Global: Re-Sequencing
Stephen Roach (New York)
[FWIW I do not think it plays out like this. China may be first, but the US will be right on China's heels - Mish ]
A lopsided world economy continues to be dominated by two growth engines -- the American consumer on the demand side of the equation and the Chinese producer on the supply side. Both of these engines are overheated and in need of cooling off. I had long thought the American consumer would be the first to slow. But now the sequencing looks different -- with China likely to lead the way. This could keep the US growth engine in high gear for a while longer -- but at a cost that could make for an even more treacherous endgame than might have otherwise been the case.
The American consumer has long provided the major source of support to global demand. From 1997 to 2004, US private consumption growth averaged 3.9% per annum -- nearly double the 2.1% pace recorded elsewhere in the advanced world. As a result, by our reckoning, the US consumer accounted for 53% of total consumption growth in the advanced world over this eight-year period -- well in excess of America’s 38% share in the advanced world’s total GDP (as measured by the IMF’s purchasing power parity metrics). Moreover, even though the US consumption dynamic has moderated since the bursting of the equity bubble in early 2000, the global leadership role played by the American consumer did not. US consumption growth still averaged 3.2% over the post-bubble 2001-04 interval -- more than two and a half times the 1.25% average pace in the Euro area and fully four times the anemic 0.8% average pace of private consumption growth in Japan. There can be no mistaking the US-centric tilt to global consumption demand that has occurred since the late 1990s.
The problem with this leadership dynamic is that it has long rested on an American consumer who has been consuming well beyond his/her means as delineated by the income side of the US economy. This is just another way of saying that America’s consumption dynamic is, in fact, the mirror image of an anemic national saving rate and an ever-widening current-account deficit. Trends over the past eight years underscore this conclusion: The US net national saving rate has averaged only about 1.5% of GDP since early 2002 -- far short of the 6% level prevailing in 1997. At the same time, America’s current account deficit is now in excess of 6.5% of GDP -- more than double the 3% shortfall evident in 1997. Lacking in income generation and domestic saving, the US consumer dynamic has been supported by the combination of the surplus foreign saving and the debt-intensive equity extraction that has been a key outgrowth of the rapid property appreciation of America’s Asset Economy.
I have long argued that the over-extended American consumer was the weakest link in the global growth chain. In what I thought was the increasingly likely event of a US current-account adjustment -- and a falling dollar and rising real interest rates that seemed likely to accompany such an adjustment -- I stressed the mounting vulnerability of the American consumer. In my mind, it all hinged on the interest rate piece of this risk assessment. A normalization of real interest rates in the US would temper excesses in property markets and sharply curtail the asset-dependent spending excesses of the American consumer. As a result, consumers would once again have to save the old-fashioned way -- out of earned labor income. The domestic saving rate would then rise -- helping the US to wean itself from excessive reliance on surplus foreign saving. The result would be a textbook rendition of a classic current account adjustment.
The interest-rate piece of this scenario seemed to be falling into place. The Federal Reserve appeared to be on a path of interest rate normalization. Moreover, concerns on the inflation front were mounting -- driven by surging oil prices, sharp gains in other commodity prices, a falling dollar, and some evidence of mounting unit labor cost pressures. At the same time, Asian central banks were sending signals of rising dissatisfaction with massive dollar over-weights in their foreign exchange reserve portfolios. A diversification into non-dollar assets would undoubtedly require a rise in dollar-based interest rates. In short, in a rising real interest rate climate, there was good reason to believe that the asset-dependent American consumer was about to lead the charge in a long overdue global rebalancing.
That was then. No longer do I feel that the American consumer will be first to go in this adjustment process. I now believe that the Chinese producer will lead the way. A two-pronged slowdown now seems likely to unfold in China -- with internal policies aimed at a bursting of the property bubble and external forces putting pressure on China’s export dynamic (see my 23 May dispatch, “What If China Slows?”). Collectively, fixed investment and exports account for 80% of Chinese GDP, and these two sectors are currently surging ahead at a 30% y-o-y rate. With the Chinese government now serious in going after the excesses on the demand, supply, and financing sides of the coastal property bubble, the investment dynamic should slow appreciably. Moreover, sparked by Washington-led, anti-China protectionist actions, Chinese export growth should also slow -- succumbing to the pressures of trade sanctions and/or the impacts of the RMB currency revaluation long sought by the West. As a result, Chinese GDP growth, which has fluctuated in a 6-9% range over the past six years and is currently holding at the upper end of that range, could well move to the lower end over the next year.
Consequently, I now believe that the Chinese economic growth dynamic is about to come under far more immediate pressure than the American consumer. This is a very important shift in the sequencing of global rebalancing. That’s because the rising probability of an imminent China slowdown is likely to have important and constructive interest-rate implications that could keep the American consumer in the game for longer than I had previously thought.
A China slowdown is bullish for bonds for two reasons -- the first being that it will have collateral impacts elsewhere in Asia. Other Asian economies -- especially Taiwan, Korea, and Japan -- have turned into important cogs driving China’s supply chain. Pan-Asian activity -- Japan, China, plus the other economies in the region -- collectively accounts for 35% of global GDP. Barring the emergence of a new source of global growth, that means a two-percentage-point slowing in overall Asian growth -- a distinct possibility in the event of a China slowdown -- would knock 0.7 percentage point off global growth. Secondly, as China slows, the world’s biggest buyer at the margin of raw materials should also suffer collateral damage: Commodity prices, which are already declining before the China slowdown even takes hold, could move sharply lower -- tempering inflationary expectations embedded at the long end of global yield curves. In my view, these are both very bond-bullish conclusions. Like most things we buy today, even the bond market now appears to be “made in China” as well (see my 31 May essay, “Rethinking Bonds”).
Which takes us back to the American consumer. As noted above, the US current-account and consumption adjustments are critically dependent on a normalization of real interest rates. But if a China slowdown rules out a move at the long end of the yield curve, it could also pin down the Fed at the short end. The possibility of a China-led global growth scare means that the US central bank risks triggering an inversion of an already very flat yield curve if it keeps on tightening while the long end remains contained. That, in turn, would prove to be a most problematic development for levered investors, US banks, and the real economy. Despite all its bluster about policy normalization, I believe that a pro-growth, pro-market Fed will be reluctant to tighten much more if a China-led slowdown unfolds first, as I now suspect. The net result could be a surprisingly benign US interest rate climate for some time to come.
If such an outcome occurs, it would undoubtedly provide the interest-rate-, asset-dependent American consumer with yet another breath of life. While that might offer some support to the near-term US growth outlook, this would not be a constructive development over the longer haul for an unbalanced global economy. It could lead to a final blow-out in already frothy US property markets, along with a last-gasp surge of refi activity to tap such newfound wealth. Not only would that push household indebtedness to ever-higher highs, but it would undoubtedly depress income-based saving even more. The result would be a further widening of an already record current US account deficit -- setting the stage for a far more treacherous endgame. All this means that the ever-present excesses of America’s Asset economy could be seriously compounded by the seemingly bullish interest rate implications of a China slowdown. In the end, such a re-sequencing of global rebalancing is the last thing an unbalanced world needs.
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