Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

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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’s entry into the WTO 15 years on.

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.

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China’s Reserves Fell by Around $45 Billion in December (Using the PBOC Data)

by Brad Setser

The pace of decline in China’s foreign reserves matters.

Not because China is about to run out.

But rather because China will at some point decide that it doesn’t want to continue to prioritize “stability” (against a basket) and will instead prioritize the preservation of its reserves, and let the yuan adjust down. Significant voices inside China are already making that argument.

And I fear that if the yuan floats down, it will stay down. China will want to rebuild reserves, and—if exports respond to the weak yuan—(re)discover the joys of export-led growth. Relying on exports is easier than fighting the finance ministry’s opposition to a more expansive (on-budget) fiscal policy, or seriously expanding the provision of social insurance to bring down China’s savings.

I thus disagree with those who argue that the “China” shock is over. It depends a bit on the exchange rate. China’s exports of apparel and shoes have probably peaked. But China’s exports of a range of machinery and capital goods continue to remain strong—and at a weaker exchange rate, China could supply more of the components that go into our electronic devices, and export far more auto parts, construction equipment parts, engines, generators, and even finished autos than it does now. “Mechanical” engineering writ large continues to be a significant part of the U.S. economy, and even more so the European economy.

china-fx-settlement-cny

One of the main indicators—PBOC balance sheet reserves—that I follow for tracking China’s reserve sales is now out for December, and it points to around $45 billion in sales. I prefer to look at all the foreign assets the PBOC reports on its balance sheet rather than just its reported foreign exchange reserves. That variable was down $43 billion in December, and $133 billion for q4. Actual foreign exchange reserves fell by a bit more—$46 billion in December and $141 billion in q4. The difference between foreign exchange reserves and all of the PBOC’s foreign assets is primarily the foreign exchange the banks hold at the PBOC as a result of their reserve requirement.
The loss of reserves in December was a bit smaller than in November. But only just. The average monthly fall in q4 was over $40 billion.

That is a pace that is ultimately unsustainable. I think China would be fine with $2 trillion in reserves, given how little foreign debt it holds. Others say $2.5 trillion. If reserves are falling by a steady $40 billion a month/$500 billion year, it is only a matter of time before China hits its limit. With China, it may be a long time though…

However, there are two reasons why I am not yet convinced that it is only a matter of time before outflows overwhelm the PBOC’s reserves and other exchange rate defenses.

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Two Trade Variables To Watch in 2017

by Brad Setser

I suspect that few variables will tell us more about the course of the global economy, and perhaps global policy, than the evolution of Chinese and U.S. exports. Sometimes the most important indicators are simple and straightforward.

China’s exports matter for a simple reason: they could provide the basis for a true change in the narrative around China’s currency.

I tend to think controls can play a role in stabilizing expectations. The trade account doesn’t signal an underlying overvaluation of the yuan. China’s goods surplus is quite substantial. And China’s exports, as the chart below shows, have outperformed U.S. exports both during the period of dollar weakness (05 to 13) and in the recent period of dollar strength (chart uses a volume index, Chinese data starts in 05).

us-v-china-real-goods-exports

With an ongoing trade surplus, the right exchange rate is ultimately a function of the scale of outflows—and those are in part determined by expectations about what others are likely to do. If everyone wants out and can get out, it is rational to try to get out first. That is why the controls could work, especially as the nominal return on safe assets in China (still) exceeds the nominal return on safe global assets. There is also a normative judgment here too: a new China shock from a significant further depreciation against the basket and against the dollar would not help the global economy, and would add to the already considerable risks of trade conflict.

At the same time, there are likely to be limits to how tight the controls can be. It should be relatively easy for China, if it wants too, to keep its state banks from running up their foreign assets. And to keep state-run financial institutions from buying U.S. corporate bonds for their portfolio. It is far harder to control the activities of China’s export sector. Chinese exporters will be far more likely to sell their dollars and euros for yuan if the exporters believe that there is real two-way risk on the currency.

And one thing that could convince the exporters that they risk losing out if they hold their export proceeds abroad is a run of decent trade data. China’s November exports were pretty strong—China releases its own export volume data with a month lag, and the latest data shows that exports were up 8% in November. In today’s global environment that is a solid increase—though the November increase needs to be evaluated in light of October’s weak numbers. December data (out Friday) will be interesting.

And U.S. exports matter for a host of reasons.

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China’s Q3 Balance of Payments Data Helps Explain Why Q3 Reserves Fell So Much

by Brad Setser

I want to step back a bit from the rather extraordinary moves in the offshore yuan market over the past few days. It seems quite clear that China’s authorities felt the need to signal that the yuan isn’t currently a one way bet against the dollar. And stepping back in this case means taking a deep dive into the details of the balance of payments data — details that come out with a quarter lag, and thus provide information that is stale from the point of view of a forward-looking market. A lot, and I mean a lot, changed in the fourth quarter.

I generally like it when China’s data series line up. Line up with each other. And, when possible, when China’s data also lines up with data reported by China’s trading partners.

