The financial crisis of August 2007 has its roots in several developments. The fall-out from defaults on loans in the sub-prime mortgage market in the United States has received widespread publicity. But monetary policy in the United States has been tightening since June 30 2004. That tightening, in turn, became necessary because of the prior stimulus to the economy by easy monetary policy after the dot.com crash in March 2000 and subsequent slowdown. So the current crisis has its roots in developments over several years. Understanding these roots is necessary to appraise the potential effects on the real economy from the current credit crunch.
 

There is concern that America may be on the brink of its biggest ever house-price bust. Both sales of homes and housing starts in the United States have slumped in recent months. The worry is that static or falling home prices will dampen consumer sentiment with lower spending and economic activity not far behind. Some commentators, like Nouriel Roubini, argue that the housing downturn will likely lead to a recession in early 2007. Any downturn will have repercussions for the world economy.

The bursting of the US housing bubble will change expected returns to housing assets and will lead to a reallocation of capital within the United States as well as between countries. This reallocation of capital will have knock-on effects for the world economy, exchange rates and international capital flows. These financial effects need to be assessed alongside the effects on the real economy from lower investment in housing and lower spending from the negative wealth effect. These are all analysed with the economywide framework used in this issue of Scenarios.
 

The World Health Organisation predicts that another flu pandemic is just a matter of time. A particular worry is a pandemic based on a variant of the H5N1 bird flu virus that has become endemic in poultry across Asia. Recent outbreaks of bird flu have occurred in Turkey, Europe, Africa and India. So far at least 83 people have died from the H5N1 virus as people have become infected from contact with diseased chickens. There is no evidence yet that the H5N1 virus has passed from human to human. But the 1918 Spanish flu pandemic — the worst the planet has seen — infected between 10 to 40 per cent of the population and around 3 per cent of those died. The 1918 Spanish flu was caused by a H1N1 bird flu virus that mutated so it could spread easily among people. If the H5N1 virus mutated to repeat anything like the 1918 pandemic severe consequences would follow for the world’s population and economies.
 

Trade ministers deferred the hard decisions from the Hong Kong WTO meeting last week. Things should come to a head around March or April 2006. It could go either way. Europe could cave in on agriculture and developing countries give ground on manufacturing and services, giving a reasonable outcome overall. Or, the talks could collapse (again) in an acrimonious stand-off. Economists know that more liberal trade will boost economic growth and trade. But little is known about the dynamic and financial effects, which can be important since trade protection is uneven across the world. Even less appreciated is the impact of failure, since some expectations of more liberal world trade is already built into markets and investment decisions. The financial effects from freeing up trade, or failure to do so, can occur quickly as expectations come into play. These financial flows can, in turn, generate short-term counter-intuitive trade effects.
 

The US government has been pressuring the Chinese to revalue their currency. Draft legislation to impose a 27.5 per cent tariff on imports from China is before Congress. The Chinese have kept a fixed exchange rate of 8.28 renminbi to the US dollar since 1995. The US government finds that ‘China’s fixed exchange rate is now an impediment to the transmission of price signals and international adjustment, and imposes a risk to its economy, China’s trading partners, and global economic growth’. A revaluation by China of the order of magnitude requested by the United States would most likely put China into recession.
 

The OECD projects the US current account to be in deficit by US$826 billion by 2006. In 1990 the US current account was in surplus. This deterioration in the current account of the United States and accompanying deterioration in the trade balance is unprecedented. It is ‘large absolutely, large relative to US GDP and large relative to the United States’ small export base’. Financial markets are worried about how and when this imbalance in the world economy will resolve itself. In this issue we examine the main causes of this growing imbalance in the world economy, its sustainability and implications for major variables like real exchange rates and interest rates as the imbalance corrects itself, which it must do at some point.
 

Oil prices have risen above the US$50 a barrel level despite a lift in output by OPEC producers. Turmoil in Iraq, unrest in Nigeria, uncertainty of supply by Yukos - the Russian oil giant - and high demand from a booming China have all played their part. Even Hurricane Ivan that hit the Caribbean and South-eastern USA played a role in disrupting oil supplies. Yet, while crude oil prices have risen dramatically, crude oil inventory levels have been increasing. And recently the OPEC President predicted US$30 a barrel shortly on the fundamental supply and demand situation. In this report, two scenarios are evaluated: a sustained lift in prices to levels recently experienced and a temporary rise with levels returning to a 'normal' US$25 a barrel. Conventional wisdom about who gains and loses under such scenarios - at least for non-oil developing countries - is challenged by the analysis here.
 

