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Stephen Roach, Morgan Stanley- Venting global tensions

Venting global tensions

By Stephen Roach 11:13AM (05-07-2006)

I continue to believe that the global economy is now in better shape than financial markets. The stewards of globalisation have finally woken up to theperils of ever-mounting global imbalances — the major macro issue that has concerned me for nearly four years. But the policy requirements of rebalancing are not without risks — especially since they entail a withdrawal of excess liquidity. In my view, the risk aversion trade that began in early May should be seen as a venting of the tension between global rebalancing and a potential shift in the liquidity cycle.

Financial markets may not have seen the end of this adjustment. The linkage between liquidity-driven asset bubbles and global imbalances is at the heart of this venting. Aided and abetted by its bubble-prone central bank, the US has taken the lead in driving this insidious process. By substituting asset-based savings for traditional income-based savings, America has pushed its domestic savings rate down to unprecedentedly low levels; in the second half of 2005, the net national savings rate was essentially “zero”. Lacking in domestic saving, the US then imports record surplus savings from abroad — which, of course, requires it to run massive current account and trade deficits in order to attract the foreign capital. America’s current account deficit, which soared to a record US$791 billion in 2005, was, by far, the largest imbalance in an unbalanced global economy, absorbing about 70% of all the surplus savings in the world last year. It is a direct outgrowth of bubble-driven dissaving that has taken the personal savings rate into negative territory for the first time since 1933.

April was a critical turning point on the global rebalancing watch. After years of denial, the stewards of globalisation, namely the G-7 finance ministers and the International Monetary Fund (IMF), finally sounded the alarm over the threat of mounting imbalances. The rebalancing fix that was endorsed has three key ingredients — the adoption of a multilateral global architecture of surveillance and consultation, general agreement on dollar depreciation and a global tightening of monetary policies.

This latter piece of the rebalancing fix is key to the liquidity withdrawal that now appears to be underway in world financial markets. One by one, all of the world’s major central banks — in the US, Europe, Japan and China — have moved to the tightening side of the monetary policy equation since late April. While there is still considerable disagreement over how far this global tightening may yet run, there can be little doubt over the implications of what has transpired so far. As measured either by price (real interest rates) or quantity (the excess of money over nominal gross domestic product) the global liquidity cycle has now shifted decisively to the downside for the first time since 2000. For liquidity-driven financial markets and the steady stream of asset bubbles they have spawned in recent years, this represents a major about-face.

In response to this turn in the global liquidity cycle, the adjustments in world financial markets have been painful but orderly. Developed world equity markets have stayed within the 10% correction band that market historians have long judged to be the norm of most mature bull markets. The biggest moves have occurred in the assets that went furthest to excess, namely emerging market equities and commodities. From their early May highs, corrections in these markets have ranged in the 20% to 30% zone — significant by any standards but all the more so in the light of the extraordinary run-ups of the past several years.

Traditionally among the riskiest of assets, emerging markets and commodities had become priced for a veritable absence of risk. I have argued that while there are, indeed, constructive fundamentals in both areas, there are good reasons for investors to remain engaged in an active two-way debate on the macro outcome for risky assets. To the extent that was increasingly less the case, the risks of corrections were high and rising in both commodities and emerging markets. In fact, that’s pretty much the way it has since played out.

I don’t think it’s a coincidence that the near parabolic increases in commodity prices in late March and April occurred just when an already vigorous Chinese economy surprised to the upside. Investors and speculators quickly became convinced that China would do little to arrest its “commodity-heavy” growth model that had drawn disproportionate support from fixed investment and exports for the past 27 years. This ignored altogether the possibility that China might tighten its policies to contain another wave of overheating and embark on a major structural transformation of its economy that would see growth shifting away from its commodity-intensive investment and export sectors to more of a commodity-efficient consumer-led outcome. And yet there is now good reason to believe that both such shifts are now underway.