So I have been bothered for some time by the large discrepancy between the fall in China’s foreign exchange reserves (as reported on the PBOC’s balance sheet, $108 billion in the third quarter) and the much smaller net sales of foreign exchange by China’s banks (as reported in the FX settlement data, $50 billion in the third quarter without adjusting for the forwards reported in the settlement data, $63 billion with the forward adjustment). Fx settlement includes all the banks, not just the central bank. Historically, though, it has been very correlated with overall reserves.

The initial balance of payments (BoP) data for the third quarter showed large reserves sales ($136 billion), sales on a scale that was consistent with the PBOC balance sheet numbers. The BoP reserves sales thus seemed to suggest a big pickup in capital outflows in the third quarter.

est_chi_off_asset_growth

However, the detailed balance of payments data suggests that the signal from the FX settlement data may be more accurate. Much of the q3 fall in China’s reserves seems tobe explained by the buildup of foreign assets by other state controlled financial institutions, not “private” capital outflows. I see a likely increase of around $85 billion in the foreign assets of state institutions other than the PBOC in q3.

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Three Takes on China to Start a New Year

by Brad Setser

Christopher Balding (Balding’s World) highlights the risks from the interaction between PBOC tightening—whether because China’s own economy has picked up or a need to mimic the Fed’s tightening cycle —and rising levels of debt (mostly corporate debt, counting the debts of state enterprise as corporate) in a carefully argued Bloomberg view column.

Adair Turner’s column “A Socialist Market Economy with Chinese Characteristics” emphasizes how surprised many were by China’s 2016 rebound: “Almost all non-Chinese economists anticipated a significant slowdown, which would intensify deflationary pressures worldwide. In fact, the opposite has happened. Central and local government borrowing in China has soared: bank and shadow-bank credit has grown rapidly: and the People’s Bank of China (PBOC) has increasingly issued direct loans to state-owned banks in a maneuver closely resembling monetary finance of government spending.”

Turner highlights the risks of large losses from the bad lending that has come with rapid credit growth, while—correctly in my view—noting that financial crises ultimately come from a run on the liability side of the balance sheet.

Turner also notes that even if a quarter of China’s investment is unproductive, the three-quarters that is invested productively still equals about a third of China’s GDP. That alone would drive a strong expansion in China’s stock of useful capital. I like to be reminded just how unique China is.

I have my own take out as part of the Council on Foreign Relations’ look at global economic issues at the start of the new year.

I was less surprised than many by China’s 2016 rebound, though there isn’t much of an electronic record to document my views. I thought that China’s 2014-2015 slowdown was in no small part a consequence of a poorly timed policy decision to tighten “off balance sheet” fiscal policy (by limiting local government financing and infrastructure investment) when real estate investment was in the doldrums. Since I viewed the 2014-2015 slowdown more as a function of policy tightening than as a direct consequences of the underlying weaknesses in China’s growth model, I also believed that policy easing was likely to support growth—even if I would have preferred more of the easing to come through a larger rise in the central government’s headline fiscal deficit and less through the usual off-balance sheet funding channels.

While both Balding and Turner emphasize the risks created by China’s rapid credit growth, I put more emphasis on what I view as the more fundamental problem: China’s exceptionally high level of savings.

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China’s November Reserve Drain

by Brad Setser

The dollar’s rise doesn’t just have an impact on the United States. It has an impact on all those around the world who borrow in dollars. And it can have an enormous impact on those countries that peg to the dollar (Saudi Arabia is the most significant) or that manage their currency with reference to the dollar. China used to manage against the dollar, and now seems to be managing against a basket. But managing a basket peg when the dollar is going up means a controlled depreciation against the dollar—and historically that hasn’t been the easiest thing for any emerging economy to pull off.

And China’s ability to sustain its current system of currency management—which has looked similar to a pretty pure basket peg for the last 5 months or so—matters for the world economy. If the basket peg breaks and the yuan floats down, many other currencies will follow—and the dollar will rise to truly nose-bleed levels. Levels that would be expected to lead to large and noticeable job losses in manufacturing sectors in the U.S. and perhaps in Europe.

Hence there is good reason to keep close track of the key indicators of China’s foreign currency intervention.

fx-settlement-cny-pboc-reserves

The two main indicators I track are now both available for November:

The PBOC’s yuan balance sheet shows a $56 billion fall in foreign exchange reserves, and a $52-53 billion fall in all foreign assets (other foreign assets rose slightly). I prefer the broader measure, which captures regulatory reserves that the big banks hold in foreign currency at the PBOC.

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Hong Kong Is Now a Negative Indicator of Chinese Tourism Imports

by Brad Setser

I haven’t written about China’s tourism imports for a while. Suffice to say they remain a puzzle.

