A Wakeup Call To Us

A Wake-Up Call for the US and China: Stress Testing a Symbiotic Relationship Stephen S. Roach Chairman Morgan Stanley As Presented before The US-China Economic and Security Review Commission of the US Congress Hearing on “China’s Role in the Origins of and Response to the Global Recession” February 17, 2009 Washington, DC A Wake-Up Call for the US and China: Stress Testing a Symbiotic Relationship Stephen S. Roach Since the turn of the century, no two nations have been more important in driving the global economy than the United States and China. The American consumer has been the dominant force on the demand side of the global economy, whereas the Chinese producer has been the most powerful force on the supply side. Few argued with the payback. Over the four and half years ending in mid-2007, world GDP growth averaged nearly 5% – the strongest and most sustained boom in the global economy since the early 1970s. But now both engines are sputtering, with ominous consequences for a world in its worst crisis since the 1930s. This poses great challenges for each nation, as well as to the bilateral relationship between them. There is hope but it comes with a big “if” – if China and the United States pull together in forging common solutions. However, if these two nations end up at odds with one another, they will both suffer – with dire consequences for the rest of a crisis-torn global economy. The stakes are enormous. There is no margin for error. A World in Crisis No nation has been spared the impacts of this wrenching financial crisis and recession. While America’s so-called subprime crisis may have been the spark that ignited the inferno, every region in this globalized world is now faltering in lock-step fashion. That includes China – long the most resilient economy in an otherwise weakened world. And it includes the rest of an increasingly Chinacentric Asia, where all economies either have tumbled into outright recession or are slowing sharply. Ten years after the Asian financial crisis wreaked havoc in the region, a new crisis is at hand. Far from having decoupled from the rest of the world, Asia’s problems – and China’s in particular – are tightly linked to the crisis and recession that started in America and have since spread like wildfire throughout the developed world. These problems have arisen, in large part, because of the unbalanced state of both economies. America’s excess consumption model is in serious trouble because the asset bubbles that have long supported it – property and credit – have both burst. China’s export-led growth model is in trouble because it is being adversely impacted by a massive external demand shock that is very much an outgrowth of America’s post-bubble compression of consumer demand. The rest of Asia – exportdependent economies, which have become tightly integrated into a China-centric supply chain – has nowhere to hide. Ten years after the wrenching upheaval of 1997-98, Asia is facing another crisis.

Significantly, these imbalances did not occur in isolation from each other. America’s consumption bubble was, in effect, sourced by an equally destabilizing Asian export bubble. And now both sets of bubbles have burst – on the demand side as well as on the supply side of the global economy. It had to happen at some point: Long simmering global imbalances have finally come to a head in a post-bubble world (see Figure 1). China: Unbalanced and Unstable During the boom, China’s imbalances actually worked in its favor. Over the 2001 to 2007 period, the export share of Chinese GDP nearly doubled from 20% to 36% while the global export share of world GDP went from 24% to 31% (see Figures 2 and 3). In other words, China’s timing was perfect. It upped the ante on its export dependence at precisely the moment when global trade enjoyed its most spectacular growth. That effectively turbo-charged China's benefits from the strongest global boom since the early 1970s, powering GDP growth at a 10.4% average rate in the seven years ending in 2007. That was then. Reflecting the impacts of a rare synchronous recession in the US, Europe, and Japan, the world trade boom has now gone bust. And Chinese exports, which had been surging at a 25% year-over-year rate as recently as mid-2008, reversed course with a vengeance – ending the year in a mode of outright contraction, falling by 2.8% in December. With exports such a large and rapidly expanding slice of the Chinese economy, little wonder measures of aggregate activity slowed in an equally dramatic fashion. Industrial output increased only 5.7% in December – one-third the average 16.5% growth pace of the preceding five years. And real GDP growth ended the year at just 6.8% – in sharp contrast to the nearly 12% pace of the preceding three years. China’s growth compression as reported on a year-over-year basis masks the severity of its recent downshift. A translation of these figures into sequential quarterly changes, such as those reported by the United States, suggests that Chinese GDP and industrial output growth were in the flat to slightly negative territory as 2008 came to an end. As seen from this real-time perspective, the Chinese economy hit a wall late last year. Such an abrupt downshift implies it will be extremely difficult for China to achieve the government’s 8% GDP growth target for 2009. An outcome closer to 6%, or even lower, is a distinct possibility. China is hardly an oasis of prosperity in a crisis-torn world. For a nation long focused on social stability, this growth shortfall is a worrisome development. It has already taken a serious toll on Chinese employment. The government has now acknowledged job losses in coastal export manufacturing businesses of over 15% – or 20 million workers – of the nation’s pool of some 120 million migrant workers. If the export and GDP shortfall persists, more slack would open up in the Chinese labor market – raising long dreaded risks of worker unrest. I remain convinced that the Chinese leadership will do everything in its power to avoid such an outcome. But in this global recession, the challenge is daunting, to say the least. Asia: China-Centric and in Peril It has become conventional wisdom to proclaim that the 21st century would be the Asian Century. China's miraculous development story is central to this vision – a transformation that many believe would inevitably push the pendulum of global power from West to East. It’s hardly an exaggeration to claim that such a tectonic shift would turn the world inside out. The Asia Dream is an exciting and powerful story – a magnet to financial and human capital from all over the world. I suspect it may be premature to crack out the champagne. The Asian century is hardly as preordained as most seem to believe. The main reason, in my view, is that the region continues to rely far too much on exports and external demand. Developing Asia’s export share hit a record high of 47% last year – up ten full percentage points from levels prevailing in the late 1990s (see Figure 4). That hardly speaks of a true economic power that has become capable of standing on its own.

