The coming of the storm

The global economy faces its gravest challenge in years as a sharp US slowdown looms. The adjustment could get ugly

  • By Taimur Ahmad
  • 16 Sep 2006
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By Taimur Ahmad 
The global economy faces its gravest challenge in years as a sharp US slowdown looms. The adjustment could get ugly
The US current account deficit has carried on for years without apparent ill effect. But if you think global imbalances have ceased to matter, think again: storm clouds are gathering – and this time, the adjustment could be severe.Analysts have long pointed out that, in the event of a US economic slowdown, the deficit would diminish. A slowing economy should help reverse the unprecedented flows of capital from developing economies in recent years. But fears are growing that, far from a slowdown, there’s a real danger of a sharp US downturn – and a possible hard landing for the Chinese economy to boot.
“Given the magnitude of the imbalances, we can’t be confident at this point that we will avoid a disorderly adjustment,” says former US Treasury secretary Larry Summers in an interview with Emerging Markets. A sharp reduction in the US current account deficit, he says, would have a contractionary effect on the global economy.
Housing market concerns
Worries are mounting too that the US economy could be savaged by a US housing market collapse – that the “orderly” housing slowdown predicted by Federal Reserve chairman Ben Bernanke could become a full-blown crash. If it caves in, it could bring down the rest of the economy with it. “The question is, what kind of slowdown will we get and how deep will it be?” says Bill Rhodes, senior vice-chairman of Citigroup.
House prices have been rising at unprecedented double-digit rates in recent years, giving homeowners massive windfalls and supporting a wave of investment in new construction. However, the number of unsold new homes is now at a 10-year high. The market is decelerating. If prices merely flatten, the economy could slow sharply as consumer spending and construction are squeezed. If house prices fall as a result of higher bond yields, the American economy could even dip into recession. 
“The housing market has turned, and the bubble is about to burst,” Stephen Roach, chief economist at Morgan Stanley, tells Emerging Markets. “No one has any knowledge of how it’s going to burst. But it could knock 1-1/2% off US consumer demand.”
Higher energy prices, rising debt-servicing burdens and negative personal saving rates increase the chances of sharp declines in US consumption and GDP growth.
“In terms of global impact, it’s a big deal because the US consumer is the world’s consumer,” Roach says. “Export-dependent developing economies will be hit hard. The impact could be huge.
“The world economy is getting a wake-up call, and the days of complacency are over,” Roach says. 
Citigroup’s Rhodes says that the spectre of stagflation is back. “If you do get a sustained [US] slowdown, capital expenditure is not going to be able to pick up. The danger we have is a return of stagflation.”
The consensus has tended to be that there will be an orderly unwinding of global imbalances. Of course, less spending and more saving is just what America needs to reduce its current-account deficit. But that’s just one projection. 
Ken Rogoff, Harvard professor and former IMF chief economist, believes there are two triggers for a severe adjustment: a slowdown in US housing prices with the knock-on effect on consumer spending; and a sharp slowdown in the Chinese economy. He says it remains very much an open question what will happen if the global financial system is “stress tested”, by a housing price collapse in the United States combined with a sharp slowdown in growth in China. 
Risk of reversal
“There’s a significant risk that the US current account might start reversing,” Rogoff tells Emerging Markets. “I wouldn’t say the odds of a sharp reversal are 50/50, but this has been a serious risk for some time.” “There’s no question in my mind that an element of housing prices is speculative. In the US especially that would have a negative impact on consumption that could shrink the current account by 2-3%,” he says. 
The risk of a crash in China is larger than it was two or three years ago, says Rogoff: “China is overheating. They lack the range of instruments [to slow down in an orderly way].”
A crash would lead to ripple effects in commodity producers such as Brazil and Africa. The world’s big oil producers would also feel repercussions from a Chinese slowdown, as would China’s Asian suppliers, such as Japan, Korea and Taiwan.
“We’re running real risks. Just how great the risks are I don’t know, but they’re certainly larger than we need to be running,” says Summers.
China’s trade surplus doubled in 2005 to exceed 7% of gross domestic product, according to the IMF, making it a key part of any resolution of the imbalances. China’s central bank governor Zhou Xiaochuan, who represents one of five economic areas participating in the IMF’s latest efforts to resolve the imbalances, says an adjustment is necessary and desirable. “The problem is the US current account deficit is close to 7%, so having some kind of adjustment I think is good,” he told Emerging Markets in an interview earlier this year.
