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Worry about a fall in China’s demand for the world’s goods, not a fall in China’s demand for Treasuries

by Brad Setser
January 18, 2009

Last week, Sam Jones of FT’s Alphaville wrote:

If the Chinese economy collapses, or even slows dramatically, then the raison d’etre for the country’s huge FX reserves – as a sterilisation measure to dampen domestic inflation – will evaporate. With that, so will China’s US Treasury holdings.

Or alternatively the Chinese could devalue the yuan. Either way, the US will be in trouble.

I like a good China scare as much as any one. But the first concern is, I think, off. A slump in China doesn’t mean an end to Chinese financing of the world, or even necessarily a fall in China’s reserves. Let me see if I can explain why.

Suppose China’s economy slows sharply — a not-impossible development given the rather starling fall in the OECD’s leading indicators for China. How would that impact China’s balance of payments?

The first impact is rather obvious. China would import less. It would buy less. And since the rise in Chinese demand helped push the price of various commodities up, it stands to reason that a fall in Chinese demand would push prices down. It probably already has. That implies a big fall in China’s import bill, and a larger trade surplus. A slowing global economy would hurt China’s exports, but in this scenario China would slow more than the world. That means China’s imports would fall more than its exports. China’s trade surplus would rise.

But, you might say, the current account surplus is determined by the gap between savings and investment. Why would that change in a slowdown? Simple. China’s slowdown reflects a fall in investment (especially in new buildings and the like). Less investment and the same level of savings means a bigger current account surplus. In practice, though, savings would also likely fall a bit — as a slowdown would cut into business profits and thus business savings. It possible that China’s households would reduce their saving rate to keep consumption up as their income fell. But it is also possible that Chinese households might worry more about the future and save more. My best guess though is that the fall in investment would exceed the fall in savings, freeing up more of China’s savings to lend to the world. That surplus savings has gone into Treasuries and Agencies in the past.

The second impact is harder to assess. A big fall in output might lead China’s savers to lose confidence in China, or rather to lose confidence in the RMB bank accounts as a stable store of value. The big fall in output might, for example, create expectations that China would devalue the RMB v the dollar — and Chinese households, anticipating the devaluation, would have a strong incentive to hold dollars. That likely means a rise in capital outflows.

Since reserve growth is a function of both the current account balance and capital outflows, it is possible that the rise in capital outflows could overwhelm the rise in the current account surplus. That seems to be what happened in q4.

In the absence of such outflows, though, the rise in China’s current account surplus would imply that China almost certainly would continue to add to its Treasury holdings. And even if there are large outflows — so large that the outflows exceed China’s current account surplus and China’s government has to dip into its reserves to meet the surge in Chinese demand for dollars — China would still be financing the rest of the world. The accumulation of foreign assets by private Chinese savers would substitute for the accumulation of foreign assets by the central bank, but money would still be flowing out of China. And some of that outflow likely would still make its way into Treasuries. Private Chinese demand for bank deposits would rise, and the world’s banks might decide to play the yield curve and increase their Treasury holdings. And if say Hong Kong intervened to keep a big inflow of funds into the the Hong Kong dollar from pushing the Hong Kong dollar up, the rise in Hong Kong’s reserves might increase the HKMA’s purchases of Treasuries.

The key point is that as long as China runs a current account surplus someone in China will be adding to their stockpile of foreign assets. It just may not be the government.

As importantly, the raison d’etre for China’s foreign exchange reserves isn’t “as a sterilization mechanism to dampen inflation.” Rather the opposite. The raison d’etre for China’s reserves is that China didn’t want the RMB to rise against the dollar, or at least not to rise by all that much. For most of the past six years, that has required the purchase of dollars by China’s government, as private demand for dollars fell far short of the private supply of dollars at the prevailing exchange rate.

The rise in China’s reserves, in turn, threatened to push inflation up. When the PBoC buys dollars, it sells RMB and thus in the first instance increases the amount of money in circulation. Since the PBoC wanted to avoid a rise in inflation, it then sold sterilization bills to remove the currency it printed to buy dollars from circulation. The net result is that the PBoC is left with a bigger balance sheet, one where it has more foreign assets and more domestic liabilities (the sterilization bills).

But China wasn’t buying dollars to hold inflation down. It was buying dollars to hold the RMB down. To keep the weak RMB and the expansion of the PBoC’s balance sheet from stroking inflation, the government had to “sterilize” the growth in its reserves and to run a tighter fiscal policy than otherwise would have been the case.

Think of it this way. A central bank that is buying reserves is growing its balance sheet — as it is adding to its assets. Some central banks expand their balance sheet by buying domestic assets (the Fed, for example). Others expand by buying foreign assets (the PBoC). The rise in the asset side of the central banks balance sheet is offset by a rise in its liabilities. If it doesn’t sterilize, the amount of cash outstanding increases. Cash, remember, is a central bank liability. If it does sterilize, the amount of sterilization bills rises. The PBoC was sterilizing because its balance sheet was growing faster than the economy’s need for new money, and it didn’t its balance sheet expansion to lead to a rise in inflation.

Now, as Michael Pettis observes, China potentially faces the opposite problem. Money is flowing out, reserves are no longer growing, deflation is a bigger threat than inflation and banks may no longer want to lend. I wouldn’t worry too much though about the risk that the money supply will shrink just because China’s reserves aren’t growing. Growing reserves can lead to money creation. But so can the same stock of reserves and less sterilization. And the PBoC has enormous scope to reduce the scope of its sterilization operations. The recent cut in the reserve requirement is an obvious example. Moreover, if the PBoC wants to expand its balance sheet, it always could start buying domestic Chinese bonds. The real challenge — as the US and UK are discovering — is getting the banks to lend in a shrinking economy!

Bottom line: A big fall in activity in China will tend to drive China’s trade surplus up. It thus would tend to increase — not reduce — China’s (net) purchases of foreign assets. Someone in China will still buying foreign assets — and likely providing indirect support for the Treasury market — even if it is not China’s central bank. A big fall in activity also means less Chinese demand for the world’s products — as well as less Chinese demand for China’s products, which frees up capacity to export. That adds to the deflationary forces in the world economy.

And right now, the risk of a shortfall in global demand strikes me as the bigger risk than a shortfall in demand for Treasuries. The last thing the US should want is a larger Chinese current account surplus, even if a larger suplus would increase China’s capacity to finance the US deficit.

What then should China do if the OECD’s indicators prove accurate?

David Dollar’s suggestions seem pretty good to me.

100 Comments

  • Posted by guest

    The fourth to last paragraph is confusing – should not one of the sentences begin “A big rise…”

    “Bottom line: A big fall in activity in China will tend to drive China’s trade …”

    “By contrast, a big fall in activity in China will instead put downward pressure…”

  • Posted by David Heigham

    The suggestions that David Dollar reports seem dead right to me. The news some months ago tha the Chinese government had decided to re-institute nationally provided health care seems to me to make it likely tha they are thinking on a large enough scale.

  • Posted by bsetser

    guest — thanks for the hint; I edited that paragraph.

  • Posted by Bob_in_MA

    Dr. Setser,

    I have a question in regards to the sterilization process.

    I assume these sterilization bills are not part of China’s national debt, per se, and that they just appear on the the PBoC’s balance sheet.

    Is the value of these roughly equal to that of the reserves? Were they sterilizing enough?

    A second question in regards to outflows from China. Mightn’t they not move to hard assets like gold, or maybe overseas resource assets (mines in Australia, say)?

    I’m no big gold bug, but there must be a lot of people in Iceland, Russia, much of the rest of Eastern Europe and even the UK, that wish they had had put more of their portfolio into nonmonetary assets, other than real estate.

  • Posted by john

    ‘Q4′ seems unlikely to continue as a trend, trade credit is already beginning to recover. I think that China’s c.account surplus seems more likely to decline on resilient demand, leaving the devaluation of the renminbi against the usd unlikely taking into consideration the us political pressures and fear of capital outflows.

    They seem to follow Keynesian style(as indicated) and hit on policy stimulus and fiscal spending together with an arsenal of resources(healthy budget balance surplus, liquid banking system, large foreign exchange reserves) which seem likely to support growth. Importantly the government still exercises a substantial amount of control over the economy. (Government spending, state-owned enterprises and bank and investments).

  • Posted by Pascal

    It has become clear that a global slump is good for treasuries and the dollar. The question is what happens when the world recovers, or should I say how fast the dollar drops and interest rates rise. China will countinue to finance U.S. since it cannot rebalance so fast.
    The crisis has also made clear that capital flows are much more important than CA balances (case in point: the Yuan)

  • Posted by Pascal

    To John: I doubt the surplus will decline, the drop in commodities prices has been too deep and the yuan is still undervalued which will support exports. China won’t save the world this time, since internal consumption growth is nowhere in sight. Maybe the next time…

  • Posted by David Pearson

    Brad,

    Much of what you say about China applied to the U.S. in early 1930. And yet, our current account surplus fell, our money supply plummeted and our savings rate fell. Why is the Depression-era U.S. not a good analogy for China? And how reliable was the U.S. as a source of financing for Europe in 1933?

