Chicken or the Egg?

Another good report from Morgan Stanley:


Chicken or the Egg?
Stephen S. Roach
Chairman, Morgan Stanley Asia

The China debate is terribly one-sided.  The same can be said for the broader  discussion over global rebalancing.  The emphasis in both cases has largely been on the destabilizing impact of the surplus Chinese saver. If China would only stop manipulating its currency, goes the argument, its current account surplus would vanish and an unbalanced world would finally enter the Promised Land of balanced growth.

What about the other side of the story? After all, barring an extraterrestrial imbalance, earthly surpluses must always be counter-balanced by deficits on the other side of the international accounting ledger. Unfortunately, the blame game has focused primarily on surplus savers, paying only lip service to profligate deficit savers.

In that spirit, it is equally important to contemplate an alternative reality. It can best be seen through the lens of America’s massive saving shortfall and its concomitant current account deficit. This version of the unbalanced world poses a very different dilemma: If the United States would only start saving again—namely, reduce its budget deficit and/or boost its long-depressed household saving rate— it would become less reliant on surplus savers such as China to fund its shortfall of domestic saving and provide cheap goods for over-extended consumers.

What came first—the surplus or the deficit? Was it China’s saving-led development strategy that forced the United States to squander its domestic saving and lead the external demand that fueled the Chinese export machine? Or was it America’s penchant for living beyond its means that required the world’s savers, such, as China to run large current account and trade surpluses to provide the US with both cheap capital and low-cost imports?

Like all disputes, there are shreds of truth on both sides of this tale. Yes, China is guilty of staying with an export-led development model for too long and for failing to provide adequate support to internal private consumption. Even so, the US was hardly an innocent bystander here. Without the profligacy of income-short America, China would have faced weaker external demand and might have had to abandon the old model sooner.

At the same time, the United States became addicted to excess consumption—drawing freely on open-ended support from asset and credit bubbles. America probably couldn’t have pulled it off without China. Without the prowess of the Chinese export machine and the surplus capital that made its way into US asset markets, the United States might have found it a good deal tougher to feed its addiction and stay the course of unbalanced growth.

The concept of shared responsibility is missing from the current debate. The West is collectively pointing its finger at China. But it hardly utters a peep about the equally important role the US has played in creating this problem. It is both ironic and hypocritical that many politicians and global thought leaders have concluded that the Great Crisis was made in America but that China should be held accountable for the imbalances that linger in the post-crisis world.

This is where I draw the line. As the global hegemon,  America should have known better. By opting for bubble-dependent growth, it made a conscious choice to shift  from income- to asset-based consumption and saving.  Yet a saving-short US economy could not have pulled off  this transformation without the support of a new form of vendor finance—namely, China’s massive accumulation of foreign exchange reserves that have been disproportionately recycled into dollar-based assets.

At the same time, Chinese mercantilism enabled the American dream of open-ended consumption—providing income- and saving-short consumers with an unlimited supply of low-cost and increasingly high-quality goods. And by turning to China’s low-wage workforce, American multinationals benefited handsomely from Chinese outsourcing options—boosting their earnings, share prices, and wealth of asset-dependent consumers.

In essence, for the United States, it was a virtuous circle of virtual purchasing power—partly made in China at the implicit bequest of the overly indulgent American consumer. This is where hypocrisy enters the equation: China is being chastised for a mercantilist currency policy by those who benefited the most from this so-called manipulation.

Of course, the blame game is always subjective. But, ultimately, this dispute goes right to the heart of the value proposition that shapes economic development. Just thirty years ago, the Chinese economy was on the brink of collapse. Export- and investment-led growth was China’s salvation-producing nothing short of a miracle in the annals of poverty reduction and economic development. China did what it had to do in order to avoid the abyss.

That was then. China knows full well that it now needs to transition to a different growth structure—one that shifts support from external to internal demand. But it puts a high value on 30 years of extraordinary progress, and does not want to squander those gains by acceding to destabilizing western demands for a large currency revaluation. That doesn’t mean China won’t bend. As it shifts to more of a consumer-led economy, China can be expected to do so with a return to the gradual renminbi appreciation strategy that was in place from mid-2005 to mid-2008.

In the end, it always pays to be wary of unintended consequences. China’s coming transition will have profound implications for the United States and the rest of the world.  It will create vast new markets that will benefit most exporters. But as China’s surplus saving gets diverted into internal private consumption, it will have less capital left over to bankroll other nations. Specifically, that means that China will be less capable of funding America’s insatiable addiction for excess consumption. And then, the chicken—or maybe the egg—will finally come home to roost.