US exports are enjoying their strongest three-year period of growth since 1987-89.    If growth rate of the first half of the year is sustained, the cumulative increase in US exports between the end of 2003 and the end of 2006 will be around 42%.   The increase from the end of 86 to the end of 89 was around 57%. 

I remained amazed that so many people think that dollar depreciation has had no impact. 

87-89 was also a period of dollar weakness.    As is the current period. Consider the following graph.

 The connection between dollar depreciation and a surge in export growth (with a llag) seems pretty clear.

The recent fall in the dollar actually has been far more pronounced if you just consider the major currencies than if you look at the broad dollar …

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At least that is how I read the latest Paul McCulley/ Andrew Balls paper.   By the way, Andrew Balls, welcome to the world of financial opinion journalism … otherwise known as economic analysis and market strategy. 

PIMCO has long believed that the increase in short-term rates would profoundly slow the economy – and thus expect the fed funds rate to “peak.”    And they consequently argue that long-term bonds are poised for a rally.    The lagged impact of the 400bp rise in short-term rates since early 2004 will slow the economy (housing will have a hard-soft landing), and as the economy slows, long-term bond yields will fall, driving up their value.

PIMCO also expects (I think) the dollar to fall, at least against some regions. 

In normal times, peak fed funds and a slowing economy would almost automatically lead long-term bond rates to fall.   That certainly seems to be the bond market's reaction to today's CPI and housing data.   10 year yields are below 5% again.

But in some sense we no longer live in normal times.   Since the US no longer saves, it depends far more on the flow of foreign savings into the US than in the past …

And if foreigners also expect the dollar to fall (or think big falls are a meaningful risk), why should they lend to the US at relatively low US rates?

As PC (a participant in the comments section) has noted, the bond conundrum could potentially become the bond conundrum in reverse.  During the conundrum, rising short-term rates did not lead to higher long-term rates.   As short-term rates rose through 4, they pushed long-term rates up – but the curve remained flat.    Perhaps not a conundrum.  But still something.

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In their latest quarterly report on China, the World Bank’s Beijing office estimates that China’s current account surplus will reach $220 billion, or 8.3% of China’s GDP, in 2006.   With an estimated $65b in net FDI inflows, the surplus in China’s basic balance of payments will be close to $285b, 10.7% of China’s GDP.

There are some problems with China’s current account data.   Reported profits on FDI in China are a bit too low, helping to push up China’s overall income balance.   And it is possible that the current account surplus may include some disguised capital inflows, as China has cracked down on other ways of moving money into China. 

But the basic story is still clear. 

China has a big surplus.   It is getting bigger, not smaller.   And the increase in the current account surplus has come even as Chinese growth – particularly investment growth – seems to have accelerated.   

The World Bank notes that if China slows its economy the same way it slowed its economy back in 2004 – by administrative controls on investment — the result would be less investment, less domestic demand, slower import growth and an even larger current account surplus.   That is why the World Bank emphasizes that exchange rate appreciation should play a role this time around.  It would help to slow China’s economy while also reducing China’s current account surplus.

The World Bank also spells out something that should be clear to any close observer of China:  China is moving up the value-added chain, and increasingly producing previously imported components inside China. 

“China’s trade basket is diversifying and moving up market.   …  The impressive increase in exports stemming from new product varieties in China was highlighted in our May Quarterly Update.    Other developments include rapid growth of exports by domestic private firms – up around 50% (yoy) in the first half – and import substitutions and broadening of supply chains by foreign firms that had previously sourced most inputs from abroad.   As a result, the share of processing exports in total exports dropped from 54.7% in 2005 to 51% in the first six months of 2006.  If this trend continues, external trade will benefit China not only by creating jobs, but also by generating more value added and profits.” (emphasis added)

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• Net long-term capital inflows to the US in the second quarter.  $185.6
• Q2 trade deficit.  $193.1b
• Estimated Q2 current account deficit — $215b-225b (personally, I think it will be toward the high end, as I suspect the income balance will turn negative)
• Q2 US financing need (assuming the net FDI outflows of q1 continue) = $240b-$250b 

I know $75b in net inflows in June topped market expectations.   But it is still a pretty bad number.   Foreign demand for US debt seems to be slowly waning.   Admittedly from a very, very high level.  The rolling 12 month total for foreign purchases of US long-term securities is now $1075b.    But it hasn’t been increasing over the past few months.  And the US needs big inflows to allow it to both invest abroad (buying foreign equities as well as financing FDI investment) and run a roughly $900b current account deficit.

Foreign demand for US debt (foreign demand for US equities remains trivial) was basically constant at around $85b in both May and June.  In June, though, American purchases of foreign securities fell from around $20b to around $10b.  That increased net inflows. 