At the same time, there can be no mistaking the increasingly China-centric character of the Asian economy – another dimension of the region's search for growth. As China boomed, the rest of Asia was more than happy to go along for the ride. A China-centric supply chain led to increasingly tighter pan-regional integration, with assembly lines in China drawing freely on inputs and components from Japan, Korea, Taiwan, Malaysia, Singapore, Indonesia, and elsewhere in the region. Yet that dependence cuts both ways – a two-way causality that is now complicating the here and now of the Asian century. As noted above, the China boom was itself very much tied to the record surge in global trade. But now with global trade contracting for the first time since 1982, China's export-led impetus has been quick to follow. This has hit China-centric Asia extremely hard. The December 2008 export comparisons were nothing short of disastrous for the other major economies in the region: For example, Taiwan's exports were down an astonishing 42% y-o-y, with the Chinese piece off 56%; Japan's exports plunged 35%, with the Chinese piece off 35%; and Korean exports fell 17%, with the Chinese piece also off 35%. In all three of these cases, China had become each country's largest trading partners in recent years – accounting for 28% of total Taiwanese exports, 23% of Korean exports, and 16% of Japanese exports. But now that the Chinese export machine has screeched to a standstill, the rest of the region has weakened even more. This puts an Asian spin on an old adage: When China sneezes, the rest of Asia catches a bad cold. I am convinced that the Asian century is coming. But the risk is that it may take a lot longer than widely presumed. All this underscores the biggest test to the Asian century – the ability of the region to stand more on its own in the event of an external shock. In the late 1990s, it was an external funding shock. Today, it is an external demand shock. These developments should put the region on notice that its leadership agenda is far from complete. Until export-led growth gives way to increased support from private consumption, the dream of the Asian century is likely to remain just that. America: Bubble-Prone and Externally Dependent There can be little doubt that this global crisis started in America. The ever-deepening recession in the US economy is very much an outgrowth of a massive post-bubble shakeout. It began with housing but has now spread to the biggest sector of all – the American consumer. At is peak in early 2007, US consumption accounted for fully 72% of real GDP – a record for the United States, and for that matter, a record for any major economy in the modern history of the world (see Figure 5). The problem with this consumption binge is that it was not supported by the US economy’s underlying income generating capacity. In the now-ended expansion, private sector labor compensation expanded at an unusually sluggish pace – falling over $800 billion (in real terms) below the trajectory of the previous four business cycles (see Figure 6). The confluence of subpar job growth and relative stagnation of real wages left consumers well short of the labor income that would typically support booming consumption. But that didn’t stop the American consumer. Drawing freely on asset appreciation – first equities and then housing – consumers uncovered new sources of purchasing power. The credit bubble was icing on the cake – enabling homeowners to extract equity at little cost from ever-rising home values and then use the proceeds to fund current consumption and build saving for the future. Net equity extraction soared from 3% of disposable personal income in 2000 to nearly 9% in 2006 (see Figure 7). There are important consequences of such a bubble-dependent consumption and saving strategy. Significantly, by shifting the mix of consumer support from income to assets, the United Sates drew down its domestic saving rate to rock bottom levels. The net national saving rate – the sum of household, business and government saving after adjustment for depreciation – plunged to a record low of 1.8% of national income over the 2002-07 period, and then actually tumbled into negative territory in 2008 (see Figure 8). The global consequences of this development are profound:

Lacking in domestic saving, the United States was forced to import surplus saving from abroad in order to grow – and run a massive current account deficit in order to attract the capital. The saving shortfall of a bubble-prone US economy is a major source of vulnerability. During good times, it made America increasingly dependent on foreign lenders, such as China, to fund economic growth. During bad times – especially in the aftermath of the bursting of the property and credit bubbles – it triggered a massive consolidation of asset-dependent US consumption. Real consumption expenditures fell at a 3.6% average annual rate in the final two quarters of 2008 – the first time in the post-World War II era when consumer demand fell by more than 3% for two consecutive quarters. Despite the unprecedented contraction of consumption in late 2008, there is good reason to believe the capitulation of the American consumer has only just begun. The consumption share of US GDP has fallen only about one percentage point from its 72% peak – still leaving this gauge four full percentage points above the pre-bubble norm of 67% that prevailed from 1975 to 2000. On this basis, only about 20% of the consumer’s mean reversion has been completed. Notwithstanding the extraordinary monetary and fiscal stimulus measures that have recently been put in place by US authorities, the post-bubble deleveraging of the American consumer is likely to be an enduring feature of America’s macro landscape over the next 3-5 years. Therein lies the essence of a massive and sustained global demand shock. The American consumer is the biggest consumer in the world (see Figure 9). And US consumption growth has long outstripped far more sluggish gains elsewhere in the developed world. Little wonder the postbubble capitulation of the American consumer proved so decisive in undermining the external demand underpinnings for China and for the rest of export-dependent Asia. Nor is it likely to be over quickly. This multi-year headwind imparted by a sustained weakening in the growth of US consumption could well be the most powerful force shaping the demand side of the global economy for years to come. Mounting Bi-Lateral Tensions The current global crisis poses new challenges to the relationship between the United States and China – quite conceivably the world’s most important bilateral relationship of the 21st century. Those challenges were underscored in the recent Senate confirmation hearings of America’s new Treasury Secretary, Timothy Geithner, when he accused the Chinese of currency manipulation. Moreover, with the US in recession and unemployment high and rising, there is good reason to fear that Geithner’s comments were just a warning shot of more China bashing on the horizon. This is an unfortunate outgrowth of the blame-game mentality that has long been prevalent in Washington. During tough times, US politicians apparently need scapegoats to deflect attention away from the role they have played in creating serious problems. Wall Street is being singled out for causing the financial crisis – despite regulatory and central bank complicity – and China, with its large bi-lateral trade deficit with the United States, is being blamed for the pressures bearing down on American workers. Washington’s “logic” for turning tough on China trade policy is based largely on three factors – an outsize bilateral trade deficit between the two nations that hit a record $256 billion in 2007, longstanding claims of RMB currency manipulation, and a seemingly chronic stagnation of real wages for American middle class workers. Fix the China problem, goes the argument, and unfair pressures on US workers will be relieved. This argument is deeply flawed. The main reason is that the US-China trade deficit did not arise in a vacuum. As noted above, a bubble-prone, saving-short US economy needs to import surplus saving from abroad in order to keep growing. That also means it must run massive current account and trade deficits to attract that capital. The US-China trade deficit, along with deficits with 100 of America’s other trading partners is, in fact, an important outgrowth of that problem. America has a multi-lateral trade imbalance – not a bilateral problem driven by unfair Chinese competition. China

