Step change

The world is increasingly caught between an Asia that is keen to produce but reluctant to consume and an America where the reverse is true. Daniel Ben-Ami examines whether recent market volatility is an expression of this imbalance.

During times of market turmoil it is not surprising that attention tends to be focused on the immediate problems. In recent weeks the prospect of an American recession and the problems of “monoline insurers” have caught the imagination. But during such times it is particularly important to try to take a detached view. Those developments that seem key at the time often appear of secondary importance in retrospect. Conversely, things that appear marginal can seem vital with the benefit of hindsight.

As Fund Strategy has already argued, the obsession with whether America is in or about to enter a recession is overblown (comment, 21 January issue. It is largely a debate about labels. By some definitions it is in recession and by others it is not. The important thing is what is really happening to the economy rather than what to call it. There seems little disagreement that the American economy is slowing to a significant extent.

A more useful approach is to see how the market volatility relates to the process of global economic rebalancing. In broad terms this refers to a relative increase in consumption in Asia and a relative decrease in America. The idea is that such a rebalancing will bring consumption and production more in line on a global level. Recent developments in the markets can be seen as part of the process of these imbalances unwinding. In other words the idea of rebalancing provides a way of linking developments in the real economy with those in the financial markets (see below for a simplified model of rebalancing).

The origins of this process go back to the bursting of the technology bubble at the start of the decade and the reaction to the September 2001 terrorist attacks. The federal funds rate fell from a peak of 6.50% in May 2000 to plateau at 1.00% from June 2003-June 2004. Such low rates bolstered American consumption as individuals and companies took full advantage of cheap credit. An important consequence of this trend was the surge in American house prices. Lending standards were also relaxed as lenders took advantage of low interest rates to expand their mortgage books.

However, this boost in consumption had the unintended consequence of boosting America’s current account deficit. The deficit surged from 3.8% of GDP in 2001 – already high by historical standards – to a peak of 6.2% of GDP in 2006. American consumers were sucking in huge volumes of imports. Another way of looking at the same figures is that in 2006 America was consuming 106.2% of its output.

This phenomenon was often one-sidedly described as the American consumer bolstering the world economy. A common metaphor was that the world was “flying on one engine” – with the engine being the American consumer.

The problem with this metaphor is that it ignores the key role of surging Asian production. America could only sustain such a large current account deficit thanks to huge capital flows from Asia and the oil-producing countries with massive purchases of treasury bonds. Asian production was, in effect, subsidising American consumption. This was a phenomenon some economists referred to as capital flowing “uphill”. The still relatively poor countries of Asia were subsidising the consumption of the richest country in the world.

Of course the Asian nations were not investing in America for purely altruistic reasons. America was still their largest trading partner. By subsidising American consumption they were bolstering the market for their own goods. The American markets also seemed like a safe and attractive home for Asia’s excess savings.

Unfortunately for those involved this process was unlikely to continue for ever like some perpetual motion machine (see box, page 26 for a contrary view). The gross imbalance between American consumption and Asian production was always likely to create problems. The key question was how.

With the benefit of hindsight the answers are becoming apparent. The period of easy credit helped create a giant housing bubble. This bubble began to burst in mid-2006 as house prices started to fall. Interest rates had crept up to 5.25% and the surge in house prices had, at least for the time being, reached its limits.

The next stage in the drama emerged in the summer of 2007. It became apparent that many mortgage backed securities included bad debt. Excess debt created during the housing boom era had been securitised. Unfortunately no one knew exactly how much debt had gone bad or who held the troubled securities.

By early January the credit crunch appeared to have eased. Inter-bank rates seemed to have returned to more normal levels. More optimistic commentators were starting to wonder whether the credit crunch was over.

It was in this context that the latest market troubles emerged. The downgrading of Ambac, a bond insurer, by Fitch was particularly unnerving because many assumed the credit crunch was over. Hundreds of billions of dollars worth of bonds it insured were also downgraded. The talk of an American recession made the markets more nervous still.

The bursting of the housing bubble and recent market volatility fits well into the framework of economic rebalancing. What would be expected after a period of excess is that American consumption will fall while savings should increase. From such a perspective a fall in house prices and in equities provides just the kind of developments needed to rebalance the economy.

Keith Wade, an economist at Schroders, argues that an American economic slowdown could be a key way such rebalances are resolved. “Such concerns are usually resolved by recession,” he says.

Certainly many strategists and economists agree that the volatility can be seen in the context of rebalancing. Julian Jessop, the chief international economist at Capital Economics, says: “This is economic imbalances coming home to roost.” He points out that there will be winners and losers in the process.

Tim Price, the director of investment at PFP Wealth Management, takes a similar view. “The market is finally working through these issues in relation to the superstructure of the American economy,” he says. “Rebalancing is starting with a vengeance”.

More difficult to answer is what is likely to happen from here? Is there likely to be a continued smooth relative decline in American consumption or can a more violent process be envisaged? And what is likely to be the impact on the other side of the Pacific? Is Asian consumption likely to increase and its current account surpluses likely to decrease?

