Global: First to Go?
Stephen Roach (from Cap d'Antibes)
I continue to see the world economy as a two-engine story — the Chinese producer on the supply side and the American consumer on the demand side. While there are signs that growth is now picking up elsewhere in the global economy, I maintain my view that most of these spillover effects are traceable either to the US or China. With both of the world’s growth engines having gone to excess, a downshift in global momentum is a distinct possibility — especially in light of recent (China) and prospective (America) policy actions. Who will be the first to go?
China gets my vote. Unlike America’s Federal Reserve, which at this point is still all talk, the Chinese authorities have moved forcefully to rein in an overheated economy. The monetary tightening campaign of the People’s Bank of China began in earnest in late August 2003, with an adjustment in reserve requirements. Since then, the PBOC has made two additional modifications to banking system reserve ratios — one in March and another in April. More recently, the State Council — the functional equivalent of the Cabinet in the Chinese government — has entered the fray with a series of administrative actions: First, in late April, capital requirements were imposed on investment activity in several overheated industries — steel, aluminum, cement, and real estate; then came a temporary moratorium on all bank lending; those actions were subsequently followed in early May by targeted price controls at the provincial and local levels of jurisdiction.
This flurry of activity speaks of a two-pronged campaign of policy restraint in China: The central bank is relying on traditional instruments of macro stabilization policy (i.e., reserve requirements), whereas the central government is implementing a series of micro measures targeted at those sectors that have overheated the most. This blended strategy is very much in keeping with the mixed character of the Chinese economy — a combination of state-owned enterprises, newly privatized entities, and an increasing number of homegrown private companies. This approach is also tailor-made for a highly fragmented Chinese economy. Beijing can only do so much at the top — provincial and local officials still have great autonomy to march to their own beat. That’s especially the case for the banking system, where local branches gather their own deposits and build their own loan books.
By operating in both the macro and the micro realms of policy restraint, the Chinese authorities are addressing the inherent tensions between the top (i.e., Beijing) and the bottom (i.e., municipalities) of this vast economy. I heard it directly from Premier Wen last March, when at the China Development Forum he expressed a very strong determination to slow an overheated Chinese economy (see my 24 March dispatch, “China — Determined to Slow”). The actions that have since followed demonstrate the conviction of that determination. And I remain confident that they will work. We continue to have an active debate over the character of the coming slowdown in China. I remain in the soft-landing camp and Andy Xie is more worried about a hard landing. But rest assured, there will be a landing in one form or another — and sooner rather than later. For the major force on the supply side of the global economy, the coming landing in China represents a serious about-face.
I wish I could speak with equal confidence about the prognosis for the American consumer. I continue to believe that US consumption demand will turn out to be the weakest link in America’s macro chain as the Fed now embarks on its long-awaited campaign of policy normalization. The problem with this call is that it sounds like a broken record — I have been bemoaning the vulnerability of the American consumer ever since the equity bubble popped over four years ago. That’s not to say there wasn’t a meaningful post-bubble shakeout for the American consumer; after all, real consumption growth slowed to a 2.8% annual rate in the three years following the bursting of the equity bubble — more than 35% slower than the five-year growth rate of 4.4% that occurred while the bubble was expanding over the 1996 to 2000 period. But the post-bubble consumption downshift was certainly milder than I had expected, and, of course, it has since been followed by a 4.3% resurgence of real consumer demand over the most recent four-quarter interval (ending in 1Q04).
Notwithstanding the shaky fundamentals of weak labor income, low saving, and excess debt, the American consumer has continued to plow ahead. I have attributed this remarkable outcome to Washington — namely, the truly remarkable confluence of open-ended deficit spending (i.e., tax cuts) and extraordinary monetary accommodation (i.e., a negative real federal funds rate). And I believe as this policy stimulus now fades, the overly extended American consumer will no longer have the wherewithal to keep driving the demand side of the US and broader global economy. Sure, jobs are on now on the rebound and that should provide some compensation for the withdrawal of the Washington “steroid effect.” But, in my view, courtesy of unrelenting cost-cutting and the global labor arbitrage that this encourages, that compensation will be partial, at best (see my 7 June dispatch, “The Baton Pass”). Moreover, as the Fed now raises interest rates, I also worry that the big surprise could be the carnage brought about by the ever-ticking household debt bomb (see my June 5 dispatch, “The Mother of All Carry Trades”).
Yet at this point in time, the consumer downshift call is only a forecast — and one with not much credibility in this Brave New Era. Addicted to shopping and the debt it engenders, the American consumer remains unflinching in the face of adversity. Last month was a classic case in point: As oil prices surged through the ominous $40 threshold, consumers bought motor vehicles with a vengeance — sales hit their high for the year at a 17.5 million annual rate. Figure that one out? Over the past weekend, I couldn’t get into my local filling station in Connecticut — three gas-guzzling Hummers had effectively blocked the pumps simultaneously. This is America.
When the Chinese authorities want to get their way, they usually win — suggesting that the China slowdown bet is a good one. When the American consumer wants to get its way, it normally wins as well — implying that the consolidation bet is risky. Consequently, with the resilience — or should I say denial — of the American consumer hard to crack, there’s little doubt in my mind that China deserves the vote as the “first to go” in the global growth dynamic. Yet there’s an ominous feature that both of these overextended engines have in common: The recent growth excesses of the American consumer and the Chinese producer have both been driven by spending on durable goods. Durable goods consumption is now greater than 10% of US GDP — an all-time high and well in excess of the pre-equity-bubble share of around 7% in 1995. Half way around the world, Chinese fixed investment has risen to more than 40% of that nation’s GDP.
Over the long sweep of history, durable goods spending cycles have followed a very predictable pattern. Such spending is “lumpy” — it involves the accumulation of long-lived assets such as cars and trucks (America) and property, plant, equipment, and infrastructure (China). When these cycles go to excess, spending typically borrows from outlays that would have occurred in the future. The payback from what economists call the “stock adjustment effect” -- the tendency of durables goods to gravitate toward a long-term optimal, or equilibrium, stock -- is a time-honored feature of the business cycle. And there can be no mistaking the excesses of the recent spike of durables demand in both countries. Fixed investment in China spiked to a 53% Y-o-Y comparison in January and February 2004, whereas growth in US durables consumption accelerated to a 10.6% annual rate in the year ending 1Q04. In both instances, China and the US have upped the ante on their long-standing durable goods binge; the most recent burst of above-trend vigor is now flashing a warning of a looming payback effect.
Needless to say, the two-engine global economy would be in tough shape if the stock adjustment effect were to hit in both China and the US simultaneously. Yet that possibility cannot be ruled out. Such a tough combination would certainly take financial markets by great surprise. The consensus expects a slowdown of one sort or another in China, but has all but given up on the case for any capitulation by the American consumer. There’s an even more ominous twist to this tale: If US consumption slows when China is coming in for a landing, the Chinese economy could be hit by a double whammy — an investment-led slowdown to domestic demand and a US-led slowdown to external demand. Such an outcome would seal China’s fate in the eyes of investors — the hard-landing play would be on with a vengeance. And even I would then have to concede that Beijing would more than have its hands full.
An unbalanced global economy has to be very careful in staging the coming rebalancing. The odds favor the Chinese producer leading the way. The risks point to the American consumer as a wild card entrant in this realignment. Yet in a two-engine world, there may only be room for one of these slowdowns.
Stephen Roach (from Cap d’Antibes) |
