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More than a grocer

by Brad Setser
May 3, 2009

A few weeks ago, the always interesting Michael Pettis argued that China is more like a friendly corner grocer – the kind who provides its customers credit to buy the store’s goods – than a banker. Chinese lending to the US does little more than finance the United States purchases of China’s goods.

“a very wide-spread claim — that China is Washington’s banker — is based on a misunderstanding of the reserve accumulation process … it is probably more useful to think of China as a shop that sells to the US and accumulates IOUs, rather than as its banker. … Banker’s lend discretionary money, whereas grocers only accept IOUs from important clients on purchases from the store.

There is no doubt some truth to Pettis’ argument, though other regions – Europe comes to mind – have managed to run a large bilateral trade deficit with China without relying so heavily on Chinese vendor financing.

But Pettis’ argument no longer works in full. Recently China has been providing the US with more financing well in excess of what the US needs to pay for its imports from China. Most grocers don’t provide store credit to help fill up their customers’ pick-up, especially grocers that don’t own any gas stations. Yet back when oil prices were here, China was in effect lending the US some of the funds it needed to cover its deficit with the oil-exporting economies – and with other goods-exporting economies as well.*

China’s rise as a true banker shows up cleanly in the most recent US balance of payments data. The detailed data tables include a table on China. And it turns out China’s $419 billion in purchases of US assets over the last 4 quarters exceeded the United States $308 billion bilateral balance of payments deficit with China.

That’s a change. Back in say 2000, China used its large bilateral surplus with the US to finance a bilateral deficit with commodity exporters – and with Asian components producers. But over time the size of China’s surplus with the US (and Europe) rose, while the size of its bilateral deficit with Asia fell. Components production migrated to China. Throw in capital inflows (at least until recently) and China was in a position to buy very large sums of US debt.

The US data for 2008 actually understates China’s purchases. There is a large gap between China’s foreign asset growth and its recorded purchases from mid-2007 to mid-2008. The dip in China’s purchases then is a statistical artifact,one tied to the timing of the survey revisions. The last survey data — which hasn’t been reflected in the BEA’s data yet — suggests that China bought about $180 billion more US assets (mostly Agencies and equities, but also some Treasuries) than currently show up in the US balance of payments data. That revision would bring total Chinese purchases of US assets from mid 2007 to mid 2008 up to $450 billion – and official purchases up to $475 billion or so.**

That is an unprecedented amount of financing for the US to receive from a single country’s government.

The US balance of payments data doesn’t provide a clean estimate of official Japanese flows – but it does allow me to strip out Japanese FDI and Japanese purchases of US non-treasury bonds and equities from Japan’s total inflows. The remainder would be a reflection of Japan’s official purchases, together with the Treasuries bought by private Japanese investors (and there are private investors in Japan with Treasuries, it isn’t just an official flow; Treasuries yield more than JGBs). Flows from China’s government now are larger, relative to US GDP, than flows from Japan’s government and safety seeking private investors ever were.

For that matter, flows from China’s government now are larger that total flows from Japan — counting all private Japanese investment in the US — ever were.

And China, unlike Japan, isn’t part of a security alliance with the US. That is why the scale of financing the US now receives from China truly is unprecedented: it is now not only tops the largest inflow the US ever received from another country, but it is clearly by far the largest inflow the US has ever received from a government that the US doesn’t consider a close military ally.

Chinese financing of the US may also fall a bit in 2009. Less private capital is flowing into China – indeed, private capital flowed out in late 2008 and the first quarter of 2009. That will allow China’s government to go back to being a grocer rather than a banker, and scale down its purchases of US assets.

At the same time, the fall in the surplus of Japan and the swing into deficit on the part of the oil exporters means that the world’s large imbalances – setting aside Europe’s internal imbalances—now largely reduce to China’s surplus (the World Bank estimates China’s surplus will top $400b, the IMF puts it at closer to $500b) and the US external deficit (estimated by the IMF to be around $400 billion in 2009).

In addition to producing bilateral balance of payments data, the US also provides (see table 5) a fairly detailed disaggregation of official (central bank and sovereign fund) purchases of US assets. Like the bilateral data on China, this data has yet to be revised to reflect the most recent survey – and it thus understates total official purchases from mid 2007 to mid 2008. It is still interesting.

For one, the data on Asia can be compared to an estimate of China’s official purchases that falls out from the bilateral data. It turns out that China now accounts for nearly all official purchases – and nearly all of Asia’s purchases.

That confirms something I have long suspected: the Gulf’s purchases, including Saudi purchases, simply don’t show up in the US data. The Saudis added huge sums to their reserves and one assumes their dollar portfolio over the last year – and Saudi Arabia (along with the rest of the Gulf) should be counted as part of Asia (the data on the Gulf is reported as coming from “Asian” oil exporters).

And since China accounts for nearly all official purchases in the data over the last four quarters, the decomposition of the official data by instrument also tells us something about changes in China’s portfolio.

