Stacked for stagnation

Tomas Hirst assesses the global economy and concludes that while both China and the West undergo structural reforms, a degree of macroeconomic cooperation is required if a more dangerous outcome is to be avoided.

With the eurozone crisis still rumbling on and the US presidential election this week it is understandable that much of the attention has focused on the economic challenges faced by West. The picture, however, cannot be complete without looking at the growing problems faced by emerging economies as they try to maintain their dynamism against a difficult backdrop.

In its latest World Economic Outlook report the IMF painted a cautious picture of the prospects for Asia. In particular it pointed to the spillover effects from sluggish advanced economies:

“Compared with the region’s growth performance in recent years, the near- and medium-term outlooks are less buoyant. This view reflects weaker anticipated external demand resulting from the tepid growth prospects in major advanced economies and a downshift in China’s and India’s growth prospects, with a return to double-digit growth in China unlikely given the policy objectives laid out in the 12th Five-Year Plan.”

Yet it would be misleading to view these spillover effects as unidirectional. Fiscal tightening and private sector deleveraging in the West is highly likely to be a major cause of slowing growth in those emerging markets that remain reliant on foreign trade for growth. Unfortunately their previously high growth levels have also been key to offsetting the legacy impact of the financial crisis in developed countries.

That the engines of global growth are now moderating could provide a major stumbling block for policymakers. Those relying on improvements in net trade to pull advanced economies out of the slump may now be forced to rethink plans while those who advocated upfront fiscal consolidation may find themselves pressed to consider limiting spending cuts for fear of significant impact on output.

As such at the heart of this debate is whether the global economy can undergo a sustainable recovery before core imbalances between surplus and deficit countries are addressed. If surplus countries are unwilling, or unable, to stimulate sufficient domestic demand to soak up reserves and draw in more foreign trade then the status quo before the crisis may well remain unchanged.

If recent history demonstrates anything, however, it is that allowing these imbalances to sustain may provide the basis for another crisis potentially of even greater proportions.

Slowing Giant

China’s annual growth rate slowed to 7.4 per cent in the third quarter of 2012. The figure marked the seventh consecutive quarterly fall in the rate of growth, though year-on-year growth in industrial output and retail sales in September offered some hope for nervous investors.

Few would argue that they have good reason to be nervous. Over the past five years those who put money into the region have experienced a bumpy ride. In sterling terms the MSCI China index has fallen 16.63 per cent since October 2007 while the average fund in the IMA China/Greater China sector has also disappointed with a 10.71 per cent loss, according to FE Analytics.

These figures compare unfavourably with the US and UK with the average fund in the IMA North America sector gaining 21.23 per cent and even the IMA UK All Companies sector remaining in positive territory returning a modest 4.42 per cent. Furthermore both have suffered significantly lower volatility over the time period.

Allowing these imbalances to continue may provide the basis of an even greater crisis

Of course, high single-digit economic growth in the world’s second largest economy remains an encouraging fact in the face of broad stagnation in developed markets. With these types of statistics, however, it is important to look past the headline number at what the major drivers are.

Over the last few months speculation has abounded in the press that the Chinese Government was primed to undertake an 8 trillion Yuan (£800 billion) spending spree to boost confidence in the country’s cooling economy. To put that in perspective it is double the size of the package passed by the Communist Party in the wake of the collapse of Lehman Brothers in 2008.

Many commentators have seen this as local party officials jockeying for position ahead of the impending party reshuffle at the 18th national party congress. Indeed much of the supposed stimulus was not only unfunded but repeats of already released policy.

Despite this, as Bloomberg reported last week, China’s Government did spend significantly more than it had budgeted for in the first nine months of the year. This has raised questions over the sustainability of the country’s growth with further increases in spending requiring a renegotiation of the government’s budget.

According to Ministry of Finance statistics spending between January and September increased by 21.1 per cent from the previous year, higher than the targeted 14.1 per cent rise. Over the same period fiscal revenue rose 10.9 per cent compared with a 29.5 per cent increase in the first nine months of 2011. This implies a current account surplus of around half the level of last year.

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The market bounce that greeted the third quarter figures, therefore, was based less on the headline numbers and more on the September data. Importantly it showed exports saw a strong bounce in the last month of the quarter.

Despite tentative hopes of a global rebalancing of trade exports remain the driving force for China accounting for 31 per cent of Chinese GDP last year, according to the World Bank. Moreover, although the sector has struggled in the face of falling western demand exports grew 9.9 per cent year-on-year in September, significantly higher than the 2.7 per cent growth seen in August.

In an interview with the Xinhua news agency Yao Jian, a spokesman for the Chinese Commerce Ministry, was quoted as saying:

“China’s trade performance in the fourth quarter is likely to maintain the recovery momentum seen in September and will probably grow at the average pace of the past three quarters.”

