When we last met in London in October, I had talked about medium and long-term issues related to globalisation and possible enduring imbalances in the medium- and long-term. I had talked in particular about the consequences of economic demographics and ageing. So I am delighted that this is now a specific subject for discussion in this meeting. Today, I will focus on possible short-term issues that may arise as the current economic imbalances are corrected. Recent data show that the global recovery has gained further momentum with various leading indicators showing a robust turnaround. Financial markets have rallied on the back of higher corporate earnings.

Emerging markets debt spreads continue to decline. The latest available data suggest a strong acceleration in world merchandise exports. Emerging Asia continues to be the fastest growing region in the world. While China is expected to grow by over 9 per cent, India is not far behind with its growth expected to be around 8 per cent in 2003-04. Economic activity in Japan has also picked up, led by exports and business investment. Japan has benefited significantly from expansion in world trade, particularly that with China. In the US, economic activity has turned quite robust. It is significant to note that in both US and Japan there are distinct signs of acceleration in manufacturing activity. In the Euro area, there is also some evidence that activity has begun to pick-up although it is lagging behind significantly in comparison with other regions. On the whole, the sentiment today appears to be much better than it was a year ago when the outlook for the global economy was weighed down by various uncertainties and risks.

Although overall global growth prospects have improved markedly, considerable uncertainties still remain. The main risk facing the global economy today continues to be the persistence of the US external imbalances which, in turn, are reflected in external imbalances in several countries in Asia. The current account deficit in the US at 5.1 per cent of GDP could pose a serious risk to global growth. This, if not corrected in an orderly manner, could seriously harm the health of the global economy. There are different views on this. Most recently, Alan Greenspan, in a lecture at the Bundesbank, expressed the view that economic flexibility in the world is now such that unwinding of this deficit will not cause serious disruption. I hope that he is right.

The very significant adjustment in the US dollar exchange rate does not seem to have translated into changes in import prices (excluding fuel), which rose by only about 1.4 per cent in 2003 in the US. Prices of imported non-auto consumer goods rose by only 0.4 per cent. It is then not surprising that there has been little palpable behavioural response in the US to the recent exchange rate adjustment through a lower demand for imports. The general expectation still seems to be that a sliding US dollar will not cause inflation to surge. Similarly, in Europe, currency movements appear to have less impact on inflation than in the past. There are different explanations being given. One is related to globalisation and "Walmartisation". The increased intensity of globalisation and the commodification of many goods have perhaps reduced the pricing power of producers, particularly of low technology goods in developing countries, whereas the pricing power of large retailers like Walmart has risen.

The question that arises then is if the new globalised economy means that exchange rate adjustments as a means of correction of imbalances have become less potent, then the swing in exchange rates to correct emerging imbalances will have to be much larger than before, bringing in their wake greater instability eventually.

According to various commentators, such as The Economist, Business Week, large investment banks and others, the US dollar-Euro rate will have to depreciate to levels such as 1.7 to 1.9 for appropriate external current account adjustments to take place. If such movements take place, and inflation eventually does rise along with interest rates, what will then happen to the world economy? How quickly will this take place? Will this now start happening over the next 12 months and if so will the current world recovery stop in its tracks before it takes off?

Thus, we need to be vigilant of the new risks that would be generated in the process of correction of current macro economic imbalances. To minimise the harmful effects, there is a need for a coordinated and cooperative approach. The current account deficit in the US is, to a large extent, a manifestation of its large saving-investment gap which widened to a high level of 5.3 per cent in 2003. The US, therefore, will have to try to curb household and government borrowings and strengthen national savings. The Euro Area continues to depend largely on external demand. It, therefore, will need to pursue some structural reforms, especially in the labour policies, to boost domestic demand. Japan also needs to continue to take some concrete measures to strengthen its financial system and reduce huge fiscal imbalances. We in India have followed a relatively flexible exchange rate policy to ensure smooth adjustment along with corrections in the world economy. Such flexibility has served us well and we can commend it to other countries.

The world leadership also needs to take appropriate steps to guard against the prospective risks. There are two areas that are particularly important at present and where G-20 leadership can play an important role. One relates to developments on the trade front. Current trends from Cancun onwards are deeply disturbing with industrialised countries slipping into a protectionist posture. This is uncalled for especially because developing countries have at last started to get out of their protectionist mindsets. The industrialised countries (US, Europe and Japan) have a major role to play in reviving the trade talks which involve serious departures from their present positions on agriculture.

Another area relates to international financial architecture, the deficiencies of which were exposed in recent East Asian and subsequent crises. We, therefore, need to ask ourselves whether we have really made progress in developing a sound international financial architecture. In particular, we need to ask whether the access limits are sufficient to deal with the kind of crises countries will face. Or are we assuming that the catalytic role of the international financial institutions is more effective than it really is? The recent experience has amply shown that while large and assured financing (e.g., Mexican bailout) has been successful to keep the markets quiet, limited financing (e.g., Argentina) has not produced good results. It is this ground reality which has led to excessive caution on the part of developing countries in building large reserves.

It is difficult to predict what kind of crises will take place in the near or medium term future. What we know with near certainty is that crises will take place in the future too. Where, how and when they will take place cannot be predicted. As I have indicated, as these exchange rate adjustments in the world’s major currencies take place, and inflation and interest rates do rise, they will bring in their wake economic debris in different places. We need to be vigilant on this point and recognise that the magnitude of financing needs that typically arises now is much larger than before. The question I will leave you with is: whether the existing financial architecture is competent for tackling such future crises and, if not, what do we need to do?