I agree with everything in this article.
And could never state it anywhere near as well as
this author.
What is not brought out is the decline in growth
a slowdown in the USA economy would have on the
rest of the world - Europe, Middle East and these
areas would also hit the Chinese economy in a negative
way.
Asia/Pacific: The Decoupling Myth
Andy Xie (Hong Kong)
Summary and conclusions
Asia is unlikely to decouple from the US when its slowdown occurs. The direct effect of an export slowdown would be significant. More importantly, Asia’s real interest rate would rise on a declining trade surplus against the US, which would slow the region’s domestic demand.
The decoupling assumption is already driving the market. It remains an untested thesis. US imports from Asia remain at a similar level to the past year, i.e., the US slowdown has not happened. When the slowdown does arrive, as I believe it will eventually, the assumption could be proven wrong.
One notable exception is China’s fixed investment. China’s low loan/deposit ratio is allowing its investment boom to last one year longer than its export boom. The lag is due to the cushion effect of the stored excess liquidity, not fundamental decoupling.
Markets rally on false assumptions
The market rally in the past month is predicated on (1) the Fed’s rate tightening cycle being over and (2) Asia decoupling from a US slowdown. Neither assumption is correct, in my view. As we have argued before (see Enough Tightening, August 8, 2006), a US slowdown, when it occurs, may not be sufficient to bring down inflation. Asia dragged down inflation in the US 10 years ago despite its strong economy. As Asia turns to inflation from deflation, US inflation could remain high despite its weak economy.
Further, the US slowdown is still an assumption. Asia’s exports remain strong (see Exports Are Still Strong, August 11, 2006). I believe that the US will slow down eventually on housing weakness. Timing is uncertain. And considering its high capacity utilization level, a mere slowdown may not even bring down its inflation in a conventional sense aside from the external factors.
Asia decoupling from the US is another assumption that drives the market rally. This is an incorrect assumption, in my view. First, US imports from Asia ex-Japan were 9.8% of its GDP in 2005. A substantial slowdown of this GDP component would certainly cause considerable slowdown in the region.
Second, as exports to the US support other emerging markets, Europe and Japan, their demand for Asian exports would surely slow when they export less to the US.
Third, the US’s trade deficit with Asia ex-Japan was 5.4% of its GDP in 2005. The excess liquidity from the trade surpluses is the most important reason for the region’s low real interest rate (see Enough Tightening). The low real interest rate is the key reason for strong investment in China and strong consumption in India — the two meaningful local demand drivers in the region.
When the US economy slows down, I believe that Asia’s trade surpluses will surely decline. The main consequence is to raise real interest rates in the region, which would cool domestic demand. This effect could be bigger than the direct effect of export slowdown. In particular, investment in China and consumption in India would slow down.
USconsumption drives global liquidity
While the Fed is the main supplier of global liquidity, it works through the US consumption that causes the US current account deficit. This liquidity effect is probably greater than the direct demand effect from US import growth.
Global trade works on the dollar standard. Emerging economies are far more dependent on trade than developed economies. Their monetary conditions are very sensitive to dollar supply. When the US current account deficit is large, dollar supply in emerging economies is plentiful and their real interest rates tend to stay low. The low real interest rates spark domestic demand booms.
Financial markets know well the income linkage between exports and domestic demand. When exports weaken, domestic demand would weaken through less production for exports. Asia is particularly vulnerable in that regard as exports are large relative to their economies.
The underappreciated linkage between the US consumption and Asia’s real interest rate poses a particular challenge to the decoupling hypothesis. Asian domestic demand has not proven its sustainability in a normal interest rate environment. As in the past, the current boom depends on low real interest rates. When the US current account deficit declines, as I expect, it will be very difficult for the region to maintain low real interest rates.
Decoupling requires reforms
Asia is capable of decoupling from the US. The region has high productivity and a low income base. In particular, China possesses the size and uniformity to build a growth model on domestic demand. However, I believe that many painful reforms must occur first before the region can grow on its own demand.
Such reforms would occur only when the US economy is down for good. The US downturn needs to be severe enough to convince the region’s governments that they cannot wait for a US recovery to revive the region. Hence, when the US downturn occurs, the region’s likely response is to hunker down and wait for the US to come back. When the US stays down, the reforms may occur. Hence, Asia decoupling from the US is a long-term prospect, in my view.
The necessary reforms include a social safety net, income distribution and financial flexibility. First, Asia lacks a social safety net necessary for a consumption-led economy. The Great Depression prompted the West to establish a social safety net to support demand, in my view, which has been maintained despite its efficiency cost.
Second, income distribution is too skewed for mass consumption to lead the economy. Asia’s income policy is Darwinian, in my view. Income is disproportionately concentrated among a minority that controls scarce resources. In many case, such scarce resources are government-granted privileges. Hence, Asian politics promote income concentration.
Income concentration is not good for mass concentration. The small minority that has money to spend can only consume so much. Luxury consumption in Asia is already buoyant. For example, expensive French bags are mostly sold in Asia, even though the region’s share in the global GDP is 10% ex-Japan.
Third, financial flexibility in the region is still insufficient to price excess capital for consumption quick enough. Capital markets in the region are underdeveloped. Family controlled or state-owned banks dominate the region’s financial system. Asia needs a revolution in capital market development for autonomous growth to take hold.
The reason that Asia does not have the necessary machinery for autonomous growth is that the Fed’s pro-growth policy solves Asia’s growth problem. Such an approach has done well. The ratio of the region’s GDP to the US’s has increased to an estimated 44% in 2006 from 22% in 1986.
The Asian Financial Crisis nearly destroyed the region’s growth model. Its temporary strategy was to devalue to become smaller. The ratio of its GDP to the US’s dropped from 37.4% in 1996 to 30.2% in 1998. As the Fed went on a liquidity binge to stimulate the US economy, Asia’s strategy began to work. Ten years after the Asian Financial Crisis, it is pretty much business as usual.
The end game
The structural dynamics between the US and Asia may shed light on how the current cycle ends and how the decoupling will happen. Inflation in the US is the only logical ending to the current cycle, in my view. Americans are optimistic and, if interest rates come down, will likely borrow to spend. The housing downturn just means that the interest rate level for Americans to borrow and spend needs to be lower. If inflation were low, the US economy would always grow. If the US keeps growing, Asia would also.
Asia’s inflation rate has risen to about 3% now from zero five years ago. If the US does not slow down, the trend is still up, as Asia is not interested in tightening, in my view (see Enough Tightening). As Asia’s deflationary pressure brought down US inflation despite its robust economy in the past, the rising trend of Asian inflation should also push up US inflation. This is why the Fed’s bet that US inflation will come down is wrong, I believe.
In the longer term, decoupling will happen when the US has a prolonged recession, in my view. It will happen one day. The yin-yang relationship between Asia and the US that supports global growth is not sustainable. But Asia will not make the first move to change the model, in my view.
As Asia becomes larger relative to the US, the Fed has to stimulate harder to create the same amount of the growth. It implies more and more debt in the US economy. Either hyperinflation or debt deflation would happen. As I have argued before, if the US inflates away its debts, it would cease to be a superpower.
We cannot predict whether the current growth model will end in two or ten years. What we can count on, in my view, is that the US has an inflation problem, and it will not come down without a growth slowdown in both the US and Asia, i.e., not decoupling. Inflation will surprise on the upside or growth on the downside (or both) in the coming months. My money is on the first option.
morganstanley.com
originally posted by MISH here:
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