Stephen Roach on the Next Asia

Opportunities and Challenges for a New Globalization

Stephen S. Roach

• Publisher: Wiley
• Year: 2009
• Print ISBN:
  9780470646045
  9780470446997
• Edition: 1
• eBook ISBN:
  9780470564226
• Topic: Business
• Subtopic: Business General
• Index: Business

As Morgan Stanley's chief Asia specialist, getting Asia right is Stephen Roach's personal obsession, and this in-depth compilation represents more than 70 of Roach's key research efforts not just on Asia, but also on how the region fits into the broad context of increasingly globalized financial markets. The book argues that the "Asia factor" is not a static concept, but rather one that is constantly changing and evolving. Broken down into five parts–Asia's critical role in globalization; the coming rebalancing of the Chinese economy; a new pan-regional framework for integration and competition; and a frank discussion of the biggest risk to this remarkable transformation–this book will help readers understand and profit from the world's most dynamic region.

Chapter 1

A World in Crisis

• Introduction • A Subprime Outlook for the Global Economy • Save the Day • Coping With a Different Recession • Davos Diary: 2008 • Double Bubble Trouble • Even When the Worst Is Over—Watch Out for Aftershocks • Pitfalls in a Postbubble World • Panic of 2008: Enough Scapegoating • Global Fix for a Global Crisis • Changing the Fed’s Policy Mandate • An Early Leadership Opportunity for Barack Obama • Dying of Consumption • Uncomfortable Truths about Our World after the Bubble • A Postbubble Global Business Cycle • America’s Japan Syndrome • Whither Capitalism? • After the Era of Excess • Same Old, Same Old • Depression Foil •

Introduction

As the greatest beneficiary of globalization, Asia continues to take an important cue from the broader global environment. With the world economy in its most wrenching crisis in 75 years, that cue is more daunting than ever before.

The origins of this crisis will long be debated. As the world still grapples with the wrenching aftershocks of what was initially billed as America’s subprime crisis, it is entirely premature to render a definitive verdict on the how’s and why’s of this mess. Suffice it say, the financial crisis that began in earnest in 2008 was the outgrowth of a confluence of failures, including massive risk management mistakes on Wall Street, egregious errors by rating agencies, staggering lapses of regulatory oversight, a politicization of the home-ownership and mortgage boom, and the search for returns by yield-hungry investors on Main Street.The most serious failure, in my view, was that of central banks.That’s especially the case with America’s ideologically driven Federal Reserve, led by market libertarians who condoned an insidious succession of asset bubbles and ignored its regulatory responsibility in an era of unprecedented financial engineering and excess leverage.

The main thesis of this chapter is that this is not just a financial crisis. The excesses in the financial markets were so extreme they ended up infecting the real side of the global economy. Nowhere was that more evident than in the United States, where asset-dependent consumers drew extraordinary support from the confluence of property and credit bubbles. In the second half of 2008—in the aftermath of the bursting of those twin bubbles—the American consumer pulled back more severely than at any point in the post-WorldWar II era. Yet that correction left the consumption share of GDP at a still elevated 71 percent in late 2008—down only 1 percentage point from its record 72 percent high in early 2007 and 4 percentage points above the prebubble norm of 67 percent that prevailed from 1975-2000. With personal debt ratios still excessive and saving rates far too low, there is good reason to believe that there is more to come in what looks to be a multiyear adjustment for the U.S. consumer. If mean reversion is in the offing for a postbubble U.S. consumer, and if that mean is close to the prebubble norm of the consumption share of U.S. GDP, then only about 20 percent of the correction has occurred.

As America has entered a major postbubble shakeout, so, too, has the rest of an interconnected world. It’s not just the cross-border linkages of trade flows that have been shocked by the capitulation of the world’s largest consumer. Liquidity-driven asset bubbles have burst everywhere—from emerging market equities to most segments of the global commodity market.The pitfalls of a postbubble world are especially daunting for an externally led Asian economy.