To be sure, the overall data matches China’s purchases only because non-Chinese sellers of dollars offset non-Chinese buyers, so the correlation isn’t perfect. But it isn’t all off either …

Warren Buffet likes to say that you find out who is swimming naked when the tide goes out. And with the tide turning – and much smaller purchases from other central banks — China’s imprint on the overall data is increasingly hard to hide. I’ll be out of business soon. The dark arts of reserve tracking aren’t that useful in world with no reserve growth — or a world where only one country is adding to its reserves.

Underlying BEA data can be found here. I used table 5 and the data for China and Japan in table 12.

* Ted Truman would object to any disaggregation of the data on the grounds that money is fungible, and China’s purchases of US debt finance a portion of not just the broad US trade deficit but also private capital outflow from the US. He is right of course, but there is still value in doing a bit of disaggregation — as it highlights the change in China’s financing of the US.
** The US data indicates that private Chinese investors — likely the state banks — were net sellers of US assets in 2008. The survey also will revise China’s corporate debt holdings down; I didn’t reflect this in my adjustment though as I believe the fall in China’s corporate bonds in the survey is also a statistical artifact. The implied fall is around $40 billion, so it wouldn’t change the overall story.

41 Comments

  • Posted by djc

    China PBoC has ‘canceled US credit card’ for deficit spending

    http://www.google.com/hostednews/afp/article/ALeqM5i4estRSYeFBIII9kezxnP4jgoGZQ

    WASHINGTON (AFP) — China, wary of the troubled US economy, has already “canceled America’s credit card” by cutting down purchases of debt, a US congressman said Thursday.

    China has the world’s largest foreign reserves, believed to be mostly in dollars, along with around 800 billion dollars in US Treasury bonds, more than any other country.

    But Treasury Department data shows that investors in China have sharply curtailed their purchases of bonds in January and February.

    Representative Mark Kirk, a member of the House Appropriations Committee and co-chair of a group of lawmakers promoting relations with Beijing, said China had “very legitimate” concerns about its investments.

    “It would appear, quietly and with deference and politeness, that China has canceled America’s credit card,” Kirk told the Committee of 100, a Chinese-American group.

    “I’m not sure too many people on Capitol Hill realize that this is now happening,” he said.

  • Posted by Blissex

    «And China, unlike Japan, isn’t part of a security alliance with the US. That is why the scale of financing the US now receives from China truly is unprecedented: it is now not only tops the largest inflow the US ever received from another country, but it is clearly by far the largest inflow the US has ever received from a government that the US doesn’t consider a close military ally.»

    But they have “aligned” interests. China, Japan and Arabia have been in effect buying USA war bonds, financing at a very low cost the Iraq and Afghanistan wars which they see as in their interests; this in addition to vendor financing.

    But most importantly China has been for a few years now, the Republican re-election committee (as David Hale joked in 1985 after the Plaza accord of Japan), providing easy financing to the USA government to fund its policies of tax cuts for the wealthy and land wars in Asia.

    They have done this so for two reasons other than to keep the dollar strong: to buy the goodwill of the USA political elites who want to be reelected, and to support the USA business elites who have the same overarching adversary (USA citizens holding USA jobs) as the Chinese elites.

    Both the Chinese political elites and the USA business elites main goal is to export USA jobs to China; the Chinese politicians to provide jobs and stability to Chinese workers, the USA businessmen to weaken and impoverish USA workers.

    Now however there is a Democratic president who they don’t know whether has the same goals (including offshoring as many jobs as possible) as his predecessor, and they have problems of their own, so they are probably trying, with the Japanese, to push the dollar as high as possible regardless, or to counteract the tendency of the dollar to be used as a safe haven currency.

    They also have less strategic problems, like what to do with their widening export/import gap, and perhaps making a show of support to the newly elected president, who has to borrow colossal new amounts of money to fund the spending that he hopes will get him reelected.

  • Posted by djc

    Robert Rubin and Larry Summers hostile opposition to an Asian Monetary Fund was based on the threat that US Dollar hegemony would be eroded. LOL.

    http://www.reuters.com/article/ousiv/idUSTRE5420L220090503

    East Asia sets up emergency $120 bln fund for crisis

    NUSA DUA, Indonesia (Reuters) – Thirteen East and Southeast Asian countries agreed on Sunday to set up a $120 billion emergency fund for use in an economic downturn, the first independent move by Asia to shield itself from financial crisis.

    Japan, the region’s biggest economy, also announced a plan to supply up to 6 trillion yen ($61.54 billion) to support its neighbors in an economic downturn.

    The initiatives were announced on the Indonesian island of Bali, on the sidelines of the Asian Development Bank’s (ADB) annual meeting, and one analyst said they could lead to some optimism in regional markets on Monday.

    “This news is not a surprise but confirmation may be taken by the optimists as a reason to continue the recent rally,” said Kirby Daley, senior strategist at Newedge Group in Hong Kong.

    “It’s definitely a step in the right direction for Asia to wean itself from dependence on the West.

    While Asian banks largely avoided the credit crisis that tore through Wall Street and much of Europe, the region has since been hit by the downturn in the West, which has eroded demand for Asian automobiles, electronics and other exports.

    The region’s economies are likely to grow just 3.4 percent in 2009, the slowest pace since the Asian financial crisis a decade ago, the ADB has forecast. It sees growth recovering to 6.3 percent next year if demand rebounds.

