-->Global: Collision Course

Stephen Roach (from Melbourne)



The world economy is on a collision course. The United States -- long the main engine of global growth and finance -- has squandered its domestic saving and is now drawing freely on the rest of the world’s saving pool. East Asian central banks -- especially those in Japan and China -- have become America’s financiers of last resort. But in doing so, they are subjecting their own economies to mounting strains and increasingly serious risk. Breaking points are always tough to pinpoint with any precision. Most serious students of international finance know that these trends are unsustainable. But like any trend that has gone to excess, a group of “new paradigmers” has emerged with a compelling argument as to why these imbalances can persist in perpetuity. That is usually the sign that the denial is about to crack -- possibly sooner rather than later.
Unfortunately, the case for mounting US imbalances is easy to document. Reflecting an unprecedented shortfall of domestic saving -- a net national saving rate that fell to 0.4% in early 2003 and since has rebounded to just 1.9% in mid-2004 -- the US has turned to imported saving in order to finance economic growth. And since it must run external deficits to attract that capital, it should not be surprising that the US current account deficit hit a record 5.7% of GDP in 2Q04. Yes, America has had a current-account problem for quite some time. But there has been an ominous change in the character of these external deficits. For starters, the US current-account deficit is no longer the means by which America funds investment-led growth that drives increases in productive capacity. In 2003, net investment in the business sector -- the portion of capital spending left over after allowing for the replacement of worn-out capacity -- remained an astonishing 60% below levels prevailing in 2000.

Meanwhile, the government’s overall saving rate -- federal and state and local units, combined -- went from a surplus of 2.4% in late 2000 to a deficit of 3.1% in mid-2004. Over the same period, overly-extended US consumers have wiped out any vestiges of saving -- taking the personal saving rate down to a rock-bottom 0.6% in July 2004. In short, America is no longer using surplus foreign saving to support “good” growth. Instead, it is currently absorbing about 80% of the world’s surplus saving in order to finance open-ended government budget deficits and the excess spending of American consumers (see my 23 August dispatch, “The Funding of America”).
The international financial implications of America’s mounting imbalances are equally astonishing. It wasn’t all that long ago that the United States was the world’s largest creditor. In 1980, America’s net international investment position -- the broadest measure of the accumulated claims that the US has on the rest of the world less those that the rest of the world has on the US -- stood at a surplus of $360 billion. By the end of 2003, that surplus had morphed into a deficit of -$2.4 trillion, or 24% of US GDP. This transformation from the world’s largest creditor to the world’s largest debtor is, of course, a direct outgrowth of year after year of ever widening current-account deficits. Moreover, reflecting the particularly sharp widening of America’s current-account deficit in the past year -- an external shortfall of 5.7% at mid-2004 that is already running 1.2 percentage points above the 4.5% gap prevailing at year-end 2003 -- America’s net international indebtedness could easily hit 28% of GDP by the end of this year.

Unless the US quickly addresses its current-account deficit problem, foreign debt is set to rise for as far as the eye can see. The best forecasts I have seen of this possibility are presented in a recent paper by Nouriel Roubini of NYU and Brad Setser of Oxford (see “The US as a Net Debtor: The Sustainability of the US External Imbalances,” September 2004). Under three alternative saving and current-account scenarios, Roubini-Setser bracket America’s net indebtedness in a range of 40-50% of GDP by 2008. This is hardly a result to take lightly. As scaled by exports -- a good way to measure the ability of any economy to service its external debt -- Roubini and Setser point out that US international indebtedness could be closing in on 300% of exports by the end of 2004. By way of comparison, pre-crisis debt-to-export ratios hit about 400% in Argentina and Brazil. Of course, America is far from a “banana republic” -- or is it?

But this is only half the story. For every debtor there is always a creditor. Popular folklore speaks of a return-starved world that has an insatiable demand for dollar-denominated assets as a claim on America’s productivity-led miracles. But in fact, private demand for most major classes of dollar-based assets has been on the wane. Foreign direct investment into the US has fallen off sharply; outward FDI exceeded inward FDI by $134 billion in 2003 -- a dramatic reversal from 2000, when inward FDI flows exceeded outward flows to the tune of $160 billion. Moreover, foreign buying of US equities has also dried up. During the first seven months of 2004, foreigners bought an average of just $0.6 billion of US equities -- well short of the bubble-driven peak of $14.6 billion but also a significant shortfall from the post-bubble period 2001-2003, when foreign equity inflows averaged $5.7 billion per month. In addition, there is even a case that can now be made for a slowing of US productivity growth in the years ahead (see my 17 September dispatch, “Productivity Endgame?”).
By default, that leaves foreign demand for US fixed income securities as the principal conduit of external financing. Contrary to widespread belief, it is not an open-ended “buy America” campaign by enthusiastic private investors from abroad. Instead, it is increasingly a policy decision by foreign officials with very different motives. Over the 11 months ending in July 2004, foreign official buying of US securities accounted for 35% of net inflows into dollars -- more than double the longer-term norm and 4.5 times the 7.6% share of 2000-02. In this case, there’s no deep secret as to the identity of the Great Enabler -- Asian central banks. The rationale is clear: Lacking in domestic demand, Asia needs cheap currencies in order to subsidize its export-led economies. Given the massive overhang of excess dollars that have arisen from America’s ever-widening current account deficits, Asian central banks must recycle their equally massive accumulation of foreign exchange reserves back into dollar-denominated assets. If they don’t do that, the dollar will fall and their currencies will appreciate. It’s as simple as that.

