Brad Setser

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There is currently a shortfall in Chinese demand for the world’s goods, not Chinese demand for the world’s bonds

by Brad Setser
January 27, 2009

The tone of some recent commentary on the Sino-American relationship almost suggests that the US is so reliant on Chinese financing that it should be encouraging China to devalue the RMB to increase China’s current account surplus – and thus its capacity to finance the US deficit. Presumably it should encourage China to limit its fiscal stimulus too, so as to better assure the financing the US needs to sustain the large increase in its fiscal deficit. The last thing the US should want is any policy change that might, well, increase Chinese demand for the world’s goods. The risk that this would reduce China’s demand for America’s bonds is too great.

I disagree.

Right now the global economy is short of demand for goods, not short of demand for government bonds. The expected rise in the US fiscal deficit does not imply a rise in the current account deficit when private demand is contracting. It thus doesn’t imply any increase in the United States need for external financing, at least not in the short-run. The more China does to support global demand, the better – even if thus means a fall in China’s current account surplus and a gradual fall in Chinese demand for foreign assets. If a strong Chinese stimulus ends up supporting the global economy – and net exports help to pull the US out its slump — all the better.

Let’s go through several key points in more detail:

The core problem in the global economy is a shortage of demand for goods, not a shortfall in demand for safe government bonds

The collapse in global trade recently has been absolutely stunning. Exports are down over 20% in a host of Asian economies. China is actually doing comparatively well. Its exports so far have fallen less than Korea’s exports, Taiwan’s exports and Japan’s exports. Global output is falling.

Treasury yields have moved up a bit recently. But they remain well below their levels in say last September. The fact that yields have fallen even as the amount of bonds the G-7 countries are trying to sell into the market has soared suggests that there has been a large increase in demand for government bonds.

This could change, of course. But right now the global data suggests a sharp fall in output – not a sharp fall in demand for bonds or a rise in the risk of inflation. More demand for the world’s goods should be welcomed.

A rise in the fiscal deficit — under current conditions – does not necessarily imply a rise in the current account deficit, or a rise in the United States need for foreign financing.

This point isn’t universally accepted. Willem Buiter, for example, argues that the US should be cutting spending not increasing it – as any increase in the fiscal deficit would feed into a dangerous increase in the external deficit.

“The US is proposing policy measures that will increase its external deficit. The $825bn fiscal stimulus over two years proposed by the Obama administration will increase the US current account deficit. It will also strengthen the real effective exchange rate of the US dollar, unless there is a loss of faith in the ability of the US sovereign to service its debt in the future through higher taxes or lower public spending. … The last thing the US economy needs is a large fiscal stimulus, or indeed any fiscal stimulus at all. A good argument can even be made for a US fiscal tightening. Expansionary monetary policy is the only instrument available to the authorities that will both boost the US economy and correct its external imbalance.

Buiter is of course right that absent a counter-cyclical fiscal expansion, the current account deficit would contract faster. But it isn’t the case that the fiscal expansion necessarily implies an expansion of the United States external deficit. That is only the case if private spending and investment are constant. Then the rise in the fiscal deficit feeds directly into a rise in the current account deficit (or puts upward pressure on interest rates, which leads to a fall in private investment and a rise in private savings to free up funds to finance the fiscal deficit). Right now, though, a host of indicators suggest that private spending and investment isn’t just contracting, but it is contracting faster than the fiscal deficit is rising.

The trade deficit is a good proxy for the current account deficit (the income surplus and the transfers deficit offset). And it fell in the fourth quarter. Calculated Risk expects it to fall further in January based on the fall in oil prices. I agree. A $30 billion monthly trade deficit works out to an annual trade deficit of $360 billion – or well under 3% of US GDP. The deficit in the fourth quarter won’t be quite that small. But the current account deficit certainly fell in the fourth quarter even as the fiscal deficit rose.

Don’t get me wrong. I worry that the rest of the world will rely too heavily on the US to stimulate domestic demand and that the US alone will have to try to pull the global economy out of its current stall, with an associated rise in both the US current account deficit and foreign demand for US treasuries. This scenario implies that the US stimulus would eventually produce an expansion of US demand for imports and the more modest stimulus abroad wouldn’t generate a comparable demand for US exports, so the US deficit would rise.

