In a simple exercise last week, we calculated the scope for fiscal retrenchment in the OECD. Using a savings/investment framework, and assuming that a return to a sustainable fiscal balance in the OECD would be achieved with about half of the necessary fiscal tightening being offset by increased private sector demand, we estimated that the aggregate OECD current account deficit would improve by about 2% of GDP, or by USD 0.8tn. The 800 billion dollar question therefore is whether it is possible for the emerging markets to make the ultimate sacrifice and lay down their balance sheets for the common good (...of developed nations). In short, the exercise looked at the scope for the emerging world’s aggregate external surplus to be reduced by USD 0.8tn or by approx 3½% of aggregate GDP. Our estimates suggested that even if emerging economies reduced their external balances materially, it would only be possible if China moved into a current account deficit. It is possible, if unlikely. There have been seven occasions under the 33 years of the Open Door policy that China ran a current account deficit, the last being in 1993 – a wild year of rampant overheating that culminated in a currency realignment and devaluation
Rebalancing outcome
From an investment perspective, the reason why all this matters so much is that of four potential outcomes, three are unpleasant. The first combination is the best, namely OECD fiscal tightening coupled with widespread emerging market stimulus. This would be positive for risk assets, while it would ensure that emerging asset classes outperformed. The second presumes fiscal tightening in the advanced economies, but without an offsetting stimulus from the developing world. This scenario would bring a slump in demand and possible depression. It would be positive for government bonds of surplus nations but little else. The third combination includes a lack of fiscal retrenchment in the OECD but demand stimulus in the emerging markets. This would be a recipe for a surge in inflation, bringing sizeable FX volatility, and would be a nightmare for fixed income assets. The final outcome is a failure by the advanced economies to improve their fiscal positions and by the emerging world to boost its economies. That scenario would be a recipe for protectionism and be disastrous for risk assets. At this stage the most favourable outcome is not a given, although the second (deflationary) option is probably the front runner.
...which lead back to China
China emerges as one of the key factors in this assessment and there have been a series of sell-side insights on the middle kingdom in recent days. The vast bulk of analysts remain optimistic, interpreting the Q3 economic data (with real GDP growth slowing to 9.1% y/y) as consistent with a “soft landing”. Some have defined a hard landing as representing two quarters where annual growth falls to 5% or below. This seems to be a growing consensus definition, but is hardly insightful, as there has not been a quarter of year-on-year growth below 5% since 1993! But what is interesting is that there is a growing gap between real GDP growth (which is trending down) and nominal GDP growth (which is trending up). So inflation remains a problem in the economy, even though consumer prices may have peaked.
The dividing line between the optimists and those who see darker things happening in China, is the property market, which has shown some signs of distress in recent weeks. CLSA estimates that there are 16 million empty properties, equivalent to about 17% of the urban housing stock – and a higher vacancy rate now than in Thailand in 1996, just before its crisis. This writer suspects, controversially, that the appropriate analogy may be with Taiwan in the late-1980s. Many emerging market crises are caused by credit booms but the catalyst has often tended to be a funding crisis, with either a balance of payments problem, or a fiscal solvency issue (or both). Taiwan may be helpful because, as with China now, it had a sizeable current account surplus and massive FX reserves. And as with China, Taiwan suffered a monetary boom that was deflated in 1989/90 with damage to its property market and banking system (the equity market declined by 80% in eight months from its peak in February 1990, before an equally dramatic 146% bounce over the following seven months). Interestingly, Taiwan was slow to revive its banks in the early 1990s, though its external assets suggested it had the means to do so. So far, China has not been slow to recapitalise troubled banks and remove non-performing loans and to place them in an asset management company
While one is sanguine about China’s domestic resilience (with USD 3tn in FX reserves, it’s hard to be other than sanguine), we are less confident that China will lay down its balance sheet for others. Social safety nets may take time to build and the ageing of its population could mean that the shift to a consumer economy is slower as the soon-to-be elderly continue to save. All this suggests that global rebalancing could be a choppy and frustrating affair.