US purchases of foreign equities basically stopped in June.   The trend is pretty clear.

• January $10b
• February $12b
• March: $12b
• April $8b
• May $5b
• June: -$1b 

We all know why – there was a bit of turmoil in emerging market equities in May and June.  That turmoil has now passed (just look at the Turkish lira).  I actually had expected US purchases of foreign equities to be more negative in June.  The US sold about $1 billion in foreign equities, less that I would have guessed.  The market turmoil seems to have come from a marked slowdown in US purchases, not large net US sales …  (edited)

Of course, there are lots of ways of financing the purchase of foreign equities offshore, and the unwinding of those positions wouldn’t necessarily show up in the US data. 

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Wrong, maybe, but not inconsistent.

Stephen Jen notes that China is not the only country with an enormous current account surplus that intervenes massively in the foreign exchange market –

“If China had been ‘manipulating’ the RMB, as many US scholars and politicians believe is the case, then the GCC countries are guilty of worse: their currencies are actually de facto pegged to the dollar, while China’s RMB regime is, at least, a heavily managed float.” 

Jen argues that the massive build-up of foreign assets in the oil states investment funds is effectively a form of currency intervention.  I agree.

And he implicitly argues that folks who complain about China’s peg but not the GCC’s peg’s are guilty of hypocrisy.    On that, I plead not guilty.

Jen adamantly believes that neither the Saudi riyal nor the Chinese RMB is undervalued.  

I, by contrast, believe both the RMB and the riyal are significantly undervalued and should be allowed to appreciate.  I am one of those – criticized by Jen – who thinks that the scale of China’s intervention is a challenge to informal “rules” of the international monetary system.   Big countries generally have not intervened on China’s scale (or for as long) to keep their currency from rising.    China now exports about at many goods as the US.  It is a big player by any standard.

I also think the Gulf Cooperation Council currencies are significantly undervalued. Indeed, unlike Jen, I suspect that with oil above $70 the GCC currencies are even more undervalued than the RMB (link here; RGE subscription required).  

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Dean Baker’s critique of Monday’s Lex column on the dollar was on the mark.  Lex made rather selective use of the facts to argue that dollar depreciation (and renminbi appreciation) has little impact on the US trade balance. 

I suspect that the new conventional wisdom is closer to Lex’s view than my view.  So I wanted to lay out my critique of Lex's argument in some detail.  

Lex discusses both the RMB/ $ and the $/ euro.  And, unusually, rather than focusing on the RMB, I want to focus on the euro.   (Graphs are below the fold). 

Before doing that though, let me just say that Lex might want to look at the evolution of the eurozone’s trade balance with China before arguing that exchange rate changes don't matter.  

It is a natural test.  The RMB has been stable against the dollar for some time, but it has been anything but stable against the euro.  And it seems pretty clear to me that the acceleration in Chinese export growth to Europe in 03 and 04 followed directly from the RMB’s depreciation against the euro from 2002 on.  China now exports about as much to Europe as to the US – and runs a significant bilateral surplus with the eurozone.  The ECB puts out the data in table 7.6 of its monthly bulletin; it sure seems to me like the eurozone’s deficit with China went from around euro 30b in 2002 to euro 75b in 2005, largely because imports from China rose from a bit over euro 60b to a bit under euro 120b in three years.   

What of the $/ euro?   Lex argues that the dollar’s depreciation against the euro has had no impact on the US bilateral deficit with Europe.  That certainly seems to be the case if you eyeball the data. 

But looking at the overall balance can be deceptive.  The exchange rate is only one of many variables that influences the bilateral trade balance. Relative growth in domestic demand also matters.    Particularly for imports.   The exchange rate matters more for exports.  At least that is what the econometrics says.

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The take away conclusion from the June data is that not much has changed. 

The headline trade deficit was unchanged (more or less) from the revised May deficit   The US oil import bill was more or less unchanged — $27b and change in June v. $28b in May.  Oil import prices were more or less unchanged at around $62 a barrel.  Oil import volumes this June were a bit lower than last June, but oil import volumes this May were a bit above oil import volumes last May — total imported barrels in May and June combined were pretty much unchanged from last May and June.

That though is in some sense bad news.  For the first siz months of the year, import volumes are about 2% lower than last year.  The May/June data though seems to suggest that such a decline is unlikely for the full year.

The good news.  Exports are up.  And it isn't just civil aircraft.    Boeing exported $3.2b in June v $3.5b in May.     Still, for the year, Boeing's exports are up by around 30% — with aircraft exports going from $15b in the first six months of last year to around $20b in the first six months of the year.  

