Brad Setser

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Cross border flows, with a bit of macroeconomics

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The Economist sides with Tyler Cowen

by Brad Setser
September 23, 2006

A quick synopsis of the last five years.

The RMB tumbles against the euro (and most European currencies).

Chinese exports to Europe surge, growing faster than Chinese exports to the US (even though US domestic demand growth generally has been stronger than European domestic demand growth).  Right now, EU-25 and Eurozone imports from China are up around 25% y/y (in euros) while US imports from China are up 16% or so.

Many economists (and the Economist) conclude that exchange rates don’t influence trade, at least not trade with China. 

Apparently relative prices only matter some of the time … 

Many things have happened since 2002.  

  • China joined the WTO. 
  • The final assembly of most computers shifted to China.  
  • Chinese productivity growth exceeded US productivity growth, increasing China’s competitiveness even in the absence of exchange rate moves (see p. 13 of Feng Lu’s presentation). 
  • Chinese wage growth lagged Chinese productivity growth (as the IMF notes, labor income fell as a share of Chinese GDP), further increasing Chinese competitiveness.  

But, processing trade or no processing trade, the enormous acceleration in China’s rate of export growth (to the world) is clearly correlated with a change in the RMB. 

From 1995 to 2002, the RMB generally appreciated in real terms because the dollar depreciated.   Exports grew, but not super-fast.  China ran a small trade and current account surplus.

From 2002 on the RMB has depreciated in real terms, again, because of the dollar.

The result:  China’s exports are set to go from around $320b in 2002 to somewhere around $940b this year.  Nick Lardy now forecasts that China will have a 9% of GDP  ($250b) current account surplus, even with oil at $60.  It will be bigger if oil falls back further.  

China's central bank turns that surplus into demand for US dollar-denominated debt, its purchases likely finance something like 1/5 of the US currnet account deficit.  

The Economist also argues that:

 “Unless Americans curb their appetite for imports bought with borrowed money—and start making more things other countries want to buy—the deficit will continue to be a problem.” 

That argument could be framed the other way around: until the central banks of the world curb their appetite for financing their exports to US, the US will continue to specialize at making exactly the thing that other countries really want to buy — IOUs.  If not Treasuries, then Agencies and mortgage backed securities.    We are rather good at it. 

I’ll let the Economist in on another little secret.   The RMB didn’t rise to 7.92 this week because currency traders took Mr. Paulson’s words to heart.   Currency traders don’t set the RMB’s value.  The PBoC does.   

I am glad that the PboC is showing a bit more flexibility – even if the Economist is not. 

The striking thing about the global balance of payments is that East Asia’s surplus continued to climb  even as the oil exporters surplus exploded.   That necessarily implies that the deficits of the world’s other oil importing regions had to rise.     The US has done its part.  And recently, Europe has too. 

And when you look closely, it isn’t all that hard to find channels linking exchange rate moves to the savings and investment balance.  The surge in Chinese business savings is one.   Bernanke’s argument that low US savings is – in part — a function of high savings elsewhere is another.

Of the channels that link changes in the RMB/ Euro to China's growing capacity to finance the United States deficit.  The huge surge in China’s bilateral surplus with Europe since 2002 sure seems to have contributed to China’s growing capacity to finance deficits elsewhere in the dollar/ RMB zone.

If you think global imbalances are a problem – and I think the Economist generally does – then both deficit and surplus countries have to adjust.      

Adjustment means things have to change, and those who have profited from the cheap Chinese goods for over-priced Treasuries and Agencies trade won’t do so well.  I understand that.  I also understand that exchange rate moves are not a panacea — and many other adjustments are needed.  I have never argued that adjustment process will be painless.  In any adjustment scenario, US demand growth has to slow.  That means US consumption growth has to slow, even if US income growth doesn't.  Ted Truman makes this point clearly.

But does the Economist seriously think China’s current growth model can continue unchanged?  Or that global adjustment will become less risky if adjustment is postponed for another couple of years, while China’s surplus rises and the US (or perhaps Europe’s) deficit rises? China’s goods exports are on track to reach $940b in 2006.   To keep up a 25% growth rate over the next four years, China’s goods exports would need to rise to around $2300b.   China already exports about as many goods as the US.   Can it really manage to export twice as many goods as the US? 

