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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.

Can the RMB be more undervalued today than it was last year?

June 23, 2009 in Currency regime, Trade protection by Michael Pettis | 55 comments

William Cline and John Williamson published on Vox an interesting piece earlier this month June 18), titled \’93Equilibrium Exchange Rates,\’94 in which they try to \’93estimate a set of medium-run fundamental equilibrium exchange rates compatible with moderating external imbalances\’94 for the 30 largest economies. They assume that a sustainable equilibrium trade balance for the US implies a current account deficit of 3% of GDP (this is conservative \’96 I would have thought \’93equilibrium\’94 would have been lower), and try to estimate the amount of currency change needed to get there. They also assume that in general not just the US but all \’93countries should strive to keep imbalances (surpluses and deficits) under 3% of GDP.\’94

Using early June 2009 exchange rates, they find that six countries \’96 most of whom are primarily commodity exporters, not coincidentally \’96 have overvalued exchange rates relative to the dollar (Australia, New Zealand, South Africa, Brazil, Colombia, Mexico), and twelve, mostly in Europe, have currencies that are marginally undervalued. Of the 30 countries, eleven have currencies that are at least 15% undervalued relative to the US dollar. For convenience sake I include their 2008 GDP and rank them by size. These are:

Country

Billions

Undervaluation

Japan

$4,908

18.1%

China

$4,221

40.3%

Switzerland

$491

19.8%

Sweden

$479

15.3%

Taiwan

$392

29.4%

Argentina

$330

18.4%

Thailand

$273

16.7%

Malaysia

$222

33.2%

Hong Kong

$215

27.9%

Singapore

$182

26.3%

Philippines

$169

18.2%

Economists can, and of course will, dispute the methodology and the extent of any perceived under- or over-valuation, but in my opinion the most valuable aspect of these exercises is not that they indicate the \’93correct\’94 exchange rate level, whatever that means, but rather that they can indicate trends or signal interesting anomalies in the aggregate. Two things are noteworthy here, I think.

The first, and most obvious, is that eight of the eleven Asian countries within the top thirty economies (the exceptions are India, Indonesia, and Korea, whose currencies are all undervalued by 4-6%) are on the above list of significantly undervalued currencies, and the list is dominated by them (eight Asians out of eleven countries on the list). This simply suggests the not-exactly-controversial thesis that Asian countries have systematically undervalued their currencies as a strategy to generate employment growth. It also suggests that Asian central banks that worry about the impact of dollar weakness on their reserve holdings are in the funny position of having created the dollar overvaluation at the same time they were actively accumulating those overvalued dollars.

The second noteworthy consequence of their exercise, which I found much more interesting, was a finding that the authors seem to find a little surprising. They say:

The main counterpart to the overvalued dollar is the undervaluation of the Chinese renminbi, along with a few of the smaller Asian currencies. We are somewhat nervous because our estimate (based on the figure of RMB 4.88 to the dollar) of Chinese undervaluation is even larger than it was a year ago (RMB 5.81 to the dollar), despite the fact that the RMB rode the dollar up by 14% in effective terms in the intervening year. It may be that our estimate is now too large because the IMF\’92s projection of the Chinese surplus seems not to have declined despite the RMB\’92s real appreciation, although the fall in commodity prices in the past year has presumably worked in China\’92s favour. But all the other potential biases, notably the way of formulating the Chinese current account target as a substantial surplus rather than the deficit suggested by the FDI inflow, are in the direction of minimising estimated undervaluation. Our analysis is one more piece of evidence that the major macroeconomic imbalance in the world today stems from China\’92s exchange-rate policy.

Leaving aside the fact of their very high estimate of Chinese undervaluation, I think the authors are saying that although the RMB rose 14% from the last time they calculated these equilibrium exchange rates, nonetheless their measure of the adjustment needed to balance trade suggests that the RMB is actually even more undervalued than it had been a year ago.

What\’92s going on? How can a currency that has risen 14% against the dollar finish even more undervalued against the dollar? Part of the answer could be differential productivity growth rates, and since Chinese productivity is growing faster than US productivity it would imply that the RMB should revalue against the dollar just to maintain equilibrium. But of course there is absolutely no way Chinese productivity grew by even a fraction of the amount necessary during that time to explain this anomaly.

But remember in my June 3rd post I argued that we make a mistake when we think only currency and tariff policies can affect trade? There is a whole list of policies that, by directly subsidizing production or by implicitly or explicitly taxing consumption, will necessarily affect the trade account. Could it be that even as the RMB was nominally revaluing, other policies were implicitly \’93devaluing\’94 the RMB \’96 i.e. policies that implicitly increased subsidies to production, and/or taxed consumption \’96 so that the net distortionary impact on trade actually increased? That could explain why a revaluing RMB is nonetheless consistent with an even more undervalued RMB in relative terms.

New lending surges

We are getting reports that June lending numbers are up on May. One of the more bizarre pieces of \’93good news\’94 recently \’96 very popular among the China bulls \’96 were claims that new lending had moderated significantly in the past two months (so don\’92t worry too much about that credit bubble everyone\’92s talking about), but this is true only to the extent that new loans in April and May were compared to the astonishing first quarter numbers. In fact net new lending in April and May was around double the equivalent amounts last year and every year in this decade.

In June, it looks like we are retuning to an upward trajectory. According to an article in the current issue of Caijing:

Commercial bank lending in the first half is expected to hit 6.5 trillion yuan, with new loans in June coming in at about 660 billion yuan, the official Shanghai Securities News reported, citing people close to the matter.
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Chinese banks lent out a record 4.6 trillion yuan in the first quarter to help start stimulus projects; while there has been a slowdown since April, the central bank says its policy remains “moderately loose.” Experts have warned against lending quality, unauthorized loan diversions, and the re-emergence of bad loans, which may cause banks to be more cautious in lending in the second quarter.