To recap quickly, China’s reported imports of tourism soared in 2014 and 2015—with imports of tourism (spending by Chinese residents travelling abroad) rising as fast as China’s imports of commodities fell (see this blog post). China’s tourism imports are $324 billion over the last 4 quarters of data, up from $234 billion in 2014—and way up from $128 billion in 2013. The tourism deficit is now big—about $210 billion over the last 4 quarters. It is one of the main offsets to China’s large ($525 billion on a balance of payments basis) goods surplus.

Much of the rise in China’s tourism imports seems to reflects the fallout of the introduction of a new methodology for calculating tourism imports, one that relies on electronic payments data rather than the numbers on actual travelers.

And it seems to me clear that either the old methodology massively undercounted spending by Chinese tourism or the new methodology overcounts it.

Consider the following scatter plot of Hong Kong’s exports of tourism (spending by non-residents in Hong Kong, e.g. Chinese and other travelers staying in Hong Kong hotels, eating in Hong Kong restaurants and the like) against total Chinese imports of tourism (spending by Chinese travelling abroad on hotels and similar services).

china-hong-kong-tourism-plot

Up until the end of 2013, a rise in Hong Kong’s exports of tourism was reliably correlated with an increase in China’s imports of tourism. More or less as one would expect.

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The November Fall in China’s Reserves and Rise in China’s Real Exports

by Brad Setser

China’s reserves fell by $69 billion in November.

With the notable exception of Sid Verma and Luke Kawa at Bloomberg, Headlines generally have emphasized the size of the fall

The Financial Times was pretty restrained compared to the norm, and the FT still highlighted that the November fall was “the largest drop since a 3 per cent fall in January.”

But the fall was actually a bit smaller than what I was expecting.

Valuation changes on their own knocked $30 billion or so off reserves (easy math—$1 trillion in euro, yen and similar assets, with an average fall of 3 percent in November).

It isn’t quite clear how China books mark-to-market changes in the value of its bond (and equity portfolio).

My rough estimate would suggest mark to market losses on China’s holdings of Treasuries and Agencies of about 1.5 percent, or $20 billion (Counting the agency portfolio and Belgian custodial book, per my usual adjustment). Bunds and OATs (French government bonds) also fell in value—but SAFE likely has a couple hundred billion in equities too, and their value rose. But it isn’t clear that all of China’s assets are marked to market monthly, so there is a bit of uncertainty here not just about the overall performance of the portfolio, but also how the portfolio’s value is reported.

Sum it all up and it is possible valuation knocked somewhere between $30 and $50 billion off China’s headline reserves.

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Do Not Tell Anyone, But the Case For Naming Taiwan a Manipulator Is Stronger than the Case For Naming China

by Brad Setser

Taiwan has an extremely large current account surplus. Over 14 percent of GDP in 2015, and over 10 percent of GDP since 2012. (See the WEO data or this chart). Relative to its GDP, Taiwan’s current account surplus is far bigger than China’s current account surplus is relative to its GDP.

Taiwan’s central bank clearly has been buying foreign currency in the foreign exchange market. The balance of payments data shows between $10 and $15 billion of purchases a year in recent years, and roughly $3 billion of purchases a quarter this year (data here).

china-taiwan-current-account-gdp-share

And Taiwan’s government clearly has been encouraging private capital outflows—notably from the the life insurance industry—largely by loosening prudential regulation, and allowing the insurers to take more foreign currency risk. Private outflows help limit the need for central bank intervention to keep the currency down, but also require private institutional investors to take on ever more foreign currency risk.

China by contrast has been selling foreign exchange reserves in the market to prop its currency up. Right now, the case that China is managing its currency in ways that are adverse to U.S. trade interests is not strong.

Plus, Taiwan’s real effective exchange rate—using the BIS data—has depreciated significantly over the past ten-plus years, unlike China’s real effective exchange rate. The fact that a weaker real exchange rate has gone hand in hand with the rise in Taiwan’s surplus shouldn’t be a surprise, but there are still a surprising number of folks who believe that real exchange rates don’t matter for trade in an era of global supply chains. In Taiwan’s case, the correlation between a weaker currency and a bigger current account surplus is clear.

china-taiwan-reer-bis

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China’s Vision for a Regional Trading Block Has its Own Challenges

by Brad Setser

One oft-made argument is that with Trump’s decision not to move forward with the TPP, China has an opportunity to fill the regional trade void. Chinese policy makers are certainly pushing their regional comprehensive economic partnership hard. Nick Lardy of the Peterson Institute, in an article by Eduardo Porter.

“China is the one major power still talking about increased integration,” said Nicholas Lardy, a China specialist at the Peterson Institute. “China is the only major country in the world projecting the idea that globalization brings benefits.”

Perhaps. But I also suspect there are significant obstacles to a Chinese-led regional trading block, obstacles that are independent of the United States.

One. If (almost) all Asian economies are running trade surpluses, they cannot just trade with each other.

There is an old fashioned adding up constraint – one country’s surplus is another’s deficit, and if Asia is running a large surplus collectively, it mathematically has to be selling its goods to the rest of the world. And Asia’s collective surplus in goods trade is now very large.

asian-goods-trade-balance

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