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What should have been discussed during the SED meetings (Part 2)

August 10, 2009 in Asian development model, Balance of payments, Consumption and production, Exports and imports, Global liquidity by Michael Pettis | 54 comments

In my last entry I tried to set out the necessary shifts over the next few years as the world, and especially China and the US, works out its imbalances. \’a0These shifts will take place, I am pretty sure, but they can do so under a \’93good\’94 scenario and a \’93bad\’94 scenario.

So what does all this have to do with the SED?\’a0 It means that the best hope for the two countries, I think, is a well coordinated set of policies acknowledging that the US savings rate must rise, and with it the Chinese must decline, but also recognizing that if this happens too quickly, or is accompanied by a collapse in trade, it will be bad for the US and terrible for China.\’a0 These coordinated policies must also acknowledge \’96 and this becomes much more difficult \’96 that the current Chinese stimulus may be making the adjustment more difficult, and much of it will have to reversed at the same time as the \’93appropriate\’94 measures aimed at spurring consumption may cause a short-term rise in unemployment.
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Finally, the while the US commits to keep fiscal spending high, to turn a blind eye to trade disputes, and to run large trade deficits for several years more, China must commit to the financial sector and currency liberalization that will effectively reduce subsidies to producers and constraints on consumption.\’a0 The SED might also discuss the ability of workers to demand and enforce wage increases, since there is a wide consensus in China and abroad that among the main reasons for low household consumption in China is that wages are rising too slowly relative to GDP, and household savings are “taxed’ too heavily via interest rate policies.\’a0 Of course discussing workers right in a bilateral context is politically difficult, even without the irony of this particular discussion, so it will probably not happen.
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When I discuss these issues, I am often confronted by the \’93aha!\’94 crowd who point out that my analysis must be wrong because if China does what I think they should do that would cause a rise in unemployment.\’a0 How can a policy be the right one if its implementation leads to a bad outcome?

That\’92s easy.\’a0 It can be the right policy if the alternative leads to a worse outcome.\’a0 That\’92s the problem.\’a0 There is no silver bullet here that can kill all the demons and leave us living happily ever after.\’a0 As I see it, the imbalances of the past decade were real and must be addressed, and we have broadly speaking three possible ranges of outcomes:

1. The US returns to its consumption orgy, the US trade deficit surges, and we\’92re back to the wonderful days of 2005. China can continue pumping out production and funding US consumption.\’a0 The problem of course is that this cannot be a permanent solution.\’a0 It just postpones the resolution of the global imbalances while fueling another asset bubble and saddling the US with even more debt and China with even more excess capacity.

2. China begins a long \’96 five or six years at least \’96 process of forcing the necessary structural changes that will permit a shift from a production-led economy to a consumption-led economy.\’a0 The changes necessary involve liberalizing interest rates and the banking system, allowing workers higher wages, and a number of other measures to boost SMEs, the service sector, and household consumption.\’a0 In the short term, however, nearly all of these measures will involve closing down unprofitable production facilities.\’a0 This must be done in conjunction with the US, so that the US adjustment is slowed down to a pace which China can absorb.\’a0 The US would do this by keeping fiscal expansion high enough to counteract the contraction in US household consumption.

3. Everyone does what they want to do anyway with no attempt at serious coordination.\’a0 US savings rise.\’a0 Chinese production rises too.\’a0 These two forces are globally incompatible and eventually lead to a sharp contraction in global GDP growth. \’a0The effects on China might include, but are not limited to, an explosion in Chinese inventory, a sharp and nasty contraction in international trade, or a brutal rise in Chinese NPLs and an unsustainable government debt burden.

High savings in China is not an accident.\’a0 Chinese trade and industrial policies that were aimed at generating employment growth by directly or indirectly subsidizing the cost of production, including currency and interest rate policies, nearly all effectively created forms of income and consumption taxes that constrain consumption even as they boost production (and a rising savings rates just means that production is growing faster than consumption), and to remove the latter you need to remove the former too.

It\’92s not so easy to increase consumption

So they have a dilemma: Remove the producer subsidies so as to allow consumption to grow, but cause subsidized producers to go out of business.\’a0 Or keep them in place, and perpetuate the production/consumption imbalance.

One way or the other Chinese policymakers are destined to be “successful” in raising the consumption share of GDP, because as the US reverses its earlier relationship between consumption growth and production growth, the rest of the world, which ran the opposite position, must also ultimately reverse.

Now for the next few years China’s savings rate will almost certainly decline and its consumption rate rise \’96 it has no other choice except to inflate a major, debt-fueled overinvestment boom \’96 but will that happen because of high growth in consumption or low production growth?\’a0 That is where policy matters very much, and the longer they wait to address the imbalance, the worse the outcome gets, I think.

Clearly Beijing wants to raise consumption quickly. \’a0Not too long ago a group government economists were reported to have reported on their website (sorry, but I lost the link):\’a0 “The new policy measures and initiatives will be the latest effort to shift growth from focusing on capital investment to a more sustainable model that gives domestic consumption a more important role in boosting economic growth.”

But they’ve been wanting to do this for a several years \’96 as they explicitly acknowledge by calling this the “latest” effort \’96 but the fact that it is harder to this now then it might have been three or four years ago doesn’t inspire me with much confidence.\’a0 It seems to me that most policies that will boost consumption in a stable and efficient way fall into one of two camps.\’a0 Measures like building the medical and social safety net, gradually getting banks to direct lending to service industries,\’a0 loosening the one child policy, and so on can be very successful, but will take years before they have much impact on real consumption.

In that camp I might add measures to force banks to increase consumer lending, because I think the last time they tried that (with car loans), nearly half the loans went NPL, suggesting that at first consumer lending will simply consist of free consumption financed indirectly by the government, when it bails out the NPLs.\’a0 This is a form of “consumption” I guess, but it is not really what the doctor had ordered.

Bad or worse
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On the other hand reversing the policies that might have repressed consumption in the past will probably work more effectively within a shorter time horizon.\’a0 These would include liberalizing interest rates and allowing them to rise (which reverses the implicit transfer from households to producers), allowing workers to organize to demand higher wages, raising the value of the RMB, and so on.\’a0 Unfortunately nearly all of these measures would hurt manufacturers, especially in the export sector, and would cause an initial rise in unemployment.\’a0 I am not sure it is possible to manage the transition without a sharp, short-term rise in unemployment caused by the downsizing of the export sector as its implicit subsidies are removed, and it isn’t clear to me that any country that has managed a similar transition has been able to avoid this. My guess is China will have to do this, but will wait until they have no choice \’96 building up in the mean time even more excess capacity and bad debt. And bad debt, as I have argued before, must be resolved at some point in the future, and unfortunately usually in a way that constrains consumption growth.

One of the things that worries me is that the trajectory of rising US savings and increased investment in Chinese production is likely to squeeze the tradable goods sector in most countries around the world as China increase its market share. \’a0This will lead to accusations that China is behaving in a predatory way, and will almost certainly lead to increased trade tensions as policymakers around the world try to protect their tradable goods sectors form \’93unfair\’94 Chinese competition.

But I don\’92t believe that China should be considered predatory. China desperately wants to raise its consumption rate, because it is highly likely that for the next few years Chinese GDP growth will be limited to something below Chinese consumption growth.\’a0 Beijing would love to find the magic policy that transforms Chinese consumption overnight and turns China into a continental economy driven by internal demand.\’a0 It would love to see the trade surplus reduced not by a collapse in exports but rather by a shifting of exports to domestic consumption and a rise in imports (this last maybe).
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The problem is that there is no such magic policy.\’a0 I cannot find any historical precedent of a country that was able to make the transition quickly and painlessly, and because of its own domestic problems \’96 especially the employment effect of the contraction in the export sector \’96 China is facing a difficult set of policy choices. \’a0The fact that the fiscal stimulus may be exacerbating China\’92s reliance on the export sector was not the plan. \’a0The fiscal stimulus is aimed at arresting a sharp and probably politically unacceptable rise in unemployment, and the fact that so much spending has gone into investment, rather than consumption, reflects rigidities in the economic and financial structure. \’a0China would love to see explosive growth in domestic consumption, but there is no way they can easily engineer such growth.

So we are stuck with policymakers, in China and elsewhere, making the best of a bad situation. \’a0They can be criticized for not beginning the adjustment process when conditions were much easier, but that is a criticism that can be spread around pretty thickly to policymakers in quite a few countries.\’a0 Anyway it is too late.

In these circumstances policy coordination matters a lot, and I see too little of it to have much optimism.\’a0 Beijing, Washington and Brussels must recognize that China and the world is still in a more vulnerable position than anyone seems to realize, and that rising US savings and rising Chinese investment create conditions for two seemingly irresistible forces to go head to head, and without coordination the consequences could be much worse than we expect.

Squeezing out the exporters

July 29, 2009 in Balance of payments, Consumption and production, Exports and imports, Fiscal stimulus by Michael Pettis | 42 comments

I am working on a fairly long entry that I will post this weekend about why a trade rebalancing and a consumption/savings rebalancing will take place in both China and the US whether or not we want it.\’a0 This week has been crazy, among other reasons because a festival in Taiwan has invited one of our indie bands and one of our experimental bands (Carsick Cars and White) to perform this weekend at the Music Terminals Festival in Tao Yuan City.\’a0 Getting visas for these kids has been brutally difficult and they actually had to cancel one of their club gigs, on Thursday, because of problems with getting things done on time.\’a0 Still, if any of my readers are going to be in Taiwan this weekend, I strongly recommend that you check out the festival, which besides the two Beijing representatives features a lot of great bands from around the world (or if you prefer club gigs, check them out Friday night at a pre-festival show at The Underworld, in Taipei).

So much for the good news.\’a0 The bad news is described in an alarming article in today’s Wall Street Journal which shows that trade tensions are continuing to rise.\’a0\’a0

European Union trade officials approved pre-emptive penalties on imports of steel pipe from China, a precedent-setting move that suggests the trading bloc is growing more protectionist in the face of the economic downturn.\’a0 Tuesday’s vote by trade officials from the EU’s 27 member states is significant, say trade experts, because they accepted an argument from steel producers \’96 including the world’s largest by volume, ArcelorMittal \’96 that punitive tariffs are needed to protect them from the threat of underpriced imports from China.\’a0 Previously, complainants have had to prove the imports had already hurt their businesses. Trade lawyers say they expect a host of industries to ask the EU for protective tariffs in August.\’a0\’a0

I have been hearing rumblings for a while about tougher stances being taken in Europe and the US in response to the perception that China is exacerbating the global contraction in demand by increasing subsidized resources available to manufacturers, most importantly by channeling a huge increase in lending at interest rates subsidized by Chinese household consumers and socializing the risk.\’a0 These new protectionist moves seems to be an expression of just this.\’a0 The article goes on to say:\’a0\’a0

Basing a claim on the threat of injury “is a perfectly legal strategy, but it has simply not, until now, been used as a matter of EU policy,” says Nikolay Mizulin, a Brussels-based trade lawyer with Hogan & Hartson LLP. \’a0This case “is a sign of growing protectionism and could open the floodgates to many more industries who believe they deserve protection.”\’a0 Mr. Mizulin and other trade lawyers say they expect many industries to seek protective tariffs next month.\’a0\’a0

As I have been arguing for over a year, as unemployment around the world rises and as the necessary contraction in US net demand picks up pace, there was inevitably going to be a conflict with China as Chinese policymakers responded to the collapse in trade in the only way they could, by substantially stepping up investment.\’a0 The result is that China\’92s trade surplus has contracted very slowly \’96 much more slowly than the contraction in the US trade deficit \’96 and the result was a huge squeeze on the tradable goods sectors around the world.\’a0

The fact that policymakers in Europe, China, Japan and the US seem to have no clue as to how difficult the transition for each of the other countries is likely to be, and so are doing not nearly enough to coordinate their response (in fact lecturing and finger waggling seem to the favorite forms of policy coordination), makes trade conflict almost a dead certainty. \’a0I don\’92t think there are necessarily any bad guys here \’96 each country is desperately doing what it can to get itself out of this mess \’96 but there is a lot of failed opportunity and I am pretty sure that the trade environment will continue to decline.\’a0

The problem is illustrated in two interesting recent pieces. \’a0My friend Dan Rosen, of the Rhodium Group, has a very illuminating July 17 report that shows the composition of Chinese growth in the past decade.\’a0 He shows that for the past five years net exports accounted for about 10% to 15% of Chinese GDP growth, before collapsing\’a0to minus 41% in 2009 YTD.\’a0

Until recently investment’s share of GDP growth peaked at around 65% in 2003 \’96 a very high share by any standard \’96 and going back the full thirty years of China\’92s reform period achieved an historical high astonishing of 81% in 1985.\’a0 From 2005 to 2008 the investment share of GDP growth averaged around 40% \’96 still high \’96 and then in the first half of this year accounted for a mind-boggling 88% of this years GDP growth.\’a0

This year\’92s growth, in other words, is almost wholly a function of the massive increase in investment, and this increase in investment started out largely in the form of reopening production facilities and producing more \’93stuff\’94, without any significant rise in consumption.\’a0 As we know, when production increases faster than consumption, either the trade surplus or inventories must rise.\’a0

On that note Xinhua published the following article on Monday:\’a0

The per capita consumption spending volume of Chinese urban residents stood at 5,979 yuan (875 U.S. dollars) in the first half of this year, up 8.9 percent year on year, the National Bureau of Statistics (NBS) announced Monday. \’a0Deducting price factors, the growth reached 10.3 percent.\’a0\’a0 The per capita disposable income of Chinese city dwellers rose 9.8 percent year on year to 8,856 yuan in the first six months. Deducting price factors, the increase reached 11.2 percent, said the NBS.\’a0

Consumption has been rising at around 9% a year for the past several years.\’a0 Notice that if GDP growth slows to under 9%, the savings rate in China will automatically decline.\’a0

The second interesting piece is put out by the Economic Policy Institute, a group I believe not noted for its commitment to free trade. \’a0It shows China\’92s share of the US trade deficit excluding oil. \’a0According to their numbers:\’a0

