"There are two trains running in East Asia, each fueled by hollow rhetoric and propelled by dangerous, self-deluding myths. Each of these locomotives heeds only its own signal, and the danger grows by the season that, if there is no coordination, a huge wreck might one day ensue.
"The two trains are, of course, China and Japan. The former, long decrepit, its wheels rusted by decades of Communist mismanagement of the economy, has lately worked up a huge head of steam. China surprised the world by announcing it had "discovered" previously unaccounted-for economic production equivalent to the output of entire countries, say, Austria, for example. Whoops: "Off the tracks! We’re coming through!"
"The other country, Japan, a longtime economic superstar, had been in the doldrums for over a decade, a victim of high costs, excessive regulation and a slow-to-adapt mentality in a fast-changing world. Japan is enjoying something of a revival, at least in a near-term economic sense, and today, the country’s conservative leadership is feeling its oats, evidently in no mood to play second fiddle to an accelerating China.
"Competition exists between these two countries on many levels, as do animosities both recent and old."
Commentary & Analysis
Collision course: China and Japan…Starring the Eurozone, with US in a cameo
Countries have interests. Most have allies. All have enemies(real, perceived, and of the manufactured variety). In times of economic turmoil enemies appear more menacing. The normal jockeying for position by a country during the good times, may often be perceived as a threat (or opportunity to manufacture a threat) by another during the bad times. It seems China and Japan, because of the inordinate impact of global rebalancing on current account surplus countries, may be locked into this game of "perceived or real" threat for some time. Interestingly, the key global economic policy choice being made inside the Eurozone could grease the slides along a collision course forChina and Japan. The impact of such a collision would likely lead to an end of the euro currency regime as we know it, but the potential impact on the global economy would be even worse.
As you know, this story started where all current day economic stories start, with the great credit crunch of 2007-08 [actually the seedssown beforehand, such as the belief "free credit’ was really free,started it all, but Ithink you understand all that by now.] The credit crunch was the catalyst leading to our currentera, or quagmire, of global rebalancing. Think of it as a global "market clearing" mechanism that slowly and inexorably plows forth. It’s pernicious and seemingly impervious to the whims of government or central bank "stimulus" efforts, [which prefer the old order to market clearing] as we have witnessed.
"Six years into this regime and the opposite of those stated objectives has been achieved: global debt has become more unsustainable, global GDP growth is declining and global unemployment is at record- high levels.
"This is a global policy failure that the monetary authorities of the major economies beganrecognizing earlier this year, when a debate arose at senior central bank level. The debate was triggered by the fact that in the aftermath of the 2008 crisis, the already excessive total (government, corporate and household) global debt increased further to become even more excessive: from $175 trillion to$223 trillion. It also became more unsustainable, from 285% of global GDP to 313% of global GDP."
In a world of global rebalancing aggregate global demand is relatively scarce. It isthe natural order, because those countries with big current account surpluses are, well, rebalancing and shrinking those deficits. This is why Professor Michael Pettis refers to the following chart as "the scariest graph in the world," in his latest missive on China:
The chart below shows the Euro Area (EA) surplus or deficit as a percentage of GDP; the forecast calls for the surplus to grow into 2014…
According to Prof. Pettis:
"The graph makesit pretty clearthat the surge in European surpluses, which was largely matched before the crisis by the surge in deficitsin peripheral Europe, is expected to be maintained even as surpluses in China and Japan, the other leading surplus nations, have dropped dramatically, butsince these northern European surpluses can no longer be counterbalanced by deficits within peripheral Europe given how indebted and troubled are their European trade partners, the hope issimply to force them abroad. In a world with weak demand and deteriorating trade relationships, in other words, the northern Europeans have decided that ratherthan boost domestic demand they will resolve their domestic problems by absorbing far more than theirshare of global demand [through exporting], to the tune of 2-3% of Europe’s GDP.
"This is absurd. If they succeed it will only be temporarily and at the expense of their alreadysuffering trade partners, and as a consequence it will just be a question of time before global trade relationships get even nastier than they have been. Of course if trade relationships deteriorate enough, and so force the imbalances back onto Europe, the result will be a surge in German unemployment with no corresponding relief in unemployment in the periphery."
Thus, if global rebalancing continues to dominate the landscape, the unintended policy impact from Germany would likely finally drive a large nail into the euro currency regime coffin.
It is also interesting to think about the consequences of Japan’s three arrow policies, specifically as it relates to China. It seems logical that if Japan’s efforts to weaken its currency continuesto succeed, a cheap Japan leads to both hot money flow and foreign direct investment flow out of China. With the growing political tensions between Japan and China triggering rising animosity and violence against Japanese companies operating inside China, said companies may be quick to move back home if the relative costs become more in-line. So, maybe Japan’s success is to China’s detriment in this rebalancing process. Thus, yet another negative self-feeding feedback loop in the making.
We could go on till the cows come home asking "what if" questions and paint various scenarios for the future and choice our bias accordingly. That said, I have attempted to think of just a few "what if’s" that would increase the probability of a China-Japan collision.
– What if China’s political leaders are not in full control of the military?
– What if the Chinese real estate market finally breaks?
– What if Prime Minister Abe is able to change the constitution and allow for an aggressive military build up in Japan?
– What if Germany refuses to increase domestic demand in order to alleviate global (and perhiphery) trade pressure?
– What if the US follows up its provocative sounding "Asian pivot" with a tightening of Chinese economic breathing room through trade sanctions?
One would think most of this stuff can be avoided. After all, if I am asking these questionsit’s likely the "best and brightest" have already built White Papers around them. But keep in mind, this stuff is linked to the hubris of politicians, not the sanity of real thinking people. Anything, as history tells us, can and will happen.
If neither China nor Japan gets some breathing room soon, the cat and mouse game of "pride versus pride" could quickly spin out of control. If so, this would most likely further exacerbate the already powerful forces of global deflation. In a world where debt levels (debt/gdp) have a spiraled to levels never witnessed before across the industrialized world as a whole, a collision between China and Japan would likely unleash a powerful self-reinforcing downside catalyst that could crush already suspect collateral values, exposing the rouse of modern central banking which implies debt doesn’t matter.
This is why despite all the analysis and machinations supporting the idea of a bond bubble in the US Treasury market, we expect bond prices to go lower in the months ahead and the US dollar to benefit from the corresponding funds flow as wrecking ball of global rebalancing swings along.