    Also, what matters is not Chinese appetite for Treasuries. This can remain constant and still fall far short of what’s necessary. Adding Treasury, Agency and FDIC-guaranteed bank debt issuance, the U.S. government will need over $2tr in financing next year. You say Chinese reserve growth will be about $300b. Who will make up the difference? If its private savings, then the current account deficit will plummet, and so will China’s surplus. If its the Fed, then the outcome for the U.S. dollar is, to say the least, highly uncertain.

  • Posted by PG

    Brad,

    What do you think the composition of “hot money” inflows has been during these years? Did it mainly consisted of capital belonging to overseas Chinese? By your estimates, it was in amounts of hundreds of billions of dollars — isn’t it too much for only such a source?

    I agree the event of hot money outflows may be beneficial for USD. The new composition may be skewed more than 70% to the USD though it may consist of other instruments than short term treasuries.

  • Posted by Albion

    Brad

    Your scenario bears few strong assumptions « the world demand for Chinese products is inelastic » and:

    Receipts from abroad by residents will grow faster than payments by residents to foreigners abroad
    Domestic expenditures will remain the same and will not increase.

  • Posted by bsetser

    Albion — all scenarios hinge on assumptions. Mine included. I am not assuming that receipts with grow faster than payments tho. I am assuming that payments (on the current account) will fall faster than receipts. I.e. exports and imports will both fall, but imports will fall more (as in q4).

    Care to spell out a scenario where a sharp internal slowdown in China leads China’s current account surplus to fall? The only one I see is that the fiscal stimulus in China is huge, and that offsets the fall in investment …

    Bob — the increase in reserves was partially sterilized, so the stock of sterilizatoin instruments (bills, bank reserves, gov deposits) is a fraction of China’s reserves. i don’t have the precise data available. Gene Ma of ISI emerging markets is good on this, and Stephen Green and Wang Tao (stanchart and UBS respectively) periodically go over the data too.

  • Posted by Indian Investor

    @Brad:
    I didn’t understand why the RMB is expected to depreciate, especially when the reported consensus is that measures to stimulate external demand are unlikely to be fruitful.
    During the Dec 2008 China SED Paulson insisted with PBoC to hold the RMB stronger and since then PBoC has reportedly been trying to stick to their unspoken agreement to maintain economic stability.
    If PBoC were to devalue the yuan, how does that help? Demand for exports isn’t going to increase tho profitability of the export operations would be higher. Devaluing the yuan would increase their import bills when looked at in foreign currency terms, wouldn’t it?

  • Posted by Albion

    Brad

    You may be willing to introduce an alternative scenario where the economy growth declines much faster than the fiscal stimulus effects.
    See the following extrapolation
    http://ftalphaville.ft.com/blog/2009/01/15/51216/the-perfect-storm/

  • Posted by Indian Investor

    @PG: Here’s my guess at the “hot money” inflows to China:
    It was mostly Currency carry trade inflows, with the Japanese Yen and US Dollar as the funding currencies. The net effect of the complicated 5 steps of the carry trade was to help a hedge fund start with no money and ensure they’re borrowing at a fixed low interest rate on the JPY and USD, and investing in equities in China at high expected returns.
    That carry trade flow has already completely reversed, causing a much higher correction in the emerging market equity indices.
    What is often mentioned as “a flight to safety” and the “flight of capital from emerging markets” is a 1998 Asian Crisis hangover terminology.
    What happened was more obviously just a flight of capital from highly leveraged global financial institutions.
    Carry trades can start unwinding at the slightest hint of macroeconomic volatility, for instance speculations about a 0.50 % increase in Bank of Japan interest rate can cause markets to fall worldwide, through the unwinding of hundreds of billions of dollars’ worth carry trades.
    The 2008 Credit Panic obviously dealt a big blow to carry traders who had to unwind everything and wait for better times to come.
    They haven’t. If the RMB is expected to depreciate, the first thing you should expect is a big surge in the Chinese equity indices, as a result of carry trade inflows to Chinese equities that use the new zero interest rate policy (ZIRP) at the Fed to fund with USD, secure with the RMB depreciation expectations.

  • Posted by Bob_in_MA

    Dr. Setser,

    Thanks, I will look them up. I would think this is really important. If they were only sterilizing 50%, that would have been juicing global demand by ca. $400B/year, right? I’ve wondered if that effect (from China and others building reserves through exports) wasn’t a much greater factor over the last few years than Greenspan’s easy money policies.

    David,

    I looked into the China/U.S.-1930s analogy and it seems a little bit of a stretch.

    In 1929, our GDP was about $100B, exports about $5B and imports about $4B. Net exports were 1% of GDP, vs. 10% for China. That seems a pretty substantial difference. Plus we had high debt levels, especially consumer debt. Nothing like our debt levels today maybe, but we were not a nation of savers like the China, Japan, etc., of today.

    In those days, it wasn’t simply that we were supporting European consumption that created all the debt, most of it was left over from WWI.

    I was reading an essay by Keynes where he makes the argument that it was in our own interest to forgive the war debt. He made the point that debt payments restricted European consumption and therefor hurt US exporters (farmers as well as manufacturers) most.

    Maybe we can convince the Asians of that? ;-)

  • Posted by Indian Investor

    @PG: You should go through the Brad Setser/Andrew Rozanov (State Street) analysis of the Yen carry trade (2007) if you want to know the steps involved in a currency carry trade.

  • Posted by Indian Investor

    @ Bob: In MA, how do people make borrowing decisions?
    Suppose somebody in MA turns up at an auto dealer’s place intending to buy a new car @ ca. $20,000/= and the finance company provides a quote for the loan.
    In Bangalore people in a similar situation calculate how much they would be paying every month to service the loan. Based on the monthly payment and the term of the loan we can tell if it’s affordable, based on our (typically monthly) income level.
    People in Bangalore rarely decide on their loans based on the People’s Bank of China Geostrategic Foreign Exchange Reserve Level.

    As for MA, the Macroeconomists would have it that every loan is signed up based on the interest rate level on it. It looks like common people in the United States go mostly by the fact that a 1.5% reduction in the mortgage loan interest rate can justify somebody with a $28/hour job buying a house that is worth $330,000/=.

    Am I right here?

  • Posted by Pascal

    at Indian Investor: The notion that expected RMB depreciation will lead to surging stock indices in China sounds absurd to me. Why would anyone put money in any instrument if the currency in question is going to be devalued?

  • Posted by Indian Investor

    @Pascal: I’m being simplistic in this example but I hope it’s useful to you:

    @Pascal: Suppose you borrow $1 million at 0.5% for 3 months. RMB/USD is at 6.00. You’re expecting it to move to 5.00. Today you convert to RMB 6 million and you realize a positive return in the equity market over those 3 months.Even ignoring those profits, now RMB/USD is at 5.00. Converting RMB 6 million back to USD, you get $1.2 million (dividing 6 million by 5 gives me 1.2 million)
    That 20% extra dollars back justifies the inflow to the RMB when you’re expecting it depreciate by 20%.
    In the classical currency carry game people look for currencies that are expected to either stay where they are or depreciate, due to monetary policy outlook for that sovereign. Inflows to that currency are from other currencies on which the interest rate is much lower, such as JPY and USD.

  • Posted by Indian Investor

    LOL :-) I’ve gone seriously wrong with my basic arithmetic, or rather with my use of “depreciate” and “appreciate” :-)

  • Posted by Qingdao

    Brad,
    Because you repeat “that seems to be what happened in q4” to reserves makes me think you did not see Lardy’s post at Peterson Institute where he takes issue with that idea. You may be correct, but maybe you could comment . “If the Chinese economy collapses” as anything like the OECD indicators suggest, Chinese decision makers will have more important things to worry about than the rise or fall of foreign exchange reserves. Finally, it does not seem far-fetched to assume the U.S. economy will turn around by the end of 09; my guess is China will look more like Indonesia in 97-98.

  • Posted by David Pearson

    Sorry Brad, but you still haven’t answered the question of how BWII can continue with the yawning U.S. financing gap. Again, its not how much China is willing to lend, but how much the U.S. is seeking to borrow. If BWII falls apart (most likely as the Fed finances U.S. borrowing), then what replaces it?

    The reason I ask is you seem to be going out of your way to calm anxieties over Chinese financing of our deficit. Its not clear why. The anxieties seem to be grounded in a realistic view of the situation, and you’ve done little to dispel that.

    Sorry to be so blunt, as yours is one of the best blogs around.

  • Posted by Bob_in_MA

    Indian Investor,

    I’m not sure I understand your last paragraph. I would say that for people borrowing to buy a car, the thinking is the same. A reduction of 1% in the interest rate reduces the monthly payment by 5%, or whatever, so a person of a given income could buy a car costing 5% more.

    The problem here wasn’t just that the person with a $28/hour job was getting a loan to buy a house worth $330,000. It was that the person with the $14/hour job was often getting a loan to buy a house worth $330,000.

    I don’t think interest rates were much of a factor, just that the lenders lost all fear of risk.