Discussing the impact of all this lending Andy Xie weighs in with another thoughtful and worried piece in the current issue of Caijing. He writes:

China’s credit boom has increased bank lending by more than 6 trillion yuan since December. Many analysts think an economic boom will follow in the second half 2009. They will be disappointed. Much of this lending has not been used to support tangible projects but, instead, has been channeled into asset markets.

Many boom forecasters think asset market speculation will lead to spending growth through the wealth effect. But creating a bubble to support an economy brings, at best, a few short-term benefits along with a lot of long-term pain. Moreover, some of this speculation is actually hurting China’s economy by driving asset prices higher.

The current surge in commodity prices, for example, is being fueled by China’s demand for speculative inventory. Damage to the domestic economy is already significant. If lending doesn’t cool soon, this speculative force will transfer even more Chinese cash overseas and trigger long-term stagflation.

He goes on to say:

The international media has been following reports of record commodity imports by China. The surge is being portrayed as reflecting China’s recovering economy. Indeed, the international financial market is portraying China’s perceived recovery as a harbinger for global recovery. It is a major factor pushing up stock prices around the world.

But China’s imports are mostly for speculative inventories. Bank loans were so cheap and easy to get that many commodity distributors used financing for speculation. The first wave of purchases was to arbitrage the difference between spot and futures prices. That was smart. But now that price curves have flattened for most commodities, these imports are based on speculation that prices will increase. Demand from China’s army of speculators is driving up prices, making their expectations self-fulfilling in the short term.

I usually don\’92t quote so much from a single source, but I think Andy Xie\’92s piece is a very good one and well worth reading (there is a lot more). He makes many of the arguments that all of us who worry about China\’92s continuing failure to adapt to the huge adjustment in the global and US economies. His conclusions:

What is happening in the commodity market is glaring proof that China’s lending surge is hurting the country. Even more serious is that it is leading Chinese companies away from real business and further toward asset speculation \’96 virtual business.

\’85Many analysts argue GDP growth follows loan growth, and inflation is a problem only when the economy overheats. This is naive. Borrowed money channeled into speculation leads to inflation. And China may face a lasting employment crisis if private companies don’t expand.

This lending surge proves China’s economic problems can’t be resolved with liquidity. China’s growth model is based on government-led investment and foreign enterprise-led export. As exports grew in the past, the government channeled income into investment to support more export growth. Now that the global economy and China’s exports have collapsed, there will be no income growth to support investment growth. The government’s current investment stimulus is tapping a money pool accumulated from past exports. Eventually, the pool will dry up.

If exports remain weak for several years, China’s only chance for returning to high growth will be to shift demand to the domestic household sector. This would require significant rebalancing of wealth and income. A new growth cycle could start by distributing shares of listed SOEs to Chinese households, creating a virtuous cycle that lasts a decade.

Putting money into speculative investments isn’t totally irrational. It’s better than expanding capacity which, without export customers, would surely lead to losses. Businesses currently lack incentive to invest. But many boom forecasters wrongly assume that recent asset appreciation, fueled by speculation, signaled an end to economic problems. That’s an illusion. The lending surge may have created more problems than it resolved.

Tags: John Williamson, William Cline

Exports versus domestic demand \’96 the argument rages

May 8, 2009 in Fiscal stimulus, Trade protection by Michael Pettis | 56 comments

Today\’92s Financial Times and last week\’92s Economic Observer had articles that display the kinds of confusion that economic crises can create among policymakers. The Financial Times article was actually an opinion piece written by Wang Qishan \’96 a Vice premier in the State Council and presumably one of the top three or four economic policy decision-makers in China.

It starts out, correctly I think, by warning that the global crisis is far from over. \’93The global financial crisis is still spreading,\’94 Wang warns, \’93The world economy is going to get worse before it gets better, and the situation remains serious.\’94 Much of the article discusses the same grab-bag of regulatory reform proposals whose purported aim is \’93to prevent a repetition of this financial crisis,\’94 which include financial regulations to \’93strengthen, on the basis of sovereign rules, co-operation in regulating international private capital flows, financial institutions and markets, financial products and intermediaries.\’94

I have already written why I think financial reform aimed at preventing financial crises (as opposed to improving the capital allocation process during \’93normal\’94 times) is largely a waste of time, and to that end I will remind my readers that Hyman Minsky, whose understanding of financial instability surpasses everyone else\’92s, argued that: \’93Stability, in a world with an uncertain future, and complex financial instruments, is destabilizing.\’94 In \’93A Minsky Meltdown: Lessons for Central Bankers\’94, a speech delivered on May 1, Janet Yellen, president of the San Francisco Federal Reserve Bank, explains:

As Minsky’s financial instability hypothesis suggests, when optimism is high and ample funds are available for investment, investors tend to migrate from the safe hedge end of the Minsky spectrum to the risky speculative and Ponzi end. Indeed, in the current episode, investors tried to raise returns by increasing leverage and sacrificing liquidity through short-term \’96 sometimes overnight \’96 debt financing.

Avoiding financial crisis, in other words, is a total pipe dream because to the extent that we are successful and enforce conditions of stability we actually increase the probability of future instability.

But that is an aside. Wang goes on in his article to propose action:

It is imperative for countries to co-ordinate macroeconomic policies and for all to adopt stimulus, fiscal and monetary policies. It is vital unequivocally to reject protectionism of all kinds.

Anti-protection sentiments are, of course, all fine and good, but it doesn\’92t make sense to define protection too narrowly. In contrast to Wang\’92s sentiments, last week\’92s Economic Observer had a very different take on protection.

China should give preference to locally-produced goods in government procurement, the Ministry of Finance said at an April 22 meeting focused on the issue. Assistant minister Zhang Tong said at the meeting that most of the public welfare projects benefiting from the government’s four-trillion-yuan stimulus package announced late in 2008 were closely related to government procurement.

