Taking its cue from a powerful liquidity cycle and the frothy financial market conditions it has inspired, the world is not prepared for a meaningful shortfall of US economic growth. That’s certainly the message I take away from my final stop of the year in China – whose seemingly Teflon-like economy would hardly be immune to a global accident made in America.
As 2006 draws to a close, the debate inside of China remains quite focused on its own internal challenges. At least, that’s the tentative impression that emerges from the first two days of a three-day swing through Beijing. With visible signs of the boom literally everywhere you turn and an IPO-led stock market surging its way back toward the highs of early 2001, the mood remains as ebullient as ever. While the latest monthly data are flashing signs of a slowdown, you would never know that in meeting with key decision-makers in Beijing.
The Chinese seem to be paying lip-service to the rebalancing imperatives that I and other macro types continue to stress – the long-awaited shift from an export- and investment-led growth model to one that draws increasingly greater support from private consumption (see my just released Special Economic Study, “China’s Rebalancing Imperatives: A Giant Step for Globalization,” December 1, 2006). Senior Chinese officials frame such a transformation as a longer-term objective of market-driven reforms. For the foreseeable future, however, they believe they have the luxury of time to cope with what they believe to be an evolutionary shift in the macro sources of economic growth.
Increased trade protectionism from the US
I fear an inward-looking China could be blindsided by more rapidly changing external developments. Two such possibilities worry me the most, and they are both made in America. First, is the risk of Washington-led trade protectionism. Understandably, China is focused on the upcoming strategic bilateral talks between top US and Chinese officials slated for Beijing next week (December 14-15). Led by Treasury Secretary Paulson, Fed Chairman Bernanke and US Trade Representative Schwab, and accompanied by Secretaries of Commerce, Labor, Energy, Health and Human Services, and Environment, this is as high-level a US delegation as I have seen that is traveling to deal with a major trade and international economic issue.
This strategic economic dialog is a very big deal in official China, where the lack of respect from the international community has long been a source of considerable concern. Yet there’s one key problem with the emphasis that China is placing on this mission: In a post-election climate, US political power has shifted away from the Bush Administration officials who will be sitting at the table with their Chinese counterparts. China doesn’t fully grasp the significance of the coming political power change and the deeply-rooted bipartisan anti-China sentiment that pervades both houses of the US Congress. By our count, fully 27 pieces of anti-China trade legislation have been introduced in the Congress since early 2005. The odds are rising that one of them will become law in 2007. The political winds have shifted in America just as China sits down with great ceremony to negotiate with the “lame ducks.”
US slowdown will affect exports
A second possibility that could provide an external shock to China would be a sharp slowdown in the US economy. America is China’s largest export market – directly accounting for 21% of its total exports over the past five years and a good deal more than that if re-exports from Hong Kong are added back in. Moreover, exports are likely to exceed 35% of Chinese GDP this year – making it, by far, the most externally dependent major economy in the world today. Yet economic conditions in China’s largest export market – the United States – are deteriorating dramatically in the final months of 2006.
This is a big deal not only for China but for other externally-dependent economies elsewhere in Asia – especially the big ones like Japan, Korea, and Taiwan. These latter economies could well be hit with a “double whammy” in the event of a shortfall in US economic growth – a reduction in their direct exports to America and a cutback in the demand for components they send to China that are then assembled in the “world’s factory” on their way to the US. Lacking in support from domestic private consumption, a China-centric Asian economy is an unlikely candidate for decoupling in the event of a US growth accident.
Signs of weakness in the US economy
It’s worth belaboring this latter possibility – only because most remain in denial over the swift and sudden deterioration in the US economy. That’s true in China, as well as in the United States and elsewhere around the world. Yet there are now signs of cumulative weakness in the US economy that have all the classic manifestations of a looming cyclical downturn. It all started, of course, in the housing market – the sector where everyone has been calling the bottom over the past few months. One of these months that call will certainly be correct.
However, October’s outsize decline in housing starts, together with downwardly-revised readings of new home sales and still sharply elevated backlogs of unsold dwellings, pose serious problems for the bottom-fishers. Keep in mind that any call on housing starts pertains to the leading edge of homebuilding activity – the initiation of a new building project. Starts always bottom first – even though they may not have done so yet. What comes next – and this is the key for the macro economy – are the lagged impacts from a fallback in newly started units that then depress subsequent trends in construction, employment in the building sector, the income generation forthcoming from such activity, the furniture and appliances that go into new homes, real estate brokers, and so on down the feed chain. Don’t kid yourself, even if housing starts have finally bottomed, there’s plenty to come in America’s nascent recession in the residential construction sector.
Meanwhile, in contrast to what you hear from the “compartmentalists,” the housing-led deterioration is rapidly spreading to other sectors of the US economy. Two consecutive monthly declines for both retail sales and manufacturing output in September and October should hardly be taken lightly – to say nothing of mixed early reports by retailers for November. A renewed decline in consumer confidence in November, rising unemployment insurance claims, and a stunning downward revision of nearly $100 billion to personal income (mainly wage earnings) in 3Q06, belies the notion that ever-resilient American consumers are poised to come out of this swoon. But the real kicker was a perfectly awful report on capital spending activity – with forward-looking orders and backward-looking shipments both sagging sharply in October.
Capex has long been billed as the recipient of the great “baton pass” – the sector that would seamlessly pick up the slack in the event of a downturn in housing and/ or consumption. The latest data suggest the proverbial baton may have been dropped – hardly surprising, in my view, since capital spending has long behaved as a “derived demand” that is highly sensitive to expectations of future pressures on capacity utilization. With the housing and consumption outlooks shaky at best, the so-called accelerator models of business capital spending are flashing precisely the type of caution that the October data on capital goods conveyed.
Is the US heading for a post-bubble recession?
Adding it all up – housing, consumption, capex, together with an upward revision to 3Q06 inventory building – and the US economy may be on the brink of its second post-bubble recession in five years. A surging bond market and a weaker dollar appear to be alone among major asset classes in figuring this out. I continue to fear the implications of that realization for other markets – especially equities and spread products, which remain priced for the veritable absence of any risk.
All this is a long way away from the hustle and bustle of Beijing. China’s performance has been so impressive for so long that I sense a growing tendency to take the boom for granted. Reflecting this belief, I am starting to detect an important shift in the Chinese mood, with long-entrenched feelings of self-doubt now giving way to a new-found confidence. There’s nothing wrong with confidence – it can be a critical element of any successful economic development strategy. But confidence must be on solid ground to fuel sustainable growth.
Lacking in support from internal private consumption, the Chinese confidence factor is increasingly dependent on a powerful export-led growth dynamic and associated gains in fixed investment – both very much tied to the open-ended expansion of China’s outward-looking export production platform. This could turn into a surprisingly precarious situation. What happens if the narrow underpinnings of China’s growth strategy are undermined by the twin surprises of Washington-led protectionism and a sudden deterioration in the US economy? Beijing is unprepared for either of those possibilities – as is, I’m afraid, the rest of the world.
By Stephen Roach, global economist at Morgan Stanley, as first published on Morgan Stanley’s Global Economic Forum