Olivier Blanchard, a professor of economics at the Massachusetts Institute of Technology, sees rebalancing as having a contradictory impact. “There is a higher likelihood of slowdown in the US, which should lead to lower interest rates, which will lead to a further dollar depreciation, further reducing the trade deficit and global imbalances”, he says. However, “higher volatility in foreign markets will make US assets more attractive, leading to less pressure on the dollar and going in the opposite direction.” The potential for two such contradictory effects shows how tricky it is to untangle the effects of global economic rebalancing.

In a way the recent American policy initiatives can be seen as attempts to counter, or at least limit, the effects of rebalancing. By slashing interest rates and announcing a fiscal stimulus package the American authorities are trying to bolster American consumption. But this is coming at a time when, at least relative to Asia, consumption levels might be expected to fall. A more charitable interpretation would be that the American authorities are trying to smooth the process of rebalancing rather than quell it completely.

In one respect an American re-adjustment is happening. The trade-weighted dollar – which measures the value of the dollar against the currencies of America’s most important trading partners – has fallen substantially since 2002. This should help rebalancing by making America’s exports cheaper and its imports more expensive. However, it is also worth noting that for four years the current account continued to rise stubbornly despite the weakening of the dollar.

Nor should it be forgotten that rebalancing is a two-way process. It is not just a question of America decreasing its consumption but of Asia increasing it. Here too there are signs that the Asian authorities recognise the need for rebalancing but are reluctant to come to terms with its consequences.

The problem here is in relation to the renminbi, China’s currency. China broke its peg to the dollar as far back as mid-2005. Instead, it announced its currency would be linked to a basket of currencies. But many experts argue it still needs to be revalued significantly before it can be seen as at a reasonable value against the dollar.

John Ip, a senior economist at Morley, argues that the renminbi will revalue against the dollar. It could happen through a straightforward currency realignment or alternatively the process could occur through inflation in China. “One way or another China’s currency will appreciate in real terms,” he says. “That is how the invisible hand will eventually be resolved.”

Diane Choyleva, an economist at Lombard Street Research, is cautious that any adjustment process in China is likely to take time. “China is overheating like crazy,” she says. “The underlying drive to save excessively will not go away for two to three years”.

Eventually she sees the state as likely to engage in a fiscal stimulus to boost domestic consumption. She also argues that China is likely to switch to buying foreign equities rather than bonds. As a result sovereign wealth funds are likely to play a more important role.

More generally in the developing world there is likely to be a trend towards higher interest rates. A relative increase in developing country interest rates compared with developed country rates could be expected as part of the rebalancing process. Such a shift would also be expected if emerging economy currencies are to rise relative to those of the developed world.

It is now possible to outline the likely effects of economic rebalancing. However, there are so many variables it is impossible to be certain about all of them or about the timing:

  • American economic growth is likely to slow.

  • The dollar is likely to fall on a trade-weighted basis. This process is already well underway.

  • Emerging economy currencies are generally likely to rise relative to those in the developed world. This could happen through movement on the foreign exchange markets or in real terms through domestic inflation.

  • Interest rates in developing economies are likely to rise relative to those in the West.

  • Sovereign wealth funds look set to become more important. This corresponds to a shift in official purchases of equities rather than bonds.

  • The American current account deficit is likely to fall in real terms while the corresponding Asian surpluses are likely to shrink.

    However, there is an important caveat to this argument. Although there is a case for rebalancing in pure economic terms, the authorities in both America and Asia seem fearful of its destabilising consequences. For instance, rather than acccept that a recession might be necessary to reduce imbalances the American authorities are stimulating their economy. This will mean less pain in the short term but it could also mean that it takes longer for imbalances to be resolved.

    Similarly, the Asian authorities often seem nervous about boosting domestic consumption. They see a high savings rate as playing a key role in their rapid economic growth. As a result a rise in consumption relative to savings is seen as potentially undermining growth.

    The irony then is that state action could stabilise markets and economies in the short term but lead to more volatility in the long term. Periods of stability followed by bouts of high volatility look like they have become the norm. The rebalancing story is probably far from over.


    Decoupling/recoupling

    One of the most heated debates on the economy and markets is on “decoupling”. The term is misleading, and used in more than one way, but it is essentially about the extent to which Asia could cope with an American slowdown. Some have a more upbeat assessment of Asia’s resilience than others.

    The reason the term is misleading is that it could be taken to mean that the world is becoming less integrated. But global trade and investment links remain extensive. If there is an objective shift it is that emerging economies, particularly in Asia, are trading more among themselves.

    Probably the key question is the extent to which Asian economies have developed an autonomous growth dynamic. If exports to America fall off, can Asia take up the slack from other sources. These could include domestic demand or perhaps demand from other sources such as exports to Europe.

    The International Monetary Fund argued in its April 2007 “World Economic Outlook” that Asia could weather an American soft landing. It gave several reasons including the effect of an American housing sector slowdown on American imports likely to be muted, America becoming a less important export destination for most Asian countries and the scope for monetary as well as fiscal intervention in Asia.

