Global economy: blinking amber

Since January 3, the BSE-Sensex has lost more than 400 points. Optimists see this as a 'healthy correction' in an overheated market.

However, as with all market 'corrections', there were specific triggers that set it off. The triggers this time were a crash in metal prices on the London Metal Exchange and the release of the December meeting minutes of the monetary policy committee of the US central bank, the Fed.

The prognosis of the US economy in these minutes turned out to be somewhat more hawkish than expected. To quote them, "The current level of the real funds rate target remained below the level it most likely would need to reach to keep inflation stable and output at its potential".

This statement meant two things to the market. For one, the US economy is growing faster at the moment than is generally perceived.

Thus, there's money to be made in the near term by pulling money out of markets like India and putting it back in the US. More importantly, the Fed is unlikely to play ball and seems set to dampen this momentum over the medium term.

In short, America's growth is likely to slow down in 2005. The ripple effects of the slowdown are likely to be felt across the globe. A global slowdown, in turn, will hurt equities as an asset class.

The fall in metal prices reflected fears of a slowdown both in the US and China.

Chinese demand almost single-handedly drove up the demand and prices of commodities like oil and metals last year. A dip in prices thus reflects fears that this trend in China's growth will reverse.

To cut a long story short, what the Sensex (and other stock market indices) priced in last week was the apprehension that both growth engines of the global economy, China and the US, are likely to lose steam this year.

I believe that these apprehensions are justified, though not entirely because of short-term cyclical concerns like inflation. The Fed's somewhat dire warning is driven as much by the long-term "structural" imbalance in the US economy as they are by overheating in product and factor markets.

I refer here to the current account deficit (roughly the deficit in goods and services trade) that the US economy runs, which is currently at about 6 per cent of GDP. I claim that the current account deficit is much more than just a mismatch on the economy's trade accounts.

It is the symptom of a deeper economic malaise, whose only cure happens to be higher interest rates and slower growth. A little bit of economic theory is useful here.

Pick up an elementary textbook on macroeconomics, flip through the first few pages and you're likely to come across a simple equation. It will tell you that the current account deficit equals the excess of investment over savings in the economy plus the budget deficit in the economy.

That, in a nutshell, is exactly what is wrong with the US economy. First, there's a yawning Budget deficit (about 4.2 per cent of its GDP in 2004) stemming from sharp tax cuts without matching cut in government spending.

Second, US households have gone on a consumption binge by pushing their savings rate down to close to zero. That has left a large gap between the domestic savings and investment rates. The high current account deficit to GDP ratio is a reflection of these two imbalances rather than an independent cause for concern.

Companies who sit on large piles of debt find it increasingly difficult to borrow additional amounts.

The same holds for economies. Foreign 'savers' who run current account surpluses with the US and have helped fund America's budget and savings-investment gaps are growing increasingly reluctant to provide funds.

The continuous fall in the dollar over the last year is a manifestation of this reluctance. Going forward, if these imbalances continue, they could manifest in a run on the dollar and a sharp spike in interest rates. In short, a financial crisis.

How can these imbalances correct themselves? Well, there are two possibilities. Either the savings-investment gap goes down, or the budget balances.

I don't think that the current US administration is likely to hike tax rates or curb spending. Thus the adjustment will have to come from the savings-investment balance. American households are likely to reduce on consumption and push savings up in 2005 as the effect of the tax cuts of 2001, 2002 and 2003 fade and there are no fresh cuts.

The Fed is going to help this process by hiking interest rates and making savings more attractive. A rise in rates would of course simultaneously make investment costlier and pull the investment rate down.

As these effects pan out, US aggregate demand and growth will soften. My colleague ABN-AMRO's US strategist Gerard Minack estimates that every percentage point increase in the savings rate shaves off GDP growth by .75 percentage point. As for timing, the consensus seems to be that the deceleration is likely in the second halfof 2005.

China's growth is also likely to cool off this year as it finally re-values its currency and goes in for the interest hikes that go with a revaluation.

I think the Chinese government has finally come around to the view that given its domestic macroeconomic problems (like overinvestment) and the weight that it pulls in the global economy, it has to adopt a market-oriented macro-management policy.

Some of my colleagues who met officials of the Chinese Central Bank, the People's Bank of China, a couple of weeks back, came away with the impression that a small revaluation of the Chinese currency is likely in the second quarter of 2005.

The initial appreciation is likely to be small, perhaps in the ball-park of 2 per cent or so, and this will mark the beginning of a slow shift to a managed floating rate system. Under the new regime, the currency is likely to appreciate by 5 per cent by the end of the year.

What indicates that China is willing to revalue its currency? For one, the central bank is in the process of putting in place a mechanism for hedging currency risk that would emerge under a floating exchange rate regime.

The basic elements should be in place by the middle of the year. Second, the Chinese financial sector, particularly the banking system, looks a little less fragile than it did a couple of years back. Thus, its ability to withstand exchange rate volatility is perhaps a little stronger.

Standard and Poor's has estimated that for the 130-odd banks that constitute the Chinese banking system, non-performing loans as a percentage of the total have dropped from 50 per cent two years ago to 35 per cent this November. This improvement has followed extensive reforms in the banking system.

What does this mean for China's growth rate? Well, there are two things that are likely to happen. First, currency appreciation would affect export growth rates.

Second, the decision to float is likely to be accompanied by another round of interest rate hikes (the central bank announced a rate hike in October 2004 for the first time in nine years) and that is likely to affect domestic spending.

However, both the currency appreciation and rate hike are likely to be moderate and thus the impact on growth rates is also likely to be somewhat muted. My bank's China analysts are forecasting GDP growth in China at 8 per cent in 2005, a drop from 9.5 per cent.

Given all this, I think the next few months could be a rough period for both equities and debt from a global perspective. As fears of a slowdown gain momentum, profit forecasts for companies will be revised down and this could hurt stock prices.

If rise in global interest rates hardens, bond prices will drop. However, on a relative scale India might fare better for two reasons. Indian industry is somewhat insulated from global cycles and the rise in domestic rates may be more muted.

Thus, Indian markets could just end up being a "safe haven" that protects investors from the vagaries of the world outside. Be that as it may, it might be a trifle foolhardy to disregard the risks that a global slowdown presents.