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06/19/2009

China's Issues...Stephen Roach

Stephen S. Roach, the chairman of Morgan Stanley Asia, had some thoughts on the issues facing China in a piece he did for the May/June issue of The National Interest. 

Roach is concerned that China doesn’t understand the gravity of the current financial danger; that it’s living in a state of denial. To wit. 

“The world is in the midst of its most wrenching financial downturn since the 1930s. From subprime to ‘no-prime,’ the once-proud icons of modern finance have all been turned inside out. An asset-dependent and increasingly integrated world has been quick to follow. The global economy is set for its first outright contraction since the end of World War II. Relative to a forty-year trend-growth rate of 3.7 percent in world output, a likely decline on the order of 1.5 percent in the world’s gross domestic product (GDP) in 2009 is all the more stunning. For a $64 trillion global economy, such a shortfall translates into $3.2 trillion of foregone world GDP. Never before has the modern global economy had to come to grips with such a severe and abrupt widening in the so-called global output gap. 

“The Chinese leadership needs to deepen its appreciation of the global shock that is now unfolding. Only then can Beijing truly comprehend the threat this recession poses to its long-successful outward-facing economic-growth model. And yet there are worrisome signs that China just doesn’t get it – that it is clinging to antiquated policy and economic-growth strategies that presuppose a classic snapback in global demand. That leaves China ill prepared for what could well be the defining feature of the postcrisis world – a U.S.-led shortfall in worldwide consumption. China’s export-led growth model is aimed right at the heart of what could well be the new weak link in the global growth chain.” 

But China is asserting itself in an attempt to influence the global policy debate – “warning America of fiscal excesses that could erode the value of China’s investments in U.S. Treasury’s [ed. currently $770 billion] and proposing a radical revamping of the global currency system….But if China pushes too hard in trying to reshape international policies and institutions without attending to its own imbalances, it could trigger further instability – possibly even a dollar crisis.” 

Roach notes that China “stands alone in the massive bet it has made on externally led growth.” By 2007, exports represented 36 percent of GDP. Roach adds that with export growth turning sharply negative in early 2009, the external-demand shock “has brought the Chinese economy to a virtual standstill.” 

In light of this, the government initiated its $585 billion two-year fiscal-stimulus package but the focus is on infrastructure (47% of the package) and Sichuan earthquake-reconstruction efforts (25%). The balance is on export industries such as textiles, steel, equipment manufacturing, and light industries as part of a recently announced “ten industry” industrial-reinvigoration plan. 

Stephen Roach: 

“By contrast, the Chinese government is only paying lip service to measures aimed at supporting internal private consumption – long the lagging sector of this rapidly growing economy. Spending vouchers have been distributed to rural households and the government has enacted a relatively modest national-health-insurance scheme…While there is nothing wrong with these proconsumption initiatives, they are far too small, in my view, to turn around China’s lagging consumption sector, which plunged to a record low of only 36% of GDP in 2007. China needs to get far more serious in funding a social safety net – especially social security and pensions – if it is to reduce the excesses of fear-driven precautionary saving and foster a more broadly based consumer culture.” 

The problem today is that China relies heavily on the American consumer, who, in Roach’s view, “has only just commenced a multiyear compression in the growth of private consumption, (meaning) China could end up being very disappointed in the lingering sluggishness of its external-demand conditions.” So if the external-demand snapback scenario doesn’t play out, you’d continue to have mounting joblessness and the potential for social unrest, which, admittedly, the government has done an outstanding job thus far in mitigating. [My opinion, not necessarily Roach’s.] 

Stephen Roach: 

“Because China is so heavily dependent on exports, the policies and economic conditions of other nations obviously have an important say in shaping the country’s destiny. The impact of the Washington policy debate cannot be minimized in that regard. America’s penchant for China bashing can hardly be taken lightly in the current climate. Over the 2005-07 period, more than forty-five separate pieces of anti-China trade legislation were introduced in Congress. The good news is that none of the bills passed. In large part, that’s because they were introduced during a period of prosperity and low unemployment. The bad news is that both of those conditions have changed in the United States – prosperity has given way to a deep recession and unemployment is soaring. That means that longstanding pressures on American workers are intensifying – as are the related pressures on their elected representatives to act. 