Chinese law stipulates that\’a0government procurement favor local goods. But the EO has learned that many officials were not satisfied with the amount of local goods that the government\’a0had purchased since stimulus funds kicked in\’a0last November. Against this backdrop, China’s State Council ordered on April 10 that government at all levels give preference to domestic goods, and new regulations tightening\’a0government procurement have been slated for legislation in 2009.

It is hard for anyone, especially the country that does most to export overcapacity, to preach free trade while putting into place such blatantly obvious restrictions on trade. Of course some might argue that this is no different than the \’93Buy American\’94 provisions discussed last year by the US congress, but I think in fact it is very different, for at least three reasons.

First, the \’93Buy America\’94 provisions were never enforced and, what\’92s more, they are in many cases against US law. Of course they may also be against the law in some cases in China, but there is a robust legal mechanism in the US that can be used to prevent the US government from enforcing rules that violate US laws or US trade agreements. Importers, American as well as foreign, can sue the US government with every expectation of winning in court, in a way that no one, especially no foreigner, would even attempt doing in China.

Second, US government procurement is a tiny fraction of total US purchases, even taking into consideration the US fiscal stimulus. In China, almost the entire stimulus package is going to expand investment in SOEs and/or government projects, so the share of government procurement in total GDP is much, much higher in China. That makes it a far more trade-constraining measure in China than it could ever be elsewhere.

Finally, and probably most importantly, China is the country that most desperately needs foreign demand to absorb its excess capacity. In a world of contracting demand, China is the country that is most likely to suffer from protection, for the same reason that it is the country that benefits most from absorbing other country\’92s badly-needed demand. In that case it is not enough to say that China is just doing what everyone else is doing (and never mind that it is much harder for foreigners to invest in China or sell to China than it is for China to do either abroad), since any dispute that resolves itself in greater trade protection hurts China worse than it hurts the other disputant.

Meanwhile the Economic Observer had also last week a very interesting (and a little troubling) editorial on just this subject. The title says a lot: \’93A shift is needed, but not overnight\’94. The article starts:

Chen Deming, head of China’s Ministry of Commerce, recently wrote in the Communist party magazine Qiushi that earnings from Chinese exports could trickle down to compensation, and ultimately end up stimulating domestic consumption. He came down against certain popular opinions in China, including that the country relied too heavily on exports, and stressed that although a withering global market has sapped demand for Chinese goods, it has also presented great opportunities. Chinese enterprises needed to push abroad under such circumstances and promote Chinese exports, he concluded.

Chen’s arguments come at a sensitive time for China’s exports. As the Canton export fair opened this past week, the export industry was not optimistic – official data just released showed another slide in China’s export value in March.

The article goes on to discuss China\’92s transition from export orientation to domestic market orientation. Although many foreign and Chinese commentators, including me, would argue that almost nothing was done to accommodate this transition \’96 indeed that China in the past decade actually deepened its over-reliance on the export sector \’96 the editorial gives the government good marks in managing the process:

In the past few years, the government has long sought to transform the economy from a export-oriented model to a consumption-oriented one, while the Ministry of Commerce strove to reduce the trade surplus. But the economy’s restructuring could not be completed within one day, and a consumption-oriented economy never meant wholly abandoning foreign trade. Eagerness for an overnight success could only lead to adverse consequences. In this sense Chen’s article reflected a realistic attitude.

We believe this was a positive sign that the Chinese government has a deep understanding of the necessity of economic transformation, and that the consumption-oriented model would remain the core of future policy. At the same time, it also meant China understood it needed to be patient throughout the process.

The editorial concludes basically by saying that although China must continue (!) improving the relative importance of domestic markets, it must \’93stabilize\’94 exports since \’93foreign demand must still serve as the engine of the Chinese economy for a period of time.\’94

I think in one sense Minister Chen is right \’96 foreign demand is still the engine of Chinese growth \’96 which is one of the reasons I am so pessimistic about medium-term growth, but of course I am a tad more skeptical than he is that in the past few years there were active policies (as opposed to formal announcements) aimed at reducing China\’92s over-reliance on exports. For example two of the most obvious steps \’96 increasing the value of the currency and allowing interest rates to rise to a \’91natural\’94 level \’96 were never really seriously tried, remembering that any increase in the RMB against the dollar, and other currencies, must be set against an even faster relative increase in productivity. This was almost certainly because polices aimed at assisting the transition would necessarily have slowed export growth, and with it economic growth in the short term.

The fact that the editorial and the original article from which it was draw were both published, and seem to be arguing a case, gives some indication, I think, of the ferocity of the debate taking place about the nature of the stimulus package. One side says: Before we can fix the economy we need relief, and that is most likely to happen by reinforcing the existing economic structure. The other side says: The longer we take to postpone the adjustment, the worse.

For the other side of the debate, Hu Shuli in last week\’92s Caijing insists that \’93Beneath the surface of China’s ‘warming’ economy are structural impediments to long-term growth that demand attention \’96 now.\’94 She dismisses the recent optimism about China\’92s \’93bounce\’94 back with “The ‘warnming’ is more show than substance.” and she goes on to say:

Since we know that credit expansion is not the best economic healer, we should spend the coming days thinking about long-term approaches that will help China survive the crisis and pursue lasting development.

China is being forced to rebalance. It\’92s clear that, regardless of the angle from which we examine the situation, our economy is being squeezed by internal and external crises. Excessive consumption in the United States is a root cause of the global financial crisis. Instead of complaining about this fact, or even quietly congratulating ourselves, China must consider what to do if the United States learns its lesson and, for example, gradually raises its household savings rate. If external demand for Chinese goods is declining, how can internal demand rise?

