Jan. 24 (Bloomberg) -- Stephen Roach, chairman of Morgan Stanley in Asia, talked yesterday with Bloomberg's Tom Keene at the World Economic Forum in Davos, Switzerland, about Federal Reserve and European Central Bank monetary policies, U.S. and Asian economies, currency exchange rates and a planned U.S. economic stimulus package.

(This is not a legal transcript. Bloomberg LP cannot guarantee its accuracy.)

TOM KEENE, HOST, 'BLOOMBERG ON THE ECONOMY': Steve Roach, welcome back to the program.

STEPHEN ROACH, CHAIRMAN, MORGAN STANELY - ASIA: Tom, it's always a pleasure.

KEENE: They have plasma screens around the Congress Hall here with famous pithy quotes, and there was Steve Roach up there this morning. What did you say in your meeting this morning that caught the attention of the 2,000 people here?

ROACH: Well, Tom, in all honesty, I think they ran the quote I said three years ago, two years ago, and one year ago. You know, if you say these things long enough, you're eventually going to be right. I did warn of a bubble-induced downturn in the U.S. that would be sharper than expected with significant global repercussions.

I attempted to debunk the global decoupling thesis, and I was very critical of the U.S. Federal Reserve for panicking in the fate of a -- face of a market swoon and doing an inter-meeting cut at a time it barely even qualifies for the type of inter-meeting tactics that the Fed can, from time to time, use quite effectively.

KEENE: Well, let's rip up the script here. But first, I spoke to a listener at ?Bloomberg On The Economy? here at Davos, a gentlemen by the name of Mack today at the meetings. And I said to John Mack, I said, Steve Roach is coming on the show, and it wasn't the question as we went back and forth of you finally being right, or the clock's right twice a day.

It wasn't the cliché. It was the overview. It was the view from 60,000 feet. As you look from 60,000 feet at this global system as with your positioning in Asia, what's forward? Is it just a conventional unwinding of a crisis? Or, is there something new forward in this new economy we're not seeing now?

ROACH: Well look, I have bet my career on the Asian growth dynamic, Tom. I'm living there now. I've got a new job. I'm no longer the firm's chief economist, but our Senior Executive in Asia. I'm very optimistic, and that may sound like an uncharacteristic word for me to utter on prospects for Asia. But, Asia's not immune from global business cycles.

If there's one part of the world that is the most levered play on globalization, it is Asia. Asia is tightly connected through trade flows, through capital flow, through information flows, of course, through labor flows to the U.S. and to other developed economies. So, when the big developed economies of the world go into a contraction mode, as appears to be the case in the U.S right now, it's ludicrous to think that Asia is going to get special dispensation from this development.

KEENE: When you filter it all in and you get the economic work of your co-heads of Economics, Richard Berner and Joachim Fels, are we talking about a global recession, which some have modeled at 2.5 percent or 3 percent? Or, are we talking about itemized slowdowns in Europe, in the U.S. that will affect Asia? Is it a real slowdown globally?

ROACH: Well, the -- this global downturn is made in America, which is pretty unusual. The rest of the world will feel it, but to a lesser extent. I think our global growth forecast officially at Morgan Stanley, builds in relatively modest downward --

KEENE: Um-hmm.

ROACH: -- adjustments in the U.S., in Europe, in Japan, and I think our guys who I have tremendous respect for, I hired them both, will end up revising their numbers down further.

KEENE: Interesting. And, folks, if you're just joining us as we begin our coverage in Davos, Stephen Roach of Morgan Stanley - Asia, there's just a number of things to talk about. I want to talk in our next half hour, really focus on this Fed cut of yesterday. So, let's move away from monetary policy.

Where are we in this financial crisis? Before you and I went out, we looked at TED spread, it's up again in middle ground. Is there any sense of getting through a financial crisis? Are we in the beginning of it? Is it just a recapitulation of August? Where are we now in that continuum?