has the largest bilateral piece of America’s multilateral deficit – not because of the value of its currency but mainly because of conscious outsourcing decisions of US multinationals. Nor is the evidence on the so-called undervaluation of the Chinese renminbi nearly as conclusive as many US experts seem to believe. For starters, the RMB is up nearly 21% against the US dollar (in real terms) since China abandoned its currency peg over three years ago. Moreover, recent academic research puts the RMB’s multilateral undervaluation on the order of only 10% – hardly a major advantage for China (see Yin-Wong Cheung, Menzie D. Chinn, and Eiji Fujii, “China’s Current Account and Exchange Rate,” a January 2009 working paper of the US National Bureau of Economic Research). Significantly, these same researchers go on to demonstrate that China’s bilateral and multilateral trade flows are not nearly as sensitive to movements in its currency as the RMB bashers would want to believe. Nevertheless, if US-China trade is diminished or closed down through forced RMB revaluation, tariffs, or other means, a saving-short US economy will still need to run a large multi-lateral trade deficit. That means it will simply end up shifting the Chinese piece of its external imbalance to another trading partner. To the extent that shift is directed toward a higher-cost producer – most likely the case – the outcome will be the functional equivalent of a tax hike on the already beleaguered American middle class. But it won’t stop there. Undoubtedly, Chinese currency managers would retaliate by reducing their purchases of dollar-denominated assets. And that would push the world’s two great powers all the closer to the slippery slope of trade protectionism. Avoiding such an outcome – strikingly reminiscent of the trade wars of the 1930s triggered by America’s infamous Smoot-Hawley tariffs – poses a major challenge to the body politic of both nations. That’s particularly true for America’s new president. Campaigning on a platform of support for beleaguered middle-class American workers, Barack Obama underscored his concerns about real wage stagnation in an era of unfettered globalization. The real wage issue is a serious issue. However, the challenge for Washington is to determine the linkage between this issue and trade policy. It may well be that real wage stagnation is related more to America’s under-investment in human capital – especially, lagging educational reforms and re-skilling programs in an era of rapid IT-enabled globalization – than it is to cross-border trade pressures. It may also be that trade deficits are far more a function of flawed policies that discourage saving – a problem that s now going from bad to worse in an era of trillion dollar budget deficits. Resolving this dilemma, without derailing globalization, will be an early and important leadership test for President Obama. Don’t Count on Symbiosis In economic terms, there can be no mistaking the natural symbiosis that has long existed between America, the consumer and low saver, and China, the producer and high saver. But this complementarity cannot be taken for granted as a co-dependence that will forever cement the bilateral ties between these countries. In fact, it may well be that US-Chinese symbiosis is nothing more than passing phase – reflecting a coincidence of mutual interests that will exist for only a relatively brief period of time. Yes, as long as a saving-short US economy continues to run massive current-account deficits to support the excesses of personal consumption, it needs a lender like China to provide foreign capital. And as long as an excess saving Chinese economy needs exportled employment growth to maintain social stability, it needs the world’s largest consumer to absorb its output. But what happens if those conditions change? If America starts to save more – a distinct possibility for its over-extended post-bubble consumers – the need to borrow surplus saving from China will diminish. Conversely, if China starts to spend more – an equally likely possibility in light of its excessive reliance on exports and investment – it will have less surplus saving to lend to the United States. If both of these adjustments are perfectly timed to occur at precisely the same moment, it is possible to envision an uninterrupted symbiosis. The odds of such an exquisitely synchronized rebalancing of both economies are extremely low, in my view. That suggests the growing likelihood

that symbiosis is likely to give way to disequilibrium – adding a new source of tension to the USChina relationship. Unfortunately, that’s not the only source of economic tension between the United States and China. Over the 2005-07 period, fully 45 pieces of anti-China trade legislation were introduced in the US Congress. While none of these bills passed, that may change. As the US unemployment rate now mounts in an ever-deepening recession, the politics of trade frictions may well gather greater support. Treasury Secretary Geithner’s warning on Chinese currency manipulation is especially worrisome in that regard. The same can be said of the “Buy America” provisions that have slipped into America’s recently enacted stimulus package. At the same time, China must also be sensitive to the impacts of its export-led growth model on its trading partners. Any subsidies – either to its own domestic wages or to its currency – take on heightened importance as China’s stature in world trade grows. As now the second largest exporter in the world, China can hardly afford to take that responsibility lightly. Moreover, if China competes unfairly by ignoring environmental degradation and pollution, the world pays a much greater price for the cross-border labor arbitrage than a simple comparison of wages would suggest. To the extent that cost-effective outsourcing ignores environmental considerations, the real wage squeeze in relatively “greener” economies may be all the more acute. Resolving the complexities of the US-China economic relationship is an urgent challenge for an unbalanced global economy. As a crisis-torn world now moves into a severe recession, the stakes can only grow larger. As both the US and Chinese economies evolve and change, a fleeting state of symbiosis could well give way to heightened tensions. The time to diffuse those tensions is now – before it’s too late. China’s Policy Imperatives Ironically, China saw many of these problems coming. Two years ago, Premier Wen Jiabao warned that the Chinese economy was “unstable, unbalanced, uncoordinated, and unsustainable.” Similar vulnerabilities were anticipated in the 11th Five-Year Plan enacted in 2006, which stressed China's need to embark on a major structural transformation from export- to consumer-led growth. But the government’s execution of this aspect of its plan was lacking. In particular, it failed to build out an institutionalized safety net – the support system necessary to temper the fear-driven precautionary saving that inhibits the development of a more dynamic consumer culture. As a result, the consumption share of Chinese GDP fell to a record low of 36% in 2007 – underscoring the dark side of China’s macro imbalances that is now so problematic in this global crisis (see Figure 10). A severe external demand shock found an unbalanced Chinese economy without a back-up plan. A pro-consumption rebalancing is the only sustainable answer for China. Pro-active fiscal stimulus measures, such as the recently announced RMB4 trillion infrastructure-led investment initiative, can help temporarily. Such efforts borrow a page from China’s counter-cyclical script deployed in the Asian financial crisis in the late 1990s and again in the mild global recession of 2000-01. But these actions are not enough to compensate for the structural vulnerabilities that China's externallydependent growth model now face as American consumers begin a multi-year retrenchment. China needs to be bold and aggressive in framing pro-consumption policies. It should start by announcing major initiatives on the safety net front. Specifically, China should sharply expand the funding of its national social security fund, which currently has only a little over US$70 billion in assets under management – not even enough to provide $100 of per capita lifetime retirement income for an aging Chinese population. China also needs to move quickly in establishing a comprehensive private pensions scheme, as well as broaden its support to nationwide health and unemployment insurance. Recent passage of an RMB850 billion three-year medical reform plan is an encouraging , but small, step in that direction. The bottom line for China: Its unbalanced economy must be rebalanced. The export-led growth formula, which served the nation well for three decades, must now give way to the internal impetus