At this juncture, structural adjustment should not be empty talk. It must involve a series of basic policies that deepen the nation\’92s economic reform. Structural adjustments can only follow the market\’92s lead and, for the most part, involve breaking up monopolies, opening the market wider, relaxing controls, and getting the pricing mechanisms right.

Instead of betting even more heavily on foreign demand to bail China out, in other words, China must urgently move towards policies that force the transition, even if those policies are painful in the short term.

And it is not just Caijing that is voicing criticism about the current stimulus policies. A number of very prominent Chinese economists have been scathing (at least in private, so I cannot reveal their names) about the failure to have taken the appropriate steps when conditions were optimal, and are now insisting that to continue increasing reliance on foreign demand is going to create huge problems for China. Increasingly I am hearing people here say that, although few expect a \’93collapse\’94, whatever that means, China is facing its own \’93lost decade\’94 of sub-par economic growth and a very difficult transition. As regular readers know, I am very inclined to agree.

Next week (Wednesday, I think) I will have a piece in the Wall Street Journal arguing that the surge in lending actually makes China\’92s transition more difficult in the medium term because it will act to constrain future consumption in China. I think Hu Shuli might agree.

Tags: Chen Deming, Wang Qishan

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

Yes, trade policies do matter

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Bizarrely enough, the article concludes with:

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

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

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

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

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

Tags: Alexander Hamilton, Argentina

The NPC meets, and Krugman refers to the savings glut

March 3, 2009 in Economic growth, Policy, Savings glut, Trade protection by Michael Pettis | 66 comments

With the tense start of China\’92s parliamentary season this afternoon \’96 and with the National People\’92s Congress meeting Thursday \’96 there isn\’92t much incentive to try to figure anything new out in China since we are likely to be given a lot more information and proposals over the next few days. What are the major topics likely to be covered in the meetings? I suspect that this article from yesterday\’92s South China Morning Post, on the topic of unemployment, gives a pretty strong hint:

If this is not addressed, it will be even more difficult for the government to maintain social stability down the road if unemployment remains high. China’s official urban unemployment rate is expected to be 4.6 per cent this year, which would make it the highest since 1980 when figures first began to be collected.

But, economists, including Zhou Tianyong from the Communist Party’s Central Party School, forecast that the real unemployment rate could reach 14 per cent, counting migrant labourers.

Senior officials estimate that up to 20 million migrant labourers have already lost their jobs because of the global economic crisis. They were mostly laid off by private firms and foreign-funded enterprises, the hardest-hit sectors.

I was told privately by a friend of mine two days ago that the number of migrant laborers who have already lost their jobs is actually closer to 30 million, but nonetheless Mr. Zhou\’92s comments reinforce some other claims to which I refer in a piece by me in the current Newsweek:

Although official estimates put urban unemployment in China at just over 4 percent of the workforce, most unofficial estimates are much higher\’97closer to 8 percent\’97and nearly everyone agrees that the figure is set to rise significantly in the next few months. Some credible estimates suggest that even if China were able to achieve the 7.5 percent growth projected in 2009 by the World Bank, unemployment would nonetheless double before the end of the year.

Clearly unemployment is going to weigh heavily on the minds of policymakers in China, like in the rest of the world, and we will have to wait and see what specific new measures are proposed over the next few days. Meanwhile I did nonetheless want to make a few comments about interesting stuff I\’92ve seen recently.

The first is a reference to an article in yesterday\’92s Financial Times, \’93Asean split on protectionism,\’94 which highlighted the difficulties of getting leaders to agree on free trade even during a conference whose primary goal was to defend free trade:

As south-east Asian leaders gathered on Friday for their annual summit, the region\’92s united front against protectionism was starting to crack under the pressure of the global economic crisis. The fight against protectionism is top of the agenda at this weekend\’92s meeting of the 10-country Association of South East Asian Nations, which on Friday signed an agreement cutting tariffs and other barriers with Australia and New Zealand.

However, the leaders appeared far apart in pre-conference comments on the balance to be struck between sustaining open markets and promoting economic activity at home. In the most forthright remarks, Abdullah Badawi, Malaysia\’92s prime minister, said every country had the right to encourage its citizens to buy local products.

\’93I think it is a normal reaction under this kind of situation. First of all we have to protect our people; we are doing the same thing. If we do not create projects by Malaysia, for Malaysians, then who will buy our products?\’94 Mr Badawi told the Bangkok Post newspaper.

For some of my readers I may be beating a dead horse, but as usual I will put up my warning that we need to be very aware of the deterioration in global trade relations that is likely to be a consequence of the rising unemployment everywhere in the world. The fact that even in a region heavily dependent on exports it is so easy (and so natural) to make the case for protectionism doesn\’92t bode well for trade discussions in North and South America, Europe and Australia. The article goes on to say:

Lee Hsien Loong, Singapore\’92s prime minister, said Asean might miss its target of establishing a regional economic community along the lines of the European Union by 2015 if member states failed to maintain open markets. \’93In this global environment, if we give the impression that Asean is not fully open for business I think we will be the losers when the new landscape emerges,\’94 Mr Lee told CNBC.

Most of the regional economies have built their prosperity on the back of export growth, and the slowdown in the US, Europe and Japan has hit them hard. \’93I think we all worry about protectionism, and not just from traditional channels,\’94 said Mari Pangestu, trade minister for Indonesia. In spite of Mrs Pangestu\’92s reservations, Indonesia is encouraging civil servants to buy Indonesian products, an echo of Barack Obama\’92s Buy American campaign that angered so many both within and outside Asia.

It may seem like a non sequiter to follow up with a second Financial Times article from yesterday, this one called \’93Emerging market finance: a gap to fill,\’94 but bear with me:

Two years ago, nearly a trillion dollars flowed into emerging markets as investors in rich countries toured the globe in the hunt for yield. Now there is a melancholy long, withdrawing roar as private capital flees to safer havens.