  • Posted by gillies

    just as lenders lost all fear of risk – so, soon, will they lose all hope of profit. the stories in the media are relentlessly bad. we live in a new era where all the swans are black – and the occasional white one is in danger of being discounted, just as the danger signs were discounted in the boom.

    most economic decisions are taken by people who can sense the mood, even though unable to follow the balance sheets. the mood is negative, cautious, and in retreat. spending for the new year in china is down much like spending was for christmas in the west.

    i wonder if everyone appreciates how this slowdown is reaching into every furthest corner of the global financial system ? we are all in the same boat. we have hollowed out the world into one gigantic – titanic – vessel, and done away with watertight compartments.

    protectionism would confine bubbles to local economies. the globalisation project is fatally flawed.

    the economic events tracked on this blog will in 2009 and beyond need to be evaluated in terms of the related political and philosophical revolutions that are at hand. people – who are also voters, savers, and consumers – are about to be hit by the practical consequences of the financial turmoil.

    obama’s task is the economic equivalent of landing on the hudson river.

    if we all get out unharmed, that will be a miracle.

  • Posted by Indian Investor

    @ Bob_in_MA:
    It isn’t as if something very new has happened with the US Banking system in 2008, and that the world is looking to people like Brad Setser, or even you, and especially not me; to go explaining its causes and so on.
    These systemic banking crises happen all the time. In the 1990s all the Japanese banks went bankrupt. In the 1980s the savings and loan banks in the US went bankrupt. The UK shadow banking system failed in the 1970s. The Indian banking system failed in the 1970s and Indira Gandhi (no direct relative of Mahatma Gandhi) nationalized the whole banking system.
    Entire Sovereigns go bankrupt all the time. The US declared that the dollar wouldn’t be convertible to gold in 1971. Argentina defaulted in 2002. There have been Mexico crises all the time; Russia defaulted in 1998, soon after Hong Kong was handed over to China in July 1997.
    The list of systemic crises and panics is endless. As I’ve said before you can think about it as one major systemic problem every year, on a worldwide basis.
    So it’s clear and obvious that all these statements about the people borrowing too much, the US banks lending too much, the PBoC building too many reserves,Chinese people causing “a glut of savings”, etc.
    All of it is plain lies. None of it can be believed by anybody who has even an iota of common sense.

    Just Plain Lies.

  • Posted by Indian Investor

    @Bob: Well you have to know that only 5% of all mortgage loans was both sub prime and adjustable rate.
    And, 35% of all American homes are owned outright by their owners, with no mortgage on them. This is 2007 data from the Mortgage bankers association reports.
    Obviously this whole global Credit Panic wasn’t caused by those home owners going bust. The Panic was triggered deliberately.
    It’s so obvious.
    This is done deliberately all the time.
    Ask Brad. He studied all the IMF Bailouts and Bail-Ins and didn’t even reveal a single truth about the corrupt, decadent IMF Macroeconomists whose only objective is make some dough on the side from the IMF staff reports.

  • Posted by Indian Investor

    Please spend a few minutes reading this post above from Dr. Brad Setser once again, with an open mind.

    None of what Brad says in this post actually makes any sense. Read it carefully again. The whole post is completely, obviously, non sense. Every part of it.

    If this comes true, and China goes devaluing the RMB in a short while from now, you will know that there is a secret link between the US Treasury and the PBoC.

    Can anybody convince me there is an independent reason why PBoC benefits from devaluing the RMB now?

  • Posted by Dale C.

    Brad,

    I love your blog. But I think you are making a mistake. You are concluding that if China slows down, its imports will slow, but the demand for China’s exports will remain robust, and therefore its current account surplus will remain the same or even grow. I think that the demand for China’s exports will fall off a cliff. China supplies all that cheap crap at Walmart that Americans don’t really need to buy after all. The American consumer is going into hibernation, and the demand for exports from China is going to plummet.

  • Posted by Indian Investor

    @Dale: I don’t see where Brad is concluding that China’s export demand will remain the same. He’s just saying that the fall in imports will be larger than the fall in exports, so the surplus will remain and increase.
    But the more important issue is that all these theories about people having defaulted their home loans and caused a major geo economic war as a result don’t hold water. It’s a war out there. This isn’t about home loans.
    It’s about owning all the oil resources of central asia and owning all the banks and industries of the whole world.
    The wild conspiratorial suggestion that this is about a few select American home buyers who defaulted, that that was caused by the PBoC’s reserves, etc … these are all just plain lies to deceive the gullible public with false graphs and data.

  • Posted by Qingdao

    Indian Investor: may I suggest you take a few deep breaths, a few tranquilizers, then go somewhere quite and start your own blog?

  • Posted by Lyle B.

    Let’s begin by granting Brad’s point: “The raison d’etre for China’s reserves is that China didn’t want the RMB to rise against the dollar, or at least not to rise by all that much.”

    If you go back to the original statement by Sam Jones, and change the part between the hyphens, it looks like this:

    If the Chinese economy collapses, or even slows dramatically, then the raison d’etre for the country’s huge FX reserves – that China doesn’t want the RMB to rise against the dollar – will evaporate. With that, so will China’s US Treasury holdings. Or alternatively the Chinese could devalue the yuan.

    Even with that change, the statement still doesn’t quite work. A collapse in China would not, by itself, cause them to stop holding the RMB down. However, a collapse in US demand for Chinese products would have that effect. The Chinese have been trying keep the yuan at a level where Americans can afford their products. If Americans are not buying their products anyway, then the raison d’etre for China’s reserves disappears. They have nothing to lose by letting the yuan rise against the dollar. The same logic applies to other countries and their currencies. If the ROW stops buying Chinese products, then there is no reason to care about the value of the yuan. They might as well let it float.

    Brad: “A big fall in activity in China will tend to drive China’s trade surplus up.” I’m not sure why; if there is an equal fall in activity elsewhere, Chinese exports could fall faster than imports. Some of the things they import (e.g., oil) are necessities, but their exports are generally not necessities.

  • Posted by chart

    wont pay too much attention to OECD indicators. looking at the chart, since when is indicators accurately predict GDP? It seems there is 2-3% deviation. Given people over-reacting to current crisis and massive government stimulus. no surprise for OECD indicators to revise up later. I think worst scenario for GDP is probably around 6-7%

  • Posted by chart

    plus look at OECD indicator and GDP chart. seems like GDP leads OECD in the past. God forbid, for some twisted reason, this time 08, OECD lead GDP, not gonna pay much attention to it. I wouldn’t surprise to OECD indicators to revise up significant at some time later like in 01 and 02.

  • Posted by chart

    http://www.youtube.com/watch?v=8PIEGK0IbA4

    love Peter Schiff, love the 6 or 7 asian & 1 american story. this crisis is not necessarily bad for Asian countries. Probably best opportunities for Asian countries to turn the economic model to domestic consumption and greater Asia economic activities.

  • Posted by Observer

    The Chinese gov’t should just allow companies in the export-manufacturing industry to depreciate their assets by 50 percent and still have enough to mail people’s paycheck. That’s one way you can have a very immediate ‘stimulus’ to the soon-to-be unemployed industrial workers.

    The longer term issue is about eliminating inefficiencies in law and governance that hinders the development of a capital market. To do this, you would need some kind of real political reform to rein in bureaucratic control, at the least. The relationship between the courts and the state also have to be drastically altered, so that commercial court cases will not make decisions based on political expediencies. Accounting rules and standards must be established and reinforced and financial markets must also be liberalized.

    If they fail to take the necessary reforms to develop a credible capital market, good luck fostering consumption while people are making negative returns on their savings at the bank. I love how there are articles out about how China’s model of bureaucrats running the economy is superior to the Western model. It’s a total farce.

  • Posted by LastGame

    Just an important note to remember. Without the hard work of Asians, in particular Chinese workers the last 30 years the United States would likely never have seen the sort of prosperity we achieved. Even if this prosperity was an illusion, we could have made it reality if we would have used these funds for education, healthcare and alternative energy. But this is not the case.

    Our U.S. international corporations were able to make profits unheard of in the past. We paid bowls of rice for jeans, shirts, plastic devices and almost every product offered in wal-mart. We had 12 year old kids getting water and cereal every 4 hours he put together 50 pairs of Nike shoes.

    After the end of slavery in the U.S. the post-industrial revolution under “capitalism” needed a route for profits to increase. Through this, the creation of free trade agreements were placed in order and “special-relationships” were signed and sealed.

    Unfortunately, all great runs come to an end. We are well aware that much like the last days of slavery, we are near the last years of using the workers in some countries such as China. It is only natural revolution that the child is nearing development for maturity and independence. International corporations having bloated Americans with gadgets and goods meanwhile looted the pockets of most peasants see much more potential opportunity in the east. This potential is evident with the 1.2B potential consumers in China and all those with big savings in Japan.

    A global monetary crash is in order. Trade relationships will be broken (as Chinese exports continue going south). In the aftermath, U.S. corporations will focus on emerging nations.

    The clock is ticking, it’s only a matter of time. The 100’s of billions issued by policy makers is peanuts. Issuing more credit is part of the consequence, not part of the solution. The black hole is so immense that the U.S. as will soon approach a stage of entire insolvency. Corporate to consumer.

  • Posted by geert

    Brad

    Two quick remarks

    I get the picture why China’s trade surplus could still widen. But let’s apply the same reasoning on Germany, also an export driven economy (reasoning: falling export, falling import and falling internal demand). But Germany’s trade surplus narrowed. Where’s the difference? At this moment, all that comes to mind is that the value added of Germany’s export is way higher.

