Brad Setser

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Chinese Handcuffs? No, Chinese trade deficit

by Mark Dow

This is Mark Dow. Brad is away.

China has become the obsession that Japan was back in the 80s. And rightly so. It is a huge place, with a robust secular growth force underlying it (remember the conditional convergence growth hypothesis?). Rumors of China doing this or that have become a daily staple of the market.

Lately, the discussion has focused a lot on their willingness to continue to buy US treasuries. I know Brad does a lot of good work on this issue in this space. Much less attention, it seems to me, has been placed on their need to buy more Treasuries.

It has long been my contention that the large global imbalances were mostly a function of risk appetite and financial innovation leading to an explosion of the money multipliers all over the world—especially in countries with a greater degree of financial sophistication and/or capital account openness (I almost said promiscuity).

Here in the US, we were the leaders. It had less to do with Greenspan, less to do with Congress, Fannie Mae, and Freddie Mac, and more to do with the private sector taking excessive financial risk. After all, it was a global phenomenon. Over the course of history this tends to happen any time there is a period of macroeconomic stability coupled with the observation that others around us are making money. People tend to pile on and take things too far. It is in our very nature. (I would recommend Akerlof and Shiller’s “Animal Spirits”, or Kindleberger’s “Manias, Panics, and Crashes” for anyone interested in these behavioral phenomena).

In this case, it led to a huge trade imbalance with China. Credit allowed us to consume beyond our means, and demand spilled out over our borders into China. The Chinese obliged and became huge holders of Treasuries. While it is true that the Chinese exchange rate regime was an amplifier of this story, I think it was more of a passenger than a driver. The driver was credit.

Today the credit bubble is popping (whence my view on inflation and the money multiplier). At the same time the Chinese are trying to prop up aggregate demand by controlling the only thing they can: domestic demand. This to me means the imbalances are in the process of going away. In fact, I have long said (and have made a few bets with friends) that the Chinese trade balance will likely be in deficit by the end of this year. This means that the need for China to buy our treasuries will have largely gone away. I realize this may be too aggressive a contention over this time frame, but I am convinced the basic story is right. And to my mind’s eye there isn’t an exchange rate regime or Renminbi level that can stop this from happening.

On Monday I posted a chart of the US trade balance, and we saw in it the dramatic swing that took hold as soon as the credit bubble popped. Overnight, the Chinese trade balance figures came out. Have a look at the chart below. Read more »

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

by Brad Setser

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

I disagree.

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

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

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

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

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As trade slows, China doesn’t rethink its growth strategy …

by Brad Setser

My title is a play on the New York Times’ online headline: “As Trade Slows, China Rethinks its Growth Strategy.” The print version of the Times carries a headline that more accurately reflects the content of Keith Bradsher’s story : “Juggernaut in Exports is Withering in China.”

Chinese exports were doing reasonably well in October but dipped in November and — if Korea’s December trade data offers any guide — will fall even more in December. Industrial production is heading down too. Bradsher’s story documents the depth of the slowdown but doesn’t offer much evidence that China is “rethinking” its growth strategy. Bradsher reports:

“In the last two weeks, Chinese officials have announced a series of measures to help exporters. State banks are being directed to lend more to them, particularly to small and medium-size exporters. Government research funds are being set up. The head of the government of Hong Kong, Donald Tsang, plans to seek legislative approval by late January for the government to guarantee banks’ issuance of $12.9 billion worth of letters of credit for exports. Particularly noteworthy have been the Chinese government’s steps to help labor-intensive sectors like garment production, one of the industries China has been trying to move away from in an effort to climb the ladder of economic development with more skilled work that pays higher wages. But now China has become reluctant to yield the bottom rungs of the ladder to countries with even lower wages, like Vietnam, Indonesia and Bangladesh.

China has been restoring export tax rebates for its textile sector, for instance, which it had been phasing out. Municipal governments have also stopped raising the minimum wage, which doubled over the last two years in some cities, peaking at $146 a month in Shenzhen. “China will resort to tariff and trade policies to facilitate export of labor-intensive and core technology-supported industries,” Li Yizhong, the minister of industry and information technology, said at a conference on Dec. 19. “

The global slump seems to have prompted China to cling to its existing export-led growth strategy. China seems to be rethinking is its previous willingness to move out of low-end labor-intensive exports as higher-end export sectors expand. With jobs scarce, that no longer seems like a great idea. China also seems to be rethinking its exchange rate policy. Here too it seems to going back to the past. Over the past several months the RMB has been effectively repegged to the dollar — going up when the dollar went up (October) and going down when the dollar went down (December). Neither policy shift constitute a real change; both reinforce the old model of trying to spur growth by subsidizing exports.