There is also a risk that the fiscal stimulus will be bigger than the what the US needs, as the contraction in private demand will prove smaller than forecast. Up until now though the error policy makers have made is that they have underestimated the power of the contractionary forces in the global economy …

Right now though the United States external deficit is falling even as the fiscal deficit is rising. That can happen because private savings is rising. Merrill’s David Rosenberg recently observed “As it becomes increasingly apparent that the $13 trillion (and counting) loss of household net worth in this cycle is not coming back, look for the savings rate to head back to the Ozzie and Harriet levels of 10 to 12%.” Private investment is also falling. Unless something changes (and much could change, starting with the price of oil), the 2009 US fiscal deficit will be north of 8% of US GDP and the 2009 US current account deficit will be around 4% of US GDP.

A Chinese fiscal stimulus means less Chinese demand for US bonds

This stands to reason: the more China spends at home, the less it has to lend to the US.

But that too simple. Chinese demand for US financial assets (really the world’s financial assets) is a function of China’s current account surplus. More government spending only reduces Chinese demand for foreign assets if the spending lead to a fall in China’s external surplus. And that won’t happen if the rise in spending offsets a contraction in private demand. Private investment is currently falling in China. Unless private savings is also falling, the fall in investment would mean a bigger current account surplus and MORE Chinese demand for foreign assets. A bigger fiscal stimulus might just limit the increase in China’s surplus.

There is also a sense that the US doesn’t benefit if China spends more domestically, so the US loses access to cheap financing without getting anything in return. But that isn’t true. The fiscal stimulus only reduces Chinese demand for foreign assets if China ends up running a smaller current account surplus. That means more Chinese imports. And more Chinese demand for the world’s goods helps those in the US who make goods. The trade off isn’t between more domestic spending and more Chinese purchases of Treasuries: it is between Chinese purchases of Boeings and Chinese purchase of Treasuries.* China’s export revenue ultimately has to be spent abroad, whether on foreign assets or foreign goods.

A fall in Chinese reserve growth means less Chinese demand for foreign assets.

This would be true if the fall in reserve growth reflected a decision to let the RMB appreciate and a fall in China’s current account surplus.

But it isn’t true if the fall in reserve growth reflects a rise in private capital outflows rather than a fall in the current account surplus.

China’s total demand for the world’s financial assets is ultimately a function of its current account surplus (which, by identity, is the same as the amount that China saves that it doesn’t invest at home). If reserve growth falls even as the current account surplus rises, net Chinese demand for foreign assets is doing up not down. The demand is just coming from private Chinese investors.

The common perception that China has to finance the United States and Europe’s large fiscal deficits doesn’t add up. The GDP of the US and the EU, combined, is something like $30 trillion (the precise sum depends on the exchange rate). They collectively will likely run a fiscal deficit of between 5 and 10% of their GDP. That works out in very rough terms to a deficit of between $1.5 trillion and $3 trillion. China is a roughly $4 trillion dollar economy with a 10% of GDP current account surplus …. or about $400 billion to lend to the world. Barring huge change, China simply isn’t big enough to finance the kind of deficits now observed in the US and Europe. Those big deficits have to be financed internally.

Then, of course, they are the set of loaded questions surrounding China’s exchange rate regime …


  • Posted by Twofish

    bsetser: china’s export subsididy via its fx policy has neen a bad jobs policy (Strong growth has produced weak employment and compensation growth) and it will leave china’s future taxpayers with large costs.

    I disagree with this one. If you look at the rate of growth of incomes and employment, you could come to this conclusion, but this ignores two important facts.

    1) during the 1990’s and early-2000’s, the state owned enterprises were shedding massive numbers of jobs, so it wasn’t that export industries weren’t creating jobs. It was that new jobs were created as quickly as old ones were being lost. At the time the movement of jobs from the state-sector to the non state-sector was considered a good thing.