of consumer-led growth. For China, the imperatives of such a rebalancing have never been greater. For the rest of Asia – to say nothing of an unbalanced global economy – China's post-crisis economic leadership role hinges importantly on this critical rebalancing. Policy Risks Needless to say, a weakened economy usually doesn’t take kindly to suggestions that it ought to increase the value of its currency. That’s especially the case for an export-led Chinese economy, where sequential growth slowed to a virtual standstill in late 2008. With overall economic growth remaining weak in early 2009 and currently running well below the 6-8% zone that China requires to absorb surplus labor and maintain social stability, the pro-cyclical implications of a tighter currency policy would only add to mounting downside risks. Little wonder that US Treasury Secretary Geithner’s recent remarks on currency manipulation were met with an incredulous response in Beijing. While such strident rhetoric hardly implies action, it is worth considering the consequences if the war of words leads to outright trade sanctions. The impacts would be felt immediately in financial markets. Given America’s reliance on China’s funding of its external deficit – a reliance that can only grow in an era of open-ended trillion dollar budget deficits – the US is in no position to risk reduced Chinese buying of dollar-denominated assets. Yet that is exactly what might occur if a proud but wounded China retaliates to currency-induced trade sanctions imposed by Washington. Such retaliation could take the form of a China that simply doesn’t show up at an upcoming US Treasury auction. That’s hardly a trivial consideration for a United States that needs about $3 billion of capital inflows each business day to fund its current account deficit. If China fails to provide its share of America’s external funding, the dollar could plunge and real long term interest rates could rise. A dollar crisis is the very last thing a US in recession needs. But it could happen if the US turns rhetoric into action in the form of imposing sanctions on Chinese trade. In short, Washington is treading on increasingly thin ice in blaming the Chinese currency for America’s woes. A post-bubble US economy is suffering from a major shortfall in domestic demand that is unlikely to be remedied by China bashing. Saber-rattling in this climate is both ill-advised and dangerous. At the same time, it is equally important to underscore what China should not do. First and foremost, Chinese policymakers must not be overly-optimistic in counting on the old external demand model to start working again. A multi-year weakening of the US consumer is tantamount to a global consumption shock that will impart a protracted drag on any export-led economy. As such, the imperatives of Chinese rebalancing have never been greater. It is increasingly urgent that China shift its growth model from one that has been overly reliant on exports to one that draws increased support from private consumption. Nor should China be tempted to use the currency lever or other subsidies to boost its export sector. In an era of rising unemployment and mounting concerns in the developed world over the benefits of globalization, such efforts could be a recipe for anti-China trade sanctions. As previously noted, those actions might then prompt China to reconsider its role as one of America's most important overseas lenders. And then, as was the case in the 1930s, the race to the bottom could be on. Wake-Up Call There has long been a dispute over the English language translation of the Chinese word for crisis. One popular view is that “wēijī” roughly translates into the compound phenomenon of both danger and opportunity. Unfortunately, that meaning – correct or not – has been lost on a world in crisis. Today, more than ever, a world in crisis and recession needs to pull together – not push itself apart. Globalization and its cross-border connectivity through trade and capital flows leave us with no other choice. The blame game is completely counter-productive in this environment. Those blaming surplussaving economies such as China for America’s unsustainable spending binge ought to be embarrassed. This is a US problem and one that must be addressed at home with a new and

disciplined approach to monetary policy, tough regulatory oversight, and more responsible behavior on the part of consumers and businesses, alike. A bubble-dependent economy that lived beyond its means for a dozen years must now accept the reality of having to live within its means – and not holding others accountable for this painful yet necessary adjustment. Similarly, China needs to accept that the export-led growth formula always had its limits. An unprecedented external demand shock driven by unheard of synchronous recessions throughout the developed world drives this point home with painful clarity. Economic development is not just about producing for others – especially if those “others” are living beyond their means. In the end, exportled growth must eventually give way to the internal demand of a nation’s private consumers. China is ready for this transition and must begin the process as soon as possible. In short, it is high time for an unbalanced world to begin the heavy lifting of global rebalancing. By framing such an adjustment in the context of the United States and China, the verdict is clear: America needs to save more and consume less, while China needs to save less and consume more. Easier said than done. But a world in crisis can no longer afford to perpetuate an unstable status quo. Global rebalancing is not a quick fix – and therefore, is not all that appealing to myopic politicians. But in the end, it is the only way to put the world back on a sustainable growth track. If there is a silver lining to this crisis, it must be in the wake-up call that it sends to politicians and policy makers throughout this unbalanced world.