Sorry about the rant – but the Lex/ Economist/ breakingviews/ City of London financial press consensus that Chinese export growth is unlinked to exchange rate moves gets under my skin.  Particularly since most such arguments are made without noting that Chinese exports did respond as one would expect to the big move in the RMB/ euro. 

I can understand the arguments that the huge surge in Chinese exports (and shift in assembly) since 2002 has been a net gain to the world.  But I have trouble with arguments that claim China's trade is not sensitive to exchange rates moves that do not even bother to note that the surge in China’s export growth rate is rather clearly correlated with the RMB’s post-2002 real depreciation.  

The FT wrote on Friday of England’s “enduring popular suspicion of most things European.”   Right now, I have a feeling that the UK's financial press shares that suspicion.  At least when it comes to looking at the eurozone data.  Maybe I should try to dig up data on how Chinese exports have responded to changes in the RMB/ pound?    Or just give up.


  • Posted by HZ

    Apparently it would be foolhardy to argue that exchange rate does not have an effect on trade balances — what about the more nuanced argument: barring open borders to free flow of labor, the deficits would persist as long as the labor arbitrage is profitable. Short term the exchange rate will impact the deficits, long term the imbalance is systemic due to the nature of labor being not directly tradable.

  • Posted by sun bin

    “But does the Economist seriously think China’s current growth model can continue unchanged? Or that global adjustment will become less risky if adjustment is postponed for another couple of years, while China’s surplus rises and the US (or perhaps Europe’s) deficit rises? China’s goods exports are on track to reach $940b in 2006. To keep up a 25% growth rate over the next four years, China’s goods exports would need to rise to around $2300b. China already exports about as many goods as the US. Can it really manage to export twice as many goods as the US? ”

    I agree with you that it is impossibble to maintain 25% for ever, because at some point it would have saturate and have to slow down. That point is perhaps already here, i.e. without any chnage in excahange rate.
    So I guess what The Economist’s answer to your question would be
    1. No 25% is impossible even if exchange rate is unchange (that makes the exchange rate argument less relevant — but not totally irrelevant, I agree with you there must be some effect on trade, although the price elasticity is probably very small around the current point
    2. if 25% grwoth is not sustainable (say RMB is frozen at 7.92), then China surplus may not reach 2300bn, maybe 1500-1800bn.
    3. if the x-rate changed more, eg to 7 or 6.5 as some advocated, China’s export to US may then be 1200-1500bn. but america’s import may not drop as much as 300bn (compare to the china exporting 1500-1800bn case) because US would have to buy from vietnam and bangladesh, so the deficit change may only be 50bn or so.

    i guess at this point the assessment need to become quite quantitative. and as we know, estimates are very imprecise…so how should we act based on such marginal difference and how uncertainties?

    p.s. my personal opinion is that China should apprecaite RMB for its own good, although not I would prefer them to do gradually. operating on a true basket (which is not what PBOC does today) is not as risky as the bureacrats thought.

  • Posted by Gcs


    “my personal opinion is that China should apprecaite RMB for its own good”

    listen the party boys know whats in their interests as things stand now

    the us and europehas to change that set of options and the consequences of taking them

    by mounting a serious threat
    to shut em out

  • Posted by Dave Chiang

    Economist Lawrence Summers rant about Global Economic Imbalances:

    Now that Larry Summers is no longer working in the Clinton Administration or the US Treasury controlled IMF, he can finally speak his mind and be free to be honest for once. Summers says it’s irresponsible for the U.S. to demand that China tackle its imbalances without addressing its own. The Bush Administration’s ulterior motive is really about adjusting China’s systematic growth and monetary policies to “correct” the excesses created by irresponsible credit-bubble policies of the Federal Reserve. The Fed is really good at what they do, delaying the inevitable. The problem is that by delaying it, they make the needed correction much more dangerous because the speculation bubble has had more time to reach ridiculous levels. – Dave C.

    “All is not well between the U.S. and China and, by extension, economies relying on their growth. Neither wants to take responsibility for its own imbalances. Both nations are engaged in a dangerous game of musical chairs. There won’t be enough chairs to go around and the music may stop at any moment.