“In times of adversity, the dark side of the American body politic tends to fixate on scapegoats. Wall Street is the domestic target du jour and China could well be the foreign focus. Washington’s ‘reasoning’ in going after China is based on three key considerations: that America’s outsize trade deficit is a recipe for job destruction and real-wage pressures; that China accounts for the largest bilateral piece of the overall U.S. trade deficit; and that China manipulates its currency as a conscious element of its mercantilist policy strategy. Never mind that these arguments are all deeply flawed. First, a saving-short U.S. economy doesn’t have a bilateral-trade problem with China, but rather a multilateral-trade problem that has led to deficits with one hundred of its trading partners. Second, the RMB has risen more than 20 percent against the dollar (in real terms) since China abandoned its currency peg over three years ago. And third, the plight of the U.S. workforce may also reflect America’s chronic underinvestment in human capital and education reforms. In times of distress and national angst, it is apparently easier for American politicians to point the finger at China rather than look in the mirror. 

“That raises the possibility of a most worrisome wild card – that after three years of anti-China rhetoric and saber rattling, the U.S. Congress imposes some form of trade sanctions on China. Unfortunately, such a possibility can no longer be dismissed lightly. After all, the new U.S. treasury secretary, Timothy Geithner, raised the Chinese-currency-manipulation flag in his confirmation hearings. Moreover, Congress opted to include a ‘Buy American’ clause into its recent stimulus package. And during his election campaign, the new U.S. president repeatedly made the distinction between free trade and fair trade when calling for the renegotiation of NAFTA.” 

So what if Congress were to act? Roach is “reasonably confident that Beijing would instruct its foreign-exchange-currency managers to boycott the next Treasury auction – triggering a full-blown crisis in the dollar and a related spike in real long-term U.S. interest rates that would exact a severe toll on a bruised and battered U.S. economy, to say nothing of the rest of the world. Yes, this would impose considerable pain and hardship on the Chinese as America’s largest holder of Treasury securities. But China would perceive this action as an all-out economic attack; Chinese national pride would then take precedence over investment considerations. In short, I have little doubt that Beijing would retaliate should Washington choose to vent its frustrations at China.” 

[Note: And wouldn’t you know, but this week China urged its people to “Buy China”; not helpful.] 

Roach places a 25-33 percent probability on the passage of anti-China trade legislation by Congress by early 2010. 

Thus far, worldwide, trade friction has been minimal given the seriousness of the financial crisis. We need it to stay that way. At the same time, China must begin to shift its economy from an external to an internal focus, or, as Roach surmises, a trade disaster is more likely than his currently assigned odds. 

Wall Street History returns next week.
 
Brian Trumbore



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Wall Street History

06/19/2009

China's Issues...Stephen Roach

Stephen S. Roach, the chairman of Morgan Stanley Asia, had some thoughts on the issues facing China in a piece he did for the May/June issue of The National Interest. 

Roach is concerned that China doesn’t understand the gravity of the current financial danger; that it’s living in a state of denial. To wit. 

“The world is in the midst of its most wrenching financial downturn since the 1930s. From subprime to ‘no-prime,’ the once-proud icons of modern finance have all been turned inside out. An asset-dependent and increasingly integrated world has been quick to follow. The global economy is set for its first outright contraction since the end of World War II. Relative to a forty-year trend-growth rate of 3.7 percent in world output, a likely decline on the order of 1.5 percent in the world’s gross domestic product (GDP) in 2009 is all the more stunning. For a $64 trillion global economy, such a shortfall translates into $3.2 trillion of foregone world GDP. Never before has the modern global economy had to come to grips with such a severe and abrupt widening in the so-called global output gap. 

“The Chinese leadership needs to deepen its appreciation of the global shock that is now unfolding. Only then can Beijing truly comprehend the threat this recession poses to its long-successful outward-facing economic-growth model. And yet there are worrisome signs that China just doesn’t get it – that it is clinging to antiquated policy and economic-growth strategies that presuppose a classic snapback in global demand. That leaves China ill prepared for what could well be the defining feature of the postcrisis world – a U.S.-led shortfall in worldwide consumption. China’s export-led growth model is aimed right at the heart of what could well be the new weak link in the global growth chain.” 

But China is asserting itself in an attempt to influence the global policy debate – “warning America of fiscal excesses that could erode the value of China’s investments in U.S. Treasury’s [ed. currently $770 billion] and proposing a radical revamping of the global currency system….But if China pushes too hard in trying to reshape international policies and institutions without attending to its own imbalances, it could trigger further instability – possibly even a dollar crisis.” 

Roach notes that China “stands alone in the massive bet it has made on externally led growth.” By 2007, exports represented 36 percent of GDP. Roach adds that with export growth turning sharply negative in early 2009, the external-demand shock “has brought the Chinese economy to a virtual standstill.” 

