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More trade tensions, and the very limited advantage of relative poverty

September 25, 2009 in Consumption and production, Exports and imports, Trade protection by Michael Pettis | No comments

While the G20 leaders make reassuring noises about international trade, I think the risk of rising trade tensions have not abated at all. As I see it, everything depends on whether or not domestic Chinese polices had any role in creating the global imbalances, and if they did, then we are still in the early stages of a difficult process of assigning the costs of the global adjustment through trade.

Beijing hates when anyone suggests that Chinese policies were partly at fault for the current global imbalances, and doesn\’92t even like people to use the phrase \’93global imbalances,\’94 but like it or not, we have to figure out whether in fact Chinese policies mattered. As I see it, China\’92s consumption rate, the lowest ever recorded, and it\’92s trade surplus, the largest as a share of global GDP ever recorded, could not help but have been caused by policies \’96 such as an undervalued currency regime, excessively low interest rates, sluggish wage growth, unraveling social safety nets, and manufacturing subsidies \’96 that were almost wholly under domestic control.

According to my understanding of Chinese growth, it was policies that systematically forced households implicitly and explicitly to subsidize often-otherwise-unprofitable investment and manufacturing that led to wide and divergent growth rates between production and consumption, and of course the gap between the two is the savings rate. If that is true, the stimulus package is only likely to exacerbate the domestic imbalance.

This matters because as the US begins the too-slow but irresistible process of raising its savings rate, something else must change too. At the global level savings must of course balance with investment, and with general expectations that investment will at best remain steady and probably actually decline over the next few, a rising US savings rate must result in one or more of three outcomes:

1. Total US savings do not rise \’96 which means US GDP must contract as the savings rate rises

2. The savings rate in the rest of the world declines, or at least grows much more slowly than in the past. Since China is the country with the highest savings rate and the largest trade surplus, this means China\’92s savings rate will decline, and this is just another way of saying that consumption growth will surge.

3. China\’92s GDP grows much more slowly.

So we are left with the almost inescapable fact that if the US savings rate increases, either China (and the rest of the world, technically, but in practice mainly China) must see much faster consumption growth or the world must experience a slowdown in GDP growth.

Consumption growth determines trade tensions

How quickly can China raise its consumption growth rate? Optimists, and those who think that Beijing\’92s policies did not contribute to the global imbalances, believe that the fiscal and credit expansion of the past several months can cause both investment-led growth and a sustainable rise in consumption growth. Pessimists point out that it was exactly these sorts of highly inefficient investment-driven policies that left China with its savings and trade imbalances, so that intensifying them can only exacerbate the imbalances over the medium term.

If the optimists are right, and China sees a long-term and sustainable surge in consumption, most of the brunt of the global adjustment will take place in the US, and China and the rest of the world will return relatively quickly to growth. If the pessimists are right, and of course I am a pessimist, the global economy is likely to suffer a period of struggling growth as tendencies to force up global savings conflict with the tendency of global investment to decline.

In that case the main mechanism for distributing slower growth among the world\’92s major economies will be through international trade. Differences in the savings and investment rates in each country show up as surpluses and deficits in the trade and capital accounts. With consumption being the most valuable commodity, both trade surplus countries, with their consumption deficits, and trade deficit countries, with their consumption surpluses, will be maneuvering ferociously to access as much global consumption as they can. In that case expect a sharp and continuing rise in trade tensions. The G20\’92s best intentions won\’92t matter.

This, by the way, seems to be a repeat of the Japanese story in the 1980s and the 1990s. As regular readers of my blog know, I believe there are lessons for China from what happened to Japan after the US stock market crash in 1987 signaled the need to end Japan\’92s dependence on a burgeoning US trade deficit to absorb its excess capacity. Japan then, as China now, responded to the collapse in its biggest export market with a credit and fiscal expansion that at first protected Japan from the employment consequences of the contraction in US net consumption, but which ultimately may have exacerbated Japan\’92s imbalances and made its adjustment all the more difficult.

The Japanese parallel

I\’92ve been speaking to a lot of investor groups in the past month, and when I discuss the parallels between China today and Japan after the 1987 US stock market crash I am often told that the comparison isn\’92t useful because of one (or both) of two major differences. The first is that since China\’92s current consumption level is so much lower than Japan\’92s in 1987, it is far more reasonable to expect a surge in Chinese consumption to replace the declining US demand for Chinese excess capacity than for a surge in Japanese consumption to have done the same after 1987. Japan might not have been able to pull it off, but, they say, it is much easier for China to do so because it is so much poorer and starting from a much lower base.

The second objection \’96 perhaps not so different from the first \’96 is that since China is so much less developed than Japan was in 1987, an infrastructure investment surge is a lot more sustainable. After all, Japan already had great infrastructure in place at the time, so that much of its new investment after 1987 was inevitably in the form of highly wasteful \’93bridges to nowhere\’94. Since China has much lower quality infrastructure stock, they argue, there is much more it can do in the way of sustainable investment.

I am always a bit puzzled by how widely-held these views seem to be, especially in China but also abroad. The idea that being poorer makes policy easier can\’92t have emerged from looking at the experience of developing countries. I suspect that it arises from assuming that poverty does not represent differences in real factors \’96 worker productivity, education, the institutional and legal framework, etc. \’96 so much as in policy mixes.

It is true that poorer countries are able generally to achieve faster growth rates than richer countries, perhaps because they have only to play catch-up, but there is little evidence from other countries that poverty leads systematically to more profitable investment or to more sustainable consumption growth. I think both objections stem from implicit assumptions that there is some highly attractive upward limit to either consumption or infrastructure investment, and that the further away we are from that limit the stronger the attraction towards it. But if that assumption weren\’92t mistaken poverty should have ended long ago.

Take consumption. At the very least if consumption growth were an inverse function of wealth, or of existing consumption levels, the US would have the slowest consumption growth rate in the world and certain African or Caribbean nations would have the fastest. This clearly isn\’92t the case.

Household income growth determines consumption growth

I would argue instead that the growth rate in consumption is partly a function of demographics and income distribution, partly a function of the willingness of banks to increase or reduce consumer credit, and more generally a function of the growth rate of household income. Other things matter too \’96 for example I agree with many of my colleagues in and out of China that a good health insurance system may reduce the need for Chinese households to save since it smoothes out expected health costs \’96 but it seems to me that absolute level of wealth is almost irrelevant in determining potential consumption growth rates. Rich people, after all, seem as determined to increase their consumption as poor people (you can easily see that in the behavior of the hordes of the new wealthy in Beijing and Shanghai), although of course the goods and services they will want to buy will be very different.

In that case what really matters to Chinese consumption growth is the rate at which wages and other forms of household income grow, and the extent of implicit taxes or subsidies that penalize or favor consumption. I exclude possible growth in consumer credit because Chinese banks have never figured out how to do this without a rapid increase in non-performing loans.

Of course it is very important to remember that household income in China is not just wages. Interest on bank saving deposits is also an important source of income, as are various social transfers. There are also a variety of hidden taxes on household income \’96 some obvious and very significant, like the low deposit rates the PBoC demands to subsidize bad lending practices and otherwise non-viable investments, others less so, like an undervalued exchange rate, which effectively creates a consumption \’93tax\’94 on imported goods.

These are the things that matter. While other factors may affect consumption rates at the margin, I think it is pretty clear that the growth in total household income \’96 wages, interest income, and other social transfers including the various \’93safety nets\’94 \’96 largely determine the growth rate in consumption in China, Japan, and in almost any country. If this is true, the relative wealth or poverty of a county says little about future consumption growth, and the fact that China is much poorer today than Japan in 1987 in no way should convince us that it will be that much easier to boost Chinese consumption.

Two asides

It is worth making two asides which may seem obvious, but are often lost in discussion. First, in discussing the resolution of global imbalances we need to take gross amounts into consideration. In other words because both the Japanese and the US economies are so much larger than China\’92s, and their consumption rates higher (more than twice as high, in the case of the US), a 1% slowdown in US consumption is not dissipated by a 1% growth in Chinese consumption, and a 1% increase in Japanese consumption does not have the same effect as a 1% increase in Chinese consumption. In both cases the change in Chinese consumption would have to be much greater.

Second, there is a big difference between consumption growth and growth in the consumption share of GDP, and this difference matters very much to the whole rebalancing debate. If Chinese consumption is growing at the 8-9% rate characteristic of the past several years, it still might not resolve the problem of a decline in US consumption even though by any standard that would represent a rapid rate of growth. If Chinese GDP is growing faster than this, as it has done for the same period, the imbalance is not only not being resolved, it is getting worse.

Chinese consumption, in other words, has to grow faster than Chinese production over the medium term in order replace a decline in net US consumption. High growth rates in China do not resolve the imbalance if production grows faster than consumption.

This is a very long way of saying that in comparing of policy responses the lower level of consumption in China is not at all an important difference between China today and Japan in 1987. Even if it creates more \’93room\’94 for a rise in Chinese consumption than in Japanese consumption \’96 a claim about which I am very skeptical \’96 it does not make it any easier for Chinese consumption to rise to the challenge in a way that Japan could not. It still means very broadly that over the medium term Chinese household income will have to rise faster than Chinese GDP \’96 something it has not been able to do at all in the last decade \’96 in order for China to absorb the declining net demand from the US for Chinese goods once its government-fueled investment boom peters out.

But what about investment \’96 must the government-fueled investment boom peter out? China has a much weaker and lower quality infrastructure than Japan did in 1987, so it seems a safe bet that China can sustain its investment boom for a lot longer than Japan could, right? This is the second objection to the comparison between China today and Japan in 1987.

