Brad Setser

Brad Setser: Follow the Money

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DeLong on the global economy

by Brad Setser
October 25, 2004

DeLong’s powerpoint notes are certainly worth checking out. The side by side graphs showing real GDP growth and then employment growth (or the lack thereof) elegantly tell the story of the 2002-2004 recovery.

However, I have a few comments on DeLong’s China slide.Professor DeLong makes two arguments. One is that the spectacular rise in China’s exports has largely come from changes in intra-Asian electronic trade, with more electronic components now being sent to China for final assembly. The other is to remember the principle of comparative advantage: The U.S. will have a comparative advantage over China in the production of something.

Actually, it is pretty obvious that we do have a comparative advantage over China in one thing — the production of budget deficits. I am being serious. To run a budget deficit, you have to be able to sell debt, and we are selling a lot of debt to China. 2004 US exports of goods to China are likely to be around $40 billion. China’s reserves are likely to rise by over $100 billion this year, and globally, the BIS reports that 2/3s of all reserve assets are in dollars. That would imply that the US is likely to export $67 billion of dollar assets to the Bank of China. In other words, our current comparative advantage is in the production of financial assets for sale abroad!

A brief aside. The data on China’s holdings of Treasuries shows a slightly slower pace of increase than I calculated above. China’s holdings of Treasuries fell a bit in January and February, likely because of plan to recapitalize state banks, but its holdings have since risen by about $20 billion. That would works out to an increase of about $40 billion for the year — less than the $70 billion I inferred from data on the growth in China’s reserves. China may be holding more agency bonds, may be hiding the size of its holdings of Treasuries by going through intermediaries, or just perhaps, may be holding fewer of its assets in dollars. But even at $40 billion, US exports of treasury bills to China will match US exports of goods to China in 2004.

DeLong’s broader argument gets part of the story right, but, in my view, not all the story. It is true that between 2000 and 2003, a lot of the growth in China’s exports to the US simply displaced other Asian exports. Overall US imports from the Pacific Rim were around $420 billion in 2000, and still around $420 billion in 2003 (US imports were roughly flat overall during this period, as imports fell sharply in 2001, both because of the recession and lower oil prices, and then picked up). However, looking forward, I suspect China will increasingly be moving into other markets. 2004 exports from the Pacific Rim are set to rise by $70 billion, to $490, driven by a $50 billion increase in imports from China — i.e. East Asia as a whole is increasing its share of the rapidly expanding US market for imports. Going forward, barring any major changes, overall imports from East Asia will keep on rising — i.e. Chinese goods will displace imports from other regions (say textiles) or US production, not just other East Asian production. Afterall, a $1.5 trillion or so economy that exports a ton and is investing 40% or more of its GDP has to keep moving into new markets.

DeLong is right to note that the US has to have a competitive advantage in something. China is earning a ton of dollars selling goods to the US, and those dollars have be used, not just hoarded. Recently, China has used those dollars to buy Treasury bills (and, no doubt, also to buy oil), but that is probably not the long-term solution. The problem, it seems to me, is that no one in the US really seems to have a good sense of where our future comparative advantage will be. I have not heard of many new investments in the US that are premised on supplying the growing Chinese market. Usually, the anecdotes are of the opposite — US firms moving to China to supply the US market.

Now I suspect that some of those firms are making a mistake, at least if they are assuming that China will retain all of its current cost advantage over the United States. If you are investing in a Chinese plant that will be at peak production between 2008 and 2010, and you are betting that the renminbi/ dollar will remain in the 8.2 range, then you are betting that the US will be able to run trade deficits of 8% of GDP or more in 2008. That seems implausible to me. Smart investors in China should assume significant real appreciation going forward.

But my bigger concern is the absence of investment in US export sectors. Indeed, I recently heard that the US capital stock is — or perhaps was — falling. Investment here in the US, by US and foreign owned firms, fell sharply in the last recession, and did not keep up with depreciation. Interesting.

It is fairly clear that the development of China as a manufacturing powerhouse is a potential boon to resource exporting countries — countries like Australia and Canada as well as Russia, Brazil, Chile and Argentina — at least so long as commodity production does not get ahead of demand. Parts of the US may benefit as well. The midwest may compete successfully with Brazil for China’s soybean market, maybe even for its pork market. But I suspect that the US will not be able to thrive solely by exporting natural resources, i.e. we won’t become Canada.

One option is to export to the resource heavy/ labor scarce countries that are clearly benefitting from the new China trade. There is nothing wrong with triangular trade. China imports from Brazil and exports to the US and the US imports from China and exports to Brazil. Another option is to find industrial or service sectors here in the US that does have a comparative advantage over China.

