The world economy since the turn of the century has been characterized by the symbiotic relationship between Chinese production of consumer goods, US purchase of those goods and Chinese willingness to recycle the profits of this trade back into US securities. Resource based economies such as Brazil and Australia also thrived in this model by providing the necessary raw materials for the production of the goods being manufactured by China. This is the infamous “global imbalance” that so many economists debated over the last few years. As the US trade and current account deficits rose, economists began to question the sustainability of the relationship and whether it could be changed without causing a major economic dislocation. As it turns out, economists were right that the relationship was unsustainable, but rather than the rebalancing causing a major economic disruption, it is the economic disruption that is driving the rebalancing.
The recycling of the Chinese current account surplus into US Treasury and Agency securities suppressed US interest rates and was a major factor in the US housing bubble. Alan Greenspan and Ben Bernanke termed this a global savings glut, essentially blaming the savers of the world for disrupting their conduct of monetary policy. Welcome, Mr. Bernanke, to the global economy. The real culprit was Greenspan and Bernanke’s over production of dollars which ultimately had to be spent on something with a US dollar price tag. That the recipients of those dollars chose to save rather than consume was and is irrelevant. If US monetary and fiscal policy had encouraged savings rather than consumption, we wouldn’t now be talking about rebalancing the global economy. If the US had balanced its budget, the flows would have at least gone to productive assets or trade rather than financing wasteful government spending. Alas, that is water under the bridge and the only question now is how to deal with the aftermath.
Since the Chinese and other emerging market economies have the money, they will determine to a large degree how the rebalancing proceeds. And since the Chinese central bank will determine the marginal demand for so many products from US Treasuries to Brazilian iron ore to Chilean copper, what they do with their $2 trillion in foreign reserves is vitally important to investors. Luckily, Chinese central bank governor Zhou Xiaochuan recently gave a speech in which he laid out various scenarios for the rebalancing:
Smooth unwinding “This is what we've talked about quite a lot these days, and it is the scenario we most want to see. U.S. households' savings rate and the overall savings rate rise, and Chinese consumer spending also rises, helping correct global imbalances. This is the most ideal. However, the restructuring will touch on many difficult issues, and it will not be easy. At the same time, we cannot assume that this problem can be easily solved just based on recent short-term data."
Chinese overcapacity “The U.S. household savings rate rises and the United States does not need as many Chinese imports as before, which leads to over-capacity, idle facilities, less employment, ushering in a period of low GDP growth for China. We must try hard to avoid this scenario. Another aspect of this scenario is that perhaps inflation could bring about a change in the real exchange rate, leading to restructuring." Domestic investment "The U.S. household savings rate rises; Chinese consumer spending does pick up, but not by enough, and meanwhile China's urbanization investment increases. The two factors cause a sufficient fall in surplus savings and savings outflows. In the process, we can assume that urban infrastructure, housing and service facilities will develop significantly to support consumer spending and employment in future. This is also an acceptable option. But we have to reform the system for financing urban development investment, for instance, the issue of municipal bonds "” a problem that has been discussed for many years." Productive capacity "U.S. households' savings rate increases and they no longer need so many Chinese imports. At the same time, as China expands its investment abroad, it transfers a portion of its productive capacity, including export manufacturing, to other developing nations. From the perspective of north-south relations, this will benefit the industrialization of developing nations and their consumption will also rise. This scenario is also heading in the right direction. In this case, China's trade surplus would no longer be a major source of conflict. An important test would be whether the United States would then have a big trade deficit with other developing nations." U.S. trade deficit "The rise in the overall U.S. savings rate is in fact neither smooth nor sustainable, including, perhaps, a reform of its healthcare system that is not smooth. And public consumption remains high without falling. However, China's adjustments are quite smooth, a portion of its productive capacity is transferred abroad, its external trade achieves reasonable balance, or its excessive savings that remain no longer flow to the United States and instead flow to other countries. In this case, the United States would maybe have imbalanced trade and savings inflow problems with other developing nations, such as Vietnam, and oil-producing countries." Worst case "What we want to see least of all is that everybody's adjustments are unsuccessful. Current international economic imbalances would continue and trade protectionism would become more and more serious."
The Chinese are actively pursuing the more attractive of the above options and investors cannot ignore the implications. The Chinese government is negotiating bilateral agreements with a number of developing countries to conduct trade in currencies other than the dollar. So far, they have opened negotiations with a wide range of countries, including Argentina, Brazil, Malaysia, South Korea, Indonesia and Hong Kong. This effort is intended to reduce the need by the Chinese and other economies to hold dollars for the sole purpose of conducting trade outside the US. The demand for US dollars, at the margin, seems likely to fall and absent a new source of demand or a concerted effort by the Fed to control the supply, the value of the dollar seems likely to continue south.
