Rudi's View | Jun 02 2010
This story was first published two days ago in the form of an email sent to paying members.
Rudi Filapek-Vandyck is currently on leave in Europe. This edition of Weekly Insights features Part II of a two-part article by Greg Peel assessing the gradual shift currently underway in global economic power from the developed West to the developing East, and the impact the Global Financial Crisis – being the private sector crisis of 2008 and the public sector crisis of 2010 – will have on that transition.
By Greg Peel
Part I of this series, Surviving The New World Order: The Shift from West To East, examined the gradual transition of global economic power from the developed economies of “The West”, being North America, the UK and Europe, and by default the likes of Japan and Australia, to the developing economies of “The East”, being China, India, the Gulf countries, Korea, South-East Asia and by default the likes of Russia and Brazil.
While still in its infancy, no more apparent was this burgeoning shift than in the “boom” period of 2004-08 – the period which gave rise to the new acronym “BRIC” (Brazil, Russia, India, China). Leading the field by a long margin was China, which with a bit of help from Western outsourcing of manufacturing capacity was leading its billion-plus population into a GDP growth period which reached a level of 13%.
When the “subprime crisis” began in mid-2007, it was first considered simply an “American thing”. By early 2008 the subprime crisis had become the global “credit crunch”, but still the world felt that America was largely getting its just desserts given its extraordinary levels of debt and that the impact beyond the US would not prove critical. Both Europe and Japan had been reemerging from periods in the economic doldrums, while the prospect of rapid industrialisation and urbanisation in China meant it was clearly “decoupled” from any economic recession in the US. Once upon a time, when America sneezed, everyone else caught a cold. But this time it was different, they said.
And they were wrong.
When the impact of the fall of Lehman Bros sent the world spiralling into the Global Financial Crisis, the December quarter of 2008 was the darkest in global economic history since the Great Depression. Europe was hit just as hard as the US, and China's economic reliance on selling manufactured exports to the West meant it, too, suffered a dramatic contraction in GDP growth. Suggestions that the East was happily decoupled from the West proved erroneous.
In Beijing, an important lesson was learned. It was indeed the latest in a series of lessons the world's post populous nation had learned since the beginning in the nineties of China's clumsy transition from fundamentally communist to largely capitalist (with communist overtones).
Having not yet sufficiently matured economically, China avoided the Asian Currency Crisis of 1997 which burst the economic bubble of the ambitious “Little Tiger” economies of South-East Asia. China learned that rapid economic expansion and a free-floating exchange rate led to runaway inflation and currency overvaluation. So China chose to peg its currency to the reserve currency of the US dollar. This meant a rolling explosion of export receipts as China moved into the twenty-first century, which Beijing dutifully fed back into the system by buying US bonds.
But in its smug attempts to prove itself a global economic force to be reckoned with, Beijing underestimated the expansionary GDP growth power of its pegged currency. Having already suffered boom-and-bust pitfalls as it took the fist stumbling steps towards capitalism, China now realised it must slow its economy down. For Beijing had learned another lesson, from its “emerging economy” predecessor – Japan.
Japan's “economic miracle” had lasted three decades from the post-war fifties to the booming eighties. But Tokyo failed to sufficiently control its economic expansion and subsequent asset price bubbles and suffered a bust that sent it into a decade of deflation from 1990, from which Japan has still not recovered. Not wishing to make the same mistake, Beijing attempted to slow down its own “economic miracle” by implementing small monetary tightening steps in the 2004-08 boom, including gradual currency revaluation.
But Beijing's “softly-softly” approach – representative of a fear that more stringent measures could actually derail economic expansion altogether – proved naïve. China was building its economy on the “sand” of export reliance while in its haste neglecting the “rock” of domestic economic strength. Thus when the GFC impacted on its export customers, China, and the world, quickly realised that the burgeoning impact of the urbanisation and industrialisation of a billion people was not yet mature enough to overcome the old world order of the supremacy of Western consumption.