But the global environment is changing in ways that will make it harder for China to avoid a sharp downturn in its exports no matter what China does. And that isn’t just because China’s efforts to subsidize its exports and limit the RMB’s appreciation against the dollar may attract the ire of the US. Bradsher reports that Indonesia is keen to find ways to limit its imports from China that do not formally violate its WTO commitments.

In Indonesia, the third most populous country in Asia after China and India, the government is already acting to limit imports of garments, electronics, shoes, toys and food — five large categories in which Indonesian producers are struggling to compete with China. Starting in the new year, importers of these products will have to be registered with the government, use only five designated ports for their shipments, arrange for a detailed inspection of goods before they are loaded on a ship or plane bound for Indonesia and then have every single container exhaustively inspected on arrival by Indonesia’s notoriously slow customs bureaucracy. The plan, intended to comply with W.T.O. rules, was adopted after heavy lobbying by Indonesian manufacturers and labor unions.

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Chieuropa?

by Brad Setser

The thesis that China and America should be viewed as a single economy – or at least as a single currency area – is due for a comeback.

After flirting with change, the RMB is once again pegged tightly to the dollar. 6.85 is the new 8.27. I would not be surprised if China’s external surplus and the United States deficit prove to be roughly equal in size in 2009 The obvious argument is that while the US runs a big deficit, Chimerica doesn’t. East Chimerica’s surplus offsets West Chimerica’s deficit. No worries. At least so long as China’s government is willing to finance the US.

The fact that the Chimerican currency union required unprecedented growth in China’s reserves was always my main objection to the Chimerica thesis. A currency union in theory shouldn’t require that kind of government intervention to keep in balance.

But Chimerica never was really financially integrated. Back when the RMB was (correctly) considered a one way bet, China erected capital controls to keep American (and other) capital from speculating on its currency. And for most of this decade, the net outflow from China to America came not from a desire on the part of Chinese savers to hold dollars but rather from a desire of China’s government to hold the Chinese currency down against the dollar. That policy required that China buy dollars in the foreign exchange market, and in the process finance the US deficit.

However, another objection may be more important. The argument that Chinese and America formed a perfect union – with US spending generating demand to offset Chinese savings, and Chinese savings financing the borrowing associated with US spending – hasn’t quite worked for the past couple of years. It leaves out Europe. And Europe, not the US, was the big spender in the world economy in 2006, 2007 and the first part of 2008.

My colleague at the Council’s Center for Geoeconomic Studies, Paul Swartz, has produced a clever graph (available on the CGS website) showing that the growth in Asian exports hinges on the growth in US and European imports. Makes sense. Paul also plotted Asian export growth against American import growth and European import growth separately — and the chart of European import growth against Asian export growth highlights just how large Europe’s contribution to Asian export growth has been recently.

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This is what a crisis looks like in the balance of payments data

by Brad Setser

At least a crisis marked by a run out of risky US assets and into safe US assets. Right now Agency bonds — think Freddie and Fannie — are considered risky assets while Treasuries are not.

A run out of all US assets and the dollar would look very different.

The October TIC data tells a striking story — one marked by a massive surge in demand by both private and official investors for “safe” assets. Foreign investors bought $182 billion of Treasuries — including $147.4 billion of short-term Treasury bills. There is no real mystery why bill yields dropped so low even as the supply of bills surged. And foreigners added $207 billion to dollar bank accounts.

Sum that up and it works out to close to $400 billion in demand for safe dollar denominated assets. If that kind of monthly inflow is annualized it is a shockingly large number.

It isn’t hard to figure out why the dollar rallied.

$400 billion in a month is far more than the US needs to cover its trade deficit. It allowed foreigners to reduce their holdings of Agencies by close to $75 billion (including a $25 billion fall in short-term Agencies), their holdings of long-term corporate bonds by $13 billion and their holdings of US equities by $6 billion without causing any strain on the dollar.

Indeed, the fall in foreign holdings of US corporate bonds and US equities (though not the outflow from the Agencies) could have been financed by the sale of $36 billion of foreign assets by US residents …

Usually I argue that the TIC data understates official flows. And this month’s data may well do so.

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Quick take on today’s US trade data

by Brad Setser

A key reason the US October trade deficit went up not down is a rise in the volume of US oil imports.

Oil imports were down 14% in volume terms in September and were up a bit over 2% in October. That is noise. The 3m rolling average for oil import volumes is still down 6% y/y — and the y/y fall is around 5%. But the rise in volume offset the fall in price (the average price of imported oil fell from over $107 a barrel to $92 a barrel), so the petrol deficit rose by $0.8b to $32.7 billion in October.

