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Friday, November 23, 2007

Global Recoupling, Japanese Exports and the Great Transformation

by Edward Hugh: Barcelona

Claus - who has an excellent and highly entertaining post on his personal blog this morning about the quandry which must exist in almost everyone's mind concerning what is actually happening to the dollar at the moment, and whither lies its future - drew my attention earlier this week to this interesting piece from Nouriel Roubini about global recoupling. Actually the Roubini post raises a number of points, all of them interesting ones, and some of them not as semantic as they seem at first sight.

But in order to get in the frame of mind to think about all of this, why don't we take a quick look at the latest set of trade figures from Japan. As Bloomberg tell us:

Japan's exports rose to a record in October as companies shipped more cars and electronics to Asia and Europe, easing concern that a slowdown in the U.S. will cool the economy's expansion.

Exports climbed 13.9 percent from a year earlier, the Finance Ministry said in Tokyo today, double September's pace. That helped lift the trade surplus 66.1 percent to 1.02 trillion yen ($9.3 billion) as imports gained 8.6 percent.

Shipments to China and the European Union surged to the highest ever, cushioning a drop in exports to the U.S., where the worst housing recession since 1991 is crimping demand. Toyota Motor Corp.'s profit rose 11 percent last quarter, helped by sales of Camry sedans in Europe and Asia.
This is, if you will, the headline grabbing story, the one that everyone notices. Record Japanese exports, with a shift in emphasis away from the US and towards Europe and China. (You can find the details in this PDF from the Japanese Finance Ministry).

Now as we can see from the chart below, Japanese exports have been doing very well indeed in value terms since the start of 2006, and even in recent months have been holding up well in ever more difficult circumstances:

Digging a little deeper, and taking a look at the year on year chart for 2007, we can see there has been a very pronounced rate of increase over 2006, and in particular we might like to note how October's pace has in fact bounced back from the slowdown which was noted in September:

But it is when we come to the actual export shares that things get really interesting, since what we find when we come to look at the composition of Japanese exports is that exports to the US actually declined year on year in October, while exports to China and the EU have continued to accelerate (as they say, to some extent exchange rates do matter) and indeed Japan is even now close to closing the trade deficit it has been running with China.

And this perhaps explains why a Japan analyst like Morgan Stanley's Takehiro Sato has been talking about "decoupling" in the Japan context, not because Japan's economy is being driven finally by internal demand (far from it), but because the direction of exports is changing, and in particular Japan is now much more sensitive to growth in Europe and some emerging economies (Asean, China) than it is to the ups and downs which occur in the US. (For a fuller explanation of the entire Japan situation see our Japan Economy Watch blog, and most recently this post from Claus).

Decoupling or Recoupling?

Returning for a moment to semantic issues, it may well worth noting that there appear to be two bipolar couplets in circulation at the present time . On the one hand we have the "recoupling-decoupling" contrast and on the other the "hard landing-soft landing" one. Now this is neither the time nor the place to enter into an examination of what it is that those who use the expression "hard landing" in the US economy context might mean when they do so (other than to say that there seem to be interpretations around to suit all palates, but that I personally do not consider that a mere recession would constitute a sufficient condition to justify use of the expression "hard landing", and while I think the odds of garden variety recessions in the United States economy and elsewhere in the developed world in 2008 are over 50%, most of this will be a far cry from what I would be willing to term a hard landing).

Instead I would like to focus here on thinking about what we mean when we talk about "decoupling-recoupling", and I have chosen the Japan case to get us started, since I think it offers and easy way in.

Basically there seem to be two versions of the "decoupling" thesis knocking about. The first of these (which is now very definitely going out of fashion very fast) was based on the idea that the global economy was finally decoupling itself from the US one due to the fact that key global engines among the G7-type economies - and in particular Germany and Japan (and following in both cases lengthy periods of structural reforms) - were finally coming out of a long period of sub-par economic growth and achieving "home grown", domestic-demand-driven, sustainable recoveries in a way which would enable them to take more of the global strain during what was perceived as being a period of inevitable US "correction".

Claus and I never actually bought this story, in particular we didn't buy it since we never thought that domestic demand would recover in countries like Germany, Japan and Italy in the way in which many were expecting, essentially for age-related demographic reasons. I think history has, more or less, borne us out on that one.