Yet all was not lost, because as the world entered the GFC, the West was wallowing in debt but China was wallowing in a huge foreign currency surplus. Armed with excess funds, and having learned from its own mistake, Beijing set about redirecting attention to its domestic economy by implementing the world's largest ever fiscal stimulus (as opposed to bail-out) package. By becoming a consumer in its own right, China correctly assumed it could put a safety net under the crumbling global economy, and that in so doing its export customers could slowly regain their own consumption capacities.
And it worked – all the way through 2009. But then in late 2009, the tiny Arab emirate of Dubai found out that it was actually wearing no clothes. And when Dubai was subsequently forced to restructure its enormous debt, somebody mentioned the word “Greece”.
Part I of this series suggested that with China leading the way on domestic economic expansion, global economic power post-GFC is now clearly undergoing a shift from West to East. But what the world quickly appreciated in early 2010 is that we are not in a “post-GFC” period at all. The monetary rescue packages implemented by Western economies across the globe in order to prevent another Great Depression had not really solved any fundamental problems, they had just managed to shift the debt burden from the private sector to the public sector – from corporations to nations. And so now we have a sovereign debt crisis.
And just as the original US subprime crisis had been dismissed in 2007 as too small an issue to be overly concerned about, so too was eurozone member Greece deemed too small an economy to have any significant impact.
But here we are again – staring in the face of another potentially destructive global credit crisis. Greece has brought attention to the debt levels of not only the weaker eurozone members, but also to those of the UK, Japan, and, inevitably, the US. China has only had one year to refocus its attention on domestic economic growth. Its GDP growth rate has regained the 12% mark, but Europe is China's biggest export customer. Is there any way China can save the world again in so short a space of time? Or are we just heading back down the path to global recession?
The good news is the analysts at DBS Group Research are convinced we are not.
DBS points out that by the middle of 2009, Asian (ex-Japan) industrial production had fully recovered pre-GFC levels. Yet US import demand didn't even begin to recover until the same time. This means Asia fully recovered before its export markets even began to return. And this was not about government spending or even inventory accumulation, DBS notes, it was about pure and simple domestic consumption.
In the post-GFC period from the September quarter 2008 to the December quarter 2009, Asia increased its consumption growth by 7.1% over pre-GFC levels while Japan managed only 0.3%, the US fell by 0.6% and the eurozone fell by 1.1%. China no longer depends on exports to the G3 as it previously did.
But does that mean Asia is now immune to another downturn in Europe or the US? “Of course not,” says DBS. Trouble in the US or Europe will never be good for Asia despite lesser dependence than previously. But it is all a matter of degree. The smaller, highly export-dependent economies of Singapore, Hong Kong, Malaysia and the Philippines would be impacted the most while the larger, more domestically driven economies of China, India and Indonesia would be impacted the least.
DBS has taken a look back to the earlier 2000-01 recession, which was caused by the bursting of the dotcom bubble. It has measured the swings in export demand sensitivity by dividing change in GDP growth by change in export growth.
With a score of 0.45, Hong Kong”s GDP growth was most impacted by loss of export growth. Singapore was next with 0.38. But Indonesia only measured 0.04, China, 0.01, and India minus 0.07 meaning it actually improved its GDP during the period. All three saw significant export contraction, but their GDPs barely budged.
But the period 2000-01 was still early days in the Asian expansion. DBS then looked at the period 2008-09 in which the global economy registered recession. The world fell apart altogether in September 2008 but by December China had begun its massive commodity import drive. By mid-2009 the world was getting back on its feet. Not only had China become a major exporter by this time but it was also following the Western lead and outsourcing its manufacturing sector to its smaller neighbours, making South-East Asia an exporter to China.