\’85Net capital flows to emerging markets will drop to just $165bn (\’a3115bn, \’80130bn) this year, down from $929bn as recently as 2007, according to estimates by the Institute of International Finance, which represents the world\’92s leading financial companies. Net lending from commercial banks, the IIF says, is likely to go into reverse. The reasons for this are not altogether straightforward. Some accuse rich governments, particularly the US, of \’93crowding out\’94 emerging markets, sucking up all the available capital to finance their stimulus packages. But Brad Setser, a former International Monetary Fund and US Treasury official, notes that as the private sector retrenches, the US current account deficit \’96 and hence its need for outside financing \’96 has actually been declining.

More likely, he says, is that emerging markets are being hit by a general decline in demand for riskier assets, as banks and investors haul money back home to shore up balance sheets and reduce borrowings. Similarly, the global shortage of the trade credit that finances cross-border commerce reflects a general desire of banks to reduce leverage, not the rich countries hogging all the available loans.

Why is this relevant to a blog on Chinese financial markets? Because if annual net capital flows to emerging markets drop by the projected $700-800 billion, an inevitable consequence is that foreign currency reserves plus net imports for those emerging market countries will also have to decline by exactly the same amount. In other words while some of this decline will be accommodated by a running down of central bank reserves, we should expect a very large decline in net imports among those developing countries, to add to the decline in net imports from North America, non-German-Europe and other trade-deficit-countries. Needless to say this decline in net imports must have as a necessary corollary an equal decline in net exports in the trade surplus countries.

My final comment \’96 hinted at in the title \’96 is on Paul Krugman\’92s Op-Ed piece in today\’92s New York Times. he starts off by discussing the viciousness of the global crisis and then goes on to ask (and answer):

How did this global debt crisis happen? Why is it so widespread? The answer, I\’92d suggest, can be found in a speech Ben Bernanke, the Federal Reserve chairman, gave four years ago. At the time, Mr. Bernanke was trying to be reassuring. But what he said then nonetheless foreshadowed the bust to come. The speech, titled \’93The Global Saving Glut and the U.S. Current Account Deficit,\’94 offered a novel explanation for the rapid rise of the U.S. trade deficit in the early 21st century. The causes, argued Mr. Bernanke, lay not in America but in Asia.

In the mid-1990s, he pointed out, the emerging economies of Asia had been major importers of capital, borrowing abroad to finance their development. But after the Asian financial crisis of 1997-98 (which seemed like a big deal at the time but looks trivial compared with what\’92s happening now), these countries began protecting themselves by amassing huge war chests of foreign assets, in effect exporting capital to the rest of the world. The result was a world awash in cheap money, looking for somewhere to go.

Most of that money went to the United States \’97 hence our giant trade deficit, because a trade deficit is the flip side of capital inflows. But as Mr. Bernanke correctly pointed out, money surged into other nations as well. In particular, a number of smaller European economies experienced capital inflows that, while much smaller in dollar terms than the flows into the United States, were much larger compared with the size of their economies.

I have written often about the savings glut hypothesis and my very strong belief that it lies at the heart of the fundamental global imbalance of the past decade, and I think it has extremely important consequences both for our understanding how the crisis will evolve and what are the likely consequences to the major players involved in the imbalance. I am a big admirer of Krugman\’92s and have been for fifteen years \’96 in the 1990s I used to read everything he wrote, and often within days of his publishing it \’96 so I am delighted that he seems to agree with Bernanke\’92s thesis, but I should add that I believe the evidence in support is so overwhelming that even if Krugman decided to deride the whole notion, I would remain convinced that the sudden and massive rise in Asian net savings following the 1997 Asian crisis was a prime cause of the corresponding and necessary decline in US savings.

I know I know, this is going to be considered a very controversial statement \’96 and inevitably someone will very stupidly demand to know why I am blaming China when obviously the full blame for the crisis should fall on the US \’96 but there it is. I just don\’92t see how recent events can be explained without the Asian Crisis of 1997 having played a major role. At least Krugman seems to agree. At any rate he finishes worryingly with:

And the saving glut is still out there. In fact, it\’92s bigger than ever, now that suddenly impoverished consumers have rediscovered the virtues of thrift and the worldwide property boom, which provided an outlet for all those excess savings, has turned into a worldwide bust. One way to look at the international situation right now is that we\’92re suffering from a global paradox of thrift: around the world, desired saving exceeds the amount businesses are willing to invest. And the result is a global slump that leaves everyone worse off.

Tags: Krugman, NPC

Can Smoot-Hawley only happen in the US?

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

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

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

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

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

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

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

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

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

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

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

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

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

provide subsidies for home appliances for rural buyers

boost demand for petrochemical products

lower the purchase tax on cars

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

improve the credit system for car purchase loans

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

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

adjust export rebate rates of nonferrous products

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

provide more credit access for firms in the petrochemical sector

boost innovation in information technologies (whatever that means)

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

give tax rebates for electronics and information product exports

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

increase credit support for ship builders

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

increase export rebates for textile producers

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

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

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

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

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

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

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

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

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

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

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

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

Tags: Goldman Sachs, People's Daily

Should China Devalue the Yuan?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Tags: Net demand

More terrible trade numbers from China

February 12, 2009 in Balance of payments, Exports and imports, Trade protection by Michael Pettis | 53 comments

Yesterday while I was preparing for my presentation in Hong Kong on the impact of slowing trade on the Chinese economy, one of the participants in the conference passed on to me the January trade numbers, which had just been released. Although they were \’93surprisingly\’94 bad, and fit perfectly within my very gloomy presentation, they were also not a surprise in the sense that they show what many of us had been expecting anyway. According to an article in today\’92s Xinhua:

A sharp fall in imports and exports in January, which included a weeklong Spring Festival holiday, has both puzzled and alarmed economists. General Administration of Customs figures released yesterday showed exports plummeted 17.5 percent year-on-year, much sharper than the 2.8 percent fall in December.

