President George W. Bush and President-elect Barack Obama walk the Colonnade to the Oval Office Monday, Nov. 10, 2008, as the President and Mrs. Laura Bush welcomed the President-elect and his wife, Michelle, to the White House. White House photo by Eric Draper

Global Economy:  The US savings rate is rising from close to zero in 2007 as housing wealth falls and economists at US investment bank Morgan Stanley say that not only will the powerful prospective cyclical downturn in the global economy be a major shock to Emerging Economies (EM) and currencies, but they believe that structural reasons for investors, such as the impact of rising US savings, suggest they should be less enthusiastic about many EM currencies beyond this impending global recession. 

The economists argue that the outsized US current account (C/A) deficits in recent years have helped flatter the C/A surpluses of many emerging economies, especially those in Asia.  At the same time, such an extraordinary boost to demand for Asian exports may have also contributed to the strong commodity cycle witnessed in the past two years. 

They say that if, however, the reversal in the US credit cycle persists, the US C/A deficit should also decline, dragging down the C/A surpluses of many EM economies and their demand for commodities.  But since exports and commodities have been two powerful engines of growth for EM, the potential growth for many EM economies, in the new ‘steady state’, should be lower than it was before the financial turmoil. 

Thus, while some investors may see the current sell-off in EM assets, including currencies, as a temporary shock, and that EM currencies and economies will eventually return to ‘normal’, they argue that the new ‘norm’ – while it may still be impressive – will likely be more tempered than the old ‘norm’.

US Private Savings Rate Is Rising Sharply

Stephen Stephen Jen & Spyros Andreopoulos  (i) US net housing wealth, as a percentage of disposable income, (ii) US net equity wealth, as a percentage of disposable income and (iii) the long bond interest rate – explain 83% of the movements in the US private savings rate.  Of these three variables, the most powerful driver is US net housing wealth, which had been in sharp decline for four quarters. 

After remaining close to zero from 2005-07, the US private savings rate surged sharply from 0.1% in 1Q08 to 2.7% in 2Q08 – a level last seen six years ago in 2Q02. 

This sharp recovery in the US private savings rate was predicted by the Morgan Stanley three-variable model.  In fact, based on what we know about the determinant variables, the US savings rate could rise to 5.7% by end-2009 – a level last seen more than a decade ago, in 1997. 

Implications for the Global Economy

Jen and Andreopoulos say that the US C/A cycle has powered several trends in the global economy in the past years.  Normalisation of the US C/A balance will also have important implications for the world, in their view. 

Implication 1.  Smaller US C/A deficits will lead to lower C/A surpluses in EM. Since 2000, the NPV (net present value) of the cumulative C/A deficits of the US totaled some US$6.0 trillion.  This figure is on the same order magnitude of the total world’s official reserves of US$7.2 trillion.  While they say that they are not arguing that all of the world’s official reserves have resulted from the US net external deficits, they believe that the rest of the world’s (RoW) official reserve positions would not have been nearly as large as they are had it not been for the US C/A deficits.  But if the US C/A deficits have been a result of the low private savings rates, which in turn was related to the housing bubble, then it is reasonable to ask what the RoW’s official reserves and export growth would have looked like in the absence of this US housing bubble.  Alternatively, instead of thinking about this ‘counterfactual’ of what would have happened in the absence of the US housing bubble, the possibility that the US private savings rate could be moving back to 5.7%, from close to zero in 2007, should have major implications for the outlook of the RoW’s C/A surpluses.  Investors should, in their view, seriously consider the scenario of a sharp compression of the trade and C/A surpluses of Asian countries in the years ahead.  This compression could be as high as 30-50% of GDP over the coming years.  Such a development is not positive for the currencies of export-oriented EM economies, unless EM economies succeed in developing their domestic demand as the new engine of growth. 

Implication 2.  EM’s potential growth could be slower than many may think.  Many EM economies have continued to be export-oriented, with domestic demand not being nearly as robust and reliable an engine of growth as many would like it to be.  More than a cyclical shock, if the compression in their C/A surpluses is as much structural as it is cyclical – the potential growth rate of EM economies may be lower than many may believe, based on the recent growth performance, and assuming under-developed domestic demand.  The economists say that they do not know what this new potential growth rate might be, but they suspect that it is lower than the average growth rate since 2000. 

