Asia May Catch Cold After All

Friday’s sudden plunge in the Dow Jones Industrial Average, falling 250 points on news of an unexpected August decline in US jobs by 4,000, could mean that investors are finally beginning to take seriously the warnings that the US economy is headed for a recession or worse.

There have been plenty of storm warnings but America’s stubborn investors, and to a large extent the financial world’s economists as well, have been ignoring them for months ‑ most recently through a global liquidity crisis engendered by America’s subprime mortgage woes. It is hard to do now. The consensus of 88 economists surveyed by Bloomberg News was for a gain of 100,000 jobs. The labor department also cut the number of jobs created in June and July by 81,000.

Meantime East Asia has been sailing along, saying its economies have finally decoupled from the American behemoth. The US consumer train that has been pulling the world along for a good two decades isn’t necessary any more.

Oh, yeah? If the US goes into recession, Asia is going to feel it. It is a question of how much and for how long. Asian central bankers, having been brought up short by bad economic policies prior to the 1997 financial crisis, have prudently allowed their currencies to realign, built foreign reserves, paid down debt and taken other measures. Asia will thus weather the American crisis better than the west.

But part of it is just the sheer size of the US economy. With a gross domestic product of US$13.21 trillion annually at official exchange rates, it is still 2.7 times that of Japan’s, the second-biggest and 5.2 times China’s, although both are closer in purchasing power parity. American stock market capitalization, at US$16 trillion, is still bigger than that of Europe and Japan combined and is eight times larger than China’s, even after the China market’s torrid run-up over the last year.

And despite all the brave talk, Asia has not abandoned its export-led growth model. Sending all those widgets to credit card-packing Americans is just too easy. Outside Japan, exports make up 54 percent of the region’s gross domestic product, up from 40 percent just seven years ago. Although economists like to point to the healthy state of intra-regional trade, the fact is that most of that inter-regional trade is made up of commodities and raw materials going into China and Japan for reprocessing into exports to the United States and Europe.

So who will they sell the exports to? American consumer debt is off the charts. Household debt as a share of personal income has risen to 125 percent over the past 20 years, with credit card debt rising from under 3 percent of disposable income in 1980 to nearly 10 percent in 2006. According to BAI, a financial industry professional organization, in 2007 Americans carried an average of 12 credit cards per household and 60 percent carried monthly balances, paying for rent, groceries and utilities with them. At the same time, America’s net savings rate has been in negative territory since 2005.

Tens of millions were betting on the equity in their homes, believing an eventual sale would generate the cash to bail them out. With the US housing downturn, that lifeline is slipping away. With their credit cards maxed out, with job growth stalling or descending and with no housing equity to convert, it is difficult to see how the American consumer is going to continue to buy Made-in-China shirts, golf clubs, ceramic pots and virtually every other non-perishable consumer item. In just the first six months of 2007, the United States exported US$30.5 billion in goods to China and imported US$148 billion to the US – a negative trade balance of US$117.5 billion

If a major export downturn strikes, China, now the world’s most formidable exporter, is first in line for trouble, and it will pass that trouble on to the rest of the region. Despite the confidence the region’s economists are displaying, there are troubling questions over China’s economy. After months of complacency over inflation, Beijing is finally getting worried. The People’s Bank of China, the country’s central bank, announced last week that it would raise the reserve requirement – the amount of money and liquid assets banks must hold in reserve – by half a point to 12.5 percent, the highest in 17 years as the country seeks to cool things off.

Led by soaring energy prices ‑ 112 percent above their post-World War II average real prices ‑ the inputs for China’s industry are going up. Margin squeezes are returning, according to a study by CLSA, the Hong Kong-based investment bank. “Given the growing credit problems in the rest of the world, Chinese manufacturers have missed their chance to pass on cost increases that will not result in demand declines,” CLSA said recently.

Food prices are another growing concern. There are complex reasons for that. Chinese leaders talk about blue ear disease, which has caused the slaughter of millions of pigs and raised the price of China’s protein staple, pork. But there are others as well. Animal feed is rising in price, at least partly because of an ill-considered and politically driven decision by American and European leaders to drive a switch to biofuels. Corn syrup for sugared soft drinks and barley for beer are rising in price. The price of raw cotton is also rising as land is converted from cotton to corn, squeezing China’s textile manufacturers as well.

Rising inflation presents China’s leaders with yet another dilemma. If they step down too hard and slow the economy, they risk exposing overcapacity problems. Chinese manufacturers, lured by the prospect of exports to the west, have been piling on factory capacity like there is no tomorrow. The higher cost of debt, combined with tighter credit as the reserve requirement rises, means companies are going to have to scale back expansion plans. But China, as fast as its economy has been growing, needs to create as many as 100 million new jobs a year to dry up the vast numbers of unemployed still left over from failed state-owned enterprises and the millions of people leaving the farm for the cities.

Luckily the yuan isn’t convertible. The government has stubbornly kept the currency from rising too fast against the US dollar, but it is questionable how long they can do that. After decades of keeping the currency at 8.20 yuan to the dollar, under US jawboning, they have allowed it to rise to 7.537. It will probably have to rise more.

If the American economy is indeed sliding into recession, US Federal Reserve Chairman Ben Bernanke will have no choice but to cut interest rates to stimulate the economy, which means the dollar will fall against other major currencies.

Most of the global financial community expects a US rate cut later this month and possibly another in October. The US dollar fell a full 1 percent to $1.376 against the euro last week and 2.1 percent against the yen to 113.38 yen. It was the second full week of weakening for the US currency, and it is almost certain that there will be more.

That means the price of Asian exports will rise in the US as the dollar weakens, cutting into Asian competitiveness. Malaysian timber, tin and rubber, Australian mining commodities and the hundreds of other commodities being shipped into China as inputs can be expected to decrease.

Where that leaves Hong Kong is uncertain. It is one of Asia’s few economies with its currency tied inextricably to the US dollar. The Hong Kong dollar, pegged at 7.8 to the US dollar, could conceivably have to decouple if the dollar goes into free fall, which lots of people are predicting. With virtually all of its foodstuffs coming from over the border, the territory faces the spectre of food inflation as China’s inflation rises and the dollar falls.

Then there is the question of global liquidity, made troubling by the integration of the world financial system. “The global capital market sell-off could have a larger impact on the Asian economies than in the past,” according to a study by Lehman Brothers, “as the world has become more financially integrated and the region’s capital markets have grown relative to GDP. The higher cost of debt and tighter credit standards can force firms to scale back expansion plans, while swooning equity markets can have negative effects on consumption. Sagging asset prices and ailing economies can feed off each other.”

After the near meltdown of the world’s financial system in August, the world’s central banks responded by pouring hundreds of billions of dollars into the system. Two of China’s biggest banks report US$12.5 billion in exposure to the US subprime market? Banks across the planet have been reporting similar stories.

The world’s central banks say they stand firmly behind the system and are prepared to pour in whatever it takes to keep it stable. But nobody knows how much debt is really out there as a result of the proliferation of insanely complicated financial instruments across the world. In the dark of night, central bankers must worry that the liquidity they are pouring into the system is like pouring water down a mine shaft and trying to fill it up. Nobody knows how deep the mine is, or how much water it will take.