    Secondly you write that the current account surplus matches the gap between savings and investments and about the sterilisation process.
    The Chinese CB must exchange the dollars that come from the outside and that want to be exchanged for the local currency by its citizens. It’s not a choice.
    If the Chinese CB using savings to invest in $ assets (I still wonder how they do it) then I need to close the circle of money flows. What does the Chinese CB sell when it purchases dollars and to whom?

    geert

  • Posted by Rien Huizer

    Looks like China has arrived. It finally faces policy options commensurate with modern, developed economy status. Fireworks, lion dances are in order. And, pse behave like a normal western country..

  • Posted by Indian Investor

    @LastGame:
    No point in presenting actual real world facts and scenarios to the brilliant Oxford Ph.D. Macroeconomists.
    They are Neros fiddling with the balance of payments data while a quarter of the American population goes jobless and many of them are already bankrupt or staring at bankruptcy. The shops in the streets are closing down, and we debate the policies of the People’s Bank of China in great depth.

  • Posted by LastGame

    @ Indian Investor

    policies of PBoC are important. once the u.s.-pboc relationship evaporates (as it will) goes the T-bill bubble and with it the dollar. PBoC is so influential in U.S. politics that members within likely requested Obama to be U.S. president, at least this was the case with several Chinese corporations (ex. baidu).

    again, as i have mentioned before policy makers cannot tackle this crisis. Chinese exports will continue massive declines that will shock many of the most respected economists.

    2008 was the panic. Be patient,sometime in 2009 we will get the shock. I’m not sure if the u.s. is insolvent head to toe, but i’d guess we’re very close. From consumer to corporation to state and national govt.

  • Posted by gillies

    perhaps we cannot afford another boom.

    perhaps protectionism is the only policy that can prevent it ?

    the countries of the world cannot afford to march into another boom, even thirty years hence, in lockstep. some thinking about the nature of capitalism, and the limits of the natural world, is required.

  • Posted by LastGame

    @ gilles, agreed.

    Obama may find his only solution is to raise taxes on U.S. based international corporations that manufacture products outside U.S. and lower taxes on u.s. based companies who keep their manufacturing based domestically.

    Protectionism is around the corner and growing at an alarming rate. Start talking to Americans across the country and people will be shocked at just how great protectionist psychology on u.s. consumers is growing.

    If i ever China, it’d likely be smart to do another quick round of maybe 1 Trillion U.S. internal stimulus. They also need new trade agreements. The U.S.-China model is terribly impaired.

    I’m worried for the systemic global risks of the fallout to come.

  • Posted by Ying

    Observer:

    I am glad that you mentioned about capital market in China. It’s China’s policy goal to establish a fair, transparent capital market system. It is also important how you define what is fair and what degree of transparency it should be. Political influences some time is not a bad thing. If there is some degree of democracy in the country, the voices of different interest will be heard by politicians and in term policies will be implemented to ensure the best interest of the majority. A system without input of the people is a utopia. A system corrupted with few rich elicits will not last too long.

    Quite a few people run into the problem of confusing economy with business. The goal of business is to make profit. The goal of running a successful economy needs a holistic views of thousands of different things. To make things work, the government has to act and think in the interest of the majority. Anyway, winning has been the motto for US for a long time. The problem is that it create losers and sometimes I am the loser. I am not a fan of Chinese style democracy, either do the American style. But it sure looks like that there are lot more diversity of ideas and thoughts in China than in the US. That’s the hope for Chinese.

  • Posted by bsetser

    bob in MA — I have corresponded with LArdy on this argument and we both have been in touch with folks in China and we now more or less agree that the recap of ABC doesn’t account for the fall in china’s reserves in q4.

    indian investor –wow, i make no sense … go figure. my argument was a pretty straightforward application of any standard model of what happens if a country has a sharp slowdown and benefits from a positive terms of trade shock (commodity prices fell)

  • Posted by Dale C.

    Long Beach container traffic (mostly from China) dropped 25% in December, and it is still dropping…

    Posted date: 1/15/2009
    Long Beach Port Traffic Drops

    By FRANCISCO VARA-ORTA
    Los Angeles Business Journal Staff

    Cargo container shipments through the Port of Long Beach dropped 11 percent in 2008 – the biggest single-year decline in more than two decades and in stark contrast to 2007 when the port had its busiest year ever.

    The number of containers shipped into and out of the port fell to 6.5 million twenty-foot equivalent units, or TEUs, a level not seen at the port since 2004.

    The slowdown picked up steam throughout the year, with December marking the weakest month for the port; container volume tumbled 25.3 percent to 429,946 TEUs.

  • Posted by Greg

    bsetser: Bottom line: A big fall in activity in China will tend to drive China’s trade surplus up

    Why do you talk about this in the future tense? Commodity prices around the world are already way off. Exports of raw materials from Brazil and Australia (just to name a couple) are already way off.

    I don’t disagree with your arguments — but the effects were already in full swing during 4Q-2008.

  • Posted by Cedric Regula

    You have to remember a lot of commodities are bought on forward futures contracts, so they could still be paying peak prices in the Q4 data.

    Tho I think Brad’s call here is a tough one without lots more data that we and maybe even the Chinese don’t have. Its all very dependent on the structure of production, ie what is the median
    “value added” of Chinese exports. For instance, they have some companies that just buy aluminum, make it into tubes and export it to people that make radiators. They may have an 80% Bill of Materials. Here if prices don’t deteriorate, exports don’t fall off that much, then I would say it’s a no-brainer that falling aluminum prices will keep PBoC treasury purchases close to the same.

    But I refuse to go out on a limb and make that prediction for the real Chinese economy.

  • Posted by Twofish

    Heighman: The news some months ago tha the Chinese government had decided to re-institute nationally provided health care seems to me to make it likely tha they are thinking on a large enough scale.

    The Chinese government has been worried about the health care system since the late-1990′s, and started actively working on the problem since early-2000′s. They have been slowly rolling out the program since 2005.

    Healthcare is a hard, hard problem. If you read the reports of pilot studies by the World Bank (google for NCMS and World Bank) you quickly realize what a hard problem it is. This is why it has take 10 years to roll out, and also why it’s not going to have any immediate impact on the current crisis. Any impact on savings and spending is probably going to take three to four years.

    Education has similar issues. It’s one thing to say “free education to everyone.” It’s another thing to go through and actually try to do it, and this is another multi-year project.

    PG: What do you think the composition of “hot money” inflows has been during these years? Did it mainly consisted of capital belonging to overseas Chinese? By your estimates, it was in amounts of hundreds of billions of dollars — isn’t it too much for only such a source?

    My current guess is that overseas Chinese transmitted the money, but the money ultimately came from American banks. The chain of money, I think goes like this.

    Chinese savers -> People’s Bank of China -> Agency purchases -> US banks -> Export credits to overseas Chinese in HK/Taiwan -> local informal money lenders -> factories in southern China -> Chinese savers

    The reason that I think there has been a sudden outflow is that US banks are cutting export credits, and this is causing people in southern China to rapidly convert from RMB to dollars.

    This is all speculative, but it makes more sense as to the flow of money than anything else that I’ve heard of, and in particular, puts a face on “hot money” which I haven’t seen before.

    It’s impossible to have money flows of hundreds of billions of dollars without global banks involved somehow, and this cycle explains how they were involved. The big thing that this explains is that people had assumed that the informal money lenders had gotten their funds from local banks, but I strongly suspect that informal banks in China may be more closely tied to the international banking system than the domestic one.

  • Posted by Rien Huizer

    Dollar’s recommendations re well informed and correct. However more important is what the Chinese gvt can (given political and logistical constraints) and will do. Fiscal is only one of many constraints on Beijing’s policy space.

    It seems that China’s “private sector” is switching from hoarding raw materials and intermediates (steel especially) to the opposite. That may reflect (1) negative export expectations (2) negative expectations re (truly) domestic spending on infrastructure, buildings and cars (3) planned reductions in investment and production levels by foreign-controlled entities. But whatever may be most important, the highly visible reductions in import volumes of raw materials must be the result of decisions taken some time ago and reflective of expectations in say september/november.

    And the collapse in Chinese demand for iron ore and coking coal seems to be worse than orderly/smooth switching to somewhat lower production levels. Is it just a temporary(somewhat panicky) inventory adjustment, to be followed by a return to more sustainable levels of raw material consumption, or is this reflective of a new steady state? If the latter is true, China’s private sector may well turn out to be a drag on the world economy, instead of an auxiliary power source, no matter what the gvt may try to do to stimulate. This may also be the first time that the Chinese public se widespread business terminations unrelated to SOE reform, but due to good old mrket forces.

  • Posted by Twofish

    Observer: The Chinese gov’t should just allow companies in the export-manufacturing industry to depreciate their assets by 50 percent and still have enough to mail people’s paycheck.

    Since China has a value added tax system, I don’t see how this works. Also many Chinese migrant factory workers don’t get a “paycheck.” and certainly don’t get it by mail. They get cash.

    The big problem with closing factories is that often the factory owner will just lock the factory doors and just leave.

    Observer: The longer term issue is about eliminating inefficiencies in law and governance that hinders the development of a capital market.