Again, I think this is a fallacy. Let\’92s leave aside the obvious problem that much of China\’92s infrastructure investment may be wasted on spending that has no social benefit or simply is stolen, not because this is a small problem but rather because most of us would easily understand that a government debt-fueled investment boom to finance the purchase of private homes in Paris or Los Angeles or even large swimming pools and luxurious dining facilities for local municipal officials must still be repaid, and that it will be repaid out of future household income that would be better and more fairly spent on future household consumption.

The problem is that even \’93good\’94 infrastructure projects, like airports, railroads and highways, also have limits. These projects have to repay their cost, including the appropriate cost of capital, because if they don\’92t, the payment must anyway be made out of future household income, acting as a drain on future consumption. Some projects can pay for themselves, and some might not pay for themselves directly but can increase economic value so that ultimately, by creating wealth, they effectively pay for themselves out of higher future income. In either case households are left wealthier even after paying for those projects, and so able to consume more.

Productivity matters

But does relative poverty really improve the value of these investments? It might seem obvious that taking a good railroad system in Japan and turning it into a state-of-the-art railroad system increases the value of the railroad less than taking a bad or non-existent railroad system in China and turning it into the same state-of-the-art railroad system. In that case China seems to have more scope for additional investment than Japan does.

But does it? Maybe not. Japanese labor costs a lot more than Chinese labor, and is far more productive, so it is not clear that the improvement in labor efficiency caused by the railroad investment is necessarily more valuable in China than in Japan, even though the absolute change in quality of the railroad service in China is certainly higher than in Japan in my example.

That is I think core of the problem. The scope for nominal improvement in infrastructure is certainly higher in China than in Japan, but nominal improvement doesn\’92t matter. It is the economic value of that improvement that matters, and the economic value of improving the railroad in China is not necessarily higher than in Japan since, for example, every hour of transportation time saved in Japan may be substantially more valuable than an hour saved in China.

In fact I would argue \’96 as have many economists, by the way \’96 that China\’92s obsession with high-technology or state-of-the art infrastructure is extremely wasteful because the benefits of the most advanced technology only justify the costs if labor productivity and labor costs are very high. This is perhaps another way of saying that China\’92s highly capital-intensive growth is far from optimal for China, and probably only reflects the fact that capital is so cheap in China, at least for the capital-intensive SOEs that get the bulk of bank financing. This means that achieving Japan-style levels of infrastructure are not necessarily the best way to invest in infrastructure. The optimal infrastructure level in China is lower than the optimal in Japan, so the fact that China starts from a lower base does not automatically mean that it has more scope for profitable investments.

Airports are perhaps a good way of thinking about this. China doesn\’92t have as many airports as Japan does (adjusting for size and population), so clearly that means that China can engage in an airport-building spree that would be folly in Japan, right? Maybe not. Chinese are far less likely to be able to afford air travel than Japanese, and are less likely to need to ship goods by air than are the Japanese, so China needs efficient air travel much less than does Japan. Simply pointing to the fact that China has fewer airports does not imply that it has more room to build airports. In fact in my opinion it is very likely that we are going see so much money spent on Chinese airports in the next few years that it is almost impossible that we will ever recoup their cost.

As an aside I am often told about, as another example of the kind of investment spending that can pull China out of the crisis, the building of \’93shadow\’94 cities next to older ones, with much better facilities. Eventually everyone is expected to move out of the old city, with its less than optimal facilities, to the new state-of-the-art version. If enough cities do this, the argument goes, China can achieve huge growth rates.

Of course it can, in the short term. And if the US government were to raze Chicago and immediately rebuild it, I suppose that they could build a far more efficient city and would certainly create a huge short-term boost to the local economy (for one thing they would probably wipe out local unemployment).

Spending must be justified

But is this a good idea? If the US government were to propose doing it I am sure President Obama would meet with a storm of criticism. It would be pointed out that the increase in productivity created by this new, improved Chicago would almost certainly be only a fraction of the cost of rebuilding the city, and the difference would represent a straight increase in net indebtedness.

They would almost certainly be right. But I think this kind of activity is actually even more wasteful in China than in Chicago because much higher productivity levels in the US mean that the resulting \’96 expensively acquired \’96 improvements in efficiency would be more valuable in Chicago than in China. So building ultra-modern facilities may appease the pride of local officials, but it may do so at a cost far greater than its true economic benefit.

What about cases in which there is very rudimentary infrastructure that is being upgraded as part of the 2009 stimulus package? Here too I am not sure that we should be overly sanguine about the surge in infrastructure investment. China already has excellent infrastructure for such a poor country, and well before the stimulus package it was widely accepted that there had already been overbuilding, misallocated capital, and wasted investment in infrastructure. The recent surge in investment might all be for very productive purposes whose resulting increase in production will easily pay off the true, unsubsidized cost, but this is an argument that would need an awful lot of proof before I would believe it.

It is hard to imagine that a system that was already misallocating capital on a huge scale (for example by almost any reasonable standard most SOEs are value destroyers, whose viability is only assured because of input subsidies and highly subsidized borrowing costs) would suddenly, under tremendous pressure to expand investments massively and quickly \’96 and with the understanding that all risks would be socialized \’96 could do so without increasing the number of unprofitable investments. Maybe I will prove to be wrong, but I do think a lot of skepticism is warranted.

By the way my argument is not that \’93Keynesian\’94 spending is a waste. I think its usefulness depends on existing capacity use, including employment, and can generate more value for the economy than it costs. My argument \’96 a much more limited one \’96 is only that infrastructure spending is not automatically more economically viable in poor countries than in rich countries. The larger possible \’93nominal\’94 improvement in the quality of infrastructure will only lead to greater economic value if the poorer country is able to capture as much economic benefit from the investment as the richer country.

If labor productivity is much lower, as it is in China, it might not be able to do so. In fact I would go further. State-of-the-art infrastructure in China is almost always harder to justify economically than in Japan.

Yet another discussion on the Asian savings glut hypothesis, and why it matters

August 20, 2009 in Asian development model, Consumption and production, Exports and imports, Policy, Savings glut, Stock market by Michael Pettis | 84 comments

The Shanghai stock market was up 4.5% in very nervous trading today but down 16.3% since its recent peak at 3478 on August 4, and still trading at more than 30 times earnings.\’a0 All this turmoil is triggering all sorts of worried comments about the sustainability of the fiscal stimulus package and whether it has already reached the end of its effectiveness (it hasn\’92t \’96 the government still has credit and fiscal firepower, and will use it if growth slows down significantly in the next few quarters).\’a0 It also makes it harder, but probably more useful than ever, to focus on the bigger picture, and this entry is definitely big picture.\’a0 It also turned out to be a very long piece, as these big-picture pieces tend to.\’a0

The topic is whether or not the global imbalances that have led to the current crisis were in any way \’93caused\’94 by the Asian savings glut, and besides arguing why I think this may be the case, I want also to argue that getting this argument right is far more important than many seem to realize. \’a0Mohamed Ariff, executive director of the Malaysian Institute of Economic Research, indirectly suggests why in a good OpEd article in today\’92s New Strait Times:\’a0

China\’a0is seen as the beacon of hope in these days of gloom and doom. This has led some observers to think China will lead East Asian economic recovery and thereby spearhead a global economic turn-around. But this faith in China as saviour may be misplaced.China’s imports from the rest of East Asia consist mostly of raw materials, intermediate products and components and parts, the bulk of it turned into manufactures for exports. China’s imports of consumer products from the region account for no more than a small proportion.

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China’s imports from its neighbours have plummeted in the wake of the slump in China’s own exports, although the Chinese economy is growing at seven to eight per cent, because China depends largely on domestic production for its own consumption, which does not spill over to the rest of the region through trade.

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Therefore, China will import more only if it can export more. For this to happen, the demand for China’s exports in the US and European markets must first recover.

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But our definition of a \’93recovery\’94 in the US, and whether it will indeed happen in the way that Ariff requires for Asian growth to return, depends in an important way on whether or not the current imbalances were caused primarily by an original distortion in US consumption or in Asian savings.\’a0

I started writing this because while googling around looking for something else, I stumbled early this week upon a blog by LSE\’92s Danny Quah with the intriguing title \’93Where in the world is Asian Thrift and the Global Savings Glut?\’94\’a0 I later found that like mine, his blog is carried by Nouriel Roubini\’92s RGE Monitor.\’a0 I also subsequently discovered by a weird coincidence that on Saturday I am sharing a panel with him in a conference at the Guanghua School at Peking University, where we will be discussing the \’93Reconstruction of Global Finance\’94.\’a0\’a0\’a0

The whole \’93savings glut\’94 debate is a controversial one because almost from the start it has degenerated into a fairly silly argument about who to blame for the global imbalances and the subsequent crisis \’96 or more specifically and more excitingly, whether the predator was wholly the foolish American consumer or the beetling Chinese saver.\’a0 Three months ago Brad Setser discussed all this in one of his blog entries that (inevitably) drew more comments than most, and as usual he provides a concise and enlightening discussion on the subject which you might want to read.\’a0 He is a proponent of the hypothesis, but nonetheless pretty fair-minded.\’a0

Professor Quah weighs in on the other side of the savings glut debate although, unlike most others in the debate, he seems not terribly concerned about assigning full blame to any of the major parties.\’a0 It is neither excess US consumption nor excess US savings that solely \’93caused\’94 the imbalance, in other words, because necessarily both sides are required for it to exist.\’a0

Except for the possibility of trade with outer space, the US deficit has to be matched dollar-for-dollar by trade surpluses in the rest of the world. Correspondingly, therefore, the rest of the world has been saving\’97consuming less than it has been producing\’97and accumulating dollar claims against the US as a result.\’a0

In this description, however large the global imbalance, a savings glut\’97wherever or however it might arise on Earth\’97has no independent existence. It makes as much sense to say the world\’92s excess savings caused enthusiastic US consumers to flood into Walmart to buy $12 DVD players, as to say US consumer profligacy made hungry Chinese peasants abstain even more and instead plow their incomes into holdings of US Treasury bills.\’a0\’a0

When two variables have always-identical magnitudes, obviously neither can usefully be said to cause the other.\’a0\’a0

Who are the predators?