    In contrast Lombard Street Research, an economic consultancy, has argued that decoupling is bunk. Charles Dumas (pictured above) said in a recent note that: “Far Eastern emerging economies cannot decouple from developments in the advanced economies as long as they persist in pursuing export-led growth” (“Decoupling debunked” January 22, 2008).

    Roughly mid-way between these two positions is the argument that tighter financial conditions and a co-ordinated central bank response help create the conditions for a “recoupling”. This is the view of Morgan Stanley’s global economics team, which at the start of the year christened 2008 “the year of recoupling”.

    It is a view shared by Andrew Milligan (pictured left) the head of global strategy at Standard Life Investments, who argues: “the pendulum is swinging back in favour of those suggesting a global recoupling of the world economy”.

    Whatever the truth about decoupling it is important not to lose sight of the big picture. Although America is still the world’s largest economy the rising countries of emerging Asia are rapidly growing in relative importance.


    A contrary view

    Although most economists argue a global economic rebalancing is necessary there are some prominent dissenters. Typically they argue that the headline figures for the American trade deficit exaggerate the true extent of imbalances. According to this view the standard picture overstates American weakness. They also point out that America has maintained a large trade deficit for a quarter of a century.

    Marc Chandler, the chief foreign exchange strategist at Brown Brothers Harriman in New York, is one of the most articulate of the contrarians. He gives several reasons why the conventional view is misplaced:

  • About half of America’s trade deficit is accounted for by trade within US multinational firms. For example, if a subsidiary of an American company in Toronto sells goods to another subsidiary in Texas that counts towards the trade deficit. But in a more meaningful sense it can be seen as intra-American trade. America’s Bureau of Economic Analysis has even developed a framework to examine such transactions (see “An ownership-based framework of the US current account 1997-2006”, “Survey of Current Business,” January 2008. Available at: www.bea.gov/scb/index.htm ). Globally intra-firm trade accounts for about a third of total trade.

  • It is no longer true that trade has to be counter-balanced by equivalent capital flows. On a global scale capital flows are far larger than trade flows. “Capital flows are their own variable,” says Chandler.

  • America has become a safety valve for the world’s excess savings. This is particularly important with the rise of what has become known as the global savings glut. Foreigners are happy to invest in America because it is a large, liquid and safe market. “If we are debtors it’s a unique kind of debt,” says Chandler.


    A simple model

    To understand the concept of rebalancing and its consequences it is best to start with a deliberately over-simplified model of the global economy. Let us assume there are only two countries in the world: call them America and China. America is a mature and relatively slowly growing economy while China is developing and growing fast.

    If there are no significant economic relations between them then the question of imbalances does not arise. But once they start to trade and invest in each other it becomes a possibility.

    Say China has a particularly fast-growing and dynamic export sector. This immediately opens the possibility that America will buy lots of Chinese exports. If its imports from China are not balanced by trade going in the other direction a trade deficit will start to open up.

    To finance its deficit it will be necessary for America to borrow money from China. In some ways this is akin to individuals using debt to finance current consumption. China may well be willing to provide such finance since it wants to sell its goods to America.

    However, although such a situation may be beneficial for a while it could reach the stage where it becomes unsustainable over the long term. There are numerous ways in which the economy can adjust to such imbalances. The most obvious is that the dollar can depreciate to the stage where Chinese exports become a lot more expensive for Americans to buy. But if, say, China decided to peg its currency to the dollar this route might not be available for adjustment.

    There are also other consequences of large Chinese capital flows into America. Such inflows of cash mean that interest rates are likely to be lower in America than they would otherwise be. In effect, the Chinese are subsidising American consumption and borrowing.

    One consequence of unjustifiably low interest rates is that a housing bubble can emerge. Since credit is cheap it becomes easy for borrowers to buy houses. Conversely, part of the adjustment process between America and China could involve a fall in American house prices. From this perspective it is also possible to see that the “credit crunch” can be seen as closely related to the problem of imbalances.

    The consequences of imbalances can be felt inside China too. Flows of capital from China to America mean that the Asian nation will consume less than it otherwise would. The Chinese population, which it should be remembered is still relatively poor, may decide to save more and consume less.

    Nor does this end the matter. There is also a debate to be had about why the two economies are out of synch. Up until recently the most common explanation would be that America is investing too little. If it invested more, so the argument goes, it could increase its growth rate and the two economies would come more closely into balance.

    But more recently the notion of an Asian savings glut has become more popular. Lombard Street Research and later Ben Bernanke, the chairman of the Federal Reserve, have both put forward this argument (see Daniel Ben-Ami “Argument built on questionable logic”, Fund Strategy, April 3, 2006. For Bernanke’s speech see: “The global saving glut and the US current account deficit” speech given on April 14, 2005. Available at www.federalreserve.gov). This effectively flips over the previous argument about investment. For proponents of the savings glut thesis the key problem is that Asia is saving too much. Overly prudent Chinese savers are, in this view, causing havoc with the world economy.

    So even from a deliberately simplistic starting point it can be seen that rebalancing links together many of the key themes in the global economy. Currencies, financial markets, housing markets, investment, trade and savings are all linked by the theme of imbalances. A fuller analysis would no doubt bring even more factors into the equation.