Morgan Stanley's Stephen Roach on the deflation emanating from Asia...
Global: Deflationary Tremors
morganstanley.com
Stephen Roach (New York)
Deflationary forces are intensifying in the global economy. That’s especially the case in Asia, a region that accounts for about 30% of world GDP. And it could also be the case for the rest of the world. Yet financial markets are leaning the other way. With hopes of economic recovery in the air, the fear of inflation is starting to creep back into asset prices. Have the markets got it right or wrong?
Deflationary trends have now taken a decided turn for the worst in China. In January, the Chinese CPI fell 1% below its year-earlier level, a third consecutive monthly decline. The January drop was well in excess of the average declines of 0.3% recorded in the final two months of 2001. In fact, it was the largest monthly price decline since December 1999. This represents a worrisome about-face for China. After approximately 18 months of deflation in the immediate aftermath of the Asian crisis, the pendulum had swung back in the direction of modest inflation; the Chinese CPI rose 0.4% in 2000 and 0.7% in 2001. But now in the face of a synchronous global recession, deflationary forces have one again taken the upper hand -- underscoring significant downside risks to our forecast of a 1.5% Chinese inflation rate in 2002. In response, the Chinese central bank -- the People’s Bank of China (PBOC) -- has just cut official interest rates for the first time in 2 1/2 years. One-year lending rates were lowered by about 50 bp to 5.3% (from 5.85%). At the same time, the PBOC also trimmed one-year deposit rates by about 25 bp to 2.0% -- hoping to lower the incentive for saving and thereby stimulate domestic consumption.
Nor is China, Asia’s second largest economy, alone in facing the perils of deflation. Japan, the region’s largest economy, has, of course, been grappling with this problem off and on since the mid-1990s. Our current forecast calls for the Japanese CPI to fall by 1.1% in 2002, the sharpest of four back-to-back yearly declines in the aggregate price level. At the same time, Hong Kong is in its third consecutive year of outright deflation -- with no end in sight. The Hong Kong CPI fell 1.6% in the year ending December 2001, actually an improvement from the nearly 4% average rates of deflation in 1999 and 2000. Singapore has also been hit with a whiff of deflation, with its CPI down 0.6% in December 2001 following a 0.2% drop in November. And Taiwan has been hit with the same affliction, with its CPI plunging 1.7% in January 2002, the same as the drop in December 2001. Our baseline scenario calls for CPI-based inflation in non-Japan Asia to hold at 2.2% in 2002, down only fractionally from an estimated 2.3% increase in 2001. However, in Hong Kong, Taiwan, and Singapore, the latest trends on the price front were tracking well below our forecasts for 2002 -- underscoring the downside risks to our Asian and global inflation prognosis.
It remains to be seen whether the rest of the world catches the Asian disease. It could turn out to be a surprisingly close call. The reason: Recessions are inherently deflationary events -- they open up a large gap between aggregate supply and demand that sharply reduces pricing leverage. Moreover, cyclical deflationary pressures typically persist well into the first year of economic recovery. That means that even economies such as the US or Europe, where deflation has been avoided so far, can hardly afford to breathe a sigh of relief if, in fact, recovery is under way.
The experience of the United States is particularly noteworthy in that regard. Over the long sweep of post-World War II business cycles, the GDP-based inflation rate is typically 1.5 percentage points lower at the end of the first year of recovery than it was in the year preceding the recession. That underscores the risks for today’s US economy, where the pre-recession inflation rate averaged 2.3%. If, in fact, the current inflation cycle conforms to those of the past, a subtraction of 1.5 percentage points would take the overall inflation rate down to 0.8% by early 2003. While that stops short of outright deflation, it is dangerously close, nonetheless. And such an outcome would also undercut our baseline forecast of 1.0% GDP-based inflation for early 2003. Interestingly enough, we see less of a deflationary risk in Europe than in the United States. Our baseline forecast calls for a 1.4% inflation rate in Europe in 2002, 0.3 percentage point above our 1.1% forecast for the US. But it could well end up being a close call on the deflationary watch for Europe, as well.
Such an outcome underscores the unique strain of deflationary risks bearing down on today’s global economy. Unlike recessions of the past, the world entered this downturn with an exceedingly low inflation rate. And cyclical forces will undoubtedly work as they always do -- pushing the pre-recession inflation rate even lower. But the perils of deflation are not just cyclical in nature. They are also driven by powerful secular forces at work in Asia -- first Japan and now China. Courtesy of globalization, the world at large is hardly immune from the Asian disease. Moreover, to the extent that Chinese economic development holds at its current breakneck pace, the global price level will continue to gravitate toward its lowest common denominator -- an economy with a cost structure that is far below that of the industrial world.
Our baseline forecast calls for muted inflationary pressures over the 2002-03 period -- average CPI-based increases of 1.3% for the industrial world and 2.4% for the world economy at large. Yet everywhere I look, the inflation statistics are coming in well below our own forecasts. In my view, that underscores the risks of a world that is still more deflation-prone than inflation-prone. Needless to say, a double-dip in the United States -- or even a swoosh-like anemic recovery -- would only exacerbate those risks. To the extent that financial markets are leaning the other way, yet another rude awakening may well be in the offing. |