Asian central banks currently hold about $2.2 trillion, or 80% of the world’s official foreign exchange reserves. As of year-end 2003, BIS data reveal that dollar-denominated assets made up about 70% of these reserves -- an astonishing overweight considering America’s 30% share in the world economy. Moreover, given the likelihood of persistent US current-account deficits, there is every reason to believe that Asian currency reserves -- as well as the dollar exposure of such holdings -- will have to rise sharply further in the years ahead. Nor should it be surprising as to who is driving Asia’s demands for dollars. Japan’s currency reserves are now in excess of $825 billion, whereas those of China have now exceeded $480 billion; collectively, these two nations account for more than half of Asia’s total foreign exchange reserves. Needless to say, should the dollar ever fall in the face of such a massive overhang of dollar holdings, portfolio losses -- the functional equivalent of an enormous welfare decline of foreign creditors -- would be staggering. America’s role as the world’s reserve currency offers no special dispensation from dollar depreciation or the staggering portfolio losses that Asian central banks would face in the event of such an outcome. That was the case in the latter half of the 1980s and is likely to be the case in the not-so-distant future, as well.

A new-paradigm crowd now argues that these trends are a manifestation of a new world order. They refer to it as a new de facto Bretton Woods II Agreement -- or a new “dollar bloc” zone that includes the dollar-pegged countries of China, Hong Kong, and Malaysia, along with “soft-pegged” economies such as Japan, Korea, and Taiwan. The argument is based on the premise that it is in Asia’s best interest to keep funding America’s current account imbalance. To do otherwise would run the risk of Asian currency appreciation -- tantamount to economic suicide for these export-led economies. And, of course, there is an added twist in an increasingly China-centric Asia. As long as the RMB peg remains unchanged, other Asian economies -- including Japan -- have no desire to lose competitiveness with China. That puts China in the role as being the linchpin of the broader pan-Asian approach toward funding global imbalances. Lacking in domestic demand, export-led Asia simply can’t afford to go it alone. Like most things in the world today, dollar buying is made in China, and the rest of Asia is going along for the ride.

This approach has the added advantage of also providing a subsidy to US interest rates that would undoubtedly rise sharply in the absence of this Asian dollar-support program. And, of course, those low interest rates provide valuation support for US asset markets -- first equities and now property -- that US consumers lever to reckless abandon (with cut-rate refinancing deals) in order to fund current consumption that then gets directed at buying cheap goods from Asia. In my view, this is an insane way to run the world. But the new paradigmers believe that this is the true “miracle” of international finance -- binding an unbalanced global economy together in a fashion we have never seen before.
There is a huge flaw in this so-called miracle, in my view. Just as America is putting itself in grave danger by squandering its national saving, America’s Asian financiers are running equally reckless policies in providing open-ended funding for these imbalances. China is a leading case in point. I have been a diehard optimist on China for over seven years. But now I am worried that China is at risk of making a series of major policy blunders that are tied directly to its role in leading the new Asian way. It was one thing to maintain the RMB peg in the face of mounting world pressures to do otherwise in recent years. I still feel this was the right thing to do on a stop-gap basis -- in effect, providing China’s undeveloped financial system with an anchor during a critical phase of its integration into the global economy and world financial markets.

But now China is digging in its heels on interest rate policy -- refusing to deploy the conventional policy instrument that is widely accepted as the principal means to restrain an overheated economy. China, instead, prefers to use the administrative edicts of its central planning heritage -- controlling the quantity of credit and project finance rather than its price. The combination of these two policy rigidities is especially worrisome. China’s central bank must keep creating RMB in order to recycle its foreign exchange reserves back into dollars; this runs the grave risk of undermining China’s ability to control its domestic money supply. But now, by holding its interest rates down, China is encouraging the very excesses that are driving its overheated economy -- a massive investment overhang and mounting property bubbles in several important coastal markets, especially Shanghai. By freezing the currency and its interest rates, China is, in effect, forcing its own imbalances to be vented in increasingly dangerous ways. This is not sustainable.

In the end, sustainability will probably be challenged by the unintended consequences of this new arrangement. Several potential implications of this new world order worry me the most: First, there is the growing risk of politically-inspired protectionism in the US. A saving short economy will continue to suffer from large current-account and trade deficits -- putting unrelenting pressure on job creation. Washington -- even though it is creating these problems with a penchant for deficit spending -- will look to scapegoats in the arena of foreign trade. US Treasury Secretary John Snow’s recent broadside aimed at Chinese currency policy is especially worrisome in that regard. Second, China is hurtling down an increasingly unstable path by mismanaging its domestic and international finances. Inflation is now on the rise in this overheated economy and could well continue to accelerate until China shifts its macro policy settings (monetary, fiscal, and currency) into restraint. A failure to do that is a recipe for the dreaded hard landing. Third, Europe is being squeezed harder and harder. Asia’s dollar pegs means that the euro has to bear a disproportionate share of any dollar depreciation -- a depreciation that is a perfectly normal outgrowth of any US current-account adjustment. Europe’s economic malaise is a source of considerable political angst in that region. As a consequence, continued Asian currency pegging and dollar-buying could raise the likelihood of European protectionism -- especially toward Asia.

In contrast with the claims of the new paradigmers, the stresses and strains of an unbalanced world are growing worse by the moment. These imbalances can be sustained only if the major nations of the world all march to the same beat. With the world’s growth dynamic now being effectively driven by just one consumer -- America -- and just one producer -- China -- the odds are growing short that such an increasingly tenuous arrangement can be sustained. China is probably the weakest link in this chain. That’s where I would look first as the potential trigger of the coming global rebalancing. I now suspect that China will flinch sooner rather than later.