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Thursday, 3 December 2009

A review of Stephen Roach's new book on China

In the first nine months of this year $126 bn of speculative money flowed into China, inflating the stock market and other asset prices. This sum is the excess in the nation’s reserves, after you deduct $327 bn in trade surplus and $64 bn in direct foreign investment. The market is voting with its wallet, it might like China’s economy but it loves the prospects of its currency even more.

The market’s view of the dollar and the renminbi gets to the heart of the issue, China and America are mirror images of each other. One saves while the other spends, one likes to invest in the future whereas the other doesn’t. The manner in which both countries’ are trying to stimulate their two economies in the wake of the financial crisis is a case in point. In the US, 15% of the funds are being spent developing carbon neutral technologies, whereas in China the figure is 85%. China is having a good financial crisis, as its stock market suggests. By contrast underperformance has become a long term trend in America. Despite the current rise, American stocks have had a miserable decade.

Tragedies always end in a death while comedies end in a marriage. When reading Stephen Roach’s recently published collection of essays, The Next Asia, there is a suspicion that one is witnessing that uniquely modern amalgam of the two, a tragicomedy in which China and America are the co-leads.

The most disturbing essay in the book relates to Roach’s appearance before the House of Representatives. In his written testimony, Morgan Stanley’s chief economist, and now the chairman of its Asian operations, attempts to explain why protectionism would be a disaster for America’s interests. Cheap goods from China and assertions that the currency is undervalued are not the key to the problem, Roach tells Congress. Placing tariffs on imports from China would be like squeezing a balloon, the problem would simply manifest itself somewhere else. Furthermore, in the wake of the financial crisis America is even more dependent on China’s investment in American bonds, so why antagonize your banker?

In his introduction Roach mentions the three mega-trends that animate our world: globalization, the IT revolution and the fact that an ageing population will require pensions. The last of these is a problem that the first two ought to have helped solve. Both globalization and the IT revolution have led to disinflation and increases in productivity. However, both these prizes have been squandered.

For twenty five years, US consumption represented 67% of GDP but, come this decade, that number surged to 72% at the peak. This rise in consumption had little to do with increasing salaries and as we now know, more to do with rising stock and house prices. Roach estimates that over the course of the last expansion, which lasted 69 months, private sector compensation, which he describes as the broadest measure of earned labor income in the US, increased by just 17% in inflation adjusted terms. This meant that it fell $480bn short of the 28% increase that occurred over the previous four business cycles. The US Bureau of Labor statistics estimates that median, inflation adjusted wages, have risen by a cumulative total of 0.9% over the seven years ending in 2007. As Roach points out, this meagre rise seems at odds with economic theory. With rather less hyperbole than John Ralston Saul, in The Collapse of Globalism, Roach has come to the same conclusion: the world’s largest submerging economy, America, is becoming just as polarized as emerging economies like China. Globalization is not working for the average American.

The imbalance will be magnified if America reverts to tariffs - the American consumer, that $10 trillion locomotive that has always pulled the World out of previous slumps, will be derailed if the protectionists on Capitol Hill have their way.

No one could be that stupid though, could they? They can in a tragicomedy. In an essay written in 2007 he estimated that the probability of America becoming more formally protectionist was 60%. He then warned that there was a disconnect between the financial markets, which seem oblivious to the risks and the direction of debate both in the Senate and Congress.

Yet while Roach is critical of his own country he hasn’t been dazzled by China. The hot money might be flowing into Shanghai property, or the Chinese stock market, but Roach fears he might be watching another slow motion train wreck. Tallyrand said of Napoleon that it was the qualities that made him great that finally caused of his downfall, you suspect the same might be true of China. The country’s response to the financial crisis is to do what it always does - invest in infrastructure. China loves fixed assets and exports, they represent more than 80% of GDP. About half the exports go to the developed countries, where consumption is fragile and the returns on fixed asset investment are falling.Between 2000 and 2008 $1.50 of credit resulted in a $1 gain in GDP, but by the first half of this year $7 of credit was required to add $1 to GDP. As China’s Premier, Wen Jiabao said in 2007, China’s economy was increasingly: “unbalanced, unstable, uncoordinated and unsustainable.” China needs less bricks and more credit cards, it needs soft infrastructure.

Warnings like these do not seem to impress investors much, which brings us to the most poignant lesson in Roach’s book. Economics does a decent job identifying the problems, where it fails miserably, is in the timing of the outcome. This tragicomedy, therefore, probably has a good more time to run.

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