But there is another sense of "decoupling" (which is the one Claus and I prefer to call "recoupling", although this is not recoupling in the way in which Nouriel Roubini uses the expression, which seems to refer to a renewed coupling to a US economy which is on its way down) and this is to do with the way in which certain emerging market economies (the EU 10, Ukraine, Russia, China, India, Turkey, Brazil, Argentina, Chile etc) are now accounting for a very substantial proportion of global growth (Claus and I have yet to do the detailed numbers on this, but suffice it to say that India, China and Russia alone will account for over 30 % of the growth in the global economy in 2007). This is a far cry from the central role which the US economy was playing in global growth in the late 1990s. So in this sense something fundamental has changed, and this is what Claus and I are calling "recoupling".

This situation can be observed quite clearly in the two charts which follow, which are based on calculations made from data available in the IMF October 2007 World Economic Outlook database. Now, as can be seen in the first chart the weight of the US economy in the entire global economy has been declining since 2001 (and that of Japan since the early 1990s). At the same time - and again particularly since 2001 - the weight of the soc called BRIC economies (Brazil, Russia, China and India) has been rising steadily. This is just one example - and a very crude one at that - of why Claus and I consider that demographics is so important, since it is precisely the population volume of the BRIC countries (and the fact that they start their development process from a very low base, ie they were allowed to become very poor comparatively, for whatever reason) that makes this transformation so significant.

Again, if we come to look at shares in world GDP growth we can see the steadily rising importance of these economies in recent years and the significantly weaker role of "home grown" US growth. The impact of the collapse of the Tech stocks/internet boom in 2001 is clear enough in the chart, as is the fact that everyone went down at the same time, and this is the old form of "coupling" wherein the US economy due, to its size (and hence specific weight) and "above-par" growth potential played a key role, and, as can be seen, when the US went down, then god save the rest. The present debate is really about what will happen if the rising dollar cost of oil and the ongoing difficulties in the financial sector caused by the sub-prime problem leads the US into recession in 2008. Will everyone else follow this time? In 1999 the US economy represented 30.91% of world GDP, and in 2007 this percentage will be down to 22.4% (on my calculations based on the forceast made by the IMF in October 2007). In 200 the US economy accounted for a staggering 40.71% of global growth, and by 2007 this share is expected to be down to 6.43%. So there are prima-facie reasons for thinking that this time round the impact of any US slowdown will not be as acutely felt in some parts of the globe as was the case in 2000, but which parts of the globe will be more affected and which less so?

The Global Economy, Who is Linked to Who?

What we have on our hands then is another type of "recoupling" (a very fertile metaphor this one, I think), and one which analysts like Richard Katz are missing, I feel, when they continue to put considerable emphasis on the "round tripping" component in those Japanese exports which are initially sent to the Asian Tigers and China (in the sense that many of these are assumed to be components for assembly and subsequent re-export) since I think we are increasingly seeing an element of autonomous local-consumption-driven demand in places like S Korea and now indeed inside China itself. Komatsu's recent decision to build a new factory inside Japan wasn't primarily driven by anticipated demand for earth moving equipment in the US economy it seems to me.

Komatsu Ltd., the world's second- largest maker of earth-moving equipment, said it will spend 5.3 billion yen ($48 million) to build a factory in central Japan to make excavators to meet rising overseas demand.

The company will spend the money on acquiring 104,500 square meters (26 acres) of land near Kanazawa port, and on construction costs of the factory, the Tokyo-based company said today in faxed statement. The plant, which will build excavators weighing 400 tons, will start production in August 2009 and will have a capacity to make 30 units annually.

Komatsu's investment follows domestic rival Hitachi Construction Machinery Co.'s move in increasing production capacity for giant excavators used in mining projects as demand expands in Indonesia, China and Russia. In January, Komatsu constructed its first domestic factory in 13 years to make large- size wheel loaders and dump trucks used in mining.

And looking at Japan exports in depth I really don't really see this indirect US dependence effect. Europe, China and Asean are all now very important for Japan, in their own right, and quite apart from the US cyclical connection, and obviously even in the event of a US recession US exports will not simply disappear from the map, they will simply reduce slightly rather than growing, but then they are already reducing and Japan is - at the time of writing - still maintaining healthy export growth. And then, of course, there will be India. So in this sense the declining share of the US economy in global growth does have a direct interpretation, since it means a decling dependence of export driven economies like Germany and Japan on extra spending on the part of the US consumer.

