should enjoy growth at or modestly above potential through next year. The main worry, therefore, is that if accidents do occur, there is little room for US macroeconomic policy-either monetary or fiscal-to do much about them.

In Canada, the weakening of recovery in 2003 reflected the strong foreign exchange value of the Canadian dollar and the slowdown in the US economy from mid-2002 to mid-2003. The Bank of Canada responded by reversing some of its earlier tightening (which had been appropriate in light of the limited slack in the Canadian economy).

With the Canadian dollar still very strong, the prospect is for the Canadian economy to grow more slowly than the US economy this year- specifically 3 percent Yr/Yr and 3¼ percent Q4/Q4 for Canada versus 4 ½ percent Yr/Yr and 4 percent Q4/Q4 for the United States. This projection of slower growth for Canada than the United States also reflects a smaller margin of slack in Canada and a potential growth rate for the Canadian economy that is somewhat lower than for the US economy. These factors also explain the projection that real growth of the Canadian economy will be less, by ¼ of one percent, than that of the US economy for 2005.

An important positive feature of the Canadian economy is that macroeconomic policy has considerably more room for maneuver than in the United States or most other countries. Not only can monetary policy be tightened (as it was in 2002/03) to ward off any inflationary threat, there is also more room to ease than in the United States or Japan and apparently more willingness to ease than in the euro area. Also, Canada has for many years followed a prudent fiscal policy that now allows room for short-term fiscal easing that is not available in the United States, Japan, or most of Europe.

In Mexico, recovery is lagging somewhat more than expected behind that in the United States, leading to a slight downgrading of my forecast for GDP growth for 2004. Nevertheless, there is now evidence that activity is beginning to pick up and should accelerate so long as the US economy remains relatively robust. The forecast is now for 3¼ percent growth Yr/Yr for 2004 and 3¾ percent growth Yr/Yr for 2005.

Mexican economic policy remains well focused on keeping inflation close to its target rate and avoiding both large budget deficits and large current account deficits. Unfortunately, the tax reform effort of the Fox administration failed to secure congressional support, and this probably signals the end of much hope for further reform under the current administration. On the other hand, the political situation of divided government, along with the deepening tradition of more responsible macroeconomic policies in Mexico, probably reduce the risk that the next presidential election cycle will bring back the instabilities that characterized the election cycles up through 1994.

In Brazil, recovery to reasonable growth has lagged even more than in Mexico, with Brazil recording slightly negative growth at the end of last year. Part of the explanation for this sluggishness is that domestic interest rates remain quite high, in nominal and in real terms. In particular, although the central bank has been able to cut the SELIC rate from a high of 28 percent in late 2002 to 16.5 percent, the real rate calculated using the past 12 month inflation rate (through February) is still nearly 10 percent; and the real SELIC rate using anticipated inflation is probably slightly higher. Real interest rates in private credit markets are significantly higher than the SELIC rate, implying a substantial impediment to an acceleration of private economic activity.

Moreover, continued high domestic interest rates have a significant negative impact on the government budget, necessitating that the government maintain a large primary budget surplus in order to forestall recurrence of a crisis of confidence such as affected Brazil in 1998-99 and again in 2002. Meanwhile, some of the constituencies that have traditionally supported President Lula are understandably upset about weak economic growth and high unemployment and are beginning to tire of his policies of fiscal and monetary restraint and economic reform. If the Brazilian economy does not get moving more rapidly fairly soon, these political difficulties will only increase, and this could feed back to undermine confidence.

Fortunately, an acceleration of Brazilian real GDP growth to about 3 percent (Yr/Yr) is reasonable to expect for 2004, reflecting the progress that has been made in domestic economic stabilization as well as the more favorable external economic environment. Evidence that growth is actually beginning to pick up would reinforce confidence and thereby contribute to growth of 4 percent or better in 2005. However, failure of growth to pick up in the next couple of quarters would likely have a mutually reinforcing negative dynamic.

