Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

Posts by Author

Showing posts for "Brad Setser"

Why Did China’s 2016 Current Account Surplus Fall?

by Brad Setser

Few policies are less liked than China’s 2015/2016 credit-driven stimulus. Even people like me who worried that slamming the brakes on credit, in the absence of more fundamental reforms to lower China’s savings rate, risked creating a shortfall in demand were not exactly enthusiastic supporters. China would be far better off if had used a rise in central government social expenditure to support demand, not yet another wave of off-balance sheet borrowing by local governments and state firms.

But the current pick-up in growth suggests that arguments that (yet another) expansion of credit wouldn’t work were a bit overdone. There are no doubt better ways to support growth than more credit. But growth did responded to the stimulus, even if there is a real debate over just how strong the response was.*

Tilton, Song, Tang, Li, and Wei of Goldman Sachs (in a report summarized here):

“Chinese policy makers wrestled with challenges throughout 2016, but large and sustained policy stimulus eventually fostered recovery. … Our China Current Activity indicator bottomed out at 4.3% in early 2015, recovered to the mid-5 percent range last year, and is now running at 6.9%. Heavy industry … has seen an even more pronounced re-acceleration”

And there is growing evidence, I think, that the pickup in Chinese demand also had positive spillovers for the rest of the world.

China’s current account surplus for 2016 fell more than I expected. To be sure, China’s reported current account is prone to significant revisions, and I wouldn’t be surprised if the (very low) q4 surplus is revised up.

Read more »

How Serious Is the Threat to Global Financial Stability From a Border-Adjustment Tax?

by Brad Setser

Neil Irwin’s column on the border-adjustment tax spurred an interesting debate. Irwin notes that a 25 percent rise in the dollar (or even a somewhat smaller rise) would have an impact outside the United States, as the dollar is a global currency.

Dean Baker and Jared Bernstein note that the dollar moves around a lot without destroying the global economy. The projected moves in the dollar are no larger than the dollar’s 20 percent or so move over the last three years. Baker: “Movements of this size happen all the time. They certainly can cause problems, but the financial system generally deals with it.”

Fair enough.*

I still worry though. There is a difference between a 20 percent move (off a long-term low) and a 30 or 40 percent move. And there is a difference between normal exchange rate volatility and large, sustained currency shifts. I would note that the 20 percent rise in the dollar in late 2014 and early 2015 contributed to the change in China’s currency regime—and China’s shift to managing against a basket roiled global markets from August 2015 to February 2016. The world survived, but it wasn’t totally smooth.

Let me focus on two specific reasons for concern:

One. Balance sheet mismatches in emerging economies.**

Two. Dollar pegs, or basket pegs heavily weighted to the dollar.

Read more »

The Dangerous Myth That China “Needs” $2.7 Trillion in Reserves

by Brad Setser

$2.7 trillion is well over 3 times China’s short-term external debt (around $800 billion per the IMF). It is roughly two times China’s external debt ($1.4 trillion, counting over $200 billion in intra-company loans). It is enough to cover well over 12 months of goods and services imports (total imports in 2016 were around $2 trillion).*

There are two good reasons why a country might need more reserves than it has maturing external debt. The first is that it has an ongoing current account deficit. A country arguably should hold reserves to survive one year without any external financing – the sum of the current account and short-term external debt. The other is that a country has lots of domestic foreign currency deposits.

Neither applies to China. China’s runs a $200 to $300 billion current account surplus, so its one year external financing need is now around $500 billion. China has a relatively modest $250-$300 billion in foreign currency sight deposits, and just under $600 billion in domestic foreign currency deposits (to put that in context, it is about 5 percent of GDP). It would take just over a trillion in reserves to cover China’s external (short-term debt) and internal (domestic fx sight deposits) fx liquidity need.

The $2.7 trillion number (or $2.6 trillion) stems from the initial application of the IMF’s new (and in my view flawed) reserve metric to China. The IMF’s metric revived M2 to reserves as an important indicator of reserve adequacy, and China is off the charts on this indicator (China has very little external debt, but a very large domestic deposit base – so a composite indicator that includes the domestic deposit base gets a very different result than metrics that focus on external debt). In the composite indicator, emerging economies with a fixed exchange rate and an open capital account need to hold 10% of M2 in reserves. That alone is about over 20% of China’s GDP – as China’s M2 to GDP ratio is a bit over 200%. For China, the weighted contributions from short-term debt, “exports” (the IMF uses exports rather than imports) and long-term external liabilities are trivial. For China, the entire reserve need more or less comes from one of the four variables in the IMF’s composite indicator (more here).