Imports fell even more dramatically, to 43.1 percent year-on-year. The combined foreign trade in January fell 29 percent year-on-year. Such a major decline in monthly foreign trade is rare in the 30 years of reform and opening up.

\’85Last month, however, was an exception because it had one full week of holiday from January 26. The Chinese Lunar New Year is the most important festival for Chinese but usually it falls in February. So this year, January had five fewer working days than those in many of the previous years. If that is considered, the Customs said, exports actually rose 6.8 percent year-on-year in January. And compared with December, they increased 4.6 percent.

As usual, the local press tried to put the best face possible on the decline by comparing numbers on a day-count basis (\’93exports actually rose 6.8 percent\’94). This only makes sense however if Chinese exporters and importers were unaware of the week-long Spring Festival holiday and made no attempts to accelerate late January transactions to fit into the January holiday schedule. Pretty unlikely, I would think.

The reality is that both exports and imports continue to contract at a rapid pace, and indicate that both foreign consumption and local consumption are in sharp decline. What worries me even more is a number that the Xinhua report, for some reason, did not bother to publish in their article on the trade data. China\’92s trade surplus for January was a mind-blowing $39.1 billion, just a smidgen under November\’92s all-time high of $40.1 billion (or about 25% higher, if we want to play the day-count game), and edging out December\’92s $39.0 billion for second place. That puts the trade surplus over the past four months $153.4 billion, well over half of all of last year\’92s record-smashing $297.5 billion trade surplus.

I know I have written about this many times, but I want to say again what that means for the global imbalance. The world\’92s consumers are experiencing a sharp contraction in demand. That contraction has to be \’93shared out\’94 among all of the world\’92s producers. The decline in Chinese exports means that Chinese producers are absorbing part of that contraction, but the bigger decline in its imports means that Chinese consumers are contributing an even greater amount to the contraction in demand. The result, with net Chinese consumption contracting by more than net Chinese production, is that non-Chinese producers must absorb more than 100% of the contraction in demand from non-Chinese consumers. It will be hard to convince them that this is fair.

Although China has tremendous domestic problems and is very worried about the employment impact of the global slowdown, my fear is that those considerations are likely to have little value for other countries also suffering from awful employment prospects. For comparison, in December Taiwan\’92s exports fell 42%, South Korea\’92s by 17%, and Japan\’92s by 35%, compared to. China\’92s 2.8%, and Bloomberg earlier this week had this article:

China said it was \’93seriously concerned\’94 at Indian barriers to its exports, highlighting global trade tensions as the worst financial crisis since World War II sends demand plummeting. India\’92s use of sanctions may have \’93a serious impact on bilateral trade relations,\’94 Ministry of Commerce spokesman Yao Jian said in a statement on the ministry\’92s Web site today. India imposed a six-month ban on imports of Chinese toys last month.

\’85India has initiated 17 trade actions, including 10 anti- dumping probes, against Chinese imports such as penicillin, hot- rolled steel, vehicle axles and linen since October, the Chinese ministry said today. It also cited additional Indian restrictions on imports of products including steel, chemicals and textiles.

\’85\’93I believe China won\’92t implement a \’91Buy China\’92 policy,\’94 Vice Commerce Minister Jiang Zengwei said at a press conference in Beijing today. \’93We just need to boost consumption, whether it\’92s through domestically made goods or foreign-made goods. We will treat them equally without discrimination. Why in the current climate should we resort to protectionism?\’94
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Why indeed? It never makes sense for the leading trade surplus country to resort to protectionism if there is any chance of a global backlash, as the US discovered to its chagrin in 1930. It may, however, make a lot more sense for countries with trade deficits to turn to protection, and there is now overwhelming evidence that this is exactly what they are doing or thinking about doing.

At any rate whether recent Chinese moves to lower interest rates, to increase dramatically the provision of credit to manufacturing companies, to reduce export tax rebates, to reduce corporate taxes, and to stall the earlier discussions over increasing minimum wages, should be considered \’93resorting to protectionism\’94 is something one can debate extensively, but the fact is that all of these moves are aimed at boosting manufacturing output and employment. Matters are made worse by the fact that most of the stimulus package so far seems to consist of an explosion in bank lending (by the way last week\’92s rumors were confirmed \’96 bank lending in January was up by RMB 1.62 trillion), and aside from the problems I discussed in my post earlier this week, bank lending is directed almost exclusively towards investment and manufacturing. Whatever effect it might have in increasing consumption could easily be exceeded by the impact it has on increasing output.

Of course the government can point to consumption-boosting measures too, and there is a lot of discussion about providing Chinese consumers with coupons to be used to consume before some expiry date (although whether these create new consumption or simply substitute for old consumption would be a tricky issue), the fact is that the transmission from domestic demand enhancement to import demand is, for whatever reason, very weak. China is still exacerbating the global overcapacity problem.

For some reason whenever I point this out there is always someone who accuses me of being \’93anti-China\’94 (and weirdly enough the accuser is not always Chinese), so let me stress that I am not evaluating, I am only counting, and it doesn\’92t matter whether or not I point this out. The fact is that quite a lot of people have made or will make the same argument, and if that argument spreads, which it seems to be doing very quickly, China is going to have to deal with it whether or not it likes. The more noise those of us who want to see China succeed make about the growing perception, right or wrong, that China is exacerbating the global problem, the better it is for China.

