Tough flying for the global
economy By Stephen Roach
Not surprisingly, an unbalanced global
economy is struggling under the weight of the
energy shock of 2005. This has not been lost on
world financial markets. Stock markets have sagged
on the fear of demand risk and bond markets have
backed up as central banks sound the alarm over
incipient inflation.
This underscores the
inherent risks of the fabled four-engine global
airplane. This gigantic 747 is now flying on just
two engines, fueled by the American consumer on
the demand side and the Chinese producer on the
supply side. If the demand engine sputters, added
thrust from the supply engine may be
destabilizing. That's a legitimate concern in late
2005. If US consumption falters in the face of
ongoing vigor from Chinese
production, it may
be difficult for an already wobbly plane to
maintain its altitude.
Nothing comes close
to equaling the impact of the American consumer in
supporting the demand side of the global growth
equation over the past decade. By our reckoning,
over the 1996 to 2005 interval, real consumption
growth in the United States averaged 3.75% per
annum - fully 70% faster than average gains of
just 2.2% elsewhere in the developed world.
The world drew support from an
extraordinary transformation in the US consumption
model - a morphing of income-based consumers into
asset-driven spenders and savers. While growth in
real disposable personal income remained on trend
at 3.3% over the past 10 years, real consumption
growth exceeded real income growth by about 0.5
percentage point per annum over this period.
Drawing support first from equity wealth effects
in the latter half of the 1990s and then from
housing wealth effects over the past five years,
the American consumer became the world's consumer.
But at a steep cost. America's
wealth-based consumption binge pushed the
income-based personal saving rate down by 5
percentage points over the past decade - taking it
deeper into negative territory than at any point
since 1933.
Fed chairman Alan Greenspan
has estimated that equity extraction from
residential property has been sufficient to have
accounted for all of the decline in personal
saving since 1995. Of course, the monetization of
wealth from homes hardly came out of thin air. It
required an enormous build-up of debt - sufficient
to take up the outstanding volume of household
indebtedness by 20 percentage points of GDP over
the past five years, equaling the gain over the
preceding 20 years.
Moreover, despite
historically low market interest rates, the debt
overhang pushed up the household-sector debt
service burden - interest expenses as a share of
disposable personal income - to a record high in
mid-2005. The world's consumer has taken the
concept of macro risk into an entirely different
realm.
The current energy shock is a very
different threat to a wealth-based consumer than
it is to an income-supported consumer.
That's especially the case since it hits
US households when they are running a negative
saving rate. In the three previous energy shocks -
1973, 1979 and 1990 - the personal saving rate
averaged about 8%. US consumers had a cash cushion
they could draw on in order to support lifestyles.
A negative saving rate offers no such cushion.
One estimate says that higher energy
product prices are the functional equivalent of an
annualized tax of around $130 billion on US
consumers, or about 1.4% of total disposable
personal income. With a negative saving rate, a
significant portion of that tax will undoubtedly
be funded by a retrenchment of discretionary
consumption. The world's consumer is now facing
major cash-flow pressures heading into the
all-important holiday buying season.
And in China ... Meanwhile,
halfway around the world, nothing seems to be
stopping the Chinese producer. With GDP growth
holding above 9% through the third quarter and
industrial output growth continuing to run north
of 16%, a seemingly impervious Chinese economy
seems all but oblivious to potentially ominous
developments in its external sector.
This
could be an accident waiting to happen. In an
energy-shocked environment, China's export-led
growth dynamic is at growing risk of decoupling
from its major source of end-market demand - the
American consumer. If US consumption slows as I
suspect, an inventory overhang could quickly
emerge in China that would undermine production
support in the months ahead.
That may not
be idle conjecture. Nicholas Lardy of the
Institute for International Economics drew my
attention to an ominous build-up of Chinese
inventories that predates any impacts of the
energy shock. According to China's National
Development and Reform Commissions (NDRC) - the
modern-day version of the old central planning
agency - the accumulation of finished goods
inventories accounted for fully 20% of the
increase in China's nominal GDP in the first half
of 2005. This represents a major step-up in the
inventory boost to Chinese economic growth.
By way of comparison, finished goods
inventories accounted for just 1% of China's
nominal GDP growth in 2004. To the extent that
Chinese economic growth was already drawing
unusual support from inventory accumulation before
the energy shock hit, any energy-related shortfall
of external demand could lead to an increasingly
destabilizing overhang of domestic production.
