Monday, January 02, 2006

Past returns do not guarantee future results

Stephen Roach:The Symbiosis Trap

The broad consensus of financial market participants has come to the conclusion that there is a new symbiosis between America’s record-setting external deficit and those willing to fund it. China is typically singled out as the most willing participant in the “symbiosis trade” — the arrangement whereby the US buys goods made in China in exchange for China’s willingness to buy bonds printed in Washington. On the surface, this seems like a terrific deal for both — providing American consumers with the interest rate subsidy needed to sustain wealth- and debt-dependent spending and helping China limit an appreciation in its currency that might otherwise hamper its export prowess. Because this implicit contract has enabled China to keep its currency tightly aligned with the US dollar, many have also referred to the new symbiosis as a “Bretton Woods II” regime — the modern-day sequel to the dollar-based international financial architecture that was adopted in the aftermath of World War II. Advocates of this view conclude that since it is in both parties’ best interests to perpetuate the symbiosis, there is no reason why it should change. With net foreign purchases of long-term US securities averaging $114 billion in September and October 2005, the latest facts are certainly not getting in the way of that logic.

I worry, however, that the sustainability of the symbiosis trade is predicated on a very dangerous ex post rationalization of global imbalances. As was the case in the midst of recent bubbles in equities, bonds, credit, and property, there are important kernels of truth to the notion of a new international symbiosis. The increased trade and capital flows that stem from the cross-border connectivity of globalization create a growing sense of co-dependence in the global economy. The US dollar’s role as a reserve currency adds confidence to the notion of an expanded dollar bloc. But at the end of the day, I do not believe that this arrangement is either desirable or sustainable from the perspective of either of the two main protagonists in the new symbiosis — China or the United States.
The risks are equally disturbing from America’s point of view. To the extent that foreign purchases of dollar-denominated assets represent the functional equivalent of a subsidy to US interest rates, asset markets enjoy artificial valuation support. The result is a surge in housing values that many Americans now perceive to be a new and permanent source of saving. This, in turn, has had a profound impact in reshaping saving and spending strategies of US consumers. In essence, the income-based consumption models of yesteryear have been replaced by asset-driven frameworks. The repercussions of this transformation are profound: The income-based personal saving rate has plunged deeper into negative territory than at any point since 1933. At the same time, US consumers can only create newfound purchasing power by extracting equity from an ever-expanding housing stock. This is where debt enters the equation — in effect, the cost of equity extraction. The overall household sector debt ratio has been pushed up by 20 percentage points of GDP over the past five years — equal to the gain in the preceding 20 years; moreover, reflecting this overhang in the outstanding stock of indebtedness, US household sector debt-service burdens have risen to record highs — even in the context of an unusually low interest rate climate. The result is unprecedented consumer vulnerability on both the saving and debt fronts.

“So what!” retorts the symbiosis crowd. After all, these are precisely the excesses — both for China and the US — that we in the rebalancing crowd have been bemoaning for years. Fair point. Moreover, a year ago, when there were widespread concerns over global imbalances, the dollar rose instead of fell — and those concerns lost credibility. As long as the world is willing to finance America’s saving shortfall, goes the argument, there is no reason to worry about sustainability. This, in my view, is the essence of the “symbiosis trap.” The consensus has been lulled into a false sense of security — believing that imbalances will remain a non-issue for the global economy and world financial markets.
The case for global rebalancing was dealt a tough blow in 2005. The dollar’s surprising appreciation led many to believe that financial markets are perfectly capable of coping with massive external imbalances. In my view, that coping mechanism has led to a false sense of complacency that could well be tested in 2006. In particular, a further deterioration of global imbalances — more likely than not over the next year — could well have adverse consequences for already-extended US and Chinese economies. The result could be a sharp decline in the dollar and related upward pressures on US real interest rates — developments that would take generally complacent investors by surprise. I have long been wary of new theories that spring up to explain away old problems. That was the problem with the so-called new paradigm thinking of the late 1990s. And it could well be the ultimate peril of the symbiosis trap.

To rip off the Matrix it will last as long as it can. Folks are spent out, real wages have been flat (and for many families have been falling) interest rates have already started to creep up. If the worst happens the folks with adjustable rate mortgages will face skyrocketing payments as well as being upside down on the note due to falling home prices. Families already living "the American dream" on borrowed money will be in the fight of their life and the folks speculating with borrowed money will loose their shirts. The bankruptcy exit is barred, lenders will not be in the mood to lend over 100% of value to refi on a fixed rate, and there will be more sellers than buyers. The coasts will be hardest hit but everyone will feel the drag on the economy. Such a recession may not have an identifiable trigger like a stock market crash rather a slowly rising flood of bankruptcy and foreclosure until a tipping point is reached and it becomes page one news.

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