Over this time, Hong Kong again fared worst with a GDP growth/export growth impact of 0.52, while this time Taiwan came in second with 0.33. China registered only 0.13, Indonesia 0.05 and India 0.04. As DBS notes, “China, India and Indonesia, Asia's largest domestically-driven economies, went through the crisis relatively unscathed”. It must be noted that China's GDP growth did rather quickly fall below 7% in the depth of the GFC, but it was back over 10% again in no time at all.
But now we have a new crisis – one which threatens to send the eurozone economy back into recession. In the meantime the US economy has been recovering reasonably well but the US knows that in order to reduce its massive deficit it must import less and export more. A weaker US dollar would help, but now the euro has crumbled the US dollar is once again strong in relative terms, and Europe is a big US export customer.
Asia sends 10.9% of its total exports to the US, but 13.3% to the eurozone. Within those Asian exports to Europe, China has the highest proportion at 22% while India exports only 11% and Indonesia 10%. But DBS notes, “While differences in country exposure to Europe may matter on the margin, it is export exposure [of total GDP] in general that matters most. China, India and Indonesia remain the least vulnerable due to their size and ability to rely on domestic demand to maintain growth”
What is also now a relief for Asia in general is that China has become a much increased export destination within the region.
There are three ways Asia could be impacted by the European crisis, DBS suggests. Firstly, by investment exposure to euozone debt or eurozone banks holding that debt; secondly, by a general widening of global credit spreads as a result of the crisis; and thirdly, by a drop off in European import demand.
In regards to the debt itself, DBS notes Asia is in a much better position than it was on the Asian crisis of 1997-98. Then it was running deficits but it has been swinging into surplus ever since, effectively “saving for a rainy day”. We saw surplus in action in 2009 as China stimulated its domestic economy and stockpiled commodity imports, thus boosting the economic fortunes of commodity exporters such as Australia.
“The bottom line is that Asia's fundamentals are much improved from ten years ago,” says DBS, “and should help it weather any contagion from Europe with relative ease”.
The concern for Australia is that its recent economic success has been based almost entirely on exporting commodities to China and elsewhere, notwithstanding the robustness of the local banking system which helped Australia through the GFC. Global funding costs may rise somewhat as a spillover from European debt re-rating, although to date such increases have been noticeable but small and nothing like the jumps experienced in the GFC. But Australia's real fear is that China will need to import fewer commodities given a reduction in its European export market for one, and the fact it had previously stockpiled a lot of commodities and thus may not need too much more for even its domestic economic growth.
There are nevertheless two points to consider. One is that before the European crisis began to really gather steam, overbought resource stocks were weakening on the news China was attempting to reduce its GDP growth from a runaway 12% or more down to a more measured 8%. While this removed some of the euphoria from the market, it is in Australia's interest that China steadily grows its economy over time rather than suffers violent boom-bust cycles.
There is now a fear that China will continue to rein in its economy at the same time the European economy is going backwards, thus providing a “double-whammy”. But while China has to date been silent on the issue, other than to suggest it is supportive of the euro and would never dump its holdings, one assumes European economic contraction will actually provide just the sort of contractionary influence Beijing was trying to create through monetary policy. Hence if China now holds back on its previously aggressive tightening measures, then Australia, and the rest of the world, is only in the same place it was before the latest crisis hit.
The second point to note is that while iron ore spot prices have declined from dizzy heights this past month, contract prices (now negotiated quarterly) have not. Indeed, while analysts have reduced earlier “onward ever upward” iron ore price forecasts to more modest increases, they are still increases given the iron ore market is expected to remain in deficit until at least 2013.
When we were building toward the GFC in early 2008, many assumed China was “decoupled” from the West and thus would prevent deep global economic recession. But in retrospect the call was too early. China had not yet paid sufficient attention to its domestic economy and was relying on its export economy instead. But now that China has used its foreign reserve stockpiles as massive stimulus for its domestic economy, and intends to do so for a while yet, China's domestic economy is growing in leaps and bounds.
So the opinion of analysts such as DBS is that the impact on Asia from a once again diminished European export market will not be enough to overcome the accelerating growth of Asian consumption.