Asian economic boom or bust?

Asia is home to the world\'s dynamic economy. However, there are clear signs of impending economic slowdown in the region - what is not clear is what the implications are for the rest of the world. Daniel Ben-Ami investigates.

Is the Asian economy heading for a slowdown? The question is clearly critical to Asia itself – home to most of the world’s population and its fastest-growing economic region. It is also important for the rest of the world. If the dynamic Asian region slows down, the rest of the global economy is almost certain to suffer sluggish growth.

As is often the case, the evidence for a slowdown is mixed. Some indicators seem to show the world economy is slowing while others signal continuing robust growth. In any event it is important to go beyond one or two months’ data to draw any definite conclusions. Short-term data sets are often subject to considerable fluctuation.

There is also so much data it is difficult to separate the key developments from the background “noise”. Economists and strategists can easily get lost in the daily release of official and private data from around the world.

For the bears there are certainly signs of a slowdown. Most clearly, low bond yields can be signs of an impending recession – although whether they are this time is a subject of debate. The Organisation for Economic Cooperation and Development’s composite of leading indicators – an index of where the world economy is likely to be heading – is also pointing downwards (see graph on page 22). In addition, the current talk of a “soft patch” or a “mid-cycle pause” will no doubt be taken by some as euphemisms for trouble ahead.

Many investment strategists accept there is some kind of slowdown, but are relatively relaxed about it. Andrew Milligan, head of global strategy at Standard Life Investments, says: “The slowdown has already begun, but it is localised rather than global.” He sees the manufacturing sector in particular suffering as a result of higher oil prices and tighter monetary policy.

Gerard Lane, an investment strategist at Morley Fund Management, takes a similar view. “Yes, there is a slowdown, but we don’t envisage a recession in the US or the UK.” He sees the current deceleration of growth as normal for this stage of the economic cycle.

To begin to assess the character of any slowdown, both in Asia and globally, it is necessary to identify the key factors. Without a logical framework it is impossible to assess the relative importance of different indicators.

From the perspective of growth in the global economy, the key regions are America and Asia. America is important because it is the world’s largest economy as well as being the most developed. Asia is also large and it is the most rapidly growing region.

On a purchasing power parity basis – taking into account the prices of goods inside the country – the US Iaccounts for just over a fifth of global output (see pie chart on page 23). In contrast, developing Asia as a whole accounts for about a quarter of global output, with Greater China at 15% and India at 6%. If Japan and the newly industrialised economies are added to the total, it brings Asia up to about 35% of global output. In other words, America and Asia together account for about 56% of global output.

At current exchange rates the figures look slightly different. If lower prices are not taken into account then developing Asia accounts for less of the world economy and America is relatively more important. Either way, the two regions together make up a substantial portion of global output.

But there is another reason for focusing on America and Asia when considering global growth. Asia is the fastest-growing area of the world economy while America is the most rapidly expanding region of the developed world. If America and Asia both slow, the prospects for global growth are dim.

Looking briefly outside of America and Asia, the outlook for growth looks sluggish (see table on page 21). The eurozone is clearly growing slowly. In addition, the recent half-point cut in interest rates by the Swedish central bank could indicate that the European Central Bank will follow. Such rate cuts are generally made when central banks are trying to mitigate the impact of a slowdown. Even in Britain, which has grown faster than continental Europe in recent years, two members of the Bank of England’s Monetary Policy Committee recently voted for a rate cut.

Japan is a slightly different case. Given its size – the second-largest economy in the world in terms of market prices – a Japanese growth spurt would certainly matter. But much of its recent growth seems to be related to the dynamism of developing Asia. Japanese trade with and investment in mainland Asia, and China in particular, is bolstering its economic growth.

This brings the argument back to America and mainland Asia – the latter with China at its core. But it would be wrong to see the two as symmetrical. As Stephen Roach, chief economist at Morgan Stanley, has long argued, the US is focused on consumption while Asia concentrates on production.

Of course neither characterisation is absolute. America is still a large producer of goods while Asian consumption is increasing. But America is increasingly consuming more than it is producing – hence its burgeoning current account deficit – while Asia produces more than it consumes.

This global imbalance can survive because Asian central banks have bought huge amounts of US treasury bonds. In effect Asia is lending America money so it can buy Asian goods. This is what Brian Reading of Lombard Street Research has called a “marriage of convenience” between the two economic blocs. It can keep going because, at least for the time being, both sides benefit from the relationship.

The different character of the two blocs gives important clues when assessing whether a slowdown is imminent. For America there is much emphasis on monetary factors such as inflation and housing bubbles – in a consumption-driven economy, these can indicate an imminent slowdown. In relation to Asia its external ties are important. Given its trading orientation, a slowdown in export growth is likely to signal a deceleration of the regional economy. However, it is also possible that domestic forces for slowdown could emerge first.