In light of this, the government initiated its $585 billion two-year fiscal-stimulus package but the focus is on infrastructure (47% of the package) and Sichuan earthquake-reconstruction efforts (25%). The balance is on export industries such as textiles, steel, equipment manufacturing, and light industries as part of a recently announced “ten industry” industrial-reinvigoration plan. 

Stephen Roach: 

“By contrast, the Chinese government is only paying lip service to measures aimed at supporting internal private consumption – long the lagging sector of this rapidly growing economy. Spending vouchers have been distributed to rural households and the government has enacted a relatively modest national-health-insurance scheme…While there is nothing wrong with these proconsumption initiatives, they are far too small, in my view, to turn around China’s lagging consumption sector, which plunged to a record low of only 36% of GDP in 2007. China needs to get far more serious in funding a social safety net – especially social security and pensions – if it is to reduce the excesses of fear-driven precautionary saving and foster a more broadly based consumer culture.” 

The problem today is that China relies heavily on the American consumer, who, in Roach’s view, “has only just commenced a multiyear compression in the growth of private consumption, (meaning) China could end up being very disappointed in the lingering sluggishness of its external-demand conditions.” So if the external-demand snapback scenario doesn’t play out, you’d continue to have mounting joblessness and the potential for social unrest, which, admittedly, the government has done an outstanding job thus far in mitigating. [My opinion, not necessarily Roach’s.] 

Stephen Roach: 

“Because China is so heavily dependent on exports, the policies and economic conditions of other nations obviously have an important say in shaping the country’s destiny. The impact of the Washington policy debate cannot be minimized in that regard. America’s penchant for China bashing can hardly be taken lightly in the current climate. Over the 2005-07 period, more than forty-five separate pieces of anti-China trade legislation were introduced in Congress. The good news is that none of the bills passed. In large part, that’s because they were introduced during a period of prosperity and low unemployment. The bad news is that both of those conditions have changed in the United States – prosperity has given way to a deep recession and unemployment is soaring. That means that longstanding pressures on American workers are intensifying – as are the related pressures on their elected representatives to act. 

“In times of adversity, the dark side of the American body politic tends to fixate on scapegoats. Wall Street is the domestic target du jour and China could well be the foreign focus. Washington’s ‘reasoning’ in going after China is based on three key considerations: that America’s outsize trade deficit is a recipe for job destruction and real-wage pressures; that China accounts for the largest bilateral piece of the overall U.S. trade deficit; and that China manipulates its currency as a conscious element of its mercantilist policy strategy. Never mind that these arguments are all deeply flawed. First, a saving-short U.S. economy doesn’t have a bilateral-trade problem with China, but rather a multilateral-trade problem that has led to deficits with one hundred of its trading partners. Second, the RMB has risen more than 20 percent against the dollar (in real terms) since China abandoned its currency peg over three years ago. And third, the plight of the U.S. workforce may also reflect America’s chronic underinvestment in human capital and education reforms. In times of distress and national angst, it is apparently easier for American politicians to point the finger at China rather than look in the mirror. 

“That raises the possibility of a most worrisome wild card – that after three years of anti-China rhetoric and saber rattling, the U.S. Congress imposes some form of trade sanctions on China. Unfortunately, such a possibility can no longer be dismissed lightly. After all, the new U.S. treasury secretary, Timothy Geithner, raised the Chinese-currency-manipulation flag in his confirmation hearings. Moreover, Congress opted to include a ‘Buy American’ clause into its recent stimulus package. And during his election campaign, the new U.S. president repeatedly made the distinction between free trade and fair trade when calling for the renegotiation of NAFTA.” 

So what if Congress were to act? Roach is “reasonably confident that Beijing would instruct its foreign-exchange-currency managers to boycott the next Treasury auction – triggering a full-blown crisis in the dollar and a related spike in real long-term U.S. interest rates that would exact a severe toll on a bruised and battered U.S. economy, to say nothing of the rest of the world. Yes, this would impose considerable pain and hardship on the Chinese as America’s largest holder of Treasury securities. But China would perceive this action as an all-out economic attack; Chinese national pride would then take precedence over investment considerations. In short, I have little doubt that Beijing would retaliate should Washington choose to vent its frustrations at China.” 

[Note: And wouldn’t you know, but this week China urged its people to “Buy China”; not helpful.] 

Roach places a 25-33 percent probability on the passage of anti-China trade legislation by Congress by early 2010. 

Thus far, worldwide, trade friction has been minimal given the seriousness of the financial crisis. We need it to stay that way. At the same time, China must begin to shift its economy from an external to an internal focus, or, as Roach surmises, a trade disaster is more likely than his currently assigned odds. 

Wall Street History returns next week.
 
Brian Trumbore