    China and Japan have each committed to provide 32 percent of the regional fund, known as the Chiang Mai Initiative. South Korea has committed to 16 percent, with the rest coming from the 10-member Association of South East Asian Nations (ASEAN).

  • Posted by Rajesh

    While we in the U.S. focus on China’s exports; China’s imports have played an important role in global finances. The rise in commodity prices during 2007 and the first half of 2008 allowed other countries to build up their holdings of U.S. dollars without necessarily running a trade surplus with the U.S. This gave the appearance of ‘decoupling’ based on this second source of dollars. However, when Chinese imports collapsed during the Olympics the market demand for dollars no longer hard this large secondary supplier.

    Note that the period when the Chinese surplus with the Euro area was rising, China was not stockpiling Euros, as the vendor financing scenario would require. Instead, although other countries were shifting currency reserves to the Euro, China continued to hold the bulk of its currency reserves in dollars.

  • Posted by Howard Richman

    Brad,

    You are absolutely correct. China’s loans to the United States went way beyond what is necessary to finance American imports of Chinese goods. They were designed to manipulate exchange rates.

    When China buys dollars in currency markets in order to manipulate currency values, it both strengthens the dollar and weakens the RMB. The result is that America’s trade balance deteriorates, primarily with China, but also with other countries. At the same time, China’s trade balance improves, not only with America but with other countries. It is mercantilism, pure and simple.

    When economic history is written, the decision of the Chinese government to stop the RMB from continuing to rise against the dollar in April 2008 will be considered one of the causes that precipitated the great recession. At the point when China switched policies, U.S. – China trade appeared to be moving toward balance. (See for example, the month-by-month graph in this blog entry.)

    Normally when a country goes into recession while the rest of the world is prosperous, as occurred with the United States at the in 2007, then that countries’ exports increase while its imports decline, which helps to pull that country out of its recession.

    But this time, China prevented America’s exports from increasing and its imports from decreasing by stopping the rise of the RMB versus the dollar by buying dollars galore on the foreign exchange markets.

    As a result of this currency manipulation, the increase in American exports was not enough to pull the United States out of the recession. Instead in October 2008, the United States dragged the rest of the world into the recession.

  • Posted by Howard Richman

    I have always thought that China’s decision to stop the rise in the RMB v. the dollar at the beginning of April 2008 was due to advance notice that Treasury Secretary Paulson was about to tell Congress that China was not manipulating its currency.

    The pretense that China is not manipulating its currency is bipartisan. Treasury Secretary Timothy Geithner told Congress the same thing in his April 15, 2009 report to Congress.

  • Posted by DOR

    When estimating how fast China’s reserves “should” be rising, I’m always struck by the stunning balance over the course of a decade. On a crude measure – trade surplus + FDI inflows – the flow of money gently moves from too much (capital outflow) to insufficient (capital inflow) over the course of a decade or so.

    Anything more than a crude measure has to assume the Chinese data are more than 80% accurate, which I’m not yet prepared to do. Someday, but not yet.

  • Posted by bsetser

    DoR — explain. most credible forecasts (see say the IMF) have china running a sustained current account surplus and thus running up its foreign assets much further unless something more (like the exchange rate) changes. There is no automatic swing toward balance.

  • Posted by bsetser

    DJC — China actually did as much to scuttle an Asian monetary fund last time around as did the US; they thought it would be dominated by japan. China’s ability to match Japan on the creditor side is a big reason why things are different this time around. Not everything — even in the 90s — revolved around washington.

  • Posted by Michael Pettis

    Brad, of course the “grocer” comment was a simplification, but it was a simplification designed to counter another very distorted and much less true simplification, that of Beijing as Washington’s banker. But one quibble, China can only directly or indirectly recycle its current account surplus, and the US must finance its own current account deficit, so ultimately the “grocer” metaphor still has explanatory power. By the way if Representative Mark Kirk really did make those statements mentioned in the article posted by one of your commenters, it indicates how little policymakers understand the basic balance of payments mechanism.

  • Posted by Cedric Regula

    oh-oh. I’d better post this wiki article before Indian Investor shows up with a bunch of questions.
    Excerpt:
    _________________________
    The balance of payments identity states that:
    Current Account = Capital Account + Financial Account + Net Errors and Omissions
    This is a convention of double entry accounting, where all debit entries must be booked along with corresponding credit entries such that the net of the Current Account will have a corresponding net of the Capital and Financial Accounts:
    X+Ki=M+Ko
    where:
    X = exports
    M = imports
    Ki = capital inflows
    Ko = capital outflows
    Rearranging, we have:
    X-M=Ko-Ki
    ,
    yielding the BOP identity.
    The basic principle behind the identity is that a country can only consume more than it can produce (a current account deficit) if it is supplied capital from abroad (a capital account surplus).[3]
    http://en.wikipedia.org/wiki/Balance_of_payments
    _________________________________
    So there. However I’m not sure why M. Pettis is saying Mark Kirk doesn’t understand BOP.
    Unless it is for perhaps some of the following reasons:
    1)China purchases of treasuries were down in Jan and Feb, but picked up in March.
    2) The Fed is doing 300B of QE, so who needs financing?
    3)We had large inflows due to US funds being repatriated, and also probably private investor and international banking flows to t-bills during the “flight to safety” period post Lehman.

