As we continue to look ahead to 2008 one of the key uncertainties facing the global economy remains the massive structural imbalance that exists between the US (and to a lesser but still significant extent, the UK) and the surplus nations of Asia and elsewhere.
We have long wondered when this profound imbalance might be addressed and whilst we are not certain that, in a year in which the Chinese host the Olympic Games for the first time, the adjustment will take place next year, the pressures for change are growing.
In his testimony to accompany the release of the Bank of England’s Quarterly Inflation Report, governor Mr Mervyn King observed that the 30% depreciation in the dollar’s trade-weighted value over the past five years was a clear indication that the US, weighed down by a mountain of debt, was in structural difficulty and that “the rebalancing in the world economy is underway”.
Support for Mr King’s view comes from an unlikely source. Brazilian supermodel Gisele Bundchen has declared, with reference to her contract with Pantene, that she no longer wishes to be paid for her work in dollars.
With fears regarding the US currency’s future so widespread we look at the dynamic by which the global imbalance might right itself.
In essence we are looking for a new angle on a theme now receiving considerable attention, both in the financial markets and in the media. In this note we look not directly at the adjustment (which we regard as inevitable) but more importantly, how an adjustment might look in an environment in which the US current account deficit falls from c6.5% of gross domestic product (GDP) to a level closer to that which might be regarded as sustainable during a period of lower capital inflows from abroad (i.e. c2%).
Without question the dollar would weaken further, but that is not all. Balance of payments crises happen when credit gets withdrawn. Not surprisingly, the knock-on impact on economic growth tends to be significant (just as it is for companies and for consumers when they spend beyond their means and credit is withdrawn).
In such circumstances consumption adjusts very quickly to the new environment. Not only does a marked decline in consumption have an extremely adverse effect on GDP on its own, but also through a marked reduction in imports (exports rise only gradually at first, in response to currency weakness and are governed by economic conditions prevailing elsewhere).
Put simply, US exports would expand only very slowly, while imports would contract markedly. But because exports and imports make up only a modest share of the economy (c10% and 15% respectively), achieving a 4.5% adjustment on the current account would be very painful.
Pressure on the dollar would intensify and interest rates would have to rise as external demand for dollars faded. Inflation pressures might be expected to increase, albeit only modestly.
None of the world’s major developed economies have current account deficits anywhere near as large as that of the US. There are, however, plenty of examples of emerging economies which have been through similar sized adjustments and quite a few developed economies which have been through a smaller adjustment than that prescribed above.
In every case (regardless of how big a country is), when credit gets cut off the economy needs to adjust and that adjustment happens very quickly (i.e. about two years if emerging economies are anything to go by, during which time the average starting deficit is about the same level as that of the US now).
During the adjustment process, GDP growth tends to slow sharply (again by c4%-5% if emerging economies are anything to go by). The slowdown is caused, in every case, by money pulling out. In the late 1980’s the US had a relatively minor adjustment as the current account deficit narrowed from 3.5% to 2.0% of GDP in response to a weakening currency.
Only later, when the US economy dived into recession, did the deficit disappear altogether. Critically, the relationship between relative growth and the current account is very strong. For the current account to adjust by as much as it’s going to have to, the US economy is likely to have to weaken a lot and stay weak for a considerable period of time.
Indeed if the period 1989 – 1991 is anything to go by, annualised growth may have to slow to as little as 1% and this, indeed, is what some forecasters are already predicting. Whilst few are brave enough yet to forecast recession, probabilities have been rising for some time and we await the timing of the first mainstream recession forecast with some interest!
In textbook terms, as the adjustment gets underway the current account deficit begins by widening as a country’s deficit responds adversely to the still strong currency and lack of competitiveness. In fact the US currency has been weakening for some time so on this occasion exports have held up relatively well.
However, as the adjustment takes over growth responds to a sharper pull-back in imports while the rebound in exports is much slower (i.e. about two years for exporters to identify a trend, respond to it and act accordingly). Therefore in the modern context while exports may have been doing relatively well they have not exactly shot the lights out.
Interesting, in this context, to consider the plight of the beleaguered European finance ministers. On average the previous drop in imports tended to be in the order of 20%. In the US case, to achieve an adjustment on the scale noted above imports would have to fall to about 12% of GDP and possibly more.
The forecast decline would in itself be almost twice as big as the adjustment that took place during the 1990 US recession and for European politicians already weighing up the potential impact of a currency suddenly in favour with everyone, the outlook for the region’s exporters is serious enough to account for a few sleepless nights! Are we bonkers?
Consider this: the reason why we think that this is how the adjustment will play out is that the basic pattern of the deterioration in the US current account is typical. Exports are uncompetitive and imports are soaring. So the unwinding will be typical too, with imports falling faster than exports grow.
The unusual part of this whole scenario is that the US currency has already been falling for the past five years and yet the deficit is getting worse, not better. In substantial part this is due to the shift in the US major trading partners over the period and in particular the increasing significance of China thanks, in no small measure, to the pegged currency.
The big beneficiary of US export uncompetitiveness has not been Europe, it has been China. 2008 sees both the Olympic Games in China and a US presidential election.
Capitol Hill already rings to the clamour for protectionist barriers to protect US businesses and jobs and Treasury Secretary Mr Hank Paulsen spends much of his time shuttling to Asia in, so far, vane attempt to encourage the Chinese authorities to abandon the peg.
Whilst it cannot be denied that the Chinese economy’s super-sized growth is stoking inflationary flames, the continued commitment to the exchange rate peg is forcing the Peoples Bank of China to push base rates ever higher, risking an economic hard landing and popular unrest in the process.
In the meantime Chinese rhetoric remains uncompromising with vague, but pointed and persistent, commentary from high ranking officials and even the state media referring to the country’s stockpile of dollars as its economic “nuclear option” available for disposal at any time.
Whether this will actually happen, given considerable vested interest in retaining the delicate status quo remains to be seen, however, it is clear that pressures, both economic and political, are building on both sides. At some point an event of seismic proportions will be unleashed. We cannot teeter along the slender tightrope suspended between Washington and Beijing for ever.
Whilst it is always dangerous to look to the past to extrapolate what might play out in the future the owl of Minerva has taken wing! The extent to which the US current account deficit has expanded is following typical lines. We therefore expect the adjustment to be typical too. The dollar, already in full retreat, will need to fall further. Rising exports may cushion the blow, but insufficiently at first.
The simple fact of the matter is, however, that the US will not be able to go on buying goods at below their true cost in exchange for Treasury bonds which are likely to be worth substantially less as the dollar continues its inexorable decline. The dollar will, however, not bear the full brunt of the adjustment and growth expectations, already on the back foot, will need to be cut back too.
By Jeremy Batstone-Carr, Director of Private Client Research at Charles Stanley