The good news is that the average price of imported oil still has a lot further to fall. I would guess that the 2008 petrol deficit (netting exports out) will be close to $400 billion. It could fall to $200-250 billion in 2009.

The bad news is that October exports were down $3b from September — and down $16b from their July peak. They almost certainly will fall more. The constellation that supported strong US export growth — strong global growth and a weak dollar — has disappeared. The really bad news is that real export growth is slowing faster than real import growth.

A longer time series shows the recent downturn in “real” exports and imports clearly.

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Global trade is shrinking, fast

by Brad Setser

It is hard to put lipstick on a pig.

China’s November trade data (a 2.2% year over year fall in exports; a 17.9% year over year fall in imports — see Andrew Batson of the Wall Street Journal) suggests that global trade is contracting quite rapidly. And since trade accounts for a rising share of global activity, it suggests that the global economy has stalled — and perhaps is contracting.

The fall in China’s exports suggests global demand is falling. And the fall in China’s imports on first blush seems larger than can be explained just by the fall in demand for imported components for China’s exports and sliding commodity prices: it suggests that Chinese domestic demand is quite weak …

The November data from Korea and Taiwan tells a similar story. All experienced far larger falls in year over year falls in their exports than China did.

Sometimes the y/y change for China paints a misleading picture — as the timing of China’s New Year can have a big impact on the data. Not in this case. The 3 month moving average is heading down too — and it almost certainly has further to fall.

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Reserves are meant to be used in bad times

by Brad Setser

Tracy Alloway of the Financial Times’ Alphaville blog — echoing Robert Sinche of the Bank of America — thinks that spending reserves to defend your own currency and support your own banks is a form of economic nationalism.

Funnily enough, I always thought that building up reserves through thick and thin — and accumulating more reserves than a country ever needed for its own financial stability — was a far more egregious example of economic nationalism. A country that only adds to its reserves is presumably pursuing a policy of intentionally holding its currency below its equilibrium value in order to support its export sector. A country like China isn’t just accumulating reserves because it enjoys financing the US, UK and many European governments at low rates ….

The tone of the the FT’s excerpts of the Bank of America report suggest that a country that sells its reserves to support its own economy hurts the global economy. Not true. It may drain liquidity from some parts of the financial market, but the sale of reserve assets finances policies that add liquidity (so to speak) to parts of the goods market.

Reserves are meant to provide a buffer against external shocks. And right now a host of emerging economies are facing a major shock. Remember, a country that is selling its reserves is trying to keep its currency from falling. That means it is trying to keep the price of the world’s goods in its market from rising — and in so doing, it is keeping demand for the world’s exports up.

And a country that draws on its reserves to make up for shortfall in export revenue is substituting the sale of foreign assets for a fiscal contraction — a contraction that would subtract from global demand growth.

Suppose for example Russia stopped intervening, let the ruble depreciate, didn’t bailout its banks (so they defaulted on their foreign debt and couldn’t finance domestic firms) and budgeted for $40 a barrel oil next year. Russian imports would collapse. That would have a big impact on Europe’s exports. The UK doesn’t make all that much these days, so this shift would hurt Germany more than the UK. But just because it helps some countries (and sectors) more than others doesn’t meant that the world doesn’t gain when a country draws on its own reserves to avoid a major contraction in demand.

Indeed, if — and it is a huge if (see below) — private savings and investment do not change as a result of the government’s decision to run a bigger fiscal deficit, selling foreign assets to make up for a shortfall in say oil export revenue and to finance a budget deficit leads directly to a larger current account deficit and more demand for the world’s goods. It isn’t a beggar-thy-neighbor policy.

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Should the currency of the country with a large and growing trade surplus and large and growing reserves depreciate against the dollar?

by Brad Setser

On Monday China apparently decided to allow the renminbi to depreciate against the dollar.

Let’s be clear: China generally still has to intervene in the market to keep its currency from appreciating. There is no other way reserves could have risen from $1.9 trillion at the end of September to “over $2 trillion” now.* Traders in China bet on where they believe the government wants the exchange rate to go, not its market-clearing rate. Private Chinese demand for dollar assets still isn’t comparable in scale to China’s $400 billion current account surplus.**

Neil Mellor of the Bank of New York believes that the renminbi’s recent depreciation is a very conscious policy choice:

Since the start of this week, however, there appears to have been a further palpable shift in policy. Following a clear shift in the wording in the latest quarterly monetary policy report and a speech over the weekend by President Hu Jintao (warning that China’s competitiveness and trade strength were being threatened), the PBOC on Monday set the central parity rate of USD/CNY aggressively higher. After four and a half months of sideward trading, the market reacted strongly to this apparent change in attitude by pushing USD/CNY to the top end of its band. The reaction in the NDF market was even more dramatic with the one-year NDF jumping 3.16% (its largest ever one day move in either direction). This upward pressure has continued over the last two days to leave the NDF now forecasting a 6% y/y rise (spurred on today by comments from Vice premier Wang Qishan that China will do all it can to stabilise exports).