This is correct, but as an aside, the discussion about enthusiastic American consumers forcing the Chinese to save, or hungry Chinese savers forcing Americans to consume, typically uses colorful but totally inappropriate images to describe the dynamics of the this process.\’a0 For example, I often hear opponents of the Asian savings glut hypothesis say, voices dripping with disbelief, that the savings glut hypothesis insists that the poor American consumer rushed out to buy another DVD player because terrible China forced him to borrow the money and buy the DVD player.\’a0 How could that possibly happen?\’a0

Well, that\’92s not how it would have happened.\’a0 In any large country, there are millions of households able and interested in increasing savings or in increasing borrowing.\’a0 Specific policies or financial conditions will determine at any given time changes in the behavior of some of these individual households, so that at the macro level, and only at the macro level, the country will have seen an increase in savings or an increase in consumption.\’a0\’a0\’a0

It is not every household that rushes out to consume when consumption rises, and this never happen because predatory savers force an otherwise unwilling consumer to buy. \’a0So if it had indeed been rising Asian savings that drove the US consumption binge, policies aimed at constraining Asian consumption and boosting Asian production (which cause savings to rise) will have initially led to a rising Asian trade surplus and US trade deficit, as the tradable goods sector in Asia expands and the tradable goods sector in the US contracts.\’a0

This surplus would be recycled into the US via purchases of highly liquid securities.\’a0 If the Fed failed to respond to this increase in liquidity by raising interest rates and contracting money (and contracting the tradable good sector), the financial system would have to accommodate the rising liquidity as it has always done throughout history \’96 by growing financial balance sheets and taking on more risk.\’a0 In that case the conditions for consumer borrowing will have been made increasingly easy, and those households who needed or were predisposed to borrow under easier lending conditions, and pressure on the parts of banks to extend credit, will do so.\’a0\’a0\’a0

As long as there are some households willing, however appropriately or foolishly, to increase consumption, the easier availability of consumer credit will cause them to increase consumption \’96 this has happened many times and in many countries, and has nothing to do with a predisposition to excess consumption.\’a0 Furthermore as recycled liquidity boosts household wealth by boosting the value of homes and investment portfolios, the rising wealth of each individual household will have an impact similar to rising income \’96 and with it consumption will rise.\’a0\’a0\’a0

So the point is the not very controversial suggestion that a surge in domestic liquidity in the US can easily cause US consumption to rise.\’a0 If that liquidity surge was \’93caused\’94 by the recycling of a large and growing trade deficit, then it is easy to see how at the macro level US consumption would rise in response to a surge in Asian savings.\’a0

Similarly, the proponents of the Asian savings glut hypothesis wonder in disbelief how an American consumer deciding to buy a DVD player could have possibly \’93forced\’94 poor Chinese peasants to cut their already minimal consumption and increase their savings. \’a0But there was no force.\’a0 A sudden explosion in binge consumption in the US would divert production from China, and as China increased the share of its output dedicated to exports, total production would not immediately be matched by total domestic consumption (Americans bought some of it) and the Chinese savings rate would necessarily increase \’96 whether at the household level or at the corporate or government level.\’a0

The interest rate argument\’a0

The point is that sarcastic comments about predatory American consumers forcing dim-witted Chinese households to save more and consume less, or predatory Chinese savers forcing helpless American households to borrow and consume, may be good debating tactics but they are misleading and explain nothing.\’a0 At the macro level either event \’96 higher Asian savings leading to higher American consumption, or higher American consumption leading to higher Asian savings, or even a combination of the two \’96 is perfectly possible.\’a0

So why should we accept the Asian savings glut hypothesis?\’a0 One argument that I first saw proposed by Brad Setser was that if the imbalances had been driven by US consumption, and therefore US borrowing needs, the consequence should have been an increase in US interest rates.\’a0 Had they been driven by excess savings, US borrowing rates would have probably declined.\’a0\’a0

In fact during most of the relevant period US interest rates did decline, even leading to the US Fed several times complaining about its inability to control domestic long-term rates.\’a0 So that pretty much settles it, right?\’a0 But Professor Quah dismisses this argument:\’a0

Many other factors could, of course, have driven down short rates: US monetary policy responded to national economic downturns in 1991 and 2001. Through the 1990s inflation rates worldwide converged and fell, together with short-term interest rates set by central banks everywhere. The burst of the dot-com bubble in March 2000 saw the NASDAQ index decline 77% in the following 18 months, prompting action by the US Federal Reserve. Japan\’92s monetary policy during its decade-long recession drove nominal interest rates there to zero.\’a0

Although he is right, this is not a completely satisfying dismissal.\’a0 The same savings glut that pushed down US interest rates could easily have pushed down global interest rates, especially in a world that was seeing rapidly rising capital flows that in many cases were aimed at \’93arbitraging\’94 (absolutely the wrong word, of course, but one widely used in the markets at the time) interest rate differentials.\’a0 After all it is often the case that, especially during periods of large international movements of capital, increases or reductions in US interest rates (or in British rates during the globalization period at the end of the 19th Century) are matched by changes in foreign interest rates.\’a0

Still, the fact is that his response does show that the interest rate argument is not final.\’a0 There might be other perfectly good reasons that explain the decline in US interest rates.\’a0

The bilateral trade argument\’a0

Quah\’92s main argument against the savings glut hypothesis, at least as far as his blog entry, seems to be that it could not have been a rise in Asian savings that drove the global imbalances because had it done so, much of the imbalance would have rested between Asia (or China, more specifically) and the US.\’a0 The strongest piece of evidence he presents is a chart that shows the US bilateral trade balances between the US on one side and China, developing Asia, the EU, and oil exporters on the other.\’a0 I have reproduced the graph below, but if you can\’92t see it well, just click on Quah\’92s blog (blocked in China, so China-based readers will need to use a proxy), and click on the graph itself for an enlargement (I wish I was clever enough to do things like that).

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As the chart shows, the US trade deficit rose nearly as quickly, or even more so, with those other regions as it did with China and/or developing Asia.\’a0 It wasn\’92t just a US-China phenomenon or a US-Asia phenomenon, it was a US-everybody phenomenon.\’a0

Quah\’92s argument seemed to be a powerful one at first, and I had to think about it for a while or else I would have to find myself deserting from the \’93savings glut\’94 camp.\’a0 In the end, however, I think his argument it turns out not to be very satisfying and I still think it runs against a timing story that better explains the imbalances.\’a0 I\’92ll say more on that later, but it seems to me that in a \’93globalized\’94 world, if the Asian savings glut hypothesis is true, not only would rising bilateral trade deficit between the US and other countries outside of developing Asia be possible, but they would even be almost necessary.\’a0

Why?\’a0 Because we have to be careful about misreading bilateral trade numbers.\’a0 It is the aggregates that usually matter.\’a0 I don\’92t have the data in front of me, but I believe that Europe did not run significant and rapidly growing aggregate trade surpluses during this period.\’a0 If that\’92s the case, then a growing bilateral surplus with the US is perfectly consistent with the savings glut hypothesis as long as you assume that trade is international and that any specific product can be produced and assembled in many countries \’96 which is of course a pretty unremarkable assumption.\’a0

So, for example, if rising Asian net savings \’93caused\’94 rising American net consumption (in the way described above \’96 no sarcasm, please), it would mean that money recycled from Asia into the US caused the US trade deficit to rise as it was intermediated by the financial system into consumer financing, even as it caused Asian trade surpluses to rise.\’a0

It\’92s the aggregate balance that matters\’a0

But, and this is the important point, the trade did not need to occur only at the bilateral level.\’a0 If rising Chinese savings was intermediated into rising US consumption and this bilateral relationship was resolved, to take a concrete example, by Chinese exporters producing shoes and American consumers buying shoes, the trade would not have had to occur directly between the two.\’a0 When Americans shop for shoes, they don\’92t care which country saw net savings rise, and when Chinese sell shoes they don\’92t care whose economy saw an increase in net consumption.\’a0 China could have produced shoes, sold them to a designer in Italy, where they would be packaged and branded, and then sold to American consumers.\’a0

In this simple case, Chinese excess savings would have \’93caused\’94 Americans to borrow money and buy the shoes, and so China would run a trade surplus, the US would run a trade deficit, and Italy would be balanced.\’a0 But Italy would nonetheless show a bilateral surplus with the US and a bilateral deficit with China.\’a0\’a0\’a0

Excess US consumption, in other words, would still have been \’93caused\’94 by excess Chinese savings in this case, but global trading and processing networks would have the bilateral trade imbalances, and their countervailing obverses, spread out though the world.\’a0 Many countries would run surpluses with the US and deficits with Asia, but at the aggregate level they would balance out at close to zero, and the US would be left with the sum of its bilateral deficits and Asia with the sum of its bilateral surpluses.\’a0

The point is that there is nothing in the Asian savings glut hypothesis that requires that all trade imbalances occur at a bilateral level and only between the participating countries \’96 that the deficit/surplus imbalances occur between the US and Asia.\’a0 It only requires that the US, as the equilibrator to rising Asian savings, have a large and growing trade deficit and Asia have a large and growing trade surplus.\’a0 If other regions also have large and growing aggregate trade surpluses that fed into the US deficit at the same time, that would perhaps be the problem Quah says it is, and either would need to be explained or would create problems for the hypothesis.\’a0 But they didn’t.\’a0