This change in the composition of Chinese (and other countries’) reserves is not limited to the conduct of trade. The Chinese have also, apparently, been accumulating natural resources. The recent rise in copper and oil prices is at least partially a result of this stockpiling and while it won’t be a continuous rise, it seems likely that the accumulation will continue over the long term. Furthermore, the Chinese government has recently announced that they will make capital available to accelerate their “going out” strategy:
"We should hasten the implementation of our "?going out' strategy and combine the utilisation of foreign exchange reserves with the "?going out' of our enterprises," he told Chinese diplomats late on Monday.
Mr Wen said Beijing also wanted Chinese companies to increase its share of global exports.
The "going out" strategy is a slogan for encouraging investment and acquisitions abroad, particularly by big state-owned industrial groups such as PetroChina, Chinalco, China Telecom and Bank of China.
This outbound investment strategy will focus on emerging economies rich in natural resources:
In an interview published in state-controlled media, the chairman of China Development Bank said Chinese outbound investment would accelerate but should focus on resource-rich developing economies.
"Everyone is saying we should go to the western markets to scoop up [underpriced assets]," said Chen Yuan. "I think we should not go to America's Wall Street, but should look more to places with natural and energy resources."
The Chinese might be more open to investing in the US and other developed economies, but as demonstrated in the Dubai Ports and Unocal deals, our politicians prefer pandering to xenophobes over encouraging investment. The collapse of the Chinalco/Rio Tinto deal proves this attitude is not limited to US politicians. Capital will flow where it is treated best and for now, that isn’t the US or other developed economies.
Surplus countries are also changing the composition of their existing US bond portfolios. They have concentrated recent purchases at the short end of the curve and have taken steps to reduce exposure to Agency securities (which explains why the Fed is targeting that debt in its purchases) and existing long term Treasury bonds. This is not confined to the Chinese since other emerging market economies also accumulated reserves. Private investment flows to the US peaked in 2000 and while they recovered some in the middle part of the decade, they fell off again in 2006 and started flowing to emerging economies such as Brazil which saw a large rise in the value of the Real. To limit the rise in their currencies, these emerging market central banks partially sterlized the inflow by purchasing US dollar bonds. And now they too are shortening maturties. As an example, in May of this year, Brazil bought $12 billion in T Bills but sold $9 billion in long term notes and bonds.
The Chinese are also pursuing the other strategies that Xiauchuan outlined. They are encouraging more consumption in China by encouraging bank lending. Chinese purchases of automobiles recently surpassed the US for the first time. They also implemented a stimulus plan that, unlike the US version, is concentrated on infrastructure investment. So the Chinese are doing everything in their power - and that power is considerable - to implement the rebalancing in ways that are designed to minimize the disruption to the world economy while at the same time advancing their own economic interests.
I can envision a rebalancing of the world economy that is beneficial to all. The Chinese will increasingly invest their surpluses in emerging economies resulting in the further development of those countries’ middle classes. Consumption in the emerging economies is already 65% of the US and could surpass the US in the next few years. This emerging market consumption along with increased Chinese consumption will keep Chinese and other Asian economies factories humming and their economies on track. Australia and Canada, along with other resource rich countries will provide the raw materials for this production.
The US also has a role to play in this emerging order. The US, despite what most seem to believe, is still the world’s largest manufacturer and third in world exports. US manufacturing is concentrated in the production of capital goods which should benefit from the expansion of the emerging market economies. The US technology sector is the undisputed world leader and should benefit. We also lead the world, by far, in the development of medical devices and pharmaceuticals. The US is also a large exporter of agricultural products which should also be positively impacted by the expansion of the emerging market middle class. Finally, US is home to some of the world’s most recognizable brands such as Coca Cola, Proctor and Gamble and Visa, and they should also benefit from the diversification of consumption to the emerging world.
The Chinese strategy is not altruistic in nature. They are embracing the changes in the world economy and attempting to turn them to their advantage. The same cannot be said of the US. As a country we are increasingly reliant on short term financing to maintain our standard of living. As Bear Stearns, Lehman Brothers and numerous emerging market economies over the years vividly demonstrated, that is not a sustainable business model. In addition, rather than enacting policies that encourage private investment, we are enacting policies that increasingly siphon off private capital to fund government directed spending of dubious benefit. If we are to benefit from the rebalancing, we need to change our policies to embrace the change rather than resist it.
