Boom or bust? The global economy in 2007

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(CNN) -- In the coming weeks, four leading economists and analysts will be looking ahead to the prospects for the global economy during 2007.

The third of these is Luisa Corrado, Professor in International and European Economics at the University of Rome Tor Vergata and currently a Marie-Curie Fellow at the Faculty of Economics, University of Cambridge, where she is also a Fellow of the Center for International Macroeconomics and Finance.

Q. How do you think the global economy will perform in overall terms during 2007?

A. Inflationary pressures in the United States seem to be under control, thanks to a steady increase in interest rates by the Federal Reserve.

US Federal Reserve chairman Ben Bernanke's policy is luckily matched by good economic news from abroad: Japan's future is looking brighter after many years of dullness, and European markets are also facing more peaceful days. Even with America having to tighten monetary policy, recovering demand in those markets can still support the global economy.

What about the Asian players? Forecasts for China's growth in 2007 predict a remarkable figure with some analysts foreseeing almost 10%, three times as fast as the U.S. It is expected that China's and India's expansion will help the world economy to grow at 4.8% overall in 2007.

However, this performance is not at all rosy. There are important changes in the Chinese labor market that cannot be dismissed in the short run and whose effects will be more visible in the years ahead.

Chinese firms are facing shrinking profit margins as labor shortages force companies to push up wages. From the textile factories to the financial and research divisions all over China, the major task nowadays is finding and retaining good workers.

Turnover in some low-tech industries approaches 50% and labor costs per hour have almost doubled in less than 5 years. No doubt the competitiveness of Chinese products abroad come from labor intensive technologies. And if labor costs keep raising this will force firms to increase market prices.

What is the fallout for the global markets? We have indirectly benefited in terms of lower inflation from Chinese cheap labor as prices of imported manufactured goods from China have been substantially lower.

Most central banks with inflation targets, such as the European Central Bank, had an easier task under such favorable conditions. If the situation will change, as it seems from the recent developments, the tasks of European Central Bank President Jean-Claude Trichet will become much 'Trickier'.

Q. What is the outlook for the US economy?

A. While China is living through one of its greatest historical bubbles, the United States is going though one of the biggest twin scares of the last decade -- the deficits in trade and in the federal budget. What seems to be especially worrying is the foreign ownership of US debt.

Recent US Treasury statistics indicate that almost one third of the debt is held by the Central Banks of Japan and China, and by several central banks in the European Union. This makes the United States susceptible to a major threat that either banks will stop purchasing Treasury Bills or start selling them massively.

Some warnings are already emerging. Recently some central banks in Europe have announced that they will sell off a large portion of their dollar securities out of worries about the twin deficits causing a downward slide in the US currency. Also the central banks of Russia and the United Arab Emirates have allegedly claimed that they may shift out of the dollar in 2007 for the same reason. So the United States must be aware of potential big players' flight from their securities.

Q. How might oil prices in particular affect economic performance next year?

A. Growing economies, especially increasing consumption levels from India and China, are certainly putting upward pressure on oil prices. Limited surplus in oil production is therefore widening the gap between supply and demand as much as 3 million barrels a day by 2008.

With this trend in place, some analysts foresee oil prices could be driven over $80 a barrel in 2007. Whether or not they will hit the $100 peak will depend on geopolitical risks in countries like Iran and on the stance of accumulation of oil reserves by countries like the United States.

Certainly, the relief coming from the momentum drop at $63.75 in September 2006 should not be considered as long lasting. We know that electoral cycles have always been a driving force for the opening of the Strategic Petroleum Reserves in order to drive down prices, and the incoming mid-term elections in the United States could be one of the reasons for this temporary drop.

Q. What individual factors are likely to be significant during 2007?

A. While the United States is running a record trade deficit of almost 7% of GDP, China is running a trade surplus of a similar size: as a result, China now has one of the largest stock of international reserves in the world. The key future development for 2007 and beyond is whether these imbalances unfold evenly or unevenly.

Indeed, China's recent decision to link the yuan to a basket of currencies, rather than having a fixed peg with the US dollar, is seen as a response to increasing international pressure. What is more important, however, are the political and economic implications of the decision toward greater exchange rate flexibility which in turn should affect the competitiveness of the Chinese exports and hopefully reduce the current account imbalances with the rest of the world -- and especially with the United States.

There are dark clouds on the horizon, including a likely downturn in the US housing market and the possibility that rising inflation would lead central banks to push interest rates up.

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