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*** Stephen Roach (6-1-04) ***


Global: Global Blow-off?

Stephen Roach (New York)
June 1, 2004

The global economy sprang to life in the second half of 2003 and hasn't looked back since. There were two initial sparks to that acceleration - the Chinese producer on the supply side of the world economy and the American consumer on the demand side. This impetus has now spread to Japan and other Asian economies, and there are even signs of modest improvement in Europe. All along, the key question has pertained to sustainability - whether this resurgence of the world economy is the beginning of a synchronous and long-lasting global upturn or just a temporary blow-off to be followed by an abrupt downshift. I continue to favor the latter possibility. Here's why.

By our calculations, world GDP probably hit a 5.0% to 5.5% annualized growth pace in the second half of 2003, a stunning resurgence by any standards. By way of comparison, that's double the anemic 2.7% average gains of 2001-02 and probably the strongest run rate for the global economy since 1984. The initial impetus came from the US, where second-half GDP growth hit 6.1%, and from China, where gains averaged 9.7% over the same period. Collectively, these two economies grew at a 7.5% annual rate in the second half of last year, when their contributions are weighted on a purchasing power parity basis - the best way to gauge their underlying contribution to the global growth dynamic. With 34% of the world (by PPP weights) growing at a 7.5% annual rate, the magic was quick to spill over elsewhere into the broader world economy.

The rest of Asia was the major beneficiary of this two-pronged impetus to global growth. That was especially true in Japan, where annualized gains in GDP hit 5.0% in the second half of 2003 before accelerating further to 5.6% in the first period of calendar-year 2004. But elsewhere in the region, accelerating momentum in the second half of 2003 has also spilled over into early 2004. For example, gains in 1Q04 hit 6.3% in Taiwan, 5.3% in Korea, 7.6% in Malaysia, 7.5% in Singapore, and 6.4% in the Philippines. India, where the data lags are longer, entered this year with a considerable head of steam, having surged at a 10.4% annual rate in the final period of 2003. All in all, growth in Asia excluding China (but including Japan) - a region that collectively accounts for another 21% of world GDP on a PPP basis - appears to have surged at a 5.5% to 6.0% average annual rate in the first period of 2004.

It is not surprising that Asia was first to respond to the stunning acceleration in China and the US. Asia remains, first and foremost, an externally-driven region that continues to suffer from a lack of internally-generated domestic demand, especially private consumption (see my 19 April dispatch, “Asia Needs a New Consumer”). As such, Asia continues to be best seen as a levered play on the growth dynamic of the American consumer, where growth accelerated by a stunning two percentage points over the past year, from 2.3% Y-o-Y in 1Q03 to 4.3% in 1Q04. In addition, Asia benefited handsomely from last year's 40% surge in Chinese imports; for Japan, Korea, and Taiwan, exports to China accounted for 32%, 36%, and 68%, respectively, of total export growth of each country in 2003. Moreover, Asian capital spending also appears to have been boosted in those industries with increasingly tight trading relationships with China. That's especially the case in Japan. By our reckoning, between 40% and 50% of Japan's annualized 5.2% GDP growth over the past three quarters is traceable to the "China factor" - China-centric increases in exports, capital spending, and inventory.

A $36 trillion world economy doesn't turn on a dime. On that basis, alone, the possibility of a more prolonged overshoot to global growth can no longer be ruled out. Dick Berner has recently made that case for the US, where he stresses four factors that could lead to an upside growth surprise in the second half of 2004 - pent-up hiring, an eventual decline in energy prices, lean inventories, and soon-to-expire tax incentives for business capital spending (see his 28 May dispatch, “The Case for Stronger Second-Half Growth”). China is also proving to be stubbornly resistant on the downside. While I have no doubt a China slowdown is coming, the 19.1% Y-o-Y growth in industrial output still evident in April only serves to underscore how tough it will be for the Chinese authorities to arrest this white-hot growth dynamic. At the same time, there is evidence that Japan's newfound cyclical momentum is also spilling over into the current period; notwithstanding statistical distortions, April trends in Japanese consumption, employment, and industrial output were all on the impressive side. Finally, there have even been a few upside surprises in Europe recently; the May business surveys held relatively firm on the heels of a modest acceleration in April, pointing to a reasonably healthy increase in Euro-zone production in the current quarter. Inertia is often the most robust predictor of what the near term holds for economic activity. And that powerful force still seems very much in evidence at this point in time.