The thing to remember is that for the rest of the world it doesn\’92t really matter what explanation Chinese policymakers give for this high and rising trade surplus. They will consider the fact that with China\’92s export of overcapacity extremely high, and growing even further, anger within their political constituencies cannot help but rise. Of course China needs to fight rapidly rising unemployment, but so does nearly every other country in the world. At all costs China must move quickly to defuse the threat of trade war, but unfortunately I see little evidence that Chinese policymakers are even beginning to understand China\’92s role in the Great Global Imbalance.

And the problem is certainly not helped by actions like last week\’92s posting, on the website of the research institute associated with China’s Ministry of Finance, of a report arguing that China’s central bank should \’93actively guide\’94 the exchange rate and devalue the RMB to about 6.93 against the dollar. The purpose of depreciating, the report said, was to help maintain economic growth and bolster employment.

Wow. It is as if they have absolutely no understanding of how dangerous the global climate is. This is very scary.

On a separate but related note, yesterday\’92s Financial Times had this story:
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China will continue to buy US Treasury bonds even though it knows the dollar will depreciate because such investments remain its \’93only option\’94 in a perilous world, a senior Chinese banking regulator said on Wednesday. China has used the dollars it accumulates selling manufactured goods to US consumers to accumulate the world\’92s largest holding of Treasuries.

However, the increasing US budget deficit and its potential impact on the dollar have raised questions about the future Chinese appetite for US debt. Luo Ping, a director-general at the China Banking Regulatory Commission, said after a speech in New York on Wednesday that China would continue to buy Treasuries in spite of its misgivings about US finances. \’93Except for US Treasuries, what can you hold?\’94 he asked. \’93Gold? You don\’92t hold Japanese government bonds or UK bonds. US Treasuries are the safe haven. For everyone, including China, it is the only option.\’94

It is good that Mr. Luo is helping to dissipate the widespread but profoundly silly worry about whether or not China will choose to stop funding the US trade deficit. It can\’92t. As long as China keeps running these trade surpluses it has no choice but to recycle the money, and the only market large enough in which to recycle so much money is the US dollar market. Even if it tried to divert more of it into the euro, this would simply force a larger trade deficit onto Europe, which is not sustainable for any length of time.

What still puzzles me, however, is how China \’93knows the dollar will depreciate.\’94 Against what? The euro? Why, because the US economy is slowing and fiscal debt is rising? Since Europe is slowing even more, and starts with a higher level of debt, I have trouble understanding why this would indicate that the euro must strengthen against the dollar. By the way the dollar has strengthened remarkably against the euro over the past six months, so perhaps the PBoC would only be forced to give back a part of its windfall? Or is it not a windfall?

Before closing this post I want to complain about one last, only vaguely related thing. On Tuesday when I arrived at the Hong Kong airport, among all the huge advertisements offering services to bankers and businesses, I saw one even larger advertisement for Credit Suisse concerning an exhibit they sponsored of \’93Emerging Asian Artists.\’94 I know this is going to sound unbearably snobbish, and I really apologize for sounding like this, but while the global financial crisis has many terrible aspects to it, there is no cloud without a sliver lining, and if the emerging artist investment class is one of the many markets that die as a consequence of this crisis (and if history is any guide at all, it will), then the global crisis can\’92t have been all bad, right?

Tags: Emerging artists

Perhaps canceling purchases of the Financial Times won’t be enough

January 28, 2009 in Balance of payments, Exports and imports, Trade protection by Michael Pettis | 8 comments

On my flight back to Beijing last night I noticed an article in the Financial Times in which Miguel Sebasti\’e1n, Spain\’92s industry minister and someone hotly tipped for finance minister, called on Spanish households to stop buying foreign goods and to buy more Spanish goods.

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\’93Right now,\’94 he said, \’93there is something that our citizens can do for their country: bet on Spain, bet on our products, our industry and our services \’96 bet, in short, on ourselves.\’94

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Mr Sebasti\’e1n then did some simple calculations. Consumption was expected to fall by \’807bn ($9bn, \’a36.6bn) this year, causing the loss of 120,000 jobs. If each Spaniard introduced the \’93Spain factor\’94 into their shopping and purchased just \’80150 of Spanish-made suits or toys instead of foreign goods, then those jobs would be preserved.

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Basically Sebasti\’e1n is calling not for more Spanish consumption but rather for Spanish households to consume fewer foreign goods and replace them with Spanish goods.\’a0 He gave as an example that Spanish businessmen could cancel their purchases of the Financial Times and the Wall Street JJunal and buy instead the local Spanish business newspapers.\’a0 The article also noted that Zapatero, Spain\’92s Prime Minister, \’93at a meeting with Jos\’e9 S\’f3crates, his Portuguese counterpart \’96 said he would personally promote Spanish and Portuguese products.\’94

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I think this pretty clearly misses the point.\’a0 The world needs more consumption, not a nationalistic switch in consumption, which anyway won\’92t really matter in resolving trade imbalances since it is pretty hard, if not impossible, to determine with precision the total local and foreign components of anything you buy (especially, I would guess, newspapers).\’a0 When this fails, it is only a short step to proposing ways that ensure that Spanish consumers buy fewer foreign goods and more local goods.

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Spanish politicians should know this, and perhaps they are merely playing to the galleys, but this kind of neighbor-beggaring talk is not part of solution to the global crisis and will only make things worse although, as I have said many times, we should not be at all surprised if trade civility continues to deteriorate.\’a0 The fact that an increasing number of policymakers are making these kinds of statement suggests something about the general mood towards international trade.

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And of course there is more.\’a0 Three days ago I read that India has banned the import of Chinese toys for six months as a way of protecting domestic toy manufacturers.\’a0 According to New Delhi\’92s PTI News Agency:

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India Friday slapped a ban on import of toys from China after cheap supplies from the neighbouring country upset the applecart of the domestic manufacturers. The ban, notified by the Directorate General of Foreign Trade, will remain valid for six months.\’a0 While the government notification did not cite the reason for the ban, sources said it was concerned over a rise in imports of toys. A concern had also been raised over the safety of children playing with the Chinese toys, which were found to be toxic. Most of the varieties, including wheeled toys, dolls, stuffed toys, toy guns, wooden and metal toys, musical instruments, electric trains and puzzles are covered under the ban.

