2008: Global rebalancing? 

The fallout from the credit crunch continues.

Risk aversion in credit markets will be prominent in the new year. This means the US consumer, the former dynamo of global growth, will be tightening his purse strings. Nonetheless, a pickup in investment spending in the developing world will keep real global growth in the 2-3% range. Combined with a sharply weaker US currency, this may herald the beginning of a long-awaited 'global rebalancing'.

A shift in the source of demand growth to East Asia and other strongly-positioned middle income economies, on the back of appreciating currencies, should provide a strong palliative to US weakness.

A combination of circumstances makes the present juncture a particularly appealing time for East Asian monetary authorities to countenance a secular domestic currency appreciation. With external demand growth weakening, the logic of stoking domestic demand will be compelling. Fortuitously, large foreign currency reserves leave East Asian economies well placed to manage the changeover. There may be little choice:

• US monetary policy is set to ease by 75-100 basis points in the first half of 2008, removing the floor from dollar adjustment.
• A policy of resistance on the part of East Asian currency authorities would prove complex, due to the challenge of domestic liquidity.

The starting point looks likely to be China, where the liquidity challenge seems most pressing. Official measures of inflation are above 6%, and may understate the true extent of urban consumer price pressures.

Euro-area growth would respond favourably to the change in global demand patterns, partly due to export dynamism:

• European exports are highly exposed to capital-intensive sectors, and will gain from a pickup in extra-Europe investment spending.
• Stronger East Asian currencies finally would provide relief to more price-sensitive components in the euro-area traded goods sector; consumer goods being a key example.

Monetary easing by the Fed will ease the pain of stretched US household finances, but not solve the problem of risk aversion among creditors. However, it will make the US traded sector sharply more competitive by removing the floor from dollar overvaluation. The result is likely to be a pickup in the traded-goods sector, both in import substitution and US exports. Although largely overlooked, the latter has shown notable prowess with the limited dollar depreciation achieved in 2007. This strength will be unmistakable in 2008.