Year

2000

2001

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\’a0
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2002

2003

2004

2005

2006

2007

2008

2009

Share

26%

27%

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\’a0
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28%

31%

35%

40%

45%

54%

69%

83%

Perhaps as a consequence of a fiscal stimulus aimed at boosting investment and production, China’s share of the US trade deficit has grown significantly. \’a0Since the US trade deficit is shrinking quickly, this means that other exporters are getting killed.\’a0 As I have argued for a while, this is not sustainable and will almost certainly cause trade tensions to erupt.\’a0

Does this mean China is behaving in a predatory way?\’a0 I don’t thinks so.\’a0 I have warned for a long time that it would be very difficult for China to make the necessary transition to a consumption-led economy quickly enough to accommodate the global adjustment taking place. \’a0Unless it is willing to see its economy collapse, there is simply no way China can reduce its negative net demand quickly enough to match the contraction in US demand and so avoid squeezing the hell out of the global tradable goods sectors.\’a0 That is why policy coordination is so important, especially between China and the USD, and of course that is why I continue to be a pessimist. \’a0I do not think this policy coordination is taking place.\’a0 I will write about this more later this week.\’a0

To continue the discussion of last week, we are getting more conflicting signals about policy confidence. \’a0On the one hand Bank of China seems to love this party. \’a0According to an article in today’s Bloomberg:\’a0

Bank of China Ltd., which doled out the most loans among Chinese banks in the first half, plans to keep expanding credit unless the government clamps down on the nation’s record lending boom.\’a0 The nation’s third-largest bank will maintain its original target of generating about 10 percent of China\’92s new loans in 2009, Beijing-based spokesman Wang Zhaowen said by telephone yesterday. Bank of China may \’93fine tune\’94 its strategy in line with any government policy changes, he said.\’a0\’a0

\’85Bank of China will continue to lend to 10 key industries with government policy support, including steel, shipbuilding and automobile, Wang said. About 30 percent of its loans went to those industries in the first half.\’a0\’a0

On the other hand two of the other members of the Big Four seem a lot more cautious. \’a0Today\’92s South China Morning Post has this article:\’a0

Mainland\’92s two biggest state-owned commercial banks have put a lid on their lending targets for the year, according to domestic media reports, in a move that will significantly slow overall credit growth in the second half. Industrial and Commercial Bank of China (ICBC) is aiming to issue full-year new loans of 1 trillion yuan (HK$1.3 trillion), while China Construction Bank (CCB) has set a goal of 900 billion yuan, Caijing magazine reported.\’a0

The two banks, mainland’s largest by market value, granted new loans of 825.5 billion yuan and 709 billion yuan, respectively, in the first half. \’a0If they stick to their reported targets, this would imply that ICBC would have already issued 83 per cent of its full-year lending total, while CCB would have already issued 79 per cent.\’a0

It is surprising to me that these members of the Big Four are responding so differently, at least in public. \’a0I wonder if the management of the different banks belong to different factions and so interpret the fiscal stimulus package differently. \’a0Perhaps my friend Victor Shih, who understand these things better than I do and who sometimes reads my blog, might comment?\’a0

Finally the Financial Times on Monday continued the thread discussed in my Saturday post with an article called \’93China warns banks over asset bubbles.\’94\’a0

Chinese regulators on Monday ordered banks to ensure unprecedented volumes of new loans are channelled into the real economy and not diverted into equity or real estate markets where officials say fresh asset bubbles are forming.\’a0 The new policy requires banks to monitor how their loans are spent and comes amid warnings that banks ignored basic lending standards in the first half of this year as they rushed to extend Rmb7,370bn in new loans, more than twice the amount lent in the same period a year earlier.\’a0

\’85Beijing\’92s concerns are echoed in other countries across the region, most notably South Korea, where the government says it is taking steps to cool a real estate bubble, and Vietnam, where the government has ordered state banks to cap new lending to head off inflation.\’a0 regulators are now concerned that too much money is being lent by the state-controlled banks and the country\’92s tentative economic rebound could come at the cost of a stable financial system.\’a0

In statements published last week, Wu Xiaoling, who recently retired as deputy governor of the central bank, warned new lending this year would probably reach as high as Rmb12,000bn, a staggering increase of 40 per cent of the entire stock of outstanding loans in just one year.\’a0\’a0

\’85Ms Wu hinted Beijing may soon raise the amount of money banks must hold on deposit with the central bank, marking a change of policy from last year when it aggressively slashed the reserve requirement ratio and interest rates.\’a0 The central bank has also ordered 10 banks, including Bank of China, to buy Rmb100bn worth of central bank notes with a maturity of one year and a return of just 1.5 per cent, according to Chinese media reports.\’a0 This move is interpreted as a warning to banks that have been the most active lenders that they should now start to rein in their excessive behaviour.\’a0

China\’92s savings problem and the consumption constraint

June 20, 2009 in Balance of payments, Consumption and production, Economic growth by Michael Pettis | 54 comments

I am, still trying to work out the implications for China of a rise in US household savings, but here is how I see it. I welcome comments that may help me refine or refute this argument.

For the sake of simplicity I am going to assume that there are only two countries, the US, which represents all the high-consuming trade deficit countries, and China, which represents all the high savings trade surplus countries. Although of course there are other players, these two represent the lion\’92s share of their respective blocs, and for the most part the impact of other large countries (Europe, Japan, the UK) simply exacerbate the problems as I see them.

For the past decade until the onset of the 2007-08 crisis, the US has been growing quite rapidly. Powering this growth has been an even more rapid surge in consumption. When US consumption grows faster than GDP, two things must happen.

1. The US savings rate by definition declines

2. If the country is running a trade deficit, and consumption is growing faster than production (assuming that investment isn\’92t falling, or is at least not falling by more than the difference), then the country must run a growing trade deficit. Another way of thinking about this is that if investment exceeds savings (and with such low savings rates, US investment needs were much higher than US savings), the country must be a net importer of capital. To be a net importer of capital the US must run a trade deficit. These are just different ways of saying the same thing.

In that case the US has been running a growing trade deficit powered by the decline in US savings. But everything must balance. If US consumption growth exceeds US growth in production (I am ignoring changes in investment because they are a relatively small part of this), then in China production must exceed consumption. This is just another way of saying that as the US savings rate declines and powers a surge in the trade deficit, the Chinese savings rate must rise and power an increase in the trade surplus. In fact this is what happened.

Notice I am saying nothing about the direction of causality. It could be US consumers who caused the change, and forced China into reacting. Or it could be China whose polices have forced an increase in the domestic savings rate (actually an increase in production greater than the increase in consumption, which amounts to the same thing), thus forcing the US financial, system to accommodate by making consumer financing easier. Or of course it could be a combination of the two. The point is that the balance of payments must and will balance. Actions in one part of the system will cause equal reactions in another part, and the direction of causality is never obvious (See Note 1).

As a consequence of the global crisis we are now seeing a sharp rise in US household savings rates. This has been partly mitigated by a sharp rise in government dis-saving (borrowing), but nonetheless aggregate US savings rates are rising, and with them US consumption must decline (See Note 2). If US GDP is also declining, the combination of a rising savings rate and a declining GDP must result in sharply declining consumption.

What does this mean for China? Obviously the US trade deficit is contracting quickly. This means that China\’92s trade surplus must also be contracting quickly.\’a0 In fact China\’92s trade surplus has been growing, and this is where my simplification (the world consists of the US and China) runs into a problem. Although all trade surpluses are contracting, the fact that China\’92s trade surplus is rising indicates that other surplus countries are bearing more than 100% of their share of the global contraction. I don\’92t think this is sustainable and ultimately, perhaps even already, China\’92s trade surplus will decline. By the way the fact that China has been able to force at least part of its own adjustment onto trade competitors will likely lead to increasing anger with China, as it already seems to be doing especially on the part of Asian competitors, and will power a further rise in international trade tensions.

Here is the important point, I think: As long as the US was consuming more than it produced, Chinese GDP growth was constrained on the bottom by the growth in Chinese consumption. In other words, China\’92s GDP had to grow faster than Chinese consumption (which means of course that the Chinese savings rate was rising). In fact, while GDP was growing somewhere in the region of 11-13% annually, Chinese consumption was growing by around 9% annually. Thanks in large part to US dis-saving, in other words, Chinese GDP growth exceeded Chinese consumption growth by around 2-3% annually.

So what next? Now that the US is raising its saving rate, this means among other things that the growth in US consumption will be lower than the growth in US GDP. If the US GDP grows slowly, consumption will be flat. If it contracts, consumption will contract sharply. In either case the US trade deficit should continue declining except in the very unlikely event that US investment grows by more than the increase in savings.

Since the balance of payments must balance, if US GDP growth exceeds US consumption growth, China\’92s consumption growth must exceed China\’92s GDP growth, and Chinese savings must decline. Chinese savings can decline because consumption rises, or they can decline because GDP declines, but they must decline.

That implies that Chinese GDP growth, rather than be constrained on the bottom by consumption growth (i.e. GDP must grow faster than consumption), will now be constrained on the top by consumption growth. China\’92s growth in GDP, in other words, will be less than its growth in consumption unless there is a surge in investment. There has, of course, been a fiscally induced surge in investment, but with rising debt and collapsing corporate profitability, I think this can at best continue for a year or two, and probably much less.

So what does that mean for future Chinese growth? When China was growing at 11-13% a year, Chinese consumption was growing by 9% a year. The rapid reversal in the earlier decline in US savings might cause Chinese GDP growth to grow by at least 1-2% below consumption.\’a0 So if we assume that Chinese consumption continues growing at 9%, this initially suggests GDP growth rates of 7-8%.

But hold on. If GDP growth rates of 11-13% translate into 9% consumption growth rates, is it reasonable to assume that GDP growth rates of 7-8% will still result in 9% growth rates in consumption? I doubt it. My guess is that the growth in Chinese consumption will also slow.\’a0 This suggests that while the US is adjusting, China\’92s annual growth rate must be significantly below 7-8%, perhaps 5-6%, or even lower. The key is the rate of Chinese and US fiscal expansion, in the former case to permit the rise in Chinese savings rates not to constrain domestic growth, and in the latter case to slow down the contraction of the US trade deficit.

But this is just a guess, and the example of Japan after the 1987 crash and the subsequent reversal in US dis-savings suggests that while a credit bubble can keep the game going in China for a few years longer, ultimately the surprise may be on the downside. On that subject let me note something that an unnamed official confessed about the impact of the US crisis on his country\’92s economy:

We intended first to boost the stock and property markets. Supported by this safety net \’96 rising markets \’96 export-oriented industries were supposed to reshape themselves so they could adapt to a domestic-led economy. This step was supposed to bring about an enormous growth of assets over every economic sector. The wealth effect would in turn touch off personal consumption and residential investment, followed by an increase in investment in plant and equipment. In the end, loosened monetary policy would boost real economic growth.

It sounds plausible and like it might work. Except that it didn\’92t. The unnamed official was not an anonymous friend of mine at the PBoC. According to Tomohiko Taniguchi, in Japan\’92s Banks and the \’93Bubble economy\’94 of the Late 1980s, the speaker was an official at the Bank of Japan and he made the comments in 1988, during a period when Japan was routinely referred to as a \’93creditor superpower\’94 (and a country, by the way, with enormous foreign currency reserves, and whose currency would within one or two decades, everyone knew, become the world\’92s reserve currency).

After the 1987 Crash in the US, many expected the Japanese markets also to crash. But they didn\’92t. After faltering briefly, the Ministry of Finance ordered the Big Four brokerages to support the market, and support it they did. Within a few months the Nikkei was testing new highs, leading a Ministry of Finance official to boast that manipulating the stock market was easier than controlling foreign exchange. Check Edward Chancellor\’92s Devil Take the Hindmost for an illuminating take on the Japanese bubble economy of the 1980s.

The comparisons with China are, and of course are meant to be, a little worrying. This is not to say that China must repeat Japan\’92s spectacular 1990 crash and subsequent lost decade (or two). It is simply to point out that none of what we are seeing in China is particularly new and far from being a source of great strength, the intense manipulation of monetary and fiscal policies and the financial markets can actually make the necessary adjustment for China much more difficult. Just as Japan failed to come to terms with the sudden collapse of the US trade deficit and tried to export and monetize its way out, China may be doing something very similar.

But one way or the other if the US is raising its savings rate and so forcing more rapid growth in US GDP than in consumption, China is likely to see its consumption growth constrain its GDP growth. This suggests to me that once the effects of the (I think) unsustainable credit bubble being inflated by policymakers here run their course, we are in for a longish period of much slower GDP growth.

Note 1. I know I will be assailed on both sides by people saying that only a fool is unable to see which way causality runs in this case, but let me suggest that if you know beyond any doubt the direction of causality here, then you probably do not understand the problem.

Note 2. Except, of course, in the case in which US GDP is rising much more quickly than the US savings rate, which is a complication I don\’92t think we need to worry too much about.

Tags: Chancellor

Debt is up, trade is down, and we still don\’92t know which way to list

June 15, 2009 in Balance of payments, Banks, Economic growth, Exports and imports, Fiscal debt and deficits, PBoC, Real estate by Michael Pettis | 35 comments

I am still working on my piece on the global savings adjustment and will probably post it in the next week or so. The main point is to discuss what the implications are for China if we see simultaneously over the next few years an increase in US savings and a reduction in global investment. For today I wanted to discuss some of the economic data coming out of China as well as a couple of debt-related issues.

