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Reading the fundamentals

Print edition : May 06, 2005 T+T-

The current downturn on Wall Street seems to have been triggered by financial investors' belated recognition that the current pace of global expansion is not sustainable.

FOR those who think global markets are the best guides to the economic health of nations and the world economy, the week ending April 15 must have been an eye opener. It was not just that on that day the Dow Jones index recorded its sharpest single-day decline (of 191 points) in close to two years, but that it came after similar three-digit declines of 125 and 104 points during the previous two days.

While market pundits paid to keep the bulls in the pit were quick to find multiple, short-term causes for this decline - poor performance in the tech sector, inflation driven by oil prices and slowing growth among them - the real fear that drives the downturn could be different. Could the market's reading be that economic fundamentals in the global economy are such that even the current level of unevenly distributed growth it records is unsustainable? According to many, it should, because evidence corroborating that view has been available for quite some time.

Now, a slew of reports released in time for the annual meetings of the International Monetary Fund (IMF) and the World Bank detail the unease that underlies otherwise optimistic assessments of the global economy. Thus, the IMF's "World Economic Outlook", which starts by saying that there are signs that the slowdown in global growth in 2004 "has begun to bottom out, and forward looking indicators appear consistent with solid expansion in 2005", immediately points to three elements of unevenness that characterise recent growth trends. First, while growth has been strong in the United States, China and many emerging market and developing countries, the record has been poor in Europe and Japan. Second, while the U.S. records a huge current account deficit of close to 6 per cent of gross domestic product (GDP), emerging market economies in Asia, Japan, and the oil producers are recording current account surpluses. Third, while the U.S. dollar has depreciated by 17 per cent from its February 2002 peak, currencies in many industrial and emerging market economies have experienced matching appreciation of their currencies.

These divergences are significant because they could imply that the current pace of global expansion may not be sustainable and that the imminent downturn may be sharp. The problem begins at the metropolitan core, the U.S., where higher than expected growth has been driven partly by deficit-financed government spending and partly by debt-financed consumer spending. The high growth this has resulted in has been accompanied by a burgeoning deficit on the current account of the U.S. balance of payments, since rising U.S. demand has to a substantial extent been met with imports from abroad, especially from low-wage, emerging economies, especially China. The rise in oil prices to record levels has complicated matters further by widening the external deficit and triggering inflation.

This generates two kinds of problems. It puts pressure on the U.S. to reduce its fiscal deficit and raise interest rates in order to dampen growth, moderate inflation and rein in the balance of payments deficit. But if growth slows in the U.S., so would it in China whose growth is heavily dependent on exports to the U.S. Aggregate exports rose by a mind-boggling 35 per cent last year, substantially helped by sales to the U.S. Further, if exports from China to the U.S. slow down it can have implications for other countries as well. Japan is a typical example. Last year, China emerged as Japan's principal market, moving ahead of the U.S. Japan's bilateral trade with China and Hong Kong totalled 22.2 trillion yen, or 20.1 per cent, of its overall trade. As compared with this, Tokyo's trade with the U.S. amounted to 20.48 trillion yen, or just 18.6 per cent of Japan's total trade. But there are important features of this trading pattern that these aggregate figures conceal.

According to Tomomichi Akuta, an economist at the UFJ Institute in Japan, Japanese subsidiaries in China exported around 4.9 trillion yen of electronics goods in 2004, of which 8 per cent were direct exports to the U.S. The exports of electronics related items from Japanese firms to their Chinese subsidiaries in that year were around 1.3 trillion yen. Of this, about 20 per cent was linked to exports by these subsidiaries to the U.S. Further, about a third of the 846 billion yen of unfinished goods exported by these subsidiaries to other Asian countries, were finally destined for the U.S., Thus a slowdown in the U.S. would, at one remove, affect Japan as well. In fact, the effect would be far greater than suggested by these figures since there are a number of non-Japanese firms in China exporting to the U.S. that import capital goods, intermediates and components from Japanese firms. What all this implies is that a slowdown in the U.S. can not only rein in growth in the other major growth-pole in the world economy, China, but also have ripple effects in the form of deceleration across the globe that can spiral into a major crisis.

For sometime now such a denouement has been avoided because of the willingness of Asian countries with large foreign exchange surpluses to invest these surpluses in dollar- denominated assets in the U.S., especially U.S. government Treasury Bills. This helped finance the U.S. current account and fiscal deficits and keep U.S. growth going. The problem now is that this pattern of financing is increasing vulnerability among Asian economies, and may be halted, if not reversed. As the World Bank's recently released annual report on Global Development Finance warns, global growth in recent years has been accompanied by the build-up of serious financial imbalances which could, in the wake of exchange and interest rate changes, result in unexpected crises of the kind seen in East Asia in mid-1997. In particular, it says, "Countries that have accumulated large dollar-denominated reserve holdings face acute pressures and large potential investment losses from the weakening dollar, though their dollar-denominated debt burdens may ease."

