Monday, March 26, 2007

Two Spillovers from the Bursting of Two Bubbles: Stephen Roach

Asian Decoupling Unlikely
March 26, 2007

By Stephen S. Roach | New York

As the US economy slows, most believe that Asia’s growth machine will fill the void. Don’t count on it. Policy makers in China and India are shifting toward restraint, tilting growth risks in the region’s fastest-growing economies to the downside. Nor is an externally-dependent Japanese economy likely to provide much compensation. To the extent the case for global decoupling is dependent on an Asian offset, prepare to be disappointed.

After years of doubt, convictions are deep that both China and India will stay the course of hyper-growth. There has been talk for years about the coming Chinese slowdown, but so far the downshift has failed to materialize. The 10.7% increase in Chinese GDP in 2007 was the fastest since 1995, when the size of the economy was less than one-third what it is today. Moreover, with India now showing impressive improvement in its macro foundations of growth – especially saving, infrastructure, and foreign direct investment – there is good reason to believe that there may be considerable staying power to the recent acceleration in economic growth that averaged 9% during the 2005-06 interval.

Incoming data give little reason to doubt the staying power of the Asian growth machine. Chinese industrial output growth has reaccelerated to an 18.5% y-o-y pace over the January-February period – up from the sub-15% comparison in the final period of 2006 and only a shade slower than the 19.5% gains recorded last June. While India’s industrial production growth is certainly not as brisk as China’s, the 10% y-o-y comparison in early 2007 remains well above the 7¼% pace that was evident in late 2005 and early 2006. Needless to say, if China and India stay their present course, the global economy would barely skip a beat in the face of a US slowdown. Collectively, China and India account for about 21% of world GDP, as measured by the IMF’s purchasing power parity framework – essentially equal to the 20% share the statisticians assign to the United States. Add in the recent acceleration in the Japanese economy – a 5.5% annualized increase in the final quarter of CY2006 for an economy that accounts for another 6% of PPP-based world GDP – and there is good reason to believe that the impact of America’s downshift could well be neutralized by the ongoing vigor of the Asian growth machine.

The Asian offset, in conjunction with a modest cyclical uplift in a long sluggish European economy, is the essence of the case for global decoupling – a world economy that has finally weaned itself from the great American growth engine. A key presumption of that conclusion is that Asia can stay its present course. There are two flaws in that argument, in my view – the first being that internal pressures are now building in Asia’s fastest-growing economies that could be sowing the seeds for slower growth ahead. In particular, both the Chinese and Indian economies are now displaying worrisome signs of overheating. In China, the symptoms have manifested themselves in the form of imbalances in the mix of the real economy, widening disparities in the income distribution, and a large and growing current-account surplus – to say nothing of the negative externalities of environmental degradation and excess resource consumption. In India, the overheating has surfaced in the form of a cyclical resurgence of inflation, with the CPI running at a 6.8% y-o-y rate in early 2007 – a sharp acceleration from the 3.8% pace of 2002-05.

In recent weeks, I have met with senior policy makers in both China and India. It is clear to me that in both cases the authorities are in the process of shifting their policy arsenals toward meaningful restraint. In China, the direction comes from the top in the form of growing concerns expressed by Premier Wen Jiabao about a Chinese economy that he has explicitly characterized as “unstable, unbalanced, uncoordinated, and unsustainable” (see my 19 March dispatch of the same name). Since those words were first uttered at the end of the National People’s Congress on 15 March, Chinese authorities have been quick to respond. There was a monetary tightening the very next day and the securities industry regulators have issued new rules that prevent companies from purchasing equities with proceeds from share sales. The former move is aimed at cooling off an overheated investment sector while the latter move is addressed at dealing with a frothy domestic stock market that increased by 100% in the six months ending in late February. I am more convinced than ever that Beijing is now deadly serious in attempting to regain control over its rapidly growing economy in an effort to shift the focus from the quantity to the quality of growth. This is good news for China but could be disappointing for the decoupling camp that expects rapid Chinese economic growth to remain resistant to any downside pressures.

India is similarly positioned. The Reserve Bank of India does not take overheating and cyclical inflationary pressures lightly. I was actually in Mumbai the day the RBI tightened monetary policy last month (13 February), and it was clear to me in my discussions at the central bank that it meant business. The RBI’s official statement following that action said it all: “(A) determined and co-ordinated effort by all to contain inflation without unduly impacting the growth momentum is not only an economic necessity but also a moral compulsion.” Our Indian economics team underscores the risk of another monetary tightening prior to the 24 April policy meeting. At the same time, the government’s annual budget contained measures that would cut tariffs on food and other price-sensitive manufactured products. Indian authorities are fixated on a mounting cyclical inflation problem and appear more than willing to take a haircut on economic growth to achieve such an objective. Our current economic forecast reflects just such an outcome – a downshift to 6.9% GDP growth in 2008 following average gains of 8.7% over the 2005-07 period.

There is a second factor at work that is also likely to challenge the view that hyper growth is here to stay in Asia – the region’s persistent reliance on external demand as a major driver of economic growth. This is less a story for India, with its relatively small trade sector, and more a story for the rest of Asia. China is at the top of the external vulnerability chain. Its export sector, which rose to nearly 37% of GDP in 2006, surged at a 41% y-o-y rate in the first two months of 2007. Moreover – and this is an absolutely critical point in the decoupling debate – the United States is China’s largest export market, accounting for 21% of RMB-based exports. As the US economy now slows, the biggest piece of China’s export dynamic is at risk. So, too, are the large external sectors of China’s pan-Asian supply chain – especially Taiwan, Korea, and even Japan. Lacking in self-sustaining support from private consumption, the Asian growth dynamic remains highly vulnerable to an external shock. That’s yet another important reason to be very suspicious of the case for global decoupling.

Decoupling and global rebalancing go hand in hand. A decoupled world is very much a rebalanced world – and vice versa. Recent trends admittedly lend some support to the decoupling thesis – especially a booming Asia economy but also a seemingly remarkable cyclical revival in Europe. The European upsurge is a welcome development, but perspective is key. At most, it will add 0.2 to 0.3 percentage point to our baseline case for world economic growth. Asia, especially China and India, is a very different story. This is a much larger segment of the global economy and is growing at rates that are three times as fast as those in the developed world. An Asian economy that only barely widens its growth multiple relative to the rest of the world could well drive global decoupling on its own.

That’s unlikely to be the case, in my view. Not only does Asia remain vulnerable to a US-centric external shock, but the region’s two most powerful growth stories – China and India – are now both very focused on matters of internal sustainability. The Premier of China has put his reputation on the line in attempting to bring an unstable, unbalanced, uncoordinated, and unsustainable Chinese economy under control. The Indian government is equally focused on an anti-inflationary policy tightening. Looking backward, both of these economies have been on an exceptionally strong growth path that – if left to its own devices – could play an increasingly important role in powering a decoupled world. Looking forward, however, it’s likely to be a very different story. With growth prospects in China and India tipping to the downside at the same time the US economy is slowing, the global economy is likely to be a good deal weaker than the decoupling crowd would lead you to believe.

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