Fiscal cliff looms large for all of us

By Ian Fraser

Published: Sunday Herald

Date: November 11th, 2012

Stability of leadership has been confirmed in the US and China – now they need stability in their economies, or the world will suffer. By Ian Fraser

Today’s global economy is like a drunk meandering his way across a busy street after a year-long binge in the wee small hours of a Sunday morning. United States President Barack Obama may come to regret taking on the role of the policeman responsible for his safety.

No-one quite knows whether this proverbial derelict will make it to the other side intact, reaching the desired destination of sustainable economic growth. There is a high risk that he will fall flat on his face or even be mown down by an unforeseen disaster, akin to the arrival of a passing boy racer.

The biggest problem in the president’s economic in-tray – one weighing down the entire global economy – is the astonishing debt burdens accumulated by most developed nations at a sovereign, corporate and individual level during the years building up to the global crash, as a result of their addiction to debt-fuelled growth.

This problem goes hand in hand with a dysfunctional banking sector that is reluctant to lend.

“Things would have been no different if Romney had got in,” says Bruce Stout, senior investment manager at Aberdeen Asset Management. “Being president of America is a poisoned chalice, isn’t it? Who’s going to wave a magic wand on the debt? The ‘fiscal cliff’ is there whoever is in power.

“The problem is the sheer size of the US debt. Arithmetically, the Americans have got to the stage where they can hardly pay the interest, let alone repay the capital. That’s dangerous.”

Beyond US shores, Obama also needs to be worried that the eurozone could break up or implode. Mario Draghi, president of the European Central Bank, gave the currency bloc some breathing space in the summer when he said the ECB stood ready to fire its bond-buying “bazooka” to help ease borrowing costs in crisis-hit countries, (the so called “Draghi Put”). However, Draghi has also admitted that stronger eurozone members are no longer insulated from the economic and fiscal woes facing the “Club Med” states. Last week, he said: “The latest data suggest that these developments are now starting to affect the German economy.”

Also last week, sovereign debt strategist Nicholas Spiro said: “There is still no eurozone banking union or fiscal union worth the name, and Europe is going to lurch from one crisis to the next until there is. We’re getting very close to the political snapping-point in Spain.”

Stout warned that countries including Greece, Portugal and Spain are at risk of returning to dictatorship, saying: “Austerity when combined with democracy is unsustainable, and the only way to make the two compatible is to stretch out the austerity as they have done in Japan.”

Another danger facing the global economy is that the post-crisis palliative favoured by most heavily indebted Western governments and central bankers – massive money printing to fund the purchase of government bonds for which external demand is thin – may lead to some form of economic collapse.

“That is economic vandalism of the highest order. That’s what the Weimar Republic tried to do in the 1920s. All you get is currency debasement eventually,” said Stout.

Stout said Obama’s first administration was forced to resort to this because China has lost its appetite and its ability to continue propping up American profligacy with the purchase of massive quantities of US government debt.

“The US has effectively become the only funder of its own deficit. That in itself is extremely dangerous,” said Stout.

Money printing by developed nations is also fuelling inflation in the emerging markets, with Brazilian president Dilma Rousseff warning it is sparking beggar-thy-neighbour style devaluations across the globe. She said in a recent newspaper interview: “Monetary expansionist policies that lead to currency depreciation are policies that create asymmetries in trade relations – serious asymmetries.”

And these economic dangers must take their place alongside more traditional kinds: the scope for armed conflict over a group of uninhabited islands in between Japan and China, Iran’s nuclear programme and other post-Arab Spring Middle Eastern and North Africa hotspots.

Against this volatile backdrop, economic commentators breathed a sigh of relief when the world’s two largest economies, China and the US, opted for continuity of leadership last week.

After a closely-fought campaign against Republican nominee Mitt Romney, Obama returned to the White House last Wednesday.

Romney had pledged to declare China “a currency manipulator” on the first day of his presidency. It may have just been campaign rhetoric, but there was a real risk that such antagonism would have sparked a trade war between the world’s two largest economies.

However, Obama’s re-election was met with a massive sell-off on Wall Street. On Wednesday, the Dow Jones Industrial Average shed 313 points, or 2.4%, to close at 12,933 – its biggest one-day fall this year. This was fuelled by fears that Obama would return to money printing via quantitative easing, something Romney had pledged to stop.

Peter O’Flanagan, head of foreign-exchange trading at Clear Currency, said: “We now expect more of the same – ie, loose monetary policy to help boost the US economy.”

Or it may have been that investors has simply turned their attention to the “fiscal cliff”. This is a series of automatic tax rises and spending cuts worth $600 billion – 4% of US GDP – that kick in on January 1, 2013 unless Congress agrees on a deficit reduction programme. This challenge remains exactly the same irrespective of the occupant of the White House.

To avoid falling off the “cliff”, Obama must hammer out a deal on tax rises and spending cuts with the Republican-dominated House of Representatives, and frenetic horse trading is likely to intensify as the deadline approaches.

If an agreement cannot be reached, then the US will almost certainly fall back into recession, with dire repercussions for the global economy. Stephen Boyle, chief economist at RBS, said: “Both Democrats and Republicans will have to sacrifice some sacred cows.”

