What a US
recession means for China By Jephraim P Gundzik
The risk of economic recession in the
United States in 2007 is increasing rapidly.
Rather than overly tight monetary policy at the
Federal Reserve, the declining value of US homes
is undermining personal consumption expenditure.
The decline in home values is likely to accelerate
next year as housing oversupply is met by
increasingly weaker demand for new homes.
Much weaker growth of personal consumption
expenditure in the
US
could slow China's real gross domestic product
(GDP) growth to about 5% next year. However,
China's ability to muster enormous resources to
contain any economic weakness argues that a
reversal in global commodity prices is unlikely.
US recession in the making In
the first half of 2006, real GDP in the US
expanded at an annual rate of 4.3%. At the same
time, real personal consumption expenditure, which
accounts for about 70% of total GDP, expanded at
an annual rate of 3.7%. Though both real GDP and
real personal consumption expenditure remained
quite strong in the first half of this year, the
US economy slowed sharply between the first and
second quarters. This slowdown was led by
weakening personal consumption expenditure, which
declined from an annual rate of 4.8% in the first
quarter of 2006 to 2.8% in the second quarter.
Apart from hurricane-induced weakness in
the fourth quarter of 2005, the last time real
personal consumption expenditure in the US fell
below 2.7% was in the fourth quarter of 2003. With
the national unemployment rate declining and real
wage growth accelerating, overly tight monetary
policy in the US has been generally blamed for the
slowdown in personal consumption. However,
official interest rates remain low by historical
standards and real interest rates are negative,
suggesting that monetary policy continues to be
quite loose.
Furthermore, both core
consumer price inflation and the core personal
consumption expenditure deflator lurched higher in
the first half of 2006, approaching 3%. In simple
terms, inflation in the US would not be increasing
if monetary policy were overly tight. Finally,
despite the clear acceleration of inflation,
policymakers at the US Federal Reserve have become
more concerned with slowing domestic economic
growth than rising inflation, as evidenced by the
Fed's decision to keep official interest rates
steady at its meetings in August and September.
With monetary policy still very
accommodative and likely to remain so until after
crucial mid-term US elections in November, the
primary factor undermining personal consumption
expenditure in the second quarter was much weaker
gains in home values. According to the US Office
of Federal Housing Enterprise Oversight, the
quarter-on-quarter deceleration of home-value
gains between the first and second quarters of
2006 marked the weakest gain in home values since
records began in 1975. Increasingly unaffordable
house prices and rapidly rising inventories of
unsold homes capped home-price gains in the second
quarter of 2006 and are likely to produce
contracting US home prices in 2007.
The
last time US home values posted an annual
contraction was more than 70 years ago. According
to the US Department of Commerce, inventories of
unsold homes reached an 11-year high this July.
Over the past year, these inventories increased by
more than 20%. The Department of Commerce also
reported that home sales declined 13% since July
2005. Though these statistics are fraught with
sampling errors and subject to large revisions,
the trend over the past 12 months has shown home
inventories rising rapidly and home-sales growth
slowing sharply. Industry experts believe these
statistics are underestimating the growth of
unsold home inventories and the contraction of
home sales.
Growing inventories of unsold
homes - a product of overly easy US monetary
policy over the past several years - are very
likely to lead to contracting home values in 2007.
Since 2001, rapidly rising home values have fueled
US personal consumption expenditure by increasing
household income via cash-out mortgage
refinancing. According to statistics produced by
Freddie Mac (the Federal Home Loan Mortgage Corp),
one of America's largest mortgage lenders,
cash-out mortgage refinancing accounted for about
50% of all mortgage refinancing between 2001 and
2004.
In 2005, cash-out mortgage
refinancing accounted for 73% of all mortgage
refinancing. In the first half of 2006, cash-out
refinancing accounted for a staggering 87% of all
refinancing. If US home values contract in 2007,
household income will also contract. This could
lead to much weaker or even contracting real
growth of personal consumption expenditure in the
US. Lower official interest rates are unlikely to
reverse the fall in home values because the
overhanging inventory of unsold homes is so large.
Home prices must decline to clear this inventory.
US consumers drive China's
growth After a lull spanning from 1998 to
2001, real GDP growth in China accelerated to an
average annual rate of about 10% between 2002 and
2005 - a period corresponding with booming growth
of personal consumption expenditure in the US.
This, in addition to an official upward adjustment
in output in 2004, made China's economy the
fourth-largest in the world at the end of 2005.
