Hobson's choice

Mar 10, 2007

By Chan Akya

The past two weeks have provided us with a tantalizing glimpse of what lies ahead for the US economy, with the blow-up in subprime mortgages helping to unravel market confidence around the world. Global equity declines have wiped out some US$2.5 trillion of wealth, the conversion of which to consumption implies a fall of between 1% and 2% of global gross domestic product.

That kind of decline cannot be made good by growth improvements in China or India; indeed, the decline hits these countries quite hard unless they can diversify their own sources of growth.

In a previous article, [1] I wrote the following:

Dependent on the munificence of strangers like no other superpower in history, a US decline is unstoppable. That said, the surge in the value of Chinese stocks underlines the desperation rather than genius of global investors ...

If the sting of a scorpion surprises a burglar, he is caught between the need to scream, risking capture, or silently bearing the pain before gingerly withdrawing into the night. Much the same logic rules the financial markets these days, where the poor returns to be had in the US markets have driven many investors to search for alternatives, even if these appear overvalued themselves. This global epidemic of pseudo-logic will end in tears for many investors, but at least the people with the real savings have the ability to recover, which the US economy appears to lack.

Both parts of this scenario have come about, namely an obvious decline in global stock markets, which was prompted both by economic concerns in the United States and maladroit financial-markets regulation by China. [2]

Borrowers and ultimate lenders

It is a good old rule of banking that when you borrow $1 million from the bank and cannot repay, you are in trouble, but if you borrow $100 million from the bank and cannot repay, the bank is in trouble. In the above scenario, linkages through the global financial system mean that Asian banks and investors were holding a substantial portion of risk linked with the poor borrowers in the US. These are the same people whose inability to repay prompted the bankruptcy of some specialist firms that lend money to poor Americans, in turn touching off the crisis described above for global equity markets.

My point in repeating the story is to highlight the fact that the other shoe has not dropped yet - ie, Asian lenders who suffered losses from buying these securities are unlikely to purchase other US obligations until a clearer picture of the economy emerges. This translates to a withdrawal of liquidity from US financial markets, adversely affecting the prospects for the rest of the year. Americans, who are used to consuming more than they produce, will have to reverse course. The result will be akin to a fat person going on a bread-and-water diet for six months: painful, but necessary.

The likely pain of the adjustment for Americans will depend much on how quickly the rest of the world goes into recession with the US. It is important to note that any "lag" will only make the US recession more painful for Americans. For example, if only the US economy goes into recession, then oil prices will likely remain near current levels, which, combined with a falling US dollar, will keep inflation too high for any interest-rate cuts. Without such cuts, which would help to reduce monthly mortgage payments for Americans, it is likely that more people will have to declare bankruptcy, which feeds the vicious cycle of falling stock markets.

In contrast, if the rest of the world catches the recession fever from the US right away, oil prices will fall and central banks around the world can cut rates. As I explain below, the second scenario is not likely, therefore the US will have to endure a painful recession all alone.

Readers looking at this week's mild recovery in asset prices should be cognizant of this risk. I expect further downturns for US equity markets in coming weeks and months; it is likely that the widely watched Dow Jones average will close this year below the level of 10,000 from about 12,200 currently as investors adjust downward their earnings expectations as well as the multiple of earnings they are willing to pay for owning shares. In turn, this would prompt declines in other stock markets around the world, particularly in South America, whose economy, if not its politicians, depends almost entirely on US economic growth.

Why the US will stand alone

In past crises, such as the 1987 stock-market crash or the recession in the early 1990s that sank the administration of president George H W Bush, the US could depend on the munificence of strangers. In particular, the world's sole superpower attracted enough money from risk-averse investors to refloat its economy. That time has, however, come and gone as developing countries no longer "need" to buy US government bonds. Indeed, as I argued in a previous article, [3] they are better served by investing in physical assets such as commodities directly rather than diverting their savings to the low-return US markets.

In addition to the economic rationale of protecting their own growth, the world's investors are also not interested in US assets for political reasons. A quick look at the world's largest repositories of savings shows the extent of the problem: Middle Eastern investors will buy anything as long as it is not American, while Asian investors are likely to be scared off by recent losses on mortgage holdings. Other countries such as oil-rich Venezuela and Russia explicitly use their reserves as diplomatic tools.

With friends like these ...

Perhaps a diversion to consider the fragile reputation of America's politics is necessary here. The lost war in Iraq has failed to make the US government honest - indeed, the opposite appears to have happened. Like an alcoholic on the run from his treatment clinic, wrecking drink cabinets, Vice President Richard Cheney stomped into the capitals of US allies as the unapologetic face of the most unpopular US administration in recent history.

In so doing, he caused more damage to America's friends than its enemies could possibly inflict in a one-week window. To name just two, Cheney's visit has virtually guaranteed Prime Minister John Howard's re-election defeat in Australia, [4] and rendered precarious the position of Pakistan's unelected President General Pervez Musharraf, who had the indignity of being admonished by the petulant "veep".

At home, the conviction of Lewis "Scooter" Libby has added another layer of concern for the besieged White House, while the poor treatment of its war veterans in hospital will likely depress even diehard Republicans. That leaves the field wide open for a Hillary assault on the presidency next year. I expect that on her way, Senator Clinton will put into play everything that the Republicans stood for, including free trade and a measured approach to China.

This is where the Asian response becomes critical. Expecting no help from the American consumer is one thing, but also to confront political assaults is an entirely different matter. The upshot is that Asian countries will be forcefully cajoled into allowing their currencies to appreciate against the US dollar in coming months, with people like US Treasury Secretary Henry Paulson urging action (as he did this week) sooner so that these countries do not have to confront something worse later on, viz a Hillary presidency.

China has the most to lose from a currency appreciation. In addition to the accounting losses on its foreign-exchange reserves, the country will also have to set aside money to rescue its banks, whose bad debts will mount precariously when the economy suddenly lurches from export orientation to domestic consumption. The only reason to rush this through now is that waiting a few more months would make the eventual impact worse for both the US and China.

Notes
1. The thief and the scorpion, Asia Times Online, January 13.
2. India 1, China 0, ATol, March 3.
3. Sun Tzu's art of investing, ATol, February 10.
4. Newspoll survey conducted March 2-4.

Copyright 2007 Asia Times Online Ltd.