America must kick its spending habit

American politicians are blaming Chinese currency manipulation for the US current account deficit. But one of the main factors is their failure to tackle rampant consumer overspending.

An accommodative Federal Reserve has led to excessive spending by the American consumer, inflated real estate prices, and made consumers feel wealthy enough to spend more than they make.

Compounding the liquidity effects of an accommodating Fed over the past three years has been the high savings rate of Asian central banks and individuals. The net impact is a reduction of risk premia across asset classes as investors are pushed to invest in riskier assets to achieve higher returns.

The resulting global imbalances have put the world in a precarious position. The American trade deficit with China grew by $201.6bn (115bn) in 2005. US politicians are blaming Chinese currency manipulation for this deficit. A bill introduced last year would put 27.5% tariffs on all Chinese goods unless Beijing moves aggressively to loosen a peg between the renminbi and the dollar.

If the bill goes through, the trade deficit with China may be reduced, but there would be profound consequences for the American economy and stockmarket, possibly leading to a recession and a big correction on markets. The severity of the potential consequences suggests China may consider this to be political posturing, as America cannot punish China without punishing itself.

The American current account deficit has continued to climb despite a double-digit decline in the real trade-weighted value of the dollar since the first quarter of 2002. This may mean the dollar has not fallen enough against a trade-weighted index, in particular against the Asian countries within that index.

Saving disparities between America and Asia must be narrowed. The US needs to save more and Asia, particularly China, needs to spend more.

China recently announced that it is in the process of addressing a great number of the factors that have led to the global imbalances. In particular, it is attempting to shift away from exports and focus investment towards private consumption. Its new five-year plan looks for 7.5% average real GDP growth through 2010, significantly lower than the 9.5% pace of recent years.

China will likely be more inclined towards renminbi appreciation to promote a shift away from the excessive share of exports in growth, and towards promoting consumption-led growth. It is developing a safety net for individuals in an effort to increase consumption and reduce savings.

While China appears to have realised the need to better manage the imbalances, America seems to be becoming more protectionist at the same time that it is reliant on unprecedented amounts of external capital to fund economic growth. While the US runs a negative savings rate, it has two possible choices: reduce growth or borrow from the rest of the world. A revalued Chinese currency will not end the American demand for capital but it may reduce it.

American consumers willlikely continue to spend beyond their means until they sense their wealth is at risk. That means a drop in asset prices – primarily real estate – may be required to slow the consumer. As difficult a job as China will have in creating a consumer environment, America may have even more difficulty ending the excess consumption without significant disruption to asset prices.

Market Implications

Commodity rally moves to agricultural
Chinese rebalancing to consumption may temper commodity inflation of oil and industrial metals, but provide a boost for agricultural commodities. As the emerging middle class begins to spend, it is possible and improvement in diet will be one of the significant initial expenditures.

Asian currency benefits
Chinas current account surplus should decline, leading to slower accumulation of foreign exchange reserves and steady renminbi appreciation as it allows its currency to appreciate. Chinas major Asian trading partners currencies should rise in sympathy versus the dollar. The same forces of strong economic growth transitioning from exports towards consumption should happen across the region, and the large surpluses may begin to dissipate with currency appreciation.

Decline in dollar-denominated assets and higher risk assets
The removal of a major buyer of American bonds may materially push up US interest rates, having consequences across all dollar-denominated assets. It may bring the return of risk premia across asset classes widening of credit spreads, emerging market spreads and higher returns for equities.

Profit misses and slowdown
An orderly slowdown in consumer spending seem unlikely, as so many forces may be at work against the American consumer. There will be a deteriorating wealth effect, as property prices fall owing to higher interest rates, higher borrowing costs, lower dollar imports, inflation and productivity decreases based on the loss of artificially cheap Asian goods. This should have a negative impact on profit margins, earnings growth and equities in general.