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> Subject: Roach: Global Economic Forum: Global Cracked Facade
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>> -----Original Message-----
>> From: Roach, Stephen (Equity Research)
>> Sent: Sunday, October 24, 2004 10:57 PM
>> To: globalecon
>> Subject: Global Economic Forum: Global
>>
>> Cracked Facade
>>
>> The delicate equilibrium in world financial markets may be starting to
>> unravel. The dollar has broken out of its recent range, credit spreads
>> are
>> widening, equities are sagging, and riskless sovereign bonds are well
>> bid.
>> The message is worrisome: For an unbalanced and increasingly vulnerable
>> world economy, the unrelenting rise of oil prices spells mounting risks
>> of
>> global recession in 2005. Financial markets are only just beginning to
>> comprehend this possibility.
>>
>> There are lots of moving parts to this story. But the one that intrigues
>> me
>> the most right now is the dollar -- down 3% against the euro and nearly
>> 4%
>> against the yen in the past two and a half weeks. In my view, this is
>> this
>> move in the dollar is a "drop in the bucket" for a US economy with a 5.7%
>> current account deficit that could easily climb in the 6.5% to 7.0% zone
>> in
>> the next year. The problem, of course, is that my currency view has been
>> a
>> lonely one over the past nine months. The Teflon-like greenback has
>> begun
>> to reverse some the depreciation of the previous couple of years --
>> unwinding about three percentage points of the 13 % real trade-weighted
>> decline that had occurred since early 2002. But in recent weeks, I have
>> felt less lonely, as the official community -- both in the US and around
>> the
>> world -- has come out in the open in expressing concerns about America's
>> gaping twin deficits and what they mean for the dollar. Fedspeak has
>> been
>> especially focused on this issue, with at least five Federal Reserve
>> governors and regional bank presidents weighing in on this key risk. I
>> don't believe in conspiracy theories, but I don't think this collective
>> expression of concern is an accident.
>>
>> A weaker dollar has long been the centerpiece of my global rebalancing
>> framework. Macro deals best with global imbalances by changing the
>> world's
>> relative price structure. With the dollar the world's most important
>> relative price, depreciation is a perfectly natural way for the global
>> economy to restore some semblance of equilibrium. But don't expect the
>> world to turn on a dime in response to currency changes. In fact, it has
>> become increasingly clear over the past decade that trade flows and
>> inflation are a good deal less sensitive to currency fluctuations than
>> was
>> the case earlier. In my view, a weaker dollar would, instead, be more of
>> a
>> signaling mechanism -- sparking a back-up in US real interest rates as
>> foreign creditors demand compensation for taking currency risk. For an
>> overly-indebted US economy, higher real interest rates would impair
>> credit-sensitive domestic demand, boost national saving, and reduce
>> America's claim on external saving. These are the characteristics of a
>> classic current-account adjustment.
>>
>> Yet the world has resisted this adjustment. That's been especially the
>> case
>> in Asia. Lacking in support from domestic demand, the Asian currency
>> bloc
>> has basically refused to participate in the dollar's depreciation,
>> putting
>> a
>> disproportionate share of the burden on the euro. Since the dollar's
>> peak
>> in early 2002, the trade-weighted euro has risen about 20% (in real
>> terms),
>> whereas the trade-weighted yen -- a good proxy for Asian currencies --
>> has
>> been basically unchanged. I have referred to the Asian currency zone
>> increasingly as a renminbi bloc, underscoring the key role that China's
>> currency peg plays in inhibiting other Asian economies from suffering any
>> competitive disadvantage with the region's super-competitive trading
>> powerhouse. Recent warnings of renewed currency intervention by Japanese
>> Finance Minister Tanigaki underscore Asia's renewed conviction to resist
>> currency-induced global rebalancing.
>>
>> The authorities are now swimming upstream. Monthly data from the US
>> Treasury reveal a sharp deceleration of foreign demand for
>> dollar-denominated assets -- $61 billion average net purchases in July
>> and
>> August versus a $76 billion average in the prior 10 months. This
>> deceleration is worrisome for two reasons -- the first being it has
>> occurred
>> against a backdrop of a dramatic widening of America's current account
>> deficit, which went from 4.5% in late 2003 to 5.7% in mid-2004. Second,
>> private investors have already turned skittish on the dollar, forcing
>> non-US
>> policymakers to up the ante in filling the void. Over the 12 months
>> ending
>> August 2004, fully 33% of net foreign purchases of long-term US
>> securities
>> have come from the official sector -- more than double the 15% share of
>> the
>> prior 12 months and over four times the portion over the 2000-02 period.
>> With private inflows into dollars now going the other way at just the
>> time
>> when America's external financing needs are exploding, extraordinary
>> pressure is being put on Asian authorities to resist the inevitable.