  • Posted by Cedric Regula

    Also, here’s a dollar index chart. It’s been in a state of indecision since March.
    http://quotes.ino.com/chart/?s=NYBOT_DX

  • Posted by purple

    They have done this so for two reasons other than to keep the dollar strong: to buy the goodwill of the USA political elites who want to be reelected, and to support the USA business elites who have the same overarching adversary (USA citizens holding USA jobs) as the Chinese elites.

    It’s just about the Benjamins as they say – or Yuan.

    Lower wages equals higher margin at the point of production for US manufacturing. At the point of consumption, U.S. capital makes money by financing the purchases of the indebted U.S. consumer. It’s a win win !

  • Posted by djc

    From Asia Times,

    Federal Reserve Chairman Bernanke blamed the financial crisis on China and on oil exporters who invested their balance of payments surplus in the US, leading to low interest rates and a credit boom in the US, thus denying Fed influence on interest rates and credit creation. Certainly, Bernanke did not understand that China and oil exporters do not decide the US current account deficit.

    Often, Bernanke has noted that the Fed’s mandate from the Congress was to promote maximum sustainable employment and stable prices. The failure of the Fed to achieve either or both objectives has been quite recurrent over the past decades. Bernanke’s aggressive policy since August 2007 has even triggered stagflation: rising unemployment and inflation. It would be more natural to have a with one single mandate – to preserve the value of money.

    US policymakers diagnosed the current crisis as lack of demand for goods and services and large excess savings in the form of a piling up of food and energy goods in the US, and totally dismissed the negative national savings rate. They believed in deflation when housing, food, and energy inflation was crippling the economy. The refusal to link the Bush administration’s war spending and excessively expansionary fiscal and monetary policies and the current financial crisis has been a main stratagem in the speeches of Fed officials.

    http://www.atimes.com/atimes/Global_Economy/KE05Dj05.html

  • Posted by Michael Pettis

    Cedric, it is neither. The claim that China can “cancel America’s credit card” may be a great way to stoke paranoia and garner press attention, but it is an almost meaningless statement. If China were ever to stop lending to the US, the value of the RMB would soar against the dollar and China’s trade surplus with the US would collapse to zero. Since neither of the latter have happened, the former clearly hasn’t either.

    The point of the “grocer” metaphor is to point out that Chinese lending to the US is not discretionary. It is the automatic consequence of China’s need for the US to absorb its vast manufacturing overcapacity. Nothing scares Beijing more than the idea that the US might undergo, or even force, a sharp reduction in its trade deficit with China which, of course, would have the automatic impact of forcing Chinese lending to the US to collapse. The two are inextricably linked.

  • Posted by Glen M

    I have to agree with Howard Richman. The purchases were needed to control exchange rates and the ability of a competitive US taking business away from China.

  • Posted by bsetser

    Michael — China can do a bit more than intermediate its current account surplus. it can also intermediate capital flows — i.e. private money going into China can be recycled back into demand for US (and other) debt. My argument is that over time, China increasingly is:

    a) using its trade surplus with Europe to finance purchases of US debt … call it a byproduct of pegging to a far weaker $ (v the euro) than back in 2000 (even if the $ isn’t as weak as it was in 07/08)
    b) when private money is flowing into china, recycling a big chunk of the capital account surplus back into demand for us debt ….

    ergo, the financial flows started to exceed the trade flows significantly.

    I agree though that Mark Kirk is extrapolating a bit much on the basis of 3ms of data, data that no doubt was influenced by:

    a) the sharp slowdown in chinese reserve growth (hot outflows don’t show up as inflows from China)
    b) the huge treasury purchases of the fall

    as long as China is running a $500b current account surplus/ pegging to the USD, it is hard to see how China doesn’t continue to buy some US assets.

  • Posted by guest

    The interest rates on long term bonds, be it in Europe or in the USA were not only depressed by the massive inflows of surplus reserves from China Russia…but as well the subject of diligent efforts from the primary dealers (see various reports from Bloomberg NYT)and a reflection of derivatives (though it is hard to read from the OOCC report which way Morgan GS HSBC interest swaps are going.It was easier to read their profits in that field and they were all profitable and were and still are highly leveraged)
    When coming into his office Mr Bernanke reminded the primary dealers to keep the bond market fluid.
    As far the ECB is concerned the LT interest rates on bonds are homothetic to the USD. The information access and support are not of the same quality as the US.They are inexistant.

  • Posted by Cedric Regula

    M. Pettis:”…The two are inextricably linked.”

    Ok, sure. The loop has been going on and getting bigger for most of the last 6 years.

    First it was fueled by China’s quest for double digit growth fueled by export growth to the world’s best consumer, which necessitated re-cycling of surplus dollars to peg the RMB.

