Asia in a Volatile World
The following is an edited version of the keynote speech made at the LBMA/LPPM Precious Metals Conference in Kyoto on 29th September 2008
My job is to talk about the world economy, with special reference to Asia. Of course, this is a moment in world financial markets when various proverbs come to mind:
We are, as the Chinese say, condemned to live in interesting times.
A saying taken from Japanese politics, however, tells us that an inch ahead is darkness.
There is also a story of a candidate in a general election who gave a speech in which he said that, under the present government, the country’s economy had been brought to the edge of a precipice. Elect his party, he said, and ‘we will take a bold step forward’.
We are, though, seeing a bold step being taken in the US. Yesterday, Congress agreed to spend up to $700 billion on a rescue package for the mortgage-backed securities market. Our questions, therefore, have to be: what are going to be the consequences of that package? What are going to be the consequences of the turmoil and volatility that we have seen in financial markets in the past few weeks and the past year? What might that do for Asia, where such excellent markets for precious metals exist, particularly China, India and Japan?
The Need for Sobriety
We must start with what is not usually present at saké receptions, namely sobriety. We must not fool ourselves. It would be astonishing if there were not quite a deep recession in the US, and almost certainly also in the UK. There will perhaps be a shallower recession in the Eurozone and Japan. Those economies account for more than half of world gross domestic product and, therefore, that is quite a sober prospect. We see a slowdown coming already in the emerging markets, and not only in Brazil, Russia, India and China.
As we take that sober view of the prospects for at least the next 12 months, let us at least remember how strong a position we start in. We have had, in terms of the world economy, the best four to five years that the world has had in the last four decades. As recently as 2001, in the aftermath of the NASDAQ stock market crash and the 9/11 terrorist attacks, we saw a very sharp slowdown in the world economy. This is not, therefore, exactly a new moment.
We should also bear in mind that, while we are always dominated in our thinking, because of its importance, by the US and by American financial markets, what we have had and look like having is, in fact, two worlds: A world of credit crunch, de-leveraging and probably a reduction in liquidity – a deflationary world in the transatlantic economies
At the same time, we have at present an inflationary world in much of Asia, in the oil- producing countries and in other emerging markets.
The US Picture
Looking at the US, which still accounts for more than 25% of world GDP, what is remarkable and noteworthy is that there is still no recession. Post-NASDAQ and 9/11, the US benefited from the so-called ‘Greenspan put’ from ultra-cheap money, which is the background to the situation that we are now in.
The underlying situation in the US domestic economy, however, is not good. House prices have been falling but, compared with the rise in the post-9/11, cheap-money period, they are still well above the long-term trend. There is some sign of steadying in the new home construction market, but house prices generally still seem to be falling. Most importantly, consumer spending is now in quite a sharp period of decline. This means that the crisis may well move on from a mortgage-related loan contraction based on a rising default rate to other asset classes.
Against that, a more optimistic point is that US companies are at present in a strong cash position. Generally speaking, while US households are heavily in debt, US companies are not. If you compare the current position in the US with the position that Japan had in the early 1990s, when it had its financial crash, the corporate position in the US looks stronger than the Japanese corporate position looked like at the time. As we know, US public borrowing is going to increase but we do not know what it is going to do to the overall budget deficit, nor to the ultimate size of US debt.
The first piece of good news, comparing the US and its policy reaction to the Japanese financial crisis in the 1990s, is that it has been more vigorous in terms of the reaction of public policy outside the central bank than was the case in Japan. It took Japan seven to eight years before bank nationalisations and recapitalisation and a strong use of public money directly in the financial system really came in to try to put a floor under the collapse of the financial system. In the US, we are only 12 to 13 months into the crisis and, already, a big rescue has been mounted.
The second piece of good news is that, while this rescue will, of course, have consequences, it would be a mistake to think that the US cannot afford it. There is scope to borrow and the US budget deficit, which will increase, is only 3% of US GDP, which is a smaller budget deficit as a proportion of GDP than in the UK.
There is, then, room for this package. It will add to public debt and, therefore, raise questions about the dollar and about possible inflationary consequences of this increase in public debt. Let us not forget that this would just take us back to the end of the 1980s, when the dollar, as a share of global foreign exchange reserves, fell to 50%. It is well over 60% now but may well decline, but that does not mean that the dollar, as the world’s principle reserve currency, is any way finished. Second, the inflationary consequences that people speculate about from this public debt expansion in the US are based on the theory that, if you have such a big debt, you will have a big incentive to reflate in order to try to erode the value of that debt. What we saw in Japan in the 1990s is that deflation did not arrive immediately but, eventually, it was a consequence of the credit contraction process. I think that, at least in the next few years, the force of deflation in the US really is going to be quite considerable, such that I would not be betting on inflationary pressure from the US.