The same can be said for the emerging market debate. As seen from the standpoint of the problems that created the last crisis in the developing world — the wrenching adjustments of 1997/98 — today’s fundamentals look nothing short of superb. The outperformance of emerging market equities over the past three years and the extraordinary compression of debt spreads in the developing world suggest investors had become comfortable with the notion that the days of crisis were all but over for this traditionally risky asset class.

Here, as well, I have argued that the debate needs to be more even-handed. After all, the proverbial “next” crisis never looks like the last one. While the developing world has, indeed, reduced its external financial vulnerability dramatically over the past nine years, it has done little to reduce the external vulnerability of its real economies. Lacking in support from internal private consumption, a faltering of the long over-extended American consumer could well do serious damage to these still export-led economies. We debate endlessly the fate of the American consumer. But with the US property cycle now turning, it seems foolish to ignore the possibility that there will be a significant consolidation in US consumer demand that would have major implications for externally dependent developing economies such as China, Mexico and even Brazil. With liquidity withdrawal now hitting a critical threshold, it seems equally reasonable to price emerging market securities for a more reasonable assessment of such a possibility. And that’s exactly what appears to have happened (see last week’s article “Putting the risk back into emerging markets”).

The key question, of course, is whether the risk aversion trade of the past several weeks has gone far enough in pricing in a more realistic assessment of risks. There are three reason I believe the answer is “no”. First of all, from the standpoint of the recent history of risk-reduction adjustments, the current shift is on the short end of historical experience. This is evident in scanning the record of our proprietary “global risk demand indicator (GDRI)”. Since 1997, major downside moves in the GDRI have had an average duration of about 15 weeks; as such, the six-week move in the current cycle is not even halfway there.

Second, I believe that the Chinese authorities will have to up the ante on their recent tightening moves in order to slow a white-hot investment sector; so far, this year’s approach has been a carbon copy of the efforts deployed in 2004 — incremental adjustments in lending rates, a modest increase in reserve requirements and administrative controls on selected overheated industries. With the Chinese economy overheated for the second time in two years, it is clear that if the incremental approach didn’t work back then, it stands even less chance of working today. I agree with my colleague Andy Xie that more Chinese tightening now lies ahead in the not-so-distant future.

Third, I think the Federal Reserve will continue to surprise the markets with more rather than less monetary tightening; its chairman Ben Bernanke has both a credibility problem and the foil of an inflation scare to justify such a policy bias. And a now-softening housing market will be hit in response, as will the asset-dependent American consumer. If the US consumer finally capitulates — a possibility the consensus has all but dismissed out of hand — commodity markets and the developing world will be the first to feel it.

The good news is that none of this speaks of a terribly disruptive endgame for global rebalancing. Had global policymakers ignored the problem, a dollar crisis at some point in the not-so-distant future was a distinct possibility, in my view. But now the combination of architectural reform, currency adjustments and monetary tightening points towards a more orderly, and hopefully benign strain of global rebalancing. However, it is important to stress that such orderly adjustments in the real economy are no guarantee for orderly adjustments in liquidity-driven markets, especially those risky assets that have gone to excess. The risk aversion trade is a clear reminder of that possibility. In the end, global rebalancing can’t occur without a shift in the global liquidity cycle — a withdrawal of the high-octane fuel that has given rise to a multitude of asset bubbles since the late 1990s. If central banks have the wisdom and courage to stay this course, asset-driven saving imbalances will finally be addressed. Investors have long presumed this day of reckoning would be postponed indefinitely. They had become hooked on the now infamous “Greenspan put” — the seemingly perpetual willingness of the world’s dominant central bank to bail out disorderly markets. Yet this approach was ultimately destined to fail — it was a breeding ground for the systemic risks of ever-mounting global imbalances and a moral hazard that could only end in tears.

In my view, that’s what this debate is actually all about — whether the world’s major central banks are finally about to close the book on the Greenspan era. The tension between global rebalancing and the liquidity cycle could well be key to rendering this verdict for world financial markets.

Stephen Roach is chief economist at Morgan Stanley Dean Witter based in New York

posted by gsg @ 11:40 AM