    The situation now is over capacity since US demand has dropped due to recession/higher private savings rate in the US. World demand has dropped too, and since the dollar strengthened against most other currencies and the RMB along with it, this put additional stress on the Chinese export sector.

    However, China seems worried at this point that they are losing any control they ever had of the situation. Note recent comments about US fiscal deficits, GSE guarantees, and worries about the dollar falling and reducing the value of their US assets. Silly comments from a macro view we all know…what else could one expect???

    But the current situation is the US fiscal financing need just quadrupled and needs to be financed by the sum of external financing, internal financing and Fed QE.

    So China is now the small kid on the block, and wondering what to do about it.

  • Posted by Twofish

    To blissex: I think you are making the huge mistake of assume that the Democratic Party is any less “elite” than the Republicans. The US has a two-party system in which both parties are equally part of the “political and economic elite.”

    You can see this by the fact that the Democrats are in the driver’s seat and are maintaining policies that are generally pro-business, pro-finance, and pro-banking.

    What did you expect?

  • Posted by Twofish

    Pettis: It is the automatic consequence of China’s need for the US to absorb its vast manufacturing overcapacity. Nothing scares Beijing more than the idea that the US might undergo, or even force, a sharp reduction in its trade deficit with China which, of course, would have the automatic impact of forcing Chinese lending to the US to collapse.

    Everyone that I’ve talked to in Chinese economic circles seems resigned that this is going to happen. The problem is lets assume the wildest most optimistic projection for exports. That would be that things go back to 2007. Even if that happened, then you aren’t going to see the double digit growth rates of the 2000′s and without that growth, China has to do something else anyway.

    Also I’ve posted some responses on your blog, that argues that people that see China as an example of the Asian development model have it fundamentally wrong, and this lens leads to some serious, serious economic mistakes.

    The big difference is that most of Chinese exports came from private, small and medium enterprises, who are shutting down because they are not getting any of the stimulus money. If you look at export industries in southern China, they are all rapidly closing shop. You seem some subsidies to shipping and ports, but that’s it, and even they are being strongly encouraged to get out of exports.

  • Posted by Glen M

    Brad,

    While China may have purchased more US debt than required to offset the trade balance, what other options did they have? Besides its reserve status, the US has been far more willing to hold trade deficits. Europe faces much more political activism wrt to protecting jobs as its perennial jobless rate is much higher than that of the US. Europe would have certainly intervened much quicker if the EURO was artificially inflated. I think that China was aware of this. Now that the US is facing European type unemployment I fully expect this willingness to end.

  • Posted by DJC.

    Twofish: The big difference is that most of Chinese exports came from private, small and medium enterprises, who are shutting down because they are not getting any of the stimulus money. If you look at export industries in southern China, they are all rapidly closing shop.

    DJC: A large percentage of Chinese exports were from small-medium enterprises around the Shenzhen-Dongguan region. Alot of those labor intensive businesses are closing shop. However in aggregate, Chinese industry isn’t doing too badly. Spurred by Chinese government industrial policy, there is somewhat of an industrial renaissance across northern industrial sectors. Already China exports more industrial machine tools than textiles. The largest manufacturer of computers, LCD televisions, household appliances in the world today is China. Telecom manufacturer Huawei is dominating 3rd world developing markets by undercutting Cisco by 30-60% on product pricing. Chinese exports to India include Power plants, and Turboprop MA-60 Aircraft. Even Australia and England are purchasing locomotives and railway passenger cars, respectively. Industrial output from the Chinese economy now exceeds the United States. It’s only a matter of time before China’s GDP exceeds the United States. Probably by 2020, the largest economic superpower will be the Chinese economy.

  • Posted by DOR

    Mr Setser,
    The sum of the change in forex reserves, minus utilized FDI inflows, minus the trade balance is the crude measure I mentioned. Sure, there’s plenty of room to quibble over portfolio flows or outward investment, but odds are such flows will not compensate for the ~20% margin of error in most Chinese data. That’s why I call it a crude measure.

    1984-91: +$31.2 bn
    1992-02 -$427.5 bn (massive capital flight)
    2003-08 +$413.5 bn (reverse swing brings it back into balance)

    Net: +$17.2 bn over 25 years.

  • Posted by Howard Richman

    Brad and Michael,

    I’ve enjoyed your discussion here and have been appreciating both of your blogs very much. Not only do you think for yourselves, but you both happen to share my desire to see more balanced US-China trade.

    Did you notice Jeffrey Bader’s call for more balanced trade with China? He’s Obama’s chief NSC advisor on Asia.

    Could be that Obama’s advisors have been reading your blogs!

  • Posted by Twofish

    The other thing is that I think that there was a pretty massive cycle of money that went something like this….

    chinese peasant -> state banks -> people’s bank of china -> us agencies -> us consumers -> us investment banks -> chinese exporters -> chinese peasant

    It’s basically that engine that was driving the export boom. Once the us investment bank/us consumer link broke, the engine stopped.

  • Posted by Twofish

    Richman: Did you notice Jeffrey Bader’s call for more balanced trade with China? He’s Obama’s chief NSC advisor on Asia.

    My reading is that they are mirroring some conversations with people in Beijing. It’s curious that they’ve put human rights and military off the table, and they are now putting on the table something that is extremely non-confrontational.

