Back To The Future

During the last decade or so, the world economy has been shaped by China and the United States.

·      China became “manufacturing plant to the world” with extraordinary speed. In the process, it drastically reshaped international trade patterns. But its sudden entry into the competitive arena also generated powerful forces of deflation in many global manufacturing sectors.

·      The United States, through its central bank, aggressively and repeatedly performed its traditional role as the world’s lender of last resort. But, thanks to the easy money environment generated by the Federal Reserve, it also enjoyed a dual boom in housing and consumption that erected it into the world’s “consumer of last resort”.

America’s consumption boom offset the deflationary influence of China’s emergence as a major exporter and probably prevented a global depression. The coming decade promises to be radically different from the one just ended, changing the backdrop against which we interpret global economic developments.

US Growth: From Amphetamines to Prozac

In the second half of the 1990s, the US economy sucked in capital from the rest of the world at an accelerating pace, a trend which was reflected in a seemingly irresistible rise of the dollar. Some money was attracted by America’s stock market bubble, but large amounts also came in to be invested more lastingly into industrial projects and corporate acquisitions.

These massive inflows of money not only boosted American financial markets, but also inflated domestic demand for consumer and investment goods throughout the economy. As a result, even as US exports continued to grow despite lukewarm demand in most other major economies, imports accelerated even faster, generating large current account deficits.

In the next several years, inflows of foreign capital into the US economy will dry up because prospective returns from US investments now look less attractive than they did during the euphoria of the bubble years. In addition, some industries, like telecommunications or the Internet, attracted too much capital in the 1990s, which was ultimately all but destroyed and is unlikely to return in similar amounts for the foreseeable future.

The dollar weakness of the past year most likely indicates that inflows of private foreign capital have already started to ebb. In fact, it could be argued that, in the absence of massive currency intervention (particularly by Japan, China and other Asian economies), the US dollar would have declined more than it already has. In the process of intervention, however, enthusiastic long-term investment in private US assets is being replaced by reluctant, defensive loans from foreign central banks to the US government. Yielding low rates and threatening to be repaid in a depreciated currency, these loans are unlikely to be forthcoming forever.

This is the main reason why the US current account deficit is becoming unsustainable: it was caused by excessive capital inflows that are now in the process of drying up.

The problem is that any narrowing of the US current account deficit is unlikely to come from increased exports. The relatively few US industries where sales (both domestic and foreign) truly suffer from an “overvalued” dollar are labor-intensive ones that compete directly with producers from China and Southeast Asia. And no conceivable amount of dollar devaluation can meaningfully affect American competitiveness against Asia: according to BNP Paribas Peregrine, for example, China’s labor costs are only 3% of the US’s.

We do expect some improvement in exports, but it will probably come from the monetary easing caused by currency intervention in the economies of our main trading partners. It is unrealistic to expect market-share gains by US products, whether in the United States or in foreign markets, on the sole basis of a lower dollar.

As for US imports, they are closely tied to domestic demand. A lower dollar, by raising the price of foreign goods for American consumers, will naturally act as a brake on consumption – and therefore on the US Gross National Product. Various economic models used by international institutions (OECD, IMF, etc.) calculate that if the dollar were the only factor affecting US balance on current accounts, it would take a depreciation more than 60%, not only against the Yen or the Euro but on a trade-weighted basis, to bring the American deficit back to acceptable levels. This is unrealistic over the near term and we believe, instead, that the rebalancing of our trade will involve more factors than currencies and will take quite a bit longer than is generally assumed.

America’s consumption of goods and services grew faster, in the last decade, than it could have afforded based on purely domestic financing resources. It will now grow, for years, more slowly than domestic financial conditions would allow, because international capital will either dry up or be withdrawn.

China: Changing Horses in Midstream

Developments in the Chinese economy are receiving extensive coverage in the media. Yet, most of the statistics thrown around need serious interpretation to become meaningful. For example, with regard to the current campaign to blame China’s huge trade surpluses for the loss of American manufacturing jobs:

·        Subsidiaries of foreign companies (many American) account for 54% of China’s exports, reflecting massive foreign private investment in this promising economy. Initially, many of the foreign investing companies had dreamed of conquering the potentially huge Chinese market. But obstacles going from hesitant policies to conflicts between central and local authorities, lack of infrastructure, confusing tax rules, challenging logistics, etc. soon convinced most of them that it was more expedient to use their new Chinese facilities for export rather than to immediately develop sales in China. This is changing, however, and most foreign producers in China are now formulating ambitious plans for the conquest of the local market.

·        CLSA points out that China’s bilateral trade surplus with the United States is almost entirely offset by its trade deficits with Asian neighbors. As a result, China’s overall trade surplus is small, declining and “within the next few months it looks as if the Chinese trade account will be firmly in deficit”. Of course, in an election year, this fact is likely to receive little publicity in America, even though China’s deficits with other Asian nations must have been one factor allowing US exports to rise in the face of recessions in Europe and Japan.

CLSA also notes that most of China’s exports today used to come from other low-cost Asian countries, including Taiwan, Singapore and Hong Kong. Now, they are assembled in China with parts and materials sourced elsewhere in Asia. The net  result of this regional trend is that total Asian imports, which accounted for 41% of total US imports in 1993, now represent only 35% (Canada and Mexico are the big winners).

The rise of US imports from China reflects mainly America’s voracity for imports in general (because of the consumption boom mentioned earlier), and the accelerating integration of economies within the Asian bloc.

·        A recent study by Alliance Capital, referring to the loss of about two million US manufacturing jobs between 1995 and 2002 (an 11% drop), points out that, proportionally, many countries fared even worse – including Brazil (20%) and Japan (16%). More interestingly, in the same period during which it emerged as “the world’s manufacturing plant”, China lost 15% of its manufacturing jobs.