The White House’s economic team is not blind to the dangers: “I do share those concerns about global imbalances,” says Matthew Slaughter, a member of the White House’s Council of Economic Advisers. “The rate of increase of the US current account deficit cannot and will not continue indefinitely.”
But what of the housing crash? On this, the White House takes a more optimistic view. “A bit of moderation in residential investment demand is what we see,” says Slaughter. “This would help us reduce the US current account deficit.”
How likely is a disorderly unwinding? “They are legitimate fears and real, and a part of the broad concern I have. What happens if we do get a sharp adjustment? I think about the asset transactions that support global imbalances. A sudden adjustment is something that would entail a sharp shift in investor demand away from US assets. Can such a scenario arise? Yes. How likely is it to arise? In light of the open and deep US capital markets, that’s a scenario that looks less likely. ”
Deficit financing
The US needs to attract roughly $8 billion of foreign capital a day to finance its current account deficit. Any substantial reduction of that inflow could send the dollar into tailspin. A gradual, medium-term depreciation of the greenback is the best-case scenario for an orderly resolution of imbalances.
Rogoff argues that boosting demand in Asia and Europe could help offset some of the impact of a US slowdown, as would an appreciation of Asian currencies. “More flexibility in exchange rates in Asia, demand-driven growth in Asia and Europe. And for the US to start saving more.”
Slaughter thinks that the changes that need to be made in order to redress the precarious international financial architecture “will be global in nature. There is no one country responsible for global imbalances. But for the US, in a macro sense it would be to close the trade deficit, to have faster export growth, slower import growth from a rebalancing of US aggregate demand away from the rest of the world, more towards domestic production.”
“The task for the US is much harder than other countries, although some people pay a lot of attention to China, but the imbalance in China seems not that serious,” Zhou says.
“To correct the imbalances to a tolerable level is not very difficult: increase international demand, try to reduce excessive precautionary savings rates and expand currency flexibility,” says Zhou. “The other option is [for China] to have a more open-door policy, including more market access for foreigners into the Chinese market, to increase the imports,” Zhou adds.
So, what needs to be done? “There is less mystery in what should be done than in the politics of getting it done,” says Summers. “The current account deficit very importantly reflects developments in other parts of the world – in a kind of investment shortage relative to the supply of savings in other parts of the world.” 
Treasury authority
Although much is made of what other countries – notably China – should do to address imbalances, attention is now turning to new US Treasury secretary Hank Paulson and how he might handle the US’s precarious international financial position. Paulson faces the task of minimizing the fallout from the inevitable adjustment.
 “The actions the US takes will have a very important impact on whether these imbalances are corrected,” Summers points out. “It’s very important for [incoming Treasury secretary] Paulson to have control over fiscal policy,” says Rogoff. “I would hope that Paulson was given a promise that he would be a major player and have an impact.” 
 As far as the US government is concerned, says Rogoff: “Any steps it can take to put social security, Medicare on track would be desirable.” 
But others remain sceptical about the authority US Treasury can be expected to muster as the Bush administration enters its terminal stretch.  “[US Treasury secretary] Paulson will be a spokesman not a policy-maker,” says Harvard economist Richard Cooper. “[former Treasury secretary Paul] O’Neill ran into trouble, then [John] Snow was brought in as a spokesman. Nothing I’ve seen suggests Paulson has a wider charge. Snow has followed a straddle between irrational pressures from Congress and sensible policy. I hope Paulson is at least as skilful,” he says. 
  • By Taimur Ahmad
  • 16 Sep 2006

All International Bonds

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1 Citi 313,852.39 1175 8.95%
2 JPMorgan 286,674.13 1305 8.17%
3 Bank of America Merrill Lynch 281,869.72 974 8.04%
4 Goldman Sachs 214,547.99 704 6.12%
5 Barclays 205,147.76 790 5.85%

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1 Deutsche Bank 31,971.88 102 6.87%
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3 Bank of America Merrill Lynch 29,065.55 82 6.25%
4 BNP Paribas 24,679.63 135 5.30%
5 SG Corporate & Investment Banking 22,195.55 122 4.77%

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Rank Lead Manager Amount $m No of issues Share %
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1 JPMorgan 14,960.44 66 7.87%
2 Morgan Stanley 13,992.90 72 7.37%
3 Citi 13,566.56 83 7.14%
4 UBS 13,028.25 52 6.86%
5 Goldman Sachs 11,994.74 65 6.31%