Unexpectedly strong growth data from three of the world's most important economies have cheered the equity market recently. Japan's GDP grew by 2.2% in the third quarter of this year, China's economy surged by 9.1% and the US jumped by 8.2% the third quarter. The market seems to be pricing in sustained world growth. What about if that is wrong, and what will the impact be on Asia? It is time to play devil's advocate.
Japan's vulnerability
The strength of investment has been a big surprise in Japan's strong GDP growth. However, the weakening performance of two key components, machinery orders and private construction orders, in recent months does not support sustained investment strength. Companies' buying of capital goods seems to have lost momentum since August, while private construction has remained on downtrend.
Investment growth depends on rising profits and capital replacement. But balance sheet retrenchment, notably debt repayment, has absorbed much of Japan's corporate profit improvement. That leaves only a residual amount for new investment. Meanwhile, the Japanese economy still has excess capacity, which tends to reduce the replacement demand for capital. Continued hollowing-out aggravates the situation, as any replacement of machinery or addition to capacity is likely to be done in the low-cost bases overseas, notably China and Southeast Asia.
It is also unlikely for consumption, which accounts for 55% of GDP, to sustain high economic growth. Japanese consumption has been kept stable over time by offsetting savings adjustment - a behaviour underscored by the Life-time Income Hypothesis. In the past several quarters when income growth fell, households kept their consumption level by cutting back on savings. If consumers behave the same way when income rises, they are more likely to replenish savings than raise spending.
Then, there is the strength of the yen. Though large Japanese manufacturers can survive a yen-US dollar exchange rate as high as 100, many smaller manufacturers may not. The negative impact of the recent rise in the yen will take several quarters to filter through the economy. This only adds to the concern about an eventual export slowdown, presumably in the second half of 2004, weighing on the future growth outlook.
China's administered slowdown
The 9.1% surge in China's GDP growth in the third quarter was a surprise, and it dispelled the concerns about the SARS damage on the economy. This robust economic performance, coupled with strong credit growth, has raised concerns about an economic overheating and asset bubble. The central bank has thus started to tighten up monetary conditions to contain the risk of an economic blowout. It also tightens for another good cause.
The sharp rise in bank loan growth since late last year appears to have been driven by the big four state banks, which still channel the bulk of the funds to the state-owned enterprises. The concern is that such loans will turn into bad debts if the state firms fail to turnaround. The authorities are trying to preempt such an outcome by reducing the flow of funds into the inefficient state companies.
The point to note is that despite all these years of reform, government control still plays a significant role in determining the direction of the Chinese economy. When Beijing wants to put a brake on economic growth, it can still do so effectively. With the central bank aiming at cooling excessive credit growth now, GDP growth can be expected to slowdown in the coming quarters.
The US un-sustainability
To a large extent, the US robust 8.2% growth in the third quarter reflects America's living on borrowed time. The bulk of the recent growth spurt stems from the surge in durable goods consumption in the second and third quarter of this year. Presumably, this should be a result of the release of pent-up demand following the economic recession in 2001, which curbed discretionary buying of durable goods. But US data shows that consumption of big-ticket items did not fall much in the last recession, hence no reason for pent-up demand.
Rather, the recent surge in durable goods demand was likely to be a result of the one-time tax cut in summer, the lagged effects of home mortgage refinancing activity and aggressive zero-financing incentives for car buying earlier this year. In other words, a significant portion of the recent surge in US consumer spending was borrowed from future demand so that consumption in the coming quarters will likely fall.
The surge in US consumer spending on durable goods accounted for about one-third of the real GDP growth in the second and third quarter. Thus, as and when spending falls, US GDP growth will follow.
Global impact
While we are not seeing another global economic recession, a potential growth deceleration in the world's most important economies are in the cards, probably in the second half of next year. The US and China were the biggest and second biggest driver, respectively, for global growth last year through their demand for other nations' exports. Any decline in their growth will thus be problematic, especially for Asia which still depends on exports to keep growth up. Japan, South Korea, Taiwan and Hong Kong will be most affected, as the Chinese and US markets account for the bulk of their exports.
Hence, there is a risk that the world stock markets might be disappointed next year, as they are pricing in a robust world economic recovery that may not be sustainable. The reality check could send stock prices down, hurting sentiment and demand via a negative wealth effect. But this also means that the days for bonds will be back after the stock market party.
Chi Lo, author of the new book "When Asia Meets China in the New Millennium", Pearson Prentice Hall, 2003, ISBN 0131028421
