A glass half empty, in three different ways

It seems to me that there are three big risks - the result of what economists like to call imbalances -- hanging over the global economy, even leaving aside the possibility of an old fashioned oil supply shock.

The first is one that Nouriel and I have discussed extensively: US dependence on the export of its debt to finance an enormous trade deficit. In 2004, Central banks supplied about 3/4 of the net financing of the US current account deficit ($475-500b of $665b), at least ½ the total foreign demand for US debt (the US needs to sell debt abroad to finance both the current account deficit and net equity outflows), and maybe one third ($400 b of $1150 b) of ALL demand for new (or more accurately, net new) US long-term bond issuance. So any cut back in central bank demand could have serious implications for the US economy.

What could prompt central banks to buy less US debt? Reserve diversification. A revaluation that reduced East Asia’s current account surplus. Or a fall in net PRIVATE capital inflows to certain emerging economies: right now, hot money flows into China finance the US, not China.

The result: higher interest rates as the US has to pay more to attract private capital from abroad. The key questions are the magnitude of the increase in interest rates required to attract private capital flows and the impact of higher rates lead on US consumption, savings and investment. This scenario has already been covered at length, both here and elsewhere; no need to go into more detail now.

The second is that US consumers are already overstretched, and the health of the US and world economy relies on their willingness to become even more overstretched. US consumption has been rising faster than US income (consumption as a share of GDP has been rising). It would be a bit of shock for the global economy for US consumption to stop rising relative to US income, let alone fall. Yet there are no shortage of potential reasons why US consumers might start to pull back: stagnant real wages; rising oil prices; a somewhat less robust housing market. Or simply the Fed’s decision to raise policy rates a bit (check out this interesting post by Dan Gross over at Slate, via Battle Panda).

Calculated Risk has done Herculean work documenting how housing price increases support US consumption, and how the housing boom has led to a boom in employment in real estate and related sectors of the economy. No competition from China there. Fed governor Don Kohn has observed that residential investment is now at a fifty year high (relative to GDP). Again, no competition from China there.

On the external side, central banks do not need to diversify their existing stock of reserves to deliver a nasty shock. They just to stop adding to their reserves. Similarly, housing prices do not need to fall to stop supporting US consumption growth. All they need to do is to stop rising at their current rate.

In simple terms, in the first scenario, the financing for the US gives out before the US consumers slows down, and higher interest rates are required to prompt the slowdown in spending required to bring the US external deficit in line with the available financing. In the second scenario, the US consumer gives out before the financing. US consumption growth would cool without any reduction in financing from the world’s central banks; higher interest rates on US external borrowing would not be needed to bring down the rate of growth in US consumption

Both of these risks are pretty well known by now, and have been widely discussed. They are also not mutually exclusive. Suppose the US consumer spending slows a bit even in the absence of significantly higher interest rates. Rather than having a current account deficit of between $850-900 billion in 2005 (the current trajectory), the current account deficit might ONLY be in the $800-$850 billion range. That is still large: a modest fall in the deficit associated with slowing US consumption growth could be overwhelmed by even larger falls in central banks willingness to finance the US at current interest rates.

I expect emerging economies and the oil exporters in the Gulf will add over $600 billion to their reserves in 2005: the major emerging economies added around $125 billion to their reserves in q1 (net of valuation gains) and that pace might accelerate during the year. $300 billion of that reserve growth is likely to come from China, and I expect other oil exporters will tend to save, not spend, the windfall associated with oil at over $50 a barrel. Global reserve accumulation may not fall (net of valuation gains) despite Japan’s absence from the market. And lots of the private financing the US will attract in 2005 is likely to be the product of either government action or the expectation of government action. Think of US firms bringing corporate profits home to take advantage of the tax holidays, private investors in Japan buying US bonds because they expect the central bank will step in to limit Yen appreciation or "private investment" from the Saudi royal family or the Kingdom of Kuwait’s oil investment funds.