With one big exception, of course.\’a0 Oil exporters did see not only rising bilateral trade surpluses with the US, but they also saw rising aggregate surpluses.\’a0 Does this somehow weaken the savings glut hypothesis?\’a0 Again no, because those surpluses reflect one thing only, rising oil prices, and in an environment of rapid US and Asian growth, we would expect oil (and other commodity) prices to rise.\’a0 In fact the savings glut hypothesis would predict that as long as the recycling was occurring efficiently, both countries would grow quickly and high commodity prices would be not only possible, but in fact highly likely.\’a0

So as I see it, this is how the arguments and counterarguments stand:\’a0

1.\’a0\’a0\’a0\’a0\’a0\’a0\’a0 The argument that declining US interest rates proves the correctness of the savings glut hypothesis is wrong.\’a0 Declining US interest rates are suggestive but not final.\’a0 Other things could have explained declining US interest rates during this period, and of course there is easily a possibility of feedback loops in which any initial decline in US interest rates could, by increasing household wealth (via rising asset values) increase consumption and the US trade deficit, leading to Asian recycling, and so on to more lower interest rates.\’a0

2.\’a0\’a0\’a0\’a0\’a0\’a0\’a0 The argument that rising US bilateral deficits with many regions around the world disprove that the savings glut hypothesis is also wrong, and much less suggestive.\’a0 On the contrary, if the hypothesis is correct and if trading is truly globalized, we would expect US bilateral deficits to be high with nearly everybody.\’a0 At the aggregate level, however, we would not expect anyone except the high-saving Asian saving countries to run large trade surpluses.\’a0

3.\’a0\’a0\’a0\’a0\’a0\’a0\’a0 There was also an argument that I associate with Morgan Stanley\’92s Stephen Roach \’96 a very smart man who by the way disagrees strongly with the hypothesis \’96 since he was the one who first made this argument to me, over a lunch at Peking University two years ago.\’a0 According to Roach there has been no significant increase in global savings during the savings-glut-hypothesis period, which pretty much demolishes the idea of a saving glut.\’a0\’a0\’a0

I disagree because the hypothesis doesn\’92t imply in any way that global savings have increased.\’a0 In a closed economic system, unless investment has increased commensurately, an increase in savings in one part of the system must necessarily come with a reduction in savings elsewhere, and this was exactly the point of ascribing the current trade imbalances to a forced rise in Asian savings.\’a0 Rising Asian savings \’93forced\’94 declining US savings by causing the US financial system to accommodate growing domestic liquidity by taking on risk (again, no sarcasm please \’96 you might disagree but in itself this is not implausible).\’a0

Timing the flows\’a0

So where does that leave us?\’a0 Before answering, I think there is another thing to think about here, as I wrote earlier in this entry, and that is the timing issue.\’a0

In a June 4, 2008 entry, much of which is reproduced here, I mentioned a very interesting paper by German economist Jorg Bibow of the Levy Economics Institute of Bard College (The International Monetary (Non-)Order and the \’93Global Capital Flows Paradox\’94).\’a0 In it the author considers the \’93paradox\’94 of high and rising capital flows from developing to developed countries during the past decade.\’a0 This is a paradox because most economic theory (and history) suggests that developing countries are net recipients of investment, not net providers.\’a0

Bibow rejects the Asian savings glut hypothesis, but my understanding of his paper is that he agrees with much of what I understand the theory to be but rejects it on much narrower technical grounds \’96 he claims that the saving glut hypothesis is based on the \’93fatally flawed\’94 (his words) loanable funds theory.\’a0 However his narrative (to be horribly post-modern for a moment) of events seems very close to my own.\’a0

What interests me most is the data he provides in his paper (and you can see the accompanying graphs by following the link to his paper).\’a0 First off, Bibow discusses the evolution of the US current account deficit over the past fifty years.\’a0\’a0

Basically, according to the data quoted in Bibow\’92s paper, the US current account has been within a range of a surplus of 1% of GDP and a deficit of 1% of GDP for most of last fifty years with two exceptions.\’a0 The first exception occurred in the mid-1980s when the US current account deficit rose to nearly 3.5% of GDP in 1986-87 before declining sharply and running into a small surplus in 1990.\’a0 The second exception began technically in 1994, around the time of the Mexican crisis, when the US current account deficit climbed to around 1.6% of GDP, before it began to decline again, but it really took off in 1997-98, when it raced forward to peak at around 7% of GDP in 2007.\’a0\’a0

As an aside I should add that there was an acceleration of the growth rate of the deficit around 2004, if I remember, and I have a pretty strong suspicion that this had something to do with the financing of the Iraq war.\’a0 As I have pointed out before, US asset markets and consumption often boom during unpopular wars, like the Vietnam War, which tend to be financed not with taxes but with money creation and debt, and often these two things lead to great markets \’96 for a while.\’a0

If the US trade deficit was driven simply by an out-of-control US consumption binge, it is a little hard to see why it would have followed a pattern of general stability marked by two surges \’96 a small one from 1984-88 and a very large one after 1997.\’a0 If it was driven by Asian savings, this pattern becomes a little easier to understand \’96 or at least, what amounts to the same thing, we can posit a more plausible story to explain it.\’a0\’a0\’a0

The narrative\’a0\’a0

I will ignore the 1980s surge because this post is already too long, but again one can tell a very plausible story based on Japanese trade policies and domestic savings.\’a0 The post-1997 surge is much larger and more interesting.\’a0 1997 was, of course, the year in which several Asian countries, after years of tremendous growth and what seemed like invulnerable balance sheets, experienced terrifying financial crises and viciously sharp economic slowdowns, which profoundly impressed Asian policy-makers and has affected policy decisions to this day.\’a0\’a0

Since the main cause of the crisis seemed to be the sudden reversal in the early 1990s of current account surpluses into substantial deficits, along with highly unstable balance sheets in which large external obligations were mismatched with domestic assets and \’93hedged\’94 with extremely low levels of foreign reserves, one of the main (if mistaken) lessons policy-makers learned was the need to run current account surpluses and to amass large foreign currency reserves to protect countries from a repeat of the disastrous crisis of 1997.\’a0

These countries, consequently, but into place \’93mercantilist\’94 policies in order to achieve both goals \’96 persistent trade surpluses and large amounts of foreign currency reserves. \’a0This (I think plausible) story is reinforced by another graph Bibow reproduces.\’a0 The global capital flow \’93paradox\’94 to which he refers in his title is the fact that developing countries are exporting capital to rich countries.\’a0 According to his data, developing countries have almost always been net recipients of private capital flows \’96 which is what one would have expected from most economic theory and history.\’a0\’a0\’a0

They have generally been net providers of official capital as far as foreign currency reserve accumulation goes, but for most of the last fifty years reserve accumulation on average was significantly less than net private inflows, so developing countries were net recipients of capital.\’a0 (For much of the 1980s the balance on both was zero or close to zero, and I suspect that this reflects negative private flows to Latin American and others among the 32 defaulted or restructuring LDCs, as they were then called, netted against positive private flows to Asia.)\’a0

It is only in 1998 that reserve accumulation among developing countries begins to take off and by 1999 it exceeds net private capital flows to developing countries.\’a0 This is when the \’93paradox\’94 of net capital flows from developing to developed countries begins.\’a0 Except for a small decline in 2001 net flows from developing countries surge almost in a straight line to around $700 billion annually (combining $1.2 trillion of reserve accumulation versus $0.5 trillion of net private flows).\’a0

I am sure there can be other competing explanations for the timing of these flows, but I am very impressed by the fact that Asian savings, as expressed in reserve accumulation, surge after 1997, as does the US trade deficit, although exacerbated by the second surge around 2004.\’a0 Given the virulence of the 1997 crisis and the tremendous shock it provided to Asian policy-makers (and policy-makers in developing countries elsewhere), it seems to me that a very plausible argument can be made that it was the effect of 1997 that caused the shift in developing-country policies that led to the surge in savings and the corresponding increase both in trade surpluses and reserve accumulation.\’a0\’a0\’a0

The surge in the US trade deficit after 1997 is also more easily explained by a shift in Asian trade policies and currency regimes than by a shift in US consumer preferences.\’a0 Of course that doesn\’92t mean that nothing relevant happened in the US.\’a0 US monetary policy was clearly too accommodative, and especially in reaction to the Iraq war, so that it exacerbated the conditions created by the Asian savings glut.\’a0 If anyone is still looking for which country to blame, my understanding of the creation of the imbalances suggests that you can blame almost anyone you like and there is a good chance that you\’92ll be at least partly right.\’a0

Why does this matter?\’a0

The issue of what drove what is not simply of academic interest.\’a0 The consequences for the world of a system in which imbalances were driven by a sudden and self-perpetuating explosion in US consumption, which then forced higher savings onto Asian countries, are very different from a system in which imbalances were driven by a sudden and self-perpetuating increase in Asian savings, which then forced higher consumption onto non-Asian countries.\’a0\’a0\’a0

Deciding whether or not the savings glut hypothesis is correct is important not just because it allows us finally to decide which country really is the evil predator, the US or China.\’a0 It matters for a very different reason.\’a0

If it was an explosion in US consumption which drove the global imbalances, then we are likely to see a fairly benign resolution to the crisis for everyone, except maybe the US.\’a0 After all in that case the imbalances were driven by US consumption excesses, and since those excesses are, like it or not, going to be resolved by the need for US households to repair their badly-damaged balance sheets, the imbalances too will be resolved, and in a way that is mostly benign for everyone except recovering US households.\’a0 This process may be postponed by current US fiscal policy, and especially by recent policies that subsidize consumption, but it will only be postponed, not derailed.\’a0