    If the U.S. wants to lead the global economy, it must do so by example. That means reducing the U.S. trade and budget deficits, and fast. Once that happens, China will have few excuses to delay change in its own backyard. Sadly, it’s not happening, and the world is a riskier place because of it.

    That was Lawrence Summers’s take on things in Singapore. When I asked the former Treasury secretary whether he thought we’d seen the worst of global imbalances, he said: “No, I don’t see evidence that there are strong correcting forces. I think the greatest area of risk is yet to come.”

    Treasury chief from 1999 to 2001, Summers says it’s irresponsible for the U.S. to demand that China tackle its imbalances without addressing its own. Summers also wonders about the precariousness of a rich country like the U.S. being supported by money from developing nations.”

    By William Pesek

  • Posted by bsetser

    HZ — doesn’t Hecksher-Ohlin (a classic trade theory) argue that free trade in goods is a perfect substitute for free labor mobility? The labor rich economy will produce labor intensive goods which will travel across borders rather than people. Obviously, that is too simplied, but it probably has some truth.

    My core argument is that that the US/ China (and EU/ China) labor arbitrage is partially a function of relative factor endowements (i.e. there are lots of people in China and not so much land/ capital — tho the capital stock is rising fast) and partially a function of exchange rate intervention …

    DC — glad you are seeing a bit of wisdom in the words of one of my former bosses.

  • Posted by Dave Chiang

    Hi Brad,

    Instead of always trashing the Chinese, perhaps it would be more productive to address the economic policies currently in place that have fostered consumption ad absurdum in the US Economy. There is the further questionable wisdom of continuing to sponsor policies which encourages the utmost degree of household-level financial profligacy. The record current account deficits are the direct result of a coordinated effort by the Federal Reserve and the Bush Administration to pump consumer spending through low interest rates and low taxes. You may not have noticed the million dollar McMansion and gas guzzler Hummer SUV craze from coast to coast, but perhaps a recession in the United States is a necessary evil to clear out malinvestments from the debt bloated economy.


  • Posted by HZ

    With both technology and capital being mobile, would either H-O (inherent capital advantage) or Ricardo (inherent technological advantage) still hold? Labor is the remaining immobile factor here.
    Agree with your argument that FX rate plays a role (and probably a signficant one) but doubtful changing it would address imbalance in the long term.

  • Posted by HK

    Brad–Coming back from Singapore, I have been dismayed by the lack of progress in reducing (if not eliminating) the global imbalances. Apparently, the IMF multilateral consultation has not worked at all. The US-China talk hailed as a diplomatic success by Paulson is nothing but the mutual recognition by the two governments that both would make no serious adjustment. I have become more pessimistic about the ability of the two governments. Only a dramatic fall of the dollar and a shooting up of interest rates can reduce the imbalances through a recession in the US.

  • Posted by Emmanuel

    Everyone, don’t forget about Schumer-Graham in the upcoming week. From the AP:

    Paulson was scheduled to meet in the upcoming week with Sens. Charles Schumer, D-N.Y., and Lindsey Graham, R-S.C., the key sponsors of legislation that would impose penalty tariffs of 27.5 percent on all Chinese products coming into the United States unless China goes further to revalue its currency.

    American companies blame the loss of nearly 3 million manufacturing jobs since Bush took office in part on a Chinese currency they contend is undervalued by as much as 40 percent. That makes Chinese goods cheaper for American consumers and U.S. products more expensive in China.

    Schumer and Graham have been promised a vote on their legislation in the upcoming week. Many analysts believe it is likely to pass, given the growing anti-trade sentiment in a nation facing skyrocketing deficits.

    Emphasis is mine. The Consumer Electronics Association is already warning against the bill:

    The Consumer Electronics Association (CEA®) strongly urges members of the United States Senate to vote “no” on legislation proposed by Senators Chuck Schumer (D-NY) and Lindsay Graham (R-SC) that seeks to address China’s currency policy by imposing a 27.5 percent tariff on imports from China.

    The Schumer/Graham approach is tantamount to a tax on American consumers and businesses, since the cost of the tariff would likely be passed on to those purchasing Chinese imports. For example, today’s average price of a flat panel television is $1,295 but would increase to $1,651 with the proposed tariff; an MP3 player’s average price today is $218 but would increase to $277; and, a digital camera’s average price today is $299 but would increase to $381.

