As America crash lands, the world looks east

With Wall Street in crisis and banks begging for cash, the West has lost its swagger. Can China step in and keep the global economy on its feet?

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Published: Mon 28 Jan 2008, 12:33 PM

Last updated: Mon 13 Nov 2023, 3:51 PM

What links Hu Jintao, president of the People’s Republic of China, with the following people: an American mom shopping at Walmart, former Citigroup boss Chuck Prince, and Federal Reserve supremo Ben Bernanke? And how is Ralph Herndon, a retired car assembly-line worker from Otisville, Michigan, connected to Mr Yu, who runs a handbag factory in Guangdong? It is the financial world’s version of six degrees of separation, the current economic crisis has revealed the close connections and interdependencies between the US, the world’s biggest capitalist economy, and communist China.

The huge glut of savings built up in Hu Jintao’s China allowed that nation to lend billions of dollars to the US, which meant American consumers could embark on a borrowing and spending spree. But too many of those loans went bad, banks racked up huge losses, and CEOs like Chuck Prince paid with their jobs. When the stock market caught on to what was happening, shares tanked on fears that the US would fall into recession. That prompted Ben Bernanke to slash US interest rates by an extraordinary three quarters of a per cent last Tuesday. As the US economy has shifted away from traditional manufacturing to service industries, car plants like the one where Ralph Herndon worked have closed, because of cheaper competition from lower-waged economies like China. The Americans now hope that China, and other emerging countries with cash reserves, will bail out troubled banks and the world economy. But as Mr Yu has found to his cost, Guangdong is not immune to US troubles - 70 per cent of his American and Canadian customers are not paying their bills on time.

The current crisis has raised fundamental questions about the merits of the American model. For many years, the US has lived beyond its means: borrowing heavily to gobble up cheap Chinese consumer goods; splashing out the proceeds of a decade-long housing boom; and preaching the benefits of liberated markets.

Now the rest of the world is anxiously glancing eastward, in the hope that as America slides towards recession, the rising economic powers of Asia - in particular, China - will help to forestall a full-blown global crisis. But as Mr Yu would attest, the hope that the Chinese dragon can slay the American bear is a pretty vain one.

A few decades ago, looking to China as the driver of global growth would have been unthinkable. Henry Kissinger, Nixon’s Secretary of State, who was instrumental in opening up the channels of communication with China in the early 1970s, told the World Economic Forum in Davos, Switzerland, last week that he had no idea at the time that Beijing could emerge as an economic competitor.

In Otisville, Herndon and his former colleagues at General Motors know all too well what it feels like to be on the sharp end of competition from China. Flying into Detroit, 70 miles away, planes soar above mile after mile of rusting cars, girders and industrial scrap in what looks like the biggest junkyard on earth. Herndon, who worked for GM for 30 years, says he was struck by a realisation last year. ‘I thought to myself, they are paying these guys in China $3 a day to do what I have done all my life. No matter what cutbacks we offered the management, there is no way we can match that. I guess we are finished.’

Now it is the turn of the banks to feel the growing muscle of the Chinese. There could have been no more potent symbol of the shift of global power than the spectacle of America’s mightiest banks begging for cash from government-backed sovereign wealth funds from China and the Middle East to cover the vast losses they have clocked up through reckless lending.

But America has relied on Asian cash for years, locked in a bizarre financial embrace with the country that has become the world’s factory, and in many ways its banker. Like many nations with a strong export sector, China has earned more than it could spend and has accumulated vast savings in the past decade.

Much of this cash has been sucked into the US, as Beijing opted for the dollar as the safest currency in which to keep its reserves. In effect, it has been lending billions of dollars to the American government.

This wall of Asian cash has helped to keep the cost of borrowing down throughout the rich world and contributed to a series of asset price bubbles, in housing and in shares. The enthusiasm of sovereign wealth funds for buying up chunks of US banks - and a range of other companies - is the latest manifestation of this phenomenon.

But economists have become increasingly nervous that the world is out of kilter, with some countries borrowing and spending too much, and others too little.

Optimists argue this will not matter, because over the past decade there has been a beneficial ‘decoupling’ in the global economic train: America is no longer the sole engine of international growth.

In its assessment of the economic prospects for 2008 this month, the World Bank set out a rosy scenario in which emerging markets would continue to expand strongly, despite the credit crunch and the slowdown already under way in the US. China, it predicted, would slow almost imperceptibly, from 11.3 per cent GDP growth in 2007 to 10.8 per cent this year.

But the worldwide stock market rout at the beginning of last week, which spread through Asian markets and back to the US and Europe, suggested investors, at least, are not convinced that ‘decoupling’ is really here. The idea of ‘recoupling’ is suddenly in vogue.

Although China has begun to generate expanding consumer demand of its own, its decade of 10 per cent annual growth has been largely on the back of an explosion in exports, so it is vulnerable to downturns elsewhere.

As he contemplates the future over a working lunch, Li Xihao, senior manager at garment manufacturer Shanghai Eswell, which exported $10m of its garments last year, is hoping that US troubles will not have knock-on effects in Sydney and Melbourne.

‘We are worried about the American economy and it’s very difficult to tell what the outlook is,’ he says. ‘At the moment our major market is Australia and that still looks OK, so hopefully the business will not be affected. ‘

Nariman Behravesh, chief economist at consultancy Global Insight, expects US consumer spending growth to halve, from 3 per cent in 2007 to 1.5 per cent this year - and warns that China will be unable to escape completely unscathed. ‘The US is too big not to be having an effect on the rest of the world.’