At the end of the day, however, I think I do need to add a kind of dollar-effect "caveat emptor" here. What we are talking about is a declining share of the US in the global economy in dollar value terms, and this decline is, by-and-large, being produced not by a large scale reduction in the rate of domestic GDP growth in the US, but by a relative decline in the value of the dollar, and as a knock-on consequence, a relative decline in the net worth of USA Inc. But be careful, since if the US economy was never worth the very high value that it acquired earlier due to the very high dollar exchange rates, it may well not be worth as little as future valuations may put on it should the dollar continue its decline.

So what I am trying to do here is distinguish between two things, the level of interdendence of the advanced economies on one another, and the key factors driving the exceptional growth we are currently seeing in the global economy. At the end of the 1990s this growth was driven by exceptional performance in the US, and now it is driven by exceptional - and one-off - catch-up growth in some huge developing economies. So the times have changed, and with them the risks of contagion from any locally based US problems. At the end of the day, however, Nouriel Roubini certainly is right in the sense that most of the EU isn't decoupled in any strong sense from cyclical movements in the US (or shielded from the impact on local property markets of the current global credit crunch), but I don't feel he is really adequately addressing the extent to which the global role of the US itself is reducing.

Two processes seem to me to be underpinning this decline. Firstly what for want of a better expression could be called the rise of the giant pandas (or pehaps the "bears", "pandas" and "elephants" following the "tigers" and the "lynxes", but well, I don't know, perhaps we are now gradually talking about all the animals imagineable across the entire human "zoo"), and secondly there is the ongoing slide in the dollar. Of course indirectly - and via the intermediary of a temporary upward structural shift in the euro - the former is really producing the latter as the already battered Bretton Woods II architecture gets steadily ground down. Both the US global GDP growth share and its absolute value share are now on the slide, and with that, logically, the level of direct coupling between the global business cycle and the US one. Indeed, with domestic US consumption taking a hit from rising energy costs and the internal credit crunch, it may in fact be the case that a US economy in need of exports for growth on a greater scale than hitherto is more closely coupled to the rest of the world than it was and in this sense some of the arrows on all our flow charts may have changed their direction.

Returning then to where we started, Claus informs us that he is "thinking a lot at the moment on this whole shift in global liquidity and capital flows and where this is all going", and he is surely not the only one. Is the move out of the dollar which we have been seeing all this year simply a temporary, cyclical, phenomen, or is there now a deeper longer term structural process underway? Many excellent conventional currency analysts, like for example Morgan Stanley's Stephen Jen, continue to assume that the dollar is now near its bottom. This may or may not be the case, I am really not sure. Normally I would go with Jen, if this process is simply a cyclical one then it would be reasonable to assume that the euro cannot rise much further without placing unbearable strain on the export dependent engines of the eurozone economy (indeed arguably it has already done so, and Angela Merkel this weekend added her name to the list of those voicing concern). But what if the move into the euro is but a stepping stone, and what if the ultimate global reserve currencies are the yuan and the rupee? If size is what counts - and the transition in the interwar years of the last century from the pound sterling to the dollar suggests that it does - then this would seem to be the logical end state of this transformation, a sort of Bretton Woods III with a much more diversified set of currencies in central bank reserves, and among these not the least significant being the newly developed economy currencies. And don't lets forget that if the central banks are now more than ever concerned about maintaining and even increasing the value of all those reserves they hold, then it makes much more sense to hold more of the weighting in currencies which are likely to rise in relative value than in those which are likely to fall over - say - a 10 to 20 year window.

So a large scale sea change would seem to be underway, and the only real question is whether a point of no return has been reached this time round, or whether the tide will again fall back (and the dollar recover some of its lost ground), before the water finally comes washing back in one unstoppable flood.