>>
>> In the end, this is a losing game. Intervention cannot neutralize the
>> deadweight of America's massive current-account deficit. That's the
>> message
>> to take from the recent fragility of the strong dollar. For what it's
>> worth, I suspect that the dollar's slide will accelerate sharply in the
>> aftermath of the US presidential election -- probably more so in the
>> event
>> of a Kerry victory than would be the case in a Bush win. Senator Kerry's
>> focus on trade and jobs puts him more in the camp of embracing
>> market-based
>> resolutions to global imbalances. In either case, however, the dollar's
>> coming depreciation will pose a great challenge for an unbalanced global
>> economy. The flip side of a weaker dollar spells currency appreciation
>> elsewhere -- forcing the export-led economies of Asia and Europe to
>> embrace
>> the reforms long needed to unshackle domestic demand. If Asia continues
>> to
>> resist, it faces a growing protectionist threat from both Europe and the
>> United States. I remain convinced that the world's unprecedented
>> external
>> pressures will be vented in one way or another -- through markets or
>> politics, or some combination of both.
>>
>> Meanwhile, the confluence of a number of other powerful forces is putting
>> added pressure on an unbalanced global economy. Three such developments
>> are
>> at the top of my list. First, oil prices have now averaged in excess of
>> $50
>> (WTI-basis) for six weeks -- satisfying about half the three-month
>> duration
>> criteria that I believe would qualify as a full-blown oil shock. So far,
>> the real side of the global economy has held up reasonably well in the
>> face
>> of this price spike, buying into the long-standing consensus forecast of
>> a
>> sharp and imminent reversal of oil prices. The longer that forecast
>> turns
>> out to wrong, the greater the threat to a complacent world. For this
>> reason, alone, I continue to place a 40% probability on a global
>> recession
>> in 2005.
>>
>> Second, the China slowdown remains the big gorilla in this unbalanced
>> world.
>> The latest batch of Chinese data point to further, albeit uneven,
>> deceleration in this overheated economy. The September figures on
>> industrial output (+16.2%) and fixed investment (+27.7%) were all a bit
>> stronger than those in August but significantly below the peak rates of
>> comparison earlier this year -- 19.4% for industrial production and 43%
>> for
>> investment. The big news, in my view, was a stunning deceleration in
>> Chinese import growth -- 22% in September versus a 36% increase in August
>> and 50% peak growth rates earlier this year. This, together with a
>> further
>> slowdown in bank lending, points to the early signs of a long awaited
>> cooling off of Chinese domestic demand. Data elsewhere from
>> China-centric
>> Asia are now corroborating this development -- underscored by renewed
>> cyclical weakening in Korea and recent slippage in Japanese export
>> growth.
>> China has a long way to go on the inevitable journey to a soft landing.
>> That will require more policy restraint and entail increased transmission
>> of
>> the China slowdown to its trading partners and commodity markets, in my
>> view.
>>
>> Third, is the potential unwinding of Pax Americana -- a development of
>>staggering implications for a long US-centric global economy. It's not
>>just
>> the dollar-current-account dynamic described above. It also has to do
>> with
>> the possibility of a diminished US productivity advantage (see my 19
>> October
>> essay, Productivity Convergence?). And it reflects the unrelenting
>> backlash
>> of re-regulation in the aftermath of the Roaring Nineties -- underscored
>> by
>> Eliot Spitzer's latest forays into the insurance and music industries, to
>> say nothing of Enron-type accounting scandals, Wall Street's travails,
>> and
>> the Sarbanes-Oxley legislation of 2002. All the stars were in alignment
>> for
>> the US economy in the latter half of the 1990s. But now, lacking in
>> saving,
>> encumbered with massive twin deficits, deeply in debt, and facing a very
>> different productivity-regulatory nexus, America needs to be viewed
>> through
>> another lens. And so does the rest of the global economy as it weans
>> itself
>> from a US-centric growth dynamic.
>>
>> I've been on this global rebalancing kick for about three years. At
>> times,
>> it has worked well as a guide to developments in the global economy and
>> world financial markets. On other occasions, that hasn't been the case.
>> But I remain convinced that it's only a matter of time when powerful
>> market
>> forces transform profound imbalances into a more sustainable state of
>> balance. Who knows what lies ahead over the near term in the financial
>> markets? But the message of the past few weeks points to cracks in the
>> façade of denial. I suspect there's more to come.
>>
>> Stephen Roach (New York)
>> --------------------------------------------------------
>>
>> This is not an offer (or solicitation of an offer) to buy/sell the
>> securities/instruments mentioned or an official confirmation. Morgan
>> Stanley may deal as principal in or own or act as market maker for
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>> research and is not from MS Research but it may refer to a research
>> analyst/research report. Unless indicated, these views are the author's
>> and
>> may differ from those of Morgan Stanley research or others in the Firm.
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>
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