Inflationary pressure from commodity prices has been a large part of the explanation for why US inflation is at 4-5% today, why the European Central Bank and the Bank of England have been constrained in their cutting of interest rates, and why inflation has taken a strong hold in Asia.
My first view on commodity prices is that, taking a medium-to-long-term view, it is a mistake to bet against the trend, which over the last 150 years has been for a consistent reduction in overall commodity prices. The trend that we have seen in the last six years has been a discontinuity, so the question is whether or not that is a long-term breaking of the trend or a short-term discontinuity. We are already seeing a substantial adjustment in the oil price, but it remains considerably higher than it was five to six years ago, and the same phenomena have been seen in metals and food.
I would say that, in general, looking at these commodity markets – and I would not presume to make any observations about precious metals – we can have no doubt in this economic climate that there is going to be a reduction in demand – and it is already here.
The question is how bad and prolonged that reduction will be, but also how fast the supply reaction is to the previous period of high prices, in which particular categories of the commodity class, and what the balance between supply and demand will be. While all the evidence from previous cycles is that the supply process is slow and suffers from cost inflation, the overall picture seems to be one of considerable investment in increased supply in many areas of commodities and in very finely balanced markets this seems to me to be quite bearish.
Many people think that oil demand has been galloping ahead. Last year, the rise in oil consumption was at the spectacular level of 1%, which produced a 100% rise in oil prices. That was because of the combination of liquidity and a tiny reduction in oil production. Oil production is, of course, a heavily politicised and cartelised affair, but we see, I would suggest, quite strong evidence that supply is at least capable of increasing:
1 Saudi Arabia is bringing on stream new capacity in the next 12 months.
1 Russia has just changed its export tax regime such that it is likely to encourage oil production.
1 Iraq, with the world’s third largest oil reserves, is at last producing more than before the invasion.
1 Other new oil producers, such as Angola, are increasing their production as much as they can
As the world economy moves into a sharp slowdown, with a recession in the transatlantic economies, the political question will be whether the Organisation of the Petroleum Exporting Countries (OPEC), particularly under the leadership of Saudi Arabia, which has spare capacity, will really seek to maintain high oil prices – i.e. in excess of $100 – which have a clearly contractionary effect on the oil- consuming countries. If I am right that the US moves into quite a deep recession in the next 12 months, the Saudi response to that will be to seek to maintain supplies and to push down the oil price in order to assist the adjustment process in the US economy. I cannot, of course, guarantee that that is true, but had we had a poll on oil prices and had we been given a range between $30 and $200, I would have been towards the bottom of that range – i.e. at the $50 mark, rather than at the famous Goldman Sachs prediction of $200.
Countries that have really been a big part of the explanation for rising commodity demand– China, India and elsewhere – are characterised by their abundance of capital. China in particular has been exhibiting quite a strong period of inflation. Strong emerging markets are those that have high savings rates and that are financing themselves from domestic resources.
China is, of course, the epitome of that strong developing country model. However, the capital surplus in China has facilitated inflation, in combination with some structural changes, particularly in demography, which is reducing the supply of cheap, young rural workers; and some policy changes, which have sought to increase incomes in rural areas and to strengthen the rights of workers under a new labour law. These have combined to put some wage cost pressure on China. China’s consumer price index has been adjusting downwards to 5% from its peak of about 8%, but producer prices remain a concern for the authorities.
Looking at it in a longer-term framework, while China may well slow down this year in response to measures seeking to reduce inflation but also in response to a decline in exports to Europe and the US, the longer- term question concerns investment and the way in which the Chinese economy has been led, not by exports, but by investment. In that regard, China has been just like Japan, South Korea and Taiwan before it, being driven by a very high level of investment as a share of GDP.
China now looks to me, in a general sense, to be quiet similar to the state that Japan was in as it entered the 1970s. Japan’s level of investment as a share of GDP peaked at 40% in 1970. Japan was the most polluting country in the industrial world at that point, with Minamata disease from mercury poisoning, with smog, with dirty water, with the consequences of a rapid growth in heavy industry that had taken place in the 1960s, and with public protests against environmental pollution increasing. It had a cheap currency, fixed under Bretton Woods, and cheap capital. However, thanks to the oil price hike of the early 1970s, it then suddenly had 25% inflation. What Japan did was to move sharply upmarket, to introduce tight environmental controls, to revalue its currency and, as a result of that, to move from being the most polluting industrial economy in 1970 to being one of the cleanest only 10 years later and a country that moved from the era of the steel mill and the shipyard to the era of the microchip and the compact car.