And just as Americans can no longer binge consume, their binge consumption will no longer force Asians to save such a high and rising portion of their income.\’a0 Asian growth, and especially Chinese growth, will be much more balanced.\’a0

But if the global imbalances were driven by a surge in Asian savings, Asian and Chinese growth will still rebalance, but the rebalancing will be much more difficult.\’a0 Why?\’a0 Because too-high Asian savings, caused in large part by post 1997 policies that encouraged differential growth between consumption and production (as I discuss here, for example), have until now been matched by too-low US savings rates.\’a0 As long as the two imbalances balanced, the world economy could continue functioning without too much distortion.\’a0

But now if we can expect net savings in the US (and perhaps in many other parts off the world) to rise, we need to see a rapid change in those policies that encouraged too-high Asian, and especially Chinese savings. \’a0In that light there was an interesting and worrying OpEd article in today\’92s Financial Times by the Peterson Institute\’92s Fred Bergsten and Arvind Subramanian:\’a0

The Obama administration is increasingly signalling that the US will not continue to be the world\’92s consumer and importer of last resort. The clearest statements came last month from Larry Summers , White House economics director, in a speech at the Peterson Institute for International Economics and in an interview with the Financial Times. The US, he said, must become an export-oriented rather than a consumption-based economy and must rely on real engineering rather than financial wizardry. Tim Geithner, the US Treasury secretary, and other top officials have spoken similarly of rebalancing US growth.\’a0

If the US really is serious about this shift towards higher savings, and if the primary source of the imbalance was the Asian savings glut, and not an original US consumption \’93glut\’94, this means that in the future US policies will be in direct conflict with still-current Asian policies, and unless the US is unable to accomplish these goals, Asian countries will need to force through an adjustment in their development policies as quickly as possibly.\’a0 Asian and especially Chinese officials have acknowledged the need to increase consumption more quickly.\’a0

But for now this adjustment in policies that encouraged too-high Asian, and especially Chinese, savings does not seem to be happening.\’a0 “The optimal choice is to expand household consumption,” PBoC governor Zhou Xiaochuan said in a speech last month. \’a0″That is, however, easier said than done. While the current income structure cannot be dramatically changed in the short term, the second-best choice is to maintain and expand investments.”\’a0 He is almost certainly right, at least except for his last statement.\’a0

In fact as I have argued many times (for example here, and here), I suspect that most of the Chinese fiscal stimulus is exacerbating the imbalances \’96 both by boosting current and future production and by creating conditions that will constrain future consumption growth.\’a0\’a0\’a0

In that case there has been no significant rebalancing yet towards more rapid consumption growth taking a greater share of Chinese production \’96 just a frenzied attempt to keep current growth rates high by boosting investment, which will almost certainly lead to capital misallocation and rising non-performing loans, and clearly unsustainable attempts by the Chinese government artificially (and unsustainably) to boost short-term consumption by subsidizing it heavily with government debt (something the US seems to have been doing too) which has the effective consequence of reclassifying fiscal expenditures as household consumption.\’a0

The end result?\’a0 Planned increases in investment in China eventually become forced increases in investment \’96 rising inventory \’96 that ultimately must lead either to writing inventory off or closing down production facilities in the future.\’a0 This is, by the way, just another way of stating the excess capacity problem.\’a0\’a0

Perhaps what we need is a real return to Confucian roots. \’a0I recently read this quote from Lao-Tzu: \’93The sage does not hoard. Having bestowed all he has on others, he has yet more. Having given all he has to others, he is richer still.\’94\’a0

Tags: Bibow

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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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

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

Trade \’96 it\’92s not just the currency

June 3, 2009 in Asian development model, Consumption and production, Exports and imports, Policy by Michael Pettis | 53 comments

One of the reasons why trade-related discussions can seem so off-the-mark, I think, is because the conditions governing international trade are much more complex than we often realize. The determinants of the international balance of trade basically include anything that affects domestic consumption and domestic production, which pretty much means nearly everything in economics. Among other things this means that there is a very wide range of government policies that can affect trade \’96 sometimes explicitly and sometimes implicitly.

Unfortunately much of the analysis and debate doesn\’92t seem to get this. For example, many economists have pointed out that the bailout of GM is effectively a protectionist measure. I think it clearly has a trade impact, and this impact is \’93protectionist\’94, although not intended that way. What is missing from the discussion, I think, is a clear explanation of why it is effectively a protectionist measure. I would argue that the GM bailout has a trade impact because it affects in specific ways the balance between production and consumption in the US (and, of course, elsewhere), and since the US trade deficit is also the gap between US consumption and US production, to the extent that the bailout affects this gap it must affect the US trade balance.

In that case we can posit at least two obvious ways in which the bailout affects the gap. First, by effectively subsidizing the cost of producing GM cars, it increases automobile production in the US. Second, by allowing GM to retain the workers it would have otherwise fired, it increases consumption in the US by the amount which the retained GM workers spend on consumption, i.e. some large fraction (depending on their savings rate) of their wages. At first I was going to suggest that the relevant number was actually not their wages but the difference between their wages and their welfare payments, since most of the workers would presumably continue to earn some money after they were fired, but then it occurred to me that their welfare payments would have reduced other government spending, so perhaps it is not relevant (this is a subject of much disagreement between Keynesians and monetarists).

Since the GM bailout almost certainly increases production by more than it increases consumption, its direct impact is to reduce the US trade deficit (although to be complete we would also need to consider how the GM bailout affects GM\’92s competitors, many of whom produce cars in the US). However there are of course secondary impacts, the most important of which is the funding of the bailout. If funding the money used to bail out GM ended up crowding out investment in other production facilities, then the question becomes whether or not those other production facilities would have involved a more productive use of the money and, therefore, had a better impact, either in the short term or in the long-term on total US production. This is also part of the debate between Keynesians and monetarists.

So because we typically think of the currency and tariff policies as the main tools to affect trade \’96 which usually means to boost net exports \’96 much of the discussion surrounding trade policies tends to be limited to these two issues (although when the subject of \’93dumping\’94 comes up the discussion becomes a lot more sophisticated). This leads to strange arguments. For example when I talk about an increase in trade frictions leading to an increase in trade protection, I am often countered by the argument that the WTO makes tariffs very difficult so that protection becomes almost impossible. This is manifestly not true, but more on that later. These, at any rate, are the two best-known trade-related policies:

\’a8 Currency policies, whose first-order impact is to determine the relative pricing of imports and exports, but there are also a series of second-order impacts that can be very important.

\’a8 Tariffs, especially import tariffs, whose first-order impact also determines the relative pricing of traded goods, usually imports.

To repeat, any policy that affects the relationship between production and consumption must affect the trade balance because the excess of production over consumption is the trade surplus (or deficit, of course, if consumption exceeds production). So currency policies affect the trade balance primarily by their impacts on diverting production and consumption. A country, for example, that devalues its currency, raises the cost of imported goods and so reduces the real value of wages. This of course usually causes total consumption to decline. At the same time it allows local producers who compete with imports, who might not have been as cost effective as foreigners at the previous exchange rate, to begin producing more goods for sale to the domestic market. The combination of reducing domestic consumption somewhat and increasing domestic production means that the trade deficit will decline or the trade surplus increase.

One thing that economists always point out, and contrary to the mercantilist view, is that this increases domestic employment, but it doesn\’92t necessarily improve local welfare. Remember that by devaluing its currency, a country is worsening the terms of trade for its own products \’96 it must now produce more stuff locally for export to pay for the same amount of imports. It also results in a net reduction in total consumption. Currency policies often involve a tradeoff between employment and total welfare in the short term. Over the long term it is not always clear that this is true, however.

Trade tariffs work in very much the same way. Devaluing the currency by 10%, for example, has the same impact as putting a 10% subsidy, or negative tariff, on exports (the government pays exporters an amount equal to 10% of the value of their exports) and a 9.1% tariff on imports.

But, as I hope these examples show, it is not just tariff and currency policies that affect the trade balance. Anything that affects the gap between consumption and production also affects the balance of trade. These include:

\’a8 Corporate and personal income taxes. Personal income taxes reduce consumption by reducing disposable income. Corporate income taxes reduce production by raising costs for producers.

\’a8 Sales and other taxes. Depending on their impact they can also affect trade. The most obvious case is a sales tax which, by raising the cost of goods, reduces real wages and so reduces consumption.

The impact of taxes on trade are complicated by the fact that taxes represent a transfer of resources, so to understand fully their impact we also need to know what the government does with new tax revenues or how it finances reduced tax revenues. These can enhance or reduce either consumption or production.\’a0 So, for example, if the government put into a place a sales tax (which reduces consumption) and used the proceeds to reduce corporate taxes (which increases production), it could cause a large positive move in the trade balance (and by positive I mean an increase in net exports).
\

\

There are a lot of other factors that impact trade, and I have randomly included the following, which I think are especially important, at least in China. Others can and will have others to add or may dispute some of my arguments.

\’a8 The level of worker\’92s wages. They impact trade in two ways \’96 by affecting consumption via affecting the purchasing power of households, and by affecting production via the cost to businesses of labor, and they tend to work in the same way as far as the trade balance is concerned. Lowering wages reduces consumption and increase production, so as to have a positive impact on the trade balance. Needless to say many economists have pointed out that low wages in China are one of the reasons for the high trade surplus.

\’a8 Unemployment benefits. Unemployment benefits tend to cause consumption to decline more slowly than production when factories close, for obvious reasons, although of course we need to take into account how these benefits are funded. I would guess that when a country\’92s workers do not receive unemployment benefits, it tends to be \’93positive\’94 for the trade balance.