ROACH: I think it's really hard to tell, Tom. I --

KEENE: I agree with that. I never say I agree, but I -- it's hard to tell. It's a right of exclusivity (ph)

ROACH: Yes. I honestly believe that at least this first wave of subprime write-downs, the bulk of that's done, because the marks that have been taken by those holding the inventory are numbers that are pretty close to zero. They're not -- they're a little bit above $0.20 or $0.30 on the dollar, but there's not much more you can write down.

What does worry me though are the second and third- round effects. As the U.S. goes into recession, then there'll be standard, cyclical pressures building on banks and other financial intermediaries that will cause yet another wave of markdowns in inventories, deteriorating lending conditions for consumers. And right now, we're all very sanguine on the state of corporate balance sheets, but inevitably there'll be some corporate distress that emerges.

KEENE: Well, Dick Berner talks about the earnings recession, has Stephen Roach considered that this idea of just animal spirit to deband credit or supply credit completely removed from the financial crisis?

ROACH: Well, I think that again, the financial crisis has its real economy corollaries or counterparts, which then feed back into the financial mechanism, which affect the performance of financial institutions. We have not seen the cyclical pressures --

KEENE: Yes.

ROACH: -- emerging in financial institutions that we normally do in downturn, and we will see that before this recession runs its course.

KEENE: I want to (inaudible) the Fed discussion, which I've been looking forward to, Dr. Roach, for our next half hour. Let's talk the dollar right now. What a rough year for the dollar? Is it, okay, we went through that. It's a cyclical correction. Have you talked to Stephen Jen about it? What does he say?

ROACH: Well you know, Stephen has got an interesting view that I actually subscribe to and that is, the dollar has been hit especially hard post early August subprime crisis because initially, it seemed as if the U.S. was alone in feeling the --

KEENE: Um-hmm.

ROACH: -- heat from this crisis. I think a lot of currency players are now coming to the view that we don't live in this brave new world of decoupling, that America's risks are global risks, because when they begin write down prospects for Japan, prospects for Europe, prospects for other Asian economies, then currency risks for those regions, those countries, will come into the equation. The dollar could actually find a bit of a bottom here as the global downturn spreads.

And then, I think the dollar will resume its long-term descent, which is in large part driven by the current account issues.

KEENE: One of the stories really below the headlines has been the recent appreciation of the renminbi. If you take dollar renminbi and you do semi-log and you throw some fancy lines across it, the correct word is an acceleration in renminbi. Why have they done that?

ROACH: I think they've done this for really one reason, Tom. They're darn worried about inflation in China. They've been reluctant to move aggressively on the currency, in large part because their financial system is still incomplete, not well prepared for the give and take of a currency volatility of a more sophisticated financial economy.

But inflation in China is an issue, and that's true of CPI. It's true of the Chinese PPI. It's true of asset prices. So, they have bought into the idea now that the currency is one instrument to be more effective --

KEENE: Um-hmm.

ROACH: -- in dealing with inflation than some of the other measures have.

KEENE: Are they getting up to a limit on their reserves, $1.4 trillion, $1.6 trillion? Some say $1.8 trillion is where the pain sets in. Are you comfortable that that's not too much money for any system to hold?

ROACH: Well, I think again given the relatively incomplete development of their debt markets, it gets tougher and tougher to --

KEENE: Because it --

ROACH: To sterilize, so --

KEENE: It's got to be close.

ROACH: So, they certainly are concerned about some operational issues in managing reserves of this magnitude, and setting up a sovereign wealth fund is one manifestation of both those concerns, as well as the objective to just achieve higher return on the reserves, as any developing economy would like.

KEENE: You mentioned higher returns. Just in the minute we've got left here in this half hour, when you say higher return, in this turmoil, this turbulence, Roach got it right. For that matter, Rabini got it right. When we look at this, does that lead to a time of lower returns on capital? Does everybody just ratchet down?

ROACH: Well, I think a lot of return has been realized in some of the riskier asset classes and as investors have rushed into high-yield corporates, into exotic securitized securities, into emerging market equities, into emerging market debt, those spreads have been driven to unrealistically low levels. And I think with risk aversion back in fashion that some of these asset classes will not deliver the way people have been expecting them to do.