    Boo-hoo-hoo, it will cost Joe Average more to buy a flat-screen TV. What a sacrifice! But seriously, I am curious as to what the chances are of this bill passing. I’ve already said it’s harebrained in that it will probably inflict more damage to the US than to China, but there’s no doubting the prevalence of protectionist sentiments at this time. Hammerin’ Hank had better do an extremely good job of horse-trading on this bill. Otherwise, I’ll probably see y’all on the highway to hell [I just love that AC/DC sound].

  • Posted by bsetser

    HK — agreed. but there was no indications that Singapore would result in anything else — the policy discussion was all on the IMF reform deal.

    DC — I rather thought this was an “Economist” bashing post, not a “China” bashing post. And I try hard to be clear that I am bashing the chinese policy of using its cetnral bank to support America’s consumption binge, not China per se.

    There are lots of US policies that should be changed. but i do think that it is hard to attribute the recent fall in the household savings rate to policies here in the uS (US fiscal is actually improving right now) — Bernanke has convinced me that it stems in part from surplus savings elsewhere in the world, and the impact that surplus has on US rates and uS asset prices.

  • Posted by Emmanuel

    Dr. Setser: I hardly ever disagree with you on substantive points, but these caught my eye –

    I do think that it is hard to attribute the recent fall in the household savings rate to policies here in the US.

    Greenspan’s easy money policies didn’t play a role? Surely Bernanke’s unwillingness to raise rates higher does little to encourage savings?

    (US fiscal is actually improving right now)

    On the surface, yes it is. However, Calculated Risk likes pointing out that the usually reported unified deficit includes surpluses from Social Security and other trust funds, masking overall increases in the national debt. The national debt is still increasing at a record pace. When the federal government borrows from those surpluses with intragovernmental debt, it still needs to pay them later, meaning more IOUs.

    I’m beary, beary (sorry for the pun) sure that there are no improvements on the fiscal front.

  • Posted by quiz

    The concept that citizens of the US suddenly decided to borrow and spend ourselves into ruination is disengenuous. The financial structure of the average American is a direct result of the Bush/Business agenda to increase corporate profiability by offshoring manufacturing to low wage China and Asia.

    The decision to save or spend is a tradeoff between consumption today or consumption tomorrow. The structure of interest rates over the past five years has had more than a passing influence on the savings vs spending decision. At the same time borrowing for consumption was driven to ridiculous lows, the return on savings was also driven to ridiculous lows, below the rate of inflation and sustained even as the asset bubbles inflated. Rational consumers, sensing correctly that the bubbles being created and sustained by the Federal Reserve were extremely inflationary, rushed out to purchase houses, cars, and everything else before the prices went out of sight.

    This was and is the corporate plan and the election of the Bush administration was the crowning moment that has made it all possible. Business and the plutocracy delivered Bush who in turn delivered Greenspan and Powell and Snow. They got rid of O’Neil for objecting.

    Meanwhile, the Bush congress has done it’s part through Keynsian stimulus to make the tax cuts look like they really, really do create a stronger economy.

    The unilateral Chinese emabarrassment is an artifact of the unholy alliance between the trans-national big business/ the Chinese government/ and, God help us, the Republican government of the United States of America.

    Schumer and Graham have the right idea. Stop it now.

  • Posted by bsetser

    I perhaps should have put more emphasis on the word recent.

    Since the end of 04, US policy rates have steadily been increased (I don’t follow the data but i think indexes of money growth have slowed as well) and US fiscal (yes, setting aside the use of the trust funds) has been far tighter than in 01-03. No new tax cuts — even as corporate tax revenues soared. Some of that revenue has been spent on the war/ prescription drugs, but if you look at the latest NIPA data, net government dissavings has fallen significantly.

    Don’t get me wrong — at this point in the cycle, i would rather have a small surplus than a small deficit — and I don’t like the very pro-cyclical US tax system (very dependent on stock options/ corp profits for revenue surprises). But there has been a shift. Again — look at the NIPA accounts.

    The result has actually been some slowing in the growth of non-oil imports, which has helped to stabilize the “Real” trade deficit (see Menzie Chinn). I stand by my argument — directionally, US policy has been far tighter than it was.