Irrespective of whether the fourth quarter is in line with expectations it appears clear that hopes of an imminent trade rebalancing have largely been unfulfilled. Although it is predicted to fall 50 basis points to 2.3 per cent of GDP in 2012, the IMF forecasts China’s current account surplus will hit 2.5 per cent in 2013.

Even with interest rates around the zero lower bound and large scale quantitative easing programmes undertaken by both the Federal Reserve and the Bank of England net trade in the West has failed to see sustained improvement.

In August the US trade deficit was $44.2bn, with the deficit between the import and export of goods with China was $28.7bn. The UK’s trade figures paint a similarly gloomy picture with August’s deficit increasing to £4.9bn over the month, up from £4.4bn in July.

Ironically part of these deficits may reflect the impact of a slowing China on western businesses. Cummins, an engine maker based in Indiana, lowered its revenue projections for 2012 earlier this month and announced cuts of between 1,000 and 1,500 jobs by the end of the year blaming weak Chinese demand. Schnitzer Steel Industries, one of the US’s largest metal recyclers, and Caterpillar have also had to lower forecasts on the back of falling demand from Asia.

The failure of advanced western economies to rebalance in line with predictions suggests the problems are more fundamental than many policymakers expected. As such addressing them is likely to prove a longer and more complex process than many had hoped.

End of the Savings Glut?

Charles Dumas addresses these issues directly in his book Globalisation Fractures: How Major Nations’ Interests Are Now in Conflict. He argues that the Eurasian Savings Glut helped to fuel the West’s mortgage boom and that unless the surplus countries can be induced to abandon them the only choices for heavily indebted advanced economies is further fiscal degradation or enforcing trade barriers.

While policymakers in the West certainly receive their fair share of criticism for becoming beholden to the “alphabet soup” of Wall Street, it is surplus countries such as China and Germany that Dumas saves some of most biting critiques for. The psychological scars left by Weimar hyperinflation and the Asian crisis of the 1990s have fostered a determination to avoid government deficits, which forced their trade partners to compensate by running deficits.

This has meant that while excessive debt is widely accepted as one of the primary causes of the crisis, the avoidance of it by surplus countries may prove equally difficult during the recovery. As highly indebted countries attempt to shrink unsustainable deficits and cut debt levels Dumas says that for the savings gluttons “the credit crunch marked the beginning of the end of either their growth or their ability to sustain a savings glut”.

Compelling the Party to dip into its reserves and boost domestic demand could pave the way for a longer-term solution

This may seem a strange claim to make when China’s economy continues to drive ahead at a solid pace over five years on from the start of the crisis. Globalisation Fractures, however, points to the folly of focusing on headline numbers while the imbalances remain unresolved.

What it suggests is that viewing the global economy as a collection of autonomous economic units fails to take account of the fundamental interconnectivity and interdependencies between participants. It is for this reason that the ‘decoupling’ theory backfired so spectacularly during the financial crisis and why it is likely to once again fall foul of on-the-ground realities.

A slowing China may be bad news for the global economy in the short-term, but compelling the Communist Party to dip into their reserves and help boost domestic consumer demand could help pave the way for a longer term solution. Dumas suggests that Chinese policymakers look at measures including housing and mortgage loan subsidies, establish a social security net, allow full freehold titles to land and real estate, and abolish controls on capital export.

Unfortunately these would require the government ceding some control over both economic levers and the citizenry. That, as Dumas notes, looks to be “conceptually impossible for China’s current rulers”.

Towards a solution

Back in 2010, when Globalisation Fractures was released, these debates may have seemed somewhat academic. After all markets had rebounded strongly from their 2009 lows and the extraordinary policy action taken by politicians and central bankers seemed to have averted some of the worst case scenarios.

Traditional economic models had predicted that advanced economies in the process of deleveraging would see a fall in their exchange rates and a consequent improvement in their trade position. This, the argument went, would help smooth the process of rebalancing away from debt-fuelled growth. Over two years of sluggish growth in advanced economies later, however, confidence in these models is being severely tested.

In part we are already seeing signs of a shift in thinking. The IMF’s report included an analysis suggesting that the impact of fiscal tightening on GDP may have been higher than it had initially forecast. Earlier predictions based on historical data, such as those by the Office for Budget Responsibility, had suggested that for every pound cut in government spending there would be about a 50p impact on output but the evidence now suggests that it has been much higher.

Jonathan Portes, director of the National Institute of Economic and Social Research, says: “In normal times, a fall in government consumption will lead to a fall in deficits, which would in turn lead to a fall in interest rates. If interest rates fall, you would see household consumption rising and also at the same time the exchange rate might depreciate improving net trade. So it is perfectly possible in normal times that the multiplier is less than 1.