Yet the China macro call is not just an
inventory call. The Chinese economy suffers from a
deeper strain of imbalances. With private
consumption having fallen to a record low of just
42% of GDP in 2004 and likely to have declined
further in 2005, China is lacking a key building
block of self-sustaining internal demand.
This is not surprising. Reflecting the
ongoing pressures of the massive headcount
reductions traceable to state-owned enterprise
reform, Chinese consumers are predisposed toward
precautionary saving. The lack of a well-developed
safety net only reinforces this tendency. As such,
China's growth dynamic has become increasingly
reliant on exports and on the investment in
infrastructure and factories required to build a
state-of-the-art export platform on a scale the
world has never seen. Collectively, exports and
fixed investment, which now account for over 80%
of Chinese GDP, are still surging at close to a
30% annual rate. The rest of the economy is simply
not pulling its weight.
The risk of the
China call is that we extrapolate this year's
forecast errors into the future. Just because
China did not slow in 2005, doesn't mean that it's
full steam ahead for years to come. It is, of
course, quite possible that Chinese officials will
turn up the dials on investment and fiscal policy
if its export markets weaken.
That was
exactly what happened in the Asian crisis in
1997-98 and again in the mild global recession of
2000-01. But in those two earlier periods, the
combined share of exports and fixed investment
amounted, on average, to "only" about 55% of
Chinese GDP - far short of the current 80% share.
China can only go to this well for so long
before it hits bottom. Unless internal private
consumption quickly springs to life, China's
export and investment-led growth juggernaut may
simply outstrip its global support base. If the
American consumer pulls back in an energy-shocked
environment, as I suspect will be the case, those
risks need to be taken seriously.
Sure,
the world has other options. Maybe Japanese or
even European consumers could ride to the rescue.
Here, I think there is a serious phasing problem.
While I am quite taken with the upside potential
for non-US consumption, I believe such rebounds
are likely to come later rather than sooner.
Moreover, in the early stages of their consumption
recoveries, the Japanese and European dynamics are
likely to be glacial rather than vigorous.
While we are increasingly optimistic on
prospects for sustainable recovery in Japan, we
are only projecting a modest acceleration in
Japanese consumption growth from 0.5% in 2003 to
1.8% in 2006. Similarly, our forecast of Euro zone
consumption calls for an even more limited
acceleration from 1.0% growth in 2003 to just 1.4%
by 2006. By contrast, over the near term, the
cyclical downside from America's consumption trend
line of 3.75% growth is likely to be larger than
the upside from the roughly 1% consumption growth
path of Europe and Japan. Meanwhile, all consumers
- except, of course, those in oil-producing
nations - will be hit by the energy shock of 2005.
Alternatively, maybe Chinese exporters
could penetrate new markets. In this instance, I
think it's wishful thinking to believe that China
can simply push a button and redirect the focus of
its export machine.
This year, the US will
probably account for 35-40% of total Chinese
exports. Implicit in this extraordinary degree of
dependence is a well-established distribution and
logistical support infrastructure to US-Chinese
trade flows. If the American consumer falters,
China doesn't just switch markets overnight.
This may also explain why Chinese
officials have been so reluctant to utilize their
new flexible foreign exchange mechanism to
engineer a stronger renminbi. Fearful of slippage
in US demand and mindful of the stickiness of
export distribution channels, currency
appreciation would create export headwinds for
China at precisely the moment its unbalanced
economy can least afford to face them. At the same
time, China's export explosion is now encountering
political resistance in major parts of the
developed world - underscoring a potential
protectionist backlash to export diversification.
In the end, it may all hinge on the
stability of a two-engine plane. The supply engine
is going at full throttle while the demand engine
is at risk of sputtering. An unbalanced global
economy has long been lacking the internal
stabilizers to cope with such a mismatch between
supply and demand.
As long as the American
consumer keeps spending, this enormous airplane
will keep flying. However, the energy shock of
2005 and the likely end of America's housing
bubble draw that key presumption into serious
question. The supply engine will have a tough time
keeping the plane aloft if the demand engine runs
out of fuel.
Investors need to pay greater
attention to the downside risks to global growth
in 2006. Such an outcome will put pressure on the
earnings underpinnings of equity markets, provide
support to bonds by drawing inflation worries into
question, and pose a serious challenge for dollar
bulls. The plane is about to enter turbulent
skies.
