The Global Cycle Has Peaked
Andy Xie (Hong Kong)
This cycle of the global economy peaked in the fourth quarter of 2003, in my view, although the market seems to believe that the momentum is still upward. A minority of investors believes in the slowdown scenario but expects slow deceleration. I believe that the slowdown in GDP growth in 2004 will range between 50% in China and 30% in most other economies relative to the growth rates in the last quarter. The main reasons are: (1) Weak income growth in the US cannot sustain its stimulus-induced consumption boom; (2) the gain in trade from the migration of the electronics industry to China has peaked; and (3) the authorities in many economies (e.g., Australia, China, and the UK) are tightening to rein in asset bubbles, which would decrease the multiplier from the low US policy rate on the global economy.
China Is Slowing
During the past six weeks, I traveled around the world to see investors. My messages were (1) that the global cycle peaked in 4Q03 and (2) that China has taken actions to slow its investment growth. My conclusion was that the beta party that began in early 2002 was ending; the key portfolio decision in 2004 is to decrease beta.
My messages did not go down well at all. There is almost uniform faith in continued growth momentum in the G-7 economies. The prevailing view is that the growth cycle in the global economy has just begun and has another two good years ahead.
The counterarguments against the case for China’s slowdown included the following: (1) China doesn’t really intend to slow investment because it has to create jobs; (2) China can’t slow because local governments act on their own; (3) capital inflows could replace bank lending, even if the government did manage to slow credit growth; and (4) China has raised its growth potential, i.e., the high growth rates in the past two years have represented secular rather than cyclical increases.
The above arguments are not supported by facts, in my view. First, China needs to create jobs, but stability is more important. If China creates jobs by accumulating inventory or creating excess capacity, it would only lead to job destruction later. Second, local governments in China do make most investment decisions, but they can only do so if funds are available. The central government has changed the rules in order to decrease both supply and demand for credit. Financial institutions’ (‘FI’) loans have decelerated by three percentage points in the past three months; their growth rate should decelerate to 12% by September 2004. Third, the change in capital inflows will be too small to replace bank credit. Last year, China’s FI loans increased by US$335 billion, while its gross foreign assets increased by US$73.6 billion. The rest of the US$162 billion increase in foreign exchange reserves last year came from Chinese banks’ converting their foreign assets into renminbi. With tighter rules on credit expansion, Chinese banks have no incentive to convert the remaining US$50 billion (or US$100 billion including the recapitalization funds from the central bank) into renminbi.
Since it bottomed in 1998, China’s economy has been accelerating for five years, first with infrastructure stimulus, second with FDI and exports, and lastly with a property boom. China peaked in the fourth quarter last year as its leadership took actions to rein in investment that would cause excess capacity and deflation. China’s growth potential remains at about 8%, in my view. The limits to China’s growth potential are not imposed by labor or capital but by the efficiency of its financial sector. Until China privatizes its financial system, as it has done with its real economy, I believe China’s growth potential will remain at the current level. The high growth that we have seen in the past two years just reflects the peaking of another investment cycle. Extrapolating the trend from the past two years would cost investors dearly, in my view.
US Stimulus and Outsourcing Have Caused the Upturn
I believe the current global cycle is based on (1) monetary and fiscal stimulus in the US and (2) gains in trade from the migration of electronics industry to China. After the Nasdaq crashed in 2000, the US Fed began an easing campaign to stimulate the US economy to offset the demand shortfall from the adjustment in the tech sector. The Fed’s interest rate cuts triggered a housing boom that offset the negative wealth effect from a deflating stock market. The Bush tax cuts offered purchasing power to American consumers during a period of low wage growth.
Weak tech demand caused prices for tech products to decline, forcing manufacturers to shift production to China. China’s exports of ‘high-tech’ products tripled between 2000 and 2003 and accounted for 40% of China’s total export growth. The relocation of the electronics industry to China is responsible for most of its above-trend export growth in this cycle.
China’s overall exports rose by US$189 billion (or 0.5% of global GDP) between 2000 and 2003. The efficiency gains for the global economy could be greater than that amount, as China can more than halve production costs for manufactured goods. China uses its export income to purchase equipment and raw materials, spreading the efficiency gain to economies that specialize in these products.
Between 2000 and 2003, US GDP rose by US$1,168 billion and China’s, by US$329 billion. The ratio between the two roughly indicates the relative importance for the global economy of monetary and fiscal stimulus in the US and the gain from China trade over that period.
The Cycle Peaked
In my view, the global economic cycle has peaked because (1) US income growth is not sufficient to replace the dissipating stimulus in the US economy; (2) outsourcing to China by the global electronics industry has peaked; and (3) policy-makers in several major economies are taking actions to cool bubbles, which would decrease the multiplier effect of low US interest rates on the global economy.
As I argue above, China’s economy has slowed as a result of credit tightening. This is likely to compress the multiplier effect from low US interest rates on other emerging economies that export raw materials to China. As China’s property sector decelerates, the demand for such raw materials should cool sharply, which would slow these economies. The growth acceleration in commodity-driven emerging economies over the past two years has much to do with China’s booming property market.
In addition, when China slows, the inflow of speculative capital is also likely to decline, and China will not have to invest as much money in US Treasuries. This is quite contrary to the view that the investment slowdown will mean more capital surplus. China’s capital surplus comes mostly from speculation, and when the economy slows, speculators tend to flee.
The central banks in Australia and the UK are indicating concern about the property bubbles in their economies. These bubbles, which boost consumption, reflect the ‘multiplier effect’ of low US interest rates in their economies. As these central banks tighten, their economies will likely slow because of declining property prices.
The gains from trade in the world economy peaked last year, in my view. We estimate about one-third of the global electronics industry moved to China in the past five years. While the migration continues, the higher base decreases the incremental impact; this is why China’s FDI has weakened. China’s contribution to the increase in global trade was double the trend rate in the past two years. Until another industry begins to move to China for export production (e.g., autos), the gain from Chinese trade will normalize to trend, in my view.
The US employment numbers have been quite weak. Even if they improve in the coming months, they are unlikely to be as strong as the historical pattern would suggest. This would imply that income growth will also be relatively weak. Thus, the post-stimulus US economy is likely to weaken.
China’s Slowdown Will Affect Other Asian Economies
China’s growth momentum is the key to the continued to bull case on Asia. Its market has accounted for all of the export increase for Japan, Korea, and Taiwan since 2000 compared with 25–30% in the 1990s. China’s imports are mostly funded by credit in one way or another. When China tightens credit, import demand will also be curtailed.
However, the impact is not as big as the numbers suggest. A considerable portion of China’s imports from Japan, Korea, and Taiwan is made up of components for exports. Taiwan’s exports to China, for example, are mostly electronics components for export production, and probably half of Japan’s exports to China fall into the same category. Korea’s exports to China, on the other hand, are mostly for China’s domestic consumption.
morganstanley.com
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An excellent article by Andy Xie.
One of his better ones IMO.
Which of course means Russ will not agree. gg/ng
China is SLOWING.
On its own accord.
So will the US as stimulus wears off.
M |
