There is no way to put a positive gloss on the December TIC report.  Total inflows — counting short and long-term flows — were negative.   The foreign securities bought by US private investors abroad exceeded the US securities bought by private investors abroad; net private were very negative.    Long-term private outflows (net) were around $8.4b, and short-term private outflows (net) were $34.1b.    Absent substantial net official inflows ($24b of long-term purchases, $31.5b total) the overall totals would have been far worse. 

Isabelle Lindenmayer  of the Wall Street Journal put it well.

"The TIC report suggests U.S. investors are starting to find confidence and value in foreign securities much the same way U.S. consumers have long found reliability and thrift from Toyotas and Hondas. Just as worrisome, foreign investors, too, may be starting to lose their appetite for U.S. securities.

… Though the TIC data are an imprecise gauge, they don't bode well for the U.S. ability to finance its huge trade and current account deficits in the long term, said analysts."

Our unnamed analysts are stating the obvious.  To finance a roughly $850-900b current account deficit, you need need over $70b of net inflows a month.   Not zero.  And certainly not a net outflow of $11b.

The disaggregated data continues to frustrate.  Overall, according to the TIC data, official investors invested $128.7b in the US in 2006 – up from $87.3b in 2005 but down from $341.6b in 2004.  Net long-term official inflows were a bit higher — $185.6b — but still below 2004 levels ($235.6b).   The big fall in short-term holdings clearly reflects the $38.5b fall in Russian short-term holdings (Russia moved a lot of dollars offshore in 2006. 

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Brazil's reserves increased by about a billion dollars yesterday.   I guess we know how many carry-trading hedge funds spent Valentine's day.

What jumped out at me in the latest quarterly from the World Bank’s Beijing office?

First, the data showing that labor income is falling as a share of Chinese GDP.    Moreover, its fall seems to have accelerated recently, just after the Chinese government started talking about the need to rebalance the economy.   See Figure 9 on p. 7.   As the World Bank hints, it will be hard to shift the basis of Chinese growth toward consumption if labor income keeps falling as a share of GDP…

Second, the data on China’s processing trade, or perhaps, the beginning of the end of China’s processing trade.   Non-processing exports are now growing faster than processing exports.   And processing import growth didn’t keep up with processing export growth (See Figures 3 and 4).    As the World Bank notes in a footnote: 

“The import/ export ratio in processing started to decline in 2005, after years of broad stability.”

Why?  Most likely because more and more components are made in China. 

Stage one involves shifting final assembly to China.  But once the one-off cost savings from that shift have been realized, getting more cost savings requires shifting parts production.   Stage two consequently involves shifting component production to China.  

The development of an internal Chinese supply chain for its final assembly plants is, I suspect, a bit reason why China’s trade surplus has increased so dramatically recently.

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It seems to me that there are at least three big stories in the US trade data, maybe four or five …

The first is that US exports grew quite strongly in 2006.  And goods exports outperformed services (and Boeing outperformed everyone).  Total exports were up 12.75%, goods exports were up 14.4% and Boeing (civil aviation) exports were up 38.8%.  On y/y basis, q4 exports were right in line with those trends.

The second is that the pace of non-oil import growth slowed.  Non-oil goods import growth (y/y) was around 9%, but the pace of growth slowed to around 7% in the fourth quarter.   The slowdown was apparent in the y/y data on US import growth from pretty much every source of goods imports other than China.  US imports from China are still growing 18%, but imports from both the rest of Asia (the rest of the Pacific Rim in the trade data) and Europe were up a bit over 7%.  The stunner — at least for me — was that total US goods imports from Canada were up only 4.5% y/y, and that total includes a lot of energy (Rachel Ziemba of RGE has more; Canadian exports to the US have been very weak recently).    

The third is that higher oil prices do lead even the US to cut back on its use of oil.  Petroleum import volumes fell 2.3% in 2006.

The fourth big story — one that is somewhat controversial for reasons that elude me — is that exchange rate adjustment works.    US exports to China were up by about $13.3b (32% — though the december increase was 21-22%, suggesting a slowdown in the pace of growth), but US imports from China were up by $44.3b.   The bilateral deficit with China continued to grow.   That is true of the Asian Pacific region writ large as well — US exports to the rest of the Pacific Rim increased by $20.5b, but imports were up by $22.8b.   The overall goods balance with the Pacific Rim deteriorated by about $33.3b.  

