Comments by Stephen Roach on Europe and the Chinese USD peg...
Global: Euro-Angst
morganstanley.com
Stephen Roach (from Cap d'Antibes)
It’s been an extraordinary time to be in Europe these past two weeks. After visiting 12 cities in 9 working days, my European straw poll speaks of nothing but angst over the pitfalls of a dysfunctional global economy. Europeans freely admit that their economic model is in serious trouble -- that their economy has all but abdicated its role as an engine of global growth. Nor do they see any real possibility of an overhaul at any point in the foreseeable future. But Europe also feels it is getting blamed for more than its fair share of the world’s problems. Everywhere I go I hear complaints that two other culprits are being let off the hook -- America, for its worrisome twin deficits, and China, for its “unfair” currency peg and. Resentments are building in Europe that may even make it even harder for the world to pull together and come up with a collective fix.
There is no getting around the sad state of the European economy. The data flow from the big continental economies -- Germany, France, and Italy -- point to the emergence of recession-like conditions this spring. Moreover, this downside tilt predates the impacts of the strengthening euro, which will undoubtedly crimp export growth. For a region lacking in internal demand, that could well be the coup de grace. Germany is clearly the weakest link in the chain, yet Europe’s policies are ill-equipped to deal with this serious asymmetrical shock. Although the ECB has now slashed its policy rate to 2.0%, Germany’s 0.8% core inflation rate implies that real short-term rates in Euroland’s biggest economy are still a positive 1.2%. By contrast, with core inflation an estimated 2.4% elsewhere in Euroland, that means real short rates are a negative 0.4% in the non-German portion of the region. That underscores the ultimate inconsistency of Euroland’s monetary policy: Policy is most restrictive in the country that is most vulnerable (Germany) and most stimulative in nations that are in the best relative shape. Such are the pitfalls of an increasingly dysfunctional United States of Europe.
Nor are there any real effective offsets from elsewhere in the region -- even the small countries are hurting. That’s especially the case in Switzerland, most likely the next victim of spreading deflationary pressures. The Swiss CPI, which is now declining on a sequential monthly basis, has slowed to a mere 0.4% on a year-over-year basis. At the same time, the economy has sagged back into recession -- with real GDP down sequentially in both of the past two quarters and off -0.6% in the year ending 1Q03. Meanwhile, short-term nominal interest rates are nearing the zero-boundary, and there has been a sharp devaluation of the Swiss franc. But with the rest of Europe in trouble, an extremely open Swiss economy has nowhere to hide. One of the wisest Swiss investors I know exclaimed, “There’s nothing left we can do to help ourselves.” The mood has even soured in Ireland, perhaps Europe’s greatest success story of the past decade. The Irish economy is still holding its own in an otherwise shaky European economy -- our 2003 estimate is for 3.0% GDP growth. But the sentiment in Dublin is now one of concern. As a senior Irish official put it to me, “We’ve gotten soft -- the good years are starting to go to our heads.”
All this underscores the growing sense of resignation that is now in the air in Europe. Sentiment is widespread that the promises of EMU are starting to ring hollow. A politically hamstrung Europe has failed to do the heavy lifting on structural reform that is required to unshackle domestic demand. Instead, the European growth model has relied on an undervalued currency to provide support to external demand. But now that the dollar has started to weaken, that currency prop is vanishing -- all but eliminating Euroland’s last leg of support. And one-size policies are ill-equipped to respond. That’s not only true of monetary policy, as noted above, but it’s also true of fiscal policy constraints as dictated by the Stability and Growth Pact. Little wonder the mood in Europe is so downtrodden these days.
But many of the Europeans I have met with were also quick to voice a growing concern over conditions elsewhere in the world. There was a palpable sense of urgency over America’s twin deficits -- a record current-account gap in conjunction with a rapidly deteriorating fiscal balance. As one of Europe’s wisest put it to me, “You have a lot of nerve piling a massive fiscal stimulus on top of an even more massive current-account deficit. You’re asking too much of the rest of the world to underwrite these growing deficits.” The concern in Europe is that America’s profligacy has now crossed the threshold from being an engine of global growth to a source of mounting global instability. Europeans accept their role as laggards in the global economy but worry that America is now making matters worse.
There is a minority view in Europe that wants to believe that it’s both possible and desirable to keep the magic of a US-centric world alive. A weakened Europe could certainly benefit from another shot of the American growth elixir. And why shouldn’t the world be more than willing to finance it? After all, given perceptions of the superior relative returns of dollar-denominated assets, America is thought to have little difficulty in attracting the capital it needs to fund its external imbalance. The problem, as I put it in response, is that a saving-short US economy is now asking the rest of the world to divert an increasingly larger portion of its surplus saving to fund America’s ever-rising twin deficits. In other words, if a non-US global investor currently has 60% of his/her assets in dollar-denominated assets, America is saying that’s no longer enough -- we want you to increase your overweight to at least 70%. When I put it that way, even the bulls flinch. “There’s no way I would do that,” said one, “without being compensated for taking the added risk.” Those are code words for demanding price concessions on bonds and/or stocks. Even in a US-centric world, there’s a saturation point for foreign willingness to hold ever larger amounts of dollar-denominated assets without receiving some compensation for the added risk that entails. That’s what current-account pressures are all about.
China came up at literally every stop in this two-week tour of Europe. As I noted in my travels to Japan last year, it’s not uncommon for weakened economies to point the finger somewhere else. China has now emerged as the leading scapegoat in this dysfunctional world. By pegging its currency to an increasingly weaker US dollar, most believe that China is now getting an unfair competitive assist. If it would only revalue the renminbi, goes the argument, the rest of the world would then have more of a chance. China’s competitive prowess, I respond, has little to do with currency. China competes mainly on the basis of labor costs, technology, infrastructure, human capital, and its passion and commitment to reform. An opening of its capital account and floating of the RMB will occur only when China has made more progress on the road to financial sector reform. Just as China has to learn to live with the rest of the world, the world has to learn to live with China. As I see it, by focusing on a scapegoat such as China, Europe and Japan are both showing signs of how desperate their own economies really are.
The angst of Europe is deepening. EMU has not delivered the structural reforms that were necessary to enable the region to stand on its own. And the currency realignment of an unbalanced world is calling Euroland’s externally focused growth strategy into serious question. A German-centric asymmetrical shock underscores the region’s rising deflationary perils. Maybe these are precisely the pressures that Europe needs to finally get its act together. Unfortunately, two weeks and 12 cities later, I see little reason to be encouraged that such a breakthrough may be at hand. |