    Except to have a capital market you also need a strong regulatory system. How to manage to find the right balance between a legal system that is too intrusive and one that is not intrusive enough is a difficult issue that takes decades to get right. However, I think that from 2001-2008, the US was too strongly underregulated.

    Also, I do not think that it is a good idea to structure an economy based on an ideology whether based on capitalism or socialism. One thing I do think is a very bad thing is when people get it into their heads that an economy *should* work in a certain way, that they don’t look at how an economic *does* run. Also trying to fit economies into simple labels is a bad idea, since often the difference between success and failure depends on the details. Whether “privatization” is good thing or not depends on what you mean by privatization and it also depends on the detailed structure of the economy.

    Saying China needs “laws and regulations” is useless because a lot depends on the exact content of those laws and regulations, and putting in a new regulatory system takes time as people go line by line through the laws and argue each point.

    (I can give you a two hundred page report that goes through the five drafts of the Securities Law, and goes article by article over the hundreds of debates that went into the law. You had people screaming at each other over whether to include three characters or not.)

    People have oversimplified and simplistic views of how the Chinese political and economic system works. When I talk about how the Securities Law evolved through the legislative process, many people are surprised that China has a legislative process.

  • Posted by Twofish

    LastGame: Start talking to Americans across the country and people will be shocked at just how great protectionist psychology on u.s. consumers is growing.

    Where and who are you talking to? I don’t get a sense of protectionist sentiment in New York City or in Texas.

    @Indian Investor: They are Neros fiddling with the balance of payments data while a quarter of the American population goes jobless and many of them are already bankrupt or staring at bankruptcy. The shops in the streets are closing down, and we debate the policies of the People’s Bank of China in great depth.

    You can be critical without being insulting. The reason we debate the policies of the People’s Bank of China (and the Federal Reserve and Treasury) in great depth is because *IT MATTERS*. Pick the right monetary policies and by mid-next year, things will be booming again. Pick the wrong monetary policies, then things will be broken for the next twenty years.

    So if you think that there is something that we should be arguing about other than macroeconomic policy, kindly please tell us what that might be. OK you have massive unemployment, banks are failing, and stores are shutting down, what do you suggest we do about it that doesn’t boil down to macroeconomic policy????

    And if your answer is *do anything at all just to prove you care* this is a horrible answer since if you do the wrong thing, it just makes matters worse.

    Again what do you think we ought to be talking about?

  • Posted by Twofish

    Also the reason that getting the data right is that if you get the data wrong, then you are just flying blind through mountains and you are going to crash the plane.

  • Posted by Observer

    Stephen Green at Standard Chartered wrote an article a couple of years ago about ‘hot money’. Explanations include loopholes on size of bank deposits, price transferring, inflated value of exports have all been attributed to the influx of dollars into the CB.

    Twofish: make the depreciation expense large enough to cover profits so the factories can still pay wages.

    Twofish: Except to have a capital market you also need a strong regulatory system.

    I think that’s what I said.

    In your quest to defend Chinese bureaucrats who abuse their power and contribute to inefficiencies in the financial system, you are setting up strawmen to beat up on when none exists.

  • Posted by Cedric Regula

    Observer:Twofish: make the depreciation expense large enough to cover profits so the factories can still pay wages.

    That sounds like a very large tax break to cover all of Chinese industry. Combine that with government stimulus/safety nets/social spending and all of a sudden we end up with the problem that China needs money !?!?

    And we thought they had all the money!!!!!!!!!!!!

    That means sell Treasuries ! Oh My!!!!

    Or issue Chinese Treasury bonds and compete with the rest of the G10 for global funds to borrow !!!!!

    I’m getting excited here…I may get more than 2% on my poor little nest egg after all.

    But then, I remind myself that China has a printing press too and what if the entire G10 just runs them full blast ????

    That could almost turn me into a gold bug again.

  • Posted by Observer

    If tax deductions can keep enough people on payroll then the government doesn’t have to wait for months or quarters til public expenditures on infrastructure and social safety nets to kick in and pray in the meantime that social stability won’t be a problem. I think the feeling is that something has to be done right now, and the choices are policy loans that will result in costly NPLs down the road or tax deductions so the financial institutions will at least stay intact.

  • Posted by Cedric Regula

    That’s the problem we have here. Stimulus programs, by definition, have to happen “right now”. But there is very little worthwhile that can be done “right now”, other than fix potholes and things of that nature. Any worthwhile infrastructure project takes at least a couple years of planning, engineering, etc…, then you start subcontracting for physical work and equipment.

    But China still is faced with the need to reduce production because the US had unsustainable demand. So layoffs will still be a problem, but they may be able to avoid industrial company bankruptcies and the associated stress on the financial system by eliminating corporate taxes. But they will still need to pay unemployment insurance.

    So all in all, this could get quite expensive.

  • Posted by Indian Investor

    Twofish:
    what do you suggest we do about it…?

    We need to set up a public transport infrastructure, such as new Metros, in all the large American cities. If it’s hard to dig up underground tunnels, you can have an Elevated Light Rail Transport System, similar to the one that’s being constructed in Bangalore.
    The projects should be executed in PPP (Public Private Partnership) mode.
    The projects will be profitable, because people will be willing to pay the ticket fare to get around the town on a Metro system. There’s already an unmet demand for this.

  • Posted by Indian Investor

    My opinion is that it doesn’t take too long to plan a metro, especially if it’s going to be ultra modern Sky Trains that give you a hard glass view of the City as you travel back and forth from work.

  • Posted by Cedric Regula

    They’ve been planning them for 40 years in Los Angeles and we finally got one tunnel from downtown to SF Valley.

    Anything energy or transport related is a 10 year project if all goes well, and it never does.

    Well, not completely true. We can buy buses faster than that.

  • Posted by Indian Investor

    Now let’s try to pitch the obvious solution in a grand macro economic scheme.
    In the short run, a public transport infrastructure leads to higher investment demand in that sector. At the same time, there might be a negative impact on investment demand in the private automobile manufacturing sector. In any case, in the crisis situation there is no investment demand for new auto factories.
    It can be argued that the long run effect of the new metros is to reduce consumption demand for private automobiles.But consumption demand is likely to reduce only for oil from the Middle East and not for domestic autos that are the result of US manufacturing.
    This is because even when there are metros, Americans can be depended on to purchase cars for travel outside their towns, and for recreational and ostentatious driving purposes.

  • Posted by Indian Investor

    @ Cedric:
    Yes, your idea is even better. Just copy large swathes from the London Bus materials and give a large order to buy buses and run them around as a public transport infrastructure in all the American towns and cities.

  • Posted by Cedric Regula

    Our cities aren’t shaped right for fixed rail. The only exceptions are NY and Chicago and they have them already. You need a large downtown employment center with spokes going out to the outer city and suburbs. But most US cities have decentralized. Call it urban blight or whatever.

    That was the problem with LA. There is no “to” and “from”. It’s like a big bowl of freeway spaghetti.

  • Posted by Indian Investor

    Let’s work on the capital flows of the thing, though. Where will the money come from, to build the new Obama government grand scheme to build Sky Train Metros all around the Seattle, Atlanta, Vegas, skylines?
    The Government will issue tax free infrastructure bonds and keep some money ready. Invite competitive bids from private players to build the things. Govt isn’t going to pay money out of the Treasury coffers at the word go here. The private players have to come to the table with their own money. Once they succeed in building, there will be some payments from the Treasury.

  • Posted by Indian Investor

    If there can be new metros in Delhi and Bangalore, I don’t see why there can’t be new metros in, say, Seattle. Especially if it’s going to be an elevated rail.

  • Posted by Cedric Regula

    I would want interest on my bonds immediately, but more importantly I would need proof that the government can use eminent domain to secure the land and avoid homeowner and environmental lawsuits blocking the plan and I don’t want to pay $500K a house for the thousands of houses they will bulldoze.

    No sir. My nest egg stays where it is.

  • Posted by Exporter to GANT

    I have to say this post is off the mark from Dr. Setser.

    Examples:
    “a fall in Chinese demand would push prices down. It probably already has. That implies a big fall in China’s import bill, and a larger trade surplus. A slowing global economy would hurt China’s exports, but in this scenario China would slow more than the world. That means China’s imports would fall more than its exports. China’s trade surplus would rise”

    Might not turn out to be true. The likely scenario is Exports fall inline wint imports ..not much spread gonna be there to create a huge trade surplus etc

    it is also possible that Chinese households might worry more about the future and save more. My best guess though is that the fall in investment would exceed the fall in savings, freeing up more of China’s savings to lend to the world. That surplus savings has gone into Treasuries and Agencies in the past.

    NO WAY ! Millions are losing their jobs. Where is the money for them to save ?

    In either case, current account surplus, trade surplus is gonna last for 6 months ? After that ?

    How long will china continue to add the reserves ?

    I think INDIAN INVESTOR is right in saying the post is a bit off the mark by Dr. Setsers standards.

    Not asking us to worry abt chinese reserve addition capabilities is like Greenspan asking US folks not to worry abt House prices…

    Some day this is gonna end !

  • Posted by Twofish

    Observer: In your quest to defend Chinese bureaucrats who abuse their power and contribute to inefficiencies in the financial system, you are setting up strawmen to beat up on when none exists.