US debt and the dollar

But first, a quick digression. Today\’92s Financial Times has an article titled \’93Fears over US sovereign debts unfounded\’94 which, as the title implies, argues that \’93Fears of a crisis of confidence in the US sovereign debt market \’96 and a subsequent dollar collapse \’96 are unfounded.\’94 On a related note Bloomberg has an article today which notes that \’93Russian Finance Minister Alexei Kudrin said the dollar is in \’91good shape,\’92 further affirming that there\’92s no substitute for the world\’92s reserve currency.\’94

It\’92s great that commentators are coming back, however temporarily, to a sense of reality and common sense. There never was likely to be a crisis in the ability of the US government to fund its deficits, and all the pleading to foreign governments to continue purchasing dollar assets was based on very fundamental misunderstandings of both the form of the global adjustment and the functioning of the global balance of payments. For the former, the problem we are facing is that as Asian savings soared over the past decade, they were accompanied by a collapse in US savings. This is not a coincidence. An increase in savings in one part of the world requires a reduction in another, and causality can work either way, so please dear readers spare me the whose-fault-is-it outrage \’96 it is not relevant here. The point is that without a marked increase in global investment, one requires the other.

The collapse in US savings was unsustainable, and it is now reversing. This creates a problem of excess global savings, which means financing deficits for creditworthy governments is not going to be a problem and will not result in soaring real interest rates. In fact Paul Krugman has a brief piece, based on numbers from Brad Setser, that shows the explosive rise in US government debt is more than matched by the contraction in household debt.

This is just another way of saying the same thing. Of course I will add my by-now-tiresome point that we do not have to worry about discretionary decisions by foreign governments as to whether or not they will continue financing the US fiscal deficit. Foreigners do not finance fiscal deficits. They finance current account deficits, and one (the current account deficit) cannot occur without the other (the financing). As long as the US runs trade deficits with China (or Russia or anyone else), those deficits will be financed, and the only thing that will stop that is a contraction in the US trade deficit, which is actually expansionary for the US economy and will reduce the need for fiscal expansion.

Remember, the US can force foreigners to invest $2 trillion a year in the US by the simple expedient of running a $2 trillion annual trade deficit. But this cannot possibly be a good thing. If we want the trade deficit to go down, we must also want foreign financing of the US to go down by exactly the same amount. This is not high-falutin\’92 economic theory, it is rather an arithmetical necessity. (By the way I tried to explain something related this Saturday when, on CCTV9\’92s Dialogue, two points were made \’96 that the contraction in the US trade deficit was causing great pain in China, and that Chinese officials were warning the US government sharply to reduce its fiscal borrowing. China cannot ask both that the US slowdown its contraction in consumption and that the US government slowdown its fiscal expansion. It is precisely the growth of the US fiscal deficit that will cause a slowdown in the contraction of US net consumption.)

The second point, that the dollar is still in \’93good shape\’94 as the world\’92s dominant reserve currency, should be obvious. I have not gotten around to writing why all these spectacular (or spectacularly reported) moves by China and others to \’93undermine\’94 the reserve status of the dollar \’96 announcements by Putin, currency swap arrangements between China and a host of countries desperate for cash, the announcement by a major Chinese banks that it will make the RMB available for international transactions, and so on \’96 are all of almost no consequence except to the paranoid. At some point I will write more about it.

Debt and risky debt structures are rising

Let me turn to debt. Last week Andrew Batson had a very interesting, and very important, I think, article in The Wall Street Journal, discussing the impact of the stimulus on the government\’92s real debt position. \’93The cost of China’s stimulus program,\’94 he writes, \’93is turning out to be much larger than official figures indicate, raising the stakes for the government’s attempt to restart high growth through massive borrowing.\’94 He points out that a lot of the spending is being funded by provincial and municipal borrowings and by corporate borrowings, \’93virtually all of which are indirectly backed by local governments.\’94

He concludes: \’93As the central government is ultimately liable for those hidden debts, China’s total state debt is closer to 35% of GDP than the 18% shown by official figures.\’94 In fact I have always argued that other not-yet-recognized liabilities, such as hidden municipal and government debt, the bankrupt AMCs, and other non-recognized debt, probably means that real government debt levels are higher than the official numbers by at least 15-25% of GDP, which suggests that, correctly counted, government debt levels may now be approaching 50-70% of GDP. If we throw in the possibility that the current bank-lending spree is also likely directly or indirectly to add to government debt burdens in the future (contingently, through a rise in NPLs), I would not be surprised if policy-makers are already starting to consider the possibility of a debt problem at the central government level. I am not saying that this must happen, but only that it is easy to construct some fairly plausible scenarios, involving the continuing global adjustment and the concomitant Chinese adjustment, that can easily suggest a debt problem.

My concerns of course were not made more palatable after I saw a very interesting article in last week\’92s Caijing (and what other magazine would have reported this?), with the unsettling subtitle \’93The property market bubble burst last year, but developers are still afloat thanks to governments, banks and a ’subprime’ solution.\’94

The article notes how unlikely it is that the massive contraction and the difficulties in last year\’92s property market were not accompanied by high-profile failures among property developers. This is because, they explain, \’93local governments and banks have intervened to prop up Chinese property developers following last year’s sharp contraction in the real estate market,\’94 and they show how this has happened.

Focusing on the case of Greentown China Holding Ltd, a large property developer that nearly went bust, they write:

Greentown faltered in the fourth quarter 2008 and stood on the brink of liquidation early this year. But it survived after a bank agreed to refinance foreign debt and a local government approved a grace period for land payments. Moreover, trust funds that use what at least one expert called a “subprime” scheme offered flexible financing for development projects.

Shou said his company has dodged the crisis. But he admitted that pulling through 2008 was extremely difficult. Indeed, Greentown saw a 10 billion yuan gap between its 2008 sales target and actual results. And debt payments loom for 2009.

The article\’92s authors, Zhang Yingguang and Gong Jing, go on to draw the unwelcome conclusions:

Industry executives think similar, short-term rescues for major property developers have occurred more frequently in recent months than generally acknowledged. For evidence, they point to the absence of high-profile failures in the industry.

This suggests that there are a lot of very dodgy debt deals out there that are based on nothing more than hopes and prayers. This doesn\’92t imply, of course, that all these deals will go bad. What I am worried about is something a little different \’96 the highly pro-cyclical nature of these deals. If China recovers, these deals will probably do fine and will be repaid, and so will never show up as contingent debt, but if economic conditions deteriorate of course that is precisely when they will go bad.

And of course that is precisely when we most desperately don\’92t want them to go bad. Throughout history credit bubbles always end up, in their later stages, with these kinds of highly pro-cyclical structures (read about investment trusts in the 1920s for example, or the Japanese real estate and lending markets in the 1980s, or, in case you\’92ve already forgotten, the sub-prime market not so long ago). As long as economic conditions and liquidity-driven asset prices continue to improve, these highly unstable structures survive and prosper, but just when you most desperately want to avoid their breakdown, when conditions turn nasty, they come crashing down on you. These kinds of structures are what I call in my book (The Volatility Machine) highly \’93inverted\’94 structures and they systematically increase volatility by reinforcing both good times and bad times.

Recent economic data

Finally, as everyone knows by now, a number of economic indicators were released last week, some good some bad. Some of the good news, according to an article in the South China Morning Post, was:

The National Bureau of Statistics said in Beijing that annual industrial output growth rebounded to 8.9 per cent in May from 7.3 per cent in April, outpacing a median forecast of 7.5 per cent. Annual growth in retail sales rose to 15.2 per cent in May from 14.8 per cent in April, slightly ahead of forecasts, partly due to a moderate pace of deflation.

For all of last year, retail sales were up 21.6 percent. Together, the two read-outs suggested a 4 trillion yuan (HK$4.5 trillion) government stimulus plan, allied with consumer spending, is starting to overcome weak global demand for the exports that powered the country\’92s breakneck growth in recent years.

Accompanied by the rise in US retail sales, this indicated to many that the Chinese stimulus package is working and that the global and Chinese economies may have bottomed out. In the author\’92s words, \’93A growing conviction that the global economy is starting to claw its way out of the deepest recession in six decades has seen stock markets rallying strongly from the depths plumbed in March, while hopes of burgeoning demand have driven prices of oil and industrial metals to multi-month highs.\’94

The next bit of good news was mainland investment levels. According to another article in the same paper:

Mainland investment surged in May on the back of government pump-priming and a recovery in the property sector, providing fresh evidence that the world\’92s third-largest economy is leading others on the path to recovery.

Investment in urban areas in fixed assets such as apartment buildings and roads rose 32.9 per cent in the first five months from a year earlier, compared with a 30.5 per cent rise in the first four months, t he National Bureau of Statistics said on Thursday.

Economists said that translated into a 40 per cent leap in May alone. Adjusted for inflation, the increase was even greater because mainland prices have been falling for several months.

Actually I think this is not good news at all. To me it indicates nothing more than that if you pump enough money into investment, investment will rise. A much more important question, and one of course not addressed by the data, is whether pumping money into investment is the best way to force the necessary adjustments in the Chinese economy, and whether this does not represent a \’91doubling up\’94 of china\’92s bet on the global recovery. That is something only time will tell, and I have written about this enough times elsewhere to leave it at that.

The bad news is that, according to a release today by the Ministry of Commerce, foreign direct investment in the mainland dropped 17.8% year-on-year in May for the eighth straight monthly fall. Honestly I don\’92t think this is such a big deal except to the extent that it gives us a \’93businessman\’92s\’94 view of economic prospects in China that is very different from the economic-recovery view so popular in the Chinese (and foreign) press, although of course it may simply reflect the desire abroad for cutting exposure and cutting capacity.

Much more interesting to me is the trade data. According to an article in Thursday\’92s People\’92s Daily:

China’s exports and imports shrank for the seventh month in row in May, the General Administration of Customs said on Thursday. Exports fell 26.4 percent in May from the same period a year ago to 88.758 billion U.S. dollars. Imports were down 25.2 percent to 75.36 billion U.S. dollars. The trade surplus was 13.39 billion U.S. dollars.

The decline in exports and imports in May were worse than the 22.6% fall in April\’92s exports and the 23.0% drop in April\’92s imports, although Goldman claims that the decline is more or less flat if measured on a seasonally-adjusted basis.

April\’92s and May\’92s trade surpluses ($13.1 and $13.4 billion) were substantially below the equivalent numbers last year ($16.7 and $20.2 billion), so from that point of view we can argue that China is finally starting to reduce the negative net demand it provides to the world. Two caveats are in order, however. First, for the first five months of the year, China\’92s trade surplus is still up more than 13% compared to last year \’96 $89.1 billion in 2009 versus $78.6 billion in 2008.

Second, imports would have fallen much faster except for the surge in commodity imports. Jamil Anderlini at the Financial Times gives one, benign, explanation for the surge:

Chinese import volumes of many commodities and natural resources surged in May, indicating a rebound in infrastructure building. That supported figures on Thursday showing fixed-asset investment was 32.9 per cent higher in the first five months of the year, compared with the same period in 2008, an implied rise of 38.7 per cent in May alone from a year earlier.

Keith Bradsher, in an article in Wednesday\’92s New York Times gives possibly a very different explanation:

Strong buying by China has helped lift commodity prices around the world this spring, but growing evidence suggests that a sizable portion of this buying has been to build stockpiles in China, and may not be sustainable.

At least 90 large freighters full of iron ore are idling off Chinese ports, where they face waits of up to two weeks to unload because port storage operations are overflowing, chief executives of shipping companies said in interviews this week. Yet actual steel production from that iron ore is recovering much more slowly in China, and Chinese steel exports remain weak.

Commodities and shipping executives describe Chinese stockpiling in recent months of a range of other commodities as well, including aluminum, copper, nickel, tin, zinc, canola and soybeans. Starting in April, China began stockpiling significant quantities of crude oil.

There have been rumors and some evidence of stockpiling for months, and if this is the case, and of course if the stockpiling is not sustainable, then the import numbers are likely to have been artificially boosted. Real demand by China for foreign goods will have actually been much lower.

Of course all of this has a trade impact. Regular readers don\’92t need me to rehash the arguments. Suffice it to say that the Chinese fiscal stimulus, rather than an adjustment to the new economic realities, in my opinion, is still based on boosting production and investment and constraining consumption, in spite of statements to the contrary (for example today\’92s People\’92s Daily has another front page article in which Premier Wen \’93stressed the importance of promoting domestic consumption\’94).

Unless the world recovers rapidly and sustainably and, more importantly, US consumers return to the heady days of financing their consumption by binge borrowing, we are going to need to see a greater trade adjustment in China. Trade tensions are not improving. Last week I had dinner with a very senior China manager at a large German company and he told me expected anti-dumping suits to surge in the first quarter of next year. As if to beat him to the punch yesterday\’92s Financial Times came up with this story (\’93China accused of predatory pricing practices\’94):

India\’92s small and medium enterprises have warned that they are suffering because of cheap imports from China. They are urging New Delhi to accelerate anti-dumping investigations and impose tougher safety and quality checks on Chinese products.

The appeal for greater government protection came amid rising tensions between New Delhi and Beijing over trade, after a high-profile dispute over an Indian ban on Chinese made toys. India\’92s Federation of Chambers of Commerce and Industry said on Sunday that a survey of 110 small and medium-sized manufacturers found that about two-thirds had suffered a serious erosion of their Indian market share over the past year, because of cheaper Chinese products.

In its statement, FICCI said the Chinese imports were between 10 and 70 per cent cheaper than comparable Indian products, a price differential that it said was \’93huge and difficult to explain\’94. Amit Mitra, the FICCI\’92s secretary-general, said Indian industries were being hurt by \’93typical Chinese predatory pricing\’94 intended to drive rivals out of business so that Chinese companies could capture the market \’96 and then raise prices to more normal levels. The bite was felt by companies in a range of sectors, including processed food, light engineering, building materials and heavy engineering, chemicals and textiles, FICCI said.

The fact that Indian wages are lower than Chinese wages is probably not enough to compensate for China\’92s much better infrastructure, but there are other reasons for the price differential. I discussed some of these reasons in an entry earlier this month.

Tags: Greendown

New trade and reserve numbers from China

April 13, 2009 in Balance of payments, Consumption and production, Exports and imports, Hot money, Reserves by Michael Pettis | 53 comments

Exports in March dropped a less-than-expected 17.1% from the same time last year \’96 below expectations of 20% and the 21.1% drop for the first two months of 2009. Most of the articles I read in the Chinese and foreign press including, not surprisingly, comments from the customs bureau, hailed this as a sign that the export slump is bottoming out. According to an article in Saturday\’92s South China Morning Post, for example:

Many economists said the export slump of the past five months was finally showing signs of abating, with the Administration of Customs describing the latest export figures as a \’93marked improvement\’94. However, they cautioned that imports would remain weak in the near future, overshadowed by prevailing low commodity prices and the de-stocking of mainland factories and overseas importers.