    2) as far as income stagnation. The problem was that Chinese SOE incomes in the early 1990’s were economically unsustainable. The SOE’s were paying out far more in wages than they were making in revenue, and this was the basic source of the NPL problem. If China had continued to keep the wage/GDP growth constant, it would now have busted banks.

    The other point is that the jobs created by the export sector were low wage, low skill jobs which is exactly what the rural countryside needed. The flip side was that because the export industry produced massive numbers of low wage jobs, people are now very seriously worried that it is gone.

    bsetser: it will leave china’s future taxpayers with large costs. at ists peak, the annual subsidiy associated with chinese intervention was as large as the TARP. And that is the estimated loss;

    True, but when you have to pay something is as important as how much you have to pay. In an economy that is growing, it makes sense to pay later, since future Chinese taxpayers will (hopefully) be much more wealthy than current ones.

  • Posted by Twofish

    Huizer: That (and only that) would realize the risk that current stimulus policies imply): the potential for stagflation.

    There are lots of things that could cause stagflation. This is why I’m so concerned about political/economic risks since if you have stimulus policies followed by a supply shock (i.e. asteroid hits Saudi oil fields), then you get stagflation.

    Right now the only thing that is changing is the demand curve. If you have a political crisis then you start hitting the supply curve at which point very bad things happen.

  • Posted by Indian Investor

    As King, So Subjects. (“Yatha Raja, Thatha Praja”), an ancient political scientist from India, Chanakya, wrote, cautioning the sovereigns that their behavior will be reflected amongst the population.
    While the US Government has high levels of Debt, the Chinese Govt has accumulated a lot of savings in the form of forex reserves. I managed to notice that India has a fiscal deficit and a trade deficit, both of which don’t seem to me to be at dangerous levels. This appears to me mirrored in the private sector “savings”, “investments” and consumption level as well in those countries.
    The common behavior of private entrepreneurs is to produce wherever it is cheapest to produce and sell wherever it is most profitable to sell. That isn’t going to change. The root cause of the “global imbalance” isn’t just in the level of imports and exports of merchandise.The fiscal policies of different governments can also be viewed as being largely independent of the levels of international trade, at least in theory. And given the unique role of the US dollar in international trade, the US is more advantageously positioned to follow a fiscal policy independent of international trade levels if it so chooses.

  • Posted by Rien Huizer


    Lots of things can cause stagflation but only strong trade restrictions can stop cyclical aggregate labor abundance in the West. And that is what is required to turn the present policies (and who knows what may be still on the drawing boards-desperate politicians always gamble for resurrection- in the US and some stupid EU countries not to mention our friends from the British Museum)into something poisonous. I know people may think I am an idiot worrying about stagflation while millions of people in the west worry about their future employment, but those people have the wrong skills and the right sentiments for trade conflicts, whilst living in a world that has become a lot more capitalist than 25 years ago.. Chinese do not have to worry though, trade friction usually hurts the protector.

  • Posted by don

    You are eactly right. Too bad others who advocate expansionary fiscal policy with no attention to the external balance don’t pay more attention to these points. Especially PK when he argues that overstimulus is not an issue – you can err only on the down side.
    We don’t need foreign demand for U.S. Treasury bonds to keep down the interest rate, because the problem is insufficient demand. Another way to make the point is to say that you don’t have to worry about the fiscal deficit ‘crowding out’ private demand when demand is deficient.

  • Posted by Emmanuel

    Your old boss is of the same opinion as Buiter that America’s CAD will increase, not decrease.

  • Posted by leftymn

    I am not at the level of macro or micro sophistication as most of the commenters here, but the Chinese are buying USA soybeans and soybeans from the world market like drunken sailors. On the other hand you only need look at world freight rate values to see that their demand for almost all other commodities in plummeting… freight values on soybean parcels of 70,000 tons from USA gulf to China may make USA soybeans cheaper delivered to South china than Chinese origin soybeans grown in NE china.

    my export ag business was weak from April to october 2008, since late November it has actually picked up to everywhere but Europe. I am not sure what that means other than inventory replacement is probably taking place. With the exception of Chinese soybean buying most buyers worldwide are living in a 60-90 day window and with credit tight and leverage low… speculative positions even by actual inventory takers is nil.