But that calculation is now outdated. The IMF has refined its metric to give more weight to the presence of capital controls, and China has tightened its controls. Assuming that there are capital controls, the IMF metric indicates that China would be fine with $1.8 trillion in reserves (though that sum rises over the course of 2017, thanks to the ongoing growth in M2 as a share of GDP).**

I am not a fan of the even the updated new metric. I am not a big fan of composite metrics in general. And if you are going to use a composite metric, I think the composite metric should put more weight on foreign currency deposits than domestic currency deposits, while the IMF’s metric typically weights all domestic deposits at 5%. The IMF’s metric thus ignores one of the key insights of balance sheet analysis.

Read more »

Does Korea Operate A De Facto Target Zone?

by Brad Setser

Fred Bergsten of the Peterson Institute has long argued for target zones around the major exchange rates. In the past twenty years, no G-3 economy has followed Bergsten’s policy advice.* The world’s biggest advanced economies have wanted to maintain monetary policy independence, and—Japan perhaps excepted, at least during certain periods—they haven’t viewed foreign exchange intervention as an independent policy tool.

China formally has a band around its daily fix, but its exchange rate is still more of a peg (now a basket peg, without any obvious directional crawl over the last 7 months) than anything else.

I though increasingly think that Korea’s exchange rate management could be described as a target zone of sorts.

It buys dollars and sells won when it thinks the won is too strong (recently, too strong has been less than 1100 won per dollar). And it sells dollars and buys won when it thinks the won is too weak (recently too weak has been above 1200 won per dollar).

As a result, Korea intervened heavily to cap won strength in q3 2016. Counting the change in its forward position, government deposits, and government purchases of foreign debt securities, its total foreign exchange purchases in q3 were roughly $12 billion (about 3.5 percent of GDP).**

Read more »

Offshore Profits and U.S. Exports

by Brad Setser

One important result of my theory about the sources of “dark matter” in the U.S. balance of payments is a concern that “border adjustment” might not generate the expected revenues. American multinationals would have a strong incentive to shift their offshore income on intellectual property rights that are now located in subsidiaries offshore back to the U.S..

A lot depends on the details of any proposed tax reform, but I think a firm with U.S. expenses and export revenues would generate a tax loss on its exports (export revenues are excluded from calculation of revenues for the purpose of the tax, and domestic expenses can be deducted). If that tax loss is refundable, exporters essentially get a check back from the government for a sum equal to their domestic labor costs (see Chad Bown on the “subsidy” component of a border tax adjustment).* Profits that now show up in subsidiaries in Ireland, Puerto Rico, Singapore, and the like** based on intellectual property that is held in the Caribbean, thanks to the low price headquarters charges for the global rights on their intellectual property, might show up back in the U.S.—and I suspect the royalties their offshore subsidiaries pay headquarters for research and design and engineering (e.g. exports) would soar.

I haven’t started to figure out how European companies that now report very little income on their direct investment in the U.S. might try to game the system. I suspect that they have an incentive to try to lower their reported intra-firm imports—e.g. reduce the transfer prices they charge their U.S. subsidiaries to lower their “border adjustment”. Auerbach, Devereux, Keen and Vella have emphasized that introducing a destination based cash flow tax in one country would have quite different effects than introducing a destination based cash flow tax in all countries.

But I also wanted to draw out the implications of the rapid growth in the offshore profits of American companies for the broader debate on globalization.

Consider the following chart: normalized versus GDP, the “reinvested” (tax-deferred, or less politely, largely untaxed as of now) profits of U.S. multinationals have more than doubled over the past twenty years, while U.S. exports of capital goods, consumer goods, and autos (my measure for “core” manufacturing exports) have stayed constant as a share of GDP. Imports of that set of goods have increased by roughly 25 percent on this measure.

Read more »

Dark Matter. Soon To Be Revealed?

by Brad Setser

The debate around the House Republicans’ proposal for a border adjusted (destination-based cash flow) tax will, I think, force an important debate about the impact of corporate tax strategies on global trade flows.* My guess is that tax strategies do have a significant impact on the trade data (one hint: the trade deficit in pharmaceutical the U.S. now runs with Ireland and Switzerland). And in turn I suspect that the revenue projections from the House’s proposals will depend in part on how firms are expected to adapt to a world where export revenues booked in the U.S.—including export revenues from the royalties on intellectual property—are not taxed. A world where the U.S. suddenly becomes tax competitive with Ireland, the Netherlands and others.

I suspect that the size of the impact will surprise many people.