Implication 3.  The global commodity cycle probably would not have been so powerful had it not been for the US credit/housing cycle.  To the extent that the commodity super-cycle we’ve witnessed in the recent years was propelled primarily by the outsized demand growth in some EM economies, pushing supply to its capacity, investors’ expectations of commodity prices should also be tempered. 

Implication 4.  The US C/A deficit could be compressed more sharply than some may think. ‘Completing the circle’, with risks to US growth biased to the downside, and the private savings rate on the rise, two opposing forces will impinge on the dollar in the quarters ahead.  On the negative side, while the US may be ‘first-in-first-out’ – if it leads the world’s recovery in terms of timing – two or three quarters from now, the US recovery is unlikely to show too much vigour, in the view of the economists, because of the rising private savings rate.  They do not expect fiscal stimulus to fully offset the structural change in US private savings behaviour.  A tepid US economic recovery could put the dollar back onto the back-foot when the RoW starts to recover.  On the other hand, the sharply lower US C/A deficit – if it materialises – should be positive for the dollar.  They say their own guess is that, in assessing these two opposing forces, investors are likely to emphasise relative growth, in the recovery phase, rather than rewarding the USD for its shrinking C/A deficit.  This notion underpins their view that the prospective further USD rally will be ‘front-loaded’ in that the dollar is likely to appreciate as the world falls into a deep recession.  However, when the world recovers several quarters from now, the US will likely lag behind other countries and the USD will give back some of the gains. 

The Past Seven Years, and the Coming Seven Years…

Jen and Andreopoulos say it is important to think about how the ‘general equilibrium’ of the global economy will change, as the US credit cycle reverses.  The powerful trends witnessed in the past seven years – (i) extraordinary global growth, (ii) outsized US C/A deficits, (iii) large C/A surpluses of some EM economies, (iv) rapid official reserve growth, (v) the rapid rise of EM, (vi) commodity super-cycle and (vii) the weak dollar – will likely not be repeated in the coming seven months, possibly seven years. The key point for EM is that, while the structural EM story remains broadly compelling, it may have been grossly exaggerated in parts, and that some EM economies have prospered on the back of the US housing/credit cycle, and not on policy efforts of their own.  Financial markets are in the process of sorting out the ‘good’ from the ‘bad’ within EM. 

Bottom Line

The economists say that the world is inter-connected, not just cyclically but also structurally.  They believe that the outsized US C/A deficits in recent years (totaling US$6.0 trillion since 2000) have powered a good part of the rise of EM.  There are signs that the US C/A deficit may shrink sharply as its private savings rate rises in the coming years.  This will reverse many of the trends we’ve witnessed in the past seven years, and expose the EM economies that rose more on the back of the US credit/housing/current account cycle than on efforts of their own.  More than a cyclical shock, investors may want to have a fundamental, comprehensive and critical reconsideration of their structural thesis on EM, if structural changes progress in the US, as expected.

Finfacts Sept 2008 Report: US Economic Conundrum: American consumers not spending enough; Spending too much

Economist Intelligence Unit forecasts one emerging market economy will experience a full blown crisis

Robin Bew, Chief Economist of the EIU said last week: "I think it’s almost certainly going to be in Central/Eastern Europe. I mean if you look at the economic indicators, the warning signs that you would normally look at if you were appearing for a traditional emerging market crisis - large external deficit, very big reliance on foreign funding, not much policy room for manoeuvre - there are a number of economies in Eastern Europe or the former Soviet Union that look very, very vulnerable. I think it’s probably difficult to pick which. Hungary, Romania, Ukraine all look very vulnerable. There are also of course economies in the rest of the world. Pakistan looks also extremely vulnerable and even if you look at Vietnam, considering 12 months ago it was almost the darling of the emerging markets, now again it looks quite stressed. So plenty of options for emerging markets to run into a lot of difficulty.

But I think the broader emerging market story is that they will keep going but at a much, much lower growth rate a) than was being experienced a couple of years ago and b) that most people are currently assuming. I think really, when you look at what many analysts are saying, they’re kind of shaving a little bit off the top for their forecasts. Essentially, the story is they haven’t decoupled. When you look at the numbers though it appears as if they have really decoupled. Our view is that you will see emerging markets get squeezed pretty hard. Russia is a great example of that. Even four weeks ago most people were saying Russia is going to shrug this off by and large, but of course now, everyone’s forecasts are busy being slashed and I think you’re going to see a lot of that happening in other countries around the world where people perhaps are overly optimistic right now."

EIU Video