Can Asia stall a global recession?

The United States' economic growth seems to be slowing and expectations are that things will worsen before they get better.

THE news came on October 27. The advance estimates for the United States Gross Domestic Product (GDP) during the third quarter of 2006 indicated a sharp, higher-than-expected fall in the annualised rate of growth to 1.6 per cent, as compared with 2.6 per cent in the previous quarter and 5.6 per cent in the first quarter. The signs are that U.S. growth is slowing and expectations are that things will worsen before they get better.

This tendency is a cause for global concern. For some time now, the U.S. with its huge trade and current account deficits has served as the locomotive for the world economy. The downturn, therefore, not just spells hardship for the U.S., but also threatens to slow global growth. In fact, talk of a global recession is widespread.

U.S. growth has for some time now been sustained by a combination of a housing boom and high consumer spending. What accounts for the recent slide in growth rates? The press release of the U.S. Bureau of Economic Analysis decomposes the fall in GDP growth rate as follows: "The deceleration in real GDP growth in the third quarter primarily reflected an acceleration in imports, a downturn in private inventory investment, a larger decrease in residential fixed investment, and decelerations in personal consumption expenditure (PCE) for services and in state and local government spending that were partly offset by upturns in PCE for durable goods, in equipment and software, and in federal government spending."

Analysts were quick to attribute the decline to a rise in imports driven by oil and a cutback in housing construction as a result of the intensification of the correction of the housing bubble. The first of these is not a cause for excessive concern as oil prices have been on the decline in recent months, falling by as much as 30 per cent over the last two months. The real problem is the implications of the unwinding of the housing boom.

The role of that boom in keeping the U.S. economy ticking has been widely recognised. The high value of pre-existing housing assets encouraged U.S. households to indulge in a consumption splurge, since their wealth position seemed to warrant a smaller sacrifice of current consumption to bolster their net worth. In fact, most households consumed more than their current income, financing excess consumption with borrowing. And the high value of their housing assets provided them with the requisite collateral with which to borrow.

What is more, this process was reinforcing. Low interest rates and high net worth triggered a debt-financed speculative boom in the housing market. Families borrowed to buy or expand a home, pushing up home prices in the process. Higher prices of their houses meant that Americans had more collateral with which to borrow more. As economist Rick Wolff put it, this "cycle of borrowing-building-and borrowing more-and building more produced an historic run-up in home prices alongside an historic rise in consumer debt".

The speculative housing boom helped push up the growth rate substantially. New housing investment triggers demand for construction material and labour and has its multiplier effects. Further, the sale of existing housing assets at higher prices encourages consumption spending, through the wealth effect noted above.

The problem is that the housing boom is winding down, and pretty rapidly. Data released a day ahead of the latest GDP figures showed that prices for newly built American homes had suffered their largest year-on-year fall since 1970. The median price of a new home fell to $217,100 in September, 9.7 per cent lower than in the same month a year earlier. And the fall is ongoing. Average house prices fell 2.1 per cent, down from a growth rate of 6.4 per cent in August. With inventories of unsold houses still high, this is likely to continue despite signs that housing sales are responding positively to the fall in prices.

The only cause for comfort at the American end is the fact that personal consumption expenditure on goods, particularly durable goods, is still rising. But that could merely reflect the lag between wealth adjustments and the resulting curtailment of consumption spending. Americans may only be beginning to realise that circumstances warrant a tighter hold on their wallets. Once that realisation dawns, the downturn could be sharper, and a return to the recession years early in this decade is a real possibility.

The debate has, therefore, shifted from the question whether U.S. growth would decelerate significantly, to whether this would have a dramatic effect on the global economy. Some impact on global growth is inevitable given the gaping hole in the U.S. balance of payments that reflected the rest of the world's exports to that country. Slower U.S. growth would mean reduced imports, and therefore reduced growth elsewhere.

However, optimistic analysts argue that this is not a cause for too much concern. The reasons, according to them, are (i) that much of the recent growth in the world economy has been the contribution of countries other than the U.S., especially those in Asia like India and China, and (ii) that it is not exports but the expansion of domestic demand in these countries that has been responsible for their growth. The clinching evidence in this view is that though export-to-GDP ratios in these countries have been high and rising, net export (exports minus imports), which is the true stimulus to investment, is still a small proportion of the GDP. Moreover, the increment in net exports makes a relatively small contribution to the increment in their GDP, which in this view is driven by domestic demand, especially domestic consumption spending (The Economist, October 21-27, 2006).

This argument misses out on three features of recent global growth outside of the U.S. First, there has been a long-term shift in the drivers of growth in the global economy. Catherine Mann of the Institute for International Economics reports a systematic trend over the 1990s in the relationship between domestic demand growth and GDP growth for countries other than the U.S. Whereas in the early 1990s non-U.S. global GDP growth was less than non-U.S. domestic demand growth, between the end of the 1990s and 2003, non-U.S. domestic demand growth fell short of GDP growth by more than 1 percentage point. That is, external demand has indeed become an important driver of growth in the global economy outside the U.S.

Second, aggregate net exports need not reflect the importance of the U.S. market, in particular for the fast growing economies of the world. It is true that the ratio of China's net exports to its GDP is a fraction of its 40 per cent export to GDP ratio. But, while a substantial share of China's exports is to the U.S., much of its imports come from countries other than the U.S. China is the location where capital goods, intermediates and components imported from non-U.S. countries such as Japan are used to manufacture goods exported to the U.S. So the net export figure underestimates the role of the U.S. economy in China's growth.

China's trade surplus with the U.S. rose to $114.2 billion in 2005, up from $80.2 billion in 2004. This is because exports to the U.S. rose by over 30 per cent to $162.9 billion, whereas imports from the U.S. amounted to only $48.7 billion. Dependence of that kind ensures that the U.S. market is an important driver of Chinese growth.

Finally, while it may be true that the "middle class market" for consumption goods in China and India is booming, resulting in a surge in domestic demand, that market is related in multiple ways to the process of the "opening up" of these economies and therefore to the performance of their export sectors. Exporting firms, including transnationals, involved in goods and services production are the ones that pay salaries that encourage consumption spending. It is the listing of these firms in the exporting or export-related enclave in the stock market that results in the financial boom that delivers more "middle class" consumers and attracts international capital into these countries. The resulting liquidity encourages financial liberalisation and triggers a credit-financed housing and consumption boom.

These elements of inter-relatedness in the post-liberalisation growth enclaves of the high-performing Asian economies make exports more important than their sheer numerical magnitude, and domestic demand less autonomous than it is made out to be. The U.S. market is a crucial destination for those exports.

Thus, the importance of Asian growth for global expansion notwithstanding, a central role for the U.S. economy in sustaining that expansion cannot be denied. In the circumstance, to expect the Asian economies to take on the role of locomotives of the global economy is to expect too much. It amounts to adopting a sanguine view in desperation, since there seems to be no other alternative shock absorber in sight.