\’a8 Subsidized costs to producers \’96 electricity, oil, commodities, etc. Subsidizing the cost of production is a very effective way to increase exports since it directly increases production by increasing the returns to producers. It also has an impact, albeit usually much smaller, on increasing consumption via its impact on employment. Since these subsidies are financed by taxes, subsidies may also constrain consumption somewhat, depending on the nature of the taxes used to fund subsidies.

\’a8 Subsidized costs to consumers. This boosts consumption, of course, although with the same caveat as above \’96 its net effect depends on how the subsidies are financed.

\’a8 Corporate lending rates. This should be included in \’93subsidized costs to producers\’94 but I put it in a separate category because it is a very important type of subsidy, especially in China. Low interest rates for manufacturers of course make it much easier to borrow money to fund otherwise unprofitable production facilities, thereby increasing production (and increasing consumption somewhat by its impact on employment). If the lending is directed at non-manufacturing activities, such as to the service sector, it will not spur manufacturing production but will still increase consumption. As an aside, in my May 20 entry I discuss an HKMA study that argues that in China 100% of SOE profitability can be explained by interest subsidies which, I argue, actually understate the true value of those subsidies, suggesting that many SOEs would actually be value destroyers if it were not for subsidized financing. This is a very important reason for the Chinese trade surplus, in my opinion.

\’a8 Deposit rates. In last week\’92s entry this claim generated a certain amount of controversy in the comments section, but it is widely believed that in some countries, like China, reducing deposit rates causes savings to increase and consumption to decline. I discuss some possible reasons in my November 27 entry, the most important of which is probably that in high savings countries in which most savings are in the form of bank deposits, the interest earned on banking deposits is a significant fraction of total disposable income, and lowering deposit rates has an effect similar to lowering wages. Of course if this is true, low deposit rates are likely to reduce consumption, just as low lending rates to producers are likely to increase production. They may also increase production by reducing the opportunity cost for corporations of investing retained earnings.

\’a8 Other credit intervention \’96 lending guarantees, directed lending, forbearance on addressing NPLs, etc. This is fairly complex since there are many ways to intervene in credit, but any policy which increases the provision of credit to manufacturers must increase production directly. It increases consumption somewhat too, as in the two previous cases, by creating employment and thus raising the total amount of wages paid. If the lending policy increases credit provision to consumers or the non-manufacturing sector, it increases consumption directly. Credit for infrastructure investment is a little more complex since it probably increases consumption today and production tomorrow.

\’a8 Special mention: cleaning up NPLs. This really belongs in the category above but in the case of China it deserves its own entry. There are two ways to recapitalize banks suffering from a surge in NPLs. One way is to recapitalize them directly. When the government does this is simply transfers money to the banks, as China did before the IPOs of the major banks. Depending on how these transfers are funded, they can have a variety of effects on production and consumption. The second way is to guarantee banking profitability by keeping a wide spread between lending and deposit rates. Policymakers may also keep lending rates very low in order to slow the accumulation of NPLs and make it easier for marginal borrowers to survive. As I discuss above, this can result in very low deposit rates, which constrains consumption, and very low lending rates, which increases production.

I focus a lot on various financial sector issues because it seems to me that it is through the banking system that policymakers can have their largest impact on the trade balance. By keeping rates excessively low (and remember that almost all interest rates in China are either fully controlled and set by the PBoC or very heavily affected by the controlled interest rates), policymakers can boost production and constrain consumption quite easily.

When production grows faster than consumption this necessarily forces an increase in the savings rates \’96 which ties this entry into my previous entry. And of course by controlling the direction of credit, either directly or indirectly by implicit or explicit government guarantees, the government has a major say in the total amount of production. It is probably not a coincidence that in the countries that followed export-oriented growth policies, the so called Asian development model, interest rates and credit tended to be highly controlled either directly or indirectly by the government and regulators. These countries have all had \’93surprisingly\’94 low interest rates and banking systems that channeled funding mostly into the manufacturing sector (when those countries had large informal banking sectors, as does China, the rates there tended to be much, much higher, suggesting that the controlled interest rates were far from an “equilibrium” level). I would argue that a controlled banking sector is a very important tool for trade policy.

Another one of the issues that this opens up is the distinction I have made many times between total consumption and net consumption. Notice that many policies increase both production and consumption. They usually do the latter by increasing employment. In many cases Chinese policies have been successful in boosting consumption in just this way. Since the world manifestly needs more consumption, as US household consumption declines precipitously, anything that boosts Chinese consumption should be a good thing, right?

Maybe not. What the world needs from China is not an increase in total consumption but rather an increase in net consumption \’96 i.e. the excess of new consumption over new production \’96 that is roughly in line with the decline in US net consumption. If consumption grows, but production grows just as fast, or even faster (and we can tell by looking at the trade balance corrected for various pricing effects and one-off purchases or sales), then the world imbalance is getting worse and the overcapacity problem will not have been addressed.

This means that many policies that may seem on the surface to be purely domestic policies are actually trade policies too, and legitimately subject to scrutiny and even criticism from abroad. This is clear from the GM bailout. I don\’92t believe that Congressmen agreed to the bailout because they wanted to engage in protectionist behavior. They did so because they wanted to protect American jobs, but they did so in a way that almost inevitably has a trade impact. The same thing is happening in China, but there is a real reluctance to consider that policies aimed, for example, at limiting unemployment among aluminum plant workers in Hunan (or is it Henan?) are not just internal matters but also international trade policies.

Exporters are complaining loudly

April 30, 2009 in Exports and imports, Inflation by Michael Pettis | No comments

The Shanghai stock market had a good day today \’96 its last trading day before the May holiday and the very long four-day weekend.\’a0 The SSE Composite is up 4.84% and trading volume was up substantially too.\’a0 What seemed to propel the market today was a bunch of companies reporting good earnings, especially the banks \’96 three of the Big Four reported very healthy first quarter earnings growth, perhaps a consequence of January\’92s huge jump in loans.\’a0 There are also more rumors about things the government might do to keep the market from falling.

\’a0

Meanwhile it seems the fight over the currency is intensifying. Chinese Academy of Social Sciences economist Li Yang, formerly a member of the PBoC monetary policy committee and currently an advisor to the powerful NDRC, was reported by Market News International to have said in a lecture today that the government should stop allowing the RMB to appreciate because of the pain it is bringing to export companies.\’a0 He said that the RMB is currently at a \’93balanced level,\’94 and elaborated: \’93One important factor to decide whether we’re at a balanced level is that our companies are making losses on this appreciation. So we shouldn’t move it any more.\’94\’a0

\’a0

I am not sure I understand his reasoning.\’a0 I have seen very little in the academic literature that suggests that a currency has reached an equilibrium\’a0level when some of its exporters are losing money.\’a0 I would have thought that any definition of equilibrium would have focused instead of the level of the trade surplus, the amount of central bank intervention, the growth rate of exports, or on any of a number of other factors that suggest that RMB is still not near an equilibrium level, but I suspect that Li\’92s argument actually has more to do with the terms of the debate within China than with economic reasoning.

\’a0

There is a very deep, and reasonable I think, concern that a significant slowdown in the exporting sector might not be matched by a sufficiently large increase in domestic consumption in the short term, and so the result may be that China will not grow fast enough to absorb new entrants into the labor market.\’a0 If we see slower growth in fixed asset investment on top of that, the reduction in Chinese growth may be significant and may have adverse unemployment consequences \’96 something the government does not want to have to deal with, especially right now.\’a0 I think there is a lot of pressure from exporters, provincial leaders and Ministry of Commerce officials to reduce the appreciation rate as a way of making life easier for Chinese exporters.\’a0 They are worried about its impact on growth, even though this probably reflects an excessive focus on the dollar \’96 as has been pointed out many times, the RMB is not appreciating in general; it is only appreciating against the dollar.

\’a0

By the way, and to support the argument that it is not the rising RMB that is hurting Chinese exporters, Gene Ma of ISI-CEBM sent me an interesting piece today.\’a0 In it his team argues that \’93he main driver behind China\’92s narrowing trade deficit is not slowing exports, but the changing terms of trade. In particular, prices of imports are rising much faster than exports.\’94\’a0 They also note that China\’92s export engine is moving northward.\’a0 \’93The share of the Pearl River Delta in total exports fell from 47% in 1995 to 30% today.\’a0 The share of the Yangtze River delta rose from 20% to 40%.\’94

\’a0

What this suggests to me, as I have discussed often on this blog, is not so much that China\’92s exports are getting clobbered.\’a0 It suggests that China is evolving \’96 very naturally I might add \’96 so that its export performance is shifting as a consequence of development differentials across the country.\’a0 China itself is not losing out to other countries as much as exporters in the Pearl River Delta think.\’a0 China\’92s export competitiveness, instead, is shifting north.\’a0 If you keep your eyes to firmly focused on the performance of the southern exporters, it would be easy \’96 but of course very mistaken \’96 to conclude that something awful is happening to China\’92s export capability.\’a0 It isn\’92t.\’a0 Not yet, anyway.

\’a0

I do think however that we may be seeing a gradual, and very positive, shift in the importance of exports to China.\’a0 I am currently reading a very interesting April 29, 2008, report by Credit Suisse called \’93China: the Beginning of the End of an Era.\’94\’a0 In the report the authors say:

\’a0

We think the end of an era in terms of China\’92s mighty export industry has just begun. Current conditions will likely go beyond the cyclical slowdown caused by the US recession, in our view. After years of currency appreciation, wage increases, and material cost surges, we think the Chinese export sector has started to crack. The introduction of the Labor Contract Law this year is probably the straw that broke the camel\’92s back.

\’a0

As part of their argument they note:

\’a0

China\’92s private consumption is seemingly on the rise, led by service consumption and rural consumption. The \’93one-child generation\’94 is emerging as an influential new force that may redefine Chinese consumer behavior. Our projections show China leapfrogging the US as the world\’92s largest consumer market before 2020.