Both the yuan and the yen are fairly weak — and certainly haven't  moved as much against the dollar as the euro and the pound over the past few years.   So it is worth comparing the evolution of the US trade balance with the Pacific Rim to the evolution of the US trade balance with Europe.    US exports to the EU increased by $27.5b in 2006 (14.8%), while US imports only increased by $21.8b (7.05%), so the US trade deficit with Europe actually fell.  

The fact that the US deficit with Europe has turned a corner while the US deficit with China and Asia writ large hasn't is something that I thought Peter Goodman and Nell Henderson's story on the recent surge in US exports missed.   The y/y growth rates in US exports to China are impressive, but aren't coming anywhere close to offsetting the increase in US imports from China.   With Europe, by contrast, the deficit is heading down (and Europe, by the way did well in 2006 — adjustment need not be painful …)

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Evaluating Chinese trade data in January and February is hard, since the timing of the Chinese new year varies.   But the January data didn’t provide much evidence that the pace of China’s export growth is slowing.  With export growth in q4 (and so far in q1) running at around 30% y/y, China’s already large trade surplus looks set to get even bigger in 2007.  

That shouldn’t be a shock.  When China starts to worry about overheating and begins to restrict bank lending, investment growth – which is a big component of domestic demand – slows.  The result is a bigger current account surplus, especially since the RMB remains weak in real terms.  I expect China’s 2006 current account surplus to come in at around $240b – and the 2007 surplus, on current trends, to rise above $300b.

Add in $70-80b of FDI inflows and perhaps a bit of hot money attracted by China’s roaring stock market and expectations of a faster move in the RMB, and well, it is easy to see how China might need to add $400b to its foreign assets next year.  If all those assets showed up on the PBoC’s balance sheet, Chinese reserves would approach $2 trillion by the end of 2008, not in 2010 … 

No wonder there is talk of giving a new state investment company $200b of seed money – and intensive efforts to encourage Chinese state pension and life insurance companies to invest more money abroad. 

Now there is a little bit of a puzzle, since the available data from h2 suggests that hot money moved out of China.   Reserve growth (adjusted for valuation) lagged FDI inflows and the estimated current account surplus (see Florian Gimbel, who cites work by Standard Chartered).  

I don’t buy it.   Not really.   Stephen Green has done the sums correctly.   But a story based on hot money outflows in the second half of 2006 doesn't hold together very well.  

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The debate over the size of the yen financed carry trade is far from settled.   Former (“The Yen carry trade is on in such huge size”) and current traders (“real money investors ain't short yen and that even the gross — as opposed to net — spec yen longs on the IMM are above their 1,3, and 5 year averages”) do not necessarily agree. 

The biggest carry trade, no doubt, is the carry trade within the G-10.  Think borrowing yen to buy US dollars, Australian dollars, pounds and even euros.   G-10 currencies generally float, which means that price moves are often the best guide to flows. 

But there is also a carry trade that involves emerging economies.    That trade can be funded in dollars, euros or yen.   That trade also leaves traces – often in the form of rising central bank reserves.   More money coming in often means faster reserve growth

And all available data suggests that the scale of the carry trade picked up recently.    
Look at Brazil.  Its reserves rose $2b (from $91.88b to $93.82b) last week, after rising by nearly $2b the preceding week ($90.03b  to $91.88b).

Look at Turkey.  We don’t have data for last week (yet), but the week before, Turkey’s reserves rose by (gulp) $2.7b – going from $61.4 to $64.1b … 

Look at India.  The reserve bank of India supposedly bought $1.5b in the market last week.  That comes after buying about $1b in the last week of January, and about $3b during the month.

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I usually talk about the growth of the foreign exchange reserves of key emerging economies, but another feature of the past few years has been the fall in their external sovereign debt.   Joanna Chung of the FT not only has the story, but covers it extremely well.

I completely agree with one of the more controversial points she makes.  After the crises at the late 1990s (and 01-02 in Turkey and Latin America) the government of emerging economies decided that borrowing abroad, usually in foreign currency, wasn’t worth the risk.    Issuing a bond governed by New York was once seen a real achievement, a sign of new found financial strength.   Not any more.  