    One of the things that I believe is that what a lot of people pointed to as “bureaucratic inefficiency” actually will turn out to be “prudent reserves” that will help China avoid the banking crisis that the United States has had. Personally, I think it was a fixation with “efficiency” that causes a lot of the problems we are seeing now. Lifeboats and fire drills are highly inefficient, until you need them, and it’s a proper role of bureaucrats (both American and Chinese) to require banks to have lifeboats and safety systems.

    Observer: If tax deductions can keep enough people on payroll then the government doesn’t have to wait for months or quarters til public expenditures on infrastructure and social safety nets to kick in and pray in the meantime that social stability won’t be a problem.

    Except that very few Chinese people and corporations pay direct taxes. The Chinese taxation system works on a value-added tax system and the government has already put in rebates on those. There is also only so much that the Chinese government can do without hitting WTO restrictions.

    Also Chinese migrant workers aren’t paid with anything like a “payroll.” The payroll and taxation system in the US is very unique, and it’s not the way things work in China. For one thing, Chinese people do not have anything like a Social Security Number and Chinese companies do not have Employee Identification Numbers, which can be used to track people for tax purposes. Without a SSN or EIN, how do you figure deductions? You can’t, which is why China has a value-added tax because to collect VAT, you don’t need national tracking numbers.

    And just getting everyone in China a Social Security Number is going to take two to three years. (Now, do you see why getting a national health care system is non-trivial.)

  • Posted by Twofish

    @Indian Investor: We need to set up a public transport infrastructure, such as new Metros, in all the large American cities. If it’s hard to dig up underground tunnels, you can have an Elevated Light Rail Transport System, similar to the one that’s being constructed in Bangalore.

    Fine. Which requires time and money, and the amount of money available is determined by fiscal and monetary conditions which depends on the actions of the Central Banks, which is why we are discussing trade balances. If we don’t discuss how much money and credit is available and the consequences of using it, then nothing else matters.

    @Indian Investor: The Government will issue tax free infrastructure bonds and keep some money ready.

    Which government, Federal, State, Local? If the Federal government funds the infrastructure, then you will have a big fight as state and local governments do not want the Federal government to tell them how to spend their money. If you have state and local governments fund this, then you have a whole raft of other issues. Most state and local governments can’t issue bonds without a voter referendum, and then even after the issue bonds, the credit markets are such that it’s hard to issue muni bonds.

    The problem with magic wand solutions is that you end up with allsorts for complexity, and this is why making policy takes time.

    @Indian Investor: Invite competitive bids from private players to build the things. Govt isn’t going to pay money out of the Treasury coffers at the word go here. The private players have to come to the table with their own money.

    Except they won’t. No private construction company is going to touch a project unless they have a guarantee of payment of some kind. Also private construction companies usually don’t operate with cash on hand, they get money from *tada* the banks, and if the banks won’t extend credit, the construction companies can’t do anything at all, and banks will not extend credit unless they have a signed contract (and maybe not even then).

    But all that is for another discussion board. If we can’t get credit to build infrastructure then none of this matters.

    @Indian Investor: Once they succeed in building, there will be some payments from the Treasury.

    Which Treasury? Is this going to be financed through user fees, through a trust fund, or through general revenues? There are about fifty different ways of structuring a public works construction contract.

    All these details matter.

  • Posted by Twofish

    The problem with using corporate income tax cuts as stimulus is that if you are losing money, then you aren’t going to be paying any taxes anyway.

  • Posted by Indian Investor

    @Twofish:
    I agree with you I haven’t worked out how this public transport infrastructure will come about. But I didn’t intend to, because this is already quite well known and understood.
    Infrastructure financing is quite a widely studied area and most of the structured finance techniques originated from there.
    It’s easy to see that while everybody is cribbing a fall in the aggregate demand, there is a clear and present supply side problem in public transport infrastructure for American cities and towns.
    When you have maillions of potential commuters on public transport in American cities, willing to pay reasonable travel fares, it should be possible to execute those projects in a public private partnership mode without affecting the indebtness and creditworthiness of the government.
    Cedric raises interesting questions as to how problems such as the destruction of private property and environmental impact can be addressed in these urban infrastructure projects.

  • Posted by cdr

    Not asking us to worry, adding all the numbers – not just the US`s –up and comparing them to what’s left might be backstopped later on (after observing all intermediate and in-between shows and commercials) by another master event (master print) in planning, on top of all the lower lying ones: the new SDRs one.

    Successful jockeying for initial positions on that out of the hat trick (to get initially allocated) might imply us turning into “developing countries” by then and after seizing whatever funds possible from them and any appearance of any sideline, based on the perceived spreads of risk.

    Of course, the high priests of creationism (printing) to whom the fraudsters turned to for temporal salvation of their woes will – by then – have to do something about those growing number of amulet (that the dollar once was derivative of) worshiping pagans.

    On another doctors orders` footnote, don’t Chinese already suffer a headache over the empty and partially useless – recently erected – Olympic infrastructure? They’d be much better of if they chose to “shot themselves in the foot” early on in this show- before another set of events gets booked into their account.

    Initiative seized tends to turn the tables in this ”eventful show”, we’re at. IMHO that is.

  • Posted by Indian Investor

    If the PBoC makes any announcements about devaluing the RMB, I will be spot on to build up a massive short position on the Nifty. It will be a sure fire signal of the final collapse of the Indian IT services wage arbitrage currency play.
    The day PBoC devalues the RMB, the USD will start to fall down and soon it will sell for around Rs. 5/= a piece instead of Rs. 48 a piece.

  • Posted by Indian Investor

    The Chinese exchanges were held up by yen carry trade and USD carry trade inflows, that have already unwound. There isn’t any “hot money” in China that’s going to unwind now.
    In Dec 2008 before the SED there was widespread expectation that PBoC will devalue and after Paulson’s insistence they assured they will appreciate the RMB further.
    It’s important to know when a country devalues and when it defends its currency.
    Studying the behavior of Thailand, Korea,etc in the Asian crisis of 1998 will give you the answer.
    When there’s a credit crisis, there’s an outflow of capital, specifically unwinding of ECB the local economy. This outflow causes a drop in forex reserves, endangering a situation where that country has to approach the IMF for an external financing bailout loan.
    To stop the outflow of capital, that country’s central bank spends from its forex reserve to defend its currency. This makes its exports less competitive, especially if there is another export oriented economy, such a Japan in this case, with a weaker currency. As exports fall and imports remain largely the same, the trade account outflows cause a further drop in the country’s forex reserves.
    As the forex reserve levels get to dangerously low levels, the central bank finally gives up and devalues the currency.
    Exactly the same sequence has been observed in the behavior of the Russian central bank during the current crisis. While Russia was spending a lot from its reserve to defend the rouble till Dec ’08, in the last weeks of Dec ’08 the rouble was devalued THRICE in the same WEEK!
    Now, it’s important for a clever investor to remember that China has exports of around $1.2 trillion and $1 trillion worth of imports per year, and that it has a forex reserve of around $2 trillion.
    Trade flow changes show that as exports fall, and commodities prices fall, China’s reserves are growing, rather than falling.

    The US Treasury is depending a lot on the availability of PBoC funding to raise capital for the stimulus plan.

    There have been a few speculative reports
    1) that PBoC is buying EUR and changing the composition of its forex reserves.
    2) that there are pilot projects on to settle trades by two of the southern provinces with other south asian countries in RMB instead of USD.

    In this context you have to correctly examine the implications of a decision by the PBoC to devalue the RMB against the USD and realize the actual effect on the USD, rather than the one postulated in Brad Setser’s blog post above.

  • Posted by Indian Investor

    So China isn’t facing even a remote chance of a collapse of its forex reserve levels in the short term. If China were to devalue slightly, or appreciate the yuan slightly, either move wouldn’t lead to a forex reserve collapse.
    If China is planning to spend huge amounts, say a few hundred billion, financing the US Treasury, PBoC will care a lot about having the RMB/USD exchnage rate reflect a healthier valuation of the USD than otherwise. If China on the other hand has shifted the composition of its forex reserve more to the EUR, and is contemplating life without the US Dollar, then the concern about “preserving the value” of its “investments in the US”, viz. the RMB/USD rate and the Treasury bonds doesn’t exist any more. China can afford to not buy any US Treasuries then, and that will make the USD collapse quite certain.

  • Posted by Indian Investor

    If the RMB is devalued, that is good for China’s exporters. They have a choice to hold on to higher profitability, or to reduce the dollar price of their exports to improve sales. This is the other factor to reason out.
    I need to be sure I don’t make any silly mistakes with the “appreciation” and “depreciation” logic here, so that I don’t end up doing the wrong thing and losing a lot of money because of arithmetical confusions.