If other Asian currencies fall along with China’s currency, the net result would be a broad depreciation of emerging Asian currencies against the dollar more than an improvement in China’s relative position in Asia. And right now Asia is the region of the world economy with the largest current account surplus – and the surplus region that stands to benefit the most from the fall in oil prices.

A global shortfall in demand (and contraction in trade) implies that almost everyone is struggling to maintain (or expand) their market share. China’s exports have stood up well to date (in nominal terms, monthly exports are running about $20b a month above their total in 2007). Monthly exports in 2008 are nearly two times as high as monthly exports in 2005. The scale of China’s recent export boom is hard to exaggerate. But there is little doubt that China’s exports – all of them, not just textile exports – are poised to slow rapidly. Korean exports fell sharply in November. It is hard to believe that China’s exports won’t also soon slow if not start to fall; the latest data on new export orders suggest additional weakness ahead.

That slowdown comes at a time when China’s domestic economy is also slowing – and consequently is extremely unwelcome. China’s latest purchasing managers index (PMI) was as almost bad as the United States’ latest PMI index.

Moreover, China — like the US – is feeling squeezed by the dollar’s recent appreciation. In real terms, the renminbi has appreciated by far more after it stopped moving up against the dollar that it ever did when it was moving against the dollar. Allowing the renminbi to depreciate against the dollar as the dollar rises would limit China’s real appreciation. It would be consistent with how a basket peg would work.

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Will the world’s macroeconomic imbalances soon reduce to China’s surplus and offsetting deficits in the US and Europe?

by Brad Setser

The recent fall in oil prices, if sustained, should bring down the external surplus of the oil exporters. $80 a barrel is well above the average price of oil for most of the 1990s – or for that matter 2003, 2004, 2005 and 2006. But the oil exporters are spending and investing (and thus importing) a lot more as well. By next year, a $80 a barrel oil price won’t generate a big surplus to be managed by the oil exporters central banks and sovereign funds.

The yen has long looked very weak relative to the euro. But that too has changed. The yen’s recent rally – if sustained – should, over time, work to reduce Japan’s surplus (though the fall in commodity prices works the other way).

That more or less leaves China’s surplus – and the offsetting deficits in the US and Europe. There is good reason to think China’s export growth should slow over the next year. Neither the US nor the European economy looks likely to expand much in the near future. The dollar’s recent rally has led to a much more significant broad appreciation of the RMB than the RMB’s appreciation against the dollar ever did. Back then, the RMB never appreciated enough against the dollar to make up for the dollar’s fall. This broad appreciation should make it more difficult for China to offset weak growth in its exports to the US with strong growth elsewhere.

But there isn’t much evidence of a slowdown in China’s exports yet. Nominal export growth is chugging along at about 20% y/y – which implies the China is on track to export about $250 billion more this year than last year. That has kept China’s overall trade surplus more or less constant even as China’s (commodity) import bill soared in the first few quarters. China’s q3 2008 trade surplus ($83.3b) was about $10b more than its trade surplus in q3 2007 ($73.2b). Yes, the pace of real export growth has slowed. But at something like 10%, China’s real export growth is still comparable if not stronger than US export growth. Net exports contributed positively to China’s GDP growth in q1. The World Bank’s economists believe that they will contribute to q2 GDP growth – and I would be shocked if they don’t contribute positively to China’s GDP growth in q3 as well.

Looking forward, export growth should slow – in both nominal and real terms. But nominal import growth should slow as well, as China’s commodity import bill falls. I don’t yet see much evidence that China’s overall surplus will fall. And lest we forget, China has by far the largest surplus of all the major economies. The great boom in China’s exports that started in 2002 or 2003 looks – at least to me – to be continuing.

china-q2-08-1.PNG

China is an outlier when it comes to reserve growth as well. In q3, many emerging economies saw their reserves fall. Not China. It – along with Saudi Arabia – likely will keep global reserve growth from turning negative. China’s stated reserves increased by $96.8b in q3, bringing total reserves to just over $1.9 trillion.

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