The US economy has suffered since the turn of the century from a lack of real investment. Foreign inflows, rather than being invested according to market forces, were diverted by Fed policy into non productive assets such as housing, automobiles and other consumption goods. Government spending, always inefficient but especially so when the spending is used to prosecute wars, consumed a larger percentage of GDP than necessary. Rather than reduce the distortions of the Fed and government spending, we are in the process of doubling down on a bet that has proven disastrous. The choice is simple; either we make the necessary changes or the market will force them on us.
Unless we change our policies, the demand for US Treasuries and the US dollar will continue to wane as China and the other emerging economies pursue their publicly stated goals. We will be left with the choice of funding our deficits through private US savings and therefore limiting private investment or depending on the Fed as purchaser of last resort. Either path leads to a further reduction in the willingness of foreigners to fund our spending, higher interest rates and higher rates of inflation. A lower dollar will eventually lead to recovery through a reduction in imports and an expansion of exports but that path leads through a minefield of inflation that will destroy US wealth and make it more difficult to expand the private investment that our economy needs to compete in the new emerging economic order. And it isn’t necessary. Policies that encourage savings and investment such as reduced capital gains taxes, lower corporate taxes, a reduced government deficit and a stable dollar would accelerate the recovery process without causing inflation.
President Obama has spoken about the need to change our economy so we don’t experience the booms and busts that have characterized the US economy of the last two decades. He is absolutely right and we have been given a golden opportunity to do exactly that. It won’t be painless regardless of the path we take, but the sooner we start enacting policies that embrace the coming changes, rather than resisting them, the sooner the pain will end. So far this administration, like the last one, is pursuing policies that just make the transition more difficult, lengthy and painful.
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Weekly Economic and Market Updates
The economic reports last week were mixed at best. New Home sales were higher and the Case Shiller index showed a slowing in house price depreciation, but Consumer confidence fell. Durable goods orders were reported lower but ex transportation orders rose 1.1%. Unfortunately, new orders for non defense capital goods fell 3.4%. Mortgage applications fell as refinancing activity dropped over 10%. Purchase applications rose modestly. Jobless claims also rose and the employment situation continues to worsen. As mentioned previously, a lot of the drop in continuing claims is a result of individuals exhausting their benefits and moving from the state to the federal dole. The big report of the week, the release of 2nd quarter GDP, was taken by the market as good news, but reading through the details is not exactly uplifting. The improvement was almost entirely due to the increase in government spending which was concentrated in defense expenditures (the spending in the stimulus bill is still being stifled by red tape). Non residential investment, residential investment, exports and imports all fell. Inventory liquidation subtracted another 0.83 from GDP. As I have said repeatedly the last few months, GDP will likely surprise on the upside due to a number of factors. The most obvious is that government spending is part of the GDP calculation and can’t help but make the number look better. We can also expect a cyclical recovery in housing, the auto industry and at some point, an end to the inventory liquidation. Unfortunately, as pointed out above, the recovery in GDP is not concentrated in the areas that will contribute to long term growth.
Stocks managed to end the month on a positive note, rising by a little less than 1%. Once again, foreign stocks outperformed their US counterparts. I am looking for some type of stock market correction to start soon. Sentiment, which has remained steadfastly bearish throughout much of the rally, has recently become more bullish and as a committed contrarian that worries me. Additionally, the employment numbers will be released next week and while there is some improvement in the US economy, it is still way too early for it to show up in the unemployment statistics. In fact, I question whether the cyclical recovery will ever gain enough momentum to significantly improve the employment situation. For whatever reason though, markets are extended to the upside and a correction would not be a surprise.
Selected charts
The dollar tried to rally early in the week but Friday’s GDP report reinforced the downtrend
The drop in the dollar picked up gold Friday
And foreign bonds, which I’ve mentioned here repeatedly over the last few months, also benefitted from the fall in the dollar
Copper, despite talk that China has stopped its stockpiling, continued to rise
International Real Estate continues to outperform the US markets
Within that sector, Asian real estate, again mentioned in previous updates, has been the leader
One surprising market which many US based investors have overlooked (but has been in our Select Countries portfolio since April) is Israel:
And lastly, the housing stocks broke out last week. I don’t think there is any reason to chase it as there is a long way to go in the housing market, but at lower prices I might be tempted
Hi. I read a few of your other posts and wanted to know if you would be interested in exchanging blogroll links?
Like walking on plowed ground wearing bifocals.
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