What is happening globally to manufacturing is what happened to agriculture in the past century, when US farm employment, for example, shrank from 32% of total US employment to 2.5% between 1910 and 1990, even as farm production kept rising.

In China, this reflects the modernization of the economy, with large employers in the state-owned sector closing or restructuring, and in the process shedding more employees than are hired in China’s new, more dynamic enterprises.

Today, China cannot count on a further acceleration of its export boom. Its formula for growth over the past decade – attracting foreign investment to finance both infrastructure construction and the development of an export-oriented modern industry – is reaching its boundaries. There are two main reasons for that. One is the growing protectionist sentiment toward Chinese exports, orchestrated by the United States. The other is rising wages in China’s prosperous “golden crescent”, which are leading a growing number of Chinese enterprises to experiment with cheap assembly in countries such as Vietnam. This is reflected in a growing flow of foreign direct investment out of China toward other countries in the region.

In any case, concerns about the environment, growing protectionism in Europe and particularly the United States, as well as the risks inherent in an unbalanced pattern of growth between economic sectors and regions: all are calling for another engine of growth for China’s economy.

As it happens, this engine has already been revving up. The Chinese consumer’s propensity to spend has always been high but, until recent years, there wasn’t a lot to spend on – hence the surprisingly high savings on apparently pitiful salaries. As consumer goods became more widely available, at least in the large dynamic cities of the South and the East, consumption began to rise in earnest. This was further enhanced by the gradual access to home-ownership promoted by the government, and eventually by the growing access to mortgages.

Much potential demand still exists even in the prosperous Southeast, and it now appears that the government is truly committed to engineer a sharing of the growth benefits with the industrial West and North as well as with rural China. In the process, it is discovering that, even in these less-advantaged regions, the mattresses were full of unused savings that are progressively being released.

However, there are dangers inherent in the transition from an export-led economy to one that is led by household consumption. One is overheating and growing pressures on the country’s infrastructure and available resources. The other, on the contrary, is that the exports engine will slowdown faster than domestic consumption can accelerate. Unknown policy responses to these conflicting pressures, on the background of a continued struggle between the new leaders and the old ones (the Shanghai “gang”), only increase the uncertainty of China’s outlook in the medium term.

Like the United States, China may be struggling for a while with conflicting forces of inflation (deriving from stimulative monetary and budgetary policies) and recession (due to a change in growth engines).

The End of Globalization?

The performances of the world’s two economic locomotives during the last decade both fostered and benefited from the liberalization of international trade and financial flows that characterizes globalization. In turn, globalization triggered change, sometimes painful but on balance positive, in economies and industries far abroad.

As these two locomotives are searching for new engines of growth, globalization, too, seems to be gasping for a new breath. After the advent of Europe, an Asian economic bloc has been shaping up at an accelerated rate. Recently, trade between the region’s economies has been far outpacing the growth in total global trade, and special free-trade arrangements have been popping up with increased frequency – not only between China and Southeast Asia, but also including Japan and India.

As a result, security considerations allowing, the world’s three main economic blocs are likely to become increasingly assertive and less accommodating to America’s view of what is best for everyone. This trend is reinforced by a general uneasiness at America’s tendency to unilateralism in foreign policy and general disregard for local cultural and societal preferences, as well as by what (justly or not) is being viewed by many governments and populations as its “adventurism”.

Economic blocs are usually promoted as instruments of free trade. They probably are, compared to a total absence of cooperation. However, compared to the global liberalization of trade and capital flows that has been the pattern until recently, they surely represent a step back toward protectionism and mercantilism. To the extent that there has been a strong positive correlation between the growth of global trade and that of the world’s growth national product, we have to be concerned that this new trend will act as a brake on global growth.

At the same time, the reversion to blocs also encourages the intrusion of government into economic life. This is reflected in more regulation, new tax complication and bureaucratic interventionism and, in each bloc, this will encourage nascent inflationary tendencies.

Investing Amid a Tug-of-War

For all the reasons delineated in this paper, once the current synchronized, global rebound from recession has run its natural course, we expect a perhaps-protracted tug-of-war between inflation and recession.

For the time being, I believe that natural resources and basic industrial sectors remain good horses for investors to ride. Their profitability will directly benefit from the first synchronized, global economic expansion in a long time and, after years of cost-cutting and subdued investment in new capacity, their profits could benefit much more than is anticipated – even now. In stock market environments where price-earnings ratios have little room to move higher, earnings leverage is the key and, as far as I can see, that’s where it is to be found today.

Beyond the most dynamic phase of this global economic recovery, however, the investment environment will become increasingly challenging.

François Sicart

November 11, 2003 (from Hong Kong)
^© Tocqueville Asset Management L.P.

The information contained herein has been obtained from sources believed to be reliable and to the best of our knowledge is complete. The validity and completeness however cannot be guaranteed by Tocqueville Asset Management.  Nothing herein constitutes investment or any other advice and should not be relied upon as such.  This document has been prepared solely for information purposes and does not constitute an offer or an invitation to buy or sell securities.  Any reference to past performance is not necessarily a guide to the future.  Tocqueville Asset Management L.P., their affiliates and their officers, directors, employees, advisors or members of their families as well as the clients for whom they manage portfolios; 1) May have positions in securities or options of issuers mentioned herein and may make purchases or sales of the securities or options while this publication is in circulation; 2) May hold directorships in corporations discussed in this publication.  The opinions expressed in this document are those of Tocqueville Asset Management as of the date of the writing and are subject to change.