  • Posted by Indian Investor

    Ok, what I’ve concluded, after a great deal of further spinning all the macro economic whirligigs in my thoughts, is that they don’t matter, and they can’t tell you what’s going to happen.
    I’m expecting that PBoC will buy a tremendous quantity of the new Treasury Bonds that are going to be issued. The US Treasury is increasing its issuance to meet the demands of the 2008 Credit Panic.
    At the same time, there is a fall in China’s exports, and the associated imports, leading to lower commodity prices and an increase in China’s trade surplus.
    I’ve now separated those two things out.
    PBoC had a Treasury buying program connected with those trade and surplus levels before the sudden increase in Treasury issuance.
    Now PBoC will simply buy up the additional T-Bond issuance, for geo-political reasons.
    This purchase of newly issued T-bonds will make the RMB weaken against the USD, for sure. So, there you have your PBoC policy to “devalue the RMB”.
    This doesn’t have to do with the Asian crisis-like reasons, and the on going Russian situation. It’s a devaluation for geo-political reasons.
    Now everything is quite clear. It was never a standard model, or its application, or the beneficial terms of trade plus fall in exports combination, or anything like that.
    You have China’s leader Wen Jiaobao worried about jobs for the Chinese people. You have Barack Obama worried about jobs the Americans. Obama will issue T-bonds and Wen will buy them. If anything different happens, both of these people are going to be in some really serious trouble.
    I think I have a better model here, that is much easier to understand, as far as I can see.

  • Posted by Indian Investor

    What I noted down from Barack Obama’s inauguration speech is that a pipeline South from the Caspian Sea through Afghanistan to an Arabian Sea port on Pakistan’s coastline is going to be the Department of State’s highest order priority.

  • Posted by Indian Investor

    I mean, my translation of the “winning a lasting peace in Afghanistan” phrase.

  • Posted by Indian Investor

    There seem to be a lot of people wondering if PBoC is going to buy the new T-Bonds or not, and how much they’re going to buy, etc.

    Now that I know PBoC is going to buy Treasury secs like there’s no tomorrow, how do I make some money out of this knowledge?

    For one thing, all the markets should go up when the PBoC actually goes and buys these Treasuries, making the USD/RMB zoom up, giving positive cues to the USD to strengthen further against all the major currencies …

  • Posted by gillies

    a lot of emphasis on what china and other foreign creditors choose to do or want to do, and how much their citizens might want to save, in the future, etc. . . . .

    but it might simply be that there is less money circulating – exports down, imports down, employment down, tax takes down, confidence in trade down.

    i mean, the simple answer to many questions might be that, regardless of what people want to do, there is simply less money circulating to do it with . . .

    surely that is a recipe for bond sales down, interest rates up, bond prices therefore in decline. incentive to save, up. cost of borrowing, up.

    leading to round two of bankruptcies, forced sales, asset declines, fear of lending, fear of borrowing.

    i think that supply and demand, if allowed to operate in a capitalist market fashion, will cause interest rates to rise as circulation of money slows ? tell me if i am wrong.

    p.s. our irish banks are all broke – if you tried to call in the property loans tomorrow. how did yours escape ?

  • Posted by bsetser

    there has been a rather large amount of critical comments on my observation that a slowdown in china would tend to increase China’s purchases of foreign assets. i don’t find the criticism persuasive.

    two points –

    a) I was keying off the FT alphaville article, which started by assuming a big slowdown in china, bigger than is expected now. they assumed that this would, relative to the current baseline, imply a smaller Chinese external surplus. i disagree. A domestic slowdown tends to increase a country’s current account surplus (with a big fall in investment the usual driver — think of asia’s 97-98 crisis)

    b) this isn’t to deny that the global slowdown will slow china’s exports. it will. but realtive to a world where the world slows and china grows, a world where china and the world both slow is one where china tends to run a larger current account surplus. the trade balance is determined by imports.

    c) it is quite possible that china’s real exports could fall faster than real imports, and trade could subtract from china’s real growth and yet china’s surplus could still rise. why — the impact of the shift in china’s terms of trade. china import a ton of commodities for its own use, and the price of commodities has fallen sharply — far more than the price of china’s exports.

    the real and nominal trade surplus might move in opposite directions. this incidentally happened with the us trade deficit when oil rose — the real balance was getting better; the nominal deficit stayed large.

  • Posted by don

    Brad Setser: “Care to spell out a scenario where a sharp internal slowdown in China leads China’s current account surplus to fall? The only one I see is that the fiscal stimulus in China is huge, and that offsets the fall in investment … ”
    What if saving and investment fall by the same percentage? Then, since the initial level of investment is much less than that for saving, the current account surplus will fall (the absolute fall in saving will exceed the absolute fall in investment).

  • Posted by don

    David Pearson responds:
    “Sorry Brad, but you still haven’t answered the question of how BWII can continue with the yawning U.S. financing gap. Again, its not how much China is willing to lend, but how much the U.S. is seeking to borrow.”
    I forgot to supply the reasoning in my post above. As DP points out, the U.S. and some other trade partners may seek to reduce their trade deficits by trade restrictions (or strong tactics to force the end of China’s currency interventions).

  • Posted by Observer

    Twofish: Lifeboats and fire drills are highly inefficient, until you need them,

    The problem for the Chinese lifeboat with the fire drill is that it just struck an iceberg for which your fire drill aint gonna do a thing. Inefficient DOES NOT mean less systemic risk, says Chinese banks of the 90s.

  • Posted by Indian Investor

    Brad:
    there has been a rather large amount of critical comments on my observation that a slowdown in china would tend to increase China’s purchases of foreign assets.

    As you can see I’ve now reasoned it out correctly and you’re right in saying that China’s purchase of foreign assets will increase.
    My point is that this follows from reasoning out the compulsions to maintain the employment of the two countries, rather than from shifts in the trade flows.

  • Posted by dunnage

    Thank you for an execellent article. Quality.

  • Posted by Indian Investor

    @gillies:
    Download and read all the recent CFR reports on all the various regions.
    Study the changes in banking ownership in more than a dozen countries.
    Get to know all the production sharing contracts, oil pipelines, gas pipelines, plan for pipelines, ownership of those, shippers and shipment levels
    Study all the reports of attacks on oil pipelines and the occurence of medium intensity wars involving armies and militant groups
    Read the history of all the previous crises, 1998 Asian crises, 1932 depression, crises in Mexico, Argentina, etc all the way back to 1340 King Edward Defaulting the Venetian banks.
    Now you have the picture. You know what’s happening, and you can tell what’s going to happen, as well.

  • Posted by assistant

    @indian investor.

    since you seem to be our magic ball…tell us what happens in 09′. what will be the biggest impact of the crisis, or the climax of our movie.

    thanks.

  • Posted by Twofish

    Observer: Inefficient DOES NOT mean less systemic risk, says Chinese banks of the 90s.

    It does, and the experience of Chinese banks in the 1990′s illustrates nicely my point.

    Lehman Brothers was only about to be insolvent for about a week before it stopped operating. Chinese state banks were able to continue to operate for about a decade even though they were insolvent, and that was because they were highly “inefficient.”

    The reason for this is that Lehman had about 3% of their assets in cash or near-cash equivalent. Chinese banks in the mid-1990′s had about 50% of their assets in cash or near-cash equivalents. What this meant was that the second Lehman went insolvent, it was game over, whereas Chinese banks in the 1990′s could continue to operate even though they had huge amounts of debt, because they had large holdings of cash.

    The same is illustrated by the commercial banks in the US. Investment banks were leveraged 30:1. Commercial banks are leveraged 10:1 and have a cash line from the government. What this means is that investment banks had days to deal with insolvency, US commercial banks have months, and Chinese banks in the 1990′s had years.

    Where the US ran into trouble is having cash reserves and not using leverage is seen as inefficiency, which it is. If you have cash reserves and you don’t use leverage, you are big and slow. But if you hit an iceberg, then you *want* to be big and slow, because the bigger and slower you are, the more time it takes for the ship to sink and the more time you have to do something. If you have five years to fix a problem, you can do all sorts of things that you can’t do if you have five days or even five hours.

  • Posted by Twofish

    @Indian Investor: I think you are completely off base with your conspiracy theories.

    What you need to do when you study history is to look at what people *at the time* thought they were doing and why, and one thing that you quickly learn is that people are horribly bad at predicting the consequences of their actions, and history also causes actions to have unexpected consequences. Sometimes unexpected good. Sometimes unexpected bad.

    The problem with reading history is we know what happened, and one thing that is interesting is to look at history with “blinders.” Read what people were doing in 1929 *knowing nothing about what happened after 1929*, and you quickly find that people seem to be doing reasonable things that had extremely unexpected consequences. The actions of the Federal Reserve and Treasury in 1929 were perfectly reasonable *given they knew what they knew*, it’s just that we have the benefit of knowing what happened. You don’t even have to go back to 1929. Go back in time to 1998, 2000, 2003, 2007 and try to remember what the world looked like at these dates. (It helps if you are older.)

    This is extremely important in trying to figure out what to do, because *we do not know the future*. It’s certain that we will be doing things that will seem bizarre and stupid to people that do know how history turned out, and it’s also certain that there will be a lot of unexpected happenings. It’s also a constant of history is that the solutions of one era become the problems of the next.

    Once you realize how important chance, fate, and the unexpected are to historical events, then the notion that the entire world is run by a few people that control everything becomes impossible to justify. There is a power elite in the world, a relatively small set of people that have the ability to make key decisions, but they are human and they cannot see the future or even totally understand the full consequences of their decisions.

  • Posted by Twofish

    I think that much of the capital flows are due to “pull” rather than “push.” It’s not that people in China are trying to convert RMB to dollars (i.e. capital flight), but rather Western banks are trying to gather every penny that they can find, and if they can find a way of pulling dollars out of China, they are.