\’a0

The problems with India and China don\’92t end there.\’a0 In today\’92s Xinhua there is an article about Chinese concerns over India\’92s anti-subsidy investigation on sodium nitrite and probe into the special safeguard measure of sodium carbonate.\’a0 The article concludes with a statement by Yao Jian, spokesman of the Ministry of Commerce:

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The current global financial crisis has serious impact on the economies worldwide and all nations need to boost cooperation in fighting the crisis, he said.\’a0 China hoped that India could show prudence and restraint in using trade remedies, as trade protectionism could only add to the grim world trade situation.

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Obviously no one needs to read my blog to come up with his own list of trade-related disputes.\’a0 During the five days I was traveling every day I was able to pick up stories in local newspapers in Singapore, Hong Kong and Thailand bewailing trade behavior and criticizing one country or another of unfair trade practices.\’a0 Of course the most important trade-related story was the statement by Tim Geithner, the new US Treasury secretary, during his Senate confirmation hearings that China was manipulating the RMB.\’a0 This has caused the predictable outrage in China and the RMB actually depreciated following his testimony, which a lot of people here have interpreted as a direct challenge to the currency-manipulation statement (although not likely, it seems to me, to serve as much of a refutation).

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I have no idea how to determine the intent of Geithner\’92s comments \’96 whether they represent a real change in attitude towards China\’92s currency policy or whether they simply indicate a heightened level of annoyance towards China\’92s rising trade surpluses in the face of this global crisis.\’a0 The main point I would make is that everyone seems to be following the rather pessimistic script I laid out nearly a year ago about how this was going to play out in terms of increasing trade friction and the exchange of criticisms and threats.\’a0 If my reasoning is correct, this suggests that 2009 could turn out to be a lot worse for China and other trade surplus countries then most expect.

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An article in yesterday\’92s Washington Post discusses the Chinese reaction to Geithner\’92s comments:

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A top official at China\’92s central bank hit back Saturday at comments by U.S. Treasury Secretary-designate Timothy Geithner, who said the Obama administration believes that China is manipulating its currency.

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Su Ning, vice governor of the People\’92s Bank of China, called Geithner\’92s remarks misleading and \’93out of keeping with the facts,\’94 and said they could sidetrack efforts to manage the global financial crisis, the official New China News Agency reported.\’a0 \’93We should avoid any excuse that might lead to the revitalization of trade protectionism. Because it will do no good to the fight against the crisis, nor will it help the healthy and stable development of the global economy,\’94 Su said during a visit to a Beijing business newspaper.

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Towards the end the article lists the standard rejoinder among Chinese officials:

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China says its price advantages are the result of the low cost of labor, land and other resources. With exports and imports plunging, China is worried about the impact of the global downturn on unemployment and instability and an aggressive U.S. trade policy will only worsen the situation.\’a0

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\’93The currency rate has already appreciated in recent years. The recent depreciation is small and temporary,\’94 said Song Hong, a research fellow at the Chinese Academy of Social Sciences. Song said the trade imbalance was caused not by manipulation but because China imports so many semi-manufactured goods from elsewhere in Asia, processes them and then exports them again.

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With Vietnam, South Korea and other Asian countries hard hit by the downturn depreciating their currencies, it was unrealistic to expect China to do the opposite, Song added. \’93It\’92s possible a trade war will occur between the two countries. Even if the U.S. doesn\’92t go too far in terms of protectionism, the new government will pressure China, and this can trigger trade conflicts.\’94

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Until Chinese officials recognize some of the problems that they themselves have created I think it is nearly impossible that this will come to a good end, and I think those last three paragraphs should worry us all.\’a0 It may very well be true that China\’92s \’93price advantages are the result of the low cost of labor, land and other resources,\’94 but if the level of the currency doesn\’92t matter to China\’92s trade competitiveness than why not simply appreciate and make everyone happy?\’a0 Since a price advantage is by definition only relevant in comparative terms, and if the level of the currency affects comparative prices, then the claim that China\’92s trade surplus is based on a price advantage and not on a low currency is not terrible meaningful.

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What worries me more is the last paragraph.\’a0 Vietnam, South Korea and a number of countries have seen their exports fall far more than have China\’92s, and in many if not most cases they are depreciating precisely in an attempt to regain their competitive levels against China.\’a0 If China sees their depreciation as a justification for their continued currency policy, I am afraid that there is no way for this process to end.\’a0 It will descend in trade war.\’a0 China, like the US in the 1920s seems unable to understand that as a major power it does not have the luxury of acting like just any other small country.\’a0 It must take the lead in the adjustment among Asian exporters, and that almost certainly means that its exports and trade surpluses should fall faster that that of the other countries.\’a0 Its actions, more than that of any of the smaller countries, must be consistent with the needs of other major economies or trade conflicts will grow.

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I return to Spain today to spend the Spring Festival week at my family\’92s home there.\’a0 I will be meeting with old friends of the family and I am curious to see what people are thinking there about China, international trade, and the effects of the US stimulus.

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A formatting problem forced me to erase the earlier version of this post along with all the comments.\’a0 Sorry for that.

Tags: Zapatero

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Trade protection

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

Can the RMB be more undervalued today than it was last year?

Exports versus domestic demand \’96 the argument rages

Trade, CPI and other numbers came in this week

Yes, trade policies do matter

The NPC meets, and Krugman refers to the savings glut

Can Smoot-Hawley only happen in the US?

Should China Devalue the Yuan?

More terrible trade numbers from China

Perhaps canceling purchases of the Financial Times won’t be enough

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