Economies of developed nations seen slowing as others power along

The forecasts for the coming year, both for the world economy and for financial markets, are being brushed up. Will another year of reasonable, though slowing, world growth be enough to sustain the markets? Or will the evident slowdown in the US economy unsettle things? Or are we perhaps focusing too much on the developed world when we should be looking at the growth of China and India?

If the string of questions is long, the range of possible responses is huge. We are in a period of transition, when each year the balance of the world economy shifts just a little towards the so-called emerging economies and away from the developed ones.

For the time being, what happens in the "old world" economies remains more important than what happens in the "new world" - but the "new" are growing much faster.

So we have to balance what we can reasonably expect, from our experience of past economic cycles, of our own economies, with the greater uncertainties in the rest of the world.

The difference in performance is stark. Global growth, a touch under 3 per cent this year, is picked by Lehman Brothers to fall to just over 2 per cent next year, before recovering a bit in 2008. Growth is projected to slow in all developed regions next year, with the US down to 2.5 per cent, the UK to 2.3 per cent and the eurozone to 1.7 per cent. Japan slows a bit, too.

The emerging economies are grouped into two: Eastern Europe, including Russia, plus South Africa; and Asia minus Japan, primarily China, India and Southeast Asia. These are expected to continue pretty much unaffected, with the European group remaining at or above 5 per cent and the Asian one at or above 7 per cent.

So the proposition is that a marked slowdown in the "old world" will be contained, while the "new world" will continue pretty much unaffected.

Lehman notes that much depends on the US housing market and it acknowledges a gloomier view, holding that the slowdown next year could presage a fully fledged downturn. But it reckons the US will keep growing through 2007 and that by 2008 the Federal Reserve will be cutting rates.

Lehman's projections for the main central bank rates suggest another quarter per cent rise in UK rates early next year, but by the end of 2007 the cost of borrowing will be back to 5 per cent. Euro rates will stay under 4 per cent, which seems about right given the zone's lacklustre growth forecast.

All this seems pretty sensible. It is what ought to happen, given what we know about economic cycles in the developed world. But each cycle is different and this one will be the first when emerging economies are almost as important as developed ones.

So the question is how the emerging economies will react. Will they, as these forecasts suggest, continue to be an engine of growth or will they depend on Western demand to keep them growing? We have no guide because this cycle is different in its balance from previous ones.

However, we can see some basics.

For example, if energy prices remain high, Russia and the Middle East will continue to do very well.

But that will not necessarily pull the rest of the world along, for both regions are building up huge cash piles that they cannot currently spend.

The growth momentum in China is clearly self-sustaining, in that a huge amount of consumer demand remains unsatisfied. So in theory it should be possible to compensate for any shortfall in demand in the US by switching to the domestic market.

For the moment, though, the problem is trying to keep a cap on growth. Given that the building boom, too, will continue at least until the Olympic Games in 2008, China does seem set to expand in at least the high single figures, and that will sustain demand for raw materials. On present trends, China will pass Germany to become the world's third-largest economy some time in 2008.

India? The business community there is currently tremendously self-confident and all the forecasts I have seen suggest growth continuing at the recent 6 to 7 per cent rate.

It remains a much smaller economy than China's, so its impact on global issues such as the demand for commodities is less marked. Still, each year at that rate makes India a more important economic power.

So that is the most likely picture for 2007: slowing developed economies and booming emerging ones.

There seem to me to be three main risks, the first two of which follow directly from the analysis above.

One, widely appreciated, is that a stalled American housing market will slow the US more than currently expected. A second, less widely remarked on, is that were the "old world" to falter it would have knock-on effects on the "new world" that aren't yet fully understood.

The third follows indirectly. It is that the financial flows between the "old" and "new worlds" - with the US in particular borrowing so much from the latter to sustain demand - are putting strains on the global banking and investment mechanism, which are also not fully understood.

This has been a wonderfully profitable year for international finance, the best ever, for vast amounts of money have been hunting for homes.

But as central bankers have repeatedly warned, these financial flows carry risks.

However, no obvious disaster is looming. Next year shouldn't be a bad year in economic terms, but it may feel a rather different one.

- INDEPENDENT