\’93It is the beginning of stabilisation,” Citibank economist Ken Peng said yesterday. “We should have seen stronger import numbers last month. We had more money in place, but we’re not importing more and that’s surprising.\’94

A Bloomberg article had the following:

The \’93collapse of global trade and China\’92s exports in the last few months was not in small part due to a freeze in trade credit and aggressive de-stocking abroad as a result of extreme uncertainty,\’94 said Wang Tao, an economist at UBS AG in Beijing. \’93As expectations start to stabilize, we expect to see export orders rebound in the coming months.\’94

I guess that different people have radically different ways of forecasting export growth. To me, it is completely meaningless to look at recent trends in China\’92s export performance in order to forecast the future. The only thing that matters is what will happen to net demand from the trade deficit countries \’96 most of which is represented by US net demand \’96 and so the recent improvement in China\’92s export performance (not really an improvement, of course, but an improvement in the rate at which it is deteriorating) really tells us very little.

The real question is will US gross and net demand continue to contract? Almost every serious economist I have spoken to believes that it will, with disagreements only on the speed, intensity and duration of the contraction. Someone whose blog I have been reading a lot lately (I like him because, aside from his Minsky-Fischer orientation, he has the audacity to claim that if you don\’92t know economic history then you don\’92t know economics and, what\’92s worse, he even insists that history extends to beyond the past twenty years), University of Western Sydney professor Steve Keen, suggests that from what he calls a non-orthodox, Hyman-Minsky point of view we should think of aggregate demand as \’93the sum of GDP plus the change in debt.\’94

That sounds right to me. Certainly debt accumulation seems to have represented the difference between the growth in US consumption and the growth in US GDP over the past decade, as I discussed in Wednesday\’92s post. If he is right, we should expect US consumption (and that of many other deficit countries, for that matter) to grow less than GDP by the amount of the deleveraging taking place. That is a lot of deleveraging.

In that case the export performance of countries like China can only get worse because the ability of deficit countries to consume China\’92s export of excess production will be contracting quickly, and in that light it doesn\’92t matter how successful you think the Chinese stimulus package may have been. Export growth depends on someone else\’92s import growth, which depends on their consumption growth, and in a world of contracting GDP, if consumption growth is even underperforming GDP growth, it is a little hard to be optimistic about export growth forecasts. The domestic stimulus is irrelevant.

Talking about the stimulus package, there has also been a lot of talk about its success as being evidenced by the way a number of indicators have bottomed out or even turned. Unfortunately it seems to me that most of those indicators fall into one of two groups. In some cases there were special circumstances that caused a surge, but whether the surge is sustainable, and in some cases whether it won\’92t be reversed in the future, is questionable. For example car sales have finally started to rise: China\’92s passenger car sales rose 10% in March from a year earlier. But this was after tax cuts and government subsidies boosted demand, and there are lots of rumors about government agencies and state-owned enterprises being persuaded to anticipate vehicle purchases. If that is the case, the surge in purchases may soon peter out, and in fact may slow sharply to the extent that planned purchases for later this year were accelerated.

The second group of positive indicators I would describe not as evidence that the fiscal stimulus is working but rather as evidence that some people are behaving as if they believe the fiscal stimulus will work. For example rising steel and concrete inventories and increased purchases of equipment suggest to me not that end demand has been created but rather that many producers are anticipating that end demand will be created. Perhaps they are right, in which case we should see more positive indicators in the future, but if they are wrong then we are likely to see nothing more than a temporary buildup that will have to be reversed.

But to get back to exports, China\’92s trade surplus for March was $18.6 billion. That sums to $62.6 billion for the first quarter, compared to $41.7 billion for the first quarter of 2008 and $114.3 billion for the last quarter of 2008. Although lower than the astonishing heights of January and late last year, the trade surplus is still much higher than this time last year. That means China\’92s export of overcapacity is still increasing, especially if you think, as I do, that February\’92s very low trade surplus ($5 billion), and possibly part of March\’92s, was caused by commodity accumulation to replenish strategic reserves.

More capacity?

In that light articles like this one from Friday\’92s Financial Times are not encouraging:

The aluminium industry has been hit hard by the global economic crisis with sharp falls in sales across the automotive, construction and aerospace industries. \’85However, a recovery has emerged in recent weeks and prices are 18 per cent off their lows. The concern in the industry now is that the nascent recovery could be nipped in the bud because Chinese smelters are busy ramping up production at a time when demand is continuing to fall.

As China accounted for about 35 per cent of global aluminium production and consumption last year, its supply and demand developments are of huge significance for the world market. Industry leaders warn that the outlook for demand remains weak

\’85However, Wen Jiabao, China\’92s premier, has made it clear that Beijing will do whatever is needed to maintain economic growth at \’93about 8 per cent\’94. This has led to huge pressure on local governments to ensure growth targets are met. One result is that aluminium smelters have been offered tax cuts and subsidised bank loans to encourage production to restart.

Last year\’92s price crash forced China to close about 3.1m tonnes (22 per cent) of its total aluminium production capacity as many of the country\’92s smelters fell into the red. But analysts at Macquarie estimate that 500,000-600,000 tonnes of capacity has recently been restarted in Henan province. \’93Local government officials, especially in Henan, have been urging the aluminium industry [the key income tax payer of the province] to restart spare production capacity immediately,\’94 says Bonnie Liu of Macquarie.

China\’92s government has also been providing significant levels of support to the domestic market. The State Reserves Bureau, which has already bought 590,000 tonnes, is expected to expand purchasing up to 1m tonnes. The State Grid Corporation has bought about 400,000 tonnes and provincial governments have indicated they will buy up to 900,000 tonnes.

Too many people who should know better assume that trade policies are limited to raising import tariffs or devaluing the currency, and since both of these were addressed in the recent G20 meeting, we can all more or less relax. This is wrong. Anything that alters the gap between total production and total consumption must have a trade impact, and if capacity is boosted in the face of falling demand, that is as likely to force up the trade surplus as import tariffs or currency devaluation.

I do not believe that will go on much longer. Over the next few months we should start seeing even more pressure on China\’92s exports as either trade friction or exhaustion (on the part of countries who have had to bear more than 100% of the brunt of the contraction in US demand) forces continued global demand contraction to switch to China.

How important will that be? Ever since The Economist came out with a consensus-busting piece last year that China is much less reliant on exports than many people think (whatever that means), well-informed people have been assuring each other that \’93China is much less reliant on exports than many people think.\’94

Maybe. But it is still very heavily reliant on exports. When your total production exceeds your total consumption by 7% of GDP (in the past 12 months China\’92s trade surplus was $320 billion, while its 2008 GDP was $4.3 trillion), you rely very heavily on foreign demand to absorb a big chunk of your output.

According to a recent Andrew Batson article in the Wall street Journal, a trio of researchers at the Hong Kong Monetary Authority revisits the whole question of China\’92s dependency on exports. I was not able to find the cited piece, so I can only limit myself to the comments in the article, but, and sorry for the long quote, here is what they find:

The paper builds on previous work by one of the authors, Li Cui, who in a 2007 working paper for the International Monetary Fund presented evidence that China was becoming more dependent on external demand over time. Indeed, net exports contributed about 20% of China\’92s economic growth from 2005 to 2007, compared to less than 10% in the previous five years. But the authors of the new paper try to go beyond that number to capture the total effect of the export manufacturing sector on the economy, including investment in new factories by exporters, and spending by people employed in those factories. That leads them to conclude that the spill-over effects from the export sector are in fact quite large.

The authors estimate that a decline of 10 percentage points in export growth would be associated with a decline of about 2.5 percentage points in GDP growth. \’93This is about at least twice as large as what could have been expected if only the direct impact of exports is considered,\’94 they write. Part of the explanation, they say, is that exports are extremely important to a group of Chinese coastal provinces, which themselves account for the majority of the national economy. So changes in export demand can cause dramatic fluctuations in those regional economies, even while the inland provinces are less affected.

But of course, China\’92s exports have recently slowed by a lot more than 10 percentage points. In volume terms, export growth rates have swung from around positive 20% in 2007 to nearly negative 20% in the first part of this year. The biggest effect of a decline in exports, the authors find, is on corporate investment, as companies scale back expansion plans. And since the sharp drop in exports is just a few months old, the full magnitude of the subsequent drop in capital spending may not yet be evident.

Foreign currency reserves

Besides export numbers the other piece of important news for me was the release of first quarter reserve numbers. According to Xinhua\’92s account:

China’s foreign exchange reserves rose 16 percent year-on-year to 1.9537 trillion U.S. dollars by the end of March, said the People’s Bank of China on Saturday. It represents an increase of 7.7 billion dollars for the first quarter, but the increase was 146.2 billion dollars lower than the same period of last year.

In March alone, the foreign exchange reserves rose by 41.7 billion U.S. dollars. The increase was 6.7 billion U.S. dollars higher than the corresponding period of last year.

This is the smallest quarterly increase we\’92ve seen in a long time. The first quarter of 2008, for example, saw reserves grow by an astonishing $153.9 billion, and 2008\’92s fourth quarter, the weakest quarter of the year by far, nonetheless saw reserves up by $40.4 billion.

2009

January

February

March

Headline reserve growth

-32.6

-1.4

41.7

7.7

Trade surplus

39.1

4.9

18.6

62.6

Net FDI

7.4

5.8

8.4

21.6

Currency gains or losses

-31.0

-16.0

15.0

-32.0

Interest income

6.8

20.4

Unexplained amount

-54.9

-2.9

-7.1

-64.9

With Logan Wright\’92s help I put together the above table to try to understand what is going on with reserves. The key thing on which to focus is the \’93Unexplained amount,\’94 which is a proxy for hot money inflows or outflows. Of course my estimates for currency gains or losses and for interest income are nothing more than estimates and may be, especially in the former case, substantially off.

Nonetheless the picture the table shows is pretty clear and pretty consistent with what we would expect. January, a time of deep gloom, saw a large unexplained outflow at least part of which may represent flight capital from nervous Chinese businessmen. Confidence seemed to rebound in February and March, with widespread (but to me doubtful) claims that the fiscal stimulus was \’93working\’94 and with the stock market rocketing up. During that time unexplained outflows collapsed to nearly zero. The only conflicting evidence was reports in the Hong Kong press of a serious increase in the amount of currency transactions among border money changers, in which the number of Chinese buying US and Hong Kong dollars with RMB rose to suspiciously high levels.

The overall picture is consistent with two different and popular predictions. First, the stimulus package is working and that China will soon emerge from the worst of the crisis. Second, that the fiscal stimulus represents a risky bet on the duration of crisis abroad, and if sustainable and recovery in global demand does not occur in the next few quarters, it will set the stage for a deeper contraction late this year and next year.

Trade determines reserve currency status

Finally, for those who might be interested in today\’92s version of my biweekly South China Morning Post piece, here is the original, pre-edited version:

People\’92s Bank of China Governor Zhou Xiaochuan generated huge controversy when he argued two weeks ago in favor of an international reserve currency to cure distortions in the global balance of payments. Although his reasons for worrying about excessive reliance on the dollar were probably correct, his proposal for an alternative currency based on SDRs was more problematic.

The SDR is not a currency. It is an accounting unit based on an artificial currency \’93basket\’94. As of January 1, 2006, the SDR valuation basket had the following weights based on their roles in international trade and finance: U.S. dollar 44%, euro 34%, Japanese yen 11%, and pound sterling 11%.

If countries accumulated reserves in the form of SDRs, they would effectively accumulate a basket of the above currencies. But of course no one needs SDRs to accomplish the same thing directly. If the People\’92s Bank of China, for example, felt that the SDR represented a more balanced and appropriate portfolio composition for its reserve holdings, nothing could have prevented it from apportioning reserves according to the SDR basket.

And yet informed observers believe that the US dollar accounts for anywhere from 65% to 70% of the PBoC\’92s total direct reserve holdings \’96 even more if we include foreign assets of state-owned enterprises and minimum reserves held by China\’92s commercial banks.

But if holding more than 44% of a country\’92s reserves in dollars distorts the global balance and creates excessive currency concentration, why do the People\’92s Bank of China and other central banks willingly do just that? Dark mutterings about US hegemonic power notwithstanding, there are no legal or physical restrictions on the ability of central banks to choose the assets they purchase. For the past decade they could easily have purchased fewer dollars assets and more euro, sterling and yen assets.

The answer has little to do with geopolitics. It is a necessary requirement in global trade that capital and trade flows balance. Countries running trade surpluses must recycle their surpluses to the countries running trade deficits. Normally this is done through private investment flows, but following the 1997 Asian crisis a number of central banks, especially in Asia, began accumulating such large amounts of international reserves that their purchases of foreign assets completely dwarfed private investment flows.

Assets which the central banks of trade surplus countries purchase will to a significant extent determine which countries run trade deficits. If central banks mostly buy US dollar assets, the US will run the corresponding trade deficit. Contrary to popular opinion, financing flows do not necessarily follow trade flows. It is often the other way around..

Let us assume that over the past decade Asian central banks had decided to acquire reserves in the amounts described by the composition of the SDR. This means, assuming trade surpluses were constant, that they would have purchased between one-half and two-thirds the amount of dollars they actually did. The balance would have gone into euro, yen and sterling.

One likely consequence is that with less demand the dollar would have been weaker relative to the other three currencies then it has been. This would have cause a relative expansion in the tradable goods sector of the US, and a relative contraction in the tradable goods sector of Europe and Japan. With the expansion in the US tradable goods sector, and its positive impact on employment, the Federal Reserve would have kept interest rates a little higher, and US consumption would have been a little lower relative to GDP. Of course the exact opposite would happen in Europe.

