Two reasons why America must take a special interest in China
Economic slowdown and Iran relations are crucial to whoever is President
OF THE many challenges posed by China to the US, I focus today on two, and will begin with the smaller. As the frenetic US presidential election campaign entered its final stretch, there came news of a surprise 0.27% rise in interest rates. The markets took feverish note. This was a major move. No, not from the US Fed - but from the Bank of China.
China’s first change in interest rates since 1995 takes the key lending rate to 5.58%. Suddenly the oil price dropped and prices of basic metals and commodities also cooled.
Ten years ago such an announcement would have scarcely caused a ripple. Now it brings an immediate realignment of currencies and markets and intense speculation as to what it all means for Asia and the world. Yet again, China makes its presence felt. But it is not the only China challenge that the new incumbent in the White House is going to face. There is the potentially huge challenge in an emerging new China-Iran axis.
But first the economy and the outlook for the White House. The growing likelihood of a China slowdown leading a global slowdown next year has big implications for America. Whoever wins the US Presidential election on Tuesday is going to face two immediate challenges on the economic front - a soaring budget deficit and a record trade deficit without recourse to that most efficacious of treatments: higher growth.
On Friday the US dollar fell to fresh six-month lows against the yen and drifted close to recent eight-month lows against the euro on news that the American economy slowed in the third quarter. Growth eased to a lower than expected 3.7%, significantly below its 4.2% increase in the second quarter.
Also on Friday came figures showing that US consumer sentiment deteriorated in October as rising energy costs and persistent job worries made Americans less optimistic about the future. The University of Michigan said its consumer confidence index dropped to 91.7 in October, down from 94.2 in September.
Fighting off this slowdown in the economy is not going to be easy, whoever wins this week. The immediate worry for Wall Street is that no clear winner emerges on Wednesday morning, with results being challenged by armies of adversarial lawyers.
For markets, businesses and America’s reputation abroad, the worst outcome would be a repeat of the ‘hung jury’ 2000 election which resulted in a 36-day legal delay, ultimately settled in the Supreme Court. That delay and associated uncertainty cost the Dow Jones Industrial Average about 700 points.
Citigroup investment bank analyst Tobias Levkovich says: "This could undermine confidence in American democracy and cause investors to flee US markets." He reckons such an outcome could wipe between 7% and 10% from the Dow Jones.
Historically, US election outcomes have had little effect on markets. In only one of the presidential elections over the past 75 years did equity markets really shift. This was in 1948 when Harry Truman won re-election though the polls favoured Thomas Dewey. Wall Street fell 10% in the subsequent month. The most positive market move was in 1980, with a 5.8% gain in the month following Ronald Reagan’s first election to the White House.
But this winter America’s economy is at a turning point, with growing uncertainty as to what the interest rate policy now is and where the next growth story will come from. Alan Greenspan, chairman of the US Fed, has made no secret of his desire to see further rises in rates. There is a clear, incipient danger of higher inflation. But with signs the economy is already slowing, higher rates would compound the pain for business.
Given the global nature of the slowdown and the failure of Europe to act as an economic counterweight, whoever wins the White House is going to be boxed in. If George Bush wins, the existing size of the budget deficit is likely to restrain any new spending programmes. At the same time, a Kerry presidency would have to contend with a Republican House of Representatives. And it may not choose to enact Kerry’s reforms.
On tax and business regulation policy, a Kerry presidency could come to unnerve investors in three ways: stricter environmental controls hitting traditional energy stocks (and stiffer petrol efficiency rules which could hit car makers); more powers for the Food and Drug Administration which could mean more regulation for the big drugs, food and tobacco industries (the latter is also likely to face a push for new federal excise duty increases on tobacco products); and potentially more control over media ownership rights.
Kerry has pledged to roll back the Bush tax cuts on dividends for top income earners - those earning more than $200,000 (£109,000) a year - and the bulk of dividends go to individuals in this tax bracket. Already there is pressure on US companies to lift dividend pay-outs as a share of earnings (see chart). Again, it is by no means certain that the House of Representatives would go along with this. On the upside, a Kerry presidency should be good for bonds. But, at present, Wall Street is wary of buying bonds because of contingent inflation worries from dearer oil and a falling dollar.
However, a weak dollar does provide a powerful competitive edge for US exporters. The US currency has already fallen by 25% against the euro since January 2002. How much further it has to go is anyone’s guess. But dollar weakness should provide the springboard for an export-led recovery in US manufacturing in due course.
But the dominant concerns will continue to be geopolitical. How will the northern hemisphere economies cope over the winter period if oil prices do not fall back much from current levels? The price is also vulnerable to any deterioration in the security situation in the Middle East. And here the challenges of a China intervention are as big for a Kerry presidency as a Bush one.
Kerry’s aim is to build, or rebuild, an international coalition to provide longer-term security for Iraq. But the security problems are by no means confined to that country. There has been growing concern in Washington over the determination of Iran to secure nuclear weapons. Kerry would prefer a coalition approach offering trade deals that might dissuade Iran from pursuing a nuclear programme. But this could be fraught with difficulty at the United Nations.
On Friday, the Chinese state oil giant Sinopec announced it has signed a $70bn (£38bn) oilfield development and liquefied natural gas agreement with Iran. China is desperate for oil, and this is its biggest energy deal with the number-two Opec producer.
What is in it for Iran? Iran could court China’s favour on the UN Security Council, where Beijing holds a potential veto over any action against the Islamic Republic’s nuclear programme.
It doesn’t take much imagination to see how this could pose potentially huge problems in seeking to secure any US-led pressure on Iran through the UN were China to use, or threaten to use, this veto. This could be a long way off, but looking at the security implications of such a stand-off for the whole of the Middle East, this has the makings of a China challenge that could come to dwarf the economic one.
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