Threats

Excerpted from Morgan Stanley's Asia/Pacific report, Scare and Dare by Andy Xie.

The structural threats in this cycle are the large US trade deficit and China's overinvestment. The US trade deficit could top 6% of GDP and China's fixed investment 50% of GDP in 2005. Neither is sustainable, in my view. This is why the growth boom is a party. However, the party persists because special factors are holding together a temporary equilibrium.

The government dominates the banking sector in China. It is sensitive to liquidity but not to capital returns. Exports and capital inflows determine the liquidity in the banking system. Both are still very strong: Exports rose by more than 30%, and foreign exchange reserves increased by US$32 billion in Jan-Feb 2005. Even though forex reserves rose half as fast as in 4Q04, current levels still imply ample money relative to investment strength. Indeed, the interbank 7D bond repo rate has collapsed to a historical low of 1.4%.

The dollar is rebounding even though the US trade deficit continues to rise. I do not believe that the weak dollar story is over. The bounce nevertheless shows unusually strong demand for dollars. What is happening, I believe, is that the trade surpluses that the oil exporters incur eventually end up with Asian central banks, which continue to purchase dollar assets. This artificial construct is covering up punitively high real interest for over-consumption in the US.

Asian central banks hope that the Fed will cool consumption in the US by increasing real interest rates substantially. The alternative is a dollar collapse that forces the Fed to raise interest rates through inflationary pressure. The Asian central banks hope that the painful roundtrip for the dollar can be avoided. The irony is that the Fed sees strong US consumption as a blessing, a sign of economic resilience. The Asian central banks could hold the bag for the Fed for a long time. Asia and America have the economic equivalent of MAD ('mutually assured destruction'), in my view. Like peace during the Cold War, this equilibrium, while unstable, may prove long-lasting.

Inflationary pressure has generally remained low during the current growth cycle. The globalization of supply, I believe, has integrated the global labor market and has substantially increased the growth threshold for wage inflation. This is why the Fed has been able to keep interest rates so low so late in the cycle.

The combination of easy money and strong growth has led to extensive financial speculation. Property, yield curve, credit spreads, and commodities have all become hubs of speculation. Oil speculation can lead to inflationary pressure. Thus, cheap money can create inflation anyway, despite globalization. This has become the weakest link in the growth cycle. The Fed has been scaring oil speculators by talking about inflationary pressure. However, the speculators keep coming back. The institutional bias for pushing up oil prices is quite strong.