Lower consumption means lower imports, and vice versa, in which case the US trade deficit would have been lower and the European and Japanese trade deficits higher by roughly the difference in the amount of dollar reserves purchased. By choosing to buy euros instead of dollars, in other words, Asian central banks would have forced a large part of the US trade deficit to migrate to Europe.

But could Europe have sustained a large trade deficit for any long period of time? For both political and economic reasons too complex to discuss here, it is reasonable to assume that Europe would not have been able to bear the burden of a substantially larger trade deficit. Most Asian policymakers know this.

That is why the US dollar is the world\’92s reserve currency, and most especially the reserve currency of Asian countries using foreign demand to boost domestic growth. In the distorted trade environment of the post-1997 world, the US was the only economy large and flexible enough to absorb the trade deficits that Asian countries required for their growth. US hegemonic power or deliberations had very little to do with it. Asia had to accumulate dollars if it wanted foreign demand to power domestic growth, and SDRs would have prevented this from happening. That is probably a good thing for the world, but a bad thing for China and Asia.

Tags: Steve Keen

Is Governor Zhou a closet Bernanke-ite?

April 8, 2009 in Balance of payments, Currency regime, Money growth, Savings glut by Michael Pettis | 64 comments

I have recently finished reading Martin Wolf\’92s latest book, Fixing Global Finance, and I strongly recommend it for its very clear laying out of the global balance of payments issues behind the global crisis. I should warn my readers that Wolf and I have come to very similar conclusions about the underlying root causes of the crisis \’96 we are both in agreement, for example, about the distorting effect of Asian policies to constrain consumption and boost investment in manufacturing output \’96 but I am mostly impressed by the fact that we come to the same conclusion from such different angles.

Wolf begins with a model based on analyzing the financial architecture of the past forty years and brings to his analysis a very US-centric view of the world, whereas my conceptual model is based on my obsessive reading in the history of financial flows between rich and poor countries and starts with a China-centric view. Somehow we end up in almost exactly the same place, which suggests to me that we may be right or, at the very least, onto something important.

I won\’92t try to summarize the book but I do want to set out two paragraphs in which Wolf explains, far more clearly than I have ever been able to, how it is that reserve accumulation in Asia \’93forced\’94 US households into overconsumption. One of the most common fallacies in popular economic analysis is to assume that countries are somehow analogous to households, and the factors that lead a household to consume \’93beyond its means\’94 are similar to those that cause a country to do so. In that case if the US over-consumed, it is no different than if a stereotypical welfare family maxed out on its credit cards, and while we can fret at the stupidity of the bankers who gave them their credit cards, ultimately the blame for the mess must rest with the innate profligacy of mom and dad.

But this is not true at all when we are talking about overconsumption at a country level. As I have tried to argue many times, the global balance of payments must balance, and significant change in any component of the balance necessarily requires adjustments elsewhere. If Country A enacts trade policies that result in a surging current account surplus, for example, Country B must see its current account deficit surge by the same amount, and the way that happens will reflect a number of factors including the structure of its financial system. Country B could try to resist the growing deficit by engineering a recession and so causing total demand to drop, but this can be very painful for both countries.

Let us assume, then, that a group of countries, perhaps in response to the 1997 crisis, decide that in order to protect themselves from a repeat of that disaster decide to engineer polices aimed at accumulating reserves and limiting external debt. The most obvious way would be to put into place policies that constrain consumption and boost savings (keep wages and interest rates low, limit credit availability to consumers, limit credit availability to small and medium enterprises and especially to the service sector, maintain an undervalued currency, etc.) and direct credit to the investment and manufacturing sector. As a consequence growth in production would exceed growth in consumption and the balance would represent the trade surplus. Trade surpluses, of course, have to be recycled as investment flows (or reserve accumulation) back to the country against which they are running these surpluses. This is not a choice, or even a real lending decision. It is the automatic and necessary consequence of running a trade surplus.

Since the US is the largest and most flexible economy in the world, and since the primary world reserve currency is the dollar (more on this later), in practical terms only the US can be the deficit country for any period of time, and so the surplus countries must accumulate US dollar assets as the obverse of their trade surplus. Martin Wolf explains what happens next:

The rest of the world\’92s capital outflow supports the dollar. At the resulting elevated real exchange rate for the United States, the output of the sectors in the US economy that produce tradable goods and services shrinks, other things being equal. The Federal Reserve cuts interest rates to expand the economy, thereby preventing excessive unemployment. As it does so, a large excess demand for tradable goods and services emerges in the United States. This finally, appears in the trade and current account deficits.

One consequence of all this is that US domestic demand has had to grow faster than real GDP, to ensure that the latter grows in line with potential. The difference between the two is, of course, the increase in the current account deficit, in real terms. With trend growth in GDP between 3 and 3.5 percent a year, domestic demand has to grow even faster. That is precisely what has happened. US real demand (or gross domestic purchases) grew faster than real GDP in 1993 and 1994 and then again every year from 1996 to 2004 inclusive. Cumulatively, between 1993 and 2004 US real GDP grew by 46 percent, while gross domestic purchases rose by 53 percent. That is how the current account deficit emerged. It is also how the United States absorbed the supply of excess capital from abroad.

In the face of a sharp contraction in those sectors of the US economy that compete with Asian manufacturers, in other words, the Federal Reserve must either permit a rise in US unemployment, in which case US consumption will decline and with it imports from Asia will decline too, or it must prevent the rise in unemployment by putting into place monetary policies that are consistent with rapid GDP growth. This argument, by the way, is not at all affected by the very common (and incorrect) argument that the main cause of the US trade deficit with China is the fact that China produces things that the US doesn\’92t want to produce, which I have tried to address in a March 9 blog entry.

Global savings glut

In either case US consumption must grow faster than US GDP, and the choice for the Fed is whether to target a \’93normal\’94 growth in consumption, and permit rising unemployment, or a \’93normal\’94 growth in GDP, and so permit rising indebtedness. The Fed must use US unemployment, in other words, as a tool to prevent Asian trade policies from leading to excess US indebtedness.

All this would have been bad enough if it hadn\’92t been for the need for the US to finance a very unpopular war, the Iraq invasion, in the way that unpopular wars have traditionally been financed \’96 irresponsibly, through borrowing and money creation rather than taxes (remember that the Vietnam War was also associated with a credit bubble in the US). Asian policies, according to this view, definitely helped create the monetary distortions, but we must remember that there were plenty of bad domestic policies compounding the problem.

At any rate for the Fed to use US unemployment as a tool to prevent Asian trade policies from leading to excess US indebtedness is obviously politically very difficult, and it is also obvious that for the past ten year the Fed chose excess indebtedness. Since the 1997 crisis we have seen both household savings and the US trade deficit break out of their normal ranges and either collapse (household savings) or surge (trade deficit). This is a necessary consequence of the process that Wolf describes.

In that light, as U.S. fiscal spending surges in response to the crisis, increased attention will be placed on the way that U.S. fiscal spending leaks out through the current account to boost employment in China and elsewhere. And just as the Chinese complain bitterly, and rightly, that the West outsources polluting activity to China via the trade account, the U.S. will complain, as Martin Wolf pointed out in a March 31 editorial in the Financial Times, that China is outsourcing fiscal indebtedness to the U.S., also via the trade account. Surplus countries, he argues, \’93relied on the private sectors of deficit countries to do their irresponsible borrowing for them.\’94 In response to the contraction in the borrowing among US households, the U.S. government, in other words, is currently choosing to borrow and spend the proceeds in order to generate job growth in the U.S. as well as in China. This can\’92t go on forever.

All of this is, of course, a variation on Ben Bernanke\’92s \’93global savings glut\’94 hypothesis, and as everybody knows, Beijing wholly rejects this hypothesis as an explanation for the current global imbalances. For Chinese policymakers, the cause of the crisis lays firmly and totally within US monetary and financial policies (or lack thereof), and absolutely no blame can be apportioned to Asian trade policies.

Or is this really Beijing\’92s view? The extraordinary thing to me is that while Beijing has insisted almost desperately that any attempt to apportion blame to China is completely dishonest, they have nonetheless more or less welcomed Bernanke\’92s hypothesis, perhaps without realizing it, through the back door. I say this because the widely-discussed essay by PBoC Governor Zhou last week, in which he assailed the reserve status of the US dollar as being the main cause of global imbalances, is as far as I can tell nothing more than Ben Bernanke\’92s hypothesis viewed from a slightly different angle.

Why? Because Governor Zhou makes the claim that the reserve status of the US dollar gives the US an unfair advantage in that it can borrow nearly unlimited amounts simply as consequences of the need for foreign countries to accept dollars as reserves and for the purpose of international trade and investment. Of course he is almost certainly right, and he is just as certainly not the first person to make this claim. I think it was De Gaulle\’92s favorite economist, Jacques Rueff, who first discussed this \’93exorbitant privilege\’94 as far back as the 1960s (NB: Martin Wolf corrects me — it was Valery Giscard D’Estaing who first said it — but I leave the mistake, and the correction, because it is one so commonly made).

But remember that if we make the very simple (and necessary) assumption that the ability of a country to run current account deficits is constrained mainly by a country\’92s ability to finance those deficits, then the ability to borrow unlimited amounts also means the ability to run unlimited trade deficits. It was the reserve status of the dollar that permitted the US to run the massive trade deficits it has during the past decade.

Had the US dollar not been the reserve currency of choice (in other words had Asian trade surplus countries not recycled their trade surpluses into purchases of US government bonds), the dollar would have had to decline against world currencies as a consequence of the rising deficit \’96 Asian currencies too, and not just European \’96 and the US trade deficit would have stabilized at much lower levels. This is also another way of saying, as Martin Wolf\’92s piece directly implies, that the Fed would not have had to choose between unemployment and indebtedness and that the binge borrowing that characterized US household behavior would have been much, much lower.

The world loves dollars because the US seems to love deficits

In fact I would go further. Because of the dollar\’92s reserve status, only the US could have possibly run the deficits necessary to absorb the huge surpluses that Asian trade policies were generating. Without the dollar\’92s status as a reserve currency, the Asian development model that stresses expanding production while constraining consumption \’96 which among other things results in trade surpluses and net investment abroad (which of course is the same thing) \’96 would have either required another reserve currency, or it would have failed.

Could there have been another reserve currency \’96 and could it be that the dollar\’92s \’93exorbitant privilege\’94 is something that Washington has enforced? Yes and no. The US economy comprises about one-quarter of the world\’92s economy and one-third of the rich-country economies. In principle it would have been very easy for any country to accumulate reserves of other rich countries \’96 nearly all of whose currencies are easily convertible \’96 so that there is no reason why the dollar portion of all developing-country central bank reserves might not have exceeded roughly one-third of the total, instead of the two-thirds or more that it currently occupies. Another third could be euros, and the rest a combination of the currencies of Japan, the UK, Switzerland, Canada, Australia, South Korea, and so on.

But it can\’92t just rest there. When a central bank chooses which currency to buy, unlike when you or I make our own portfolio decision, it is also determining the direction of net trade flows. Those other countries would have had to match the investment surplus (net inflows on the capital account) with an equally large current account deficit. If China had followed this balanced policy of reserve accumulation, in other words, the only thing that could possibly have stopped them, and a very big impediment it would have been, was the political or economic willingness and ability of those countries to run the corresponding trade deficits with China.

That, of course, is the problem. Given their much more limited economic flexibility and their less ebullient financial systems, those other countries probably would have never been able to sustain the necessary levels of trade deficit, and they would have almost certainly moved aggressively against China to limit the development of unfavorable trade balances. China, in other words, chose to hold US dollars not because the US government has somehow enforced reserve status on the US dollar and denied it to other currencies (Washington could never have prevented China from buying euros or yen or anything else), but simply because no other country is able to run deficits of the necessary magnitude.

The argument, then, that the dollar\’92s status as the reserve currency and brings an exorbitant privilege is simply the other side of Ben Bernanke\’92s savings-glut coin. Without the dollar\’92s reserve status, the global savings glut would have never occurred, or rather it would have never resolved itself in the way it did, and Asian development models aimed at engineering trade surpluses would have had to fail.

So is Governor Zhou a closet Bernanke-ite? He would probably be surprised at this question, and even more surprised at my answer, I think, but I cannot see how you can separate the two arguments \’96 his on the perils of the dollar\’92s dominant reserve currency status and Bernanke\’92s on the impact of high Asian savings on the US balance of payments. He and Bernanke agree fundamentally on the roots of the imbalance.

By the way, the model I have been using to explain the imbalances also addresses another contentious question between the US and China which I did not really think about until I read a fascinating short piece by MIT\’92s Simon Johnson on his blog, more in reference to Europe but relevant nonetheless. China, as we know, is very worried that the US will resort to monetary policy rather than fiscal policy to address collapsing demand in the US. The former hurts China (supposedly because it might cause an erosion in the value of the dollars the PBoC holds), whereas the latter helps by slowing the contraction in US net demand and giving China more time to adjust its overcapacity problem.

It turns out that there may be another reason, even more powerful, and as soon as I read this paragraph by Johnson I had one of those \’93Aha!\’94 moments that means I am going to have think much more seriously about the implications:

Remember this. If you run an expansionary fiscal policy (building bridges), I have an incentive to free ride (selling you BMWs) and not engage in a similar fiscal stimulus. But if you run an expansionary monetary policy, your exchange rate will tend to depreciate, putting pressure on my exporters and I\’92ll be pushed – by BMW-type producers – towards providing a parallel monetary stimulus.

This may be why monetary rather than fiscal stimulus makes sense for the US, and less sense for trade surplus countries. It prevents, or at least reduces, the leaking-out of employment generation effects of US borrowing and spending.

