Global Stability and the Crash to Come
Mar 07, 2005
stratfor.biz
Summary
A strongly growing U.S. economy will dominate global economic news for the next few months even as Japan and Europe stagnate -- or sink. The good times, however, cannot last. The coming break will be sharp and hard -- and of Chinese origin.
Analysis
The dominant feature of the global economy is -- and has been for some time -- continued strong growth in the United States. The United States closed out the fourth quarter with growth at 3.8 percent, racking up a 4.4 percent overall growth rate for all of 2004.
Such growth is not just "adequate" or "rapid" -- it is probably unsustainable. During the heady days of the 1990s boom, average growth was "only" 3.7 percent. What is particularly remarkable about the current American growth is not simply its pace, but its staying power.
According to the U.S. Federal Reserve, the final word in U.S. monetary policy and de facto manager of the U.S. economy, the economy continues to perform superbly. Only the Cleveland district -- consisting of Ohio, West Virginia, western Pennsylvania and eastern Kentucky, where a mix of heavy manufacturing and rising input costs have combined to create the entire expansion's sole laggard -- is not reporting strong across-the-board growth. And even there, overall reports are upbeat, just not red hot.
Across the country, consumer, manufacturing and business spending is not just rising, but accelerating. The agricultural sector is strong, and the shipping industry is humming along with both imports and exports.
The only potential threat on the horizon now is in the housing market, where the past five years' repeated record performances finally appear to be easing off. A downturn in housing could negatively affect not just home prices, but consumer spending as well. However, for housing to turn into a negative -- as opposed to just a non-record positive -- the United States would first need to suffer from several months, or perhaps even a year, of sharp contractions. At this point there is no sign of that -- even on the horizon.
The slight dip in housing -- the only real "negative" in the system -- has not yet affected any part of the broader economy appreciably. Increases in commercial construction and lending have more than compensated for dips in housing construction and lending.
If anything, Stratfor fears the United States is growing too fast. Apart from bubbles, an economy as large and diverse as the United States rarely grows so uniformly and so quickly across all regions and sectors.
But this is not a bubble. Among other things, bubbles occur when capital is being allocated irrationally -- such as during the tail end of the dot.com boom, when everyone and his grandmother seemed to be considering investing in gardenwidgets.com, or some other improbable investment. That does not seem to be the case now.
Moreover, bubbles tend to occur when inflation is high, since there is irrational demand for a wide array of materials and base products. The core Consumer Price Index -- the United States' most commonly cited measure of inflation -- for January was a whopping zero, despite the fact that labor costs are rising rapidly. If, however, this is a bubble, it is the most atypically productive and profitable bubble we have ever seen. This hypergrowth most likely cannot last for long, but it seems bizarrely locked into place for the next six months, there being no forces strong enough to dislodge it.
The situation, of course, is not nearly as bright elsewhere.
Japan spent most of 2004 proudly droning on about how its economy was doing fine, just fine, thank you, and about how it was finally emerging from its seven-year deflationary spiral -- all this despite the fact that the government had yet to implement a single meaningful policy to resolve its bad loan crisis, its state debt crisis, its local debt crisis, its corporate debt crisis, its consumer spending crisis, its deflation crisis, etc. Stratfor, recognizing the extent of Japanese wishful thinking, scoffed at these claims.
On Feb. 16, Tokyo revised down months of statistics, admitting that far from growing strongly, Japan had been in recession since April 2004. And deflation -- far from disappearing -- had become so entrenched that the central bank was considering redefining deflation to make the problem go away by administrative trickery.
In essence, the same problems that Japan has suffered since 1989 continue. Since then, the Japanese government has used deficit spending to keep the economy going and currency manipulation to cause exports to artificially surge to maintain sales and market share. These are bad policies that sustain growth at the cost of higher debt, but do nothing to fix the underlying problems of inefficient capital allocation (economist-speak for not lending to firms who actually have a clue about making money, instead opting to support firms with crony politicial connections.) In February 2004, Japan boldly -- and foolishly -- stopped both fresh deficit spending and currency interventions. As Stratfor expected, growth ground to a halt by April 2004, and the country entered its fifth recession in 15 years.
In 2005 one of two things will happen. Either the recession will drag on, or -- more likely -- Japan will go back to its bad habits in order to artificially create growth.
In Europe, the situation is not as dire, but it is hardly glorious. Even European Central Bank President Jean-Claude Trichet has noted that strong international demand helping European exports represented the brightest spot in Europe. Once again, Europe has hitched its wagon to America's star in a positively Japanese manner.
Germany and Italy are experiencing negative growth, and will most likely officially slip into recession in the first quarter of 2005. At this point the only thing likely to keep the eurozone as a whole out of recession is mediocre growth in France, but even that cannot be counted on. The three major eurozone economies -- France, Germany and Italy -- are stuffed to the gills with deficit spending.