    One very strong and surprising impression that I get from Chinese people is how many people from China are extremely dissatisfied with “China as factory.” The standard complaint is that the product gets made in China but most of the wealth gets exported to the United States.

    So I don’t see that much resistance to lowering the US/China trade deficit with one extremely important caveat. I suspect that China would be willing to let the RMB rise, in exchange for the US keeping US companies open for Chinese investment.

    Which means that you may see a situation in which the trade deficit goes down, but large parts of the US economy are purchased by China, and I wouldn’t be surprised if in a few years that there are accusations that China is overvaluing its currency so that it can buy American companies cheaply.

    One other thing about increasing the value of the RMB is that it makes it easier for Chinese companies to hire skilled Americans to work in China.

    I suspect that trade is going to be “yesterdays battle.”

  • Posted by Cedric Regula

    2fish:”chinese peasant -> state banks -> people’s bank of china -> us agencies -> us consumers -> us investment banks -> chinese exporters -> chinese peasant”

    That would be the simplified flow, except I don’t think the Chinese peasant was really in the loop. Real wages in China declined, and that is the current problem with having a domestic driven consumption economy in China today.

    So I think it’s probably company deposits of profits(dollars) into the state banks which flowed up to the PBoC and back to the US. Then they collect value added taxes on business and that was in excess of government spending and headed to the US as well.

    It went into GSE’s and Treasuries. The quickest conceptual path back to the consumer is thru GSEs financing cheap mortgages. But GSEs were a popular investment among US investors as well. Commercial banks also had a pool of money they thought they could get better rates for than trying to compete with F&F, so we had plenty of sub-prime and HEW as a result. Then the IBs securitized everything that F&F wasn’t buying, so the system had a seemingly endless supply of money. So lots of shopping at Wal-Mart and Home Depot, remodels and a new car for the garage.

    And fiscal deficits do matter. If you can imagine a world where the consumer had to actually pay the entire federal budget, things would have broke down much sooner in the private sector.

  • Posted by Twofish

    Cedric: That would be the simplified flow, except I don’t think the Chinese peasant was really in the loop. Real wages in China declined, and that is the current problem with having a domestic driven consumption economy in China today.

    That is not true. Real wages in China have increased enormously over the last decade. The statement that people have made is that the real wages have been going up more slowly than GDP, which is a rather bogus statistic.

    Also the statement that China isn’t consuming is also not true. Chinese consumer demand has also increased enormously over the last 30 years. It’s that the economy has grown even faster than wages or demand. All that wealth went into savings, which means that Chinese banks were able to recapitalize themselves and absorb some deep shocks.

    The basic source of this wealth is pretty simple. A Chinese peasant farmer really isn’t producing anything. They are working in the rice field, but if they weren’t there, they could be replaced with a machine, and the same amount of rice gets produced. Move them from the field to a factory or a store, and productivity goes up, because they are doing something useful.

    The other factor is that there are *lots* of Chinese peasants. If you get each one to save an extra US$10/month, you end up with US$60 billion dollars at the end of the year.

    Cedric: Then the IBs securitized everything that F&F wasn’t buying, so the system had a seemingly endless supply of money. So lots of shopping at Wal-Mart and Home Depot, remodels and a new car for the garage

    And this supply of money was backed by a supply of new wealth. One shouldn’t assume that because the system broke down that it was all a lie, and there was no real wealth creation going on. There was massive amounts of wealth creation going on.

    The problem is not wealth creation. The problem is wealth distribution. Wealth is based on knowledge and social networks, which means that if you are excluded from knowledge and social networks, you end up being poor.

  • Posted by djc

    The global environment is extremely negative for savers. The prices of property and shares, though having declined substantially, are not good value yet and may decline further. Interest rates are near zero. The Fed is printing money, which will eventually inflate away the value of dollar holdings. Other currencies are not safe havens either. As the Fed expands the money supply, it puts pressure on other currencies to appreciate. This will force other central banks to expand their own money supplies to depress their currencies. Hence, major currencies may take turns devaluing. The end result is inflation and negative real interest rates everywhere. Central banks are punishing savers to redeem the sins of debtors and speculators. Unfortunately, ethnic Chinese are the biggest savers.

    Diluting Chinese savings to bail out America’s failing banks and bankrupt households, though highly beneficial to the US national interest in the short term, will destroy the dollar’s global status. Ethnic Chinese demand for the dollar has been waning already. China’s bulging foreign exchange reserves reflect the lack of private demand for dollars…

    America’s policy is pushing China towards developing an alternative financial system. For the past two decades China’s entry into the global economy rested on making cheap labour available to multi-nationals and pegging the renminbi to the dollar. The dollar peg allowed China to leverage the US financial system for its international needs, while domestic finance remained state-controlled to redistribute prosperity from the coast to interior provinces. This dual approach has worked remarkably well. China could have its cake and eat it too. Of course, the global credit bubble was what allowed China’s dual approach to be effective; its inefficiency was masked by bubble-generated global demand.

