September 27, 2006
By Jephraim P Gundzik
Asia Times
The risk of economic recession in the United States in 2007 is increasing rapidly. Rather than overly tight monetary policy at the Federal Reserve, the declining value of US homes is undermining personal consumption expenditure. The decline in home values is likely to accelerate next year as housing oversupply is met by increasingly weaker demand for new homes.
Much weaker growth of personal consumption expenditure in the US could slow China's real gross domestic product (GDP) growth to about 5% next year. However, China's ability to muster enormous resources to contain any economic weakness argues that a reversal in global commodity prices is unlikely.
US RECESSION IN THE MAKING
In the first half of 2006, real GDP in the US expanded at an annual rate of 4.3%. At the same time, real personal consumption expenditure, which accounts for about 70% of total GDP, expanded at an annual rate of 3.7%. Though both real GDP and real personal consumption expenditure remained quite strong in the first half of this year, the US economy slowed sharply between the first and second quarters. This slowdown was led by weakening personal consumption expenditure, which declined from an annual rate of 4.8% in the first quarter of 2006 to 2.8% in the second quarter.
Apart from hurricane-induced weakness in the fourth quarter of 2005, the last time real personal consumption expenditure in the US fell below 2.7% was in the fourth quarter of 2003. With the national unemployment rate declining and real wage growth accelerating, overly tight monetary policy in the US has been generally blamed for the slowdown in personal consumption. However, official interest rates remain low by historical standards and real interest rates are negative, suggesting that monetary policy continues to be quite loose.
Furthermore, both core consumer price inflation and the core personal consumption expenditure deflator lurched higher in the first half of 2006, approaching 3%. In simple terms, inflation in the US would not be increasing if monetary policy were overly tight. Finally, despite the clear acceleration of inflation, policymakers at the US Federal Reserve have become more concerned with slowing domestic economic growth than rising inflation, as evidenced by the Fed's decision to keep official interest rates steady at its meetings in August and September.
With monetary policy still very accommodative and likely to remain so until after crucial mid-term US elections in November, the primary factor undermining personal consumption expenditure in the second quarter was much weaker gains in home values. According to the US Office of Federal Housing Enterprise Oversight, the quarter-on-quarter deceleration of home-value gains between the first and second quarters of 2006 marked the weakest gain in home values since records began in 1975. Increasingly unaffordable house prices and rapidly rising inventories of unsold homes capped home-price gains in the second quarter of 2006 and are likely to produce contracting US home prices in 2007.
The last time US home values posted an annual contraction was more than 70 years ago. According to the US Department of Commerce, inventories of unsold homes reached an 11-year high this July. Over the past year, these inventories increased by more than 20%. The Department of Commerce also reported that home sales declined 13% since July 2005. Though these statistics are fraught with sampling errors and subject to large revisions, the trend over the past 12 months has shown home inventories rising rapidly and home-sales growth slowing sharply. Industry experts believe these statistics are underestimating the growth of unsold home inventories and the contraction of home sales.
Growing inventories of unsold homes - a product of overly easy US monetary policy over the past several years - are very likely to lead to contracting home values in 2007. Since 2001, rapidly rising home values have fueled US personal consumption expenditure by increasing household income via cash-out mortgage refinancing. According to statistics produced by Freddie Mac (the Federal Home Loan Mortgage Corp), one of America's largest mortgage lenders, cash-out mortgage refinancing accounted for about 50% of all mortgage refinancing between 2001 and 2004.
In 2005, cash-out mortgage refinancing accounted for 73% of all mortgage refinancing. In the first half of 2006, cash-out refinancing accounted for a staggering 87% of all refinancing. If US home values contract in 2007, household income will also contract. This could lead to much weaker or even contracting real growth of personal consumption expenditure in the US. Lower official interest rates are unlikely to reverse the fall in home values because the overhanging inventory of unsold homes is so large. Home prices must decline to clear this inventory.
US CONSUMERS DRIVE CHINA'S GROWTH
After a lull spanning from 1998 to 2001, real GDP growth in China accelerated to an average annual rate of about 10% between 2002 and 2005 - a period corresponding with booming growth of personal consumption expenditure in the US. This, in addition to an official upward adjustment in output in 2004, made China's economy the fourth-largest in the world at the end of 2005. Surging output has not been matched by surging private consumption growth. In fact, the real growth of private consumption in China has remained well below the real growth of GDP since mid-1990s. As a result, the ratio of private consumption to GDP has declined steadily, reaching a record low of 40% in 2005.
