Why signs of recovery could be very bad news

PUBLISHED : Friday, 29 May, 2009, 12:00am
UPDATED : Friday, 29 May, 2009, 12:00am

Investors in the Hong Kong stock market were in a jubilant mood on Wednesday.

Overjoyed that consumer confidence in the United States surged this month, and encouraged by signs that heavy investment is supporting rapid growth in China, they concluded that the long-awaited economic recovery is now well under way.

In response, they piled into Hong Kong-listed stocks, pushing the Hang Seng Index up 5.26 per cent to its highest close since the beginning of October last year (see the first chart below).

What few stopped to consider amid the euphoria, however, is that the sort of recovery they hope is indicated by recent data would be one of the worst possible outcomes of the current financial crisis.

On the surface, things don't look so bad; quite the opposite.

The latest Conference Board survey of consumer sentiment revealed a remarkably upbeat mood among US shoppers, with its closely watched index of consumer sentiment shooting up to hit 54.9 this month, the strongest reading since September last year (see the second chart).

Investors interpreted the gain as a sign that efforts by the US authorities to encourage consumer spending are finally working. Anticipating a revival of US imports from China, they snapped up the shares of companies exposed to transpacific trade. Li & Fung, for example, rose 10.82 per cent.

Recent noises from China also appear to point to a recovery in trade. On Wednesday, the State Council promised to try 'a thousand ways and a hundred plans' to boost the export sector, including raising tax rebates for labour-intensive exports and setting up an US$84 billion export credit guarantee fund.

Domestic developments, too, have been interpreted as encouraging. With mainland urban fixed-asset investment up 30.5 per cent in April compared with a year before, economists have been busy revising up their growth forecasts, and investors have rushed to buy into firms seen likely to benefit, like banks and infrastructure plays.

Yet, while these indications of recovery appear to be good news in the short term, in the longer run they look ominous.

The picture of recovery they paint is one in which US consumer demand revives towards pre-crisis levels while in China rapid growth is maintained by ever-increasing investment and government support for the export sector.

In other words, investors are betting on a reversion to the conditions that prevailed before the crisis, in which US consumers spent too much and saved too little while in China high investment squeezed out consumption - the very conditions that created the imbalances that caused the crisis in the first place.

The trouble is that, if these conditions were unsustainable before the crisis, they will be equally unsustainable afterwards. A reversion to low savings rates in the US alongside the maintenance of high savings and investment rates in China will merely perpetuate the existing imbalances, heightening the risk of another, even more severe crisis in the future.

Happily, it may not happen. A closer look at the Conference Board survey indicates the upturn in sentiment is based mainly on improving expectations, themselves probably driven largely by the recent rise in the stock market rather than by any improvement in underlying conditions.

Meanwhile, in China, the bank lending levels that are powering the current investment boom look unsustainable, which means any decline in lending over the coming months is likely to lead to a tailing-off in growth.

In other words, the apparent recovery that investors are betting on could prove to be a false dawn. That's bad news for the investors who bought so eagerly into Hong Kong stocks on Wednesday, but if it gives the world's economic imbalances a chance to adjust, it could just turn out to be a good thing in the long run.