This is not to argue that American inflation or an Asian trade slowdown are the fundamental causes of any future global malaise. It is more that these are the areas in which problems could well manifest themselves first.

The debate about inflation is particularly muddled. This is because it is really two discussions in one. There is the question of the practical implications of inflation rates for investors. Then there is the more complex one of what changes in consumer prices are signalling about economic prospects.

Discerning the practical implications of inflation is relatively easy. High inflation is bad for bonds – it erodes their capital value – while low inflation is good for them. Equities, in contrast, do relatively well in a high inflation environment as they are more likely to retain their value in real terms.

The inflation outlook also affects the relative performance of different countries. Japan is likely to benefit from a more inflationary environment as it has suffered from deflation for several years. In contrast, markets such as America and Britain are likely to do better at times of low inflation.

In addition to the practical debate on inflation there is a more covert, although important, discussion of how it reflects changing economic prospects. The underlying assumption is that there is a golden mean level for inflation – perhaps 2% a year in Britain. If inflation is much greater, it can signal that economic growth is unsustainable. Sooner or later there will be economic overheating and growth will slow. If, in contrast, inflation is much lower than the desirable level, it can signal that the economy is already slowing.

This framework explains how the current debate on inflation prospects fits into the debate about global markets. Although both sides seem to anticipate a slowdown, there is disagreement about the form it is likely to take.

According to the latest Merrill Lynch survey, most fund managers shifted to becoming less concerned about inflation in May and June after two years of anxiety. The publication of several sets of data suggesting that inflation was falling no doubt played a role in influencing fund manager views. These included the biggest monthly fall in the “prices paid” component of America’s Institute for Supply Management survey since July 1973. (see “Managers’ inflation fears subside”, Fund Strategy, June 20, 2005, page 10). It seems that most fund managers believe that global economic growth is already slowing.

In contrast, economic consultancy Lombard Street Research sees rising inflation in America in the short term. Its argument points to the sharp rise in labour income growth in America recently. The conclusion is that the US is likely to suffer from higher inflation and a squeeze on profits. As a result it could suffer a “hard landing” in 2006 after an acceleration of growth in the second half of this year.

Either way it seems likely there will be some form of American slowdown. And given that Asia is still heavily dependent on exports, a slowdown in the West – and America in particular – is likely to have a heavy impact.

Many argue that a slowdown in Asian exports is already apparent. David Bowers, chief global strategist at Merrill Lynch, says: “We are definitely seeing Asian export growth slowing big-time.” He points to North-east Asia – including Japan, South Korea and Taiwan – as an example of this trend.

Others counter that Asia is becoming more self-sufficient economically. But this is based on wishful thinking rather than an examination of the facts. It is true that Asian consumers have become richer over time. However, relative to the size of the Asian economies the export sector is still key. Lombard Street Research argues that, if anything, the relative importance of the export sector has risen since the Asian financial crisis of 1997/8.

This relationship is acknowledged by many experts. Andrea McNee, chief investment officer of Britannic Asset Management, says: “Asia is very much tied to the external cycle.” Similarly, Jacob de Tusch-Lec, a European equity strategist at Merrill Lynch, says: “China is much more dependent on the US consumer than most people think.”

So it looks like an American slowdown will, sooner or later, cause Asia to slow down too. But what about the forces of slowdown within Asia? Some argue that China shows signs of growth deceleration. If they are right then there is also likely to be a domestic impetus towards an Asian slowdown.

The main debate about an Asian slowdown focuses on China. Here again there is disagreement. Some argue that China is so dynamic it is likely to overcome any problems it encounters, while others disagree.

Part of the problem lies in interpreting Chinese official statistics. Most authorities question their reliability. Michael Thomas, head of equities at Threadneedle Investments, is probably typical in taking a reasonably upbeat view of Asia while questioning the figures. “Asia continues to perform pretty well – if you believe the numbers.”

But there are ways round the headline figures for output growth that help give a better idea of the real state of the economy. For example, the figures for trade, because they have counterparts outside China, can be a more accurate gauge of real developments.

Morgan Stanley and Lombard Street Research argue that China is already experiencing an economic slowdown. Diane Choyleva, an economist at Lombard, says domestic demand growth in China has slowed significantly. “The Chinese economy has been kept going by strong export growth,” she says. But the latest data shows not only flat imports but a halt to export growth too. From her perspective, not only has China’s “hard landing” begun, but it is also vulnerable to external shocks.

Morgan Stanley’s Roach argues along similar lines. Although he had assumed American growth would slow first, he now argues that the Chinese slowdown will precede the US. He points to China’s export growth – currently 30% year-on-year – as unsustainable. He also sees a property bubble that is fit to burst. (Morgan Stanley Global Economic Forum, June 13, 2005).