Sub-Prime Crisis Moves US Toward A Different Future By Terrell E. Arnold 4-17-8 In the past few weeks we have watched frantic movement of the Federal Reserve and the US Treasury to stanch the financial bleeding of major American financial institutions that gambled quite freely on a gigantic pyramid. If asked, any official of one of those institutions might look you in the eye and say "there is no pyramid," then explain that what they did was produce securities that were based on reasonable risks backed by collateral of the most reliable form: mortgages on identified parcels of developed American real estate." Indeed, the real estate, per se, was not the problem. However, their paper was not land titles or mortgage documents themselves; it was a security backed by bundles of so-called "sub- prime" mortgages, but the bundles-based securities had received AAA, that's triple A ratings by the country's leading rating agencies. Those ratings were based on the apparent notion that bundling the underlying mortgages would spread the risks of loans to "subprime" borrowers, and in any case it would take a bundle of defaults for the risks to be significant. The ratings, as it emerged after the fact, were also made by organizations that had a vested interest in the outcome. After that balloon burst, in a late March 2008 interview with Deborah Solomon for the New York Times, former Treasury Secretary Paul O'Neill blew the raters' assertions out of the water by saying: "If you have 10 bottles of water, and one bottle had poison in it, and you didn't know which one, you probably wouldn't drink out of any of the 10 bottles." By this measure, the ratings themselves were a sham. Bundling would be risk enhancing, not risk mitigating, and that is the way markets for those securities have responded to defaults. From the beginning the high risk mortgages in the bundles, many written for a favorable "come on" rate to the borrower, were scheduled to move upward to higher interest rates. Over time, average returns on these mortgages would be greater than that of fixed rate mortgages; that represented good business for the lenders, and of course for their hedge fund collaborators. It was an incredible pyramid built not on the Giza stone that would make it last for millennia, but on the sands of economic vulnerability and risk that would bring us to where we are. Through an incredible

permutation, high risk loans at the lender-borrower level were transformed into allegedly risk-free and highly profitable CDOs (collateralized debt obligations) at the top. To be sure, the probability that one of a bundle of ten mortgages might go belly up was materially higher than the risk that all ten would fail, so bundling appeared to be a risk mitigation strategy. However, that risk mitigation potential was intrinsically low because all ten were in a high risk, sub-prime category for which a default could be triggered by an economic slowdown, worst case a recession, or significant increases in mortgage interest rates. Those higher rates began to kick in at about the same time an economic slowdown caused real estate values to falter. Facing higher interest rates and disappearing equity, borrowers began to default in large numbers. At that point, at least in market perception, the AAA-rated bundles were suddenly worthless. The problem was compounded by a surge in defaults on fixed rate mortgages that also was triggered by sharp declines in the market value of the properties involved. As real estate values-the heart of most personal asset pools-went galley west, it was time for everybody to register shock and for affected financial institutions to run for cover. However, the immediate official concern was not about homeowners but about the builders of the sub-prime pyramid. As IMF analysts put it in their March 2008 World Economic Outlook, the United States was "plagued by profound errors in risk management among its leading financial institutions." While we taxpayers were never asked, the Fed and Treasury moved briskly to bail out one of the major gamblers, Bear Stearns, to the tune of $19 billion that we are unlikely ever to see again. In the above-cited New York Times interview, Paul O'Neill also shot down that maneuver, saying: "They saved the financial system from a panic collapse. I reject the notion that they helped Bear Stearns. Bear Stearns was destroyed." He may be right in the sense that Bear Stearns may never recover from the loss of market confidence in its judgment, but if the bailout actually staved off a financial collapse, our money may have been well spent. However, Bear Stearns was not alone. Too many people had put too many eggs in one speculative basket. Even the peaks of the pyramid builders, Citibank, Morgan-Stanley and others, wrote off multi- billion dollar exposure strings that would boggle the mind, while a stock market built on the unrealistic profitability of such gambling, threatened to collapse if its wanton expectations were not assuaged. As reported in Timesonline, the

Wachovia bank suddenly had to raise $8 billion to cover losses, heavily in the California sub-prime market. According to a Wachovia official, "the propensity to default rises dramatically once equity in a borrower's property falls to zero". That propensity appears to have applied with equal rigor to more affluent fixed rate mortgage borrowers. The damages were not confined to the United States. The sub-prime based securities were attractive to foreign investors as well. In truth the crisis is a vivid demonstration of how easily both risks and opportunities move in today's international markets. British, German, French, Japanese and other banks had bitten into this sweetbread, and they were now carrying bundles of this paper that marketwise were worthless and asset wise represented a mess of bad investment judgment calls that had to be explained to shareholders. In a report on the global implications of this crisis, the Global Financial Stability Report (GFSR) of the International Monetary Fund, IMF analysts estimated that the global losses associated with or otherwise contributing to the crisis approached a trillion dollars, the great bulk but not all of it in the United States. Assessment of this crisis and what to do about it dominated discussions in meetings this past weekend of the International Monetary Fund (IMF) and the World Bank in Washington, with discussions of the advanced economy Group of Seven on the side. The IMF report appears to have dominated the discussion without leading to any fresh courses of action for dealing with the crisis. That was because each G-7 member-and others to be sure-naturally sought to protect its own position in the matter, while the general opinion appears to have been that it was mostly up to the United States to clean up its own mess, even if others had to clean up pieces of it. As the Governor of the People's Bank of China put it in his written statement, "The biggest risk to the global economy remains the financial crisis emanating from the U.S. sub-prime mortgage sector." He may have said that looking uncomfortably over his shoulder at China's trillion dollar plus foreign exchange holdings, mostly in dollars. The crisis has underscored the increasingly discomfiting reality that the global financial system consists of an aggregate of national systems that do not add up to a global financial manager. The IMF and the World Bank, originally created in 1945 with a view to provision of global financial management, have not gotten very far. Sixty plus years later, there still is no international banker or lender of last resort. More depressing, there is no global banking rule maker or regulator. The global system is actually based on the coincident, case by case evolved compatibility of nearly 200 national

