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Asia Pacific The Motorcycle Diary - The Twilight Zone View GEF Archive

US consumption and Chinese investment have supported the global boom since 2002.  The two prosper as a pair: the deflationary pressure of the latter offsets the inflationary pressure of the former.  This ‘motorcycle’ economy thrives on the productivity gains from European and Japanese factories relocating to China.

The weakening US housing market, continued land inflation in China and sustained high oil prices are causing instability to this equilibrium.  The global economy may shift from the goldilocks of low inflation and high growth to a mild form of stagflation.

Investors have few hiding places as the world shifts to stagflation.  Commodities and properties have already inflated.  At best, inflation allows prices of goods and services to catch up with asset prices.

The bond market is at most risk.  Most bond investors subscribe to the Fed’s view that economic slowdown would bring down inflation.  But the deflationary effect of globalization has run its course, while the massive money supply released by central banks to deal with deflation in the past is still out there and is causing inflation.

The origin of the motorcycle economy

Mr. Greenspan made the ‘irrational exuberance’ speech in 1996.  It shook up the financial market and investors expected the Fed to come after asset inflation.  But Mr. Greenspan did not follow through.  The speech served to embolden the financial market to inflate financial assets.

Asset inflation naturally led to strong demand, especially consumption, in the US economy.  It could cause inflation and force the Fed to tighten.  This type of natural punishment for lax monetary policy was delayed by what was happening in China.

The Asian Financial Crisis happened in 1997.  The Chinese economy was already in a downturn from the overheating between 1992 and 1996.  The deflationary effect of the crisis threatened to push China into a deep recession.  China adopted a Keynesian-style government-led investment program to stimulate the economy.

China was already in deflation.  The investment stimulus, though it could ease deflation in the short term, would lead to more deflation by creating overcapacity.  This natural punishment for the Keynesian stimulus was offset by rapidly rising demand from the US.

The two countries have got on famously since.  China’s exports have grown fivefold from US$151 billion in 1996 to an estimated US$934 billion in 2006.  As a share of GDP, exports grew to 36% from 18% in the same period.  In 1996, US exports were 4.1 times China’s.  In 2006, they are estimated to be 1.1 times.  China’s exports could exceed the US’s next year.

On the US side, its current account deficit grew from US$125 billion in 1996 to an estimated US$870 billion in 2006.  As a share of GDP, the deficit grew to 6.5% from 1.6%.  The US trade deficit, which results from the asset inflation in the US, was the inflationary force that offset the deflationary force from China.

The manufacturing relocation from Japan and Europe to China was the dynamic that made the process work.  The most effective part of China’s investment program was in building an excellent infrastructure in a low-wage country.  That attracted Japan and Europe to move manufacturing to China, which caused many products to be re-priced against Chinese labor cost, which offset the inflationary force from the US’s asset inflation.

The motorcycle has been overheating

As long as the deflationary force from manufacturing relocation to China and the inflationary force from the US asset inflation just balance each other, the motorcycle economy works well.  The global economy shows what analysts call goldilocks — low inflation and high growth.  The unstable part is a rising US current account deficit that may threaten the stability of the dollar.  As the dollar is the currency for global trade, it has remained stable despite the rising deficit.

Emerging inflationary signs suggest that the goldilocks economy is reaching its limits.  There are three sources of inflation.  First, the manufacturing relocation to China has peaked.  Manufacturing FDI into China peaked in 2004.  It appears that the easy part of moving factories to China is winding down.  This means that the productivity gain from integrating China into the global economy has peaked, i.e., China cannot offset rising inflationary pressure in the US.

Second, China’s export success has led to a massive build-up of liquidity in the system.  It led to three inflationary consequences.  First, it fuelled China’s demand for commodities, especially oil.  The financial market saw China’s demand and began to front-run it.  The resulting momentum has led to a massive commodity bubble.  While it may be a bubble, as long as China’s demand remains strong, the bubble is not likely to burst.  The commodity bubble has become a main source of inflation.

Second, China’s land price has skyrocketed.  The business cost has gone up with it.  While the cost of factory land itself is lagging due to policy protection, a rising land price raises business costs in many other ways; for example, labor cost rises for experienced white-collars who are in short supply and could ask for wage increases in line with rising property prices.

Third, the global economy is experiencing a shortage of skilled labor after three years of above-trend growth.  China’s minimum wage policy is raising factory labor costs — a significant factor in the global inflation story.  The shortage of skilled labor is becoming a significant factor also.

Inflation brings the motorcycle economy to an end.  Either the US or China will have to tighten to deal with inflation.  The resulting deceleration in growth will cause the productivity growth rate to slow further, as it slows down globalization, which adds to tightening pressure.

Towards stagflation

While the goldilocks period may be ending, most central banks are not taking inflation seriously.  The low inflation in the past has made central bankers confident that any inflation problem is likely to be short-lived.  Hence, the Fed is guiding investors to ignore inflation today and focus on a low-inflation future that it promises slower growth will bring.

The reluctance to tighten has created the global real policy rate of about half a percent compared to the average of 1.5% in the past 13 years.  When the level of money is high and inflation is on the rise, a low real interest rate is likely to add fuel to the fire.

On the growth front, the biggest uncertainty is US consumption.  As the US housing bubble bursts, US consumption could come down also.  This is not assured.  The US has developed an entrenched culture of ‘borrow and spend’.  It allowed the US consumption to survive the tech burst, 9-11 and the energy shock.  The ‘borrow and spend’ culture could allow US consumption to survive again.

If US consumption does not weaken with the US housing market, however, global inflation is likely to accelerate even faster, as growth will surprise on the upside, with real interest rate still low.  Hence, central banks could be persuaded to raise interest rates again.

If US consumption does slow down, it may not be sufficient to bring down inflation.  China has built a funding cushion to keep investment going for another year if its exports do not grow.  The global economy will still grow close to its trend of 3.5%.  Hence, growth will not be low enough for inflation to come down.  The low real interest rate could continue to inflate the commodity bubble, causing more inflation.

A mild form of stagflation could happen in 2007 with growth at 3.5% and inflation 4% for the global economy.  The bond market would not do well in such a scenario.  The equity market would not perform well either, as interest rates remain high and earnings slow down with economic growth.

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