Asia Pacific: Cyclical vs. Secular Deflation [Edit: The undercurrent theme for 2003]
morganstanley.com
Andy Xie (Hong Kong)
Last night the S&P 500 closed at 70.6% of current US GDP. The recent decline may appear horrific and unjustified. I believe it is merely a normalization -- giving back the extra gains that investors received during the bubble (see Free Falling, July 22, 2002). The market ended 1996 at such a relative valuation. It was a bull market then; the difference is of course that there are many more people involved in the financial industry today.
The normalization still has some distance to go, in my view, and may undershoot. I believe the next big risk to stock prices around the world is deflation. East Asia has experienced deflation for five years; Asian deflation may spread for two reasons, one cyclical and the other secular.
First, the bursting of equity bubbles around the world raises the cost of capital for businesses and decreases consumption power via a negative wealth effect. Though there are various estimates to support or refute this assertion, the hard fact is that the loss of stock market capitalization around the world has amounted to roughly two-thirds of world GDP. Its negative effect on the spending power of both business and consumers should be quite significant and last for years to come. This downward shift in global demand might be sufficient to cause cyclical deflation.
Second, East Asia has increased its competitiveness enormously in the past five years. Even though East Asia has tried near-zero interest rates and maximum fiscal deficits, it hasn't been able to solve its deflation problem with such traditional macroeconomic responses. A by-product of its deflation is its vastly improved competitiveness (see Winning the Deflation Battle, August 22, 2002). East Asia suffered declining market share in the US for seven years between 1994 and 2001, as price reductions didn't generate sufficient demand increase to offset its negative effect on value.
The tide appears to be turning. East Asia's market share in the US is stabilizing or even improving, as East Asian economies are restructuring around China to become more competitive. Better quality and lower prices are finally attracting sufficient demand increase for East Asia to maintain or even improve its market share in the US. It also means that East Asia is successfully exporting inflation.
East Asia's inability to solve its deflation internally is mainly due to surplus labor in China. China's labor pool is so massive that it would take more than a decade to absorb. China's surplus labor matters to global prices because China has invested massively in infrastructure and education. The productivity gap between China and other export-oriented East Asian economies is closing much faster than the wage gap, as China's wages reflect its excess labor supply rather than labor productivity.
This is a secular deflationary force that grows exponentially with China's increasing capability to use modern technologies. China now accounts for about one-fifth of the annual increase in global trade. When China learns to make more products, Chinese prices become global prices. For a small export economy, global prices eventually become its prices, as a small share in global production would fully employ its labor force. When China gets into a business, global demand won't be sufficient to absorb its surplus labor. Thus, the deflationary force emanating out of East Asia is no longer just the aftershock of the 1998 Asian Financial Crisis.
Deflation may become inevitable if zero interest rates and acceptable budget deficits are insufficient to increase demand against (1) a cyclical decline in demand and (2) a secular redistribution of production to lower-cost regions. After a massive bubble, this condition is more likely to be true. First, the demand curve should shift downward substantially due to higher capital cost and less wealth. While interest rates may decline to near zero, the weighted average cost of equity and debt still has increased dramatically for businesses around the world.
Second, capacity expansion during the IT bubble may exceed conventional estimates. IT has done two jobs extremely well. Distribution efficiency has made a quantum leap through improving coordination. It cuts down labor requirements in the biggest sector of a service-based economy and has far-reaching consequences for the medium-term unemployment rate. IT has also made a quantum leap in the internal workings of a modern corporation. The IT network is a substitute for middle managers, who are the backbone of a modern service-based economy as worker bees and middle class consumers.
The impact of IT on coordination is reducing the friction in globalization. Location is a less important factor in the optimal allocation of resources (see Does the Web Favor Greater Economies of Scale? March 3, 2000). The scope for cost arbitrage across national boundaries has increased substantially. This technological factor is reinforcing East Asia's success in exporting its deflation to the global economy.
Even as the IT bubble has burst, its promise for productivity increases is being realized and is undermining the post-World War II white-collar economy in established, mature economies. Its disruptive impact on labor and consumer markets could keep demand subdued for an extended period of time.
These factors may be too great for conventional fiscal and/or monetary policies to overcome. A period of deflation could become inevitable for major economies around the world. Unconventional policy (e.g., monetization of fiscal debt) may have to be adopted globally to solve deflation at some point. In a year or two, a G-7 Summit on deflation may have to be convened to coordinate anti-deflation policy and maintain the stability of major exchange rates during monetization.
Until such a summit takes place, financial markets are likely to price in a higher risk of deflation over time. This means (1) that government bonds will continue to appreciate, (2) that credits become more expensive, and (3) that returns on capital continue to trend downwards. |