Yu in Guangdong would agree. More than 1,000 miles north, shoppers are snapping up clothes and accessories in Beijing’s department stores. But his factory has thrived by aggressively marketing exports and has little to gain from the purchases of its compatriots.

‘American economic problems have a very big influence on our business,’ he laments. ‘We export mainly to America and Canada and because of the economic crises about 60 to 70 per cent of our bills haven’t been paid in time. Even our old customers have all kinds of excuses. The exchange rate is dropping as the lending rate is going up and the salary for workers has also been increased, so it is getting more and more difficult to earn money. Many small factories have closed already and I guess I need to look for another job after spring festival [New Year].’

Stephen Green, an economist with Standard Chartered specialising in China, agrees that prospects are clouded in the short term. ‘Inflation in China hasn’t got better and the US situation is looking serious, so there’s going to be a hit. But China is going to continue growing. We see it slowing from 11.5 per cent growth last year to 9.5 this year and 8.2 per cent next year. A large part of that is from the trade side.’

But the linkages of international trade are not the only mechanism for propagating the crisis. When rumours emerged that the People’s Bank of China would have to write off a quarter of its $7.95bn of sub-prime securities last week, it underlined the importance of global financial markets in transmitting woes around the world .

‘When people talk about decoupling, they’re talking trade, but the linkages are very strong in finance,’ says Behravesh. ‘It came as a big surprise to people that sub-prime manifested itself so fast in Europe and elsewhere.’

Hugh Young, MD of Aberdeen Asset Management Asia, warns that foreign investors nursing losses are likely to respond by taking a more cautious approach and bringing their cash home. That could exacerbate the stock market plunge in Asia, and make it harder for companies there to raise cash: ‘We have no idea how much might be repatriated and by the time you start talking about it, it might already have happened. The Asian investor could take up the slack, but I don’t know at what price.’

Even if China continues growing rapidly this year and the world escapes all-out recession, the speed at which the sub-prime fallout was amplified and spread has raised fundamental questions about the Anglo-Saxon economic orthodoxy of liberated financial markets.

Since the radical financial liberalisation of the Thatcher and Reagan years, reining in the world’s banks has become a taboo. But the damage wrought on ordinary borrowers and businesses by reckless lending could be felt for years. ‘Beneath it all is this philosophy for regulators which says the markets are generally right,’ says Professor Avinash Persaud, of consultancy Intelligence Capital. ‘But the reason we have financial regulation is that we have market failures.’

Philip Augur, a former investment banker and author of The Greed Merchants, which looked at the banks’ role during the dotcom crash, believes it is time for financial institutions to be more firmly controlled: ‘Deregulation seems to have become ‘unregulation’. Financial services institutions are too large and powerful to be left to their own devices. Governments have had to intervene to save the world economy from significant instability. A different, more prudent approach will be needed in the future.’

Joseph Stiglitz, a Nobel prize-winner and former chief economist at the World Bank, says: ‘This is the third crisis for American financial markets in 20 years, and that should tell us something. The sub-prime issue is about predatory lending, but it has gone badly wrong. The situation has been created by financial institutions that have run amok.’

According to Stiglitz, the banks ‘talked up’ their ability to manage risk, but the liquidity squeeze shows ‘they didn’t know what they were talking about’. He adds: ‘The banks’ incentive schemes need looking at. We thought these structures were about maximising corporate profits, but it seems they were more about maximising the profits of senior bankers and chief executives. There is an ideology that says the markets can solve all problems, but they don’t.’

The UK, which under Gordon Brown’s chancellorship deliberately mimicked the US approach, looks particularly vulnerable to both prongs of the current crisis - the comeuppance of consumers and governments living beyond their means; and the retrenchment of an over-mighty financial sector.

‘The UK economy benefited disproportionately from the growth of the financial sector, so I would say it’s more vulnerable than most, because this sector of the economy is going to contract ,’ says Russell Jones, fixed income strategist at RBC Capital Markets.

‘I think the UK is quite vulnerable: you have a financial crunch, and it dominates the London economy, and in that sense the UK economy. Separately, we have the housing situation,’ says Behravesh.

Bank of England governor Mervyn King has long talked about the ‘rebalancing’ he would like to see in the UK economy, and he made clear in a speech last week that he believes a period of pain is necessary. ‘Tighter credit conditions mean that, as a nation, we are likely to save more of our income this year than in the recent past. In the short run, that will slow economic activity, possibly quite sharply,’ he told his audience in Bristol. ‘The adjustment which not only the British but the world economy is experiencing is necessary as the imbalances, between spending and saving and between domestic demand and trade, unwind.’

The unwinding King hopes for has been postponed many times as central banks have stepped in to kick-start the borrowing binge just as a reckoning seemed in order. In Davos, Stephen Roach, the bearish Asian president of Morgan Stanley, criticised Alan Greenspan for failing to rein in the boom several years ago: ‘The Fed’s attitude is that it is here to clean up after bubbles burst, not prevent them from happening... this is a dangerous, irresponsible and reckless way to run the world’s largest economy.’

When the cash taps have been turned on so long, it can be hard to turn them off. As Graham Turner, of consultancy GFC Economics, says: ‘We caused this problem by having runaway credit growth, now we’re trying to solve it by cutting interest rates. It’s rather like a heroin addict: you can say they shouldn’t have got addicted, but once someone is addicted, you don’t take away their drugs overnight.’ The big question now is whether the US - and the UK - will finally have to go cold turkey. --Guardian News Service

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