China is now a major player in the world economy and its economy has been booming. Last year imports grew by 40 per cent. China has accounted for over 20 per cent of global growth over the last three years. Last year China's real GDP grew by 9.1 per cent. Bank credit is up 21 per cent, inflation is rising and some economists believe the true inflation rate is above 5 per cent.

Authorities have moved to cool the economy. They are likely to succeed. The key questions are whether the economy is in for a hard or soft landing and what does that mean for other Asian and world economies.
 

China's economy, imports and exports are booming. Foreign exchange reserves are accumulating. These are the consequences of market reforms, and a perceived favourable investment climate by foreigners. They are also the result of a large fiscal stimulus and the maintenance by authorities of a fixed exchange rate with the US dollar. United States leaders have called on the Chinese to revalue their currency. So far the Chinese have resisted. The effects of revaluing the currency are not as obvious as it might seem, especially for third countries, because of a variety of offsetting factors.
 

In just two and a half years there has been a massive turnaround in the projected United States fiscal position. Although the turnaround has given a short term stimulus to the economy, the medium to long term effects are negative for US real investment and growth. Just as was experienced during the Reagan deficits of the early 1980s, this will unfold as higher real interest rates and an initially strong US dollar. Other things given, the US dollar would appreciate by around 11 per cent, which is the opposite to current market opinion. Clearly, something else is happening. That 'something else' is the worries by foreigners about the US economy. If foreigners worry about the size of the deficit and lose their appetite for US securities, the exodus of funds could cause a depreciation of the US dollar of around 12 per cent with major effects on the US economy.
 

SARS could cost Hong Kong nearly 5.5 per cent of GDP in 2003 and China 2.4 per cent of GDP assuming the outbreak is brought fully under control this year. That is enough to tip Hong Kong into recession, but not China. The greater impact on Hong Kong is due to their much larger tourism, travel and retail sales sectors. The high cost arises from changed behavior of people, increased costs of conducting business and an increase in country risk caused by the uncertain outcomes. Costs are accentuated in China and Hong Kong because of the maintenance of a peg of both currencies to the US dollar which causes a tightening of monetary conditions rather than a loosening. Should SARS persist over the next decade, or another similar outbreak occur, real GDP in both Hong Kong and China could fall by 7 per cent and 6 per cent respectively in 2003 alone. That means China could also be in recession as well as Hong Kong.
 

War with Iraq could cost the world economy up to 2 per cent of GDP by 2005 (0.7 per cent reduction in annual growth of major countries from 2003 to 2005) under a pessimistic scenario. Private investment would be one of the casualties and equity prices are likely to fall. Even a short war could have significant effects. The main economic costs stem from the increase in fiscal deficits due to extra government spending rather than higher oil prices and greater uncertainty, although all effects compound to give the final result. This analysis does not evaluate the potential benefits of a war to global security which, under various scenarios, could be substantial.
 

The giant US telecommunications company WorldCom overstated earnings by a massive US$3.8 billion. The company has filed for bankruptcy. Coming hard on the heels of the collapse of Enron and financial scandals at Xerox and Tyco, among others, investors have backed away from the market. America's Dow Jones index has lost 20 per cent of its value between mid-May and mid-July this year. This loss of confidence in equities and the sharemarket slump, if sustained for a couple of years, warrants a downward reappraisal of economic prospects.
 

Japanese economic growth in the December quarter last year was -1.2 per cent. It was the third consecutive quarter of negative growth and marked a decade of low growth and deflation. The problems are well known: rising unemployment, rising bankruptcies, dysfunctional banks saddled with a large proportion of non-performing loans and a severe downturn in business investment. Since the asset bubble burst at the end of the 1980s, consumer demand has remained weak. A sensible macro policy could lead to recovery. Growth could be 5 per cent higher in 2004 and 22 per cent higher than otherwise by 2010.
 

"The terrorist attacks in the US have had a major impact on the US and world economies. The September 11 attack came at a time when the US was already weakening, and monetary and fiscal policy eased in response. The events of September 11 have caused a major reassessment of economic prospects by market participants and policy makers. Terrorist attacks could have cost the US 1 per cent of GDP in 2001 and 2002 and 2003. Longer term US growth is slightly lower than before. The findings suggest the US stockmarket may be overbought and emerging markets may be oversold."