With a number of economists raising the probability of the US economy sliding into recession next year, the implication on the global economy may range from a fundamental shift in pattern of trade and material flow to a new currency regime where Asian currencies start playing a significant role.
Alan Greenspan, last month said the odds of hard landing of the US economy have increased as consumer spending may slow down due to a decline in house prices. Similar assertions have been made by likes of Richard Syron of Freddie Mac to Lawrence Summers of Harvard University. Although, the mood is more of caution rather of panic at this point, the world may just come out unscathed whatever the fate may hold for US economy.
After 16 years into the current cycle of US trade deficit, which began in 1991, the trend has reversed marking a fundamental shift. For the past two decades, US mainly bought and borrowed while rest of the world sold and saved. The US has been considered having the safest and most liquid financial market and consequently it has been the recipient of the global excess savings. It may be in the interest of Japan, China, Russia and Europe to maintain surpluses against the US in the long run as they tackle serious demographic changes expected to occur in the next few decades.
The US current account deficit that hit an all-time high of 6.8% at the end of 2005 of GDP was down to 5.5% earlier this year. Instead of depending heavily on the US economy as the global growth engine, the world economy could start to become more evenly balanced. No other country seems to have benefited from the seemingly insatiable consumption by the US consumers than China. There is an interesting and ironical connection between US consumers and China. To pay for these imports, the US has to attract $2.1 billion in foreign investment every single day.
Since China opened its economy three decades ago, it has been growing at a blistering pace. It has clocked more than 10% average GDP growth rate for the last 30 years, which is higher than what most developed economies witnessed during their growth days. America was one of China?s most important export markets.
Exports kept the factories humming and provided employment to thousands of unskilled and semi-skilled migrant rural workers. To maintain the competitive edge in exports, China pegged its currency to the US dollars. To maintain its peg and keep the interest rate low, it started accumulating massive foreign exchange reserves by mopping up foreign currency. This was in turn invested in dollar denominated assets, mainly the US government bonds.
While in theory, foreign central banks investing in the US government bonds and thereby funding the budget deficit signifies the strength of the US economy, this has, however, now reached to a stage where more than 40% of national debt is owned by foreigners.
The long-term interest rates, which is driven by government-bond pricing is now controlled by foreign central banks, mainly Japan and China and mortgage rates are directly linked to government bond yields and long-term interest rates.
Increasing housing prices was one of the important underlying factors in strong consumer spending and resultant above average growth of US economy since the recession of 1991. With the current turmoil in credit market and meltdown in housing prices, the consumer spending is almost certain to slow down. Moreover, the dollar has been hammered in the last 10 months to a new low which may trigger fear of higher interest rates and inflation if the foreign central banks decide not to invest in the US treasury bonds any more.
Recent data shows that long-term capital flows measured just $19 billion in July as compared to $91 billion the previous month. Soaring interest rates will increase mortgage rates making borrowing for home more difficult and thereby decreasing the demand for new homes. It is estimated that every 6% drop in dollar value reduces American income by 1% and coupled with reduced consumption this may nudge the US economy into recession.
With a mere 50% probability of such an event occurring, one would expect it to send shock waves to markets in China, one of the largest trading partner for US. However the reality is quite different. The Shanghai stock exchange composite index recently crossed 6,000 marking new high with the price-earnings ratio based on historic profits touching almost 50.
China, which has traditionally punched below its weight, has now started playing a bigger role in the global economy. At market-exchange prices, this year China will contribute more towards global GDP growth than the US. While the fate of US economy seems downbeat, the fate of the world?s economy may now also hinge on the strength of Chinese economy.
The primary threats are formation of asset bubble, surging inflation, slump in exports to the US and over-investment. The share prices have more than quadrupled since 2005. This is, without doubt, a bubble waiting to burst but the implication of the bust may not have significant impact on the economy.
The bulk of the shares is still held by the government through state owned enterprises and the remaining value of the tradable shares is only 35% of GDP. This accounts for only 20% of household financial assets that may not adversely influence the consumer spending in the event of the market downturn. A nastier impact of fallout in stock market would be in corporate profitability. According to a study by Morgan Stanley, more than 30% of profits reported by listed companies came from share price gains and other investment income. A stock-market crash would impact the corporate profitability and make borrowing from banks more difficult curtailing future investments.
China has gradually shifted its export focus from the US to the European Union (EU). The growth in exports to EU in the last quarter has outstripped growth in exports to US by a factor of three. While export constitutes 40% of China?s GDP, it only contributes to 25% to the growth of GDP. The growth in Chinese economy is increasingly driven by domestic consumption rather than external dependency.
The slowdown in the US consumer consumption may shave off half a percent of China?s GDP growth, but not enough to have any material impact on its already high growth rate. Instead it may actually help the Chinese government to cool off the overheating economy. It will help China reduce the burgeoning trade deficit with US, which is often used as a weapon by the US to pressurise China to appreciate its currency faster. The Chinese economy is at a juncture where high savings and investment rates are coupled with soaring asset prices and upward pressure on inflation and currency. It will be interesting to see how China?s economy fares in a rebalancing world economic order.
The author heads the Beijing branch for Infosys in China and is also a fellow of India China Institute. His views are personal