The governments of emerging economies are not borrowing — at least not in foreign markets — even through the money is there for the taking.   At rather attractive rates too. Chung:  

The reluctance to accumulate foreign debt also appears tied to a change in attitude toward global capital markets, which just a few years ago were seen as the quick route to jump starting economic growth.   ….   [the succession of financial crises from 1982 on] have taught steadily taught developing countries that a reliance on volatile world capital market is has serious consequences.   When the world economy is strong and liquidity is plentiful, bankers and bond investors alike have been happy to lend money to developing country governments.  But when times have turned tough and when governments have really needed the money, the markets have denied them access to finance.”

The US, as we all know, has no such concerns about its reliance on global capital markets.  It borrows in its own currency, which certainly helps.  But it also has never encountered a time when it needed money and the market wasn’t there …. 

Then again, the US doesn’t really rely on private capital markets.  The US has a much bigger official lifeline than the IMF ever provided emerging economies (and I don’t here the Wall Street Journal railing against the resulting moral hazard).  The world’s central banks – the key ones — have been willing to finance the US when private markets aren’t willing to do so.  Without any conditions, political or economic.

At least so far.

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The G-7 punted on the yen, more or less.  They didn't highlight yen weakness in their closely watched paragraph on exchange rates.  Though, as Morgan Stanley points out, the language on Japan ("Japan’s recovery is on track and is expected to continue. We are confident that the implications of these developments will be recognized by market participants") presumably was meant to send something of a signal. 

I wonder if the markets will pick up on the "recovery is on track" language,  or will take the absence of stronger language on the yen as an "all clear" sign to make even bigger bets on yen weakness.  

The G-7 did talk explicitly about the RMB.  That isn't a surprise, but Chinese presumably still don't  like being singled out.  China isn't a part of the G-7, and its currency was called out.  Japan is a part of the G-7, and its currency wasn't mentioned.  Yet by some measures the yen is now as undervalued as the RMB.   That sort of thing rankles the Chinese — even though it would be a far bigger deal for the G-7 to talk about the yen than the yuan precisely because Japan is a part of the G-7.

Intellectually, though, the language on the renminbi makes sense.   The G-7 called for an appreciation of the RMB in real effective terms. 

In emerging economies with large and growing current account surpluses, especially China, it is desirable that their effective exchange rates move so that necessary adjustments will occur

That is right.   China's current account surplus looks set to increase even further from its already enormous (8-9% of GDP) 2006 levels on the back of strong export growth and stable or falling commodity prices.  The RMB appreciated against the dollar (modestly) last year, but since the dollar slid v the euro by far more than the RMB rose v. the dollar, the RMB didn't move much in real effective terms.   The RMB/ euro matters, not just the RMB/ dollar.   Remember, China now trades as much with Europe as with the US. 

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Or, for that matter, Icelandic krona and Turkish lira … 

Borrowing at 1%, maybe less, in a depreciating currency, and buying an appreciating currency that pays 12.4% or so is pretty good business.  The Turkish lira pays more 20% , as does the Icelandic krona (14.25% — Kaupthing Bank has a nice description of the yen funded krona carry trade).  But they are a bit more volatile – for a comparison of BRL and YTL volatility last year, see the last two charts of this presentation.    And since last July, it is has been really good business.     

The 2 and 20 crowd doesn’t even need to use that much leverage on yen funded carry trades in the Brazilian real, Turkish lira or Icelandic krona to maintain their position at the top of the income distribution.    That kind of spread works with real money.  Or if you finance it with low-yielding Latin currencies rather than yen …

My colleague Victoria Saddi has noted that Brazil seems to have attracted $10b in portfolio inflows in January alone, judging from the balance of payments data.  It attracted $14b in all of 2006 (There was a little sell off in May and June that slowed things down). Brazil’s reserves increased by over $5b in January.   That is a $60b annual pace.   $60b is huge.  It is about twice what the IMF provided back in 2002 – funds that in all probability kept Brazil from a messy default.

Moreover, the pace of reserve growth seems to be accelerating.  There are press reports (in Portugese) that Brazil bought $2.5b in three days at the end of last week.  That is real money – almost China style money.    China has to buy about $1b a business day to keep the RMB down.    In the past couple of days, Bloomberg reports that Brazil's central bank bought around $0.5b a day.  That isn't quite China's pace, but relative to Brazil's economy, it is a lot.  The central bank's data, which lags just a bit, shows that Brazil's reserves are up $2b in the first few days of February.   