I first started looking at the impact of firms’ tax strategies on the balance of payments back in early 2006, as part of a debate over the sustainability of the U.S. trade and external deficit. One argument at the time was that Americans had nearly magical skills at cross-border investing—magic that produced a surplus on net foreign direct investment (FDI) income (the dividends that American firms receive on their foreign investment relative to the dividends foreign firms receive on their U.S. investments) that would perpetually negate the United States’ interest payments on its net external debt. That magical surplus on investment income in the balance of payments effectively made conventional measures of U.S. external debt sustainability moot.

Harvard’s Ricardo Hausmann has always had a way with words. He named the forces that kept the U.S. income balance positive even as the U.S. ran persistent trade and current account deficits: dark matter.

Time, I think, has helped bring the sources of dark matter—or, put differently, the sources of the United States’ exorbitant privilege—into the light. I suspected back in 2006, and now suspect even more strongly now, that “dark matter” is largely a function of the tax strategies employed by firms like Apple (here is a 2005 Wall Street Journal article focusing on another large tech firm).

The “income” the U.S. earns on its equity investment abroad now heavily shows up in low-tax jurisdictions. The “stock” position is now relatively balanced (the market value of U.S. direct investment abroad was $7 trillion at the end of 2015, which is not that different from the $6.5 trillion value of foreign direct investment in the U.S). The net income the U.S. earns on investments abroad essentially comes from the difference between the low cash returns foreign companies report on their U.S. equity investment and the large returns American firms report on their non-repatriated (e.g. tax deferred) income abroad.

Read more »

Imports Normally Would Have Subtracted More From 2016 U.S. Growth

by Brad Setser

I follow the news, some would say obsessively. I know there are far more important things afoot than backward looking analysis of the United States’ 2016 economic performance.

But I do think in some ways the U.S. was lucky not to have slowed more in 2016.

Why? Because import growth stalled, and imports did not subtract as much from U.S. growth as normally would be expected (and yes, that obviously wasn’t the dominant narrative of the 2016 election).

Plus the U.S. essentially got a small GDP boost as a result of a bad harvest in Brazil that raised U.S. soybeans exports in q3 (a rise that was only partially reversed in q4). The U.S. isn’t (yet) a commodity-driven economy, but it also isn’t (yet) a robot-based intellectual property rights (IPR) royalty-driven economy totally divorced from natural sources of economic volatility.

Imports are essentially a function of domestic demand growth and the exchange rate. More domestic demand than the exchange rate: the exchange rate in nearly all careful studies tends to have a stronger impact on U.S. exports than on U.S. imports. In the Fed’s U.S. international transactions model, for example: “The equations for goods and services exports predict that a 10 percent appreciation of the real dollar would reduce the level of overall real exports by about 7 percent after three years. After three years, the model predicts that real imports would be almost 4 percent higher.”

Over the last twenty years the negative contribution of imports to growth—think of it as U.S. demand that is shared with the world—has been about 25 percent of U.S. domestic demand growth. So typically 75 percent of any increase in U.S. demand goes toward domestic output, and 25 percent goes to the rest of the world (the U.S. of course also benefits from demand growth elsewhere, as growth outside the U.S. pulls up exports).

That is somewhat higher than that import share of GDP—as one would expect, if, over time, the import share of GDP is rising.

But something strange happened in 2016. From mid-2015 to mid-2016 (I like to look at the change over four quarters, a typical year-over-year comparison is the average over the last four quarters versus the average over the preceding four quarters so it uses eight quarters of data rather than four) U.S. imports were essentially flat (the negative contribution over four quarters was only 5-10 basis points of GDP) while U.S. demand growth—even counting inventories—contributed 1.5 to 2 percentage points to GDP growth.

Read more »

The Price of U.S. Imports From China Keeps Falling

by Brad Setser

The way trade is to be taxed at the border may—or may not—be about to change radically. But rather than speculate on the nature of the new world, I wanted to highlight one feature of the old.

I sometimes hear that China is loosing trade competitiveness because of rising domestic costs. And thus Chinese manufacturing firms need to move out of their ancestral homeland, either to low cost manufacturers like Vietnam or even to advanced economies like the U.S., in order to remain competitive.

I do not see it in the data. At least not in aggregate — the stories of individual sectors of course could differ. .

If the price of imports from China (as reported by the U.S. Department of Labor) is compared to the price of U.S. made finished goods and the price of domestic manufactures, Chinese goods not only look very competitive, but broadly speaking have been gaining in price competitiveness against U.S. made goods ever since the yuan stopped appreciating—and with the yuan depreciation of the past year, are poised to become even more competitive.

us-import-price-indexes

China maybe has lost a little of its previous edge over Canada and Europe thanks to the depreciation of the Canadian dollar and the euro over the past couple of years. But broadly speaking, the price of goods imported from China is back to where it was in 2004 (when the data series starts) while price of manufactured goods from the United States wealthier trading partners has gone up since then.