Non-oil imports also look to be rising.  May's import data must have been revised up.  And June is definately an increase over May — and a meaningful increase over the January-April period.  That is in some sense to be expected.    Barring a US recession, one would expect some increase in non-oil imports.

I won't try to match Menzie Chinn's graphs, which provide a nice breakdown of the oil and non-oil trade deficit (both in nominal terms and as a share of GDP).

I would note that the nominal trade deficit has been roughly stable for the last three quarters.   It was $195b or so in the fourth quarter, $191b in the first quarter and $193b in the second quarter.   

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We know that China's monthly trade surplus is still rising.  July's surplus was close to $15b.  Tomorrow we will know if the US deficit is still rising. 

I usually offer my analysis of the trade data soon after it is released, but I will be tied up all day tomorrow.  So rather than analysis, I'll give you my recommendations for what to watch.

First, what is happening to non-oil imports?  It is easiest to just look at non-oil goods imports rather than non-oil goods and service imports.  Non-oil goods imports have been around $127b all year.  They were on the weak side in May — only $126b.    Non-oil imports are a sign of economic activity.  But I cannot entirely rule out the possibility that they might grow a bit faster than they have so far this year even if the economy slows.

Second, does the June data confirm the uptick in May's monthly exports — goods exports were $84b, v $81-82b earlier this year, and total exports were $118-119b rather than $115b — or not?   Strong export growth obviously would be an unambiguously good sign.    The monthly data so far this year hasn't shown a strong trend increase in exports — but that could change if the June data shows another solid increase over the May total. 

I also enjoy comparing China's goods exports — around $80b in July — to US goods exports.  China is on track to overtake the US later this year or early next year …  it already is getting close.

Third, what happens to real oil imports?  Prices are likely to be up.   Does that lead to a cut back in demand?  Or does demand recover after a slow start this year.

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Same facts, two different interpretations.   One from the Wall Street Journal; another from the FT.

I tend to side with the FT.  China already saves more than it invests.   It doesn’t need access to foreign savings.  It does still want access to foreign technology …   tangible as well as intangible.  And no doubt it likes the political support that foreign partners provide during trade disputes.

But a bit more textile investment isn’t really going to make all that much difference to China’s future development.  And China – at least the folks at the central bank – question the wisdom of offering foreigners tax breaks and high returns when China is taking the funds they bring into China and socking them away in China’s reserves.

Those reserves pay 5.25 (on the short-end) and what, 5%, on the long-end.

If FDI in China earns a return of 15%, in aggregate, China is borrowing from borrows the world at 15% to buy Treasuries that earn 5%.  That isn’t obviously a good trade.   The intangibles — the technology transfer, the political support — have to worth a fair amount to make up for the negative carry.

It isn’t that FDI inflows to China have slowed – they are still in the $60-70b range.  It is more that China’s economy has grown in dollar terms so much that FDI is now a declining share of Chinese GDP.

And – hat tip to the New Economist – it is clear that China doesn’t just want to be destination for foreign direct investment.   China’s going global policy is meant to encourage Chinese outward FDI. 

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I spend a lot of time thinking about reserves.  And I have long been puzzled by the modest April increase in China's reserves.   China’s trade surplus was solid.  There is no particular reason to think that FDI inflows into China slowed dramatically in April.  And hot money flows to the rest of Asia picked up, so a fall in hot money flows into China seemed, well, somewhat implausible.

Plus, the euro rose substantially against the dollar in april – going from around 1.21 to around 1.25.   That should have pushed the dollar value of China’s euro reserves up.   No matter how I thought about it, i couldn't figure out why China added only $20b to its reserves in April.  I was expecting around $30b.

A light bulb went off in my head today when I read in the Wall Street Journal that the fall in US long-term bond yields (and increase in bond-prices) in July added around $7b to Japan’s reserves, pushing Japan’s total reserves up to almost $872b.    The ten year rate when from 5.15 to 4.9 in July.   

I have been adjusting for valuation changes from currency moves.  But not for valuation changes from interest rate moves.  And valuation changes from interest rate moves just may explain the slow pace of China’s April reserve increase (around $10b after my adjustments for currency valuation, well below China’s roughly $20b a month average).   

Looking at the data on the St. Louis Fed, the ten your treasury bond are went from 4.86 to 5.15 in April. 

I think most observers think that China has a more aggressive reserve portfolio than Japan (notably holding more mortgage backed securities).    China’s April 2006 reserve increase would make a lot more sense if China had a lot of duration in its portfolio, and thus was exposed to the rise in US ten year rates.  Valuation losses there would have offset of China’s valuation gains on its euros. 

Just a thought.

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