systems. But there is more to the story. The sub-prime crisis grew in the context of real and portentous developments across global trade, financial and economic systems. The Fed, Treasury and Wall Street, distracted by their own crisis, probably have had little time to focus on the tectonic plate shifts in the global system that probably mean they cannot go home again. The epicenters of international trade and finance simply are shifting. In essence, a good part of the wealth that might be needed to finance a recovery is in the wrong places or pockets, mostly in Asia, and when the dust settles, the global configuration will be different. Some say the first effects of the crisis will be downsizing or consolidation. That would mean the write-offs of major institutions would just disappear, making the global asset pool cleaner but smaller. That could also mean that the great bulk, if not all of the transactions of banking and other financial institutions would show up on their books, making the system transparent by shedding a multitude of off balance sheet transactions that dominated the sub- prime securities mess. Whatever the approaches, the system is unlikely ever to be the same again, because the facts underlying global developments are profound. For starters, the solutions do not lie merely with changes in liquidity. They lie with recognition and adjustments around real changes in global economic structures including the scale and distribution of productivity and wealth. The sub-prime crisis simply adds to the adjustments already made necessary by those global changes. The first base in this new configuration is what has been happening to the dollar. Mirroring the dynamics and strength of the American economy, the dollar has been the dominant world currency ever since World War II. It has served as medium of exchange, as the core of many personal asset hoards, and as a reserve currency for countries with weak or US trade-linked national monetary systems. Of long term importance, international oil prices have been stated in dollars, a nod both to the historic strength of the dollar and the dominant US roles in oil trade. However, as other economies have grown, diversified and prospered the dollar has faced rising competition from the Japanese Yen, then the Euro and, most recently, from the Chinese Renmembi or Yuan and the Brazilian Real. These new challenges reflect both the growing global strength of other economies and accumulating flaws in the strength of the American

economy, notably continuing Federal deficits, rising international debt and growing import dependence. Those developments weakened the Dollar by exposing it to the competition of other currencies, reduced its traditional role as a stabilizing international trade benchmark, and sent its value plunging as resource prices rose in response to increasing global demand for oil and industrial materials. To the degree that the United States is able to reduce its debt, curb its appetites for imported goods, adjust its affluent lifestyles, extricate itself from absurd levels of military expenditure, and restrain inflation, in short, put its economic house in order, declines in the value of the Dollar can be mitigated. However, the declining role of the Dollar in the world economy appears persistent. Moreover, the exposure of Americans to foreign exchange risks they never experienced before is an already visible consequence of the change. The as yet incomplete Iranian and other oil exporter efforts to switch to Eurodenominated oil prices will only make US exchange risk exposure worse. Whereas the United States in the past has enjoyed comfortable trade surpluses while trading partners carried discomfiting deficits, the shoe is now tightly on the other foot. These gross shifts have been developing for decades. In every year since 1990 real GDP growth in leading developing countries has been faster than in advanced countries. In the years since the mid-1990s, China has grown faster than either the United States or the European Union and it has overtaken Japan as the global second place national economy. Those tendencies have grown since the beginning of the new century. In terms of GDP stated at purchasing power parity, the United States is now not only behind the European Union, it is being rapidly overtaken by Asian economies. World Bank estimates show that the Asian combination of China, Japan and India exceeds the United States and is breathing down the neck of the European Community for global first place. With the numbers for smaller Asian economies such as Malaysia, Asia is already globally in the lead. This list of ten accounts for more than 80% of world GDP, while the United States alone accounts for 20%. As a rude benchmark of the change, in the early 1990s the United States accounted for 30% or more of global GDP. That means the relative weight of the US in the world economy has declined in a decade by roughly the GDP (at purchasing power parity) of China and India combined.

These developments affect every political, economic and financial calculation for the future. The most unfortunate feature of the immediate crisis is that it was precipitated by a combination of greed and runaway risk miscalculation. It probably cannot be rectified without substantial losses by many financial and banking institutions, not all of them large and multinational. It has already caused enormous hardship for a multitude of homebuyers, and in a recessionary period there is more of that to come. This is as much a crisis of expectations as it is a problem of ability to pay. The default on fixed rate mortgages is due to diminished expectations, the loss of asset value. It remains to be seen whether the bailouts being contemplated in Washington will rescue the institutions involved or the homebuyers. Advance signals indicate the institutional players will fare best, and one hopes they will emerge leaner and more prudent. At the same time, it seems clear enough that the best interests of troubled homebuyers lie with a solution that enables them to hold on to their real estate and wait out the restoration of their equity as markets rebound. It also remains to be seen to what extent the crisis will result in more effective regulation and oversight of banking and other financial institutions, including the rating organizations who blessed the sub-prime fiasco with AAA ratings. There were lessons learned on all sides here, but they will take some digesting. Global changes may be slowed while this American misadventure works itself out. But those global changes are pervasive and enduring. It is not in the interest of humanity at large to have the development of other economies truncated by American efforts to feed its excesses. The elitist reaction to that might be the famous remark of Marie Antoinette "Let them eat cake." However, in a world where easily half of humanity is hungry and a slice of that population wants to correct the defect by violent means, assuring that there is enough to feed everybody is the more humane and prudent choice. Aggravating food scarcity by turning basic foodstuffs into motor fuel is neither an economic nor a humanitarian response. It does show that in a pinch national needs take precedence over global ones. America's real choices and opportunities have evolved in a compelling fashion over the years since World War II. As the most advanced nation left standing at the end of that conflict, The United States saw work to do. The home agenda was to bring itself out of a war economy and into a peacetime environment. The foreign policy agenda was to promote and support the recovery of post war Japan and Europe and, in some measure, their

surroundings. Happily, those two agendas combined at the level of good policy is good business. The country had virtually automatic markets for everything it could produce. Altruism and self interest combined in a most productive manner. The relatively affluent American society was a natural dividend, and it remained so, even as the restored economies became increasingly productive and competitive. But things began to change, especially with the end of the Cold War. The containment strategy that ultimately dominated the US Cold War posture actually provided an umbrella for potentially pre- emptive military moves that positioned the US virtually everywhere any economic resource of importance could be had. The altruistic agenda slowly fell behind the selfinterested one as global resource procurement and market competition became more forceful. When the Project for the New American Century (PNAC) surfaced in the early Bill Clinton presidency with plans to invade Iraq and with a global military power agenda, the altruistic side of American foreign policy had pretty well atrophied. The game had become power maintenance by military dominance. The PNAC designers appeared to have no clear-cut economic agenda, but their military scheme, if it succeeded, would have provided more than adequate cover for a self-centered and pre-emptive resource acquisition strategy. As perceived by other advanced and advancing nations, this scheme drove 21^st century global resource acquisition strategies toward a nineteenth century capitalist model. One only has to look at Darfur, the Congo, Zimbabwe, and much of Central Asia as well as the Middle East to see how neo-colonial present day resource acquisition has become. That others, e.g., China, India, Brazil, other advancing countries, are coping more or less successfully with this resource acquisition environment is part of America's current problem set. Prices are rising globally for virtually everything. In the case of foodstuffs, the increases are devastating. This faces US policy makers with across the board price inflation for most goods and services at a time when the US economy is diving toward a recession made worse, if not actually driven, by the sub-prime mortgage crisis. The global tragedy of the sub-prime mess is that the securities that were designed to exploit the eventual high rates of return on those mortgages were of little to no benefit to global economic advancement. What their failure has done is to seriously distract US policy managers from the vital business of working through the large and fundamental changes that are occurring in the US economic environment. In the end, the sub-prime mess is likely to