There is one potentially significant problem with the U.S. data here. About a quarter of U.S. imports from China are computers and cell phones. And getting the right “price” for goods marked by rapid technological change over time is hard. I suspect that the gap over time between the evolution of Chinese prices and U.S. finished goods prices would be smaller if computers and consumer electronics were removed. In fact, I would be thrilled if the BLS put out such a series. The area of real overlap between the U.S. and China increasingly is in the production of machined parts and capital goods (suggestions for how best to capture this most welcome, the right measure of U.S. prices might not be final goods excluding food and energy).

Setting that caveat aside though, I do not doubt that the basic story in the U.S. import price data is true: Over the past couple of years, the combination of U.S. workers and U.S. industrial robots has been loosing price competitiveness to the combination of Chinese workers and Chinese industrial robots.

Read more »

Chicken Feet And China: Back to the Future

by Brad Setser

Yes, this is a blog about chicken feet exports—technically, NAICS code 311615, “poultry processing.”

Welcome to the glamorous world of tit-for-tat trade spats. The biggest trade case of 2009 was the tires “421 safeguards” case, which prompted China to respond with duties on U.S. exports of chicken parts.

The possibility that the U.S. and China could embark on a cycle of sanction and counter-sanction will, I expect, force a new group of people to explore the nooks and crannies hiding in the data on U.S. exports to China.

Some of the sectors are well known.

Aircraft, of course. They are one of several sectors that account for about 10 percent of total U.S. exports to China and Hong Kong. Along with autos. Auto exports fell a bit in 2015, but in 2014 auto exports were almost as big as aircraft exports. Mostly SUVs I think, with many coming from the German transplants. In numeric terms, the legacy of the United States once powerful electronics manufacturing sector matters—though there hasn’t been much growth, alas, since the crisis.

Hopefully everyone now knows about the bling—gold and jewelry are about a third of U.S. exports to Hong Kong (and have at times been as much as ten percent of combined exports to China and Hong Kong).

And then there are the commodities. Soybeans of course. They can account for as much as 10 percent of total U.S. exports to China and Hong Kong if the price of beans is high. Cotton and hides and other inputs for clothing are a decent chunk — around 3 percent — of U.S. exports to China and Hong Kong. Wood pulp and timber account for about 4 percent of combined exports to China and Hong Kong. Metals are about 4 percent of US exports to China and Hong. And so on. Not all U.S. exports to China are super high-tech.

U.S. chicken part exports to China are mostly feet, from what I understand. A clear case of the gains from trade that emerge from different culinary preferences.

Read more »

China’s WTO Entry, 15 Years On

by Brad Setser

Late last year Tim Duy asked for an assessment of the decision to allow China to join the WTO, now that 15 years have passed.

Greg Ip met the call well before I did, in a remarkable essay.

But I will give my own two cents. Be warned, this isn’t a short post. Frankly it is an article disguised as a post. I added the subheadings to make it a bit easier on the eye.

Autor, Dorn, and Hanson Deserve All the Attention They Have Received

It now seems clear that the magnitude of the post-WTO China shock to manufacturing was significantly larger than was expected at the time of China’s entry into the WTO. China already had “most-favored-nation” (MFN)/“normal trade” access to the U.S. market, so it wasn’t clear that all that much would change with China’s WTO accession. But China’s pre-WTO access to the U.S. came with an annual Congressional review, and the resulting uncertainty seems to have deterred some firms from moving production to China.

The domestic labor market adjustment to the “China” shock was not smooth. Autor, Dorn, and Hanson’s research shows the China shock left a significant number of Americans temporarily without jobs and left some workers and communities permanently worse off. The U.S. labor market isn’t as homogenous or as flexible as many thought; displaced workers in the most exposed regions often dropped out of the work force rather than finding new, let alone better, jobs.

Similar effects to those that Autor, Dorn, and Hanson found in the U.S. also seem to be present in manufacturing intensive parts of a number of European countries (France, for example). Bob Davis and the Wall Street Journal also deserve credit for their reporting on this topic: Davis and his colleagues really helped flesh out the narrative that goes with the Autor, Dorn, and Hanson data.

Not All China—The Underreported Impact of Dollar Strength (2000-2002)

All that said, the shock from the rise in imports that came with China’s WTO entry was not the only source of the enormous decline in manufacturing jobs between 2000 and 2005.
The broad strength of the dollar from 2000 to 2002 mattered.

Read more »