Tuesday, May 18, 2004

China And The US: The Great Unravelling Begins?

Well, here's another update on the highly possible pending global crisis. Some say Auerback is a little too bearish, but I have been following him for some time now, and he seems fair enough minded to me. I believe the times warrent the likes of Marshall, Roach and Xie. Even though the world is slowly advancing, she marches ever closer to the precipice of a great cliff. My bets are 2005, as are many - then watch out. Let's see how right I turn out to be.

The Great Unravelling Begins?
Marshall Auerback

...Today, by pursuing a more unilateralist foreign policy, the United States will have to absorb all of the costs without help from traditional allies. Its actions over the past 10 years (even before the Iraq war) have almost seemed calculated to lose the country as many friends as possible. The real risk is that the US now runs the risk of third world style debt trap dynamics on its own.

It is worthwhile pondering the risks facing the US economy today by re-examining the emerging markets’ crisis of 1997/98, whose parallel with today’s American economy grows more strikingly ominous. After 1995 the rise of the U.S. dollar and the depreciation of the Japanese yen and the Chinese Yuan led to a loss of export competitiveness in Asian economies whose currencies were effectively pegged to the U.S. dollar. The capital inflows exacerbated the real appreciation of the Asian currencies. The appreciation raised input prices relative to output prices, squeezing profits and hurting export growth. The Japanese recession reduced export profits. As a consequence of these external “shocks,” Thailand and Malaysia developed large and out-of-character current account deficits.

As manufacturing came under pressure, more and more investment went into the property market and the stock market. In Thailand, Malaysia, and Indonesia, asset bubbles began to blow out and the fringe of bad industrial investments also expanded. The rising inflow of foreign capital—mainly bank loans and portfolio capital rather than foreign direct investment—went disproportionately into unproductive activities with a high component of speculation. The continued fast growth rates (that supported the perception of an unchanging “miracle” in Southeast Asia) concealed a rise in the ratio of “bubble” to “real” growth, much as we see in the US today.

Right up to the eve of July 1997 the continued fast growth of the “miracle” economies of East Asia looked to be one of the certainties of our age. None of the four main crisis-afflicted countries (South Korea, Thailand, Malaysia, Indonesia) had had a year of significantly less than 5 percent real gdp growth for over a decade by 1996—Korea not since 1980, Thailand not since 1972. The crash was even more devastating to people’s living standards and sense of security than the Latin America crash of the 1980s. Some estimates suggest that around 50 million of the combined over 300 million people of Indonesia, Korea, and Thailand fell below the nationally defined poverty line between mid-1997 and mid-1998. Many millions more who were confident of middle-class status felt robbed of lifetime savings and security. Public expenditures of all kinds were cut, creating “social deficits” that matched the economic and financial ones. Nature was pillaged as people fell back on forests, land, and sea to survive. Indonesia’s real gdp shrank 17 percent in the first three quarters of 1998, Thailand’s 11 percent, Malaysia’s 9 percent, and Korea’s between 7 and 8 percent. It took nearly two years to reach the bottom.

The miracles led to the biggest financial bailouts in history. The imf mounted refinancing to the tune of US$110 billion, almost three times Mexico’s US$40 billion package of 1994–95 (the biggest in the imf’s history to that date). Yet the investor pullout continued through 1997 and 1998, the panic feeding upon itself. The fact that the collapse continued in the face of the largest bailouts in history suggests that something was awry with the imf’s bailout strategy, a matter of concern to countries elsewhere that might find themselves needing imf emergency funding in future.

The contractionary wave hit many other middle-income and low-income countries beyond Asia, particularly through falls in the price and quantity of commodity exports like grains, cocoa, tea, minerals, and oil. Russia’s renewed financial crisis and default in August 1998 triggered more contractionary shockwaves. Even countries that had diligently followed free market policy prescriptions (such as Mexico) were hurt as investors sold domestic currency for U.S. dollars in fear that any “emerging market” could be the next Russia or Indonesia. Brazil and some other Latin American countries in 1998 came perilously close to repeating the East Asian disaster.

This is what potentially lies in store for the US in 2004/2005. Obviously, Mr Greenspan will do all in his power to prevent this eventuality, but against a backdrop of Chinese tightening, a Korean central bank which is now exhorting its citizens to pay down debt and save more (despite a 20% national savings rate), and a natural tendency of East Asian toward continued neo-mercantilism (understandably brought about as a consequence of the events of 1997/98), the range of options available to the Fed are miniscule.

And protectionism is not much of a solution either, given that this would further highlight America’s limited range of policy options available. When foreign investors see a nation resorting to protectionism, they often interpret this as a sign of weakness, and accordingly seek out higher risk premiums, which the US can ill afford at this juncture. Protectionism also means in effect “biting the hand that feeds the US economy”, because to the extent that protectionism succeeds in reducing the imbalances in US trade, also reduces the increase in dollar savings held in the hands of foreigners. Assuming no change in their portfolio preferences away from US assets (a not entirely realistic assumption, as there may well be some form of retaliation which reduces the proclivity to hold dollars), there is in fact less foreign savings available then for them to disperse additional external financing requirements at the margin.

The greater the debt, the more deflation-prone the economy. A further complicating variable in the case of America is when too much of this debt is held by foreigners, many of whom are not well pre-disposed to the US today. That enhances the risk of capital flight, higher interest rates – in effect, reinforcing the deflationary vulnerabilities at the core of the US problem. Capital flight becomes an even bigger problem if there is nothing in the way of an external growth offset, which is clearly a problem in the event that China begins to slow dramatically, given the latter’s important secondary role as global locomotive. The great unraveling might therefore be rapidly coming upon us. ...Link

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