Stephen S. Roach (New York)
Oct 30, 2006
SourceSurely, there must be more to a $46 trillion global economy than the American consumer and the Chinese producer. Not only is that the current verdict of financial markets, but it is consistent with the sentiment I have been picking up from a broad cross-section of our clients -- business executives, investors, and senior government officials -- as I travel the world this fall. While they concede the possibility that these two engines of global growth may, indeed, slow in 2007, there is a general belief that other economies are now perfectly capable of filling the void. Hope springs eternal that such a global decoupling would allow an increasingly vibrant global economy to keep growing while barely skipping a beat. My advice: Don’t count on it.
Given the dominant role that the US consumer has played in driving the demand side of the world economy and the equally important role played by the Chinese producer in shaping the supply side, decoupling won’t be easy. By our calculations, China and the US collectively have accounted for an average of 43% of PPP-based global GDP growth over the 2001-06 period -- well in excess of their combined 35% share of world output. Globalization makes decoupling from such a concentrated growth dynamic especially difficult, as ever-powerful cross-border linkages have become increasingly important in tethering the rest of the world to these dominant engines of growth. Decoupling requires economies to cut the cord and develop new sources of growth. In my view, for an economy to be classified as a “decoupler” it must satisfy three conditions: First, it must have self-sustaining domestic demand -- especially private consumption. Second, it needs to have a diversified export mix -- both in terms of products and destinations. And third, it must have policy autonomy -- the ability to establish independent settings for monetary, fiscal, and even currency policies.
The global decoupling thesis can be drawn into serious question on all three counts. That’s especially the case with respect to the lack of support from domestic demand outside the US. It is important to make the distinction between the two major components of private domestic demand -- consumption and fixed investment. What concerns me the most in this regard is underlying weakness in private consumption outside the US. Investment strength isn’t likely to provide an enduring offset. Inasmuch as business capital spending is basically a “derived demand” -- largely dependent on expectations of the capacity requirements of future growth in consumer-driven end-market demand -- consumption support is absolutely critical for an economy to prosper on its own.
Therein lies the problem: Real consumption growth in the world’s second and third largest economies -- Japan and Germany -- remains stuck in a sluggish 1.5% zone. Nor has the rest of Europe fared any better, with overall Euro-zone consumption on an anemic 1.3% growth trajectory over the past five years. Moreover, contrary to popular perception that heralds the birth of the young and vibrant Asian consumer (see the cover story in the 21 October issue of The Economist, “America Drops, Asia Shops”), private consumption has actually been a drag on economic activity in this key region of the world. That shows up most clearly in declining consumption shares of Asian GDP -- the best way to measure the growth impetus of any sector. By IMF estimates, consumption shares in all of emerging Asia fell from around 70% of GDP in 1970 to less than 50% in 2005. In particular, China’s private consumption share fell to a record low of 38% of GDP in 2005 and most likely has fallen further in 2006. Nor is Japan an exception to Asia’s anti-consumer mindset; the consumption share of Japanese GDP fell from 58% in early 2002 to 56% in mid-2006. The message here is inescapable: Euphoria over the emergence of the Asian consumer is premature, at best; this region’s growth story is still very much dominated by surging exports and fixed investment.
Not only do Teflon-like US consumers reign supreme in terms of relative growth performance, but they also have the scale that the rest of the world is lacking. In 2005, US consumption totaled about $9 trillion -- 20% larger than consumer spending in Europe, 3 1/2 times that of Japan, nine times the size of China’s consumer, and fully 17 times the scale of Indian consumption. While I am actually quite bullish on Indian consumption, it is far too small to offset consumption weakness in the larger economies. Chinese consumption is also puny by comparison, and the case for a consumption-led rebalancing of China’s investment- and export-led growth dynamic is still at least 3-5 years in the future. Europe and Japan have the only consumers with a mathematical possibility of filling the void left by a shortfall of US consumption. Yet, with the global labor arbitrage putting unrelenting pressure on real wages and labor income in these high-wage economies, they are the least likely to pull it off.