    US households have a range of incentives to spend — the ease of extracting home equity, a tax system that penalizes work not energy use, the fed’s assymetric response to bubbles that kept rates low from 02-04, etc — and a range of incentives to over-invest in housing. But i don’t think any of those structural incentives led to the fall in household savings in 05.

  • Posted by dryfly

    Really fine post Brad. Sums the situation up pretty well.

    But I do agree with Dave Chiang on one point – I would think the US could start doing things to push this adjustment along from our side of the pond without directly hammering on them to change first.

    Are there WTO sanctioned things the US could do to initiate a rebalancing that wouldn’t be completely Smoot-Hawleyish? Or that wouldn’t require completely rolling up US demand (both domestic & import)?

    If so I’d like to read about them – especially heading into this election season. You could almost start the essay with the assumption the Chinese won’t blink first, something HAS TO BE DONE, so what do we do now?

    Have you given that one some thought?

  • Posted by DOR


    WTO sanctioned thing the US could do to initiate a rebalancing that wouldn’t be completely Smoot-Hawleyish:

    Reduce the fiscal deficit by rolling back the GOPers tax cuts for the rich and pork for the uber-rich.


  • Posted by MacroCynic

    I noted the following comment in today’s FT with interest –

    “It may well be that we’re coming to the end of quite a long period where goods prices were being driven down by globalization and the absorption of China and India,”

    Sir John Gieve
    Bank of England’s deputy governor for financial stability

    Has the BoE only just noticed the impact of China on inflation?

    The deflationary environment caused by China (+ India & Russia) addition to the global market place has clearly not been recognized by those central banks solely focused on targeting inflation.

    Asset price bubbles are the result of overly accommodative Central Bankers. The historical treatment of Developing Countries by the IMF will now be felt by many Developed Countries as the influx of short term finance risk being withdrawn from the table. Regardless of falling growth, I expect we shall now start seeing imported inflation … another China effect?

  • Posted by bsetser

    I second DOR.

    Sustaining higher s-t rates to offset the impact of PBoC purchases on long-rates is another.

    End mortgage deduction would be another, tho it is a political non-starter, esp. with home prices already falling.

    But all focus on restraining overall domestic demand,not targetting Chinese imports specifically.

    WTO makes that hard. that is why China joined!

  • Posted by Guest

    hmmmm… what else has reached nearly $1 trillion?

    “Mortgage-backed securities issuance soared from $184.5 billion in 2000 to nearly $1 trillion in 2005, generating more than $1 billion in fees last year.”

  • Posted by bsetser

    and anyone who has looked closely at China’s reserves would argue that there is a clear reason why MBS issuance and Chinese reserve growth seem correlated …

  • Posted by Joseph Wang

    Schumer-Graham right now is political theater. There is no companion bill in the House and there isn’t enough time to do anything with the bill before the recess. So what Schumer and Graham want essentially is an up-or-down vote for a bill that has no chance to pass just before people go off to campaign for mid-term elections……

    Since nothing is going to get done, it sounds good to me…..

  • Posted by Cyrus

    “It may well be that we’re coming to the end of quite a long period where goods prices were being driven down by globalization and the absorption of China and India.”

    I am skeptical of this claim. The savings in production costs made by locating manufacturing facilities in China et al have not yet been fully reflected in lower retail prices. I think it more likely that we are now entering a second phase of globalization, where weak demand in developed countries heightens price competition, forcing the savings made by relocating manufacturing in the first place to be finally passed onto the consumer.

  • Posted by Anonymous

    Dear Brad,

    Your Economist bashing is right. It is a terribly intellectually-enfeebled journal these days, which seeks in nearly all its articles to produce accuracy out of two or more inaccuracies, and by holding absolutely no fixed view on anything to either cover its tracks, and its ass.

    Of course they are not alone in this activity rather it appears to be the prevailing modus operandi.

  • Posted by DOR

    1913 Chinese railway bonds . . .


  • Posted by MrBill

    “”The unilateral Chinese emabarrassment is an artifact of the unholy alliance between the trans-national big business/ the Chinese government/ and, God help us, the Republican government of the United States of America.””

    RE put a stop to it now!

    I agree. That is why I am so fired up by all the policy ideas coming out of the Democrats right now ahead of the elections in November to tackle these problems and unholy alliances…. not.