    The other thing is that any sort of sustained economic slowdown in China could lead to a political crisis, and I haven’t seen anyone publicly think through how a political crisis in China would affect the world economy (most likely because thinking about this is too depressing and scary). The last major political crisis in China was in 1989 when it had nowhere the world impact that it does now. I can think of situations in which political crisis -> Chinese government crackdown -> US human rights reaction -> China dumps Treasuries to sink US economy. There are a lot of outcomes for a political crisis, but I can’t think of any scenarios in which a political or economic crisis in China would cause China to buy more Treasuries or be good for the world economy.

    Some other things that can be done:

    1) I think that the situation is much too fluid to say whether Chinese purchases of Treasuries will go up or down. It may be more productive to just list the factors that influence that decision so that you have a framework for seeing what happens as things evolve.

    2) The other thing to do is start at the end. What is the “very bad thing” that you are afraid of happening, and then work backwards to see how you get to that very bad thing.

    There is some good news. I’ve seen figures that say that the property market in China is stabilizing. Prices are still going down, but lots of people are snapping up cheap deals in real estate, and so the volume of real estate sales is actually going up.

    I think the huge savings is going to be very helpful for China to recover, since if you have lots of money in the sidelines, the markets don’t collapse when there is a massive price drop. You see a super-cheap house or super-cheap stock. The buyer has cash. The seller has cash. The buyer and seller both shake hands. The buyer gets a really good deal. The seller takes a loss but has cash. This is the way that markets are *supposed* to work.

    The problem right now in the United States, is that this won’t happen if the buyer and seller both have large debts. You don’t have buyers with ready cash, and what cash they have, they want to keep. The sellers are also broke so they can’t sell and realize a loss.

    An exercise for Austrian economists is to look at market microstructure. Austrians have developed a rather rigorous framework for going from the individual actions of buyers and sellers into social good. The basic idea is simple which is that the buyer and seller will only undertake exchanges that improve each others well-being, and therefore a system based on market exchanges will naturally deal to an improvement in social well-being.

    What I think Austrians should do is to look at situations where this breaks down.

  • Posted by Observer

    Twofish:

    It doesn’t matter how much cash you are holding. You can have 100% of your holdings in cash, but if the value of that cash in a particular currency drops down to less than the liability, then you would still be insolvent.

    The only advantage that the Chinese banks enjoyed is that the government is the shareholder, and thus the banks don’t have to worry about raising equity. If that’s a necessary disadvantage for private markets, so be it. But don’t confuse the Chinese government’s credit line as a sign that inefficiency works better. It doesn’t.

  • Posted by Twofish

    Observer: It doesn’t matter how much cash you are holding. You can have 100% of your holdings in cash, but if the value of that cash in a particular currency drops down to less than the liability, then you would still be insolvent.

    But being insolvent doesn’t kill a bank. It’s when people show up at your door step wanting cash that you don’t have that you are dead. You can run an insolvent bank for years as long as you have the cash to pay out withdrawals.

    Observer: The only advantage that the Chinese banks enjoyed is that the government is the shareholder, and thus the banks don’t have to worry about raising equity.

    1) Commercial banks in the US have lines of credit with the Federal Reserve. Investment banks didn’t, that’s why they’re are no more commercial banks in the United States.

    2) Also Chinese banks did have to worry about moral hazard issues in the end. If the Chinese government just wrote a check every time a bank needed money, then it would go into a black hole, and eventually the government would run out of money.

    So you have to think long and hard about how you recapitalize the banks, because you if you do the wrong thing, you will end up having to write check after check after check. This means that it is extremely important that you have time to think.

    3) The US government has the power to seize an insolvent bank and has done so (Washington Mutual). Depending on how bad things get, the government may end up nationalizing large parts of the banking system this year. One you reach a certain point then nationalization becomes inevitable.

    If people think that the government is going to take over a bank, then no private investor is going to put money into that bank because their shares are going to be diluted, and at that point the only one that can put money into a bank is the government.

    We aren’t quite at that point yet, but we aren’t that far away from it.

    In the case of TARP, there was a massive crisis and the US government didn’t have time to think about what to do. Right now something will have to be done about the commercial banks, but we have a few weeks to think about what that thing is.

    Observer: If that’s a necessary disadvantage for private markets, so be it.

    Personally, I don’t care whether the economy is private, public, some mix of the two, neither, both. I just want something that works. It seem obvious to most people that the system in place over the last eight years doesn’t work. The hard part is figuring out what to do about it.

    Observer: But don’t confuse the Chinese government’s credit line as a sign that inefficiency works better. It doesn’t.

    If you get 1% more GDP growth for five years, and then lose it all in a banking crisis, then the system is broken. Also, one thing that has become clear is that bank require some government credit line which is why all banking institutions in the US now have them. Once the government extends a credit line, then the government and the taxpayers are going to demand some control over the management of the bank, which is also what is going on.

    So at this point the US banking system no longer is anything like a private market system any more (and really the US banking system hasn’t been a private market system since at least 1933).

  • Posted by cdr

    It`s the same advantage that the US (and other western) banks will soon have pleasure to meet.

  • Posted by Michael

    @Twofish – under your point #1, I think you mean to say that’s why there are no more INVESTMENT banks in the United States.

  • Posted by Observer

    Twofish: tough to have a debate if you keep shifting the line of defense. You go from arguing that holding liquidity reduces the risk of insolvency, to insolvency isn’t the end of the world, to that as long as the government forces the taxpayers to protect the privileged elite like China has, everything is ok. All hail to the chairman.

    What we know is that China isn’t the only economy that has tried to gear growth towards a particular type of industrial policy, yet I don’t hear you exalting the virtues of the Japanese banking regulators or Korean regulators.

  • Posted by Twofish

    Observer: You go from arguing that holding liquidity reduces the risk of insolvency.

    No I’m not arguing that. I’m saying that holding liquidity reduces risk, by reducing the chance of a risks *when* a bank risks becoming insolvent.

    Observer: What we know is that China isn’t the only economy that has tried to gear growth towards a particular type of industrial policy, yet I don’t hear you exalting the virtues of the Japanese banking regulators or Korean regulators.

    Because Japan and Korea are different from China. In particular one reason I think China has been successful is that it doesn’t have much in the way of an industrial policy. There is nothing in China like the Japan’s MITI or Korean chaebol. Also I don’t say very many good things about Japanese banking regulators because they aren’t very good. Don’t know that much about Korean banks.

    Also, I don’t think industrial policy is a very good thing since it leads to micromanagement and distorted incentives. The reason I look very carefully at banks is that on the whole, they end up making the decisions about who gets credit and who doesn’t in a way that the government really has difficulty doing.

    The problem here is that I think you are insisting on putting economies into two groups, whereas things are more complex. You can see examples in history of good state involvement in the economy, you can see examples of bad state involvement. Similarly state non-involvement can be either a good thing or a bad thing.

    One other point is that things change. The Soviet Union and Japan had large amounts of growth in the 1950′s and 1960′s by huge amounts of capital investment and urbanization. This growth end in the 1970′s so by the 1990′s, both economies had major problems. Right now China is more like Japan-1950 than Japan-1990, so it isn’t a bad thing if China did massive amounts of capital driven growth as long as it realizes that it is probably going to end around 2020, and that it spends the time preparing for the transition.

    It’s really easy to live in a two shade world. You can divide everything into “good” and “bad.” My problem is that the world is very complicated. So when I look at the similiarities and differences between the Japanese and Chinese banking systems, I have to go into some excruciating detail, rather than just label “good” or “bad.”

    The evolution of the Japanese financial system over the last 100 years is very interesting. One of the more interesting things is MacArthur imposed in Japan in the late 1940′s a banking and industrial system that was American. But after the occupation troops left it didn’t take very long for it to evolve into something quite different.

  • Posted by Counterpointer

    Brad

    We shredded the World Bank report over at CR a month ago, and rightly so. As I pointed out, the absence of a treatment of transportation and energy was key. In the last crisis these were the two main indicators that we wanted and couldn’t get!

    I was there, it was real, and we all fed in from our cosy appts in Ta Yuan.

    Hao ji le!

    Regards

    C

  • Posted by Observer

    Fixing the exchange rate regime is probably the most potent industrial policy out there.

    And yes, gray income is a very powerful disincentive because it erodes a significant portion of incipient capital upfront with no guarantees whatsoever that the pigs won’t come back for more in the future. Let me ask you a question: would you invest in a mutual fund that has a front-end load of 5% and discretionary management fees of 5~10%, or one with .5% and minimum management fees? Please don’t say this is hard to decide.

  • Posted by Ian

    What about the hot money flows? Even if China continues to post a current account surplus (as it should be expected to as part of its ‘export-led growth’ strategy), the balance of payments also consists of the capital account, right?

    What if distress selling of RMB-denominated assets for repatriation to repay USD-denominated debt causes the hot money outflows to surpass the current account surplus?

    Would we not see a downward pressure on the peg? If so, would not US treasure purchases exacerbate the devaluation pressure? So rather than increasing its USD holdings, the Chinese central bank would be obliged to sell off US T-bills to defend the peg.

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