The new topsy-turvy global equilibrium

I find myself constantly asked what will happen to the stock market in 2007. I protest that predicting markets astrology more than economics, but in vain.

So, here is my astrological forecast for 2007. Taurus, the great bull of the markets, will be in the ascendant. Ursa Major ( the Great Bear) will blanked out by white clouds. I hope that sounds sufficiently professional for me to turn astrologer.

Could I be wrong? Yes I could be calamitously, hilariously wrong. The potential calamities include fresh terrorist strikes on the USA, a collapse of the US dollar, and a housing crash across Western economies. Murphy’s Law says that anything that can go wrong will go wrong. But it does not say that this will be the case in 2007. So let me make bold to say that the chances are at least 80% that the world economy will continue to boom, and the Indian market along with it.

In my four decades as a journalist, I have never seen the world economy look so good. Developing countries as a whole grew by a whopping 7% in 2005, the fastest in history. Earlier, the only miracle economies were tiny states like Singapore, Hong Kong, Korea and Taiwan. Today, the miracle economies countries include the biggest countries in the world in terms of population—China, India, Pakistan. Even Africa has grown at 5.5% per year four years in a row. Asian growth has fuelled demand for all commodities, benefited commodity exporters such as Africa, Latin America, the Middle East and Russia.

Sustainable? Well, I have made skeptical noises for so long, and to such little effect, that I simply must stop. No flash in the pan can last so long. We are witnessing is a new, high-growth equilibrium that does not exist in any textbook.

Textbooks say that rich countries have excess savings while poor countries are chronically short of funds. This, say the textbooks, will lead to trade surpluses and high savings rates in rich countries, along with trade deficits and low savings rates in poor countries. Equilibrium will be reached through a capital flow from capital-surplus rich countries to poor, capital-scarce ones.

But the real world has turned textbook theory topsy-turvy. The richest country, the US has the lowest savings rate (negative in terms of disposable household income) and the biggest trade deficit (approaching $ 750 billion, or the entire GDP of India). Meanwhile most Asian countries, led by China, have huge savings and trade surpluses. The resultant global imbalances are massive, yet cause no crises since the largest debtor and deficit country, the US, finances its deficit by simply printing greenbacks.

In the long run this is unsustainable. But in the long run we are also dead. As long as the world has an appetite for dollars—and that could be the case for many years— there seems no danger to the topsy-turvy equilibrium based on spendthrift Americans and Asian save-oholics.

Individuals would never accept an unending flow of dollars: their appetite would wane. If commerce alone determined outcomes, the dollar would crash. But the biggest buyers of dollars are neither individuals nor commercial entities. They are central banks.

Ordinary investors would never accumulate assets whose oversupply creates a ridiculously low yield. But no central banker has ever been sacked for buying dollars. Excess world savings invested by central banks in dollar securities have forced down the yield on 30-year US treasury bonds to just 4.8%, far lower than the short-term US rate of 5.25%.
Any commercial fund manager who did this would be sacked instantly. Economist Larry Summers has estimated that countries could increase their GDP by a clear 100 basis points if their central banks shifted a modest part of their forex reserves out of US treasuries into the safest index equities. But central bankers aim not to maximize yields but to manage something very uncommercial called the national interest. And so they opt for safety beyond all commercial norms, and stick to dollars.

Besides, Asian central banks want to keep their exchange rates at levels that encourage export and economic growth. Rather than let the surplus savings of their countries be reflected in currency appreciation, Asian central banks are buying up dollars on forex markets to keep their currencies down.

Finally, central bankers have accumulated such huge dollar hoards that they now have a vested interested in a strong dollar. A dollar slide will dent the value of their forex reserves, and so they have a perverse incentive to accumulate more and more dollars just to prop up that currency.

Is there a limit to the dollars central banks can accumulate in this fashion? Actually, no. Central bankers control their own printing press, and can print as much as they want to buy dollars. So, in the new topsy-turvy equilibrium, the US treasury can keep printing dollars without limit to finance over-consumption. And Asian central banks can keep printing domestic currency without limit to buy those excess dollars.

A crunch will come only when central banks publicly admit that their dollar treasure trove is somewhat illusory. That will be like the emperor recognizing that he has no clothes. This could lead to a panicky exit of central banks from dollars. That day still looks some way off.

This column about Indian stock markets said nothing so far about India’s economy. Why? Because stock market trends are now mainly global, not national The Sensex has zoomed mainly because of global events: a surplus of global savings is chasing assets of every kind round the world from stocks to bonds to gold to real estate. Rapid Indian GDP has certainly an additional India factor for world investors. Yet if today’s global surplus of savings contracts for some reason, the India factor will not save the Sensex from collapse. The future of the Sensex is bright not because Indians have suddenly become geniuses, but because India has become part of then global economy at a particularly opportune time.

 

What do you think?