In Argentina, real GDP snapped back about 8 percent last year, after a disastrous drop of almost 11 percent in 2002. Continued strong growth of about 6 percent or more (Yr/Yr) is forecast for 2004-as the Argentine economy continues to recover from a cumulative output decline of almost 25 percent between the peak in mid-1998 and the trough in mid-2002. A highly competitive exchange rate and strong world prices for key Argentine exports are clearly aiding recovery. This process should continue at least through next year, when growth is projected to be 4½ percent. In the longer term, however, the deep-seated problems of Argentina's domestic financial sector and the lack of access to global capital markets arising from Argentina's sovereign default will begin to impinge more forcefully on the continued progress of the Argentine economy.

Elsewhere in Latin America, growth should strengthen this year in Chile, reflecting the improved global economic environment and the upsurge in world copper prices. After two years of economic devastation linked to domestic political turmoil, Venezuela may resurge with strong positive growth-but this depends on whether and how the ongoing controversy over President Hugo Chavez is resolved. Individual circumstances also affect the economic prospects of other Latin American countries, but generally the picture is the most positive it has been in some years due to a generally more favorable global and regional economic environment.

Asia

The other key engine of global economic growth, besides the United States, is Asia-specifically the emerging market economies of Asia, and especially China and India.

After suffering some downside effects from the SARS crisis early last year, the Chinese economy recovered spectacularly and recorded 9 percent growth (Yr/Yr) for 2003 as a whole. The Chinese authorities slowed the growth of domestic bank credit in the autumn in an attempt to moderate the surge in domestic investment, but the effect was apparently no more than marginal, and more recent efforts may not fare much better. It now appears that the Chinese economy is set for another year of spectacular growth in 2004, with real GDP forecast to rise another 8.5 percent (Yr/Yr).

Nicholas Lardy, the Institute's expert on China, will discuss the performance and prospects for the Chinese economy in greater detail, including the substantial and growing importance of China to the rest of the world economy. For this note, suffice it to say that performance like that of the Chinese economy over the past nine months may continue for a short time but cannot be sustained in the longer term. A massive surge of investment up to 45 percent of GDP, financed by massive increases in money and credit, will come to an end at some point. This happened rather messily with the Chinese economic boom of the early 1990s, which ended in an upsurge of inflation, a necessary tightening of the real growth of money and credit, and a sharp economic slowdown. The Chinese authorities intend to manage the situation better this time around, and they may do so. But a significant slowdown in the present rapid pace of Chinese economic expansion is unavoidable sometime soon. And the sooner the relevant policy actions are taken (including some upward adjustment of the exchange rate), the better are likely to be the longer-term results for China and for the world economy.

Though less spectacular than China, India also has recently enjoyed a substantial pickup in economic growth, with real GDP growth of 8 percent now officially projected for the fiscal year ending in March 2004. Good weather and a favorable outcome in the agricultural sector contributed to this result, and this will help to boost year-on-year growth for 2004 of 7¾ percent. The nonagricultural economy has also been performing very well, and this performance is expected to continue through 2004/05 whatever the vagaries of the weather, yielding a forecast of year-on-year growth for 2005 of 6½ percent. [Note: The Indian economy has a significant weight (4.6 percent) in the WEO/PPP based index of world GDP, but this weight is significantly less than that of China (with a weight of 11.6 percent). Also, the Indian economy has far less important trade linkages to the rest of the world than China.]

The rest of the economies of emerging Asia collectively account for about 9 percent of world GDP. These economies suffered differentially from the SARS crisis and other specific disturbances, which generally tended to depress economic growth during the first half of 2003. Subsequently, growth has accelerated in virtually every country, although to somewhat different degrees-with Malaysia and Thailand doing relatively well while Korea and Taiwan continued to experience some difficulties.

Cutting through the fog of country-specific idiosyncrasies (such as Korea's comparatively heavy dependence on imported oil), it is reasonable to expect that these emerging Asian economies will have a quite good year in 2004 but that things may slowdown somewhat in 2005, along with somewhat slower growth in the United States and in China. Consistent with this presumption, the forecast is for 6 percent real GDP growth for 2005 and 5¼ percent real GDP growth for 2005.

Meanwhile, Japan has recently recorded surprisingly strong economic growth, with real GDP rising at an estimated 6 percent annual rate in the final quarter of 2003. This performance, which exceeds even my relatively optimistic expectations, appears to be associated with a general upgrading of economic sentiment in Japan and portends stronger growth persisting through 2004 and into 2005-aided by the strong performances that are expected from Japan's key trading partners in Asia and North America.