KEENE: Wow, was all you can say. We come in, there's this turmoil. There's equity markets over the weekend. We're close to Martin Luther King. I see the economist's notes coming out. If they're going to act, they're going to do it in the morning. Half an hour later, boom, there they -- there are. Were you surprised at this inter-meeting cut?

ROACH: I was shocked, Tom. I'll be honest with you. You know, you've been doing this long enough, there aren't too many things that shock you. But, I was in a car winding my way up to the Davos. I get to the hotel at five minutes after 2:00 in the afternoon, Davos time. I'm tired. It takes me a while to turn the computer on. I turn the computer on at like 2:20, and I thought somebody had put a virus into my computer.

KEENE: Um-hmm.

ROACH: I mean, here we are. We've got a Fed meeting a week away. What did they learn about the economy over the last few days that prompted them into this action? They learned nothing about the economy. What they did learn is that global equity markets were in the tank, and they felt compelled to act on the basis of a market signal rather than an economic signal in an extraordinary inter-meeting move.

And you know, it really did disappoint me. It showed the Fed in a market-friendly mindset that you don't like to see if you're a believer in a disciplined and determined stance and monetary policy that is aimed at breaking out of the bubble-nurturing mode that's been in place now for, I'd say, eight or nine years.

KEENE: You and I were talking today, and folks to paint the picture for you, think 2,000 movers and shakers and people, maybe they're not movers and shakers, but they're coming here and paying a substantial fee, crowding into a coffee room, fighting for decent Espresso, and they ended up on a couch with Stephen Roach and us talking about this chart that I have here on the Bloomberg, Steve, and it's 30 years of the DOW with two deviations. All we've done is come down to the support of the 30-year DOW.

And folks, that support, is it about 11,600, which is pretty close to where we are now. The long-term fancy moving average is down another 800 points. Is this a Fed or a central bank or a government system and a financial system that just has forgotten that you can have slowdowns and corrections?

ROACH: Look, Tom, I think that's a fair point, and we've had a fairly abrupt move back to these trends in the last few weeks as equity markets do what they're put on this planet to do, and that is discount cycles both on the downside and the upside.

As it becomes evident that there's a down-cycle unfolding in the U.S., why wouldn't you expect equity markets to rethink overly optimistic earnings and expectations and bring the price of the broad indexes into better alignment with a more reasonable assessment of earnings risk in a recession?

It didn't strike me that the markets were factoring in some Armageddon-type scenario. They were simply factoring in a normal cyclical downturn. And what we've learned about markets over the last 10 to 15 years is when they get an idea, they don't take time to factor these things in gradually.

KEENE: Um-hmm.

ROACH: It happens very quickly. So, why do we have central bank panic in the face of what I think is a fairly normal --

KEENE: And --

ROACH: -- adjustment?

KEENE: And the distinction, going back to your Chatham House comments of, I'm going to guess, eight months ago or whatever where you created an uproar, can you go back into the United Kingdom? That was a joke.

ROACH: No. I go back in --

KEENE: But, they'll let you through customs?

ROACH: -- in disguise.

KEENE: Okay. You go in disguise? But, the comments you made at Chatham House and here we have a bank over there, a bank in -- the ECB. They're not doing it by the chairman's script, are they?

ROACH: No. You know, not everybody chooses to do it the Fed's way. I mean, Greenspan laid it out pretty clearly in the -- in defense of his stance in the late 90s is that, who are we to identify a bubble ahead of time? We'll wait until the bubble bursts, and we'll come in and pick up the pieces. So, what does that mean?

We just sit back, and we let the U.S. go from bubble to bubble to bubble to bubble, and we're always picking up the pieces? What happens if the bubbles get bigger and bigger and bigger if, in fact, they have done?

And you know seven years ago, Tom, when the equity bubble burst in the U.S., the sector that dragged the U.S. into recession was capital spending, which was peaking out at about 13 percent of U.S. GDP. Now, the sector that's at risk is the asset-dependent, saving-short, overly indebted American consumer, 72 percent of --

KEENE: Is it that high?

ROACH: Real GDP.

KEENE: I did not know that.

ROACH: 72. So it's 5.5 times the size of the CapEx sector that caused such an uproar seven years ago.