    China is aware that it must become independent from the dollar at some point. Its recent decision to turn Shanghai into a financial centre by 2020 reflects China’s anxiety over relying on the dollar system. The year 2020 seems remote, and the US will not pay attention to something so distant. However, if global stagflation takes hold, as I expect it to, it will force China to accelerate its reforms to float its currency and create a single, independent and market-based financial system. When that happens, the dollar will collapse.

    http://www.nakedcapitalism.com/2009/05/andy-xie-if-china-loses-faith-dollar.html

  • Posted by bill j

    2fish is right on the circulation of savings. But it was not just from peasants, Chinese workers many living in hostels with very few opportunities to consume their entire wage, also save disproportionately high amounts. And Chinese SOEs very profitable from the turn of the millennium onwards were also constrained in their ability to invest by raw materials shortages and potential inflation.
    The credit collapse from September onwards broke that circuit temporarily and plunged the world into a very serious recession.
    But now that China has reoriented its production towards even higher rates of domestic investment, the bail outs have eased the credit crunch and trade has begun to revive, so that circuit is reasserting itself.
    That’s why its wrong to simply assert that the global imbalance – China’s surplus paying for US deficits – is only a cause of crisis. It certainly created the conditions for this crisis through reducing US interest rates with the effects we all now know, but at present through doing the same thing, reducing US interest rates, it is enabling the US to reflate its economy pretty rapidly and consequently limiting the scale of crisis and collaps it helped create.
    Pardoxical huh.

  • Posted by RED

    An interesting discussion on the US Chinese trade deficit. The “savings glut” is much talked about, what is less so is the “demand deficit” this “savings glut” creates.

    In simple terms if Chinese save US dollars based on exporting, and this money is not used to reciprocally purchase US goods (ie sterilised), well then of course you get unemployment in the USA, duh no demand, their is $2t of demand for US products sterizised by China, another $1t in Jap hands, probably more through the rest of Asia. If they spent this money on US products the recession is over.

    The Asians will, in due course, rue the day they set this up as their economic strategy for they simply cannot keep accumulating dollars. Or put another way, their ability to accumulate dollars can only be exceeded by our ability to print them. The cycle can only end badly unless it is stopped.

    When it is stopped, what happens? The Chinese and Asian currencies appreciate, and demand returns to the USA with a much lower dollar. This will eventually wreck the Asian economies because thats how economics works. Stray too far to one side, and economics pulls you back the other way.

    The Chinese cannot maintain a peg and mercantilist strategy for ever. Look what its done to the Japenese economy for the last 20 years. Mercantilism doesn’t work in the end. Having balance works

  • Posted by Twofish

    RED: In simple terms if Chinese save US dollars based on exporting, and this money is not used to reciprocally purchase US goods (ie sterilised), well then of course you get unemployment in the USA, duh no demand.

    Not clear at all. Most jobs in the US are service jobs and not manufacturing, and a lot of these jobs depend on the trade deficit. Two examples are longshoremen that unload Chinese goods and cashiers at Walmart.

    Curiously, most of the Chinese annoyance at the trade deficit has to do with the fact that the good jobs involving US-China trade are overseas, and Chinese get stuck with the crap jobs that don’t pay very much.

    RED: If they spent this money on US products the recession is over.

    No. If China stopped shipping products, lots of people in Walmart immediately lose their jobs. Now you could argue that there are going to be new factories, but that takes a few months.

    The fact that we have a recession at all is because of these time lags. If we could instantly create jobs, then we would have done it in October. But it is much easier to fire someone that to hire someone, which is why we have a recession lag.

    RED: Or put another way, their ability to accumulate dollars can only be exceeded by our ability to print them. The cycle can only end badly unless it is stopped.

    That’s not the big limit. The big limit is the pool of savings that can be sterilized. Each time the PBC puts a dollar into circulation, it has to take out 8 RMB from the economy, otherwise you get inflation. China can do that because it has this pile of savings. Saudi Arabia can’t.

    RED: This will eventually wreck the Asian economies because thats how economics works.

    People are complex, and social systems are even more complex. I’m very distrustful of arguments that say “well that’s just how things work.”

    RED: The Chinese cannot maintain a peg and mercantilist strategy for ever. Look what its done to the Japenese economy for the last 20 years. Mercantilism doesn’t work in the end. Having balance works.

    This is a big pet peeve of mine, when people talk about the Japanese and Chinese economy as if they are similar when they are not. There are *some* similarities in them, but there are *some* similarities between the Chinese economy and the economic of Peru.

    Talking about China and Japan as if they are basically similar will give you some very misleading conclusions about China (and for that matter Japan). In particular, China intentionally made some decisions in the mid-1990′s, so that it *wouldn’t* look like Japan, and it ended up copying the United States.

    Just to name some differences:

    * China is a early developing, rural nation. Japan is a developed, urbanized nation.

    * China has high cost of capital. Japan has low cost of capital.

    * China exports are light manufacturing with little value added. Japan focuses on high technology products with heavy value added.

    I can list about a dozen other differences, and the similarities are extremely superficial, and in a lot of cases it is because its the United States is unique.