accelerate the transition of the US economy to a new position in the global system. Unless several major world economies-Japan, European Union, China, India, Brazil, and others-suddenly contract instead of continuing to grow at faster than US rates, the US weight in the global system will continue to decline; the Dollar will continue to play a reduced role in the global trade and payments system. Such is the price of success. An economic diversification that the United States led through the early post World War II years has now caught on. The only thing that could prevent the US role in this future system from declining would be for the rest of the system to fail. The real policy challenge for US leadership therefore is to face this prospect, assess the realistic weight of the United States in likely future configurations, and try to maximize the US opportunity in them. A military power strategy won't cut it. We are already going deeply into debt to sustain the present military posture. Other countries are not enamored of a US trying to run the world at the real or implied point of a gun. The system now needs truly global leadership. The United States can lead in that direction, helping to create and strengthen the institutions that will provide global leadership in the common interest. It is not leading now; it is forcing or trying to force global conformity to a self-centered US model, and that strategy eventually will fail. Such failures as the sub-prime fiasco only hasten the time when the present US model must be abandoned.

Credit crisis, Asian style: a top Hong Kong analyst sets the stage. by Lo, Chi The International Economy • Fall, 2008 •

The 2007-08 subprime crisis has more than a few similarities with the 1997-98 Asian crisis when it comes to causes and symptoms. But do not expect the western world to stage a fast recovery as Asia did from the regional crisis ten years ago. The subprime crisis is a man-made crisis, not a black swan event. To correct their mistakes in the coming years, regulators in the developed world will try to re-regulate banks. The danger of the subprime crisis to Asia is that it may send a wrong signal to the region, especially to China, and deter financial liberalization and innovation. As the post-subprime crisis adjustment will be about asset deflation and de-leveraging, which will last for years, medium-term global growth will experience a structural downward shift, unless the developing world raises consumption sharply. The drop in developed world consumption will put an end to the emerging markets' export-led development model, crimping growth in Asia's export-led economies in the coming years. IT'S NOT A BLACK SWAN Some analysts argue that the subprime crisis is a "black swan" event. The term "black swan" comes from the ancient western concept that all swans are white. In that context, a black swan was a metaphor for something that could not exist. Ever since black swans were discovered in Australia in the seventeenth century, the term "black swan" has been used to connote the actual happening of a highly unlikely event with unprecedented and devastating effects. But the subprime crisis itself is not a black swan, though the resultant credit crunch and confidence crisis may qualify. This is because all the events and factors leading up to the current crisis were known. From a macro perspective, the Asian crisis and the subprime debacle have similarities in their causes and symptoms--namely a prolonged period of low interest rates leading to moral hazard, imprudent lending, regulatory oversight, excessive investment, and asset bubbles. But the advent of financial derivatives has made the subprime crisis more complicated. The U.S. current account deficit ballooned to above the crisis threshold of 5 percent of GDP before the subprime crisis broke, just as in Asia before the 1997-98 financial crisis. Notably, Thailand, where the Asian crisis started, had a current account deficit of over 8 percent of GDP prior to the crisis; the United States had a current account deficit of 6 percent in the year before the subprime crisis! Americans have gone on a debt-financed spending spree for over a decade, pushing the loan-to-deposit ratio in the banking system to over 100 percent. Everything from personal consumption to financial investment has been funded by debt. The blow-out in the U.S. loan-to-deposit ratio resembles vividly the situation in Asia prior to the regional crisis. Asia financed its excessive spending by foreign borrowing, as have the Americans. Foreign debts in both America and the three Asia crisis countries that needed International Monetary Fund bailouts (Korea, Thailand, and Indonesia) all soared before their respective crises.

However, nearly all of America's foreign liabilities are denominated in U.S. dollars, due mainly to the dollar's reserve currency and international trade status. Moreover, the U.S. government still enjoys strong international confidence in its debt servicing and repayment ability. Hence, the United States has not suffered a sudden seizure of capital inflow, and there has not been a dollar crisis. This is quite different from the Asian crisis when massive capital outflow caused a regional currency crisis alongside the financial crisis. THE ASIAN CONNECTION When one considers Asia's role in the U.S. financial crisis, it is certainly not a black swan. First, shiploads of cheap goods from Asia, notably China, helped keep U.S. inflation down. This prompted the Americans, and the U.S. Federal Reserve, to think that they could spend lavishly without igniting inflation at the same time. Second, Asian central banks' holdings of over $4.3 trillion in foreign reserves, combined with billions of petrodollars from the Middle East, provided the United States with enormous liquidity. This was mostly poured into U.S. Treasury and mortgage-backed securities, suppressing U.S. bond yields, inflating the housing bubble, and encouraging excessive U.S. household borrowing to fund consumption. Asia's high savings also created ample liquidity and cheap credit for enhancing the leveraging power of western banks and speculators, thus fueling global asset bubbles. Through carry trades, these international players borrowed at low Asian--especially Japanese-interest rates and swapped the proceeds into high-yield currencies and markets. In a nutshell, frugal Asians, with the Chinese and Japanese accounting for over 40 percent of the world's central bank reserves, have lived below their means with savings flowing westwards to allow the spendthrift Americans to live beyond their means. While it lasted, this cross-Atlantic saving-spending mischief became a stable disequilibrium, enabling Asia to supercharge growth by lending to America so that it could buy Asian exports. Now that the party is over, Asia will suffer too as the financial excess implodes. [GRAPHIC OMITTED] THE END GAME The deepening of the U.S. subprime crisis, despite the Fed's repeated massive liquidity injections, shows that the markets have failed to clear on their own and the global financial system has stalled. There are two routes to the end game--either a global financial meltdown or a full-scale government bailout. History and the recent government actions suggest the latter. Going forward, forced consolidation will speed up with bank failures in the United States. Declining bank credit and bank retrenchment are going to hurt economic growth further. This is because bank credit goes to support real corporate and consumer spending, while non-bank credit (by those investment banks) goes to finance portfolio investment and does not affect real spending directly. The situation in Europe is worse, due to the European Central Bank's inflexible monetary policy, until late in October 2008. Property prices in many European countries will keep falling before they can stabilize late in 2009. The yield curves in both the United Kingdom and eurozone are inverted, suggesting economic recession ahead. While Asian growth experienced a V-shape rebound a year after the Asian crisis, thanks to its young and vibrant economic structure and a quick return of confidence, don't bet the same on Europe and the United States. Even if the global concerted reflation and bailout efforts manage to stabilize confidence in the global