\’a0

If they are right, and their argument is certainly plausible, we may be at the beginning of a process of rebalancing the Chinese economy away from the export sector and towards the domestic market.\’a0 This is obviously a very healthy and necessary part of China\’92s long-term development, but it is worth noting that there is no reason to expect the process itself to be an easy one.\’a0 I have mentioned several times before on my blog how it took the very deep and painful crisis of 1798 to turn the US economy away from its dependence on exports towards a healthier domestic focus.\’a0 China\’92s refocus may also come with a difficult adjustment period.\’a0 Part of the reason for the fight over the appreciation of the RMB is, I suspect, the reluctance to pay the cost of this adjustment.

\’a0

There is one fascinating piece of information that comes from the report that gives a sense of the scale of the demographic adjustment that China is undergoing: \’93Thirty-five years ago, for every one hundred people, representing new labor worldwide, thirty came from Chinese. Today, the number declines to thirteen and\’a0\’a0\’a0 is projected to be only three in thirty-five years.\’94\’a0 Wow!\’a0 This is a huge slowdown in the rate of growth of the working population \’96 one of the inevitable consequences of the one-child policy.

\’a0

One other thing worth noting that has nothing to do with trade: according to today\’92s China Daily a senior official from the NDRC, Xu Zhimin, director of the NDRC’s economic operations department, said that the government will not increase the price of refined oil or electricity until inflation is brought under control.\’a0 The NDRC has reportedly wanted for a while to deregulate the price of energy and resources, but they are too worried about inflation to do so now.

\’a0

Needless to say, if you believe the inflation problem is largely a problem of expectations, they may be right to postpone deregulation.\’a0 If you believe it is a monetary problem, however, freezing prices of electricity will only cause the momentary pressure to show up in other kinds of inflation.

\’a0

P.S.\’a0 For those who read my blog directly, once again the firewall here in China seems to have gotten worse, making it very hard for me to participate in the \’93Comments\’94 section.\’a0 Sorry for not responding to comments, although of course I do read them.

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

Trade, CPI and other numbers came in this week

March 11, 2009 in Currency regime, Exports and imports, Inflation, PBoC, Policy, Trade protection by Michael Pettis | 51 comments

Deflation and debt
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On Monday CPI and PPI numbers for February came out. CPI was down 1.6% year and year and PPI was down 4.5%, in line with or slightly below expectations and, according to Bloomberg, the highest rate of deflation among the 78 countries they follow. Some of this may be caused by one-off factors, especially declining food prices, and most of the press and analyst commentary suggested as much, but the figures are still too hazy to say with any certainty whether or not deflation is likely to become a problem. Qi Jingmi, an economist with the State Information Centre, a government think-tank, was quoted in an article in the South China Morning Post as saying “I worry about PPI. The sharp fall in PPI shows that the financial crisis is gradually spreading to the real economy.”
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The PBoC’s Governor Zhou has already promised that China will do whatever it takes to prevent deflation, although at this point it is hard to find anyone who believes in the 4% target inflation for 2009. According to an article Friday in Bloomberg he said that \’93We would rather be faster and heavy-handed if it can prevent confidence slumping during the financial crisis.\’94 The article goes on:
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Chinese central bank Governor Zhou Xiaochuan pledged \’93fast and heavy-handed\’94 policies to restore confidence and prevent the global financial crisis from deepening the nation\’92s economic slump. \’93If we act slowly and less decisively, we\’92re likely to see what happened in other countries: a slide in confidence,\’94 Zhou said at briefing in Beijing. The central bank has \’93ample room\’94 to fine-tune monetary policy after a record surge in lending in January, he said.

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I continue to be very skeptical about the actual amount of control the PBoC has over monetary policy. Until last summer despite PBoC intentions to run “prudent” or “tight” monetary policies all the evidence suggested out-of-control money growth, and since then their promises to expand aggressively have been at least somewhat undermined by evidence of monetary contraction. I am convinced that given the currency regime, net foreign inflows or outflows more than other factors determine underlying money in the system, and since the PBoC has very little control over the net flows, and so little control over the rate at which it is forced to monetize those flows, monetary conditions are at least as likely to reflect external conditions as domestic policy.
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That is why what interests me most about the inflation numbers is what they suggest about monetary conditions — a subject on which it is very hard to get complete data and for which we often need to draw inferences from other parts of the economy. In that light, it is worth noting that the money-versus-pork debate seems to have died down since last summer with the decline of inflation at year-end, but I suspect it is going to revive soon enough, as I discussed in one of my entries in December. For example, a Bloomberg article on Monday had this to say:
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China isn\’92t yet facing \’93typical\’94 deflation, where falling prices are accompanied by shrinking loans and money supply and an economic recession, central bank vice governor Yi Gang said, according to the state-run Xinhua News Agency. The central bank has \’93sufficient\’94 policy tools to combat deflation, Yi said, without elaborating.

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Maybe it is indeed true that falling prices are not accompanied by shrinking loans and money supply, but it seems to me that we can’t really say for sure. We think we know that loans aren’t shrinking because loan growth numbers in the official banking sector pretty clearly show rapid loan growth, but as I have written many times before, much of January’s loan growth represented either balance sheet rearrangements or other forms of loan growth that don’t represent real credit growth to the economy (and by now that is a pretty widely accepted interpretation of the January numbers, although many bank analysts continue to talk up the loan growth as effective).
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In addition, there is still anecdotal evidence that the informal banking sector is having difficulty expanding and even that their balance sheets may actually be shrinking. Real credit in China, in other words, is expanding much more slowly than the headline numbers suggest and may even be contracting. We don’t really know. For those who care, the current issue of Forbes has a very interesting article by Gady Epstein on one part of the shadowy credit market in China.
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By the way I assume that Vice Governor Yi is indirectly referring to Irving Fischer’s debt-deflation thesis. But in my opinion, and if I read Fischer correctly, the risk for China is not a financial collapse induced by excess and unstable leverage. In spite of the haziness of the debt accounts I really don’t think China has the amount and kind of leverage that is likely to lead to a collapse in asset prices (although my one caveat is that we don’t really know the relationship between asset collateral and debt in the informal banking sector). The risk instead — and a highly probable risk although the timing is a little hazy — is that China will see many years of sub-par growth as it works off its addiction to excess capacity and makes the tough and slow transition to a domestic-led economy. I think Nick Lardy’s warning of a “long landing” rather than a “hard landing” is what we should expect. I am only guessing here, and haven’t really worked it out, but perhaps monetary reflation, which I think would have been Fischer’s proposal for the US today, is not likely to be of much help to China.
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Trade figures are out
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Meanwhile, and back to the real world, February trade numbers were released today. As I guess pretty much anyone who reads my blog would know, the export numbers were terrible. Exports plunged 25.7% in February year on year, even though this year February did not include the Spring Festival holidays, and so was substantially longer than February 2008. The foreign press seems mostly to think that the sharp decline in exports came as a huge surprise to most experts, while the Chinese press seems to think it was largely expected (the SSE Composite declined on the news, but only by 0.9%). I have always believed that the fact exports were dropping much more rapidly in the rest of Asia than in China was clearly not sustainable, and that it was just a question of (very little) time before we began to see Chinese exports hit much more sharply. I do not believe the process is over.
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According to an article in today’s Xinhua:
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China’s exports plummeted 25.7 percent year-on-year in February, the fourth straight monthly decline, as global demand shrank, the General Administration of Customs said Wednesday. Exports contracted to 64.90 billion U.S. dollars, while imports slumped 24.1 percent to 60.05 billion U.S. dollars. The sharp declines reflected weakening external demand, which would persist throughout the year as the global recession deepened, said Zhang Junsheng, an economics professor at the University of International Business and Economics. “These huge falls were inevitable, given the global downturn,” he said.

…Exports of labor-intensive products contracted more moderately than total exports, reflecting the government’s moves to raise export rebates starting last July, the agency said. Garment and accessory exports fell 11 percent to 14.62 billion U.S. dollars, while those of toys sank 17.1 percent to 850 million U.S. dollars.

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I have heard several times reference to the fact that the increase in export rebates has helped the textile sector, although I would have guessed that this wouldn’t be something policymakers would want to advertise to the outside world. Along that line I think we are going to see a lot more pressure on policymakers somehow to “deal” with the problems in the export sector. On Monday Commerce Minister Chen Deming announced a cut in export taxes. According to an article in Tuesday’s Financial Times:
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China will reduce export taxes to zero and give more financial support to exporters as it tries to increase its share of global trade in the current crisis, the country’s commerce minister announced on Monday. China would “use all possible measures to ensure the stable growth of our exports and prevent a large drop in external demand”, Chen Deming said in an interview published by a Communist party newspaper. “We should increase our share of the global market… We must transform ourselves from a big export nation to a strong export nation,” he continued.

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It’s probably not a good idea to announce a drive to increase China’s share of the global export market, especially since for the last several months, while the world has suffered a collapse in demand, China’s share of exports has risen dramatically, but this may have been said primarily for domestic consumption. Yesterday Chen spoke again about trade. According to an article in People’s Daily:
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China’s foreign trade faces grim times in the coming months, Commerce Minister Chen Deming said yesterday even as the government tries to take steps to boost trade.

…Chen said the government would support exporters, in particular those of electronic goods and machines that account for 57 percent of the country’s exports. The government has raised export rebate rates and will expand the coverage of export credit insurance and encourage financial institutions to offer export credit services to boost exports, he said.