Lacking dynamism from its main source of external demand—the U.S. consumer—Asia faces two distinct possibilities: slower growth or the imperatives of uncovering new sources of growth. Since the latter option takes time to implement, I conclude that the Asian growth dynamic is likely to be a good deal slower in the years ahead than the 7 percent growth pace that has been realized since the turn of the century. For now, I would pencil in about 5 percent growth in panregional GDP for Developing Asia over the next three to five years.

A similar downshift is likely to be in the offing for the global economy. Notwithstanding the massive policy stimulus that has been injected into the system, America’s multiyear consumer retrenchment will provide stiff headwinds to global growth for quite some time. In that important respect, policy stimulus will be “pushing on a string”—leading to something resembling a Japanese-like outcome for a postbubble world economy. There will be no V-shaped recovery from this global recession. When it comes in earnest—probably at some point in 2010—the rebound in world economic growth is likely to be unusually anemic.

Meanwhile, it’s important not to get too far ahead of this story—a postcrisis world still has to pick up the pieces from a wrenching global recession. This is a profound challenge to policy makers, regulators, and politicians—to say nothing of posing a challenge to the free-enterprise system of market capitalism. To date, the policy response has been very short-term oriented. In effect, it has marshaled the heavy artillery of fiscal and monetary policy, together with government-sponsored capital injections and bailouts, toward rescuing and restarting a damaged and dysfunctional financial system.

Although this short-term focus is understandable in light of the extraordinarily dangerous freezing up of global credit markets, there are deeper longer-term issues that policy makers must also confront.At the top of the list are the daunting imperatives for a postbubble world to come up with nothing short of a new recipe for economic growth. In effect, the unbalanced global growth model of the past decade—dominated by America’s excess consumption and Asia’s excess saving—needs to be turned inside out. The United States needs to save more and consume less while Asia needs to save less and consume more. Policies need to be directed toward those twin objectives with an aim toward fostering the long-awaited rebalancing of a postbubble world.The crisis that began in 2008 is a wake-up call that global rebalancing can no longer be deferred to that proverbial another day.

The problem is not with capitalism but with its system of governance. As such, this crisis is a wake-up call to central banks, regulators, and their political overseers—the authorities who are charged with being the ultimate whistle-blowers in an era of excess. Sadly, that didn’t happen as a bubble-prone world lurched headlong toward disaster. Central banks were especially derelict in their responsibilities. Although the monetary authorities did a terrific job in winning the war against the Great Inflation of the 1970s and early 1980s, they failed in their efforts to manage the peace of the postinflation global economy. Blinded by ideology, monetary policy makers paid little or no attention to the imperatives of financial stability. Instead, they believed incorrectly that the world was learning to live with its imbalances. Needless to say, the postbubble world is paying a horrific price for this dereliction of duty.That leaves the body politic with little choice other than to alter the policy mandate of central banks to incorporate an explicit focus on financial stability. A crisis like this must never be allowed to happen again.

A Subprime Outlook for the Global Economy

October 18, 2007

After nearly five fat years, the global economy is headed for serious trouble.This will come as a surprise to policy makers and investors, alike—most of whom were counting on boom times to continue.

At work is yet another postbubble adjustment in the world’s largest economy—this time, the bursting of America’s massive property bubble. The subprime fiasco is the tip of a much larger iceberg—an asset-dependent American consumer who has gone on the biggest spending binge in the modern history of the global economy. At the turn of the century, the bursting of the dot-com bubble triggered a collapse in business capital spending that took the United States and global economy into a mild recession.This time, postbubble adjustments seem likely to hit U.S. consumption, which, at 72 percent of GDP, is more than five times the share the capital spending sector was seven years ago.This is a much bigger problem—one that could have much graver consequences for the United States and the rest of the world.

There is far more to this story than a potential downturn in the global business cycle. Another postbubble shakeout poses a serious challenge to the timeworn inflation-targeting approach of central banks. It also challenges the body politic’s acceptance of a new strain of asset-dependent global economic growth. Subprime spillovers have only just begun to play out, as has the debate this crisis has spawned.

