steven roach - "an unprepared world"

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    Global: An Unprepared World

    Stephen Roach (New York)

    Globalization is a wonderful subject to debate. Basically, that’s all I’ve been doing for most of the past two weeks — first at our own MacroVision exercise and more recently at the World Economic Forum in Davos. In many respects, these were two of the most intellectually enriching weeks I have spent in a long time. Yet as I now decompress and ponder the experience, I am left with a nagging sense of concern. As I see it, investors are largely unprepared for some big changes coming in the global landscape in 2005.

    This potential disconnect is most evident in the debate over the US and China — currently the twin engines of global growth. America’s imbalances are widely recognized as both worrisome and unsustainable. There is a minority that believes in the new paradigm of the fungible global saving pool — that the allocation of capital, consumption and production now flows seamlessly to its destinations of highest return or comparative advantage. In its simplest sense that translates into a world where China produces, America consumes, and the rest of the world gladly pays the bill and goes along for the ride. But with global imbalances expanding at an accelerating rate, even advocates of this point of view are starting to have second thoughts. America’s deficits are now being framed as a problem that will come to a head sooner or later. The hope of the global consensus is that it will be later.

    As I have noted ad nauseum, macro is not particularly good on these issues of timing — in making the distinction between the proverbial sooner or later. But my suspicion is that 2005 will be a critical year in being able to make that distinction. I rest my case mainly on the likely behavior of the Federal Reserve. At present, the US central bank is running an utterly absurd monetary policy of maintaining a “zero” real short-term interest rate — a nominal federal funds rate of 2.25% that is basically equal to the core CPI inflation rate. That will undoubtedly change this week, but not by much. When the dust settles after what is likely to be yet another “measured” tightening of 25 basis points, the real short-term interest rate will only be fractionally in positive territory. This is well below what most believe to be a “neutral” position for the Fed’s key policy lever — somewhere in the 2% zone in real terms. Which, of course, says there is a good deal more tightening to come if the Fed is serious about containing the inflationary and speculative risks it cited in the minutes of the December FOMC meeting.

    This could be a recipe for a flash point that has a lot to say about the “sooner or later” aspect of global rebalancing. Last year’s Fed tightening was inconsequential — all it did was lift short-term real interest rates from negative territory to zero. This year’s Fed tightening is likely to be a very different animal — taking the policy rate from zero toward a large enough positive number that deals with the very risks the Fed, itself, is now citing. For financial markets, the zero real federal funds rate is the candy of the carry trade — allowing investors and speculators to borrow short and pocket the spread anywhere else on the yield curve. In 2005, the Fed is going to take the candy away. This points to a likely unwinding of a multitude of carry trades that have driven spreads on risky assets to unbelievably low levels. Those include high-yield and emerging market debt, investment-grade debt, and the “refi trade” that has underpinned consumer equity extraction from increasingly overvalued homes.

    This underscores a potentially critical moment of reckoning for the US economy and for a US-centric global economy. Extraordinary monetary accommodation has been the glue that has held a post-bubble US economy together these past five years. But the easy money has given rise to an asset-driven saving and spending mindset. That development, in conjunction with an unprecedented shift in the federal government’s saving position — a budget that went from surplus to deficit — has pushed America’s income-based saving position to record lows: The net national saving rate has averaged just 1.5% since early 2002. Lacking in domestic saving, the rest is history — a US that has to import surplus saving from abroad to grow its economy, and run massive current-account and trade deficits to attract the foreign capital. And, of course, Japan and China have led the charge in financing this asset-dependent spending binge because they couldn’t stomach the alternative.

