Stephen King: Developing economies show the way for the US and EU to recover

Emerging nations spend their money on investment goods, not modern-day ephemera

Only a few years ago, the world economy was dominated by the US. When it sneezed, the rest of the world caught a cold. Nowadays, however, the evidence suggests that the US is increasingly dependent on the rest of the world. To understand why, you have only to look at the peculiarities of recent US data releases.

Despite all the encouraging signs of recovery in recent months, the US unemployment rate continues to rise. In October, the rate rose to 10.2 per cent, despite a half-decent bounce in overall output in the third quarter. Unemployment is in danger of reaching a new post-war high. If recovery is on the way, why are companies letting workers go? Why are they not re-hiring to meet higher future demand? The answer may come from the varying fortunes of different parts of the US economy.

The Institute for Supply Management (ISM) publishes monthly indicators measuring the health of the manufacturing and non-manufacturing sectors. Both have shown some improvement in recent months but, whereas the manufacturing survey points to an economy quickly returning to health, the non-manufacturing survey paints a less convincing picture. Activity across service industries is just about expanding but employment most definitely is not.

Indeed, the gap between employment conditions in the two sectors is the biggest since the mid-Nineties, when ISM first released data on the non-manufacturing economy. This gap deserves some serious prodding. Most of the time, employment prospects in US manufacturing are not as encouraging as those in non-manufacturing. That should come as no surprise: the US manufacturing industry has been in relative decline for decades, at least partly as a result of increased opportunities for out-sourcing to countries with supplies of cheap labour. But non-manufacturing includes the kinds of activities that Americans regard as strengths: arts, entertainment and recreation; accommodation and food services; finance and insurance. Yet, according to ISM, businesses in these three categories are still struggling.

If manufacturing is doing so well, why are these other areas of the US economy, which used to offer so much promise, doing so badly? One possible explanation is the decline in the dollar, which has improved manufacturing competitiveness. Against a basket of currencies, the dollar has lost around a third of its value over the last eight years and around 10 per cent of its value over the last 12 months. Certainly, US exports rebounded smartly in the third quarter of 2009. However, imports rebounded at an even faster rate, suggesting that the dollar has played no significant role, at least not yet.

Another explanation which is more plausible is that the manufacturing ISM survey says more about global rather than local economic conditions. It captures the world trade cycle, which is still dominated by trade in manufacturing, and reveals more about the health of the global economy than it does about the performance of the US itself. Indeed, the recovery in the US manufacturing ISM survey closely matches recoveries in similar surveys across Europe. At first sight, these similar experiences look odd: the euro has hugely appreciated against the dollar, suggesting that eurozone companies should be struggling compared with their American counterparts. However, big companies on either side of the Atlantic now have global production platforms: their global prospects may not be hugely affected by movements in exchange rates. More important for them are changes in the manufacturing inventory cycle.

In the early months of 2009, manufacturing companies were de-stocking aggressively, primarily via cutbacks in manufacturing production. Now, helped along by "cash for clunkers" and related car-scrappage schemes, de-stocking pressures have eased and production has bounced back, at least temporarily.

The improvement in global manufacturing conditions may also reflect a shift in the balance of global demand. A generation ago, the emerging nations were tiny in economic terms and their influence on the major industrial nations was minimal. Following decades of, in some cases, extraordinarily rapid growth, many emerging nations are now major players on the world stage. Unlike the developed nations, they spend their money on investment goods and not on the ephemera associated with modern-day consumption. And their spending is only going to get bigger. As my Hong Kong-based colleague, Qu Hongbin points out, Beijing's subway system is tiny compared with London's Underground, yet its population is far bigger (and I've just returned from Mumbai where there is no subway system at all).

The emerging nations have pulled out of this crisis faster than the developed nations. Part of the reason has been a renewed focus on precisely the kinds of infrastructure projects which help to explain otherwise odd developments elsewhere in the world. If Western demand is so depressed, why are oil prices so high? Why are commodity-producing nations – for example, Australia and Norway – raising interest rates when no lead has been given by the US or the eurozone? Why are German capital goods exporters doing well when the euro has appreciated such a long way?

The answer to all these questions is the enhanced economic muscle of China, India, Brazil and other emerging nations. Meanwhile, life for domestic non-manufacturing companies remains tough in the US and Europe. The reasons are not hard to fathom. The credit crunch is ongoing. Banks don't have the funding of yesteryear and, as a result, are having to ration credit more aggressively. Shortages of working capital leave companies scrabbling around for cash: firing workers is one simple way of improving cashflow in these difficult times. Even with the recovery in financial markets seen over recent months, job losses in the financial sector more broadly will probably continue. And while the various subsidy schemes may have lifted demand for cars, they may have diverted demand away from other areas.

More generally, the US economy and, for that matter, the UK economy, fell off the edge of a cliff two years ago. They have both suffered a hard landing and are now trying to climb back up in an attempt to return to some sense of normality. It is going to be a long, hard climb. In an economic battle for the survival of the fittest, companies will be under tremendous pressure to keep tight control over their costs, even as activity begins to rise again. Labour markets are, therefore, likely to remain weak. Moreover, with the credit crunch still very much in place, new start-up companies will be few and far between, implying that many people will end up leaving the labour force altogether, as they have been doing so in droves in the US in recent months.

The silver lining will come in the form of rapid productivity growth as output rises faster than job creation. That, though, is cold comfort. The best decade for American productivity growth in the 20th century was the 1930s simply because employment fell even faster than output. We won't see any repeat of those conditions but, with Western economies still on economic life-support, the best hopes of recovery lie not with the US or Europe but with growing demand in the emerging world. We have to hope that, when the US sneezes, the emerging nations go shopping.

stephen.king@hsbcib.com