Surging output has not been matched by surging
private consumption growth. In fact, the real
growth of private consumption in China has
remained well below the real growth of GDP since
mid-1990s. As a result, the ratio of private
consumption to GDP has declined steadily, reaching
a record low of 40% in 2005.
Low wages and
China's high rate of unemployment have contained
the growth of private consumption. According to
official statistics, real wage growth in China was
exceptionally strong between 2001 and 2005, at an
average annual rate of about 11%. Strong real wage
growth has been exclusively an urban phenomenon
benefiting registered workers. Real wage growth in
rural China, where more than 60% of the population
resides, has been much weaker and is the primary
reason that the income disparity between urban and
rural China has widened over the past 15 years.
Moreover, real wages for rural migrant
workers in urban areas, which constitute as much
as 60% of the urban workforce, have also grown
considerably slower than real wages for registered
urban workers. Though the government has
recognized the equal rights of migrant workers,
they face significant wage and benefit
discrimination. In addition to being underpaid and
under-benefited, migrant workers also face
non-payment of wages by employers. Like official
wage statistics, official unemployment statistics,
which indicate China's unemployment rate has been
about 4% since 2001, do not reflect actual labor
conditions in China.
Because rural migrant
workers generally receive no social benefits, they
are unable to register as unemployed. This
excludes more than one-half of the urban workforce
from China's urban unemployment data. Urban
unemployment would be between 6% and 8% higher if
unemployed migrant workers were included in
unemployment data. Adding unemployment in rural
areas would push China's nationwide unemployment
rate up by 10-15 percentage points.
Rather
than private consumption, external demand,
originating primarily from US consumers, drives
economic growth in China. Between 2001 and 2005,
China's annual average rate of export growth was
25%. Exports grew by 35% in 2004 and 28% in 2005.
The very strong nominal growth of exports
accounted for about 2% of real GDP growth in 2004
and about 4% in 2005. In the first half of 2006,
net exports accounted for about 2.5% of real GDP
growth.
Including goods re-exported from
other countries and Hong Kong, China's exports to
the US account for about 50% of total exports.
Thus export growth is largely determined by the
growth of US demand. Because almost all of China's
exports are consumer goods, personal consumption
demand in the US drives China's export growth. In
addition to exports, external demand also plays a
key role in the growth of investment in China.
External demand dictates the growth of
investment in manufacturing capacity in the export
sector. External demand also influences China's
investment in domestic infrastructure, such as
power generation, ports, and road and rail
transport, which is critical to expanding
manufacturing and export capacity. Finally,
external demand also influences China's domestic
investment in real estate, which is necessary in
securing locations for new manufacturing and power
plants, as well as housing for employees.
External demand directly and indirectly
drives about 65% of all domestic investment in
China. As with exports, robust demand in the US
arising from strong real growth of personal
consumption expenditure has produced astounding
investment growth in China, which averaged over
21% annually between 2001 and 2005. Rapid real
growth of personal consumption expenditure in the
US, which averaged over 3% annually between 2001
and 2005, accounted for almost one-half of China's
economic growth over the same period.
How China can cushion the blow A
sharp slowdown or contraction of real personal
consumption expenditure growth in the US in 2007
will lead to much slower economic growth in China.
China's export growth could be flat or even
negative while investment growth could be cut in
half. In addition, rationalization in China's
export sector could lead to much higher urban
unemployment, especially among China's migrant
workforce. This could heighten already increasing
social instability, further undermining private
consumption growth and economic growth in China.
A US economic downturn next year will
undoubtedly have a strong negative impact on
China's economy. However, this impact could be
mitigated by the government's marshaling of
China's considerable resources, including the
country's nearly US$1 trillion of foreign exchange
reserves. In addition to these reserves, China has
enormous fiscal resources that it can employ to
boost the economy either directly or indirectly
through the country's massive state-owned banking
system - not exactly music to the ears of foreign
investors who have poured money into China's
banks.
Though dependent on consumer demand
in the United States, China's economy could easily
withstand a US economic recession because of its
vast resources and its ability to extend these
resources through the still-dominant state-owned
economic structures. As a result, slowing US
economic growth does not imply a significant
reversal in global commodity prices, especially
oil prices. Even if economic growth in China slows
to 5% in 2007, demand for energy and crude oil in
China will remain quite strong.
Even more
intriguing, economic recession in the US and
slower economic growth in China could speed the
reorientation of China's economy away from
external-demand-driven growth toward
private-consumption-driven growth.
Jephraim P Gundzik is president
of Condor Advisers. Condor Advisers provides
investment risk analysis to individuals and
institutions worldwide. For more information,
please visit www.condoradvisers.com.
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