In the backdrop of President George Bush's forthcoming visit next month and India's closer integration with the global economy, we need to start paying greater attention to the US economy, which has effectively functioned as the sole engine powering the global economy for the past decade and a half.
Even though our merchandise exports to the world is neither very large ($13 billion out of total exports of $79 billion in 2004-05) nor expanding very fast - during 2000-2005, India trade with the US increased by 63 per cent while our trade with China increased by 521 per cent - the success of our Information Technology (IT) and IT-enabled services is almost totally dependant on the US market with about two thirds of total domestic production focused on the US market.
Over the last decade, the US economy has been growing at around three-and-a-half per cent year-on-year and its annual population growth is around two-and-a-half per cent; both considerably higher than what Europe and Japan have achieved. Further, its inflation rate of two to three per cent and unemployment rate of 4.9 per cent are indications of a robust economy that is not in any danger of overheating.
In fact, the median period of unemployment is only nine weeks, or half of those lose their jobs find a new one in nine weeks, well before their unemployment benefits run out (26 weeks). Such labour market flexibility that encourages employers to take on new workers in anticipation of demand, knowing that they can always retrench when demand peters out reflects the fact that the strongest unions are in the public sector covering government employees, service workers, teachers, nurses, etc.
But it is not that the US economy faces no challenges. In fact, its primary near term challenge is of tackling its current account deficit projected at $810 billion which is 6.5 per cent of its GDP with trade deficit (excess of imports over exports) alone at $726 billion or 5.8 per cent of GDP.
The deficits are financed mostly by East Asian Central Banks - China, Japan, Taiwan, South Korea and Hong Kong. This makes the US economy vulnerable to a shift in the preferences of these Central Banks, from the dollar to the Euro, GBP or the Japanese Yen.
The effect of such a shift would be a depreciation in the value of the dollar and a resultant hike in US interest rates. The latter would effectively burst the US housing bubble, which has allowed house-owners to lower their repayment (amortisation) installments and to use the extra cash to keep on consuming.
However, the dollar which has been under pressure since the mild recession of 2000-2001 and the effects of 9/11, actually gained in value in 2005, rising 3.5 per cent on a trade weighted basis. This was primarily on account of provision in the US tax code that allowed companies to repatriate their retained foreign earnings; the resultant inflow caused the dollar to rise, but this was a one-off happening and it is likely that the currency would start moving southwards again.
There is the point that US investments abroad earns substantially more than what the US pays out for its use of foreign funds, allowing the US to maintain a net positive balance. The sheer size of the US current account year-on-year would lead to a reversal of this situation, with outflows of interest payments soon overtaking inflows from dividends (from US investments globally).
The issue of the value of the dollar is one of speed and level, that is, how fast will it depreciate and at what level it will stabilise. Mathematically, since imports into the US are 60 per cent larger than exports, the dollar must drop 30 per cent in value to bring the current account deficit to a manageable three per cent of GDP. But sentiments and interests often override mathematical models.
A fall in the value of the dollar, particularly an abrupt one, would hit East Asia as hard as it would hit the US. One, the domestic economies of the former are extremely dependant on maintaining, and increasing, exports to the US and a weak currency means that the US would buy less.
Two, since these countries hold trillions worth of US assets, particularly dollar denominated bonds, they would not like to see any depreciation of the dollar. But the situation is clearly unsustainable and indications are that debtors have started diversifying their positions and moving into other currencies and assets. The debtors are looking at new markets as well as stimulating their domestic demands so that their dependence on exports is lessened.
One should close at mentioning a much larger threat to the US economy which is from the pending social security deficit that would make the present challenges seem very minor. The present social security system, a creation of FDR's New Deal, is an unfunded one, referred to as 'pay-as-you-go' system where an individual's benefits are not related to his/her contributions. In other words, current workers pay for current retirees, hence total contributions are limited to the ratio of current workers to current retirees.
The current ratio, also called the dependency ratio is still a healthy 3.3 workers for every one retiree, but in 30 years, this will fall to two. The US would have to bite the bullet either by reducing benefits or by raising contributions and the sooner it does so, the more chances it has of sustaining its growth and prosperity levels.
However, the situation is not alarming as in other developed countries. Italy, Japan and Austria are reaching the level of one worker to one retiree in less than a generation. This is due to higher levels of birth rates and immigration in the US, something the US business community and academia have grasped. Accordingly, they have been in the forefront of objections of increased barriers to the grant of study - and work - related visa, and to the phenomenon of outsourcing.
In fact, they have consistently argued for liberalising of existing regimes and it is to them as much as to the White House and the Hill that India needs to reach out.
The author is Visiting Senior Fellow, Observer Research Foundation, New Delhi.
Source: The Pioneer, New Delhi, February 16, 2006.
* Views expressed in this article are those of the author and do not necessarily reflect those of Observer Research Foundation.
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