    Both China and Japan run large trade deficits with the United States, but that is because everyone runs large trade deficits with the United States. Both China and Japan have more state intervention in their economy than the US does, but that’s true for just about every country in the world.

    So in cases where Japan and China both look magenta, it’s not that Japan and China are magenta, it’s more a function that you are wearing magenta colored glasses.

  • Posted by Twofish

    djc: Unfortunately, ethnic Chinese are the biggest savers.

    That’s going to change very, very rapidly in ten years or so. Most Chinese savings is for retirement, and when China ages, people are going to start pulling out savings at a massive rate.

    Also, the younger generation are much less likely to save. It’s not that Chinese people are “culturally” more likely to save. Cultural and ethnic explanations are usually garbage, and useless garbage. It’s that rich people with poor childhoods are more likely to save. People in their 50′s are more likely to save. Chinese in their 20′s aren’t.

    djc: China is aware that it must become independent from the dollar at some point. Its recent decision to turn Shanghai into a financial centre by 2020 reflects China’s anxiety over relying on the dollar system.

    Shanghai already is a regional financial center, but there is just no way that it can be a global financial center by 2020 since it is inside the currency firewall. Fortunately, the PRC already has a global financial center in Hong Kong.

    Also, you don’t become a world financial power by pulling in, but by pushing out. Long term, China needs to have Chinese banks with headquarters in NYC and London. That’s the big next leap.

  • Posted by Twofish

    djc: The dollar peg allowed China to leverage the US financial system for its international needs, while domestic finance remained state-controlled to redistribute prosperity from the coast to interior provinces.

    It’s actually not how things work. The big banks are state-owned, but they are not state-controlled, and the relationship between the Chinese government and the major Chinese banks are roughly akin to the US government and Citigroup.

    State efforts to move wealth from the coastal regions to the interior have generally been disasters. The major Chinese banks have been getting *out* of rural interior areas, because capital naturally flows away from poor areas.

    The wealth movement is basically privately driven. There are two parallel economies in China, and they can be described as the “earth economy” and the “water economy”.

    Neither are particularly state controlled, and talking about the difference between the two economies in terms of state control is misleading.

  • Posted by Twofish

    earth economy – big banks, SOE’s, construction and infrastructure, RMB based, interior provinces

    water economy – informal banking, mostly small private enterprises, trade and light manufacturing, dollar based, coast provinces.

    The terms earth and water are better because other terms are misleading. For example, calling one socialist and the other capitalist really doesn’t describe how these two economies work.

  • Posted by Glen M

    Twofish,

    the differences you listed are highly temporal.

  • Posted by Twofish

    Glen M: The differences you listed are highly temporal.

    Yes and no. The current differences between the earth and water economy are connected to the current Chinese economy, but there have been two economic modes or production in China ever since the Song dynasty. see Hill Gates “China’s Motor: A Thousand Years of Petty Capitalism”

    He calls the modes of production the bureaucratic-tributary mode of production and the petty-capitalist mode of production.

    Today’s Chinese state owned enterprises are historically continuous with industrial enterprises that Wang An-Shih tried to set up in the Song dynasty.

  • Posted by Blissex

    «The other thing is that I think that there was a pretty massive cycle of money that went something like this….

    chinese peasant -> state banks ->»

    I am not at all sure this is happening. The chinese masses make too little money to save much.

    The big saver is the Chinese government, whose “savings” largely come from currency operations. That is they save money by hoarding dollars that are sent from the USA to pay for imports and to pay for investments in China.

    That is the Chinese central bank takes a huge cut during foreign exchange and that’s the savings — they are saved “profits” from currency intermediation.

    It is not like 1 billion people each saving a few hundred dollars a year. Middle class and upper class chinese do save due to the collapse of the welfare system, but nowhere like necessary to generate those colossal “savings”.

  • Posted by Twofish

    Blissex: I am not at all sure this is happening. The chinese masses make too little money to save much.

    Multiply any small number by a billion and you get a big number. Also, most Chinese people don’t pay rent or have home mortgages.

    Blissex: The big saver is the Chinese government, whose “savings” largely come from currency operations. That is they save money by hoarding dollars that are sent from the USA to pay for imports and to pay for investments in China.

    This won’t work. If you pump dollars into the Chinese economy and don’t take anything out, you end up with inflation. You need a pool of savings for everything to work.

    Also capital is flowing from China to the United States.

    Blissex: It is not like 1 billion people each saving a few hundred dollars a year.

    Yes it is a 1 billion people each saving a few hundred dollars a way (along with several thousand corporations saving a huge amount of money).

  • Posted by Matthew Cohen

    So let’s say that the Chinese have some version of portfolio investment theory and decide that they have had enough of increasing their dollar holdings as much as they have been (maybe this has already happened).

    How much does the dollar have to fall vs the RMB to get the US/China trade deficit to a level where the Chinese are comfortable continuing to buy that level of US assets on an ongoing basis (assuming no one else is stepping up to the plate)?

    Here are 2 USD Yen rates just out of the blue
    1985-04-01 251.8455
    1988-11-01 123.2020

    What happens when the RMB value of that many assets (the dollar-based ones) falls that much (what is the economic and even political impact)?

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