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The pressure to fix the export sector is clearly rising. My friend Isaac Meng was quoted later on in the same People’s Daily article explaining why policymakers are taking a decision which is not likely to make already-difficult global trade relations much easier:
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“Global trade and demand [are] collapsing and so are the currencies of many of China’s competitors and customers,” said Isaac Meng, an economist with BNP Paribas. “This is putting huge pressure on China’s export industries and the government to push all the buttons to boost the economy.”

At a press conference on Friday Zhou Xiaochuan, the central bank governor, refused to rule out a devaluation in China’s currency, the renminbi. “If you can tell us clearly what is going to happen [in the countries where the financial crisis started], it would be easier for us to tell you what measures we will take,” Mr Zhou said when asked directly whether he would rule out a devaluation of the renminbi.

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In a sign of how contentious the debate has gotten within China, the trade worriers put in a counterclaim. This from a Bloomberg article:
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China should let the yuan rise 3 percent against the dollar in 2009 to deter capital outflows and help the country make overseas acquisitions, said Wang Jian, a researcher affiliated with the nation\’92s top planning agency. China\’92s foreign-exchange reserves grew by the least in more than four years in the fourth quarter as sliding exports prompted traders to step up bets on yuan depreciation. People\’92s Bank of China Governor Zhou Xiaochuan pledged last week to maintain yuan stability as investors pull money out of emerging- market assets because of slowing global economic growth.

\’93A weaker currency will prompt massive amounts of foreign capital to flee the country,\’94 said Wang, secretary general of the China Society of Macroeconomics, a Beijing-based research institute under the National Development and Reform Commission that advises the government. \’93It won\’92t help exports. Foreign consumers still won\’92t have enough money to buy.\’94 At least $1 trillion of \’93hot money\’94 may have entered China, Wang estimated, as the yuan gained 21 percent against the dollar since the central bank ended a fixed exchange rate in July 2005. Depreciation would risk spurring a sudden exit of those funds, causing turmoil in the financial system, he said in an interview yesterday.

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I think hot money flows are one of the potentially destabilizing factors we need most to worry about because the PBoC’s currency regime means that monetary conditions, as I discuss in the first half of this entry, are largely determined by net inflows or outflows. In that light it is worth noting that while imports in February were also very bad — they dropped 24.1% year on year — the February trade surplus was much, much lower than for any month in a long time. China’s trade surplus for February was $4.8 billion, lower than the $7 billion rumor I mentioned a few days ago and much lower than the roughly $34 billion average monthly surpluses of the past six months (and $39.1 billion for January).
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This may be a very good thing for China as it goes into the G20 meeting, since it takes a little of the sting out of China’s growing export of overcapacity, but one month of “good” numbers after a long series of absolutely awful numbers won’t mean much, and we need to figure out more about the composition of imports. In particular I am interested in seeing whether imports include a lot of one-off rebuilding of commodity reserves. By the way with last month’s “low” trade surplus, some people are arguing that the era of massive monthly surpluses are over. This is from MarketWatch:
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“The bigger shock figure was the decline in the trade surplus to $4.8 billion as exports fell faster than imports,” said [Royal Bank of Scotland's chief China economist, Ben] Simpfendorfer. “February’s trade surplus typically falls because of seasonally strong commodity imports and seasonally weak consumer exports,” he said. “So, the decline in the trade surplus will likely be reversed next month. Nonetheless, the surplus will not bounce back above a $20 billion monthly rate this year.”

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Trade and industrial policies
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I hope Simpfendorfer is right. The Washington Post seems very worried about the trade-policy outlook. In an article titled “US to Toughen its Stance on Trade,” it warns that US policy seems increasingly dissatisfied with global trade and says that “the Obama administration is aggressively reworking U.S. trade policy to more strongly emphasize domestic and social issues.” Today’s New York Times also had a worried editorial on President Obama’s trade agenda, which included the following:
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Trade will play an important role in the world\’92s eventual recovery, transmitting economic growth from one country to the next. Protectionism leads to further protectionism, and yielding to its temptation could unleash destructive trade wars that would crush any chance of recovery. Unfortunately, few politicians are willing to tell their constituents that unpopular truth. Instead, governments are succumbing to protectionism\’92s dangerous lure. In recent months, Russia has jacked up import barriers on cars, farm machinery and other products. The European Union has reintroduced subsidies on dairy products. Europe, India and Brazil raised tariffs on imported steel.

Protectionism is also taking subtler forms, like Britain\’92s requirement that bailed-out banks favor domestic lending. The United States is not immune. The stimulus bill had a \’93Buy America\’94 provision, and it made it more difficult for companies receiving stimulus dollars to hire foreign workers under the H-1B visa program. President Obama\’92s choice for United States trade representative, Ron Kirk, appears ambivalent about the value of free trade. As part of his confirmation hearings this week, Mr. Kirk testified that he would work to expand trade but also argued \’93that not all Americans are winning from it and that our trading partners are not always playing by the rules.\’94

…If ever there was a need for collective action \’97 on fiscal stimuli, monetary policy, aid to the developing world, fighting protectionism \’97 it is now. A place to start the rethinking is China and how to encourage increased domestic consumption and investment in China and other cash-rich Asian countries so they can start pulling the world out of recession.

China\’92s leaders, in particular, need to understand that export-led growth no longer works for them or for the world. The United States will have more influence if it stops beating on Beijing for its foreign-exchange policy and engages China\’92s leaders as partners, not rivals. Vigorous trade will help the world recover. For that to happen, the United States will have to provide strong leadership and a clear commitment to fighting protectionism. Any sign of ambivalence from Washington will only make things worse.

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The whole debate over trade is going to be framed within US and European discussions about fiscal stimuli since it is not at all clear that Chinese policymakers are contributing much more than some fairly smug, and perhaps hypocritical, statements about how everyone must embrace free trade. But the US and European discussions don’t seem particularly positive right now. According to today’s Financial Times:
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Disagreements between the European Union and the US over how to combat the global recession widened on Tuesday as EU governments made clear they had little appetite for piling up more debt to fight the collapse in output and jobs. Finance ministers from the 27-nation bloc insisted in Brussels that it was doing enough to support world demand and did not need at present to adopt another fiscal stimulus plan, as Washington is urging.

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I hesitate to enter these very deep waters, but I think the Europeans, at least as described in this article, might be right. There is a real need for an adjustment in consumption in the US, and I don’t think it makes sense for the US to attempt to replace excess household consumption with excess government consumption. One way or the other the US, along with China and most other countries that have contributed to one side or the other of the global imbalances, is going to have to accept a demand contraction.
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Trade friction is an issue that will not easily go away. Not all the information released this week was bad, however. Some was good and some was neutral — by which I mean it could be read either as bad or good depending on your economic model. According to an article in today’s Bloomberg:
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China\’92s investment spending surged as the nation poured money into roads, railways and power grids to counter a plunge in exports, which a separate report showed fell by a record in February. Urban fixed-asset investment climbed a more-than-estimated 26.5 percent in January and February combined to 1.03 trillion yuan ($150 billion) from a year earlier, the statistics bureau said today in Beijing.

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The fact that fixed asset investment surged might suggest that the fiscal stimulus plan is having an effect and will counteract to some extent the slowdown in other parts of the economy. A worrier (me) would be very nervous however that the stimulus ended up worsening the overcapacity problem, in which case any benefit would be more than paid for next year. More unambiguously good news involved February car sales, which are up substantially and suggest that some government policies are getting consumers to go back to buying cars, although this was accompanied by bad numbers on car exports.
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The mainland\’92s sales of domestically made vehicles surged 25 per cent in February from a year earlier, as a tax cut for small cars and other measures helped revive the market, an industry group said on Wednesday. February\’92s sales totalled 827,600 units, up 12 per cent from the 735,000 sold in January, the China Association of Automobile Manufacturers said in a report posted on its website. Production in February totalled 807,900 units, up about 23 per cent from the year before, it said.

…However, despite the apparent rebound in China\’92s own car market, a slump in demand is crimping sales overseas: exports in January fell 33.5 per cent from a year earlier, to US$2.66 billion, the group said. The impact was most severe for domestic-brand cars, with January exports falling 64 per cent from a year earlier to 16,300 units, it said. Imports of vehicles also took a hit amid the deepening economic downturn, falling 20.3 per cent from a year earlier in January to US$1.73 billion, it said.

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Finally before closing, and for an indication of rationality that sometimes seems to be missing from foreign expectations about China, few analysts in China seem to buy the idea so popular in the West that somehow Chinese policies may be enough to pull the world out of its economic crisis. Tuesday’s People’s Daily had a long article on the subject. Among other things it said:
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A China-driven recovery of world economy is “unrealistic”, economists said amid hope, after the world’s attention was drawn to China’s annual parliament session, that the country’s stimulus plan would help the whole world out of the recession.

…Economists said they believe China would be able to keep its growth at about 8 percent this year, a growth rate long believed to be minimum to create enough jobs and maintain social stability. However, they said it is wild wish to count on the country alone to fuel the global recovery, as China’s economy accounted for only five percent of the world’s total.

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To pin hope of the global recovery only on China is similar to charging a colt with an overwhelmingly big carriage and hoping it to drag the cart along, they said. Beijing-based economist Wang Xiaoguang warned that actually China’s influence is very “limited.” He said China’s stimulus package might help store up some investors’ confidence in world economy, but “China alone could not revive the world.”

Tags: Art, Irving Fischer

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

« Older entries

Exports and imports

More trade tensions, and the very limited advantage of relative poverty

Yet another discussion on the Asian savings glut hypothesis, and why it matters

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

Squeezing out the exporters

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

Trade \’96 it\’92s not just the currency

Exporters are complaining loudly

New trade and reserve numbers from China

Trade, CPI and other numbers came in this week

Can Smoot-Hawley only happen in the US?

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