Game Over for the American Consumer

The American consumer has been the dominant engine on the demand side of the global economy for the past 11 years.With real consumption ■ 5 ■ growth averaging nearly 4 percent over the 1996-2006 interval, U.S. consumption expenditures totaled over $9.6 trillion in 2007, or 19 percent of world GDP (at market exchange rates).

Growth in U.S. consumer demand is typically powered by two forces—income and wealth (see Figure 1.1). Since the mid-1990s, income support has lagged while wealth effects have emerged as increasingly powerful drivers of U.S. consumption. That has been especially the case in the current economic expansion, which has faced the combined headwinds of subpar employment growth and relatively stagnant real wages. As a result, over the first 69 months of the now-ended expansion, private-sector compensation—the broadest measure of earned labor income in the U.S. economy—increased only 17 percent in real, or inflation-adjusted, terms.That was nearly $480 billion short of the 28-percent increase that had occurred, on average, over comparable periods of the past four U.S. business cycle expansions.

Figure 1.1 The Macro Drivers of U.S. Consumption

Source: Office of Federal Housing Enterprise Oversight (OFHEO), Federal Reserve, U.S. Bureau of Economic Analysis, Morgan Stanley Research.

Lacking in support from labor income, U.S. consumers turned to wealth effects from rapidly appreciating assets—principally residential property—to fuel booming consumption. By Federal Reserve estimates, net equity extraction from residential property surged from 3 percent of disposable personal income in 2001 to nearly 9 percent by 2005—more than sufficient to offset the shortfall in labor income generation and keep consumption on a rapid growth path. There was no stopping the asset-dependent American consumer.

That was then. Both income and wealth effects have come under increasingly intense pressure—leaving consumers with little choice other than to rein in excessive demand.The persistently subpar trend in labor income growth is about to be squeezed further by the pressures of a cyclical adjustment in production and employment. In August and September 2007, private sector nonfarm payrolls expanded, on average, by only 52,000 per month—literally one-third the average pace of 157,000 of the preceding 24 months. Moreover, this dramatic slowdown in the organic job-creating capacity of the U.S. economy is likely to be exacerbated by a sharp fall in residential-construction-sector employment in the months ahead. Jobs in the homebuilding sector are currently down only about 5 percent from peak levels, despite a 40 percent fall in housing starts; it is only a matter of time before jobs and activity move into closer alignment in this highly cyclical—and now very depressed—sector.

Moreover, the bursting of the property bubble has left the consumer wealth effect in tatters.After peaking at 13.6 percent in mid-2005, nationwide house price appreciation slowed precipitously to 3.2 percent by mid-2007. Given the outsize overhang of excess supply of unsold homes, I suspect that overall U.S. home prices could actually decline in both 2008 and 2009—an unprecedented development in the modern-day experience of the U.S. economy. Mirroring this trend, net equity extraction has already tumbled—falling to less than 5.5 percent of disposable personal income in the second quarter of 2007 and retracing more than half the run-up that began in 2001. Subprime contagion can only reinforce this trend—putting pressure on home mortgage refinancing and thereby further inhibiting equity extraction by U.S. home owners.

Figure 1.2 The Overextended American Consumer

Source: U.S. Bureau of Economic Analysis, Morgan Stanley Research.

With both income and wealth effects under pressure, it will be exceedingly difficult for savings-short, overly indebted American consumers to maintain excessive consumption growth. For a U.S. economy that has drawn disproportionate support from a record 72 percent share of personal consumption (see Figure 1.2), a consumer-led capitulation spells high and rising recession risk. Unfortunately, the same prognosis is likely for a still U.S.-centric global economy.

Don’t Count on Global Decoupling

A capitulation of the American consumer spells considerable difficulty for the global economy.This conclusion is, of course, very much at odds with the notion of “global decoupling”—an increasingly popular belief that depicts a world economy that has finally weaned itself from the ups and downs of the U.S. economy.

