Great article by Andy Xie on US-China & Asia growth, and new economic structure
Asia Pacific: The Dollar Block Shines
Andy Xie (Hong Kong)
A Liquidity Rally?
Last week, I visited Europe and US-based investors who follow Asian markets. The investor sentiment had clearly shifted from what I had sensed during my last visit three months ago. There were few unqualified bears. Half of the investors that I met with thought that we were seeing a major bear market rally, while the other half thought that a new bull market had begun. Both camps believed that equity markets would go significantly higher by year-end. Most expected a summer consolidation and were prepared to buy into any significant dip.
Most investors recognized the current rally to be liquidity-driven -- an increase in risk appetite had encouraged investors to reduce cash in their portfolios. Fundamentals would have to improve for markets to move higher. Investors with global portfolios were particularly interested in which region would perform above expectation.
The big idea for performance differentiation was currency. Investors believed that a weak dollar would lead to improved economic performance for the dollar block -- China and the US. They held the opposite view during the prior bull market. This is consistent with the current market view that deflation poses a significant risk to the global economy. The economy and currency are negatively correlated during times of deflation and positively correlated during periods of inflation.
Structural Factors to Sustain Dollar Block
I concurred with the views that (1) massive stimulus in the US would trigger a rebound in the global economy and (2) the US and China axis would account for most of the growth in the global economy. I share the view that a weak dollar would contribute to the outperformance of the dollar block. However, I believe that structural factors are playing far more important roles than exchange rates at sustaining the superior economic performance of the dollar block.
1. Exchange rates. The euro-dollar rate has rallied by 10% from the beginning of 2003 and by 20% from the average value in 2002. The strong euro has curtailed the benefits of any US recovery to Europe. The euro zone grew its exports by 18% in dollar terms between 1997 and 2002, while Japan and the US did not grow their exports at all. The euro zone was essentially competing against East Asia ex-Japan for market share through competitive devaluation. The euro revaluation, however, has taken the euro zone out of competition for market share.
Japan’s exports have stagnated since 1994. The US recovery may increase Asian demand for Japan’s capital goods. It would not, however, compete against other Asian economies for export market share. Japan gave up on the market share game when it did not devalue its currency during the Asian Financial Crisis.
2. Europe outsourcing. In addition to exchange rates, two structural factors are helping the dollar block. First, Europe is moving toward outsourcing. Relocation of production capacity from Europe to China has been massive in the past few years. Both pull and push factors are at play. China’s improvements in infrastructure and human capital, its growing domestic market and availability of cheap local financing have been major pull factors. Disillusionment with the pace of structural reform and stagnant local markets at home have been the push factors. In this regard, Europe’s corporate sector is following Japan’s for similar reasons.
China is attracting growth from Europe and Japan, which is helping the US indirectly. The US policy makers should think hard about this. China is the most important force in sustaining US living standard today, in my view. The renminbi peg to the dollar guarantees the US financial stability, even as its balance sheet deteriorates. If one only looks at the bilateral trade balance, it would create a highly distorted picture.
Europe and Japan would certainly experience stagnation in this new world. However, both are experiencing population decline. Their focus is quality of life rather than growth. Their pensioner populations are growing rapidly, requiring cheap imports to sustain living standards. The distribution of growth in the world today is far more logical than what most policy makers believe. Growth is not and should not be the game for Europe and Japan.
3. Spreading China industrialization. Second, China’s industrialization is spreading. Geographically, the Yangtze River delta has come of age. Its contribution to China’s export growth has increased from 27% between 1993 and 1998 to 41% since. Its total exports should exceed Pearl River delta’s exports for the first time this year. This region has a population of about 137 million, about double that of the Pearl River delta.
Domestic private enterprises are prominent in the Yangtze River delta’s development. China’s exports were dominated by enterprises that migrated into China from Hong Kong and Taiwan and, later, by multinational corporations. Chinese private enterprises are joining the picture for the first time. Their exports have more than doubled this year. I believe that this is the most important development in China’s competitiveness. This force would eventually broaden China’s exports to most products in the global economy, in my view.
China-US Axis and Dollar Standard
China’s competitiveness does not result from its currency. Rather, it is due to a combination of rapid productivity growth and massive surplus labor. The latter turns the former into a permanent relative price change. For example, when China reduces the production of motorcycles by 50%, it would lead to a permanent reduction in motor cycle prices relative to, say, oil.
China’s productivity increase represents a permanent relative price change between labor and scarce resources. I believe that this point is widely misunderstood. When one company can make motorcycles in China, thousands would follow. Thus, the value of a motorcycle relative to oil would shift from Japan’s labor cost to China’s. Exchange rate adjustments would not be able to push back this force. As China learns to make more products, it will eventually devalue labor relative to scarce resources in general. This is not an exchange rate issue. If China appreciates its currency, it would lead to reduction in nominal wages, which are determined by global demand for Chinese exports.
The China-US axis is not just due to China pegging its currency to the dollar. It is due to (1) China determining marginal production costs and (2) the US determining selling prices due to its large and open market. The renminbi peg links production cost to selling price. It makes perfect sense. If China floats its currency, the renminbi would still track the dollar, in my view.
The China-US axis causes the Fed monetary stimulus to stay within the dollar block. Commercial banks have cut back cross-border lending. Money now flows around the world via FDI and trade. Because China accounts for most of the marginal increase in global trade and FDI, when the Fed increases money supply, it flows to China and quickly comes back into the US treasury market.
Because the China-US axis is determining both production cost and selling price, the rest of the world is also under pressure to peg its currencies to the dollar. Otherwise, no one would want to accumulate capital in its markets -- the risk would just be too high. When the ECB starts to manipulate the euro-dollar rate, I believe the world will finally complete its transition toward the dollar standard.
The hole in the dollar standard is the US’s vast current-account deficit. The level that the rest of the world pegs to the dollar may experience sudden changes from time to time to address this imbalance. The dollar standard, however, should survive for a long time to come, in my view.
Dollar Block to Outperform in Next Two Quarters
Europe and Japan will underperform in the current global recovery, in my view. They are too removed from the stimulus epicenter. Stock markets have rallied around the world due to an increase in risk appetite. Differentiation in economic growth rates would lead to differentiation in stock market performance in the next two quarters. This is why the dollar-block markets would do better in the coming two quarters, in my view.
Chinese stocks listed in Hong Kong represent the most leveraged play on the Fed stimulus. IT stocks have played this role before, as the Fed stimulus mainly inflated IT demand. Property stocks played this role prior to the tech bubble, when cross-border lending was a major force in global capital flows.
Other East Asia economies should benefit from the Fed stimulus via China. The corporate sectors in Hong Kong and Taiwan, for example, are mostly engaged in China, and their markets would benefit from the earnings linkages. Their economies, however, do not benefit much from the Fed stimulus.
Korea’s corporate sector has been successful in selling cars and mobile phones to Chinese consumers at healthy profit margins. Its stock market benefits from the Fed stimulus through its corporate revenue linkages to China, while its economy also benefits, as its corporate profits are still generated using local labor sources.
The natural resource-based economies are closest to the Fed stimulus outside of the China-US axis. China is about increasing employment, which leads to increasing demand for natural resources. Natural resource prices should thus increase when the Fed cuts interest rates.
Conclusion
The China-US axis is redefining how the Fed policy affects global economy and who benefits from it. In my view, financial investors should benefit by following this dominant force in the global economy today. |
