Current Economic Conditions

A key factor behind global imbalances is the savings-investment surpluses in Asia. While the US needs to thwart the trend deterioration in its external imbalance, the US is likely to have time to normalise its current account (C/A) deficit, because global excess savings are likely to remain immense for some time. The imprudent US consumer has been the fall guy. I am sympathetic to the popular view that the imprudent US consumer is to blame for the US C/A deficit. However, I strongly believe that the market has not paid enough attention to another equally important factor: savings surpluses of the rest of the world. In particular, the size of the savings surpluses of Asia has been immense, helping to depress long bond yields around the world, as well as to finance the US C/A deficit. Savings less investment (S-I) balances in Asia ex-Japan. For North Asia (China, Korea, Taiwan, and Hong Kong), the S-I balances rose from a low of 2% of GDP in 1996-97 to close to 6% now. Similarly, the S-I balances for SE Asia (Indonesia, Malaysia, Philippines, Singapore, and Thailand) have risen since the Asian Currency Crisis, rising from a low of around 2.0% of GDP then to close to 12% now. I make the following points. AXJs savings rates have been consistently high. During the period 1990-2003, the average savings rate has been around 33% of GDP for both North Asia and SE Asia, with China having the highest savings rate of 44.5% in 2003 (which most likely rose to 46% or so in 2004). There were no major rises or falls in the savings rate in this 14-year period. I believe there are two structural reasons (in addition to possibly a cultural reason that Asians see savings as a virtue) why savings rates are so high in Asia: First, Asias capital market is highly inefficient. To reach a given level of targeted wealth at some point in time, it takes higher level of savings every year. Second, demographics are a factor, particularly for China. The one-child policy may have already begun to weigh on consumer behaviour. In anticipation of a sharp deterioration in demographics, and in the absence of a credible social insurance scheme provided by the government, it is not a surprise that the savings rate in China is high, and rising. AXJs investment rates have been volatile. In contrast to the savings rate, the investment rate has been much more volatile. This is because Asia goes through violent investment cycles. An investment bubble may be unfolding in China right now. Few would argue that China should engage in more investment and capacity-building this year. Any prospective growth deceleration will likely be centred on investment, not consumption. If that occurs, Chinas S-I surplus (i.e., C/A surplus) will widen further. Asias weak financial system is problematic. The boom-bust cycles in Asia have, in my view, a lot to do with Asias weak financial system, i.e., the inability of the capital markets to intermediate capital in an efficient manner. Specifically, a weak financial system has resulted in three tendencies. First, savings rates are forced to be higher than they would otherwise be. Second, the resultant cheap capital lowers the hurdle for investment. Third, there is a general lack of ability for the capital markets to discriminate between investment projects. Asias excess savings have made it easy for the US to run an outsized C/A deficit in the past four years. Extraordinarily large fiscal and monetary stimuli meant that the US savings rate had to be driven lower. This was judged, evidently, by US policymakers, to be the least risky of the policy choices available, as foreign financing would be ample: The conundrum of low long bond yields is another facet of these excess savings from outside the US. The US cannot run such large C/A deficits forever, but time is on the US side. One related question is whether the US will have enough time to stabilise its external imbalance without first seeing a collapse in the USD. Since last June, I have held a constructive view on the USD, arguing that it had corrected enough. However, I believe the US will need to thwart the upward trend in its C/A deficit. But until Asias S-I balances start to narrow, global excess savings will be abundant and will buy the US the needed time to engineer a soft landing in the external deficit and the USD. *Reference:MorganStanley Global Economic Forum No Euro Money, No Euro Honey - Yank Yes, in Europe Prostitution is Legal, Just like it is in the Money Markets 2005 Implications Can the euro maintain its rise against the dollar in 2005 despite weak economic results? To a large extent, the answer to that question will depend far more on dollar fundamentals rather than the Euro-zone's economic performance. If the US can curb or at least stem the rise of its ever-escalating deficits, the dollar should regain some of its strength against the euro. With the Fed focused on hiking interest rates until the fed funds rate reaches the 3.50% level sometime in 2005, the dollar should enjoy a material carry trade advantage over the euro, which presently yields 2%. If US exports can expand market share then the US Current account deficit could indeed stabilize and begin to recede while the Capital Account spurred on by the interest rate differential would increase creating the proper economic environment for dollar appreciation. However, if US growth begins to slow, the Fed may have to halt it rate-tightening program and the dollar will likely continue its slide. Recent economic data has been of some concern for USD bulls. The latest Non-Farm payrolls figures showed an increase of only 112K against 200K projected while the latest Challenger report noted that US corporations posted 104,530 job cuts in November, which was a 2.6% increase from the previous month and the third consecutive month that layoffs exceeded 100,000. Most recent retail sales numbers have also been disappointing with Wal-Mart registering a paltry 0.7% year over year gains while the Redbook Retail index recorded a fifth consecutive down week of sales. In short, if the US cannot begin to "grow" out of its economic problems in 2005, then the dollar is likely to resume its downward path regardless of Euro-zone fundamentals as investors and speculators will continue to discard dollar denominated assets. Stumble It!