The other China

Talking about BMWs, my argument, of course, is not so much about China and the US as it is about trade surplus and trade deficit countries. In that light there was a very interesting article in Monday\’92s Financial Times about the difficulties Germany is facing in adjusting to the changes in the global balance. Many people assumed that Germany, which was in a very \’93strong\’94 position (high savings, large trade surplus, low debt \’96 which are all more or less the same thing, really), would weather the crisis easily, but of course it should have been self-evident that a crisis that affects the deficit sides of the global balance of payments must also affect, by the same amount, the surplus sides:

The risk is that \’96 like Japan in the 1990s \’96 Germany faces a \’93lost decade\’94, or a protracted period of economic malaise as it waits for the global economic tides to turn and struggles to find domestically generated sources of growth. \’93I am convinced it is going to be a slow recovery,\’94 says Mr Staake. \’93Who is going to be buying anything?\’94

This downfall is all the more galling because, even a year ago, the country could have expected to weather the global economic storms. There was no danger of a housing crash; prices had been flat for a decade. Consumers had saved; companies had not increased leverage dramatically. \’93From a structural point of view, this recession should never have happened,\’94 says Commerzbank\’92s Mr Kr\’e4mer.

With hindsight, however, Germany was a sitting target after the collapse of Lehman Brothers investment bank in mid-September. Its exports were equivalent to more than 47 per cent of GDP last year \’96 compared with less than 20 per cent in Japan and about 13 per cent in the US. Its industrial base is skewed towards producing machinery and equipment \’96 \’93investment goods\’94 account for more than 40 per cent of its exports \’96 and towards emerging European and Asian economies.

While the crisis was focused on US housing and capital markets, Germany was unaffected. But after Lehman\’92s failure paralysed banks, and confidence nosedived globally, companies around the world shelved investment plans \’96 leaving German factories turning out goods nobody wanted to buy. Industrial production in January was more than 20 per cent lower than a year before; overseas orders for investment goods had almost halved.

\’93Who is going to buy anything?\’94 Good question, and one that must be answered by policymakers planning to export their way out of the crisis.

I especially love the statement \’93From a structural point of view, this recession should never have happened.\’94 One of my standard complaints about most economists, especially those who focus on a single country or group of countries, is that they ignore balance-sheet and balance-of-payments effects. Of course it should have been obvious that a crisis in the deficit countries would affect the surplus countries \’96 in fact it should have been obvious that the impact on the latter should have been worse.

Meanwhile, and as a continuing part of how the crisis will evolve, there is an interesting article in today\’92s Bloomberg about one of the ways in which the Chinese fiscal response to the crisis risks making the imbalance, and China\’92s long-term adjustment, worse.

China\’92s shipbuilding industry may be about to get a bailout — from its customers. The government may force state-owned shipping groups to buy more vessels as foreign carriers scrap orders, according to Steve Man, an HSBC Holdings Plc analyst in Hong Kong. That risks increasing costs and overcapacity among shipping lines grappling with a collapse in global trade.

\’93They \’91encourage,\’92 but my thinking is it\’92s more of a directive,\’94 said Man. \’93It hurts every player in the industry and creates excess capacity that will take longer to absorb after an upturn.\’94

As I have argued many times, the constraints of the Chinese development model and limitations in the financial system mean that it will be very hard for China to shift its behavior quickly enough to match the possible adjustment in the US and elsewhere. Bailing out the ship-building industry is one way in which Beijing\’92s fiscal reaction \’96 while understandable from an employment point of view \’96 may exacerbate the adjustment. Washington\’92s bailing-out of the automobile industry is the same sort of mistake, I think, but in the US case it is much easier to justify. The US must reduce its net consumption, and if boosting production is economically inefficient in the long term, at least it fits within the overall adjustment in the short term. This is not the case with China \’96 it should be boosting consumption directly, and not indirectly by boosting capacity.

There is a lot more I wanted to discuss today, but this blog entry is getting to be way too long. But just one quick thing, yesterday I was having coffee with some visiting friends from Goldman when one of them received a notice that there were credible rumors on the March increase in new loans. We had all been expecting a very big March number \’96 between RMB 1.3 and RMB 1.6 trillion.

It turns out that the true number may have been an astonishing RMB 1.9 trillion.

That means that for the first three months of the year we have had loan increases of RMB1.6 trillion, RMB 1.1 trillion, and RMB 1.9 trillion. This amounts to RMB 4.6 trillion for the first quarter of 2009, compared to RMB 4.5 trillion for all of 2008. Notice to my students: learn more about how to resolve and restructure bad loans. This will be a great career option for you over the next few years.

Tags: Exorbitant privilege, Zhou Xiaochuan

Did China experiencing January hot money outflows?

March 17, 2009 in Balance of payments, Hot money, PBoC, Reserves by Michael Pettis | 33 comments

The market (or at least that part of the market that obsesses over balance of payment flows) has been swept with rumors today that foreign exchange reserves were down in January by $30 billion. \’a0My experience with these sorts of rumors is that they tend to be fairly accurate, and I suspect they will soon be confirmed.

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If true, what does this imply about hot money flows? \’a0The PBoC\’92s accounts have been more opaque than ever and it is extremely difficult to figure out what is really happening, but let me give try at least to bracket the range of outcomes.

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China\’92s trade surplus in January was $39.1 billion. \’a0It probably earned another $6-7 billion in interest income plus the reported $7.5 billion in FDI. \’a0This means that absent other effects reserves should have risen in January by $52 to $54 billion.

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But there were other effects. \’a0China holds part of its reserves in currencies other than the dollar, and these declined in dollar terms January (the dollar appreciated). \’a0The total loss here may be around $30-40 billion.\’a0 That means that absent other effects reserves should have risen by at least $15-20 billion. \’a0If reserves in fact declined by $30 billion, it would indicate at least $40-50 billion in unexplained outflows. \’a0Is this all hot money?

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Brad Setser recently wrote a widely-read entry in his blog in reference to an article by Jamil Anderlini of the Financial Times about SAFE investments in equity markets that may have lost them $80 billion or more. \’a0If this is true, and it seems plausible, some of those losses may have occurred recently, although since the most vicious equity markets were last year, very little of that loss should have occurred in January \’96 and it is anyway an open question whether the PBoC would value these investments at book or at market. \’a0Perhaps a small part of the unexplained $40-50 billion represents equity losses, but this cannot explain much of it.

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We also know that China has stepped up its purchase of foreign commodities, either directly (which would have shown up already in the trade numbers) or indirectly via investments in commodity producers. \’a0The latter would have caused \’93unexplained\’94 dollar outflows from the PBoC. \’a0It is not clear that much, if any, of this happened in January, but perhaps some of the outflow represents new outward investment of this sort.\’a0 We don\’92t know.

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Against that there is the question of whether December\’92s 150 basis point reduction in minimum reserves represents a reversal of dollar assets held at the central bank by commercial banks (remember that earlier increases in minimum reserves in 2007 and 2008 had been redenominated into dollars, and so their reduction should have reversed that process).\’a0 If it did, and this would consist of about $30-40 billion, it would actually increase the unexplained amount. For the sake of conservatism, let\’92s assume that this hasn\’92t happened.\’a0 We should know when the PBoC release its balance sheet numbers if the \’93Other dollar assets\’94 account changed significantly.

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Where does that leave us?\’a0 There are about $40-50 billion in unexplained outflows and however you look at it there it is hard to believe that we haven\’92t seen at least $20-30 billion of hot money outflows in January. \’a0From my many years experience in developing markets I should say that the informational content of hot money flows is often wider than many people at first think. \’a0Much of the discussion about whether Chinese businessmen are bringing in or taking out money hinges on their perception of whether or not the currency will appreciate or depreciate (and in spite of the popular view of evil foreign speculators masterminding the flows, the truth is that the vast majority of this money is likely to be controlled by local businessmen).

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But I would argue that usually a much bigger driver of hot money flows is the local perception of risk in the country experiencing the flows. \’a0If hot money is flowing out of China, it could be because local business owners believe the currency will depreciate, but I think it is more likely that the flows represent their concern that local investment opportunities \’96 for example their businesses \’96 have become increasingly risky and uncertain.\’a0 Hot money flows tell us at least as much about risk perceptions as they do about profit opportunities, especially when the world is in trouble.

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By the way, this exercise should indicate yet again why all the discussions and debate in China and the US \’96 about whether or not China should continue financing the US fiscal deficit \’96 are wholly beside the point, as I have been arguing almost monomaniacally for years.\’a0 China cannot finance the US fiscal deficit, nor can any other country.\’a0 China can only finance the US trade deficit, and it must do so by recycling its current account surplus, either via Chinese investors, or via central bank purchases of US dollar assets.\’a0

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If there are hot money outflows from China large enough to cause the central bank to lose reserves, the central bank will not only stop buying US Treasury bonds and/or other dollar assets, it will have to sell something, which is most likely to be US dollar bonds.\’a0 It has no choice.\’a0

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Chinese investors who have taken money out of the country, on the other hand, will now effectively be responsible for recycling the Chinese current account surplus.\’a0 They might decide to buy US Treasury bonds (and I suspect indirectly and directly many will), but they could also\’a0buy gold, Venezuelan bolivares, Moroccan real estate, or in fact anything else they choose, and it is their buying that will determine how the Chinese trade surplus gets allocated among China\’92s trading partners.

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The other point to consider in all this is the impact on Chinese monetary conditions. \’a0A net outflow from the central bank has to be financed by retiring central bank bills or \’93destroying\’94 RMB. \’a0This implies monetary contraction, and it is still difficult for me to see how this would not have a contractionary effect on underlying money.

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Note 1:\’a0 Wednesday’s edition of the New York Times has an interesting article\’a0on Pingyao, a stunningly beautiful town about an hour from Taiyuan, in Shanxi province which, if it weren’t for the coal-dust-infested air, would remind me of San Miguel de Allende or some of the other old and protected silver-mining towns north of Mexico City.\’a0 I visited three years ago and plan to go back because of my interest in Chinese financial history.\’a0\’a0Pingyao was probably China’s first financial center (although temples already operated as early banks thousands of years ago) and headquartered the largest and most famous piaohao –\’a019th Century merchant trading companies whose businesses had expanded to taking silver deposits in one city and making them available in other cities (travelling was dangerous), collecting the emperor’s taxes and transferring revenues, and ultimately to making loans.\’a0 This is only marginally related to my blog, but for those readers interested in this kind of stuff, I encourage you to read about Pingyao and the piaohao.\’a0 It is a fascinating story.\’a0

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Note 2:\’a0 Once again my site is blocked in China.\’a0 I don\’92t know why\’96 I hope it only has something to do with last week\’92s NPC meeting and will be fixed soon\’a0\’96 but\’a0until it is resolved my formatting will be screwed up and I won\’92t be able to respond to comments.\’a0 For China-based readers, I think you can access this site easily on SeekingAlpha.com

Yes, trade policies do matter

March 9, 2009 in Balance of payments, Policy, Trade protection by Michael Pettis | 31 comments

One of my blog readers, Kalasend, responded to Thursday\’92s entry by asking about the composition of US-Chinese trade, and I think the question is interesting enough to be discussed in a separate entry, rather than in the comments section. In his response he pointed out that \’93China\’92s exports are mostly light manufacturing goods like toys, garments and other labor intensive goods which the modernized west simply lack the competitiveness and the will to do.\’94

I have heard this statement many times before, usually as part of a broader argument that since China is mainly exporting things that the US and Europe can\’92t or don\’92t want to make, macroeconomic policies aimed at adjusting the trade relationship are unlikely to make a difference on the actual trade balance. We are stuck, in other words, with the current trade relationship and probably for very good reasons.

Although I think there is a lot to be said for this argument, I nonetheless think it is fundamentally wrong for at least three reasons. The first reason is just the obvious point that macroeconomic policies that alter the factors that affect production and consumption necessarily affect the balance between the two, and the trade account is simply that balance. If the United States, for example, decided to provide large amounts of very low-cost credit to the US manufacturing industry, US production would automatically rise faster than US consumption, and so the US trade deficit would shrink. It may not be easy or possible to predict in advance the actual changes in the composition of the trade balance, and those changes might even be harmful in the longer term, but they would nonetheless occur.

By the way, any country that engages in any form of industrial policy must, at the very least, believe that my first objection to the argument above is correct, otherwise industrial policy aimed at altering the mix and structure of industrial activity would simply be a waste of time. I would also add that the none other than one of my great heroes, Alexander Hamilton, understood this very well when he designed the policies \’96 especially in his 1791 Report on the Manufacturers \’96 that virtually created the US as a manufacturing power and which were subsequently copied, very explicitly, by Germany after 1870 and Japan shortly thereafter. This is from the first paragraphs of his Report:

The expediency of encouraging manufactures in the United States, which was not long since deemed very questionable, appears at this time to be pretty generally admitted. The embarrassments, which have obstructed the progress of our external trade, have led to serious reflections on the necessity of enlarging the sphere of our domestic commerce: the restrictive regulations, which in foreign markets abridge the vent of the increasing surplus of our Agricultural produce, serve to beget an earnest desire, that a more extensive demand for that surplus may be created at home: And the complete success, which has rewarded manufacturing enterprise, in some valuable branches, conspiring with the promising symptoms, which attend some less mature essays, in others, justify a hope, that the obstacles to the growth of this species of industry are less formidable than they were apprehended to be, and that it is not difficult to find, in its further extension, a full indemnification for any external disadvantages, which are or may be experienced, as well as an accession of resources, favorable to national independence and safety.

My second reason for arguing against the claim \’96 that trade and macroeconomic policies can\’92t affect the trade balance because China produces things the US won\’92t \’96 is that both the US trade deficit and the Asian trade surplus have grown sharply in the past decade. Unless we make the argument that rising US asset prices caused US households significantly to increase their purchases only of things that Americans never made before, it is hard for me to see how this could have happened without some process in which US producers of those goods were replaced by foreign producers of those goods.

And if this only happened in the past ten years, I find it hard to be believe that this process of foreign producers replacing US producers is irreversible (I don\’92t even bring up the impact of Chinese textile producers in recent years on the southern European textile industry). Could it really be true that the decline of the US car industry or parts of the steel and chemical industries reflects refusal by Americans to continue their production, and so is irreversible? Can it be true that this process was not speeded up by specific policies affecting the car, steel or chemical industries in the exporting countries? On a related point, the Chinese government has recently announced that China plans to build a domestic competitor to Airbus and Boeing, but if the trade balance was simply a function of China making things that the US or Europe are no longer willing or able to make, wouldn\’92t this whole airplane-manufacturing strategy be a complete waste of time and likely to have zero impact on Chinese purchases of foreign airplanes?