The problem is that no one seems to have a good idea what they are, or to be investing in them now. No doubt, such sectors will emerge, particularly as China’s exchange rate adjusts, as it must. But the process of discovering where our comparative advantage lies and reorienting our economy to exploit that niche may well take time, and probably won’t be painless.

Of course, so long as China –and for that matter Japan — is willing to buy an ever increasing number of US treasury bills, we can continue to specialize in budget deficits, and put off our day of reckoning!


  • Posted by General Glut

    Last year I told my students that the US has one for-now unassailable comparative advantage: it is the only country in the world that produces the USD. They thought it was funny at the time, but how true it is.

    One marvels/fears if/when global demand for this funny and unique commodity dries up, however . . .

  • Posted by glory

    i don’t think you can minimize japan as an afterthought, they are by far the biggest players in the dollar recycling trade across the pacific, holding $722bn in treasurys compared to china’s $100bn or so that you mentioned.

    as long as exports continue to drive japan’s growth, there’s deflation and the ZIRP obtains, i don’t see why they wouldn’t continue to intervene in currency markets as they did in the spring at around 105 yen/$.

    also, at least for the time being, i’d worry more about caribbean banking centers’ dollar reserves, which have exploded to $90bn, almost doubling from a year ago. i think they’d be far more likely to stop purchases or sell treasurys, and who knows what that would precipitate?

  • Posted by brad

    glory — very fair point on japan. they clearly have been the biggest source of support for the dollar this year, and the biggest buyer of treasuries, far exceeding china.

    any sense of what is driving the expansion in the caribean banking centers?

    I also suspect oil exporters will have to take on a larger role supporting $/ treasury market as the global current account surplus gets redistributed from asia (to a degree) to oil producers by oil north of 50 — but i have not (yet) found the data to support the hunch.

  • Posted by jade

    > any sense of what is driving the expansion in the caribean banking centers?

    explosion of hedge funds and the carry trade.

  • Posted by brad

    jade –

    so us hedge funds based in caribbean for various reasons are borrowing $ from us banks and broker dealers and buying long-term treasuries. In BOP terms, that would show up as rising us external assets (the loans to the caribbean) and rising us external liabilities (treasures held offshore) — with limited net BOP financing. Or are the hedge funds borrowing from japan to buy us treasuries (a new inflow in BOP terms, intermediated through the caribbean). Some of both? something else? most curious

  • Posted by jade

    Some of both but lots of the former. Maybe one can figure out more from the BEA’s BOP data which includes broker/dealers and banks.

    Greenspan & Co. are very aware that they created the carry trade. You can go back to March when they started rumbling about inflation and the end of low rates – in large part to get the hedge funds to unwind their trades. Traders weren’t happy but the unwinding was pretty orderly, in my opinion. Now though, with the US economy not doing as well as numbers in March-April were showing, the carry trade is back on – but perhaps with less leverage than before. I don’t know how well the Fed will orchestrate an orderly unwind again, and as glory suggests, there’s a lot more inherent volatility and risk with the hedge fund players.

  • Posted by brad

    Jade, thanks.

    I had sort of naively assumed that the spread pickup between short-term money borrowed from the banks and long-term treasuries was not enough to make it all that attractive a trade (so the hedge funds were looking at higher yielding, higher carry assets like corp. debt and EM debt). But presumably the absence of credit risks lets you gear up the long-term treasury trade, making it attractive. I will try to see what the TIC and BEA data is saying.

  • Posted by Mark


    What do you mean by suggesting that Canada thrives “soley” by exporting natural resources? Check out out export stats at Exports of agriculural, energy, forestry and industrial materials only accounted for 47% of total exports in 2003.

    I’m sure you’d agree that the US should be MORE like Canada in the fiscal area.

  • Posted by brad

    only 47% … hmm. And that was before the full run up in energy prices in 2004 — which I presume is part of the reason why Canada’s exports to the US are growing fast this year in US $ terms. Among the G-7 (now not so) industrialized countries, Canada is by far the biggest natural resource exporter …

    I’ll grant you that I did exagerrate a bit for effect — I think Ontario has an autos and auto parts industry tied in with Detroit, and you all seem to be making lots of regional jets up north these days. And you are right, I’d be happy to import Canadian fiscal policy!

  • Posted by brad

    jade –

    in light of your comments, i think the best explanation for the net outflows via banks and nonbank financial intermediaries in q1 and q2 of 04 is that they were lent to the caribbean (i.e. to hedge funds) to finance the purchase of debt securities, either treasuries or something that yields a bit more. that data fits with that story — thanks for the tip.

  • Posted by jade

    yes, that’s right. also, hedge funds are often mandated by their investors (usually asian govts/pension funds) not to invest in speculative credit or emerging markets, so the universe of investable assets is smaller

  • Posted by jade

    brad – my last comment was in response to your 10/27 11:20AM post. regarding your last comment, you’re welcome.