Low wages and China's high rate of unemployment have contained the growth of private consumption. According to official statistics, real wage growth in China was exceptionally strong between 2001 and 2005, at an average annual rate of about 11%. Strong real wage growth has been exclusively an urban phenomenon benefiting registered workers. Real wage growth in rural China, where more than 60% of the population resides, has been much weaker and is the primary reason that the income disparity between urban and rural China has widened over the past 15 years.
Moreover, real wages for rural migrant workers in urban areas, which constitute as much as 60% of the urban workforce, have also grown considerably slower than real wages for registered urban workers. Though the government has recognized the equal rights of migrant workers, they face significant wage and benefit discrimination. In addition to being underpaid and under-benefited, migrant workers also face non-payment of wages by employers. Like official wage statistics, official unemployment statistics, which indicate China's unemployment rate has been about 4% since 2001, do not reflect actual labor conditions in China.
Because rural migrant workers generally receive no social benefits, they are unable to register as unemployed. This excludes more than one-half of the urban workforce from China's urban unemployment data. Urban unemployment would be between 6% and 8% higher if unemployed migrant workers were included in unemployment data. Adding unemployment in rural areas would push China's nationwide unemployment rate up by 10-15 percentage points.
Rather than private consumption, external demand, originating primarily from US consumers, drives economic growth in China. Between 2001 and 2005, China's annual average rate of export growth was 25%. Exports grew by 35% in 2004 and 28% in 2005. The very strong nominal growth of exports accounted for about 2% of real GDP growth in 2004 and about 4% in 2005. In the first half of 2006, net exports accounted for about 2.5% of real GDP growth.
Including goods re-exported from other countries and Hong Kong, China's exports to the US account for about 50% of total exports. Thus export growth is largely determined by the growth of US demand. Because almost all of China's exports are consumer goods, personal consumption demand in the US drives China's export growth. In addition to exports, external demand also plays a key role in the growth of investment in China.
External demand dictates the growth of investment in manufacturing capacity in the export sector. External demand also influences China's investment in domestic infrastructure, such as power generation, ports, and road and rail transport, which is critical to expanding manufacturing and export capacity. Finally, external demand also influences China's domestic investment in real estate, which is necessary in securing locations for new manufacturing and power plants, as well as housing for employees.
External demand directly and indirectly drives about 65% of all domestic investment in China. As with exports, robust demand in the US arising from strong real growth of personal consumption expenditure has produced astounding investment growth in China, which averaged over 21% annually between 2001 and 2005. Rapid real growth of personal consumption expenditure in the US, which averaged over 3% annually between 2001 and 2005, accounted for almost one-half of China's economic growth over the same period.
HOW CHINA CAN CUSHION THE BLOW
A sharp slowdown or contraction of real personal consumption expenditure growth in the US in 2007 will lead to much slower economic growth in China. China's export growth could be flat or even negative while investment growth could be cut in half. In addition, rationalization in China's export sector could lead to much higher urban unemployment, especially among China's migrant workforce. This could heighten already increasing social instability, further undermining private consumption growth and economic growth in China.
A US economic downturn next year will undoubtedly have a strong negative impact on China's economy. However, this impact could be mitigated by the government's marshaling of China's considerable resources, including the country's nearly US$1 trillion of foreign exchange reserves. In addition to these reserves, China has enormous fiscal resources that it can employ to boost the economy either directly or indirectly through the country's massive state-owned banking system - not exactly music to the ears of foreign investors who have poured money into China's banks.
Though dependent on consumer demand in the United States, China's economy could easily withstand a US economic recession because of its vast resources and its ability to extend these resources through the still-dominant state-owned economic structures. As a result, slowing US economic growth does not imply a significant reversal in global commodity prices, especially oil prices. Even if economic growth in China slows to 5% in 2007, demand for energy and crude oil in China will remain quite strong.
Even more intriguing, economic recession in the US and slower economic growth in China could speed the reorientation of China's economy away from external-demand-driven growth toward private-consumption-driven growth.
Jephraim P Gundzik is president of Condor Advisers. Condor Advisers provides investment risk analysis to individuals and institutions worldwide. For more information, please visit www.condoradvisers.com.