The global decoupling thesis is premised on a major contradiction: In an increasingly globalized world, cross-border linkages have become ever more important—making globalization and decoupling inherently inconsistent. True, the recent data flow raises some questions about this contention. After all, the world seems to have held up reasonably well in the face of the initial slowing of U.S. GDP growth that has unfolded over the past year. However, that’s because the downshift in U.S. growth has been almost exclusively concentrated in residential building activity—one of the least global sectors of the U.S. economy. If I am right, and consumption now starts to slow, such a downshift will affect one of the most global sectors of the United States. I fully suspect a downshift in America’s most global sector will have considerably greater repercussions for the world at large than has been the case so far.

Figure 1.3 The Myth of an Asian Decoupling

Source: International Monetary Fund,Asian Development Bank, Morgan Stanley Research.

That’s an especially likely outcome in Asia—the world’s most rapidly growing region and one widely suspected to be a leading candidate for global decoupling. However, as Figure 1.3 clearly indicates, the macrostructure of Developing Asia remains very much skewed toward an export-led growth dynamic. For the region as a whole, the export share has more than doubled over the past 25 years—surging from less than 20 percent in 1980 to more than 45 percent today. Similarly, the share going to internal private consumption—the sector that would have to drive Asian decoupling—has fallen from 67 percent to less than 50 percent over the same period.

Nor can there be any mistake about the dominant external market for export-led Asian economies. The United States wins the race hands down—underscored by a 21 percent share of Chinese exports currently going to America.Yes, there has been a sharp acceleration of intraregional trade in recent years, adding to the hopes and dreams of Asian decoupling. But a good portion of that integration reflects the development of a China-centric pan-Asian supply chain that continues to be focused on sourcing end-market demand for American consumers.That means if the U.S. consumer now slows, as I suspect,Asia will be hit hard—with cross-border supply-chain linkages exposing a long-standing vulnerability that will draw the global decoupling thesis into serious question.

A downshift of U.S. consumption growth will affect Asia unevenly. A rapidly growing Chinese economy has an ample cushion to withstand such a blow. Chinese GDP growth might slow from 11 percent to around 8 percent—hardly a disaster for any economy and actually consistent with what Beijing has tried to accomplish with its cooling-off campaign of the past several years. Other Asian economies, however, lack the hypergrowth cushion that China enjoys.As such, a U.S.-led slowdown of external demand could hurt them a good deal more. That’s especially the case for Japan, whose 2 percent growth economy could be in serious trouble in the event of a U.S.-demand shock that also takes a toll on Japanese exports into the Chinese supply chain. Although less vulnerable than Japan,Taiwan and South Korea could also be squeezed by the double whammy of U.S. and China slowdowns. For the rest of Asia—especially India and the ASEAN economies—underlying growth appears strong enough to withstand a shortfall in U.S. consumer demand. But there can be no mistaking the endgame: Contrary to the widespread optimism of investors and policy makers, the Asian growth dynamic is actually quite vulnerable to a meaningful slowdown in U.S. consumption growth.

The Great Failure of Central Banking

The recent chain of events is not an isolated development. In fact, for the second time in seven years, the bursting of a major asset bubble has inflicted great damage on world financial markets. In both cases—the equity bubble in 2000 and the credit bubble in 2007—central banks were asleep at the switch. The lack of monetary discipline has become a hallmark of an unfettered globalization. Central banks have failed to provide a stable underpinning to world financial markets and to an increasingly asset-dependent global economy.

This sorry state of affairs can be traced to developments that all started a decade ago. Basking in the warm glow of a successful battle against inflation, central banks decided that easy money was the world’s just ...

Table of contents

• Title Page
• Copyright Page
• Dedication
• Acknowledgements
• Introduction
• Chapter 1 - A World in Crisis
• Chapter 2 - The Globalization Debate
• Chapter 3 - Chinese Rebalancing
• Chapter 4 - Pan-Asian Challenges
• Chapter 5 - U.S.-China Tensions
• Afterword
• Sources
• About the Author
• Index