I would suggest that China, looking at least on a five-to-10-year horizon, is going to try to follow something of the same type of trajectory as Japan did. China is going to have slower growth in the near term – from 12% to 9% – but also, I would suggest, a gradual revaluation of the currency in order to improve and increase control over inflation, and quite a strong effort to increase environmental and regulatory enforcement, because of issues such as the current baby milk scandal and growing public protests about pollution. I would also suggest that, 10 years’ from now, China may well have shifted sharply upmarket and become much cleaner and, therefore, may well have followed something similar to the path taken by Japan in the 1970s.
India also has an inflation problem; in fact, a problem that is more acute in many ways than China, with inflation on a wholesale-price basis of over 12%. As a result of that, it has had a sharper tightening of monetary policy in recent months, although it still has negative real interest rates if you take the inflation measure seriously. India’s slowdown is, therefore, in the immediate term, likely to be more pronounced. Forecasts of 7.5% for growth this year probably leads towards even more of a slowdown next year.
However, India is looking like an East Asian country at last, with investment, which had been disappointing in the 1990s, surging to 35% of GDP in the last five years, increasingly financed by domestic resources. India is 15 years behind China. It is a country that has the sort of severe weaknesses of infrastructure that China had in the early 1990s. However, thanks to this investment boom, India is beginning to improve that infrastructure and to roll out quite a strong period of infrastructure investment. That process will be slowed down by the credit crisis because India does require borrowing from abroad, unlike China. It will also be held back by the slowdown in India’s domestic growth.
Nevertheless, I suggest that a good bet for India over the next 10 years is that it will follow a path similar, in some ways, to China’s in the 1990s, with growth being led by a continued effort to roll out infrastructure investment and by an increasing emphasis on and success from manufacturing. Currently, manufacturing accounts for only 25% of India’s GDP versus more than 50% in China, but it is growing faster than services. The new symbol of India’s potential should, I think, be the Tata Nano car, the world’s cheapest car, now rolling off production lines, despite protests from farmers about land seizures.
Japan had a lost decade in the 1990s, in the sense that growth was far below the potential that we had believed possible from the 1980s, and that the financial crisis of the late 1990s led to deflation. There has, however, been a strong recovery since 2002, since which time Japanese growth has been quite healthy, up to the last six months. Thanks in part to oil and food prices, inflation has returned to Japan. What Japan has seen, however, is a weakness in domestic demand, due to the dominance in job creation of part-time rather than full-time jobs, which is important because wages and benefits for part-time jobs, under new labour laws introduced in the early part of this decade, are much lower. Japan has, then, seen one of the biggest increases in inequality among rich countries and has been the only country in the OECD that, over the last 15 years, has had an increase in the level of absolute poverty. Japan now needs stronger domestic demand but there is no sign of it coming, and it has a vulnerability to a reduction in exports to the US and Europe. It is also characterised by political stalemate: by a lack of effective government response to the economic situation, because the Japanese political system is in a period of transition, with, for the first time in post-war Japanese history, the opposition party having a very strong position in parliament, thanks to elections in the Upper House in 2007, but that position in parliament is a destructive position rather than a government position. We will probably see an election in the Lower House during the next two months and I would suggest that the most bullish outcome from that would be a victory for the opposition party, because it would mean that the same party had a majority in both houses and was capable of carrying through reforms and effectively implementing government policy in a way that the current government does not have a chance to.
Japan’s weakness is shown by the way in which wages have not responded strongly to rising growth and, therefore, not supported growth in domestic consumption to replace exports. Nevertheless, let us put Japan in context. Looking at it on the basis of per capita GDP, Japan has seen the second fastest growth in living standards in the last five years among the major OECD countries. The UK’s performance is certainly now going to worsen. Japan should, therefore, not be counted out as far as growth and a recovery from the current situation is concerned.
As Japanese delegates at this conference know, three years ago I published an article in The Economist and a book on the Japanese market in 2006 called Hiwa Mata Noboru (The Sun Also Rises), and I believe that that is the potential for the Japanese economy. A proper government and a resumption of reform will lead, I would suggest, to a rise in investment and productivity growth, followed by stronger growth for the Japanese economy. It is nice, at this point in the world economy and financial markets, to end at least on an optimistic note: the sun does also rise.
Bill Emmott is an independent writer, speaker and consultant on international affairs. From 1993 until 2006 he was editor of The Economist, the world's leading weekly on international current affairs. He has published eight books, contributed articles to many publications and given countless talks and lectures. His latest book, Rivals, is about the rising economic and political power of Asia.