Traditionally, deficit spending is used in a stimulus package in one big surge to kickstart broader growth in the private sector. Like Japan, the Europeans have now been engaged in middling deficit spending for so long they are incapable of using the technique to restart growth; deficit spending has instead become life support. They now need it simply to maintain their substandard growth.
Complicating matters, stimulus into their economies is about to lessen. As part of the EU's 2005 expansion, money is being redistributed from the older western to the newer eastern members. That means less money from EU structural development funds and fewer agricultural subsidies will be flowing to French, German and Italian beneficiaries. Overall eurozone growth outside the newer members is faltering, and with the funding redirection, the stage is set for overall slower growth, not faster growth.
This is likely to be doubly true in France, where the government just got its fourth finance minister in a year. Thierry Breton, the newest one in the swivel chair, is a successful businessman, among other things, and has pledged to run France like a business. While Stratfor does not expect Breton to be around long enough to achieve anything particularly noteworthy, even a middling attempt to get French government finances under control necessitates either less spending or higher taxes. Either will result in slower growth in the short term.
Against such a backdrop, Stratfor does not expect there to be much movement in the energy markets. No new major supplies will come on line in 2005, and the demand picture is rather clear. European and Japanese growth has stalled, not collapsed -- just as oil demand will stall, not collapse. Any softness those regions might produce will be tightened by demand growth in the United States and, of course, China.
The geopolitical risks of 2004 -- a year that saw major stress in oil producers as varied as Iraq, Nigeria, Russia, Saudi Arabia and Venezuela -- appear to be bleeding away. That should take some of the edge off prices, but in the absence of a demand reduction one should not expect any major shifts. There likely will be fresh volatility as Russian authorities go after Yukos' other production subsidiaries -- Samaraneftegaz and Tomskneft -- but as Riyadh becomes more confident in confronting its militants, and the Sunni insurgency in Iraq gets boxed in by the Shia and Kurds, there should be a ceiling on oil prices. That is, of course, barring an outright war between the United States and Iran, or a total shut-off of Venezuelan crude supplies.
This is the state of affairs that Stratfor expects to last for a few months: no dramatic changes in either supply or demand. The result will be that economic growth in much of the world will take its cue from one singular: the strength of the dollar.
U.S. interest rates already are the highest out of the three major economies, and the Federal Reserve has made no secret of its intention of pushing them higher still despite inflation's being in check. As the gap widens, money will flow into the United States as investors take advantage of the disparity. The result will be a rising dollar. Do not expect a quick rise, however. Many oil producers and central banks are quietly changing their dollars into other currencies because of the U.S. currency's weakness. The dollar is turning the corner, but it took these oil players more than two years to begin abandoning the dollar; their return need not be appreciably faster even if the incentive to leave begins to diminish.
The net result of a strengthening dollar will be accelerating inflation in any country that does not actively link its currency to the dollar whether with a peg or through currency manipulation. Nearly all oil contracts are denominated in dollars even if the crude is produced, transported and consumed entirely in the Eastern Hemisphere. That fact has reduced the negative effects of oil's recent march upward. As the dollar strengthens, exports from nondollar-linked economies will strengthen as well. But improved export activity will come at a crippling cost as the relative weight of oil erodes purchasing power and boosts inflation.
Rising U.S. interest rates will have one additional notable effect. China's development model, like those of much of Asia before it, depends on maintaining cash flow. So long as credit is cheap, debts can be rolled over and profitability does not matter. However, the Chinese economy has become overdependent on international capital markets during the past year, with most of corporate China's new debt being short-term in nature.
Such debt is extremely vulnerable to interest rate hikes. As rates rise, that debt will become impossible to maintain, and China will face the beginnings of a financial crisis. Given the makeup of the Chinese financial system, such a development is unavoidable. The only questions regarding the crisis to come are time frame and severity.
Such a crisis will dramatically affect demand for oil. Current oil consumption in China is at about 6.5 million barrels per day (bpd) to 7 million bpd of crude, half of which is imported. However, that oil is almost exclusively used by the country's industrial sector -- whereas coal is used to produce nearly all of the country's electricity. An economic collapse triggered by problems in the country's industrial sector would hit oil demand disproportionately hard.
How fast and far China will fall is an open question. But one thing is certain: China is huge, and when it falls, it will not fall alone. The result of even a mild recession could knock 1 million bpd of consumption off the top in just China, and a deep grinding collapse could possibly eliminate Chinese imports altogether. Such a development would dramatically diminish international crude oil prices. In 1997, the Asian financial crisis knocked out 6 million bpd of demand; prices fell by nearly three-quarters as a result.
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