Accordingly, I have upgraded my forecasts for Japan to 3½ percent real GDP growth for 2004 (Yr/Yr) (and 3¼ percent Q4/Q4 for 2004) and 3 percent for 2005 (both Yr/Yr and Q4/Q4). These forecasts reflect my view that there is a good deal of slack in the Japanese economy and that a revival of confidence that strengthens domestic demand growth can run for a considerable distance before running into any supply-side or policy resistance.

As growth of domestic demand strengthens in Japan, the case for continued massive official intervention by the Japanese authorities to resist appreciation of the yen becomes more and more tenuous. This policy did make sense in the very special circumstances of the past couple of years because traditional macroeconomic policies in Japan had reached the limit of their effectiveness in combating deflation. Quantitative monetary easing (with short-term interest rates effectively at zero) and sterilized official intervention to resist yen appreciation and thereby aid net exports were effectively the only policies available to help stimulate economic recovery in Japan. But this situation now appears to be changing in the favorable direction that permits Japanese economic recovery to be sustained without massive intervention to resist orderly appreciation of the yen.

In Australia, growth was reasonably well sustained last year despite the large appreciation of the Aussie dollar, with real GDP in the fourth quarter up by 4 percent over its year-earlier level. Robust consumer demand, aided by income gains associated with rising prices of commodity exports, appear likely to sustain output growth at about 4 percent for 2004. So far, consumer price inflation seems to be within the comfort zone of the Australian Reserve Bank, but monetary tightening could become an issue again later in the year. As the margin of slack is not very large in the Australian economy, it is prudent to project that growth in 2005 will be closer to 3 percent than to 4 percent.

Europe

Persistent sluggishness in the euro area, especially its three largest economies, is the principal reason global growth has fallen below potential for the past two years. Indeed, from late 2002 through the middle of last year, the euro area registered virtually no growth, and economic activity in France, Germany, and Italy actually showed small declines. Subsequently, growth has picked up in the euro area (including France and Germany) but has remained well below potential.

Growth in the euro area has been disappointing for several reasons, with the explanations differing somewhat country by country. Partly, the sluggishness since 2000 is the product of the general economic forces (decline in global equity values, unwinding of investment excesses, rising global energy prices, and monetary policy tightening of 1999-2000) that induced the general global economic slowdown that began in late 2000. Partly, the continued sluggishness in the euro area reflects the relatively timid responses of monetary and fiscal policy in the euro area-especially in comparison with the vigorous policy responses in the United States (and some emerging market countries). Also, slow progress in implementing key structural reforms when the euro area was performing well in the late 1990s probably complicated recovery and reduced confidence when conditions turned less favorable. And more recently, the sharp strengthening of the euro against the US dollar and most Asian currencies has retarded net exports as a source of growth for the euro area.

Looking ahead, it is reasonable to expect that growth will pick up in the euro area this year and next. The general economic forces that induced the global slowdown are now largely spent, and the normal forces of cyclical recovery should take hold in the euro area as elsewhere in the world economy. Monetary policy in the euro area is not providing as much stimulus as in the United States (and probably Japan), but monetary policy in the euro area is not restrictive. Similarly, despite the strictures of the Stability and Growth Pact, fiscal policy in the euro area is not restrictive.

Four months ago, I forecast that growth in the euro area would rise to 2 percent (Yr/Yr) and to 2½ percent (Q4/Q4) for 2004. In view of the modest real GDP gains recently reported for the fourth quarter and the rises in world oil prices and in the foreign exchange value of the euro in recent months, those forecasts now look slightly optimistic. They are revised down to 1¾ percent growth (Yr/Yr) and 2 percent growth (Q4/Q4), respectively. These forecasts assume that the European Central Bank (ECB) will not cut interest rates further unless the euro appreciates above $1.35 and that the ECB will refrain from tightening at least through the end of this year.

For 2005, I expect modestly better performance from the euro area, with output growing 2½ percent on both a (Yr/Yr) and a (Q4/Q4) basis. The reasons for this modestly stronger growth forecast are that confidence should improve with evidence of stronger growth in 2004, oil prices (and other commodity prices) are projected to decline, and the negative effects of a stronger euro should begin to wear off.