What is of concern is the way in which these reserve holdings have been accumulated. Partly because of deflation in some contexts and competitive domestic production in others, the years since 2000 have seen developing countries as a group recording healthy trade and current account balances. The aggregate current account deficit of these countries declined from $84 billion in 1996 to $8 billion in 1999; it turned into a surplus of $43.6 billion in 2000, which rose to touch $152.7 billion in 2004. More recently, net capital flows to these countries have also surged from a stable figure of just above $200 billion a year during 2000-02, to $282.1 billion in 2003 and $323.8 billion in 2004. Combined with expanding current account surpluses, these capital flows have contributed to an accelerated accumulation of foreign exchange reserves by developing countries - reserves rose by $81.7 billion in 2001, $171.7 billion in 2002, $292 billion in 2003 and $378 billion in 2004. While these reserve increases are concentrated in Asia, the phenomenon of reserve accumulation was widespread with 101 of 132 developing countries reporting an increase in reserves during 2004.

The point is that a substantial proportion of these accumulated reserves is invested in U.S. government treasury bills. As the dollar weakens, the value of these bonds in terms of other global currencies decline. Investing countries suffer significant losses, making them reluctant to hold dollar-denominated assets. But if they hold back future investments and reduce past exposure they would be refusing to finance the U.S. current account deficit, forcing the U.S. to hike interest rates to attract capital. This, together with downward adjustment of the U.S. fiscal deficit, would curtail growth with its attendant global implications. This is a cause for concern for the World Bank, which predicts: "A reduction in the pace at which central banks are accumulating dollars, a weakening in investors' appetite for risk, or a greater than anticipated pickup in inflationary pressures could cause interest rates to rise farther than projected, provoking a deeper-than-expected slowdown or even a global recession."

The thrust then is to try and prevent a crash of this kind, by ensuring a slow depreciation of the dollar without any major collapse of growth. The World Bank makes a case for a sensible policy mix to which all countries make a contribution: "Tighter U.S. monetary and fiscal policy, a relaxation of European monetary policy (relative to the U.S.), and a managed appreciation of some Asian currencies would reduce the likelihood of a sharp depreciation in the dollar or an abrupt hike in interest rates by reducing global imbalances, increasing demand for dollars, and lowering inflationary pressure in developing countries." Put simply, U.S. deficit reduction must be accompanied by export increases and import declines that are not all due to dollar depreciation, but due to supporting adjustments elsewhere in the globe such as an easy monetary policy in Europe and a revaluation of the Renminbi in China.

Raghuram Rajan, the IMF's Chief Economist, concurs: "All regions have to play their part. They seem to be agreed on that but their attitudes towards the needed policy changes seem much like Saint Augustine's: Lord give me chastity... but not just yet." The best scenario from the point of view of the U.S. would of course be one in which it is able to curb imports into the country and boost exports, so that the fiscal adjustment required for balance of payments adjustment is lower and the effect of the fiscal adjustment on growth is partly neutralised by the export stimulus. Initially, exchange rate adjustments were expected to deliver this result: a gradual depreciation of the dollar combined with a sharp appreciation of currencies in countries with large current account surpluses that are major exporters to the U.S. The principal target was China, but the prescription was directed also at other emerging market economies in Asia, including India.

With China seeming reluctant to go in for a major revaluation and with textile exports from China having surged, it appears that this strategy is not working. According to a recent estimate, China's exports probably rose by 32 per cent in March, after climbing 37 per cent in the previous two months, helped by surging sales of clothes, electronic goods and machinery to the U.S. and Europe. In the circumstance, protection seems to be the answer that the U.S. is seeking. According to China's official statistics, apparel exports to the U.S. rose 147 per cent in February to $650 million. Growth rates are much higher in quota-freed categories. China's exports of knit shirts to the U.S. surged 603 per cent to $1.6 million in February. Cotton trouser exports to the U.S. market were up 548 per cent to $60 million. In response, the U.S. has decided to impose restrictions on textile imports using a clause in China's World Trade Organisation (WTO) accession conditions that permits limiting export growth in instances where domestic markets in the U.S. and Europe are disrupted by exports from the country.

However, this may not deliver the expected result in the form of reduced imports into the U.S. It may merely replace imports from China with imports from India, Bangladesh or Central America. If the U.S. action has to yield the desired result, protection must be more widespread. This is a scenario that the World Bank and the IMF would like to avoid, because its effects on global growth can be even worse and more immediate than would otherwise be the case. But there is little hope that the spring meetings of the Fund and the Bank in Washington can help fashion a consensus that prevents such a result and ensures a soft landing for the global system.

In the circumstances, the recent downturn on Wall Street could be evidence that financial investors have once again rather belatedly recognised the danger of a looming global recession. But, maybe they at least have not fully forgotten how to read the fundamentals.