A Resilient World Economy
By Laura D'Andrea Tyson
Just a few weeks ago, when global equity markets were still soaring, hundreds of business and political leaders made their annual pilgrimage to the World Economic Forum in Davos, Switzerland, to discuss what was in store for 2007. The mood was upbeat and the forecasts rosy. Another "Goldilocks" year of strong global growth with low inflation was the consensus. To be sure, the U.S. economy was slowing as its housing sector swooned, but growth in both Europe and Japan was rebounding, China was continuing to surge ahead at 10% per annum, and India's growth was not far behind.
One reason for optimism: Emerging markets accounted for more than 50% of global output--a milestone achieved in 2006--and the world economy was simply not as dependent on U.S. growth as it had been for most of the previous decade. Reflecting the bullish sentiment, 9 out of 10 CEOs surveyed in Davos predicted a strong 2007 for the global economy. But this forecast was before the large, unexpected losses that have slammed global markets since late February. Was the Davos consensus wrong? Is it time to reassess the outlook for the world economy? I don't think so.
AT THE BEGINNING of 2007, global financial markets were "priced for perfection." Wall Street was enjoying the longest period without at least a 2% daily fall for more than 50 years. Meanwhile, risk premiums on assets such as corporate debt, especially that of highly leveraged companies, and emerging-market debt were at historic lows. The appetite for risk was fed by long-term interest rates that had reached 25-year lows and by the spectacular growth of credit derivatives. The global money supply was growing at its fastest pace since the 1980s, resulting in both excess liquidity in credit markets and excess complacency. In short, evidence was mounting that financial markets were poised for a correction.
Nowhere were the signs more apparent than in China, where the stock market had soared from historic low to historic high in one year. Millions of new individual investors, both young and old, were rushing to invest in China's illiquid and immature stock market for the first time, using bank loans, credit cards, and retirement savings to buy a piece of the action. A few days after his appearance at Davos, Cheung Siwei, an influential vice-chairman of China's National People's Congress, warned of a bubble in the country's stock market and urged investors to pay more attention to risk. His comments sparked rumors of possible government policies to stem market speculation in advance of the party congress' annual March meeting. It seems likely these rumors played a role in triggering a massive sell-off of shares that caused China's stock market to plunge by nearly 9% on Feb. 27.
The correction in China's overheated market may not have been entirely unexpected, but its ability to prompt sharp and sudden reductions in the prices of almost every risky asset everywhere else in the world was. Correlations between financial market changes in developed countries have increased significantly in recent years as capital flows among them have soared. But China's stock market remains small and insulated from foreign investors, and there's no evidence investors sold assets in other parts of the world to cover losses there. Nonetheless, Shanghai's plunge unhinged global markets, leading Morgan Stanley (MS ) economist Stephen S. Roach to quip that "like nearly everything else in the world these days, it now appears that global stock market corrections are made in China."
In fact, China's stock market plunge was like a wake-up call for investors globally, prompting a reassessment of risk that has increased credit spreads and returned market volatility to more normal levels. But all of this has happened without any real change in the underlying economic fundamentals, which remain strong. The U.S. economy has indeed slowed but the odds of recession are low. Europe is enjoying its strongest growth in years despite unresolved structural problems. The yen is appreciating in response to Japan's stronger growth, while China and India are growing rapidly--possibly to the point of overheating.
Overall, the rise of the emerging market economies is providing the biggest boost to both global supply and global demand since the Industrial Revolution. There are certainly economic risks ahead, but they are not new ones. It's just that investors are now paying more attention to them.
Views expressed in Outside Shot are solely those of contributors.
Laura D'Andrea Tyson, a professor of business and economics at the University of California at Berkeley, was chairman of the Council of Economic Advisors in the Clinton Administration.