KEENE: Yes.

ROACH: And that's what happens when you have a central bank that is asleep at the switch that refuses to look at asset markets.

KEENE: Well, I already know starting our Davos coverage that that's the observation going to 72 percent of GDP with consumption. What is a normative level for consumption?

ROACH: Over the 25 years ending in 2000, it was 67. And the problem with the -- going from 67 to 72 is, we did it on the basis of sub-par income growth, which is why the income base savings rate fell, and the consumers did it through equity extraction, borrowing against increasingly over- valued homes. And now, the housing bubble has burst, so the asset doesn't give you as much collateral as it did. And the free and easy credit that you got from the credit cycle --

KEENE: Um-hmm.

ROACH: -- is unwound, courtesy of subprime. So, the game -- that game is over, and the consumption share is probably going to fade.

KEENE: Let's go domestic. I don't know if you've talked to Dick Berner about this fiscal stimulus. Out of Wisconsin, out of the textbooks of many years ago or your analysis now, can it work?

ROACH: Well, I think fiscal stimulus to the extent that it is targeted to those that are feeling the distress, lower to middle-income Americans who through no fault of their own will lose their jobs, see pressures on real incomes' amount, they're certainly deserving of targeted, albeit temporary, assistance.

But the broader question, Tom, is this. America doesn't save. Our net national savings rate, the savings rate of individuals, of businesses, and the government sector adjusted for depreciation, it's averaged a record low of 1.4 percent of national income for the past five years. So, since we don't save and we like to grow, we import surplus savings from abroad, run massive current account and trade deficits to attract the capital.

How are we going to fund the -- another one of these massive fiscal stimuluses, especially if we do as many are recommending, enact something like a permanent tax cut? Who's going to pick up the tab? Are we going to go to foreign investors again and say, ?come on, you know help us out, we need your money.? And by the way, the foreign investors might say, hey, maybe it's a time for us to get a concession on the terms that we're giving you the money on, like through the dollar, real interest rates.

KEENE: Yes. You couldn't even see the dollar through our interest rates. How do you respond to those that say, Steve Roach, that savings can also be a capital gain portion as we see our 401ks go to 201ks, as Catherine Cowdary (ph) would say? But how do you respond to those that say, savings is hidden in asset gain?

ROACH: Well, I think that's been the story of the last ten years. We've discovered the joys of asset-based savings. But, guess what? That cuts both ways as we see now where the asset of choice, the residential property, is going down. So with assets under pressure, not just property, but as you can see on your screen, stocks, the imperatives of saving out of income are becoming more and more significant. And that, to me, spells a significant realignment between domestic consumption and income generation.

KEENE: In the little bit of time we have left, I've got to bring it back to Asia and what must be excitement for you to move there. We just had an important election in Taiwan. What did the reaffirmation of the older party in Taiwan, what did that mean to Mainland China?

ROACH: I think it was a sigh of relief. The last thing that China wants is a friction politically with Taiwan.

KEENE: What do they want? What do they want with Taiwan?

ROACH: I think -- under Chen Shui-bian, there was a risk here that the separatists would continue to put pressure. What China's looking for, again, is no timetable for imminent political reunification, but something over time that brings China and Taiwan together, as we've seen in Hong Kong, as we've seen in Macau. And China is more than willing to allow separate systems to operate, as we've certainly had the case in Hong Kong, but is intolerant of political separatism.

KEENE: What's been the biggest surprise of moving from moving from economics to management.

ROACH: I think you know learning what the entrepreneurs and what the companies are doing. Last year in China, Tom, we led 21 IPOs of Chinese companies, 19 of them were private companies, 2 were state-owned. That's a flip-flop from what it used to be. It used to always be the state-owned companies that would privatize. So China's really developing now new companies, a powerful micro story to go along with, which has always been a very good reform and macro story.

ROACH: That's been a surprise to me.

KEENE: Stephen Roach, thank you for kicking off our Davos coverage with us.

***END OF TRANSCRIPT***

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#<253382.323457.1.0.69.26862.25># -0- Jan/24/2008 13:17 GMT

Last Updated: January 24, 2008 08:17 EST