I cannot rule out a scenario where the US has to pay more to attract private financing from abroad even as the US economy slows. The Fed sets short-rates in the US, but not long-rates - which, barring an increase in US savings, depend in large part on the willingness of foreigners to add to their portfolio of dollar bonds. A slowing US economy could easily need to attract $750-800 billion in net financing. That would be a lot harder if central bank dollar reserve growth slowed to say $250 billion and Japanese investors lost faith that the MOF would limit yen appreciation.

The analogy is imperfect in lots of ways, but it is worth remembering that Argentina had to pay more to attract financing from 1999 on even as an economic slump reduced its current account deficit.

Above all, though, I want to add a third risk to the mix.

The bursting of China’s investment bubble.

Investment in China is already very high relative to China’s GDP, and it continues to grow faster than the overall economy, so as a share of GDP it keeps jumping up.

Chinese statistics almost certainly both understate China’s GDP and overstate investment: investment may not really be over 50% of GDP and savings may not really be something like 55% of GDP. But even if investment is a smaller share of GDP, no one doubts that investment in China has been rising EXTREMELY rapidly recently.

There are lots of reasons for this: real interest rates in China are still very low, if not negative; hot money inflows into China mean that the banking system is flush with cash; credit growth continues to be strong, even if not quite as strong as in early 2004; investment in production for export must be very profitable at the current exchange rate, even if labor costs are rising (you can not grow exports at 35% y/y for several years without a rapid expansion of capacity), people in China seem to think that real estate prices only rise ... .

But that does not mean this level of investment is sustainable.

It won’t burst for the same reasons that the investment bubble in Southeast Asia burst. China circa 2005 is not Thailand circa 1997: China has a current account surplus, not a deficit; it does not rely on foreign savings/ short-term borrowing from the world’s private banks to finance domestic investment. But its bubble could still burst for other reasons -- US protectionism, a US consumer slowdown that generates enormous spare capacity in the export sector, a oil shock that the government of China cannot suppress by controlling energy prices, or something else -- maybe just too many office towers and apartment buildings relative to "real" as opposed to "speculative" demand.

Ideally, any fall in investment in China would be accompanied by an acceleration in consumption growth (a fall in savings), helping to support China’s own economy and limited the external fallout of the bursting of China’s investment bubble. There are lots of reasons why savings could fall along with investment- business will be less profitable, reducing business savings, Chinese consumers draw on their savings to sustain their current pace of consumption growth even as the overall economy slows. But there are no guarantees this would happen: Nick Lardy notes that, in the past, savings has tended to rise in China when investment has fallen ...

If investment in China fell and savings did not, China’s current account surplus would rise to truly extraordinary levels - to 10% of GDP or more.

A higher current account might lead to even faster growth in China’s reserves, and even more cheap financing for the US. Vendor financing would get a shot in the arm - China would invest less of its savings at home, freeing up more to finance the US. Be careful though. China’s rapid reserve accumulation hinges both on its current account surplus and on its capacity to attract foreign funds. China’s current account surplus would likely rise, but it might not attract as much hot money. The overall impact on the pace of China’s reserve growth is ambiguous.

And don’t forget that a bursting of the China bubble would be a shock to the global economy - above all to commodity producers. Oil exporters would have less to money to add to their reserves. Of course, the US (and European) oil import bill would also fall. Still, right now, the commodity price shock is redistributing global income toward places that have a high propensity to save. The net effect of a fall in commodity prices might be less global savings.

The overall impact is hard to predict. What is sure is that a slumping China would want to export its way out of its slowdown. But the US -- which already has an enormous deficit -- cannot easily be the locomotive that pulls China out of its troubles. An analogy to the fiscal deficit might help: if you run large fiscal deficits in good times, your capacity to respond to a downturn with fiscal stimulus is constrained.

That is why the current huge US external imbalance is a risk to the world economy in another sense: it makes it harder for the US to play its traditional role as the locomotive of global demand when other countries slow. If China tanks, someone else might need to step up and play the United States’ traditional role as the world’s importer of last resort ...