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“None of those things are happening, however. So why would you think the multiplier is less than 1? What mechanism remains to offset the reduction in government consumption? It is difficult to see what evidence there is to support the assumption of multiples lower than 1.”

Although the IMF’s methodology has subsequently been questioned, it nevertheless remains interesting that one of the key voices in supporting efforts to reign in government spending has become cautious over its own advice. It is particularly interesting that this volte-face occurred after signs that emerging market growth was moderating – removing one of the necessary conditions of offsetting fiscal tightening.

The problem for government’s in these countries is that they are now confronted by perverse incentives. Further weakening in the US or the eurozone could add pressure on them to maintain current account surpluses in order to provide a buffer against another downturn. But, as indicated above, these policies could help to prolong underlying imbalances in the global economy and increase the likelihood of more severe crises in future.

Here the IMF appears to propagate this confusion. In a chapter of the WEO entitled “Resilience in Emerging Markets and Developing Economies: Will it Last?” the authors write:

“Should the external environment worsen again, emerging market and developing economies will likely end up recoupling with advanced economies, much as they did during the Great Recession. And even in the absence of an external shock, homegrown shocks could pull down growth further in some key emerging economies. To guard against such risks, these economies will need to rebuild their buffers to ensure that they have adequate policy space.”

This thinking seems rather backwards. The fiscal buffers supported by the IMF are necessary to soften the blow of a demand shock from the West. In turn these are necessary because of the reliance of emerging economies on exports to drive economic growth.

Given that advanced economies look to be drifting into a “New Normal” phase of lower trend growth or even stagnation an economic policy that relies on maintaining a positive trade balance to drive growth may prove counterproductive. Few would argue for the type of shock therapy reforms seen in Russia during the 1990s but a gradualist approach to reform that helps foster a growing consumer base can only aide necessary social and economic rebalancing.

That said the structural shifts required for China to maintain a decent pace of growth over the long term will undoubtedly require a degree of pain in the adjustment. Hopefully the new administration will seize the chance to invest in industries that can safeguard the country’s future and help to foster innovation by funnelling government money into non-traditional areas.

Not only would this accomplish an improvement in the current economic climate but a forward thinking programme could also boost confidence in the government’s commitment to look out beyond the export-led boom.

For a compelling case to be made to the Communist Party this rebalancing should not be viewed as a solely Chinese problem. The West must also undergo deep structural reforms to improve productivity and competitiveness in global export markets. It might also in certain cases mean slowing the pace of fiscal consolidation to allow for a smoother transition.

It should be noted that historically the points at which rising powers have begun to challenge the supremacy of an established order have been marred by conflict. While it is far from inevitable that it will prove the case this time around such a scenario is far from implausible, especially considering the creditor/debtor trap that China and the US have fallen into.

Indeed we can already see indications of this in Republican presidential candidate Mitt Romney’s pledge to label China a “currency manipulator” and the Obama administration’s move to raise tariffs against solar panel imports. Given the stakes, though, starting a trade war seems an inadvisable route to take to address the long-term problems facing the world’s two largest economies.

Resolving this situation will take a degree of macroeconomic cooperation not seen since the immediate aftermath of the credit crunch. There seems to be little political appetite for this at the moment but the alternatives paint a far darker picture for the future than most analyses currently allow for.

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Can China rebalance its economy?

Frances Hudson, global thematic strategist at Standard Life Investments, says:

“China will ultimately have to rebalance its economy. The export pick-up has been a cyclical phenomenon and you’ve seen similar improvements across Asia.

“There are signs that it is starting to happen. The risks surrounding the US fiscal cliff and the country’s demographic problems are well known. For the US government it is a massive exercise in keeping the plates in the air but at some point people will lose confidence.

“Reserve and central bank buying of Treasuries has already dropped off significantly, which has been fine because the Federal Reserve has soaked them up. The question now is what happens when QE stops.

“Unfortunately in terms of domestic consumption, there has been a drop off even in luxury goods that had held up well over the crisis. That said the grand rebalancing was never likely to be achieved quickly. If you assume it takes the same amount of time to unwind as it took to develop it could be decades.

“In the meantime, however, the residential market in China remains a concern. With regulatory changes preventing people from buying multiple properties developers have been left in something of a hole. The announced increases in stimulus spending look pretty much cosmetic and it appears that the government is simply hoping that the economy sorts itself out.

“The Chinese political position is all about preserving power for the Communist Party. They do have a plan for universal healthcare in future and I think they will ultimately achieve meaningful reforms.

“Perhaps what the financial crisis has done is reduce the long-term potential growth for emerging markets as it has done for the developed world. People are much more focused on the risk side than they were and a lot of money is going to insuring against negative scenarios. For asset managers attention has shifted towards sustainable income.”