Brad Setser

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Cross border flows, with a bit of macroeconomics

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China’s Estimated Intervention in January

by Brad Setser

It should go almost without saying that China’s ability to maintain its current exchange rate regime matters.

The yuan has been more less stable against the CFETS basket since last July. If the current peg breaks, China will struggle to avoid a major overshoot of its exchange rate.

Christopher Balding recently has argued that the fall in the dollar (on say the Fed’s dollar index) in 2017 is more or less the same as the yuan’s depreciation against the basket—which would make China’s exchange rate regime now more a pure peg against the dollar rather than a true basket peg. Hence the lack of movement against the dollar in past few weeks. Maybe. I though am inclined to think that the yuan’s depreciation against the basket this year just undid the upward drift against the basket that came when the dollar appreciated last year, and China is still aiming to keep the currency more or less stable against the basket, not stable against the dollar. Time will tell.

Right now, the exact nature of China’s peg now matters less than China’s ability to maintain some kind of peg, and thus to avoid a sharp depreciation. If there is a depreciation, either the world will absorb a new wave of Chinese exports—a 10 percent real effective exchange rate depreciation should raise China’s real trade balance by about 1.5 percent of China’s GDP, or by roughly $180 billion (using this IMF study as a baseline for the estimate, it is summarized here)—or a wave of protectionist action will limit China’s export response, and in the process threaten the global trading rules.* Neither is a good outcome.

The data for the next few months will be critical. China does seem to have tightened its outflow controls—despite the official denials. FDI outflows certainly have slowed. Hopefully the screws will be placed on a few other categories of outflows—there are plenty of categories in the balance of payments that show a buildup of foreign assets that, in my view, should be controllable. The rise in Chinese bank loans to the world, for example.

I also still think the yuan’s movement against the dollar is an important driver of outflows, so a sustained period of stability in the yuan’s exchange rate versus dollar—whether because the broad dollar is falling and that means the yuan needs to rise to maintain a basket peg, or simply because China starts to prioritize stability versus the dollar—should lead to a reduction in pressure.** Finally China does seem to be tightening its domestic policy, at least a bit. Higher money market rates should also help support the yuan.

The proxies for intervention for January do suggest some reduction in pressure in January—though pressure by no means entirely went away.

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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.

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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.

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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.

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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.

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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 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.

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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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