In China too there are signs of continuity and coherence at the political level, with outgoing president Hu Jintao and premier Wen Jiabao handing over the country’s reins to Li Keqiang and Xi Jinping.

Li (57) and Xi (59) are seen as unlikely to deviate too far from the generally successful state capitalism model pursued by their predecessors. The new regime’s biggest challenge will be gradually slow the pace of economic growth to more sustainable levels without causing social unrest. They are seen as very unlikely to attempt to introduce more democracy to the People’s Republic.

A number of prominent hedge fund managers, including Jim Chanos, founder and president of Kynikos Associates, and Scot Hugh Hendry, founder of Eclectica Asset Management, have been predicting a property crash in China and a possible currency crisis. Hendry recently told a conference that he was: “Very fearful of the events that may befall the Chinese.”

However, AAM’s Stout rubbished such talk. He said: “There’s no need to worry about China. They have lots of savings. They don’t have democracy, they have a one-party system, and they have a different type of economic model that allocates capital in a completely different way to the way to the – supposedly – free market economies. There’s absolutely no reason to be worried about China. If their banking system were to go bust, they’d nationalise it overnight.

“There’s no way China can continue to grow at 10% per annum. It is going to have to grow at 3% to 5% if there’s going to be sustainable non-inflationary growth. Its leadership realises this.”

Economic commentator Satyajit Das has compared healthy emerging market economies such as Malaysia to “corks” being tossed about in a gigantic economic ocean.

Stout acknowledged that emerging markets are never going be fully insulated from global economic uncertainties. However, he cited counties including Malaysia, alongside Mexico, Indonesia and Thailand as ones that are performing well at the moment, commenting: “All have decent growth of 4%-6%.”

Sam Vecht, investment manager, of BlackRock Frontiers investment trust, said countries such as Bangladesh and Vietnam have “long-term growth drivers”. As production costs soar elsewhere in Asia, Vecht said these countries are becoming more competitive.

He said: “Taiwanese manufacturers are looking to shift production to countries like Vietnam where the minimum wage [in Hanoi] is $95 a month.” He added that in China’s cheapest province for manufacturing, wages are about $137 per month.

But Stout concluded that a key difference between developed and less developed nations is that the latter still have policy options open to them. He said the problems afflicting countries like Britain are pretty intractable and could go on for at least another two decades.

He said: “The problem is that developed countries don’t have any policy options left – either monetary nor fiscal. Interest rates are at 0.5%, so there’s no room for manoeuvre there, and there are no options on the fiscal side because we’ve got the biggest deficit we have ever had. People like George Osborne just don’t know what to do, and I’ve yet to see any evidence that printing money will solve anything.”

Stout said that, by contrast, emerging economies in Asia and Latin America “still have orthodox policy options open to them: they still have fiscal policy options – they can raise and lower tax, they can alter spending plans, whatever they want – and they have monetary policy options open to them – they can raise rates lower rates. Developed nations including the US and UK have no such options.”

Amid this sea of economic uncertainty, the fact the world has lost its ideological bearings has not helped. The erstwhile “neoclassical” school of economics is increasingly discredited.

“The crisis is not only a crisis in the economy, but also a crisis in economics,” said Nobel Prize-winning economist Professor Joseph Stiglitz last week. “Standard models have contributed to policies that led to the crisis and have provided us with little guidance on how to respond.”

China looks to the future

At the Communist Party’s 18th National Congress, a  lavish, stage-managed affair in the Tiananmen Square’s Great Hall of the People last week, the handover of power to Communist functionaries Li Keqiang and Xi Jinping was rubber-stamped by 2,600 stony-faced delegates.

In a 90-minute speech the country’s outgoing leader Hu Jintao outlined the achievements of his administration and the challenges facing his successors.

Hu said the biggest tasks ahead for Li and Xi face include ironing out inequalities of wealth, promoting growth through consumption, tackling environmental problems and reducing energy use. He said all could be addressed through a “scientific outlook on development.”

China’s economic growth rate has slowed to its lowest rate since 1999, with economists predicting it will slow to 7.7% this year from the 9.3% seen in 2011, partly because rising wages are making things in China less competitive. Hu said the country needs “a new growth model” and said the new regime would “work hard to improve the quality and efficiency of the economy,” and “continue to deepen our economic system reform and stick to the policy of expanding domestic demand.”

Hu said: “On the basis of making China’s development much more balanced, coordinated, and sustainable, we should double 2010 GDP and per capita income for both urban and rural residents by 2020.” China’s income per capita remains stubbornly low. It is 21,810 Yuan (£2,186) for City dwellers and 6977 Yuan (£700) in rural areas. Hu said China aimed to be “a moderately prosperous society” by 2020.

In the wake of the Bo Xilai corruption scandal and allegations of looting by China’s outgoing premier Wen, Hu said the Communist Party was firmly committed to “combating corruption and promoting political integrity” adding that any failure to properly tackle this could prove “fatal” for the party, potentially risking “the collapse of the party and the fall of the state.”

This article was first published in the Sunday Herald on November 11th, 2012

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