Notice I am leaving aside the issue of whether or not it is in the US long-term interest to continue manufacturing things that can easily be manufactured in much less developed countries. I happen to believe that the future of the US, and indeed its great strength, is the fact that it is at the forefront of technological innovation and that it always skips forward to higher levels of productivity, and perhaps there is enough of a social Darwinist in me to wonder if the pressure placed on the US by industrial policies in less advanced countries might, while causing undeniable pain in the short term, actually speed up this brutally innovating process. That, however, is more of a normative judgment (I think I am using the word \’93normative\’94 very loosely) than a statement of fact.

My third reason for disagreeing against the argument that the US can\’92t make the stuff it imports from China, so trade policies are irrelevant, is that the hidden assumption in this argument is that trade balances can only change at the bilateral level. But of course this is not true. If US policies or conditions cause a contraction of net demand, and Chinese policies or conditions cause a contraction of net supply, that doesn\’92t mean that Americans will start producing domestically things that China used to produce and sell to the US.

What is more likely to happen is that the trade accounts of several countries at different stages of productivity and technology will all adjust, so that US producers of high-tech product A end up taking domestic market share away from producers in a slightly less advanced economy, whose producers of slightly-less-high-tech product B then take market share away from an even less technologically advanced economy, and so on down the chain to China. Given the complexity of international trade relations, any significant change in trade conditions or policies is likely to lead to a whole series of shifts among many different countries.

So far it may seem like I am making a case for trade protection, but I assuredly am not. I strongly believe that the US, and most other countries, generally benefit from open trade, and that it is in the best interests of the US, Europe, Japan and China to understand and work out those benefits within a stable institutional framework, but I also think the ease with which people who oppose trade protection make muddled or easily refutable arguments does no good to their position. In my opinion policies do matter to trade, and if we reject those policies it should not be on the specious grounds that they will have no impact.

But to turn from the airy world of abstractions to the real world, what is happening in the world of trade? Today\’92s Xinhua has an article urging Argentina to lift recently-imposed trade restrictions on Chinese goods.

Chinese business circles are deeply worried about the protectionist measures against Chinese products that the Argentine government has taken, a senior diplomat at the Chinese Embassy said in an interview published in La Nacion newspaper Sunday. “These import measures are discriminatory,” said Yang Shidi, economic and commercial counselor of the Chinese Embassy in Argentina.

The measures that Argentina has adopted since 2008 have affected many Chinese products and run contrary to the memorandum of understanding signed by China and Argentina in 2004, in which the Argentine side recognized China’s market economy status, Yang said. Argentina calculated the dumping margin for the Chinese products on the basis of the prices of a third country, he said.

“It is not fair,” because the costs of raw materials and manpower as well as productivity in China are different from those of other countries, Yang said. He stressed that a World Trade Organization member must respect related rules and regulations while introducing measures to protect its own trade. China stood firm against trade protectionism and urged to solve trade frictions through international consultation and cooperation, Yang said.

I checked out the original article in La Nacion and then wrote to an old Argentine banking friend of mine to ask what he thought about the article. He sent me the email equivalent of a grimace and said something unprintable about China\’92s standing firm against trade protection. I suspect that given the wide-spread perceptions, whether fair or not, of forceful Chinese intervention in trade matters, it probably doesn\’92t help China\’92s case to lecture too smugly against the evils of protection. From my friend\’92s reaction, and many, many conversations I have had and emails I have received, I am willing to bet that these lectures mostly just infuriate people.

There\’92s more, and bigger, on the trade front. Japan posted its first monthly current account deficit in 13 years (since January 1996) and its largest since the data first became available nearly 25 years ago. The deficit was $11.3 billion, with the merchandise deficit totaling $8.7 billion \’96 largely on the back of a whopping 46.3% drop in exports (imports were down a very scary 31.7%).

These extreme conditions, not just in Japan but throughout Asia, are not going uncontested. Bloomberg today had another very worrying article about the response of Asian central banks:

Asian central banks are abandoning a six-month campaign of defending their currencies, reversing course to cheapen exports that are falling the most in a decade. Policy makers from India to Malaysia to Taiwan are letting their currencies depreciate after South Korea gave companies an edge by allowing the won to weaken 19 percent against the dollar this year. Shipments from South Korea, Indonesia, Taiwan and Malaysia fell 17 percent in January to $79 billion, twice the drop of April 1998, when the Asian financial crisis was wiping out a third of the region\’92s economy, according to data compiled by Bloomberg.

It seems that we may be on the brink of a series of competitive devaluations, and it\’92s no good for all us rational people to agree that competitive devaluations are useless. They are only useless in the aggregate, but individually it will be very difficult for policymakers to continue withstanding the pressure for more depreciation.

If we see a lot more weakness in Asian currencies, and a partial reversal of the trend so far in which other Asian countries have had to absorb far more of the global contraction in demand than China, I wonder how significant the pressure will be on China to allow some depreciation. My guess is that policymakers will hold off on devaluation pressure as much as they can while using every other means to achieve a similar effect \’96 via subsidized labor, credit, and other costs to manufacturers \’96 but ultimately the howling of the export sector is likely only to increase.

But not everybody is as pessimistic about trade as I am. Daniel Ikenson, at the Cato Institute, had an Op-Ed piece in today\’92s South China Morning Post arguing that fears of trade protection are seriously overstated.

Yes, India did recently raise tariffs and place other restrictions on some imported steel products, and Ecuador raised tariffs by 5 per cent to 20 per cent on 940 different products. There have been similar actions in other countries and more are likely in the months ahead. But that kind of “backsliding” is permitted under World Trade Organisation rules. The WTO affords some flexibility to governments to occasionally indulge protectionist pressures, which allows the system to bend rather than break. The risk of such measures causing a perceptible drop in global trade flows is remote.

According to recent estimates from the International Food Policy Research Institute, if all WTO members raised all tariffs to their maximum allowable rates, the value of global trade would fall by 7.7 per cent over five years. That’s a substantial decline from the 5.5 per cent yearly rate of growth during this decade, and would be quite painful.

But, to put matters in perspective, global trade plummeted 66 per cent during the protectionist pandemic in the first half of the 1930s. The absence of rules in the 1930s meant that there were no proffered courses of action, no sources of adjudication or remediation, and no limits to the actions governments could take in response to external economic policies. Today, we have rules and respected institutions that have worked reasonably well to ensure the integrity of the trading system. Nearly 400 disputes have been resolved successfully during the 14-year history of the WTO, and there have been no trade wars.

In the 1930s, there were far fewer domestic constituencies advocating against protectionism. Today, there are burgeoning interests in a diversity of countries who favour lower tariffs because their livelihoods depend on access to imported raw materials, components and capital equipment. The fact that most WTO members’ tariffs are well below their maximum allowable rates suggests that something besides the rules compels openness to trade.

He may be right, of course, but I am not comfortable with comparisons between the relatively benign trade environment of the recent past and that of the 1930s. The recent past should be compared with the 1920s, when the trade environment was also relatively benign, but it changed sharply as unemployment rose and net demand contracted. We need to wait to see if this happens again.
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By the way, while on the subject of trade, there are big rumors that February\’92s trade surplus has collapsed to $7 billion. If this is true (and these sorts of rumors often are), it would broadly be a very good thing, I think, and would certainly relieve trade friction pressure, but the real trick will be to see why it declined. One suggestion making the rounds: China has significantly increased its import of commodities to rebuild commodity stockpiles. That would be a less-than-good reason for a drop in net exports. Let\’92s see what the number is.

Meanwhile whereas many people are happily celebrating the \’93recovery\’94 of the Chinese economy, I continue to be extremely skeptical and worry that whatever short term boost we have recently seen may be coming at the cost of a reduced ability to engineer expansion later (and to tell the truth I am not really sure what that boost was, since it seems to me that the best and most widely celebrated \’93indicator\’94 of economic recovery has been that the contraction implied by PMI was less in January than in November and December \’96 a weird indicator of recovery). I increasingly think Nick Lardy was remarkably prescient when he argued that the hard-landing/soft-landing debate (was it two years ago?) had it all wrong \’96 what we were going to see is a long landing.

For example the steel industry isn\’92t looking all that good. On Friday Bloomberg published an article which began:

Baosteel Group Corp., China\’92s largest steelmaker, said prices are close to its production costs, indicating that the country hasn\’92t had a \’93real\’94 demand recovery. Baosteel is \’93cautious\’94 about the demand outlook, Wang Jing, the company\’92s general manager for international trading, said in an interview in Beijing, while attending the National People\’92s Congress.

Benchmark steel prices in China jumped 46 percent between November and February on optimism that the government\’92s 4 trillion yuan ($585 billion) stimulus package would revive metals demand. The price recovery was because of traders replenishing inventories, Wang said today. \’93Demand hasn\’92t had a substantial recovery, but output rose faster because of higher prices,\’94 Wang said. \’93Our prices are on the verge of production costs.\’94

Also, in spite of all the eagerness to boost consumption, it seems that old habits die hard. Last weeks\’92s China Daily had an article celebrating the return of thrift to China\’92s feckless youth:

Many Chinese are tightening their belts during the country’s economic downturn despite government efforts to boost domestic consumption and replace evaporating export orders.

Wang Hao, 24, a Beijing office worker, made a public resolution in June last year to limit his weekly living expenses to 100 yuan ($14.6 dollars). That’s the cost of eight Big Macs in China. “The financial crisis has taught a spending lesson to young people in China, including me,” said Wang.

Bizarrely enough, the article concludes with:

The frugal lifestyle seems to be endorsed by authorities. In a commentary published last week in the People’s Daily, the writer said frugality did not conflict with the government’s demand-stimulating policies, as it called for reasonable rather than reckless spending. Frugality could also help people spend their limited money on the most needed things. “The neo-frugal way of living should become a fashion, especially in the financial crisis,” said the writer Wang Jinyou.

Before closing, as if I need to extend an already too-long post, I thought I might throw in something a little bit lighter. Today\’92s People\’92s Daily has an article on the recent development model, from which I quote:

As some Western media questions why China works, the world’s economic experts and scholars are also wondering the same thing: What tools China has to keep its economy resilient and why it is well-positioned to weather the financial crisis?

The answer lies in the nation’s unique growth mode featuring a “scientific outlook on development.” Over the three decades of reform and opening-up, China has evolved its own growth mode that aims to achieve development through scientific approaches based upon China’s national conditions and the international situation, analysts said.

The essence of such a growth mode is to seek a balance between development, stability, equity and clean environment, they said.

Tags: Alexander Hamilton, Argentina

Can Smoot-Hawley only happen in the US?

February 26, 2009 in Balance of payments, Consumption and production, Exports and imports, PBoC, Trade protection by Michael Pettis | 33 comments

Yesterday in a meeting I was asked by an investor why, even while I have been writing maniacally about the crucial importance of global cooperation, I was so consistently pessimistic about the possibility of the major economies arriving at a \’93grand bargain\’94 that will minimize over the long term the cost of the current crisis. I think, in fact, that a nasty fight over trade is very probable and I worry that not only will trade conflict come as a huge shock to China\’92s economy, but also that Chinese actions and public statements are actually contributing more to that probability than all the buy-America, buy-Europe talk filling the air.

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Let me pluck one reason from the headlines of today\’92s People\’91s Daily, the official mouthpiece of the country\’92s ruling party. The article, titled \’93Buy American can\’92t save the US economy\’94, is based on interviews with a number of Chinese commentators. One question:
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Why does the US, which has always advocated trade liberalization, put forward such a clause? Can the “Buy American” provision offer effective solutions to the US’ economic problems? What impacts will the implementation of this economic plan produce?

All the responses are the same. The US, according to this article, is playing dangerous games with global trade even while Chinese policymakers are trying to hold back the tide of protectionism. The response by Song Hong, Director of the Research Section of International Trade at the Chinese Academy of Social Sciences (CASS):

The US is a country that has a tradition of free trade. But the US Congress has tarnished its own reputation with narrow-minded and selfish acts that place US interests above global interests. During the 1930s, the Smoot-Hawley Tariff Act enacted by the US Congress greatly aggravated the global economic crisis. Today’s situation seems to repeat that historic tragedy.

It is really worrying that the stupid and destructive Smoot-Hawley Act, which was terrible not because it was passed by the US but because it was passed by the country with the largest export of overcapacity in the world at the time, is perceived by some as something that can only happen in the US, and not in China. On the contrary, US policies can be extremely unhelpful, of course, and it would come as no surprise to me that many of their policies turn out to be harmful to US and global interests, but the US cannot possibly engineer a repeat of Smoot-Hawley\’92s disastrous impact on global trade and the US economy. As the largest trade deficit country in the world anything that results in a contraction in net US demand is not only not bad, it is a necessary part of any adjustment.

The US cannot give us another Smoot-Hawley. In 2009 only China and Germany are really in a position to enact the current version of Smoot-Hawley \’96 to engineer polices that expand their massive export of overcapacity or, what amounts to the same thing, their massive import of demand \’96 and if you want to figure out who might be doing it, you need only to look at the direction of trade surpluses.

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The response by Li Quan, Deputy Director of the Department of International Economy and Trade at Peking University, to the questions posed by the People\’92s Daily was:
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The reason why the US emphasizes the protection of the steel industry is that its steel sector is a declining industry that does not have any international comparative advantage. At the same time the sector is of strategic importance to the US, as evidenced by the fact that Steel City Incorporated, based in Florida, has close relations with the US government. As a matter of fact, in 2002, following the September 11 attacks, the US openly raised the rate of import duties on iron and steel in order to protect its own steel sector. EU countries complained about US protectionism and submitted the case to relevant institutions of the WTO for judgment, eventually leading to the US’ defeat.

Although I agree with Professor Li about the value of the steel industry to the US, what depresses me about the prospects for trade war is that there doesn\’92t seem to be any recognition on his part that boosting steel production by any country is harmful to the global adjustment process. Apparently only American boosting of steel production is. I just don\’92t think this makes sense.