No wonder State Street’s positioning data shows that an exceptionally large number of investors are betting on the Brazilian real.  

Brazil’s government is understandably concerned that this inflow will push the real up too much, undermining Brazil’s competitiveness.  Sure, Brazil sells a lot of soy and a lot of iron ore.   But Brazil also makes goods that compete with Chinese goods – and, for that matter, Argentine goods.   And while high inflation is pushing up the real value of the Argentine peso (despite nominal exchange rate stability), the same cannot really be said of China.    The real has been appreciating v. the yuan. 

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When I saw that the US was initiating a WTO case challenging China's various tax favors and export rebate, I knew who to turn to for analysis.  

Emmanuel — a regular participant in the comments section – has long encouraged me to take a closer look at China's export rebates in particular.    

Rather than do that, I decided to give the floor over to him for a day.    Emmanuel's guest post follows. 

Emmanuel: 

The dispute over China’s large and growing trade imbalance with the United States centers on the perceived undervaluation of the yuan. Yet, other components of Chinese trade policy aside from its foreign exchange regime have largely eluded attention–until now. US Trade Representative Susan Schwab has just requested dispute settlement consultations with China in the World Trade Organization over Chinese measures that appear to contravene WTO rules. These consultations are just the first step in what may end up in judicial proceedings, though only about forty percent of such disputes reach the point of being resolved through rulings. If the US and China are unable to resolve this dispute after a period of bilateral consultations lasting sixty days, then the US can ask the WTO to form a panel to settle this dispute. (Continues)

Emmanuel:

Targeted are income tax reductions and refunds, value-added tax (VAT) exemptions, tariff exemptions, discounted lending rates, and exemptions from mandatory worker benefit contributions said to be made available to Chinese and foreign-invested enterprises (FIEs) satisfying certain export performance requirements. Also cited are income tax and VAT refunds given to companies that purchase Chinese-made equipment and accessories. See 4.2.1 (b) and (c) here for sample benefits to FIEs–many of which have ties to China’s neighbors. USTR charges that these are in violation of WTO stipulations on Subsidies and Countervailing Measures for they “require recipients to meet certain export targets, or to use domestic goods instead of imported goods.” Until the actual complaint is posted on the WTO site, there is still uncertainty over the specific products and measures in question (hat tip: International Economic Law blog).

The USTR charges that while it has repeatedly mentioned its concerns to them, Chinese officials have not taken steps to remove these measures. The timing of this episode attracts interest: Why is it only now that the US is acting despite knowing about these measures before? The Financial Times suggests that the administration is responding to pressure from the Democratic congressional majority over the bilateral trade imbalance, and that Bush is keen on winning congressional support for extending his fast-track authority in trade negotiations once it expires at midyear. This authority might be crucial if an international agreement is made during the restarted WTO Doha development round. I would add that election season 2008 is near, hence these efforts to garner political support–especially in the rust belt. If this matter is favorably resolved before reaching the adjudication stage, Republicans should gain clout with those in the manufacturing sector. Even if the case does reach the adjudication stage, it should still give Republicans political capital for they can point to “doing something” about China as proceedings will be ongoing right in the middle of the campaign season. It is a heads-up move politically. 

Some of these export-promotion measures are considerable, like export-tax rebates. In 1994, China introduced a national value-added tax system that had a main rate of 17%, with a rate of 13% applied to basic goods. Exporters were able to claim rebates of 17% and 13% respectively, effectively negating the VAT. While these rebates were reduced twice to 10% and 6% by 1996, the onset of the Asian financial crisis meant that China had to find a way of maintaining its export competitiveness. Though it did not devalue the yuan for doing so would have likely caused doubts over the soundness of China’s finances at a time when other Asian economies were in crisis, China did increase the rates of these rebates to compensate. According to official statistics, the average rebate rate reached 14.75% by 1999 and 15.6% by 2002. More recently, China has lowered rebates on export goods from high-pollution industries like steel and textiles. While the rates on these rebates have bounced around, the amount spent has increased in recent years together with China’s export growth. Below is a chart depicting what China has spent on these export-tax rebates in dollar terms using year-end conversion rates:

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