    Like in 1994, 2005 is likely to be the year when the Fed finally gets “real” on real short-term interest rates and the carry trades they have spawned. But unlike the case in 1994, more than a decade later, the US has been transformed into an asset-dependent economy that has given rise to massive global imbalances. To me, all this smacks of sooner rather than later on the rebalancing watch. Based on all my discussion and debates in the past few weeks, I would say that the world is largely unprepared for this possibility. The Fed is widely thought to be the world’s central bank and wouldn’t dare risk such an outcome, goes the logic. By inference, that means the world is perfectly content with the alternative — the folly of financing itself on an increasingly shaky foundation of ever-risky carry trades. A truly independent central bank has no choice other than to take the candy away. And a US-centric world will have to figure out how to cope with the aftershocks. The key question, in my view, is whether the Fed has the courage to act.

    Similarly, an increasingly integrated global economy has to find a much better way to cope with China. The China debate has now reached a feverish pitch — especially on the RMB currency issue. The Chinese were well represented in Davos and every utterance by a Chinese official or banker was scrutinized by the press and the markets for hints of any imminent action on this front. In one of the final sessions at the World Economic Forum, Li Ruogu, Deputy Governor of the People’s Bank of China, stated unequivocally that the decision has already been made to shift gradually to a more flexible currency regime. But he went on to underscore that there is no timetable for such an action. But, as I saw it, the message from China was sooner rather than later on this count as well. The operative word on this issue came from the senior member of the Chinese delegation at Davos — Vice Premier Huang Ju. China, he stated, was well advanced in its preparation for a more flexible currency regime.

    If that wasn’t a wake-up call, the next session at the World Economic Forum was. Literally, a few minutes later on the same stage, John Taylor, US Under Secretary of Treasury, used precisely the same language in stating that China is now taking steps to prepare for the shift a more flexible currency system. The emphasis on the word “prepare” stands in sharp contrast to earlier language, which always contained references to terms such as “stability” or “fixed.” Those words were not used in Davos. I don’t want to read too much into the nuances of language, but I think there is an important message here. I don’t think it was an accident that both Chinese and US officials selected the same new word to characterize an issue that has taken on increasing significance in world financial markets.

    Personally, I think the Chinese currency issue is totally misunderstood. For starters, I can’t conceive of a likely move in the RMB that would have any impact on Chinese competitiveness or on the US current-account deficit. Sure, if the peg goes, other Asian currencies could follow suit — allowing the dollar to continue the requisite decline that America’s current-account deficit requires. That would undoubtedly also trigger some diversification out of dollar-denominated assets by foreign investors and central banks — only underscoring the likely of a back-up in longer term US interest rates that would have happened in any case. The only RMB outcome that would shock the markets would be an Asian-crisis-style adjustment. With over $600 billion of official foreign exchange reserves at its disposal, the odds of that are close to zero, in my view. China has ample resources to manage any currency adjustment it wants.

    I do think this is a big deal for China. Over the past 26 years, China has made phenomenal progress largely by successfully executing an open, trade-oriented development model. It has relied on its enormous reservoir of national saving to improve the infrastructure that supports its manufacturing platform. And it has used this infrastructure, along with aggressive tax incentives and a vast low-cost labor force, to attract huge inflows of foreign direct investment. Currency stability is key for any outward-looking growth model. But now China is coming of age and must shift to a more balanced, market-oriented framework. To do that, it needs to focus more on stimulating domestic demand — its consumption share of GDP is only about 55%. At the same time, China also needs a more flexible policy apparatus to smooth out the inevitable cyclicality of market-driven adjustments. That points to flexibility in terms of fiscal, monetary, and yes, even currency policy. The Chinese know and understand this, and are definitely moving in that direction. Timing is their business — not ours. But when they shift currency regimes, I think it will be a very positive sign of the maturation of the Chinese growth miracle. I don’t think the rest of the world gets this point at all.

    All this speaks of world financial markets that are not well positioned to cope with two of the biggest issues on this year’s macro agenda — a significant move in real short term interest rates in the US and the deeper implications of an eventual shift in China’s currency regime. Timing is always tricky in this business, but I think the Chinese have put it best: The time to prepare is now.


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