In retrospect, we should have seen it coming. In response to last year's global deflation scare, the Authorities threw all caution to the wind. The political cycle has only served to reinforce this bias - not just in the US and Europe but also in Asia, where the political calendar is now in one of its most active cycles on record. Whatever the motive, the levers of monetary and fiscal stimulus were fully engaged in most major economies of the world. The growth dynamic of a long US-centric global economy was also boosted by a conscious effort to depreciate the dollar; dollar-pegged regions such as China were quick to benefit from this realignment of currencies. Aided by a rebound in confidence following the completion of the ground phase of the war in Iraq, policy traction took hold with a vengeance in the second half of 2003.

But the US paid a steep price for this renewed burst of economic growth. America's structural imbalances, which had already gone to excess, only worsened as the world was lifted by yet another strain of US-centric growth. That was underscored by unprecedented twin deficits in the current account and the federal budget, along with an all-time low in national saving and a record high of household sector indebtedness. China also paid a steep price for its growth surge; bottlenecks, property bubbles, runaway bank lending, and excess investment spending are all telltale signs of overheating that threaten the sustainability of economic expansion. In short, the costs of this global blowout cannot be minimized.

History demonstrates that economic cycles often sow the seeds of their own reversal. This one is not likely to be an exception. Three key counter-cyclical forces are now falling into place that are likely to restrain economic growth in 2005: First, a normalization of the Fed's monetary policy stance will test America's newfound asset-driven growth dynamic; not only will it challenge conditions in asset markets, themselves - especially property - but it will also pose a stern test to the wherewithal of the overly indebted US consumer. Second, to the extent that the recent elevation in oil prices reflects greater pressures on the demand side rather than from the supply side of world energy markets (see our 28 May dispatch, “The Great Oil Debate”), little immediate relief can be expected as global growth remains surprisingly brisk. At $40, higher oil prices are a heavy tax on the world's energy consumers. At $50, the tax would probably turn into a shock. In either case, the outcome is a distinct negative for global growth, especially if it takes the form of a geopolitically-induced shock. In light of ongoing and mounting tensions in the Middle East, such a possibility can hardly be ruled out. China's efforts to slow an overheated economy are a third counter-cyclical development in the offing; while the measures haven't had an impact yet, I continue to believe it's only a matter of time before there is a distinct slowdown in the pace of Chinese industrial activity. As these factors come into play, I have little doubt that the global growth cycle should turn decisively to the downside by early next year.

All this paints a picture strikingly reminiscent of the boom-bust cycles of yesteryear. Around the world, the authorities pulled out all stops in 2003 in playing the growth gambit. It worked, but at a cost - a record state of global imbalance that has only gone further to excess. The reflationary efforts have created a growth spurt that could well be borrowing from future gains - 10% growth in durables consumption by the American consumer over the year ending 1Q04 and a 43% surge in Chinese fixed investment over the same period. These are the signs of an overshoot that almost always elicits a payback, as the stock of durable goods and productive capacity returns to long-term sustainable equilibria. And, now, as US interest rates rise, oil prices move higher, and Chinese authorities up the ante on tightening, that payback could well be exaggerated to the downside. To the extent that this year is turning into a global blow-off, I worry about precisely the opposite for 2005. In my view, this is shaping up more and more as the boom that finally begets the bust.

http://www.morganstanley.com/GEFdata/digests/20040601-tue.html