Nor does the second factor -- export-diversification -- provide much support for global decoupling. As America’s record $800 billion trade deficit suggests, exporters around the world are still heavily dependent on the US as the main engine of global demand growth. That’s especially the case for America’s NAFTA partners: Canada, the 8th largest economy in the world (at market exchange rates), sends 84% of its exports to the US -- enough to account for fully 27% of its GDP. Mexico, the second largest economy in Latin America and the 13th largest in the world, ships 86% of its exports to the US -- enough to account for 24% of its GDP. But the impacts of US-centric trade flows are also evident elsewhere. In China, the fourth largest economy in the world, shipments to the US account for about 40% of total exports (allowing for re-exports through Hong Kong) -- enough to amount to nearly 15% of its GDP. And, by inference, Asia’s increasingly China-centric supply chain is heavily dependent on China’s major export market -- the US. That means a US slowdown would not only send China-led reverberations to Japan, Taiwan, and Korea but it would also have ripple effects throughout the global commodity-producing complex that has become so dependent on China in recent years -- namely, Australia, New Zealand, Canada, Brazil, parts of Africa, and, of course, Russia.
Elsewhere in the world, it’s a mixed bag in terms of US-centric export concentration. In Japan, where the five-year export growth trend (+5.2%) has been more than three times the pace of private consumption growth (1.6%), fully 24% of its total exports currently go directly to the US. Moreover, it also turns out that another 14% of Japanese exports go to China -- now its second largest export market -- which, as noted above, is itself highly levered to end-market demand in the US. Consequently, it’s hard to envision Japan escaping the consequences of a US slowdown. Europe, where only about 8% of total exports go to America, is probably best situated to withstand a shortfall of US demand, but increasingly tight trade linkages to Asia also leave European exports indirectly exposed to the US. In short, there can be no mistaking the world’s US-centric pattern of export growth -- a characteristic that leaves a consumption-short global economy highly vulnerable to any protracted pullback by the American consumer.
Policy autonomy is the final piece of the global decoupling puzzle, and I‘m afraid there is not much ground for optimism on that score either. Insofar as fiscal policy is concerned, budget deficits are already excessive in most parts of the world -- suggesting little further latitude for stimulus. The policy mantra in G-3 central banking circles is “normalization” -- aimed at bringing an end to an era of excess monetary accommodation. The recent cyclical deterioration in inflation underscores the imperatives of such a policy campaign. While it may make sense for America’s Federal Reserve to ease monetary policy in 2007 if the US economy starts to fade, such actions would not be appropriate either for the European Central Bank or the Bank of Japan. That’s because the Fed has completed the normalization process, whereas the ECB and the BOJ have only just begun -- leaving them with considerably less leeway to provide the countercyclical easing that a successful global decoupling would require. Interestingly enough, monetary authorities in the developing world may be able to lean the other way -- largely because quasi-pegged currency regimes still tie their monetary policy stance to that of America’s Fed, which could move into an easing mode on 2007. That’s especially the case for China. But given the fragmentation of the Chinese banking system, along with the government’s increasingly determined cooling-off campaign, I think it is unlikely that China can succeed in using discretionary stabilization policy to de-link its economy from the US.
All in all, the case for global decoupling is a weak one. The non-US world continues to be heavily dependent on exports as a major source of growth -- with the bulk of that dynamic overly reliant on end-market demand in the US. If, as I suspect, the US consumer now enters a sustained slowdown in a post-housing bubble climate, there will be unmistakable reverberations on US-centric export flows in many major regions of the world. Lacking in internal demand to fill the void left by a US-led shortfall in external demand, and with only limited policy options available to counteract such a development, America’s slowdown could quickly become a global slowdown. Meanwhile, Beijing’s increasingly determined efforts to cool off a runaway Chinese investment boom could transmit an equally powerful downshift through its pan-Asian supply chain and the world’s commodity complex.
Contrary to widespread belief, a US- and China-centric global economy hasn’t changed its stripes overnight. A failure to rebalance has left an unbalanced world highly vulnerable to a slowdown made in both America and China. To me, that means the risks to global growth remain skewed to the downside of consensus expectations, which are currently centered on the IMF’s latest forecast of 4.9% world GDP growth in 2007. Global decoupling could certainly prove me wrong, but I think such a possibility is wishful thinking.