A year after equity markets across the world got their first whiff of the problems in the US mortgage market, it’s time for some stock-taking.
How badly has the US economy been hurt? Why have emerging equity markets been hit so badly? Why should we suffer for what is essentially a US and, to some extent, European problem? And could things get worse?
It’s best to let US economist Brad Setser, from the Council on Foreign Relations, do the talking about the US economy. Here’s what he said in his blog: “The US household sector still runs a deficit. Household savings isn’t falling anymore, but it also hasn’t really increased. Rising oil bills have eaten into spending on other items, but overall spending is holding up. Residential investment is down.
But the household sector as a whole still runs a deficit—though a somewhat smaller deficit than before. Mortgage lending hasn’t even collapsed. Demand for ‘private’ mortgage-backed securities has disappeared. But the agencies stepped in and bought mortgages both for their own book and for the mortgage-backed securities that they guaranteed.”
How come the US has so far managed to get off so easily from what seems to be such a calamitous event? One often-cited reason is the immediate reaction by the US Federal Reserve, which slashed interest rates and agreed to accept dodgy securities as collateral for its loans. But Setser points to another, bigger reason: Other countries have been willing to continue to provide credit to the US in its time of crisis. Over the last 12 months, foreign central banks’ purchases of the US financial assets have been close to $680 billion (Rs28.9 trillion).
At a time when the US dollar was crashing and when the US financial system was tottering, the central banks of China and of the West Asian nations were buying dollars hand over fist. In short, the old game continues: the US consumes, China produces and the surplus is invested in US bonds, keeping interest rates low there and stoking debt-fuelled consumption. As a result of high oil prices, the Gulf countries have now joined China in parking their surpluses in the US.
Unfortunately, the other leg of the game, of recycling the money from the US back into emerging markets, has hit a roadblock. Unlike Asian central banks, US investors have become risk-averse. The consequence for emerging equity markets, heavily dependent on foreign capital, is a sharp fall in prices.
But there are signs that the game may be in its last stages. Chinese exports have started slowing, falling in June to their slowest pace in four months.
Even more interesting is the direction of exports—growth in exports to the US has been just 8.9% in the first half of the year, while exports to the European Union increased by 27%. That’s because the euro has gained against the dollar and, with the yuan pegged against the US currency, Chinese goods to Europe have become cheaper.
Europe, however, is slowing. The Economist magazine forecasts that growth in the euro area is going to slow down to 1.3% in 2009, compared with 1.7% this year. Japan recorded its first drop in exports in four years last June, with exports to the US dropping 15.4%, its 10th monthly decline and exports to Europe dropping 11.2%, the second month of decline.
So far, exports to Europe had provided the boost for Asia’s export machines. But if Europe slows, what will happen to the export surpluses? The same question applies to the Gulf, because “demand demolition” as Lehman Brothers calls it, will push down energy prices.
Once the surplus starts declining, then so will the rate of rise in foreign exchange reserves of the Asian central banks. And that in turn will mean fewer dollars to recycle to the US Treasury. Simply put, if the US economy slows further and is followed by a slowdown in Europe as well, that will set the stage for the unravelling of the economic system that has linked China and the US in such a close symbiotic relationship that historian Niall Ferguson coined a new term for these twin economies joined at the hip: Chimerica.
Once free money from China and other countries is no longer available, then the US will finally start to feel the pain. There are already some who want to hasten the process. Former Morgan Stanley economist Andy Xie, writing in the Chinese magazine Caijing, says, “The US can monetize the losses from its financial crisis because the dollar is a global currency and monetization causes the dollar to depreciate, but not collapse. As international investors hold $16 trillion of US dollar financial assets, monetization is a preferred strategy for the US; foreigners may share one-third of the cost through inflation and dollar depreciation. To stop it, foreign investors should sell the US treasuries now to drive up the bond interest rate sky high, which would deter the Fed from printing money. So far, international investors, mainly central banks, are scared stiff and don’t know what to do. The US is taking advantage of the opportunity to stuff the world with its losses.”
That may be true, but a deep US recession benefits no one. The collapse of liquidity brought about by the breaking up of Chimerica may lead to an unprecedented global crisis. It’s all very well to say that the old game is no longer sustainable, but the problem is that we have yet to come up with an alternative.
Manas Chakravarty looks at trends and issues in the financial markets. Your comments are welcome at firstname.lastname@example.org
To read all of Manas Chakravarty’s earlier columns, go to www.livemint.com/capitalaccount