And decision time on this is surely not far away now, since the eurozone is in particular difficulty this time round given that both the export dependent parts of the zone (namely Germany and Italy, but increasingly I imagine smaller players like Finland and Austria) are now struggling with the high value of the euro, while at the same time the property-boom-driven members (Spain, Greece, Ireland) are being weighed down in the ever-tightening grip of the credit crunch. And again, as Claus and I have been arguing time and time again (and here), all of this does then leave the eurozone (via the Germany/Austria/Italy corridor) incredibly exposed to any financial and real economy problems which may be (or in fact arguably are) on the point of breaking out in Eastern Europe. It is the "coupling" with the emerging economies in Eastern Europe (which are surely much more vulnerable and exposed at the moment than are the mainstream BRIC economies and other developing powerhouses like Turkey, or even Argentina).

This is why I use the expression "great transformation" in the title to this post, since this is what we seem to be witnessing. Hitler's Wermacht general's may well have proved incapable of "breaking out" of the ring of encirclement which the Russian army had placed around them in Stalingrad, but the BRIC economies really now do seem to have it within their grasp to make what would really be a historic "panda-" rather than panzer-lead breakout from the economic encirclement and poverty in which they have been trapped for so many decades now.

Basically in both the above-mentioned cases demography does seem to be playing quite a central role, since demographically informed economic theory can help us understand both why some (though not all, ie Russia is different) of the BRIC economies are finally in a position to "break out" (the demographic dividend) and why those developed economies whose populations have median ages over 40 ( a select group whose number is little by little becoming a larger and larger proportion of the G23 economies - although notably this group does NOT include the US, the UK or France) are not able to generate sufficient domestic demand growth to take over the reigns from a weakened US economy and actually act as structural drivers of the global economy, but are instead destined to ride on the backs of those economies which may be considered to form part of the new group of emerging economy growth leaders (in the case of Japan China and emerging Asia, and in the case of Germany Central and Eastern Europe).

As I say demography helps us understand both these phenomenon (and possibly even how they are interconnected) since the key factor in explaining why it is the above mentioned group of emerging economies who are leading the charge (and not another group, always stripping out, of course, those commodity driven economies which are themselves riding on the back of the global growth boom) is the attainment of near- or below- replacement fertility and with this the possibility of a "normal" (which is not we can now see "normal" as understood by neo classical economics) expansion wherein domestic demand begins to achieve the status of an autonomous and independent driver of growth. This process is also known as the demographic dividend and I have recently explained in detail how this is working out in the case of Argentina (and here in the case of Turkey).

So we do have some sort of "recoupling" process at work out there, but it is not clear at this point just how sustainable this is. China's economy is, for example (and is extremely well known), extraordinarily dependent on exports, and even if some of the weight of these exports can be shifted towards Europe, it is not clear that China can resist a slowdown in both Europe and the US, and clearly it is not clear that Japan can resist a slowdown in the US, Europe and China etc etc.

So even if the global economy is now recoupled when compared with the position we had at the end of the 1990s this does not mean that it has become "uncoupled", indeed as I have been arguing repeatedly globalisation now means that the global economy as a whole is more tightly "coupled" now than it has ever been.

There is another detail which I would wish to draw attention to here before signing off, and that is that not all the emerging economies are alike. I have already suggested that methodologically it may well be necesssary to strip out the high fertility oil exporters (Nigeria, the gulf states, Venezuela etc) which for their own reasons may well be unable to generate stable autonomous local-demand-driven growth, but we also need to think about the cases of those emerging societies which have now had below replacement fertility for two decades or more. This would be principally the whole of Eastern Europe (including Russia) and of course China (with the one child policy). What is not clear in these cases is where they are going to get the labour supply from as we move forward to fuel both catch up growth in labour intensive sectors like construction and some kinds of manufacturing industry (the lower value added components) and the new human capital in sufficient quantities to make possible the rapid transition from one sector to another which is necessary to achieve the potential high rates of productivity growth.

This is why what has been happening in the Baltics and Bulgaria (where growing labour shortages coupled with construction booms are sending inflation rapidly through the roof) seems to us to be so important. The Baltic economies may - to use the words of the Economist - be "pipsqueaks", but they are a very useful and important laboratory. What, we need to ask ourselves, will happen if the "Balitic syndrome" spreads to Romania, and then to Poland? And what if Russia then follows in a domino-like chain? And what, oh woe of woes, will happen if this process (really I would argue when, rather than if) reaches China (and just how far are we away from this possibility?). So with these rather preocuppying thoughts I will leave you on this rather grey and wintry day here in Barcelona. Recoupling is taking place, but which of the chain links will hold, and which will break. Aha, if only we knew!