Before drawing to a close it is necessary to consider the impact of rising oil prices. There are many who argue that high oil prices will hit East Asia particularly hard as they are, in effect, a tax on growth. While oil producers benefit from higher crude prices, those countries that are mainly involved in manufacturing, like most of East Asia, lose out. Asian output could suffer with oil prices at a record level, at least in notional terms, of $60 a barrel.

But the picture is more complex than appears from the oil price alone. The price per barrel is not independent, but is determined by a range of other factors. One of the most important is demand from Asia, and particularly China, itself. So to a certain extent the price of oil is an expression of growing Asian demand rather than the cause of a slowdown. From that perspective a fall in the price of oil could be a sign that Asian growth is slowing.

Several conclusions can be drawn from the factors examined in this article. First, a global slowdown is likely – indeed there are signs it is already happening – although its impact looks set to be uneven. Some areas of the world, notably the eurozone and Japan, are already experiencing sluggish growth.

Asia, the most dynamic area of the world economy, is likely to slow too. Apart from anything, the region is far from immune from the general workings of the world economy. However, it also looks economically strong enough not to go into a full-blown recession.

In addition, the “marriage of convenience” between America and Asia should be carefully monitored. If for some reason it no longer suits one side to maintain the relationship, it could have serious consequences for the global economy. Protectionist sentiment or rows over China’s currency peg to the dollar could accelerate the break-up of the relationship.

The overall outlook looks like a slowdown in the pace of growth rather than a severe contraction. Bouts of volatility are also possible – especially in areas that have experienced overheating.

Finally, rising asset prices are compatible with an economic slowdown. Surges in house prices in many countries, including America and Britain, do not seem to be justified by fundamentals. There is also a question mark over recent share price rises. There is reason to believe that, at least in some cases, such rises are unsustainable.

For the investor, the key conclusion is probably not to expect rapid growth, even in emerging equity markets. There is also the likelihood of volatility ahead, although it is important not to panic in such a situation. As ever, it is best to focus on the longer term rather than become preoccupied with short-term market fluctuations.

An Asian savings glut?

In recent months a new explanation of the massive imbalances between America and Asia has become the orthodoxy. The new argument, favoured by the American authorities, puts the blame for the imbalances on Asia rather than America.

The conventional view portrays American profligacy as the cause of global imbalances. The Americans are consuming beyond their means and such behaviour has led to the widening current account deficit between America and the rest of the world. The ultimate solution, from this perspective, is for Americans to save more and consume less. If America were more constrained, so the argument goes, the world economy would come back into balance.

Then in March a governor of the Federal Reserve, Ben Bernanke, gave a speech that turned the argument on his head.* He conceded that America saved too little relative to Asia, but said the problem was with Asian excess. Rather than Americans saving too little, the problem was with Asians saving too much. Since not all this saving could be used for investment within Asia, much of it found its way into American financial markets.

From this perspective America is doing a wonderful service to the rest of the world. It is absorbing savings that could otherwise wreak havoc in Asia – perhaps by pushing up asset prices and fuelling inflation. By recycling Asia’s surpluses the American financial markets are, in this view, keeping the world economy going. In the longer term the solution is seen as Asia developing more efficient financial markets along the lines of the American model.

Not surprisingly, Bernanke’s theory has proved popular in Washington. He has been promoted to become chairman of George W Bush’s council of economic advisers. Bernanke is also widely seen as the likely successor to Alan Greenspan as chairman of the Federal Reserve. Greenspan himself has endorsed the idea of an Asian savings glut, as have influential commentators such as Martin Wolf of the Financial Times. It was also the subject of a recent cover story (July 11) in Business Week, one of America’s leading business magazines.

Others have criticised Bernanke and the Fed for propagating such self-serving arguments. Morgan Stanley chief economist Stephen Roach was particularly scathing, saying: “No one has a bigger stake in dismissing the perils of the Asset Economy than its architect, the Fed.” (Morgan Stanley Global Economic Forum, July 5, 2005). Roach argues that the Fed, by keeping American interest rates so low for so long, has played a key role in creating global imbalances.

From such a perspective not only is the Bernanke argument wrong, but it is irresponsible. It means that the American authorities escape blame for creating the problem in the first place. It also makes it harder for the world economy to make the adjustments needed to bring it back into balance.

But there is a more fundamental reason for questioning both the Bernanke framework and those of his critics. The importance attached to differences in savings rates as the main driver of imbalances is open to dispute. Although such explanations are in vogue at present, this has not always been the case. In the past factors such as capital investment have been seen as more important. Perhaps revisiting some of the older discussions will provide an answer to the conundrum.