Current Economic Conditions

A key factor behind global imbalances is the savings-investment surpluses in Asia. While the US needs to thwart the trend deterioration in its external imbalance, the US is likely to have time to normalise its current account (C/A) deficit, because global excess savings are likely to remain immense for some time. The imprudent US consumer has been the fall guy. I am sympathetic to the popular view that the imprudent US consumer is to blame for the US C/A deficit. However, I strongly believe that the market has not paid enough attention to another equally important factor: savings surpluses of the rest of the world. In particular, the size of the savings surpluses of Asia has been immense, helping to depress long bond yields around the world, as well as to finance the US C/A deficit. Savings less investment (S-I) balances in Asia ex-Japan. For North Asia (China, Korea, Taiwan, and Hong Kong), the S-I balances rose from a low of 2% of GDP in 1996-97 to close to 6% now. Similarly, the S-I balances for SE Asia (Indonesia, Malaysia, Philippines, Singapore, and Thailand) have risen since the Asian Currency Crisis, rising from a low of around 2.0% of GDP then to close to 12% now. I make the following points. AXJs savings rates have been consistently high. During the period 1990-2003, the average savings rate has been around 33% of GDP for both North Asia and SE Asia, with China having the highest savings rate of 44.5% in 2003 (which most likely rose to 46% or so in 2004). There were no major rises or falls in the savings rate in this 14-year period. I believe there are two structural reasons (in addition to possibly a cultural reason that Asians see savings as a virtue) why savings rates are so high in Asia: First, Asias capital market is highly inefficient. To reach a given level of targeted wealth at some point in time, it takes higher level of savings every year. Second, demographics are a factor, particularly for China. The one-child policy may have already begun to weigh on consumer behaviour. In anticipation of a sharp deterioration in demographics, and in the absence of a credible social insurance scheme provided by the government, it is not a surprise that the savings rate in China is high, and rising. AXJs investment rates have been volatile. In contrast to the savings rate, the investment rate has been much more volatile. This is because Asia goes through violent investment cycles. An investment bubble may be unfolding in China right now. Few would argue that China should engage in more investment and capacity-building this year. Any prospective growth deceleration will likely be centred on investment, not consumption. If that occurs, Chinas S-I surplus (i.e., C/A surplus) will widen further. Asias weak financial system is problematic. The boom-bust cycles in Asia have, in my view, a lot to do with Asias weak financial system, i.e., the inability of the capital markets to intermediate capital in an efficient manner. Specifically, a weak financial system has resulted in three tendencies. First, savings rates are forced to be higher than they would otherwise be. Second, the resultant cheap capital lowers the hurdle for investment. Third, there is a general lack of ability for the capital markets to discriminate between investment projects. Asias excess savings have made it easy for the US to run an outsized C/A deficit in the past four years. Extraordinarily large fiscal and monetary stimuli meant that the US savings rate had to be driven lower. This was judged, evidently, by US policymakers, to be the least risky of the policy choices available, as foreign financing would be ample: The conundrum of low long bond yields is another facet of these excess savings from outside the US. The US cannot run such large C/A deficits forever, but time is on the US side. One related question is whether the US will have enough time to stabilise its external imbalance without first seeing a collapse in the USD. Since last June, I have held a constructive view on the USD, arguing that it had corrected enough. However, I believe the US will need to thwart the upward trend in its C/A deficit. But until Asias S-I balances start to narrow, global excess savings will be abundant and will buy the US the needed time to engineer a soft landing in the external deficit and the USD. *Reference:MorganStanley Global Economic Forum No Euro Money, No Euro Honey - Yank Yes, in Europe Prostitution is Legal, Just like it is in the Money Markets 2005 Implications Can the euro maintain its rise against the dollar in 2005 despite weak economic results? To a large extent, the answer to that question will depend far more on dollar fundamentals rather than the Euro-zone's economic performance. If the US can curb or at least stem the rise of its ever-escalating deficits, the dollar should regain some of its strength against the euro. With the Fed focused on hiking interest rates until the fed funds rate reaches the 3.50% level sometime in 2005, the dollar should enjoy a material carry trade advantage over the euro, which presently yields 2%. If US exports can expand market share then the US Current account deficit could indeed stabilize and begin to recede while the Capital Account spurred on by the interest rate differential would increase creating the proper economic environment for dollar appreciation. However, if US growth begins to slow, the Fed may have to halt it rate-tightening program and the dollar will likely continue its slide. Recent economic data has been of some concern for USD bulls. The latest Non-Farm payrolls figures showed an increase of only 112K against 200K projected while the latest Challenger report noted that US corporations posted 104,530 job cuts in November, which was a 2.6% increase from the previous month and the third consecutive month that layoffs exceeded 100,000. Most recent retail sales numbers have also been disappointing with Wal-Mart registering a paltry 0.7% year over year gains while the Redbook Retail index recorded a fifth consecutive down week of sales. In short, if the US cannot begin to "grow" out of its economic problems in 2005, then the dollar is likely to resume its downward path regardless of Euro-zone fundamentals as investors and speculators will continue to discard dollar denominated assets.