Very ironically the same issue of People\’92s Daily has another headline: \’93China announces stimulus plans for nonferrous metals, logistics.\’94 The article starts:

China’s State Council on Wednesday announced support plans for the country’s nonferrous metals and logistics sectors. Presided over by Premier Wen Jiabao, Cabinet members agreed to promote company restructuring and will offer subsidized loans to support technical innovations within the nonferrous metals sector. The export rebate rates of nonferrous products should be adjusted, said the Cabinet without elaborating.

That\’92s not all. Today\’92s Xinhua helpfully lists China\’92s stimulus package for ten different sectors announced between January 14 and today. These consist of machinery, textile industries, shipbuilding, autos, steel industries, electronics and information industry, light industry, petrochemical sector, nonferrous metals and logistics.

Nearly all of these products are in global oversupply, so the full focus must be on boosting consumption, right? Wrong. A quick run-down of the related article shows that some of the measures are certainly pro-consumption:

provide subsidies for home appliances for rural buyers

boost demand for petrochemical products

lower the purchase tax on cars

provide one-off allowances to farmers to upgrade their three-wheeled vehicles and low-speed trucks

improve the credit system for car purchase loans

But too many of them are actually likely to decrease Chinese contribution to global consumption (i.e. increase its negative contribution) by acting more to boost production than consumption:

promote company restructuring and offer subsidized loans to support technical innovations within the nonferrous metals sector

adjust export rebate rates of nonferrous products

lift processing trade restrictions on some labor-intensive, technology-intensive, energy-efficient, and environment-friendly products

provide more credit access for firms in the petrochemical sector

boost innovation in information technologies (whatever that means)

increase financial input for the country’s electronics and information industry

give tax rebates for electronics and information product exports

encourage large auto companies, as well as major auto-part makers, to expand through mergers and acquisitions so as to optimize resources and improve their competitiveness on the international market (does this mean prevent bankruptcies?)

increase credit support for ship builders

suspend construction of new docks and the expansion of slipways (which doesn\’92t increase production but, I think, might slow investment-based consumption)

increase export rebates for textile producers

help auto manufacturers raise their share of the auto market in China from 34% to 40%

create a special textile-industry fund for structural adjustment and technological upgrading

The problem, as I see it, is while an awful lot of experts here are busy explaining why the US must be careful about how quickly it reduces its contribution to global demand, which the US absolutely must do as part of its adjustment process, they seem to miss the point that China must increase its contribution to net demand, but it is actually reducing it. It may be confusing to many if I claim that subsidizing credit to steel producers or auto manufacturers is the 2009 equivalent of Smoot-Hawley \’96 after all isn\’92t Smoot Hawley all about tariffs? \’96 but the point is the reason Smoot-Hawley was such a disaster is because it involved an attempt by the largest trade surplus country in the world to increase its trade surplus in spite of collapsing world demand, and the 2009 equivalent must necessarily be Chinese or German moves that have the same effect.

And for my Chinese readers whose hackles are being raised by all this \’93criticism\’94 of Chinese policy, please know that I am not pointing all this out in order to provide ammunition for trade warriors in the US and Europe. I am only pointing it out because there is a real and growing risk that while busily crying \’93Smoot-Hawley\’94 at the US, China is going to blunder its way into the same terrible mistake the US made in 1930, and my conversations with US and European officials convince me that frustration levels are already too high. Needless to say it is not just readers of my blog who have noticed that China\’92s trade surplus has risen inexorably during the time this crisis has taken place, and even a very superficial reading of the world press suggests that this is causing rising anger. Trade conflict would be terrible for China, and I don\’92t see how it can end well for China if something doesn\’92t change soon.

It\’92s not that no one in China understands this. Nearly all of the non-government economists I speak to (ok, maybe not a representative sample) are worried by the direction events are taking and many of them are even more pessimistic than I am about the prospects for trade conflict. The WSJ blog translated a very interesting comment by the PBoC. According to their translation:

China has a problem of high savings and low consumption. For a long time our country\’92s economic growth has been mainly driven by investment and exports, and the ratio of final consumption [in gross domestic product] has been in a gradual declining trend. The share of investment [in GDP] has steadily risen from 36.6% in 1992 to 43.5% percent in 2008, while the share of consumption has dropped from 62.4% in 1992 to 48.6% in 2008, well below the world average. The high share of investment and exports and the low share of consumption are not conducive to the healthy and stable development of the economy.

The significant slowdown in global economic growth and the great downside risks for the future will directly affect China\’92s exports and investment in the tradable [goods] sector. Since external demand is inadequate, the driver for economic growth must come from increasing investment or consumption. Because the investment-led model of economic development increases the pressure on resources and environment, leads to a widening of the income gap and urban-rural inequality, and can easily lead to large fluctuations in economic growth as serious excess capacity emerges in some industries, it cannot be sustained for the long term. Therefore it is necessary to, in accordance with the requirements of the \’93scientific outlook on development,\’94 speed up the transformation of our economic development model, and strengthen consumption as a driver of economic growth, in order to achieve a balanced growth pattern based consumption, investment and exports.

The PBoC is right, of course, but what I would add is that they need either to speed up the process very rapidly so as to head off rising trade frictions (very difficult at best), or they need to get together with the US and Europe and work out a viable long-term plan that will allow them to adjust at a reasonable pace while heading off trade conflict.

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Meanwhile more of the wrong kind of news comes from Goldman Sachs, via an article in today\’92s Bloomberg:
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China investors should be \’93defensively positioned\’94 as a decline in the nation\’92s tax receipts signals a steeper slowdown in spending than retail sales figures show, according to Goldman Sachs Group Inc. \’93Tax data show much sharper deceleration in income and consumption in the past few months than suggested by official retail sales or income growth figures,\’94 Goldman Sachs analysts Joshua Lu, Caroline Li and Fiona Lau wrote in a note today.

Value-added tax has \’93de-linked sharply\’94 from retail sales figures, the analysts wrote. VAT rose 1 percent in the fourth quarter from a year earlier, while retail sales gained 21 percent, according to the note.

\’85Growth in China\’92s individual income-tax receipts \’93slowed down significantly\’94 in the second half and shrank in December and January, the Goldman Sachs analysts wrote. This compares with nominal wage growth of 21 percent in the third quarter, the report said. \’93We think the government\’92s fiscal stimulus package announced so far may help create jobs, but may not necessarily help boost wages which, in our view, is the key driver of consumption growth,\’94 the note said. \’93As such we are not hopeful that China\’92s consumption slowdown will bottom out soon.\’94

I am not smart enough to figure out whether or not Goldman\’92s methodology makes sense, but the furious drop in imports relative to exports makes me anyway doubt any evidence that Chinese consumption isn\’92t slowing sharply.

Tags: Goldman Sachs, People's Daily

Should China Devalue the Yuan?

February 15, 2009 in Balance of payments, Currency regime, Exports and imports, Trade protection by Michael Pettis | 35 comments

As I reported in last Thursday\’92s blog entry, last week the research institute associated with China’s Ministry of Finance published a report on its website arguing that China’s central bank should “actively guide” the yuan\’92s exchange rate and devalue the currency to about 6.93 against the US dollar. The purpose of depreciating, the report said, was to help maintain economic growth and bolster employment

An exchange rate of 6.93 implies a depreciation of 1.5%. This is not much of a big deal and unlikely to make much of a difference in Chinese export prices, so I wonder why they would even say this except as a trial balloon. It is not just the research institute that has been making the devaluation argument. Although a number of officials have publicly called for stability in the exchange rate, within China there has been a heated debate about the country’s currency strategy, with several prominent commentators and economists arguing that China needs to devalue the yuan, by substantially more than 1.5%, so as to help Chinese manufacturers achieve greater competitiveness in the global export markets.

I think this kind of talk shows how mutually incompatible China\’92s two policy objectives are in the short term. First, China wants to boost domestic employment by boosting investment and helping restore manufacturing profitability. Second, China is under pressure, and this will almost certainly increase, to reduce its export of overcapacity, and China must address this pressure before it leads to worsening trade friction.

These policy goals might not seem mutually contradictory on the surface, but I would argue that this is only because policymakers \’96 and many commentators, it seems \’96 are failing to distinguish between total demand and net demand. Global demand is contracting, so anything that China does to boost total domestic demand is good for the world, right?

Not necessarily. Domestically, any increase in total demand will have positive implications for employment, but globally the world needs increases in net demand \’96 that is, consumption minus production. Since China provides negative net demand to the world (it runs a trade surplus), what the world needs from China as global demand contracts is a reduction in the amount of negative net demand China provides.

China can boost total demand by boosting manufacturing \’96 every worker not fired is a worker able to consume more \’96 but boosting manufacturing also boosts Chinese production. If it increases production relative to consumption, then China is actually reducing net demand, even while it is increasing total demand. That this is happening, by the way, shows up in the rising trade surplus.

In that light devaluing the currency would be a mistake. Although it might make Chinese manufacturing exports seem more competitive in the near term, there are at least two sets of problems with devaluing the yuan. First, as should be very apparent, the slowdown in China’s exports is not a function of rising domestic costs but rather caused by declining global demand. With imports contracting rapidly, it is a mathematical necessity that countries like China that export excess capacity will, in the aggregate, be forced to export less. The fact that China’s exports have contracted by much less than most of its Asian trading neighbors suggests that in fact China has suffered much less than the average Asian exporter from the contraction in global demand, which makes the argument that China is losing export competitiveness hard to sustain. In that case devaluing the currency would almost certainly set off competitive devaluations.

Some in China are arguing that other Asian countries are already devaluing, so by devaluing China would simply be keeping up, but this argument is a weak one. With Chinese exports declining by less than other Asian countries, and the Chinese trade surplus rising, it will be hard, as I point out above, to argue that China has lost trade competitiveness.

More importantly China is the third largest economy in the world and has the largest trade surplus in the history of the world. It cannot act as if it were a Vietnam, whose economy is small enough that devaluation would only have a slightly negative impact on the global balance. China must understand the impact of its actions on the global, which necessarily must constrain its behavior.

This is because with global demand contracting, any attempt by China to force more overcapacity onto a struggling world \’96 i.e. reducing net demand even further \’96 will require an even sharper contraction in manufacturing among its trade partners. China’s trade surplus is the measure of the amount of overcapacity, or negative net demand, it is exporting into the global economy, and January’s astonishingly high trade surplus of $39 billion, the second highest on record, caps a six month period during which China’s already record-breaking trade surpluses have surged. But with global demand contracting, any increase in China’s trade surplus requires that manufacturers in the rest of the world on average must cut production and fire workers by more than the amount implied by the global contraction in demand.

This will almost certainly lead to widespread claims that China is playing unfairly. Already China is in serious trade disputes with India and Indonesia, and with protectionist sentiment on the rise in the US, Europe, and the rest of the world, this is not the time to create more protectionist fury. A devaluation of the yuan, however small, would be seen as China\’92s answer to the Smoot-Hawley tariff increase, the notorious bill passed by the US Congress in 1930 that put the nail in the coffin of international trade (and a great example of the US failure to understand in 1930 that, like China today, it was too big to ignore the global impact of its domestic policies). In that case devaluation would almost certainly lead to an increase in trade friction.

In the 1930s, Smoot-Hawley had that very effect, and as the country with the world’s largest trade surplus in the 1920s, the US found itself, ironically, as the greatest victim of the contraction in world trade it did most to sponsor. As I have argued many times in a world of contracting demand, it is countries with excess capacity or negative net demand \’96 the trade surplus countries \’96 who are most vulnerable to a collapse in international trade. Even more than the US in the 1930s, China would suffer enormously from trade war.

The second set of arguments against devaluation involves a little longer term thinking, and so might easily be ignored in the panic of the crisis, but China\’92s economy must make the transition from export orientation to reliance on its domestic market. The process is never easy. To devalue the currency now would mean failing to take advantage of the shift that is already taking place and would push the economy in the wrong direction \’96 that of further constraining already-too-low domestic demand, while increasing the importance of the export sector in the Chinese economy. The difficult transition from export reliance to reliance on domestic consumption is not a problem that can be evaded, and postponing it will only make the transition worse.

As counterintuitive as it may seem, I think China should actually continue revaluing the yuan, but before doing so it must reach an explicit agreement that in exchange for revaluing, its trade partners will maintain open markets for China\’92s exports. This is key, and on Wednesday I think I will have a piece in the Financial Times that tries to make this point very explicitly. A trade war would force China to adjust quickly, and I think that would be socially disastrous for China, and at any rate given the structure of the country\’92s financial system and development model it cannot make the transition quickly.

As the world\’92s leading provider of excess capacity, China cannot avoid a difficult adjustment in a world of collapsing global demand. The goal of policymakers must be to slow the necessary adjustment over several years by negotiating an orderly decline in global trade imbalances. This requires cooperation, not devaluation. Sunday\’92s softer G7 communiqu\’e9 which, according to an article in today\’92s the Financial Times, \’93adopted milder language than recently regarding China\’92s handling of its currency,\’94 is a welcome step towards more civil discourse, but it should not mask the risk of rising protectionism. Among themselves the G7 can be as diplomatic as they like, but governments respond to domestic pressure, and nothing creates pressure like rising unemployment. Japan\’92s awful 2008 Q4 GDP numbers (down an astonishing 12.7% on an annualized basis) shows just how heavy that pressure will be.

I am off to Washington DC later today to testify before the US-China Commission and meet a bunch of friends in Treasury and State. On Saturday I will try to write about what I hear there.

Tags: Net demand

« Older entries

Balance of payments

What should have been discussed during the SED meetings (Part 2)

Squeezing out the exporters

China\’92s savings problem and the consumption constraint

Debt is up, trade is down, and we still don\’92t know which way to list

New trade and reserve numbers from China

Is Governor Zhou a closet Bernanke-ite?

Did China experiencing January hot money outflows?

Yes, trade policies do matter

Can Smoot-Hawley only happen in the US?

Should China Devalue the Yuan?

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