financial system, history shows that the post-bubble adjustment in developed economies would take a long time. After the Resolution Trust Corporation was set up in 1989, it took almost a year for U.S. stocks to reach bottom, and two years for credit and economic conditions to normalize. In its 1992 financial crisis, the Swedish government also enforced a wholesale government bailout to guarantee all bank liabilities and recapitalize the banks, but the Swedish stock market and economy still took more than two years to recover. Japan was even worse, as the set-up of the Financial Supervisory Agency in 1997 to clean up bank balance sheets did not help the economy recover until five years later; and some are still wondering if the economy ever did manage a true recovery. The post-subprime crisis adjustment will be about asset deflation and de-leveraging, especially in the finance and household sectors. This type of adjustment will last for years because it takes a long time for the financial sector to rebuild capital. The subprime crisis is a manmade crisis, not a black swan event. To right their mistakes in the coming years, regulators will not let banks securitize lending and shift it off their balance sheets to create new lending capacity easily. The developed world's banking sector will become slimmer, less risky and less profitable. Money markets will also be smaller and dearer so that banks will have to rely more on traditional funding sources for deposits. A plain vanilla banking model of simple lending and borrowing will return, and fancy derivatives will be gone. Spendthrift debt-financed U.S. consumers will have to retrench also; the U.S. current account deficit will need to continue to shrink to rebalance global saving and investment habits. Thrift will replace leverage throughout the developed world. The huge bailout costs also mean taxes across Europe and America will rise in the coming years, further crimping consumption power. CHINA, AN ISLAND IN THE STORM Market information shows that the Chinese banks have limited exposure to the U.S. subprime crisis. Weighted average exposure of the seven largest Chinese commercial banks (Industrial and Commercial Bank of China, Bank of China, China Construction Bank, China Merchant Bank, Industrial Bank, Citic Bank and Bank of Communications) to Lehman's default amounts to only 0.02 percent their total assets. Even if we include the U.S. government mortgage agency debts, the Chinese banks' exposure to the total subprime assets amounts to only 0.5 percent of their total assets. From a macro perspective, Chinese banks have been reducing their foreign asset holdings in recent years, suggesting that they had been cutting foreign risk exposure well before the subprime crisis. China's banking system has been seen as the Achilles' heel of its economy due to poor asset quality, lack of market discipline, and an opaque operation model. The banking industry is still heavily regulated, risk control systems are still defective, and policy intervention still distorts the price of credit. So much improvement is still needed. But one cannot deny that things have changed for the better in recent years. The government's recapitalization efforts have worked with its public listing and foreign ownership strategies to improve the banking fundamentals. This is seen in the steady decline in the Chinese banks' non-performing loans and increase in their capital-asset ratios. Ironically, Chinese banks look more solid than their western counterparts on the back of the U.S. subprime crisis. While the U.S. banks have been lending aggressively and imprudently over the past decade, causing the banking system's loan-to-deposit ratio to explode, the Chinese banks have been scaling back lending activity. The fall in the Chinese loan-to-deposit ratio reflects both Beijing's credit control to rein in runaway growth in

recent years and improvement in risk control among the Chinese banks. For example, in the mortgage loan business, the minimum down payment is 30 percent and the average mortgage loan life is less than twenty years. These are much more stringent than the conditions in many developed markets. Rising competition among banks, public listings, and foreign ownership have also brought in some market discipline to the Chinese banking sector. From a systemic risk perspective, the Chinese banks are by default safer than their western counterparts because of government ownership, heavy regulations, and their un-sophistication that bar them from getting involved in the highly leveraged investments and product development. China's closed capital account also helps minimize volatile capital flows. Hence, there is no counter-party risk, no confidence crisis, and no disruption of credit flow in the Chinese banking system as there is in the developed world. IMPACT ON ASIA Despite China's relative stability and its increasing importance in global demand, a western-world recession seems inevitable as part of the post-crisis adjustment. As a result, global growth will experience a structural downward shift in the coming years, unless the developing world raises consumption sharply. This looks unlikely in the short-term. The drop in consumption in the developed world will put an end to the emerging markets' export-led development model that had supercharged their growth for over a decade, because external demand will be weak going forward. This also means that growth in the export-led economies will be constrained for many years to come. From a policy perspective, the danger of the subprime crisis and the subsequent re-regulation of the global banks is that they may send a wrong signal to China and other Asian countries that financial innovation is bad and government control is good, as the restrictive Chinese model seems to have shown. This will be extremely unfortunate if it delays or even deters further financial liberalization in the developing world. Emerging market regulators should take the subprime crisis lesson seriously, and improve their regulatory systems but not shy away from financial liberalization and innovation. Chi Lo is Research Director at Ping An of China Asset Management (Hong Kong) Ltd., and author of Understanding China's Growth (Palgrave, 2007)