Risk aversion in credit markets will be prominent in the new year. This means a material retrenchment for the U.S. consumer, erstwhile motor of global growth. Nonetheless, a pickup in investment spending in the developing world will keep real global growth in the 2-3 percent range. Combined with a sharply weaker U.S. currency, this augurs the beginning of a long-awaited “global rebalancing.”
Credit conditions will continue to tighten in the U.S. economy as markets pull back from exposure to a deteriorating U.S. household balance sheet. Home equity extraction will no longer be an option to sustain consumer spending. The combination suggests marked weakness in the U.S. consumer sector, forcing a period of adjustment onto the pattern of global growth experienced since the beginning of the current post-2001 business cycle. In isolation, the combination would spell a difficult year for the global economy.
Abrupt adjustment is in the cards, spelling a slowdown in global growth in the first quarter.
However, conditions outside the U.S. economy are primed to respond to the shock:
• East Asian turning-point. A combination of circumstances makes the present juncture a particularly appealing time for East Asian monetary authorities to countenance a secular domestic currency appreciation. With external demand growth weakening, the logic of stoking domestic demand will be compelling. Fortuitously, large foreign currency reserves leave East Asian economies well placed to manage the change-over. There may be little choice:
U.S. monetary policy is set to ease by 75-100 basis points in the first half of 2008, removing the floor from dollar adjustment.
A policy of resistance on the part of East Asian currency authorities would prove complex, due to the challenge of domestic liquidity.
The starting point looks likely to be China, where the liquidity challenge seems most pressing.
Official measures of inflation are above 6 percent and may understate the true extent of urban consumer price pressures.
Adjusting the proportions of growth emanating from internal and external demand means fostering growth in domestic investment and consumer spending:
After years of rapid GDP growth, there is a severe shortfall in supporting infrastructure — moreover, there will be increasing need to invest in pollution controls — which can be financed on budget and off.
Private sector spending will follow, encouraged by a strengthening currency.
This is a virtuous process, since appreciating currencies ease the import bill associated with a ramp-up in imports of ores, fuels and other commodities associated with growth in the non-traded sector — particularly construction. Again, ample foreign exchange reserves remove some of the concerns typically associated with booms in the non-traded sector of emerging economies, 1990s East Asia being the quintessential example. Average reserves coverage of M1 (the central bank’s theoretical liability under currency flight) was 246 percent as of July 2007, compared to 170 percent in December 1996.
• European export dynamism. Euro-area growth would respond favorably to the change in global demand patterns, partly due to export dynamism:
European exports are highly exposed to capital-intensive sectors, and will gain from a pickup in extra-Europe investment spending.
Stronger East Asian currencies finally would provide relief to more price-sensitive components in the euro-area traded goods sector; consumer goods being a key example.
Providing additional support will be spending from oil exporters, who also are likely to be forced into a secular or stepped appreciation against the dollar.
• U.S. trade sector growth. Monetary easing by the Fed will ease the pain of stretched U.S. household finances, but not turn around risk aversion unfolding among creditors. However, it will make the U.S. trade sector sharply more competitive by removing the floor from dollar overvaluation.
The result is likely to be a pickup in the traded-goods sector, both in import substitution and U.S. exports. Although largely overlooked, the latter has shown notable prowess with the limited dollar depreciation achieved in 2007. This strength will be unmistakable in 2008.
While the balance of probability lies with global vitality, downside risks are material:
• Financial sector disturbance. Financial intermediation changed appreciably in the current business cycle, with risk having been distributed widely among holders of securitized assets, some of which have proven unworthy of their investment-grade rating. The danger is that policy options are not straightforward:
Previously, authorities could rescue a single institution, or even a group (as in the 1980s U.S. savings and loan crisis).
Today, the strain from a collapse in particular assets would be spread widely, and in some places probably deeply.
The trigger for such an implosion could be failure of a major credit insurer. Such an eventuality would trigger loss of investment-grade credit status for underwritten securities, in turn producing forced sales by institutions mandated to hold premium-only credits. Forced sales are a recipe for price collapse, creating potential for insolvency where exposure is significant. The policy response is not straightforward. Part of the danger of this scenario is the fact of being in “uncharted” territory:
Learning is accomplished through mistakes.
• OECD-wide house price weakness. The negative wealth effect from falling house prices would be more significant than that from falling share prices experienced at the end of the 1990s dot-com bubble. However, policy tools to counter it are robust:
Policy rates are high in the most overvalued markets, suggesting ample ability to resuscitate markets with rate cuts.
Integrated capital markets such as the United Kingdom’s would be more affected than those where housing finance is still segmented, such as France and Germany.
• Oil price shock. A further sharp rise in oil prices would place a burden on U.S. policy in particular, as it would limit the Fed’s room to respond to GDP weakness. However, this is a perennial worry, and the odds currently favor weakness in oil prices. A durable spike is difficult to envision.
Moreover, energy intensity of output is far lower today than during previous oil price shocks.
This cycle looks unlike other bouts of credit tightening, insofar as emerging markets have rarely been better placed to withstand the strain. This is due to the buoyant external conditions these markets enjoyed over the past two to three years, in most cases resulting in a positive net foreign asset position of the economy. Under such conditions, the risk of currency and financial crisis in developing countries is sharply reduced.
Oxford Analytica is an international consulting firm providing strategic analysis on world events for business and government leaders. See www.oxan.com.