AFTER spending last week in Davos, talking to politicians, officials and corporate chieftains, what did I learn about the outlook for the world economy? Or at least about the views of movers and shakers on the biggest economic issues of the year ahead? Let me begin with the good news: US economic growth. Apart from the professional economists, everybody at Davos could see that the US economy is doing fine. Business confidence is palpably improving and, as Carly Fiorina, the chief executive of Hewlett Packard, noted in her summary of US industrial conditions, the focus of corporate strategy and investment is shifting clearly from cost reduction to capacity growth.
President Bush will take no significant steps that might weaken this self-sustaining recovery. Nobody seriously believes that the Bush Administration will either raise taxes or substantially cut government spending. The other side of this coin is that almost everyone — this time, including the economic theorists and central bankers — expects the dollar to continue falling.
The reason for this consensus (which I personally dissent from) is the universal agreement that the Bush Administration will take no serious action to cut America’s “twin deficits”. With tax increases and major spending cuts off the agenda, pious speeches and bullish economic projections would remain the favoured instruments of currency management and deficit control. The only thing that could force US economic policy to become less expansionary would be an upsurge of inflation. But this is a risk that doesn’t seem to bother anybody except me (and I have been consistently wrong on this issue for the past two years).
But if “something must be done” about the global economic imbalances where should we look for major policy changes this year? One place not to look is China, at least according to officials and businessmen who came to Davos from Beijing and Shanghai. The Chinese contingent were more or less unanimous in predicting no revaluation or major change in currency regime this year. More intriguing, since government officials always deny currency reforms before they occur, were the explanations offered. It seems that the Chinese authorities really would like to move to a more flexible exchange rate in the future, probably in 2006. But the probability of this happening should be gauged by an indicator that the market has totally misunderstood — external pressure.
Politically, it is well known that the Chinese want to avoid any change in their currency regime under overt foreign pressure. But even more significant is their attitude to financial pressure. The Chinese see it as very risky to abandon the exchange-rate peg during a period of financial turbulence. If China did this, the yuan could overshoot on the upside, drawing in unwanted hot money and exacerbating capital spending and property bubbles.
But there is also the opposite danger. The yuan could collapse suddenly if speculators became disillusioned with the revaluation story, and this would expose the Chinese economy to inflation and solvency risks. The Chinese see no reason to face these uncertainties, given that their current account surplus is quite modest and their domestic inflation is now under control again, after last summer’s food price spike. The implication is that any time we see yuan forward rates rising on the basis of market revaluation rumours, we can be sure that the Chinese authorities will do no such thing. Only when the markets are calm and capital flows are more or less balanced will the Chinese even consider a currency move.
Does this mean that the yuan will be pegged to the dollar forever? Not according to Chinese sources. China recognises the long-term advantages of running an autonomous monetary policy and knows that a floating currency will be needed before its integration into the global economy is complete. At some point, therefore, it will probably move from the present fixed system to some kind of managed float. The optimal timing for the first such changes would be next year, when the domestic banking system must be opened to limited foreign competition under China’s WTO agreement.
If China is not going to adjust its currency, what about Japan? The Japanese at Davos were fairly subdued about the short-term outlook for their economy, pointing to an inventory correction, especially in electronics, and a slight tightening of fiscal policy, which may weigh on the economy for another three to six months. Looking further ahead, however, there was considerable optimism. Macroeconomic policy is stable, corporate cashflows are strong and banks are in far better shape than they have been for over a decade. In addition, the technology cycle is seen as moving in Japan’s favour, as explained in my article in December when I returned from my trip to Japan. On balance, therefore, steady 2 per cent growth, accompanied by a gradual reduction in unemployment and improvement in consumption seems on the cards.
As for the currency, the Japanese will continue to resist “excessive” and rapid appreciation, but there seems to be a growing acceptance that the yen may have to strengthen, especially against the euro, in the year ahead.
What, then, is happening in Europe? And what is being done to protect the European economy from bearing all the risks of a global adjustment to the US imbalances? The short answer to both questions is “nothing much”.
The European economy will be lucky to equal last year’s pathetic 1.8 per cent growth rate and stagnant unemployment. The European Central Bank and even the German business community still seem remarkably complacent about the threat they face from the strong euro. European businesses are responding to the strength of the euro by shifting their production to low-cost areas such as Iberia and Eastern Europe, or moving it altogether out of the EU. But this diversion of investment outside Europe is undermining employment, investment and consumer confidence in the core European economies. As a result, the main economic impact of euro appreciation is not seen in falling exports, but in weak investment, rising unemployment and stagnant consumer demand.
This displacement of economic pain from exports to investment and consumption may explain the surprising tolerance of the overvalued euro among European businessmen.
For companies, the strong euro is another excuse to cut back their operations in core-Europe and increase their “natural hedging” by investing in Asia and the US. As one senior German executive put it rather proudly: “Well-managed companies should be able to deal with currency changes, provided they are not too fast. The long-term solution is to increase our natural hedging so that our production is spread around the world to suit the structure of our global sales.”
Yet this “natural hedging” is demolition of traditional export-oriented industrial structures, for which the Anglo-Saxon economic model has long been denounced.