As in the past few years, growth in the three largest euro area countries will lag somewhat behind the average of smaller members, with Germany (burdened by its eastern lander) struggling to reach even 2 percent annual GDP growth.

After a slowdown early last year, the United Kingdom saw a significant acceleration of growth by year-end and maintained the growth advantage it has achieved in recent years versus the major continental European economies. For 2004, growth appears likely to proceed slightly above potential (about 3 percent on a Yr/Yr basis), supported by household spending and a buoyant housing market. Fiscal policy is broadly neutral (with a slight expansionary tilt). Monetary policy faces some interesting challenges because margins of slack are slim and there is concern about a possible bubble in housing prices, but consumer price inflation remains meaningfully below the official target. Most probably, monetary policy will remain on hold until the balance of risks becomes clearer. For 2005, with output expected to be at potential, it seems prudent to project that growth will be about in line with potential-about 2½ percent.

Central and Eastern Europe had a pretty good year in 2003, mainly thanks to strong growth in two of the larger economies, Russia and Turkey. Both of these countries should continue to do quite well in 2004, with forecast growth rates of 6 percent and 5 percent, respectively. At this stage, it is reasonable to expect some slowing of growth for both countries in 2005 as a natural reaction to three or more years of above-trend performance.

Elsewhere in Central and Eastern Europe, economic performances last year were positive but not impressive. In particular, the Czech Republic, Hungary, and Poland each grew at rates that are below their potential as successful transition economies. Growth in these countries should generally be stronger (by about 1 percent) in 2004 and 2005, thanks to the strengthening of growth in Western Europe (and globally) and to the favorable effects on confidence and on external financing flows of accession to the European Union. The large budget deficits and the substantial and growing external imbalances of a number of these countries are cause for concern. However, the favorable financial environment for emerging market borrowers suggests that these concerns are unlikely to become serious problems before 2005 or 2006.

The Middle East and Africa

For four important reasons, for both the Middle East and Africa, 2004 promises to be the best year for economic growth in some time, and prospects for 2005 are about equally good. First, many of the economies in both regions are heavily dependent for their export earnings on sales of oil and other commodities. In general, the prices of these commodity exports (except cocoa and coffee) are quite high-at or near multiyear peaks. The high world oil price directly benefits Saudi Arabia and the smaller oil exporters from the Persian Gulf, as well as a number of African countries, including Algeria, Nigeria, and Angola. Several other countries benefit indirectly from higher oil prices through export sales to oil exporters, remittances from expatriate workers, and other transfers-although oil importing countries also suffer from higher import costs. Meanwhile, the boom in prices and exports of industrial and precious metals (including gold) is particularly important for several countries in southern Africa.

Second, aside from the global boom in commodities, the general improvement in the global economy is an important positive for both the Middle East and Africa. Leaving aside oil and some other commodities, where prices are effectively determined in worldwide markets, Europe is the most important industrial-country trading partner for most of these two regions, and the general lack of buoyancy of the European economy in recent years has been a problem. From this perspective, the comparatively modest growth forecasts for European growth in 2004/05 (relative to Asia and North America) may not look particularly promising. But the key point is that growth in Europe is projected to pick up considerably in 2004 from what it has been for the past three years, and in contrast to Asia and North America, growth in Europe promises to be at least slightly stronger in 2005 than in 2004.

Third, military conflicts and political and social upheavals have played a decisive role in the economic performances of a number of countries in both the Middle East and Africa. The conflicts and upheavals are not all over; turmoil continues in Iraq, between the Israelis and the Palestinians, and in Côte d'Ivoire, Zimbabwe, and central Africa. But the intensity of conflict and turmoil appears to be less than in recent years.

Fourth, looking more specifically at the largest economies in the two regions (Algeria, Egypt, Morocco, Saudi Arabia, Nigeria, and South Africa, and leaving Israel aside) economic prospects for 2004 and 2005 seem generally better than in recent years.

Table 1: Global Growth Prospects (assessment of April 1, 2004)
Annualized Percentage Real GDP Growth Rates
Year over Year (Yr/Yr) and Fourth Quarter to Fourth Quarter (Q4/Q4)